Treatment of Repurchase Agreements and Refunded Securities as an Acquisition of the Underlying Securities

SECURITIES AND EXCHANGE COMMISSION

17 CFR Part 270

[Release No. IC-24050; File No. S7-21-99]

RIN 3235-AH56

Treatment of Repurchase Agreements and Refunded Securities as an

Acquisition of the Underlying Securities

AGENCY: Securities and Exchange Commission.

ACTION: Proposed rule.

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SUMMARY: The Commission is proposing for public comment a new rule and

related rule amendments under the Investment Company Act of 1940 that

would affect the ability of investment companies to invest in

repurchase agreements and pre-refunded bonds under the Act. The

proposed rule would generally codify and update staff positions that

have permitted investment companies to ``look through'' counterparties

to certain repurchase agreements and issuers of municipal bonds that

have been ``refunded'' with U.S. government securities and treat the

securities comprising the collateral as investments for certain

purposes under the Act.

DATES: Comments must be received on or before November 23, 1999.

ADDRESSES: Comments should be submitted in triplicate to Jonathan G.

Katz, Secretary, Securities and Exchange Commission, 450 5th Street,

N.W., Washington, D.C. 20549-0609. Comments also may be submitted

electronically at the following E-mail address: [email protected].

All comment letters should refer to File No. S7-21-99; this file number

should be included on the subject line if E-mail is used. Comment

letters will be available for public inspection and copying in the

Commission's Public Reference Room, 450 5th Street, N.W., Washington,

D.C. 20549. Electronically submitted comment letters also will be

posted on the Commission's Internet web site (http://www.sec.gov).

letters should refer to File No. S7-21-99; this file number

should be included on the subject line if E-mail is used. Comment

letters will be available for public inspection and copying in the

Commission's Public Reference Room, 450 5th Street, N.W., Washington,

D.C. 20549. Electronically submitted comment letters also will be

posted on the Commission's Internet web site (http://www.sec.gov).

FOR FURTHER INFORMATION CONTACT: Marilyn Mann, Senior Counsel, Office

of Regulatory Policy, at (202) 942-0690, or Alison M. Fuller, Assistant

Chief Counsel, Office of Chief Counsel, (202) 942-0660, Division of

Investment Management, Securities and Exchange Commission, 450 5th

Street, N.W., Washington, D.C. 20549-0506.

SUPPLEMENTARY INFORMATION: The Commission today is requesting public

comment on proposed rule 5b-3 [17 CFR 270.5b-3] and conforming

amendments to rules 2a-7 [17 CFR 270.2a-7] and 12d3-1 [17 CFR 270.12d3-

1] under the Investment Company Act of 1940 [15 U.S.C. 80a] (the

``Act'').\1\

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\1\ Unless otherwise noted, all references to rule 2a-7 or rule

12d3-1, or to any paragraph of those rules, will be to 17 CFR

270.2a-7 and 17 CFR 270.12d3-1, respectively.

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Table of Contents

Executive Summary

I. Background

A. Repurchase Agreements

B. Pre-Refunded Bonds

II. Discussion

A. Proposed Rule 5b-3(a): Treatment of Repurchase Agreements

B. Proposed Rule 5b-3(b): Treatment of Pre-Refunded Bonds

C. Availability of Rule 12d3-1 for Repurchase Agreements

D. Conforming Amendments to Rule 2a-7

E. Request for Comments

III. Cost-Benefit Analysis

IV. Summary of Initial Regulatory Flexibility Analysis

V. Statutory Authority

Text of Proposed Rule and Rule Amendments

Executive Summary

osed Rule 5b-3(a): Treatment of Repurchase Agreements

B. Proposed Rule 5b-3(b): Treatment of Pre-Refunded Bonds

C. Availability of Rule 12d3-1 for Repurchase Agreements

D. Conforming Amendments to Rule 2a-7

E. Request for Comments

III. Cost-Benefit Analysis

IV. Summary of Initial Regulatory Flexibility Analysis

V. Statutory Authority

Text of Proposed Rule and Rule Amendments

Executive Summary

Repurchase agreements provide investment companies (``funds'') with

a convenient means to invest excess cash on a secured basis, generally

for short periods of time. In a typical fund repurchase agreement, a

fund enters into a contract with a broker, dealer or bank (the

``counterparty'' to the transaction) for the purchase of securities.

The counterparty agrees to repurchase the securities at a specified

future date or on demand for a price that is sufficient to return to

the fund its original purchase price, plus an additional amount

representing the return on the fund's investment.

The Commission is proposing a rule that would permit funds to

``look through'' certain repurchase agreements to the securities

collateralizing the agreements for various purposes under the Act.

Because a fund looks to the collateral as the ultimate source of

repayment for its loan, the Commission staff has taken a ``no-action''

position in order to allow funds to treat certain repurchase agreements

as investments in the securities making up the collateral rather than

as a loan to the counterparty

s to the securities

collateralizing the agreements for various purposes under the Act.

Because a fund looks to the collateral as the ultimate source of

repayment for its loan, the Commission staff has taken a ``no-action''

position in order to allow funds to treat certain repurchase agreements

as investments in the securities making up the collateral rather than

as a loan to the counterparty. Proposed rule 5b-3 would codify these

positions and allow a fund to treat a repurchase agreement as an

acquisition of the underlying collateral in determining whether it is

in compliance with the investment criteria for diversified funds set

forth in section 5(b)(1) of the Act.\2\ The proposed rule also would

codify staff no-action positions that allow a fund that enters into a

repurchase agreement with a counterparty that is a broker-dealer to

``look through'' the repurchase agreement to the underlying collateral

for purposes of section 12(d)(3) of the Act, which prohibits a fund

from acquiring an interest in a broker-dealer.\3\ The proposed rule

would require the value of the collateral at all times to be sufficient

to fully cover the amount payable under the repurchase agreement (that

is, the amount that the counterparty would repay the fund to repurchase

the securities). In addition, the fund must evaluate whether the

counterparty is creditworthy and the repurchase agreement must qualify

for an exclusion from any automatic stay of creditors' rights under the

federal

Bankruptcy Code or other insolvency laws.

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\2\ 15 U.S.C. 80a-5(b)(1).

\3\ 15 U.S.C. 80a-12(d)(3).

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erparty is creditworthy and the repurchase agreement must qualify

for an exclusion from any automatic stay of creditors' rights under the

federal

Bankruptcy Code or other insolvency laws.

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\2\ 15 U.S.C. 80a-5(b)(1).

\3\ 15 U.S.C. 80a-12(d)(3).

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Proposed rule 5b-3 would provide similar ``look-through'' treatment

for purposes of section 5(b)(1) of the Act in the case of investments

in pre-refunded bonds, the repayment of which has been fully funded by

escrowed U.S. government securities. As in the case of repurchase

agreements, a fund may view its investment in pre-refunded bonds as an

investment in the escrowed government securities rather than in the

original bonds.

The conditions proposed for the treatment of repurchase agreements

and pre-refunded bonds under the proposed rule would be substantially

the same as those required by rule 2a-7, the rule governing money

market funds, and would codify and update long-standing staff no-action

positions.

I. Background

A. Repurchase Agreements

Repurchase agreements provide funds with a means to invest idle

cash at competitive rates for periods as short as overnight.

Economically, they may be viewed as loans from the fund to the

counterparty in which the securities that the fund purchases serve as

collateral for the loan and are placed in the possession or under the

control of the fund's custodian during the term of the agreement.\4\ By

investing in repurchase agreements, funds can expand their available

options for the productive investment of short-term cash. At the same

time, fund participation in the market for repurchase agreements

benefits other market participants by enhancing their ability to borrow

to meet their short-term needs.

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ment.\4\ By

investing in repurchase agreements, funds can expand their available

options for the productive investment of short-term cash. At the same

time, fund participation in the market for repurchase agreements

benefits other market participants by enhancing their ability to borrow

to meet their short-term needs.

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\4\ See The Handbook of Fixed Income Securities 198 (Frank J.

Fabozzi ed., 5th ed. 1997). Most repurchase transactions involve

Treasury bills and other U.S. government securities, but bank

certificates of deposit and bankers' acceptances, as well as

commercial paper from major corporations, are used as well. See

Jeanne L. Schroeder, Repo Madness: The Characterization of

Repurchase Agreements Under the Bankruptcy Code and the U.C.C., 46

Syracuse L. Rev. 999, 1005 (1996). When the counterparty lends to,

rather than borrows from, the fund, the transaction is termed a

``reverse repurchase agreement.'' Reverse repurchase agreements

raise issues under section 18 of the Act [15 U.S.C. 80a-18] because

they can be viewed as the issuance by the fund of a senior security.

