Members of the New York Stock Exchange. Inc.

Members of the New York Stock Exchange. Inc.

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One New York Plaza

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Donald M. Feuerstein

EFFECTIVE August 19, 2022, THIS LETTER IS

MODIFIED.

Please consult the following web page for more information:

https://www.sec.gov/divisions/investment/im-modifiedwithdrawn-staff-statements.

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Division of Inves tment Management Regulation ' .

Securi ties and Exchange Commission ','

500 North Capitol Street

Washington, D. C. 20549

SEC Reference No. 74-638

RECDI S~E.C.

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NOV

7 1914

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Dear Mr. Rosenblat:

In an interpretive response of December 27, 1971, to State Street Bank and

Trust Co. you enumerated certain guidelines under the Investment Company Act

of 1940 for the lending of portfolio securities by registered investment

companies. You further elaborated on these guidelines in responses of Nay 22,

197f, to State Street; of May 23, 1972, to this firm; and of july 29,1974,

to Standard Shares, Inc. We are probably the larges t borrower of securi tieß

and have developed a somewhat different s truc ture for securities loans. In

addition, a number of additional technical questions have been raised with

us by potential lenders. The purpose of this letter is to seek further interpretive responses concerning these matters.l/

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. 1. Are marketable securities issued or guaranteed by toe U.S. Government

or its agencies acceptable as collateral? (Guideline (1))

The form of securities loan usually considered by the Staff involves a deposit

of cash collateral, which the lender invests in "high yielding short term inves tments which give maximum liquidity to pay back the borrower ~vhen the sew

curities are returned." Al though this has been the usual st.ructure for loans

of corporate securities until recently, there is another s tru0ture, which has

long been used for loans of U. S. Government and agency securities and is now

most often used by Salomon BrotheTs for corporate securities also. 2/ A form of

loan agreement reflecting this type of loan is attached. In essenc~, the borrower deposits with the lender as collateral marketable securities, usually

U.S. Government and agency securities, and pays the lender a "loan premium"

computed as a percentage of the da'j.ly market value of thÈ. loaned securities.

Any yield on the deposited collateral belong~ to the borrower. Thu", the

collateral is looked to solely for security not for compensation,

l/ For convenience, ~oJe refer to the guideline numbers in your first response

when pertinent.

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1/ The largest lender of securities is probably the Board of Governors of the

Federal Reserve Sys tern, which lends U. S. Government securities to recognized dealers against U.S. Government collateral as part of its open. market operations.

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We see no reason to require the delivery of cash 'as collateral to the exclusion of the very securities in which the investment company would be permitted to invest the cash immediately upon its receipt, so long as the securities

delivered as collateral have a market value at least equal to the amount of

cash that would otherwise have been deposited. Indeed, it may be preferable

for the lender to have securities as collateral rather than cash. We have

re tained spec ial counsel to inves tiga te, among 0 ther things, the pas i tion of

a lender of securities in the event of the insolvency of the borrower. We

have been informed by such counsel that, although the better view is that a

valid security interest may be perfected in cash collateral, the matter is not

free from doubt.

Recently, permission has been granted for the use of U. S. Treasury bills as

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10-15 per cent of the collateral. If marketable securities are acceptable in

principle as collateral, a second reach of our inquiry is whether all marketable U. S. Government and agency securities, whether long or short term and

whatever th€ir yield, would qualify for 100 per cent of the collateral. If

the sole purpose of the collateral is as security, then the sole test for se'lecting the collateral should be whether it "gives maximum liquidity." Since

the yield on the collateral is reserved by the borrower, its level should not

be relevant. All public issues of U.S. Government securities and almost all

public issues of u.s. agency securities are highly liquid, coming essentially

from the same source as the cash itself. Moreover, the '~igh yielding short

term" securities of other issuers would have considerably more risk than those

of U.S. Government and its agencies whatever the latter's maturity or yield.

Indeed, that would be the explanation for the former's high-.ir yield.

2.

