United States: SEC Comments On Legality Of Security Interest In Mutual Fund Assets

by Bibb L. Strench, Esquire

In a letter to the Federal Reserve Bank of Boston dated January 8, 1999, the SEC staff confirmed that a mutual fund would not violate Section 18(f) of the Investment Company Act of 1940 (the "1940 Act") if it pledged its assets to a bank as security for a loan extended by the bank. Section 18(f) of the 1940 Act prohibits an investment company from issuing any class of senior security with certain exceptions. Section 18(g) of the 1940 Act generally defines "senior security" to mean any security evidencing indebtedness and any stock of a class having priority over any other class as to distribution of assets or payment of dividends.

One exception to the Section 18(f) prohibition is a borrowing from a bank, which is permissible provided that the mutual fund has and maintains asset coverage of at least 300% for all borrowings. Another exception is a loan by a bank or other institution made for temporary purposes that does not exceed 5% of the value of the fund’s total assets. Loans repaid within 60 days are considered temporary.

The SEC’s letter was in response to a meeting between the SEC and the Federal Reserve Bank of Boston in 1998 and a letter sent by the Federal Reserve Bank seeking clarification on certain issues involving security interests that were discussed at that meeting. The Federal Reserve Bank’s letter noted that mutual funds typically engage in bank borrowings for two purposes: (1) to raise cash on a short-term basis to meet greater-than-expected redemption requests; and (2) to leverage the fund on a more long-term basis as part of an investment strategy. Short-term loans generally are unsecured. Banks making long-term loans to finance leverage strategies generally obtain a security interest in the fund’s assets to secure the loan. In theory, the security interest could be viewed as being a senior security issued by the fund to the lender subject to Section 18(f) since it will give the lender rights to fund assets that differ from the rights of fund shareholders.

It is common practice for a lending bank also to be the fund’s custodian. The Federal Reserve Bank raised the issue of whether a bank’s dual capacity as both a lender and custodian to a mutual fund might affect its security interest in the fund’s assets. The Federal Reserve Bank asserted that a bank’s dual role would not jeopardize the bank’s perfected security interest and, thus, the bank would have priority to fund assets over shareholders’ claims in the event that the fund was liquidated. Any conflicts of interest raised by the dual role could, in the Federal Reserve Bank’s view, be addressed in loan and security agreements between the bank and the fund.

The SEC did not directly respond to the Federal Reserve Bank’s conclusion that a custodian bank with a perfected security interest would have priority over shareholders in a fund liquidation. The SEC staff did, however, acknowledge that the SEC has not in the past objected to a bank taking a security interest in fund assets to secure a loan made to a fund. For example, Rule 17f-2(c) of the 1940 Act clearly contemplates bank security interests in fund assets. The SEC also apparently agreed with the Federal Reserve Bank’s statement that unsecured short-term loans for redemptions through loans or lines of credit do not raise any significant regulatory issues in the SEC’s view.

Bibb L. Strench is Of Counsel in the Securities and Investment Company Practice of the law firm of Stradley, Ronon, Stevens & Young, LLP. Mr. Strench resides in the firm’s Washington D.C. office.