[Federal Register Volume 61, Number 61 (Thursday, March 28, 1996)]
[Rules and Regulations]
[Pages 13956-13984]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 96-7334]



      

[[Page 13955]]

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Part IV





Securities and Exchange Commission





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17 CFR Part 230, et al.



Revisions to Rules Regulating Money Market Funds; Final Rule

  Federal Register / Vol. 61, No. 61 / Thursday, March 28, 1996 / Rules 
and Regulations  

[[Page 13956]]


SECURITIES AND EXCHANGE COMMISSION

17 CFR Parts 230, 239, 270, and 274

[Release Nos. 33-7275; IC-21837; S7-34-93]
RIN 3235-AE17


Revisions to Rules Regulating Money Market Funds

AGENCY: Securities and Exchange Commission.

ACTION: Final rule.

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SUMMARY: The Commission is adopting amendments to rules and forms under 
the Securities Act of 1933 and the Investment Company Act of 1940 that 
govern money market funds. The amendments tighten the risk-limiting 
conditions imposed on tax exempt money market funds by rule 2a-7 under 
the Investment Company Act of 1940; impose additional disclosure 
requirements on tax exempt funds; and make certain other changes 
applicable to all money market funds. The amendments are designed to 
reduce the likelihood that a tax exempt fund will not be able to 
maintain a stable net asset value.

EFFECTIVE DATE: June 3, 1996. Several different compliance dates apply 
to the amendments. For specific compliance dates for particular 
amendments, see Section V. of this Release.

FOR FURTHER INFORMATION CONTACT: Martha H. Platt, Senior Attorney, 
(202) 942-0725, or Kenneth J. Berman, Assistant Director, Office of 
Regulatory Policy, (202) 942-0690, Division of Investment Management, 
Securities and Exchange Commission, 450 Fifth Street, N.W., Washington, 
D.C. 20549. Requests for formal interpretive advice should be directed 
to the Office of Chief Counsel (202) 942-0659, Division of Investment 
Management, 450 Fifth Street, N.W., Washington, D.C. 20549.

SUPPLEMENTARY INFORMATION: The Securities and Exchange Commission 
(``Commission'') is adopting amendments to rule 2a-7 [17 CFR 270.2a-7] 
(``rule 2a-7'' or the ``rule'') under the Investment Company Act of 
1940 [15 U.S.C. 80a-1 et seq.] (``1940 Act''), the rule governing the 
operations of money market funds (``money funds'' or ``funds'').1 
The Commission is also adopting a new rule, rule 17a-9 under the 1940 
Act [17 CFR 270.17a-9], and amendments to the following rules and 
forms: rule 134 under the Securities Act of 1933 [17 CFR 230.134]; 
rules 2a41-1, 12d-3 and 31a-1 under the 1940 Act [17 CFR 270.2a-41-1, 
270.12d3-1, and 270.31a-1]; Form N-1A [17 CFR 239.15A and 274.11A]; 
Form N-3 [17 CFR 239.17a and 274.11b]; and Form N-SAR [17 CFR 274.101]. 
The Commission is also publishing three new or revised staff guides to 
Forms N-1A and N-3 that do not appear in the Code of Federal 
Regulations.

    \1\ Unless otherwise noted, all references to rule 2a-7, as 
amended, or any paragraph of the rule, will be to 17 CFR 270.2a-7 as 
amended by this Release.
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Table of Contents