May the compensation for a securities loan be the payment of a loan

premium by the borrower at the current market rates for comparable securities loans? (Guideline (4))

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As indicated in the previous point, when marketable U. S. Government and agency

securities are used as collateral, Salomon Brothers compensates the lender by

paying a loan premium negotiated with the lender on the basis of going rates

for such loans. The rates are normally a percentage, expressed on an annual

basis, of the daily value of the securities loaned. The aggregate amount of

payment depends upon the duration of the loan. Thus, at the outset of the

loan both the borrower and the lender kno~v the price qf the loan, and the compensation to the lender is not dependent upon its success in profitably investing in the short-term paper market. In addition to the possible advantage

under the insolvency laws mentioned previously, the inves tment company avoids

the administrative expense and burden of reinvesting cash collateral when it

is compensated by such a loan premium. Obviously, the adviser to the fund who

negotiates the loan premium would have a fiduciary obligation to obtain a satisfactory premium related to current market rates for comparable loans that

would be equivalent to its obligation to select appropriate investments and

obtain best execution. The payment of a loan premium by the borrmver is in

the nature of interest and would clearly seem to fall within the guideline if

the rate is reasonably related to the current market.

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3. Is the requirement of marking to the market ¡limited to the market value

of loaned securities? (Guideline (2))

Marking to the market to reflect changes in the market value of the loaned

securities and, if securities are acceptable collateral, the collateral is

a very simple procedure. It would also be theoretically possible to require

such adjustment of the collateral to reflect changes in the obligations of

the borrower to make payments in respect of dividends and daily interest accrual on the loaned securities and to pay the accrued loan premium. Since

these amounts are small relative to the market value of the loaned securities

and vary from loan to loan and from time to time for a single loan, computing these into the collateral coverage requirement would be difficult and

cause an expense tothe lender that is unnecessary to the security objective

of the Staff's collateral requirement. In addition, registered investment

companies would be less competitive than other potential securities lenders.

minimum colA lender, of course, could require something in excess of the

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lateral requirement set by the Staff. The lender, and indeed the borrower,

might choose to do this to avoid the expense of numerous additions to, or

deletions from, the collateral as the daily market values fluctuate. The

attached form of loan agreement calls for 102 per cent coverage in securities.

We submit, however, that this is best left to negotiation, since a 100 per

cent coverage requirement effects complete security for the basic obligation

of the borrower.

4. May the return of loaned securities be made on 6 business days' notice?

'(Guideline (3))

'.'.....,)

A broker-dealer borrows securities because it needs them to make delivery to

a third person; the borrower does not usually retain them for any appreciable

time. When a loan is terminated, securities identical to the loaned securities, but probably not the same certificates, are returned. 1~ese must be

obtained by the borrower when notice of termination is given by the lender.

When the borrower purchases them in order to make a return to the lender, the

borrower's seller normally has five additional business days within which to

make delivery to the borrower. The ability of the borrower to redeliver them

to the lender in the same five business days depends upon its seller's making

delivery to it early enough, certainly no later than the early morning of the

fifth business day, for the borrower to turn them around and make redelivery

to the lender by the end of the fifth business day. More often than not, however, such deliveries are made late enough on the fifth business day to preclude, as a practical matter, redelivery to the lender that same day. Thus,

there is little real likelihood, as distinct from a hope, that the requirement

contained in Guideline (3) could be met in most cases. We submit that allowing a one day turn-around is practically necessary and creates no material

additional risk to the lender. Nor would a sale hy the lender be materially

delayed, since it need not have physical possession of the securities to make

a sale.l/ We should prefer that a securities loan contract be written in a

manner that reflects what can actually be required.

d/ See Rule lOa-l(c)(2) under the Securiti.es Exchange Act of 1934,.

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5. Mayan investment company's board of directors delegate to the investment adviser the authority to negotiate particular securities loans?

