The staff of the SEC’s Division of Investment Management (the “Staff”) provided no-action assurances to registered funds permitting them to invest in the Term-Asset Backed Securities Loan Facility (“TALF”) under certain conditions without treating the borrowing as a senior security and without requiring the program’s unique collateral arrangement to fully comply with the custody requirements under the Investment Company Act of 1940, as amended (the “1940 Act”). As more fully described in the December 2, 2008 Alert and the May 5, 2009 Alert, the TALF program was established by the Department of the Treasury and the Federal Reserve Board to increase the credit available in the markets by supporting the issuance of various types of asset-backed securities (“ABS”) through the provision of loans to ABS purchasers. Under the program, the Federal Reserve Bank of New York (“FRBNY”) provides non-recourse loans to eligible U.S. holders of certain AAA-rated ABS less a slight haircut (between 5 and 16% of the loan depending on the types of ABS purchased). The loans are secured at all times by the ABS, which are to be transferred to a participating “primary dealer” chosen by the purchaser and delivered at the loan closing to the Bank of New York Mellon (“BNY Mellon”) as administrator and custodian of the TALF program. The non-recourse nature of a loan means that, in the event that a purchaser does not repay a loan, the purchaser will incur no financial obligation beyond the loss of the collateral.
Senior Securities. The no-action relief was prompted by concerns that participation in the TALF program could raise issues for registered funds under Section 18 of the 1940 Act, which limits the extent to which registered open-end and closed-end funds may issue senior securities. Section 18(g), in part, defines a “senior security” as “any bond, debenture, note, or similar obligation or instrument constituting a security and evidencing indebtedness.” Under Section 18, open-end funds are generally prohibited from issuing senior securities, except for bank borrowings constituting one third or less of the fund’s net assets after the borrowing. Closed-end funds may issue senior securities in the form of equity or debt but are limited to one class of each and subject to asset coverage requirements that limit the amount of senior securities a fund may issue. The Staff has taken a broad view of what constitutes a senior security. The no-action relief addresses the concern that the TALF loans, as evidences of indebtedness, may be deemed senior securities subject to the restrictions of Section 18.
The request for relief cited the SEC’s position under which a fund engaging in a reverse repurchase agreement could address the Section 18 concerns raised by the arrangement if it “covered” its full obligations under the agreement by establishing and maintaining certain segregated accounts. The request reasoned that the arrangements for TALF loans were analogous to those for reverse repurchase agreements in that both would entail, in economic reality, loans to a fund secured by underlying securities. The request proposed to segregate liquid assets that would be marked-to-market daily to “cover” a fund’s obligation’s under the TALF loan in a manner akin to the way in which reverse repurchase agreements may be covered. The segregated amount would be in addition to the ABS collateral deposited with the primary dealer. Additional liquid assets would be added to the segregated assets whenever the segregated amount falls below the fund’s obligations under the TALF loan. Accordingly, a fund investing in the TALF program would have asset coverage of at least 200% at all times.
Custody. Section 17(f) of the 1940 Act and the rules thereunder specify the manner in which a fund’s assets must be custodied and includes differing requirements depending on whether the assets are held at a bank, broker-dealer or with the fund itself. Although pledged in connection with a TALF loan, a fund’s ABS collateral would continue to be fund holdings and thus subject to Section 17(f) custody requirements. Under the TALF program, a fund may only engage in transactions through a primary dealer with which it must initially deposit its eligible collateral. The request for relief was prompted by concerns that the manner in which a primary dealer held fund assets might not comply with Section 17(f) and the rules thereunder, e.g., a primary dealer that is a broker-dealer would likely find it impractical to physically separate a fund’s TALF collateral from the assets of other customers as required under Rule 17f-1.
Conditions. Without expressing any legal conclusions on the issues presented, the Staff acknowledged the intent of the TALF program and provided no-action assurances to any open-end or closed-end fund participating in the TALF program based on certain representations, including that: (1) the fund’s participation in the TALF program is governed by the TALF standing loan procedures (the “Procedures”) and master loan and security agreement executed by a primary dealer as agent to the fund with the FRBNY and BNY Mellon; (2) the borrowing by the fund will be collateralized solely by “eligible securities” as defined in the Procedures, the FRBNY can only enforce its rights against those “eligible securities” despite any changes in the value or ratings of such assets, and the TALF loan may be pre-paid at any time by the fund at no penalty; (3) the fund will segregate liquid assets in an amount equal to the fund’s obligations under the TALF loan, will not use the eligible securities collateral to meet such segregation requirements and will add additional liquid assets whenever the value of the segregated assets drops below the amount of the fund’s obligation under the TALF loan; and (4) the investment in the eligible securities and borrowing under the TALF program is consistent with the fund’s investment objective, policies and limitations as stated in its registration statement.