Executive Summary

I. Background
II. Amendments to Rule 2a-7
    A. Preliminary Matters
    B. Portfolio Quality and Diversification
    1. Five Percent Diversification Test
    a. Application to Tax Exempt Funds
    b. Scope of the Diversification Standards
    2. Quality Limitations on Portfolio Securities
    a. Proposed Limitations for Single State Funds
    b. Application of the Second Tier Securities Tests to Conduit 
Securities
    c. Definition of the Term ``Conduit Security''
    C. Diversification and Quality Standards for Put Providers
    1. Put Diversification Standards
    a. Uniform Diversification Standards for Conditional and 
Unconditional Puts
    b. The Twenty-Five Percent Put Basket
    c. Issuer-Provided Demand Features
    d. Multiple Puts and Guarantees
    2. Quality Standards
    a. Rating Requirement for Demand Features
    b. Providers of Puts in Excess of Five Percent of Fund Assets
    c. Certain Unrated Securities
    3. Conditional Demand Features
    4. Other Issues Applicable to Put Providers
    a. Accrued Interest
    b. Notice of Substitution of Put Provider
    c. Liquidity Requirements for Money Funds and the Three Business 
Day Settlement Cycle
    5. Short-Term Ratings
    D. Other Diversification and Quality Standards
    1. Repurchase Agreements
    2. Pre-Refunded Bonds
    3. Diversification Safe Harbor
    4. Three-Day Safe Harbor
    E. Asset Backed Securities and Synthetic Securities
    1. Background
    2. Definitions
    3. Diversification Standards
    a. Diversification: General
    (1) Special Purpose Entity as Issuer
    (2) Looking through the Special Purpose Entity
    b. Diversification: First Loss Guarantees
    4. Quality Standards
    5. Maturity Standards
    F. Variable and Floating Rate Securities
    1. Maturity Determinations: Floating Rate Securities
    2. Maturity Determinations: Variable Rate Securities
    3. Adjustable Rate Government Securities
    4. Other Issues Concerning Adjustable Rate Securities
    a. Background
    b. Recordkeeping Requirement
    G. Other Amendments to Rule 2a-7
    1. U.S. Dollar Denominated Instruments
    2. Investment in Other Money Funds
    3. Board Approval and Reassessment of Certain Securities
    4. Recordkeeping
    5. Defaulted Securities
    6. Technical Amendments
III. Amendments to Disclosure Rules
    A. Single State Funds
    B. Disclosure Concerning Exposure to Put Providers
    C. Risk Disclosure in Certain Communications
IV. Exemptive Rule Governing Purchases of Certain Portfolio 
Securities By Affiliated Persons
V. Compliance Dates
    A. General Compliance Date
    B. Grandfathered Securities
    C. Disclosure and Reporting
VI. Regulatory Flexibility Analysis
VII. Statutory Authority
VIII. Text of Rule and Form Amendments

Executive Summary

    The Commission is adopting amendments to rule 2a-7 under the 1940 
Act, the rule that governs the operations of money funds. The primary 
purpose of the amendments is to tighten the risk-limiting conditions of 
the rule applicable to tax exempt money funds and thereby reduce the 
likelihood that a tax exempt fund will not be able to maintain a stable 
net asset value. The amendments also affect taxable money funds in 
certain respects. In addition, the Commission is adopting revisions to 
the prospectus disclosure requirements for tax exempt money funds and a 
new rule exempting certain transactions from the 1940 Act's limitations 
on affiliated transactions.
    In considering these amendments, the Commission has made changes 
from the proposal designed to simplify compliance with the rule while 
retaining the degree of flexibility necessary for money funds to 
operate in accordance with their investment objectives. A brief summary 
of the rule amendments is provided below.

Issuer Diversification and Quality Standards

    The amendments extend the rule's diversification requirements to 
tax exempt funds. A ``national'' tax exempt fund is limited to 
investing no more than five percent of its assets in securities of a 
single issuer (other than Government securities) (the ``Five Percent 
Diversification Test''). A ``single state'' tax exempt fund is subject 
to the same limitation but only with respect to seventy-five percent of 
its assets; the remaining twenty-five percent of a

[[Page 13957]]
single state fund's assets (``twenty-five percent basket'') may be 
invested in securities of one or more issuers, provided that they are 
``first tier securities,'' as the term is defined in the rule. A tax 
exempt fund is limited to investing five percent of its assets in 
``second tier securities'' that are ``conduit securities,'' as these 
terms are defined in the rule, with investment in the conduit 
securities of any one issuer limited to one percent of fund assets. To 
provide an additional element of flexibility, a security subject to an 
``unconditional demand feature issued by a non-controlled person,'' as 
defined in the rule, will be subject only to the rule's put 
diversification requirements.