These issues were addressed in Investment Company Act Release No.

10666 (Apr. 18, 1979) [44 FR 25128 (Apr. 27, 1979)] (``Release

10666'').

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Two provisions of the Act may affect a fund's ability to invest in

repurchase agreements

S.C. 80a-18] because

they can be viewed as the issuance by the fund of a senior security.

These issues were addressed in Investment Company Act Release No.

10666 (Apr. 18, 1979) [44 FR 25128 (Apr. 27, 1979)] (``Release

10666'').

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Two provisions of the Act may affect a fund's ability to invest in

repurchase agreements. Section 12(d)(3) of the Act generally prohibits

a fund from acquiring an interest in a broker, dealer, or

underwriter.\5\ Because a repurchase agreement may be considered to be

the acquisition of an interest in the counterparty,\6\ section 12(d)(3)

may limit a fund's ability to enter into repurchase agreements with

many of the firms that act as counterparties.\7\ Section 5(b)(1) of the

Act limits the amount that a fund that holds itself out as being a

diversified investment company may invest in the securities of any one

issuer (other than the U.S. government).\8\ This provision may limit

the amount of repurchase agreements that a diversified fund may enter

into with any one counterparty.

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\5\ With minor exceptions, section 12(d)(3) prohibits an

investment company from purchasing or otherwise acquiring ``any

security issued by or any other interest in the business of any

person who is a broker, a dealer, [or] is engaged in the business of

underwriting.'' The staff has taken the position that fund

repurchase agreements with banks that are engaged in a securities-

related business, including dealing in government securities, may be

subject to the prohibitions of section 12(d)(3). See Letter from

Gerald Osheroff, Associate Director, Division of Investment

Management, to Matthew Fink, General Counsel, Investment Company

Institute (May 7, 1985) (``May 7, 1985 Letter'').

\6\ See American Medical Ass'n Tax-Exempt Income Fund, Inc., SEC

No-Action Letter (Apr. 23, 1978); May 7, 1985 Letter, supra note 5

ent securities, may be

subject to the prohibitions of section 12(d)(3). See Letter from

Gerald Osheroff, Associate Director, Division of Investment

Management, to Matthew Fink, General Counsel, Investment Company

Institute (May 7, 1985) (``May 7, 1985 Letter'').

\6\ See American Medical Ass'n Tax-Exempt Income Fund, Inc., SEC

No-Action Letter (Apr. 23, 1978); May 7, 1985 Letter, supra note 5.

\7\ Brokers and dealers (as well as banks that are engaged in

securities related activities) often act as counterparties in

repurchase transactions. See Schroeder, supra note 4, at 1004. If

funds are unable to enter into repurchase agreements with these

counterparties, they effectively may be unable to participate in

this market.

\8\ To be classified as a ``diversified'' fund under section

5(b)(1) of the Act, a fund is required, with respect to 75 percent

of its assets, to invest no more than 5 percent of its assets in the

securities of any one issuer (excluding cash and cash items,

government securities, and securities of other investment

companies). The remaining 25 percent of the fund's assets may be

invested in any manner. Section 13(a)(1) of the Act [15 U.S.C. 80a-

13(a)(1)] prohibits a fund that is classified as a diversified

company from changing to a non-diversified company without

shareholder authorization.

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A fund investing in a properly structured repurchase agreement

looks primarily to the value and liquidity of the collateral rather

than the credit of the counterparty for satisfaction of the repurchase

agreement.\9\ In two separate no-action positions issued in 1979 and

1980, the staff stated that, for purposes of sections 12(d)(3) and

5(b)(1) of the Act, a fund may treat a repurchase agreement as an

acquisition of the underlying collateral if the repurchase agreement is

``collateralized fully.'' \10\ Because most repurchase agreements are

collateralized fully by highly liquid U.S

purchase

agreement.\9\ In two separate no-action positions issued in 1979 and

1980, the staff stated that, for purposes of sections 12(d)(3) and

5(b)(1) of the Act, a fund may treat a repurchase agreement as an

acquisition of the underlying collateral if the repurchase agreement is

``collateralized fully.'' \10\ Because most repurchase agreements are

collateralized fully by highly liquid U.S. government securities, this

``look-through'' treatment allowed funds to treat repurchase agreements

as investments in government securities. As a result, a fund could

invest in repurchase agreements with the same counterparty without the

limitations of sections 12(d)(3) or 5(b)(1).\11\

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\9\ See infra note 16 and accompanying text.

\10\ In 1979, the staff announced that it would not recommend

enforcement action under section 12(d)(3) if the repurchase

agreement was ``structured in a manner reasonably designed to

collateralize fully the investment company loan.'' Release 10666,

supra note 4. The following year, the staff applied this no-action

position to a fund's compliance with the diversification

requirements of section 5(b)(1) of the Act. MoneyMart Assets, Inc.,

SEC No-Action Letter (Sept. 3, 1980).

\11\ Repurchase agreements with broker-dealers affiliated with

the fund would, of course, continue to raise serious questions under

sections 17(a) and 17(d) of the Act [15 U.S.C. 80a-17(a), 15 U.S.C.

80a-17(d)]. See Release 10666, supra note 4, at n.24.

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ct. MoneyMart Assets, Inc.,

SEC No-Action Letter (Sept. 3, 1980).

\11\ Repurchase agreements with broker-dealers affiliated with

the fund would, of course, continue to raise serious questions under

sections 17(a) and 17(d) of the Act [15 U.S.C. 80a-17(a), 15 U.S.C.

80a-17(d)]. See Release 10666, supra note 4, at n.24.

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The assumptions underlying the 1979 and 1980 no-action positions

were challenged in the early 1980s as a result of the bankruptcy of

Lombard-Wall, Inc., a large issuer of repurchase agreements, and the

insolvency of several others.\12\ The court in the Lombard-Wall case

held that the purchaser of securities in a repurchase agreement was

subject to the automatic stay of the Bankruptcy Code,\13\ and could not

close out its position without the approval of the bankruptcy

court.\14\ This decision created uncertainty regarding the status of

repurchase agreements under the Bankruptcy Code and exposed a fund to

the risk that it might be unable to liquidate the collateral securities

immediately upon the insolvency of the counterparty.\15\ Because of the

possible adverse effect of counterparty insolvency on a fund's

liquidity, the Commission issued a staff release that added a condition

to the staff's earlier no-action position. In addition to requiring the

repurchase agreement to be fully collateralized, the staff now required

the fund to evaluate the creditworthiness of the counterparty.\16\

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f counterparty insolvency on a fund's

liquidity, the Commission issued a staff release that added a condition

to the staff's earlier no-action position. In addition to requiring the

repurchase agreement to be fully collateralized, the staff now required

the fund to evaluate the creditworthiness of the counterparty.\16\

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\12\ See In re Lombard-Wall Inc., No. 82 B 11556, bench op.

(Bankr. S.D.N.Y. Sept. 16, 1982).

\13\ 11 U.S.C. 101 et seq.

\14\ See Omnibus Bankruptcy Improvements Act of 1983, S. Rep.

No. 98-65, at 47 (1983) (discussing In re Lombard-Wall Inc.).

\15\ As a consequence, the repurchase agreement might be an

illiquid investment subject to restrictions on the amount of these

investments in a fund's portfolio.

\16\ Investment Company Act Release No. 13005 (Feb. 2, 1983) [48

FR 5894 (Feb. 9, 1983)] (``Release 13005''). Release 13005 called

for the evaluation of the counterparty's creditworthiness to be made

by the fund's board of directors. In a recent letter to the

Investment Company Institute, the staff revised this position to

permit a fund's investment adviser, rather than the fund's board, to

evaluate the creditworthiness of counterparties and otherwise assume

primary responsibility for monitoring and evaluating the fund's use

of repurchase agreements. Investment Company Institute, SEC No-

Action Letter (June 15, 1999).

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Congress later amended the Bankruptcy Code to resolve this

uncertainty.\17\ As amended, the

uate the creditworthiness of counterparties and otherwise assume

primary responsibility for monitoring and evaluating the fund's use

of repurchase agreements. Investment Company Institute, SEC No-

Action Letter (June 15, 1999).