(Guideline (4))

In order to be competitive with other lenders of securities, investment companies must be in a position to respond almost immediately to requests from

broker-dealers for securities loans. It would not be practicable for the

adviser to delay entering into a securities loan until the directors approved

the terms of a particular loan. The risk involved in collateralized securities

loans is at least not substantially greater, and possibly less, than the risk

invol ved in open contrac ts with broker-dealers for the purchase and sale of securities. The board of directors is clearly able to delegate to the adviser

the selec tion of securi ties for purchase or sale and the negotia tion of price

and commissions. The same should be possible with respect to securities loans,

so long as the borrower is not affiliated wi th the adviser. While it may be

appropriate for the board of directors of the investment company to give prior

approval to the general form of contrac t used for such lending, the board should

be able to delegate to the adviser the selection of particular securities for

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lending and the negotiation of particular terms for securities loans to unaffiliated borrowers. All such lending transactions would be subject to review

by the board of directors as is the case with respect to portfolio purchase and

sale transactions. The adviser has a fiduciary obligation to obtain the best

terms in lending transactions comparable to its fiduciary obligation to obtain

best execution in purchase or sale transactions. We assume, of course, that

securities collateral for securities loans would be held by the investment company's custodian or otherwise in compliance with Section l7(f) of the Act, ahd

that the company's fundamental policies include the general right to make loans

and contain no prohibition against the lending of portfolio securities.'

6. May the lender enter into an alternative arrangement with the borro~.;er that

would have like effect to the lender's voting the loaned securities?

(Guideline (6)) ~.

Terminating a loan is not the only way for a registered investment company to exercise its statutory responsibilities with respect to voting on material events

affecting the investment. When it can be assured by other means that securities

on loan will be voted in accordance with its wishes, we submit that this should

be an acceptable "ay to carry out any fiduciary obligation to vote proxies, Hithout requiring what might otherwise be an uneconomic decision to call the loan.

For example, the third person to whom the borrower delivered the loaned securities

and who holds record ownership might provide the borrower with an executed blank

proxy, or an executed proxy voted in the manner which the lender wishes, Hhich

the borrower would then transmit to the lender for submission to the company whose

securities were being voted. Thus, the borrower would be in a position to have

its loaned securities voted as it determined while continuing to obtain income

from the securities loan.

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1/ See Rule lOa-ICc) (2) under the Securities Exchange Act of 1934.

REeD S.E.C.

NOV 7 1974

Salomon Brothers

Alan Rosenblat, Esq.

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7. Does an investment company's obligation to re.turn collateral on termination

of a securities loan create a senior security under Section 18 of the Act?

Although we believe that a negative answer to this question is not only clear

but also implicit in your prior interpretative responses, some investment companies ,vould like a specific interpretation to this effect. A "senior security"

is defined in the Act to mean "any bond, debenture, note or similar obligation

or instrument constituting a security and evidencing indebtedness and any stock

of a class having priority over any other class as to distribution of assets or

payment of dividends." The obligation of the lender during the period of a sesecurities loan to return collateral upon termination of the loan does not fall

within this definition. Were an obligation to return collateral considered to

be itself a loan by the secured party, every form of pledge loan would thereby

create two indebtednesses: the borrower's promise to pay contained in the note,

and the lender's promise to return the collateral securing the money obligation.

I t would produce the incongruous resul t that a lender receiving protection for its

loan would be hurting its own financial condition.

,8. How much of the portfolio may be loaned?

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We understand that the Staff has previously expressed the view that not more

than 30 per cent of the inves tment company's total portfolio may be out on

loan at anyone time. Although some limitation seems prudent, we have no basis

for selecting any particular percentage. We should, however, appreciate confirmation if this in fact is the Staff's position.

* * *

Based on the above analyses I am of the view that under the Act, if an agreement subs tantially in the form attached is used by a registered investmént

for

company (with appropriate modifications in the case of cash collateral)

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securities lending:

(1) Marketable u.S. Government and agency securities are acceptable collateral.