Diversification and Quality Standards Applicable to Providers of Puts 
and Demand Features

    The amendments provide that a fund cannot, with respect to seventy-
five percent of its assets, invest more than ten percent of its assets 
in securities subject to puts from, or directly issued by, the same 
institution. The remaining twenty-five percent of a fund's assets 
(``twenty-five percent put basket'') may be subject to puts from, or 
directly issued by, one or more institutions, provided that the puts 
are first tier securities. A fund may not invest more than five percent 
of its assets in securities subject to puts that are second tier 
securities.
    As proposed, a demand feature is an ``eligible security'' (as 
defined in the rule) only if the demand feature (or its issuer) has 
received a short-term rating from a nationally recognized statistical 
rating organization (``NRSRO''). A conditional demand feature is an 
eligible security if the limitations on its exercise can be readily 
monitored by the fund's board of directors (or its delegate). The 
amendments as adopted, however, do not specify the conditions that may 
be included in a conditional demand feature.

Asset Backed Securities and ``Synthetic'' Securities

    The amendments clarify the credit quality, diversification and 
maturity determination standards applicable to synthetic and asset 
backed securities (``ABSs''). Among other things, an ABS must have a 
rating from a NRSRO to be eligible for fund investment.

Interest Rate Risk Analysis

    The amendments also clarify that floating rate and variable rate 
securities (``adjustable rate securities'') must reasonably be expected 
to have market values that approximate their amortized cost values on 
each interest rate adjustment date through their final maturity dates. 
The amendments require funds to review periodically whether such 
securities can reasonably be expected to have market values that 
approximate their amortized cost values upon readjustment of their 
interest rates.

Exemptive Rule

    The Commission is adopting rule 17a-9 under the 1940 Act to permit 
(but not require) an affiliate of a fund to purchase from the fund 
securities that are no longer eligible securities at the higher of 
their amortized cost values (including accrued interest) or market 
values, without having to obtain a Commission order.

I. Background

    Money funds are open-end management investment companies registered 
under the 1940 Act that have as their investment objective generation 
of income and preservation of capital and liquidity through investment 
in short-term, high quality securities. More than $775 billion in 
assets is currently invested in approximately 25 million money fund 
shareholder accounts.2 Approximately sixteen percent of money fund 
assets ($127 billion) are held by funds that have as their principal 
objective distribution of income exempt from federal income taxes 
(``tax exempt funds'').3 Approximately one third of the assets 
held by tax exempt funds ($43 billion) are held by funds that seek to 
distribute income that is also exempt from the income taxes of a 
specific state or locality (``single state funds'').4 The balance 
is held by funds that do not limit their investments to securities 
exempt from the income taxes of a specific state (``national funds'').

    \2\ IBC's Money Fund Report at 2, Dec. 29, 1995 (``Money Fund 
Report''); Investment Company Institute Mutual Fund Fact Book at 58-
59 (35th ed. 1995). For a summary of the development of money funds, 
which were first introduced in the early 1970s, see Investment 
Company Act Rel. No. 17589 (July 17, 1990) [55 FR 30239 (July 25, 
1990)] (``Release 17589'') at nn.3-7 and 15-18 and accompanying 
text.
    \3\ Money Fund Report, supra note 2, at 2.
    \4\ Single state funds are currently available for sixteen 
states: Alabama, Arizona, California, Connecticut, Florida, 
Massachusetts, Michigan, Minnesota, Missouri, New Jersey, New York, 
North Carolina, Ohio, Pennsylvania, Texas and Virginia. Id.
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    Unlike other investment companies, money funds seek to maintain a 
stable share price, typically $1.00 per share. This stable share price 
of $1.00 has encouraged investors to view investments in money funds as 
an alternative to either bank deposits or checking accounts, even 
though money funds lack federal deposit insurance, and there is no 
guarantee that money funds will maintain a stable share price.5

    \5\ A money fund is required to disclose prominently on the 
cover page of its prospectus that: (1) the shares of the fund are 
neither insured nor guaranteed by the U.S. Government; and (2) there 
can be no assurance that the fund will be able to maintain a stable 
net asset value of $1.00 per share. See, e.g., Item 1(vi) of Form N-
1A. The prescribed legend must appear in money fund sales literature 
and advertisements as well. See paragraph (a) of rule 34b-1 under 
the 1940 Act, and paragraph (a)(7) of rule 482 under the Securities 
Act of 1933 (``1933 Act'').
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    To maintain a stable share price, most money funds use the 
amortized cost method of valuation (``amortized cost method'') 6 
or the penny-rounding method of pricing (``penny-rounding method'') 
7 permitted by rule 2a-7. The 1940 Act and applicable rules 
generally require investment companies to calculate current net asset 
value per share by valuing portfolio instruments at market value or, if 
market quotations are not readily available, at fair value as 
determined in good faith by, or under the direction of, the board of 
directors.8 Rule 2a-7 exempts money funds from these provisions, 
but contains conditions designed to minimize the deviation between a 
fund's stabilized share price and the market value of its 
portfolio.9 If the deviation does become significant, the fund may 
be required to take certain steps to address the