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Congress later amended the Bankruptcy Code to resolve this

uncertainty.\17\ As amended, the

Bankruptcy Code now protects participants in repurchase agreements from

the Code's automatic stay and preference avoidance provisions when the

collateral consists of U.S. government and agency obligations,

certificates of deposit, and eligible bankers' acceptances.\18\ In

1996, when we amended the money market fund rule (rule 2a-7, which had

codified the staff's position on repurchase agreements in connection

with that rule's diversification requirements),\19\ we tied the

availability of the ``look-through'' more directly to the preferred

treatment given to repurchase agreements under the Bankruptcy Code and

related insolvency statutes.\20\ We noted that if the collateral did

not qualify for special treatment under these statutes, a fund could

encounter significant liquidity problems if a large percentage of its

assets were invested in a repurchase agreement with a bankrupt

counterparty. In that case, the credit risks assumed by the fund would

be directly tied to the counterparty rather than the issuers of the

underlying collateral.\21\

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atutes, a fund could

encounter significant liquidity problems if a large percentage of its

assets were invested in a repurchase agreement with a bankrupt

counterparty. In that case, the credit risks assumed by the fund would

be directly tied to the counterparty rather than the issuers of the

underlying collateral.\21\

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\17\ Before the passage of the Bankruptcy Amendments and Federal

Judgeship Act of 1984, Pub. L. No. 98-353, 98 Stat. 333 (1984)

(``BAFJA''), the treatment of a repurchase agreement under the

Bankruptcy Code depended upon whether it was characterized as a

secured loan or a purchase and sale transaction. If the transaction

was characterized as a secured loan, the borrower-counterparty would

retain at least an equitable interest in the securities, and the

securities would be subject to the automatic stay provisions of the

Bankruptcy Code, preventing the lender from taking any action

against the borrower's property. If the transaction was

characterized as a purchase and sale, the repurchase obligation

would be viewed as an executory contract, which the bankruptcy

trustee could accept or reject. Until acceptance or rejection, the

fund would be exposed to the market risk of the securities.

Regardless of the transaction's characterization, it was unclear

whether ``mark-to-market'' payments (the payments required to keep

the repurchase agreement fully collateralized) could be voided by

the trustee as preferential transfers. The BAFJA amendments removed

qualifying repurchase agreements from the operation of the

Bankruptcy Code's automatic stay and preference avoidance

provisions. See 11 U.S.C. 101(47) (defining repurchase agreement);

11 U.S.C. 559 (protecting repurchase agreement participants from the

Bankruptcy Code's automatic stay provisions).

\18\ See 11 U.S.C. 101(47); 11 U.S.C. 559

preferential transfers. The BAFJA amendments removed

qualifying repurchase agreements from the operation of the

Bankruptcy Code's automatic stay and preference avoidance

provisions. See 11 U.S.C. 101(47) (defining repurchase agreement);

11 U.S.C. 559 (protecting repurchase agreement participants from the

Bankruptcy Code's automatic stay provisions).

\18\ See 11 U.S.C. 101(47); 11 U.S.C. 559. The Federal Deposit

Insurance Act also provides preferred treatment to repurchase

agreements in which a bank is the counterparty. See 12 U.S.C.

1821(e)(8)(A), (C) (affording preferred treatment to ``qualified

financial contracts''); 12 U.S.C. 1821(e)(8)(D)(i) (defining

qualified financial contracts to include repurchase agreements); 12

U.S.C. 1821(e)(8)(D)(v) (defining repurchase agreement).

In broker-dealer insolvencies, the buyer's ability to liquidate

the repurchase agreement collateral is subject to the possible

imposition of a judicial stay obtained by the Securities Investor

Protection Corporation (``SIPC''). Representatives of SIPC, however,

have indicated that SIPC would consent, and urge the trustee to

consent, to the liquidation of repurchase agreement collateral upon

SIPC's receipt of certain documentation, including an affidavit from

the buyer that it has a perfected security interest in the

collateral. See Letter from Michael E. Don, President, SIPC, to Seth

Grosshandler, Cleary, Gottlieb, Steen & Hamilton (Feb. 14, 1996);

Letter from Michael E. Don, Deputy General Counsel, Office of the

General Counsel, SIPC, to Eugene Marans, Cleary, Gottlieb, Steen &

Hamilton (Aug. 29, 1988).

\19\ See Revisions to Rules Regulating Money Market Funds,

Investment Company Act Release No. 18005 (Feb. 20, 1991) [56 FR 8113

(Feb. 27, 1991)], at nn. 30-33 and accompanying text.

\20\ See Revisions to Rules Regulating Money Market Funds,

Investment Company Act Release No. 19959 (Dec. 17, 1993) [58 FR

68585 (Dec. 28, 1993)] (``1996 Amendments Proposing Release''), at

nn

n (Aug. 29, 1988).

\19\ See Revisions to Rules Regulating Money Market Funds,

Investment Company Act Release No. 18005 (Feb. 20, 1991) [56 FR 8113

(Feb. 27, 1991)], at nn. 30-33 and accompanying text.

\20\ See Revisions to Rules Regulating Money Market Funds,

Investment Company Act Release No. 19959 (Dec. 17, 1993) [58 FR

68585 (Dec. 28, 1993)] (``1996 Amendments Proposing Release''), at

nn. 168-74 and accompanying text; Revisions to Rules Regulating

Money Market Funds, Investment Company Act Release No. 21837 (Mar.

21, 1996) [61 FR 13956 (Mar. 28, 1996)] (``1996 Amendments Adopting

Release''), at nn. 116-19.

\21\ 1996 Amendments Proposing Release, supra note 20, at n.172.

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The Commission is proposing a new rule 5b-3 that would codify the

staff's positions that a fund may look through a fully collateralized

repurchase agreement to the underlying securities for purposes of

sections 5(b)(1) and 12(d)(3) of the Act,\22\ supplemented by the

requirement of rule 2a-7 that the repurchase agreement qualify for an

exclusion from any automatic stay of creditors' rights under applicable

insolvency law. Because the conditions for looking through a repurchase

agreement for purposes of sections 5(b)(1) and 12(d)(3) are

substantially the same as the conditions under rule 2a-7, the

Commission is proposing to codify the same standard for all three

purposes.

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\22\ The Commission expects to withdraw the staff positions if

we adopt the proposed rule.

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B. Pre-Refunded Bonds

ially the same as the conditions under rule 2a-7, the

Commission is proposing to codify the same standard for all three

purposes.

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\22\ The Commission expects to withdraw the staff positions if

we adopt the proposed rule.

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B. Pre-Refunded Bonds

Pre-refunded bonds are municipal bonds the repayment of which has

been fully funded by a deposit into escrow of U.S. government

securities. From time to time, a municipality may choose to refund

previously issued bonds prior to their call date by issuing a second

bond, the proceeds of which are used to purchase U.S. government

securities. These securities are placed in escrow, and the principal

and interest on the escrowed securities are used to pay off the

original bonds.\23\ The holders of the original bonds no longer look to

the municipal issuer for repayment, but rather to the escrowed

securities.

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\23\ See, e.g., Robert Zipf, How Municipal Bonds Work 44-47

(1995).

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In 1993, the staff issued a no-action position permitting funds,

under certain conditions, to look through pre-refunded bonds to the

escrowed government securities for purposes of the section 5(b)(1)

diversification requirements.\24\ When the Commission amended rule 2a-7

in 1996, it codified this position for purposes of the money market

fund diversification requirements, but omitted the condition that the

pre-refunded bonds of any one issuer could account for no more than 25

percent of the fund's assets.\25\ The Commission proposes to codify

this revised treatment of pre-refunded bonds for purposes of section

5(b)(1).\26\

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urposes of the money market

fund diversification requirements, but omitted the condition that the

pre-refunded bonds of any one issuer could account for no more than 25

percent of the fund's assets.\25\ The Commission proposes to codify

this revised treatment of pre-refunded bonds for purposes of section

5(b)(1).\26\

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\24\ T. Rowe Price Tax-Free Funds, SEC No-Action Letter (June

24, 1993). In the letter, the Division of Investment Management

agreed not to recommend any enforcement action if a fund treated an

investment in municipal bonds refunded with escrowed government

securities as an investment in the government securities for

purposes of section 5(b)(1). This no-action position was based on

certain representations, including that (1) the deposit of the

government securities was irrevocable and pledged only to the debt

service on the original bonds, (2) payments from the escrow would

not be subject to the preference provisions or automatic stay

provisions of the Bankruptcy Code, and (3) no fund would invest more

than 25 percent of its assets in the pre-refunded bonds of any

single municipal issuer.