(2) Compensation for lending secuTi ties may be the payment of a loan premium

by the borrower at current market rates.

(3) Six business days' notice for the return of the loaned securities is per-

missible.

(4) The investment company may enter into alternative special arrangements for

the voting of loaned securities.

(5) Marks to the market are required only for net increases in the market value

of the securities loaned and/or net decreases in the market value of the

collateral relative to each other. ~. '

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(6) The board of directors may delegate to the investment adviser the authority to select and negotiate particular securities loans to the same extent

that it may do so with respect to particular purchases and sales.

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Alan Rosenblat, Esq. - 6.

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(7) A securities loan does not CTeate a senior security under Section 18

of the Act by virtue of an investment company's obligation to return

collateral to the borrower upon termination of the loan.

(8) No more than 30 per cent of the investment company's total portfolio

may be out on loan at anyone time.

I should appreciate your response as to whether the Staff agrees with these

opinions.

~~M.F~

Sincerely,

General Partner and Counsel

RESPONSE OF THE OFFICE OF CHIEF COUNSEL

DIVISION OF I~~EST~ffiNT ~~NAGE~lliNT REGULATION

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Ref,' Br9thers

No. 74-638

y S~lomon

File No. 132-2

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The following is a response to your eight questions concerning

the terms and conditions under which registered investment companies

may lend their portfolio securities.

1. Are marketable securities issued or guaranteed by the U. S.

Government or its agencies acceptable as collateral? (Guideline (1))

We would not object to the use of securities issued or guarantèed

by the United States Government or its agencies as collateral fot' such

loans, provided that the other guidelines"'oc;mcerning collateral set

forth in my previous interpretations in this area are satisfied. In

order to avoid confusion, we would like to comment on your statement

11

that, "although the better view is that a valid security interest may

be perfected in cash collateral, the matter is not free from doubt.

This doubt apparently stems from the fact that the original Uniform

Commercial Code did not specifically include cash in any of the categories of collateral in Section 9 of the Code. However, the Code never

specifically excluded cash, and, in any event, has been revised to pro~

vide for the perfection of a security' interest in money . Although most

states, including New York, have not yet adopted this revision, the

revision is nevertheless strong evidence of an intent to include money

as a form of collateral a security interest in Hhich can be perfected

by that

possession.

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collateraL.

a persua~;ive

argument

that a security interest in money can be perfected through possession

under the original Code, 8ee Coogan, Kripke, & Weiss, T~e Outer Frin~es

of Article 9: Subordinati 0.Q..L.)\.ri;reolllents, Security Interenti, in Noney

and DepoJ3ik" N8gativt~ Pl('!dg~ Cir)li)e~)2~participaticiri Agr,eements,

'19 Harv. L. Rev. 229, 261-3 i.i 9(~ . .

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2.

May the compensation for a securities loan be the payment of

a loan remium b the borrower at the current market rates for

comparable securities loans? Guideline (4 )

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,We Hould have no objection if the compensation to the investment

company took the form of a ioan premium so long as the intent of Guideline 4 is satisfied. To satisfy the Guideline the loan premium should

,give proper weight to prevailing interest rates, dividends, interest or

other distributions on the loaned securities, and any increase in the

market value of such securities.

3.

Is the re uirement of markin~ to the market limited to the

market value of loaned securities? (Guideline 2)

We would not object if, as a matter of general practice, adjustments

in collateral were not made to reflect changes in the obligations of the

borrower to make payment in respect of dividends and daily interest accrual

on the loaned securities and to pay the accrued loan premium, provided that

the amount of the original collateral is reasonably cålculated to account

for such changes and that, if at any time it appears that the original collateral is inadequate, appropriate adjustments are made.

4. May the return of loaned securities be made on 6 business

days i notice? (Guideline (3)).