[[Page 13958]]
deviation, including selling and redeeming its shares at less than 
$1.00 (``breaking a dollar'').10

    \6\ Under the amortized cost method, portfolio securities are 
valued by reference to their acquisition cost as adjusted for 
amortization of premium or accretion of discount. Paragraph (a)(1) 
of rule 2a-7, as amended.
    \7\ Share price is determined under the penny-rounding method by 
valuing securities at market value, fair value or amortized cost and 
rounding the per share net asset value to the nearest cent on a 
share value of a dollar, as opposed to the nearest one tenth of one 
cent. Paragraph (a)(15) of rule 2a-7, as amended. See also 
Investment Company Act Rel. No. 13380 (July 11, 1983) [48 FR 32555 
(July 18, 1983)] (``Release 13380'') (adopting rule 2a-7) at n.6, 
and Investment Company Act Rel. No. 12206 (Feb. 1, 1982) [47 FR 5428 
(Feb. 5, 1982)] (``Release 12206'') (proposing rule 2a-7) at n.5.
    \8\ See section 2(a)(41) of the 1940 Act [15 U.S.C. 80a-
2(a)(41)], together with rules 2a-4 and 22c-1 [17 CFR 270.2a-4 and 
270-22c-1]. See also Accounting Series Release No. 118 (Dec. 23, 
1970 [35 FR 19986 (Dec. 31, 1970)] (board may appoint persons to 
assist in determination of securities' values).
    \9\ If shares are sold or redeemed based on a net asset value 
which has been either understated or overstated in comparison to the 
amount at which portfolio instruments could have been sold, the 
interests of either existing shareholders or new investors will be 
diluted. See Investment Trusts and Investment Companies: Hearings on 
S. 3580 Before a Subcomm. of the Sen. Comm. on Banking and Commerce, 
76th Cong., 3d Sess. 136-138, 288 (1940), Report of the Staff of the 
Division of Investment Management of the Securities and Exchange 
Commission on the Regulation of Money Market Funds Before the 
Subcommittee on Financial Institutions of the Senate Committee on 
Banking, Housing, and Urban Affairs at 9 (Jan. 24, 1980), and 
Release 17589, supra note 2, at n.7.
    \10\ Paragraphs (c)(6) and (c)(7) of rule 2a-7, as amended.
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    In February 1991, the Commission amended rule 2a-7 (the ``1991 
Amendments'') 11 to respond to developments in the commercial 
paper market since the rule was adopted in 1983.12 Among other 
things, the 1991 Amendments permit funds to invest only in ``eligible 
securities,'' defined generally as securities that are rated in one of 
the highest two short-term rating categories by the ``requisite 
NRSROs,'' 13 or comparable unrated securities. Taxable funds must 
further limit their investments in the securities of any one issuer 
(other than Government securities) 14 to five percent of fund 
assets (``Five Percent Diversification Test''),15 and limit fund 
investment in second tier securities 16 to no more than five 
percent of fund assets, with investment in the second tier securities 
of any one issuer being limited to the greater of one percent of fund 
assets or one million dollars (``Second Tier Securities 
Tests'').17