\25\ The Commission also eliminated the 25 percent limitation

for funds other than money market funds that rely on the staff no-

action position set forth in T. Rowe Price Tax-Free Funds. 1996

Amendments Adopting Release, supra note 20, at n.122.

\26\ The Commission expects to withdraw the staff position if we

adopt the proposed rule.

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II. Discussion

A. Proposed Rule 5b-3(a): Treatment of Repurchase Agreements

et funds that rely on the staff no-

action position set forth in T. Rowe Price Tax-Free Funds. 1996

Amendments Adopting Release, supra note 20, at n.122.

\26\ The Commission expects to withdraw the staff position if we

adopt the proposed rule.

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II. Discussion

A. Proposed Rule 5b-3(a): Treatment of Repurchase Agreements

Proposed rule 5b-3 would permit a fund to treat the acquisition of

a repurchase agreement as an acquisition of the underlying securities

for purposes of sections 5(b)(1) and 12(d)(3) of the Act, if the

obligation of the seller to repurchase the securities from the fund is

``collateralized fully,'' as defined in the proposed rule.\27\

Consistent with the staff's no-action positions, the proposed rule also

would require the board of directors or its delegate to evaluate the

counterparty's creditworthiness.\28\ A similar requirement would be

added to rule 2a-7.\29\

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\27\ Proposed rule 5b-3(a). A fund would be permitted to look

through only that portion of the repurchase agreement that is

collateralized fully. Any agreement or portion of an agreement that

is not collateralized fully would be treated as a loan by the fund

to the counterparty. Even if a repurchase agreement is

collateralized fully, a fund may elect to look to the counterparty

rather than the underlying securities in meeting the diversification

requirements of section 5(b)(1).

\28\ Id. See Release 13005, supra note 16; Investment Company

Institute, supra note 16.

\29\ Proposed rule 2a-7(c)(4)(ii)(A). This requirement is not

new. In Investment Company Act Release No. 22383 (Dec. 10, 1996) [61

FR 66621 (Dec

alized fully, a fund may elect to look to the counterparty

rather than the underlying securities in meeting the diversification

requirements of section 5(b)(1).

\28\ Id. See Release 13005, supra note 16; Investment Company

Institute, supra note 16.

\29\ Proposed rule 2a-7(c)(4)(ii)(A). This requirement is not

new. In Investment Company Act Release No. 22383 (Dec. 10, 1996) [61

FR 66621 (Dec. 18, 1996)] (proposing technical amendments to rule

2a-7), at note 32, the Commission stated that a money market fund

must continue to evaluate the counterparty's creditworthiness in

order to minimize the risk of becoming involved in bankruptcy

proceedings, consistent with the no-action position stated in

Release 13005.

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The proposed rule generally would incorporate the definition of

``collateralized fully'' currently employed in rule 2a-7.\30\ A

repurchase

agreement would be collateralized fully if: (i) the value of the

underlying securities (reduced by the costs that the fund reasonably

could expect to incur if the counterparty defaults) is, and at all

times remains, at least equal to the agreed resale price; \31\ (ii) the

collateral for the repurchase agreement consists entirely of cash

items, U.S. government securities, or other securities of a high

quality; \32\ and (iii) the repurchase agreement qualifies for an

exclusion from any automatic stay of creditors' rights against the

counterparty under applicable insolvency law in the event of the

counterparty's insolvency.\33\

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\30\ Rule 2a-7(a)(5).

\31\ Proposed rule 5b-3(c)(1)(i) requires the value of the

securities collateralizing the repurchase agreement to be, and

during the entire term of the agreement to remain, at least equal to

the resale price. The term ``resale price'' is defined in paragraph

the

counterparty's insolvency.\33\

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\30\ Rule 2a-7(a)(5).

\31\ Proposed rule 5b-3(c)(1)(i) requires the value of the

securities collateralizing the repurchase agreement to be, and

during the entire term of the agreement to remain, at least equal to

the resale price. The term ``resale price'' is defined in paragraph

(c)(7) of the proposed rule as the acquisition price paid to the

seller plus the accrued resale premium, i.e., the return on

investment specified in the agreement. Consistent with prior staff

positions, the market value of the securities held as collateral

must be marked to market daily during the entire term of the

agreement to ensure that the collateral is at all times at least

equal to the resale price, and the repurchase agreement should

provide for the delivery of additional collateral if the market

value of the securities falls below the resale price. See Letter

from Gerald Osheroff, supra note 5. Under the proposed rule, the

fund's expected return on its investment may be either the full

amount specified in the agreement or the daily amortization of the

difference between the purchase price and the resale price specified

in the agreement. This allows the counterparty to add to the

collateral as interest on the loan accrues. See 1996 Amendments

Proposing Release, supra note 20, at n.176 and accompanying text.

\32\ Proposed rule 5b-3(c)(1)(iv). Any securities other than

government securities must be rated in the highest rating category

by the ``requisite NRSROs.'' Id. See also infra text accompanying

notes 41-43 (describing this proposed quality requirement and

requesting comment). ``Requisite NRSROs'' are defined in paragraph

ents

Proposing Release, supra note 20, at n.176 and accompanying text.

\32\ Proposed rule 5b-3(c)(1)(iv). Any securities other than

government securities must be rated in the highest rating category

by the ``requisite NRSROs.'' Id. See also infra text accompanying

notes 41-43 (describing this proposed quality requirement and

requesting comment). ``Requisite NRSROs'' are defined in paragraph

(c)(6) of the proposed rule as any two NRSROs, or, if only one NRSRO

has issued a rating at the time the fund acquires the security, that

NRSRO. ``NRSRO'' is defined in paragraph (c)(5) as any nationally

recognized statistical rating organization, as that term is used in

paragraphs (c)(2)(vi)(E), (F) and (H) of rule 15c3-1 [17 CFR

240.15c3-1] under the Securities Exchange Act of 1934 [15 U.S.C.

78a-mm], that is not an ``affiliated person,'' as defined in section

2(a)(3)(C) of the Act [15 U.S.C. 80a-2(a)(3)(C)], of the issuer of,

or any insurer or provider of credit support for, the security.

\33\ Proposed rule 5b-3(c)(1)(v).

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The rule 2a-7 definition of ``collateralized fully'' also requires

either the fund or its custodian to have physical possession of the

collateral or a book entry to be maintained in the name of the fund or

its custodian.\34\ This provision derived from a Commission staff

position requiring funds to acquire actual or constructive possession

of repurchase agreement collateral.\35\ In lieu of this requirement,

the proposed rule would require the fund to perfect its security

interest in the repurchase agreement collateral and maintain the

collateral in an account with the fund's custodian or a third party

that qualifies as a custodian under the Act.\36\ This proposal, which

we believe generally would not require a change from current practice,

is intended to update the definition of ``collateralized fully'' in

light of the 1994 revisions to the Uniform Commercial Code, which

address the evolution of the i

ral and maintain the

collateral in an account with the fund's custodian or a third party

that qualifies as a custodian under the Act.\36\ This proposal, which

we believe generally would not require a change from current practice,

is intended to update the definition of ``collateralized fully'' in

light of the 1994 revisions to the Uniform Commercial Code, which

address the evolution of the indirect system for holding

securities.\37\ The updated requirement would, we believe, more

accurately reflect the steps that a fund should take to protect its

interests in repurchase agreement collateral. The Commission requests

comment on this proposal. Should the definition of collateralized fully

specifically require funds to perfect their security interests in

repurchase agreement collateral by obtaining ``control'' of the

collateral? \38\

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\34\ Rule 2a-7(a)(5)(ii).

