Revisions to Rules Regulating Money Market Funds

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.

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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.

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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'').

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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.

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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].

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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.

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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.

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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.

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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.

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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).

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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.

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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.

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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.

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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.

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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.

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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).

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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.

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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.

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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.

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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.

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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.

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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.

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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.

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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.

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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.

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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.

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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.''

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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.

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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'').

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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.

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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.

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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.

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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.

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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.

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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.

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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]]

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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.

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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.

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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.

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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.

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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.

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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).

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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.

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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.

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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.

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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.

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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.

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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.

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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.

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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.

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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.

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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.

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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.

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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).

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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.

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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.

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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.

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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.

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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]]

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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.

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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.

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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.

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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.

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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).

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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.

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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.

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(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'').

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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.

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(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.

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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.

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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.

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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.

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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.

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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.

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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).

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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.

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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.

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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.

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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.

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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).

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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.

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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.

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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.

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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.

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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.

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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.

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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.

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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.

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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.

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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.

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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.

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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.

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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

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