    \11\ Investment Company Act Rel. No. 18005 (Feb. 20, 1991) [56 
FR 8113 (Feb. 27, 1991)] (``Release 18005''). The 1991 Amendments 
were proposed in Release 17589, supra note 2, and became effective 
on June 1, 1991.
    \12\ Before the 1991 Amendments, rule 2a-7 permitted funds to 
invest in ``high quality'' securities, that is, securities that had 
received at least the second highest rating from one NRSRO. See 
Release 13380, supra note 7, at n.34. In the summer of 1989 and the 
spring of 1990, several taxable funds held approximately $125 
million in defaulted commercial paper issued by Mortgage and Realty 
Trust or Integrated Resources Inc.; in the fall of 1990 several 
funds held commercial paper issued by MNC Financial Corp. that was 
downgraded to below high quality, resulting in a significant decline 
in its market price. In all three cases, the commercial paper had 
the second highest rating from one NRSRO when purchased by the funds 
and thus was eligible for fund investment under rule 2a-7 as then in 
effect. Shareholders of funds that held these commercial paper 
issues were not adversely affected, however, because each fund's 
investment adviser purchased the paper from the funds at amortized 
cost or principal amount or otherwise agreed to indemnify the fund. 
See Release 17589, supra note 2, at n.18 and accompanying text.
    \13\ ''Requisite NRSROs'' are defined as: (1) any two NRSROs 
that have issued a rating with respect to an instrument or class of 
debt obligations of an issuer, or (2) if only one NRSRO has issued a 
rating with respect to such instrument or issuer at the time the 
fund purchases or rolls over the security, that NRSRO. Paragraph 
(a)(19) of rule 2a-7, as amended.
    The term ``NRSRO'' is defined in paragraph (a)(14) of rule 2a-7 
to have the same meaning as in the Commission's uniform net capital 
rule [17 CFR 240.15c3-1(c)(2)(vi)(E), (F) and (H)]. The Commission's 
Division of Market Regulation responds to requests for NRSRO 
designation through no-action letters. Currently, the Division of 
Market Regulation has designated six NRSROs: Duff and Phelps, Inc., 
Fitch Investors Services, Inc., Moody's Investors Service Inc., 
Standard & Poor's Corp., and two specialized NRSRO's: IBCA Limited 
and its subsidiary, IBCA Inc., which is recognized as a NRSRO only 
with respect to its ratings of debt issued by banks, bank holding 
companies, United Kingdom building societies, broker-dealers and 
broker-dealers' parent companies, and bank-supported debt, and 
Thomson BankWatch, Inc., which is recognized as a NRSRO only with 
respect to ratings for debt issued by banks, bank holding companies, 
non-bank banks, thrifts, broker-dealers, and broker-dealers' parent 
companies. In recognition of the expanded use of credit ratings in 
Commission rules, the Commission solicited comment on the process 
employed to designate rating agencies as NRSROs and the nature of 
the Commission's oversight role with respect to NRSROs in a concept 
release issued in 1994. Exchange Act Rel. No. 34616 (Aug. 31, 1994) 
[59 FR 46314 (Sept. 7, 1994)].
    \14\ Under paragraph (a)(13) of rule 2a-7, as amended, the term 
``Government Security'' means those securities issued or guaranteed 
by the United States or its instrumentalities--the definition of 
that term given in section 2(a)(16) of the 1940 Act [15 U.S.C. 80a-
2(a)(16)]. It does not include securities issued or guaranteed by 
the state governments or instrumentalities. For a discussion of 
securities issued by government-sponsored enterprises (``GSEs''), 
see Joint Report on the Government Securities Market (Jan. 1992) at 
p. D-1.
    \15\ Paragraph (c)(4)(i) of rule 2a-7, as amended. A limited 
exception is provided for certain securities held for not more than 
three business days. See infra Section II.D.4. of this Release.
    \16\ A ``second tier security'' is an eligible security that is 
not a ``first tier security.'' Paragraph (a)(20) of rule 2a-7, as 
amended. A first tier security is generally a security that is rated 
by the requisite NRSROs in the highest rating category for short-
term debt obligations, and comparable unrated securities. Paragraph 
(a)(11) of rule 2a-7, as amended.
    \17\ Paragraph (c)(4)(iv)(A) of rule 2a-7, as amended. The 1991 
Amendments also shortened the maximum dollar-weighted portfolio 
maturity that a fund may maintain from 120 to ninety days, and 
codified the actions that a fund must take when certain events 
occur, including defaults and rating downgrades. See paragraphs 
(c)(2) and (c)(5) of rule 2a-7, as amended. The 1991 Amendments also 
require that the cover page of fund prospectuses and certain fund 
advertisements and sales literature state prominently that 
investment in a fund is not guaranteed or insured by the U.S. 
Government and that there can be no assurance that a fund can 
maintain a stable net asset value per share. See Form N-1A, item 
1(a)(vi); Form N-3, item 1(a)(ix); rule 482(a)(7) under the 1933 Act 
[17 CFR 230.482(a)(7)]; and rule 34b-1 under the 1940 Act [17 CFR 
270.34b-1].
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    The 1991 Amendments did not apply the Five Percent Diversification 
Test and the Second Tier Securities Tests to tax exempt funds.18 
At that time, the Commission concluded that most tax exempt funds could 
not satisfy these tests without substantially restructuring their 
portfolios and, perhaps, losing some of their tax advantages.19 
Single state funds were thought to present particular problems because 
they concentrate their investments in debt securities issued by a 
single state (or issuers located within that state), making 
diversification more difficult to achieve. After the adoption of the 
1991 Amendments, the Commission closely examined the characteristics of 
short-term tax exempt securities, the markets in which they trade, and 
tax exempt fund portfolios to determine what, if any, revisions to rule 
2a-7 should be proposed to provide tax exempt fund investors with 
protections similar to those afforded taxable fund investors by the 
1991 Amendments.