\35\ See Release 13005, supra note 16, at n.2 and accompanying

text. In Release 13005, the Division stated that the requirement of

actual or constructive possession was intended to ensure that the

fund would be able to liquidate the collateral immediately upon any

default or insolvency of the seller. Constructive possession

included the transfer of book-entry securities. See id. The staff

also provided guidance with respect to the custody requirements in a

letter from Kathryn McGrath, Director, Division of Investment

Management, to Matthew Fink, General Counsel, Investment Company

Institute (June 19, 1985)

liquidate the collateral immediately upon any

default or insolvency of the seller. Constructive possession

included the transfer of book-entry securities. See id. The staff

also provided guidance with respect to the custody requirements in a

letter from Kathryn McGrath, Director, Division of Investment

Management, to Matthew Fink, General Counsel, Investment Company

Institute (June 19, 1985). Among other things, the letter noted the

staff's position that ``a repurchase agreement is fully

collateralized only if the collateral is in the actual or

constructive possession of the investment company.'' The letter also

noted that the staff would consider a fund to have constructive

possession of collateral when the collateral has been transferred to

the fund's custodian or to the care of a third party to the

repurchase agreement that would qualify as a custodian for fund

assets under section 17(f) of the Act [15 U.S.C. 80a-17(f)].

\36\ Proposed rule 5b-3(c)(1)(ii), (iii).

\37\ See generally UCC, Revised Article 8--Investment Securities

(With Conforming and Miscellaneous Amendments to Articles 1, 4, 5,

9, and 10) (1994 Official Text with Comments), 2C Uniform Laws

Annotated (West Supp. 1997), Prefatory Note at I.D., II.B., II.C.,

II.D. As of April 1, 1999, the 1994 amendments to UCC Article 8 had

been adopted by 48 states, the District of Columbia, and Puerto

Rico. The most recent information regarding the status of proposed

UCC revisions in the state legislatures can be obtained by

contacting the National Conference of Commissioners on Uniform State

Laws at (312) 915-0195.

\38\ Under the 1994 revisions to the UCC, the primary means to

perfect a security interest in investment securities is by obtaining

``control'' of the securities. See UCC, Revised Article 8, Secs. 8-

106, 9-115(4). In general, obtaining ``control'' means taking the

steps necessary to place a secured lender in a position where it can

have the collateral sold off without the further cooperation of the

debtor

1994 revisions to the UCC, the primary means to

perfect a security interest in investment securities is by obtaining

``control'' of the securities. See UCC, Revised Article 8, Secs. 8-

106, 9-115(4). In general, obtaining ``control'' means taking the

steps necessary to place a secured lender in a position where it can

have the collateral sold off without the further cooperation of the

debtor. See UCC, Revised Article 8, Prefatory Note at II.D.

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We understand that some funds engage in ``hold-in-custody''

repurchase agreements (``HIC repos'')\39\ with their custodians as a

means of investing cash that they receive late in the business day.

Some commentators have suggested that these transactions entail the

risk that the fund would not be able to liquidate the collateral

promptly if the custodian were to become insolvent.\40\ The Commission

requests comment on risks posed by these transactions and whether HIC

repos should be considered ``collateralized fully'' under rule 5b-3.

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\39\ In a HIC repo, the seller merely segregates the collateral

during the term of the agreement, rather than transferring it to the

buyer or to a third party. Ellen Taylor, Trader's Guide to the Repo

market 25-26 (1995).

\40\ See Seth Grosshandler, Lech Kalembka & Daniel Feit,

Securities, Forward and Commodity Contracts and Repurchase and Swap

Agreements Under U.S. Insolvency Laws (1995), available in LEXIS,

721 PLI/Comm 401, 434 (qualified financial contract provisions do

not protect the right of a purchaser of securities under a HIC repo

to compel delivery of the securities from the FDIC as conservator or

receiver); see also id. at 416 (Bankruptcy Code does not appear to

protect the right of a purchaser of securities under a HIC repo to

compel delivery of the securities from the bankrupt)

XIS,

721 PLI/Comm 401, 434 (qualified financial contract provisions do

not protect the right of a purchaser of securities under a HIC repo

to compel delivery of the securities from the FDIC as conservator or

receiver); see also id. at 416 (Bankruptcy Code does not appear to

protect the right of a purchaser of securities under a HIC repo to

compel delivery of the securities from the bankrupt).

---------------------------------------------------------------------------

Most repurchase agreements are collateralized with U.S. government

securities, and the staff positions with respect to section 5(b)(1)

have limited the collateral to those securities.\41\ Under the proposed

rule, cash collateral also could be used, as well as other high quality

securities. The Commission is proposing to limit the high quality

securities that may be used as collateral based on the same standards

currently contained in rule 2a-7 for money market funds.\42\ The high

quality requirement is designed to limit a fund's exposure to the

ability of the counterparty to maintain sufficient collateral.\43\ In

addition, use of this rule 2a-7 standard would permit a fund complex to

establish uniform criteria for repurchase agreements among funds.

Comment is requested whether the rule should include these minimum

quality standards for collateral. Are there any other criteria that

would be preferable?

---------------------------------------------------------------------------

icient collateral.\43\ In

addition, use of this rule 2a-7 standard would permit a fund complex to

establish uniform criteria for repurchase agreements among funds.

Comment is requested whether the rule should include these minimum

quality standards for collateral. Are there any other criteria that

would be preferable?

---------------------------------------------------------------------------

\41\ See MoneyMart Assets, supra note 10. The staff's no-action

positions with respect to the treatment of repurchase agreements for

purposes of section 12(d)(3) did not expressly limit the type of

eligible collateral. See Release 10666, supra note 4; Release 13005,

supra note 16.

\42\ Rule 2a-7(a)(5)(iii); see also supra note 32.

\43\ Securities of lower quality may be subject to greater price

fluctuation. In the event of a steep drop in the market value of the

collateral, it may be difficult for the counterparty to deliver

additional securities sufficient to ensure that the repurchase

agreement remains fully collateralized. If the counterparty does not

deliver sufficient additional securities and thus defaults, the fund

may be unable to realize the full value of the repurchase agreement

upon liquidation of the collateral. In addition, high quality

securities are generally more liquid than lower quality securities.

A fund could more readily liquidate high quality securities in the

event of a counterparty default.

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As discussed above, the proposed rule also requires the fund to

evaluate the counterparty's creditworthiness.\44\ This evaluation,

which currently is required

es are generally more liquid than lower quality securities.

A fund could more readily liquidate high quality securities in the

event of a counterparty default.

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As discussed above, the proposed rule also requires the fund to

evaluate the counterparty's creditworthiness.\44\ This evaluation,

which currently is required

under staff no-action positions, is designed to require the fund to

determine whether the counterparty presents a serious risk of becoming

involved in bankruptcy proceedings.\45\ The Commission requests comment

on the need for this evaluation of the counterparty's creditworthiness

in light of the proposed requirement that repurchase agreements qualify

for the preferred treatment now given to certain repurchase agreements

under the Bankruptcy Code.\46\

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\44\ See supra note 28 and accompanying text.

\45\ See Release 13005, supra note 16, at n.6.

\46\ When we proposed amendments to rule 2a-7 in 1993, we

requested comment on the need for a credit risk determination in

light of the amendments to the Bankruptcy Code. 1996 Amendments

Proposing Release, supra note 20, at n.173 and accompanying text.

Most commenters urged that the determination be retained.

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B. Proposed Rule 5b-3(b): Treatment of Pre-Refunded Bonds

Proposed rule 5b-3 would codify for purposes of section 5(b)(1) the

conditions specified in the staff's no-action position permitting a

fund to treat an investment in a ``refunded security'' as an investment

in the escrowed U.S. government securities for purposes of section

5(b)(1).\47\ The rule, however, would not limit the amount of pre-

refunded bonds of any one issuer that a fund could acquire.\48\

---------------------------------------------------------------------------

fied in the staff's no-action position permitting a

fund to treat an investment in a ``refunded security'' as an investment

in the escrowed U.S. government securities for purposes of section

5(b)(1).\47\ The rule, however, would not limit the amount of pre-

refunded bonds of any one issuer that a fund could acquire.\48\

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\47\ Proposed rule 5b-3(b).

\48\ See T. Rowe Price Tax-Free Funds, supra note 24.

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Under the proposed rule, a ``refunded security'' would be defined

as a debt security the principal and interest payments of which are to

be paid by U.S. government securities that have been irrevocably placed

in an escrow account and are pledged only to the payment of the debt

security.\49\ The escrowed securities must not be redeemable prior to

their final maturity, and the escrow agreement must prohibit the

substitution of the escrowed securities unless the substituted

securities are also U.S. government securities.\50\ Finally, an

independent certified public accountant must have certified to the

escrow agent that the escrowed securities will satisfy all scheduled

payments of principal, interest and applicable premiums on the refunded

securities.\51\ This treatment corresponds to the treatment given to

pre-refunded bonds in rule 2a-7.\52\

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\49\ Proposed rule 5b-3(c)(4).

