The staff of the SEC’s Division of Investment Management (the “Staff”) granted no-action relief permitting two registered investment companies, via separate requests for relief, to treat mortgage-backed securities (“MBS”) issued or guaranteed by U.S. federal agencies or government-related guarantors ("Government MBS") as being part of the same industry together with private mortgage-backed securities (“Private MBS”) for purposes of each company’s fundamental industry concentration policy (“Concentration Policy”) adopted in accordance with Section 8(b)(1) of the Investment Company Act of 1940, as amended (the “1940 Act”).
Concentration Policy Requirements
Section 8(b)(1) of the 1940 Act requires a registered fund to state in its registration statement whether it reserves the freedom to concentrate investments in a particular industry or group of industries. If such freedom is reserved, Section 8(b)(1) requires the fund to include in its registration statement a statement briefly indicating, in so far as practicable, the extent to which the fund intends to concentrate its investments, i.e., the fund must state its Concentration Policy. Section 13(a)(3) of the 1940 Act requires a fund to obtain shareholder approval to change its Concentration Policy.
Neither the 1940 Act nor the registration forms for open-end and closed-end funds specify how to define an “industry” for purposes of a fund’s Concentration Policy. Former Guide 19 to Form N-1A provides that a fund may select its own industry classification; however, such classification must be (1) reasonable and (2) should not be so broad that the primary economic characteristics of the companies in a single class are materially different.
Closed-End Fund Request for No-Action Relief
A new closed-end investment company in the process of registering under the 1940 Act (the “Closed-End Fund”) planned to invest 80% of its assets in fixed-income securities and proposed to implement a Concentration Policy to invest “at least 25% of its total assets in mortgage related securities,” including both Government MBS and Private MBS. The Closed-End Fund represented that it had included narrative disclosure accompanying its fundamental investment restrictions to clarify that notwithstanding its general policy of excluding securities of the U.S. Government and its agencies or instrumentalities when measuring industry concentration, Government MBS would not be excluded from "mortgage related securities" as such term is used in the Closed-End Fund’s Concentration Policy. In connection with the Staff’s review of the Closed-End Fund’s registration statement, the Staff requested that the Closed-End Fund revise its Concentration Policy to clarify whether the Closed-End Fund will invest at least 25% of its assets in Private MBS. The matter was ultimately referred to the Office of Chief Counsel for the Division of Investment Management. The Staff advised the Closed-End Fund that the Staff would not recommend enforcement action if the Closed-End Fund implemented the Concentration Policy, provided the Closed-End Fund promptly sought confirmation of its position in a formal written request.
Open-End Fund Request for No-Action Relief
An open-end investment company registered under the 1940 Act (the “Open-End Fund” and collectively with the Closed-End Fund, the “Funds”) that invests 80% of its assets in mortgage-related securities had a policy that restricted the Open-End Fund from investing “more than 25% of its total assets in the securities of issuers in a particular industry or group of industries other than obligations issued or guaranteed by the U.S. Government or its agencies or instrumentalities.” The effect of this policy was to limit the Open-End Fund’s ability to invest in Private MBS to less than 25% of the Open-End Fund’s assets. By classifying Government MBS and Private MBS as a single industry, the Open-End Fund's investment adviser, based on its analysis of economic conditions affecting the MBS in which the Fund invests, would have the flexibility to increase or decrease the Fund's exposure to Private MBS above or below 25% of the Fund's assets without violating the revised Concentration Policy. To secure this added flexibility, the Open-End Fund sought and obtained shareholder approval of a Concentration Policy to permit the Open-End Fund to invest more than 25% of its assets in mortgage-backed securities, including both Government MBS and Private MBS. The Open-End Fund then sought no-action relief from the Staff to treat Government MBS and Private MBS as being part of the same industry for purposes of its Concentration Policy.
In granting each request for relief, the Staff cited representations by the Closed-End Fund and Open-End Fund that Government MBS and Private MBS have similar economic and risk characteristics. In particular, the Staff noted that both types of instruments responded to similar developments affecting housing and real estate markets, and were subject to similar risks, including prepayment, extension, and interest rate risks. The Staff also reiterated its view that to satisfy the standard under Section 8(b)(1) for describing a fund’s Concentration Policy, “a fund must clearly and precisely describe, with as much specificity as is practicable, the circumstances under which the fund intends to concentrate its investments.” The Staff’s responses also acknowledged prior Staff guidance permitting a fund’s Concentration Policy to exclude securities issued by governments or political subdivisions of governments, and stated that in granting the relief the Staff did not intend to preclude a fund from excluding those securities from its Concentration Policy on the basis that those issuers are not members of any industry or group of industries.