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I t is our present view th?t permitting a six-day notice period for

the return of loaned securities would appear to sanction possible

fails to deliver if an investment company sold loaned securities on

the same day it called for the return of such securities. You have

stated that, an investment company could sell loaned securities because Rule lOa-l(c) under the Securities Exchange Act of 1934 provides that securities may be sold even if the seller does not have

physical possession of them. However, we note that Rule 10a-2 (a)

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under the 1934 Act contemplates possible fails in such circumstances.

In our view, extending the notice period in Guideline 3 to six days

would substantially increase the chances for such fails, and, in

fact, ~vould assure fails if the full six days were actually used.

Moreover, pennitting a six-day notice perióa might raise problems

under the NASD Rules of Fair Practice, if an i~vestment company

wanted to sell loaned securities. In an interpretation of Article

III, Section I of the Rules of Fair Practice, the NASD's Board of

Governors has' stated that no member shall execute a sell order for

a customer unless (1) the member has possession of the securities;

or (2) the customer is long in his account with the member; or

(3) the customer gives reasonable assurance that the security will

be delivered within five business days of the execution of the

order; or (4) the securities are on deposit with certain types of

depositories and instructions have been given to deliver the securities against payment (see NASD Securities Dealers Manual, p. 2037).

Finally, the present five-day notice period in Guideline 3 is consistent with New York Stock Exchange Rule 160 which requires the

borrower of securities, after notice, to redeliver borrowed securities within the nonnal settlement time of five days. In view of

these factors, we do not consider it advisable to alter Guideline

3 at the present time.

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5. Mayan investment company's board of directors dele~ate to the

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investment adviser the authorit to neaotiate articular

securi ties loans? Guideline 4

Assuming that the fund i s board of directors first approved the

lending of its portfolio securi ties and the general limi ta tions on

such lending, including a general form of contract for such lending,

we would not object if a fund's board of directors delegated to the

investment adviser ,the authority' to negotiate particular loans, provided that such a delegation would be consistent with the terms of the

advisory contract. However, our taking this view should in no way be

considered as relieving fund directors of their fiduciary duties.

6. May the lender enter into an alternative arrangement with the

borrower that would have like effect to the lender's voting

the loaned securities? ( Guideline 6))

We would not object to the use of any practicable and legally

enforceable arrangement to ensure that fund directors are able to fullill

their fiduciary duty to vote proxies with respect to loaned portfolio

securities.

7. Does an investment company's obligation to return collateral

on termination of a securities loan create a DenioI' security

under Section 18 of the Act?

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The creation of an obligation on the part of an investment

company to return collateral upon the termination of a loan of portfolio securities may involve the issuance of a senior security wi thin

the meaning of Section 18 of the Act. However, we w~uld not recommend

ahy eiûorcement action for violation of Section 18 because of the

creation of such an obligation, so long as all the Guidelines we have

established for securities loans are satisfied.

8. How much of the portfolio may be loaned?

It is our view that no investment company should have on lqan

at any given time securities representing more than one-third of 'its

total asset value. In permitting the loaning of portfolio irecurities,

we recognize that there are substantial differem:es between a secured

loan of securities and a borrowing of money secured by a pledGe of

securities. However, there are similarities as welL. One significant

similarity is that, Hhether an investment company loans it securities

or pledges them, to some extent it sacrifices control over its portfoliò. A company which pledges securities for a loan obviously loses

control of tho~;e securities. A company \.¡hich loans' portfolio securi ties loses control ,to the extent that, if the borrower defaults,

the investment company may not be able easily to replace the securities

at advantageous prices. Of course, the risk of default is reduced in

view of the collateral and the right to terminate the loan. However,

as indicated, there is no guarantee that the lendin¡; compnily will be

able to restore itself to stritu2 ~ rinte in case of a default. Section

18 effectively limitß the extent to ""hich an investment company can

relinquish control over its portfolio by pledging securities, and we

believe that it is appropriate to use the Section 18 limitation as a

model for such conditions i:i the case of loaned securities.

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Alan Hosenblii t, Chief Goum.;el '

Division of Investmont ¡'hnageiiient Regulation

RG:ds APR 4 197~