\50\ Proposed rule 5b-3(c)(4)(i), (ii).

\51\ Proposed rule 5b-3(c)(4)(iii). The proposed rule makes an

exception to the certification requirement if the refunded security

has received the highest rating from an NRSRO. Id.

\52\ See rule 2a-7(a)(20), (c)(4)(ii)(B); see also 1996

Amendments Proposing Release, supra note 20, at section II.A.3.

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C. Availability of Rule 12d3-1 for Repurchase Agreements

proposed rule makes an

exception to the certification requirement if the refunded security

has received the highest rating from an NRSRO. Id.

\52\ See rule 2a-7(a)(20), (c)(4)(ii)(B); see also 1996

Amendments Proposing Release, supra note 20, at section II.A.3.

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C. Availability of Rule 12d3-1 for Repurchase Agreements

The Commission also proposes to amend rule 12d3-1, which provides

an exemption from the prohibition in section 12(d)(3) on acquiring an

interest in a broker-dealer or a bank engaged in a securities-related

business.\53\ The amendment would affect only repurchase agreements

that do not meet the conditions for looking through the agreements to

the underlying collateral. As discussed above, if a fund enters into a

repurchase agreement with a broker-dealer or other counterparty that is

engaged in securities related activities, and the fund is unable to

look through the agreement to the underlying collateral, the fund may

be in violation of section 12(d)(3) of the Act.\54\ Rule 12d3-1

provides an exemption from section 12(d)(3) under certain conditions,

but a note appended to rule 12d3-1 currently makes the rule unavailable

for repurchase agreements that fail to meet the requirements for look-

through treatment set forth in Investment Company Act Release No. 13005

(``Release 13005'').\55\ We are proposing to eliminate that note, and

thus allow funds to rely on rule 12d3-1 even if the repurchase

agreement does not meet the requirements of Release 13005. The

Commission requests comment whether it is appropriate to permit funds

to enter into repurchase agreements with broker-dealers when the

transaction does not meet all of the requirements of proposed rule 5b-

3, but does meet the requirements of rule 12d3-1.\56\

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greement does not meet the requirements of Release 13005. The

Commission requests comment whether it is appropriate to permit funds

to enter into repurchase agreements with broker-dealers when the

transaction does not meet all of the requirements of proposed rule 5b-

3, but does meet the requirements of rule 12d3-1.\56\

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\53\ See supra note 5.

\54\ See supra notes 5-7 and accompanying text.

\55\ See Release 13005, supra note 16. Rule 12d3-1 provides an

exemption for purchases of securities of any entity that derived

fifteen percent or less of its gross revenues from securities

related activities in its most recent fiscal year, unless the

acquiring company would control the entity after the purchase. If

the entity derived more than fifteen percent of its gross revenues

from securities related activities, the rule provides a limited

exemption based on the amount and value of the securities purchased.

The note to the rule states: ``Note: It is not intended that this

rule should supersede the requirements prescribed in Investment

Company Act Release No. 13005 (Feb. 2, 1983) with respect to

repurchase agreements with brokers or dealers.''

\56\ A fund investing in a repurchase agreement that does not

meet the requirements of the proposed rule would not be able to

``look through'' the agreement and must instead treat the

counterparty to the agreement as the issuer.

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D. Conforming Amendments to Rule 2a-7

to

repurchase agreements with brokers or dealers.''

\56\ A fund investing in a repurchase agreement that does not

meet the requirements of the proposed rule would not be able to

``look through'' the agreement and must instead treat the

counterparty to the agreement as the issuer.

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D. Conforming Amendments to Rule 2a-7

We are also proposing conforming amendments to rule 2a-7. These

amendments would add to rule 2a-7 the requirement that a money market

fund must evaluate the counterparty's creditworthiness in order to

treat the acquisition of a repurchase agreement as an acquisition of

the underlying securities.\57\ In addition, the proposed amendments

would replace the definitions of ``collateralized fully,'' ``event of

insolvency,'' and ``refunded security,'' currently set forth in rule

2a-7 with cross references to the corresponding definitions set forth

in proposed rule 5b-3.\58\

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\57\ Proposed rule 2a-7(c)(4)(ii)(A). As noted above, this

merely codifies a current staff requirement. See supra note 29.

\58\ Proposed rule 2a-7(a)(5), (11) and (20) (cross-referencing

proposed rule 5b-3(c)(1), (2), and (4)).

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E. Request for Comments

Any interested persons wishing to submit written comments on the

proposed rule and rule amendments that are the subject of this Release,

to suggest additional provisions or changes to the rules, or to submit

comments on other matters that might have an effect on the proposals

contained in this Release, are requested to do so. The Commission

specifically requests comment whether a fund should be allowed to look

through any other types of investments to underlying securities for

purposes of diversification, the prohibition of section 12(d)(3), or

any other provision of the Investment Company Act

t

comments on other matters that might have an effect on the proposals

contained in this Release, are requested to do so. The Commission

specifically requests comment whether a fund should be allowed to look

through any other types of investments to underlying securities for

purposes of diversification, the prohibition of section 12(d)(3), or

any other provision of the Investment Company Act. Commenters

suggesting alternative approaches are encouraged to submit suggested

rule text.

The Commission also requests comment whether the proposals, if

adopted, would promote efficiency, competition, and capital formation.

We will consider these comments pursuant to our responsibilities under

section 2(c) of the Investment Company Act.\59\ The Commission

encourages commenters to provide empirical data or other facts to

support their views. For purposes of the Small Business Regulatory

Enforcement Fairness Act of 1996,\60\ the Commission also requests

information regarding the potential impact of the proposed rule and

rule amendments on the economy on an annual basis. Commenters are

requested to provide empirical data to support their views.

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\59\ 15 U.S.C. 80a-2(c).

\60\ Pub. L. No. 104-121, Title II, 110 Stat. 857 (1996).

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III. Cost-Benefit Analysis

The Commission is sensitive to the costs and benefits imposed by

its rules. For the most part, the proposed rule would codify current

staff positions. By codifying a number of staff no-action positions

issued over a nearly twenty year period, the proposed rule should make

it easier for funds to determine whether, and under what conditions,

------------------------

III. Cost-Benefit Analysis

The Commission is sensitive to the costs and benefits imposed by

its rules. For the most part, the proposed rule would codify current

staff positions. By codifying a number of staff no-action positions

issued over a nearly twenty year period, the proposed rule should make

it easier for funds to determine whether, and under what conditions,

they are permitted to look through repurchase agreements or pre-

refunded bonds to the underlying securities for purposes of sections

5(b)(1) and 12(d)(3) of the Act. In addition, the proposed rule would

use substantially the same standards currently specified in rule 2a-7

for the treatment of repurchase agreements and pre-refunded bonds by

money market funds. With this uniform treatment, fund complexes that

include money market funds may be more efficient in monitoring

compliance with the requirements of the rules for all types of funds.

As discussed above, the proposed rule would be limited to

repurchase agreements in which the underlying collateral consists of

cash items, U.S. government securities, or other securities that meet

certain quality standards. As proposed, the rule tracks the language of

rule 2a-7, generally requiring any ``other securities'' to carry the

highest rating of two national rating agencies (``NRSROs,'' as defined

in the rule). This proposed requirement is intended to ensure that the

market value of the collateral will remain fairly stable and that the

fund will be able to liquidate the collateral quickly in the event of a

default. This limitation on collateral is more restrictive than the

staff's position with respect to the treatment of repurchase agreements

for purposes of section 12(d)(3),\61\ but it is less restrictive than

the staff's position with respect to section 5(b)(1).\62\ Since most

repurchase agreements are collateralized by U.S

d will be able to liquidate the collateral quickly in the event of a

default. This limitation on collateral is more restrictive than the

staff's position with respect to the treatment of repurchase agreements

for purposes of section 12(d)(3),\61\ but it is less restrictive than

the staff's position with respect to section 5(b)(1).\62\ Since most

repurchase agreements are collateralized by U.S. government securities,

which clearly fall within the proposed rule's limitations, it appears

that the limitation will not have any significant impact on funds.

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\61\ Release 13005, supra note 16, did not specify the type of

collateral, merely noting that the ``securities most frequently used

in connection with repurchase agreements are Treasury bills and

other United States Government securities.''

\62\ The staff's no-action position in MoneyMart Assets, supra

note 10, was conditioned on the collateral consisting entirely of

U.S. government securities.

---------------------------------------------------------------------------

The proposed rule is limited to repurchase agreements that qualify

for an exclusion from any automatic stay under applicable insolvency

law. Although this requirement is included in rule 2a-7, it was not a

feature of the staff positions, which generally pre-dated the relevant

changes in the Bankruptcy Code. Again, because most repurchase

agreements qualify for an exclusion, this limitation should not have

any significant impact on funds. The limitation will, however, provide

important protections for investors by ensuring that a fund can

liquidate the collateral quickly in the event of the counterparty's

bankruptcy.

The proposed amendment to rule 12d3-1 would eliminate the ``Note''

to the rule that renders the rule unavailable to repurchase agreements

xclusion, this limitation should not have

any significant impact on funds. The limitation will, however, provide

important protections for investors by ensuring that a fund can

liquidate the collateral quickly in the event of the counterparty's

bankruptcy.

The proposed amendment to rule 12d3-1 would eliminate the ``Note''

to the rule that renders the rule unavailable to repurchase agreements.

The Commission believes that funds should be allowed to rely on rule

12d3-1 in cases in which a repurchase agreement does not meet all of

the conditions of proposed rule 5b-3. This amendment will provide

additional flexibility for funds without impairing investor interests.

The Commission requests comment on the costs and benefits of the

proposed rule and rule amendments. To the extent possible, please

quantify any significant costs or benefits.

IV. Summary of Initial Regulatory Flexibility Analysis

The Commission has prepared an Initial Regulatory Flexibility

Analysis (``IRFA'') in accordance with 5 U.S.C. 603 regarding proposed

rule 5b-3, and the conforming amendments to rules 2a-7 and 12d3-1. The

IRFA indicates that the new rule would codify the staff's position that

a fund may look through a fully collateralized repurchase agreement to

the underlying securities for purposes of sections 5(b)(1) and 12(d)(3)

of the Act, and add the requirement of rule 2a-7 that the repurchase

agreement qualify for an exclusion from any automatic stay of

creditors' rights under applicable insolvency law. The IRFA indicates

that proposed rule 5b-3 also would permit a fund to treat the

acquisition of certain pre-refunded bonds as an acquisition of the

escrowed securities for purposes of section 5(b)(1) of the Act. In

addition, the IRFA explains that the proposed amendment to rule 12d3-1

would eliminate the ``Note'' appended to the rule in order to allow

funds to rely on rule 12d3-1 even if the repurchase agreement is not

collateralized fully

ould permit a fund to treat the

acquisition of certain pre-refunded bonds as an acquisition of the

escrowed securities for purposes of section 5(b)(1) of the Act. In

addition, the IRFA explains that the proposed amendment to rule 12d3-1

would eliminate the ``Note'' appended to the rule in order to allow

funds to rely on rule 12d3-1 even if the repurchase agreement is not

collateralized fully. Finally, the IRFA states that the conforming

amendments to rule 2a-7 are intended to simplify and update the

provisions of that rule that address repurchase agreements and refunded

securities.

The IRFA sets forth the statutory authority for the proposed rule

and rule amendments. The IRFA also discusses the effect of the proposed

rule and rule amendments on small entities. For purposes of the

Investment Company Act and the Regulatory Flexibility Act, a fund is a

small entity if the fund, together with other funds in the same group

of related funds, has net assets of $50 million or less as of the end

of its most recent fiscal year.\63\

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\63\ 17 CFR 270.0-10.

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The IRFA states that proposed rule 5b-3 will affect (i) any fund

that invests in a repurchase agreement with a broker, dealer,

underwriter, or bank that is engaged in a securities-related business,

when the investment may otherwise be prohibited by section 12(d)(3) of

the Act, and (ii) any fund that holds itself out as a diversified

investment company under section 5(b)(1) of the Act and that invests in

repurchase agreements or pre-refunded bonds.

As of December 31, 1998, there were approximately 4,300 registered

funds. Of this number, the Commission staff estimates that there are

approximately 269 funds that are small entities. These funds could be

affected by the proposed rule's treatment of investments in repurchase

agreements for purposes of section 12(d)(3) of the Act

of rule 2a-7, and it appears that the updated

provision would not require a change from current practice. The

proposal thus should not have a significant economic impact on a

substantial number of small entities.

The IRFA states that the proposed amendment to rule 12d3-1 will

affect any fund that invests in a repurchase agreement with a broker,

dealer, underwriter, or bank that is engaged in

a securities-related business, when the investment may otherwise be

prohibited by section 12(d)(3) of the Act. As stated above, there were

approximately 4,300 registered funds as of December 31, 1998, of which

approximately 269 funds were small entities. These funds would benefit

from the proposed amendment to rule 12d3-1, which would allow funds to

rely on that rule even if the repurchase agreement does not meet the

requirements of the Commission staff positions.

The IRFA explains that the proposed rule and rule amendments would

not impose any new reporting or recordkeeping requirements. The

proposals do not involve major changes in compliance requirements

because they mainly codify existing Commission staff positions. The

IRFA states that the definition of ``collateralized fully'' in proposed

rule 5b-3 supplements prior staff positions by requiring that the

repurchase agreement qualify for an exclusion from any automatic stay

of creditors' rights under applicable insolvency law. The definition

also has been updated to reflect the 1994 revisions to the UCC. It

appears, however, that this change generally would not require a change

from current practice. There are no rules that duplicate, overlap or

conflict with the proposed rule and rule amendments.

The IRFA discusses the various alternatives considered by the

Commission that would accomplish the stated objective, while minimizing

any significant adverse impact on small entities

ns to the UCC. It

appears, however, that this change generally would not require a change

from current practice. There are no rules that duplicate, overlap or

conflict with the proposed rule and rule amendments.

The IRFA discusses the various alternatives considered by the

Commission that would accomplish the stated objective, while minimizing

any significant adverse impact on small entities. In connection with

the proposed rule and rule amendments, the Commission considered the

following alternatives: (a) The establishment of differing compliance

or reporting requirements or timetables that take into account the

resources available to small entities; (b) the clarification,

consolidation, or simplification of compliance and reporting

requirements under the rule for small entities; (c) the use of

performance rather than design standards; and (d) an exemption from

coverage of the rule, or any part thereof, for small entities. The IRFA

notes that the proposed rule and rule amendments are not intended to

effect major substantive changes to the current treatment of repurchase

agreements and pre-refunded bonds, but would essentially codify a

number of no-action positions taken by the Commission staff. Because

the proposed rule and rule amendments are designed to clarify the

appropriate treatment of investments by funds in repurchase agreements

and pre-refunded bonds for various purposes of the Act, and to provide

investment flexibility for funds of all sizes, it would be inconsistent

with the purposes of the Regulatory Flexibility Act to propose to

exempt small entities from their coverage. Further clarification,

consolidation, or simplification of the proposals, or specification of

different compliance standards for small entities, would not be

appropriate, because the proposals set forth the minimum standards

consistent with investor protection. For the same reasons, the use of

performance standards would be inappropriate

propose to

exempt small entities from their coverage. Further clarification,

consolidation, or simplification of the proposals, or specification of

different compliance standards for small entities, would not be

appropriate, because the proposals set forth the minimum standards

consistent with investor protection. For the same reasons, the use of

performance standards would be inappropriate. Overall, it appears that

the proposed rule and rule amendments would not have an adverse effect

on small entities.

The IRFA states that the Commission encourages the solicitation of

comments with respect to any aspect of the IRFA. Comment is

specifically requested on the number of small entities that would be

affected by the proposed rule and rule amendments, and the likely

impact of the proposals on small entities. A copy of the IRFA may be

obtained by contacting Marilyn Mann, Securities and Exchange

Commission, 450 5th Street, N.W., Washington, D.C. 20549-0506.

V. Statutory Authority

The Commission is proposing new rule 5b-3, and is proposing

amendments to rule 2a-7 and to rule 12d3-1, pursuant to the authority

set forth in sections 6(c) and 38(a) of the Act [15 U.S.C. 80a-6(c) and

80a-37(a)].

List of Subjects in 17 CFR Part 270

Investment companies, Reporting and recordkeeping requirements,

Securities.

Text of Proposed Rule and Rule Amendments

For the reasons set out in the preamble, Title 17, Chapter II of

the Code of Federal Regulations is proposed to be amended as follows:

PART 270--RULES AND REGULATIONS, INVESTMENT COMPANY ACT OF 1940

1. The authority citation for part 270 continues to read, in part,

as follows:

Authority: 15 U.S.C. 80a-1 et seq., 80a-34(d), 80a-37, 80a-39

unless otherwise noted:

* * * * *

2. Section 270.2a-7 is amended by revising paragraphs (a)(5),

(a)(11), (a)(20) and (c)(4)(ii)(A) to read as follows:

Sec. 270.2a-7 Money market funds.

PART 270--RULES AND REGULATIONS, INVESTMENT COMPANY ACT OF 1940

1. The authority citation for part 270 continues to read, in part,

as follows:

Authority: 15 U.S.C. 80a-1 et seq., 80a-34(d), 80a-37, 80a-39

unless otherwise noted:

* * * * *

2. Section 270.2a-7 is amended by revising paragraphs (a)(5),

(a)(11), (a)(20) and (c)(4)(ii)(A) to read as follows:

Sec. 270.2a-7 Money market funds.

(a) Definitions. * * *

(5) Collateralized Fully means ``Collateralized Fully'' as defined

in Sec. 270.5b-3(c)(1).

* * * * *

(11) Event of Insolvency means ``Event of Insolvency'' as defined

in Sec. 270.5b-3(c)(2).

* * * * *

(20) Refunded Security means ``Refunded Security'' as defined in

Sec. 270.5b-3(c)(4).

* * * * *

(c) Share Price Calculations. * * *

(4) Portfolio Diversification. * * *

(ii) Issuer Diversification Calculations. * * *

(A) Repurchase Agreements. The Acquisition of a repurchase

agreement may be deemed to be an Acquisition of the underlying

securities, provided the obligation of the seller to repurchase the

securities from the money market fund is Collateralized Fully and the

fund's board of directors (or the person delegated by the board under

paragraph (e) of this section) has evaluated the seller's

creditworthiness.

* * * * *

3. Section 270.5b-3 is added to read as follows:

Sec. 270.5b-3 Acquisition of repurchase agreement or refunded security

treated as acquisition of underlying securities.

(a) Repurchase Agreements. For purposes of sections 5 and 12(d)(3)

of the Act (15 U.S.C. 80a-5, 80a-12(d)(3)), the acquisition of a

repurchase agreement may be deemed to be an acquisition of the

underlying securities, provided the obligation of the seller to

repurchase the securities from the investment company is Collateralized

Fully and the board of directors or its delegate has evaluated the

seller's creditworthiness.

purposes of sections 5 and 12(d)(3)

of the Act (15 U.S.C. 80a-5, 80a-12(d)(3)), the acquisition of a

repurchase agreement may be deemed to be an acquisition of the

underlying securities, provided the obligation of the seller to

repurchase the securities from the investment company is Collateralized

Fully and the board of directors or its delegate has evaluated the

seller's creditworthiness.

(b) Refunded Securities. For purposes of section 5 of the Act (15

U.S.C. 80a-5), the acquisition of a Refunded Security shall be deemed

to be an acquisition of the escrowed Government Securities.

(c) Definitions. As used in this section:

(1) Collateralized Fully in the case of a repurchase agreement

means that:

(i) The value of the securities collateralizing the repurchase

agreement (reduced by the transaction costs (including loss of

interest) that the investment company reasonably could expect to incur

if the seller defaults) is, and during the entire term of the

repurchase agreement remains, at least equal to the Resale Price

provided in the agreement;

(ii) The investment company has perfected its security interest in

the collateral;

(iii) The collateral is maintained with the investment company's

custodian or a third party that qualifies as a custodian under the Act;

(iv) The collateral consists entirely of cash items, Government

Securities or other securities that at the time the repurchase

agreement is entered into are rated in the highest rating category by

the Requisite NRSROs; and

(v) Upon an Event of Insolvency with respect to the seller, the

repurchase agreement would qualify under a provision of applicable

insolvency law providing an exclusion from any automatic stay of

creditors' rights against the seller.

(2) Event of Insolvency means, with respect to a person:

rchase

agreement is entered into are rated in the highest rating category by

the Requisite NRSROs; and

(v) Upon an Event of Insolvency with respect to the seller, the

repurchase agreement would qualify under a provision of applicable

insolvency law providing an exclusion from any automatic stay of

creditors' rights against the seller.

(2) Event of Insolvency means, with respect to a person:

(i) An admission of insolvency, the application by the person for

the appointment of a trustee, receiver, rehabilitator, or similar

officer for all or substantially all of its assets, a general

assignment for the benefit of creditors, the filing by the person of a

voluntary petition in bankruptcy or application for reorganization or

an arrangement with creditors; or

(ii) The institution of similar proceedings by another person which

proceedings are not contested by the person; or

(iii) The institution of similar proceedings by a government agency

responsible for regulating the activities of the person, whether or not

contested by the person.

(3) Government Security means any ``Government Security'' as

defined in section 2(a)(16) of the Act (15 U.S.C. 80a-2(a)(16)).

(4) Refunded Security means a debt security the principal and

interest payments of which are to be paid by Government Securities

(``deposited securities'') that have been irrevocably placed in an

escrow account pursuant to an agreement between the issuer of the debt

security and an escrow agent that is not an ``affiliated person,'' as

defined in section 2(a)(3)(C) of the Act (15 U.S.C. 80a-2(a)(3)(C)), of

the issuer of the debt security, and, in accordance with such escrow

agreement, are pledged only to the payment of the debt security and, to

the extent that excess proceeds are available after all payments of

principal, interest, and applicable premiums on the Refunded

Securities, the expenses of the escrow agent and, thereafter, to the

issuer or another party; provided that:

2(a)(3)(C)), of

the issuer of the debt security, and, in accordance with such escrow

agreement, are pledged only to the payment of the debt security and, to

the extent that excess proceeds are available after all payments of

principal, interest, and applicable premiums on the Refunded

Securities, the expenses of the escrow agent and, thereafter, to the

issuer or another party; provided that:

(i) The deposited securities shall not be redeemable prior to their

final maturity;

(ii) The escrow agreement shall prohibit the substitution of the

deposited securities unless the substituted securities are Government

Securities; and

(iii) At the time the deposited securities are placed in the escrow

account, or at the time a substitution of the deposited securities is

made, an independent certified public accountant shall have certified

to the escrow agent that the deposited securities will satisfy all

scheduled payments of principal, interest and applicable premiums on

the Refunded Securities; provided, however, an independent public

accountant need not have provided the certification described in this

paragraph (c)(4)(iii) if the security, as a Refunded Security, has

received a rating from an NRSRO in the highest category for debt

obligations (within which there may be sub-categories or gradations

indicating relative standing).

(5) NRSRO means any nationally recognized statistical rating

organization, as that term is used in paragraphs (c)(2)(vi)(E), (F) and

(H) of Sec. 240.15c3-1 of this chapter, that is not an ``affiliated

person,'' as defined in section 2(a)(3)(C) of the Act (15 U.S.C. 80a-

2(a)(3)(C)), of the issuer of, or any insurer or provider of credit

support for, the security.

(6) Requisite NRSROs means:

(5) NRSRO means any nationally recognized statistical rating

organization, as that term is used in paragraphs (c)(2)(vi)(E), (F) and

(H) of Sec. 240.15c3-1 of this chapter, that is not an ``affiliated

person,'' as defined in section 2(a)(3)(C) of the Act (15 U.S.C. 80a-

2(a)(3)(C)), of the issuer of, or any insurer or provider of credit

support for, the security.

(6) Requisite NRSROs means:

(i) Any two NRSROs that have issued a rating with respect to a

security or class of debt obligations of an issuer; or

(ii) If only one NRSRO has issued a rating with respect to such

security or class of debt obligations of an issuer at the time the

investment company acquires the security, that NRSRO.

(7) Resale Price means the acquisition price paid to the seller of

the securities plus the accrued resale premium on such acquisition

price. The accrued resale premium shall be the amount specified in the

repurchase agreement or the daily amortization of the difference

between the acquisition price and the resale price specified in the

repurchase agreement.

4. Section 270.12d3-1 is amended by removing the appended Note.

By the Commission.

Dated: September 23, 1999.

Margaret H. McFarland,

Deputy Secretary.

[FR Doc. 99-25253 Filed 9-28-99; 8:45 am]

BILLING CODE 8010-01-U