    \18\ Tax exempt funds continue to be subject to a 
diversification test with respect to puts, as they had been prior to 
the adoption of the 1991 Amendments. Paragraphs (c)(4)(v) and 
(c)(4)(vi)(B) of rule 2a-7, as amended.
    \19\ Release 17589, supra note 2, at Section II.6.
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    The results of the Commission's examination of the tax exempt 
markets were reflected in amendments to rule 2a-7 that were proposed 
for comment on December 17, 1993 (``Proposing Release'').20 A 
primary objective of the proposed amendments was to tighten the 
diversification and portfolio quality standards applicable to tax 
exempt funds to make them more similar to the standards applicable to 
taxable funds. The proposed diversification and quality standards for 
tax exempt funds took into account the different investment objectives 
and portfolio compositions of national funds and single state funds, 
and would have established different requirements for each type of tax 
exempt fund.

    \20\ Investment Company Act Rel. No. 19959 (Dec. 17, 1993) [58 
FR 68585 (Dec. 28, 1993)] at Section I.A.
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    The Commission received comments on the proposed amendments from 
seventy-one commenters, including twelve municipal issuers, twenty-two 
mutual fund complexes, and nine professional and trade 
associations.21 The comment letters reflect a wide variety of 
views on almost every topic discussed in the Proposing Release. A 
number of commenters, expressing a general concern over the complexity 
of the rule, urged that the rule's diversification and quality 
standards for taxable and tax exempt funds be as consistent with each 
other as practicable so that the rule would not become too complicated.

    \21\ The comment period for the Proposing Release was extended 
from April 6, 1994 to May 6, 1994. See Investment Company Act Rel. 
No. 20184 (Mar. 31, 1994) [59 FR 16576 (Apr. 7, 1994)]. The comment 
letters and a summary of the comments prepared by the Commission 
staff are included in File No. S7-34-93.
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    As part of its evaluation of the proposal, the Commission 
considered recent events in the markets for municipal securities that 
had a significant effect on money funds. One such event was the 
bankruptcy of Orange County, California, a large municipal issuer of 
short-term taxable and tax exempt notes.22 At the time of

[[Page 13959]]
Orange County's bankruptcy, a number of taxable and tax exempt funds 
held notes issued by either Orange County or municipalities that 
invested in investment pools managed by the Orange County treasurer 
(``Orange County notes''). While no fund holding Orange County notes 
has broken a dollar to date (in large part because of actions taken by 
their advisers to support the funds' share prices) the Orange County 
bankruptcy reinforced the need to amend rule 2a-7 to address issues 
unique to tax exempt funds.23

    \22\ On December 6, 1994, Orange County and investment pools 
managed by the Orange County treasurer (``Orange County Pools'') 
filed for protection under chapter 9 of the Federal Bankruptcy Code 
[11 U.S.C. 901 et seq.]. The U.S. Bankruptcy Court for the Central 
District of California subsequently determined that the Orange 
County Investment Pools were not eligible to seek protection under 
chapter 9. See ``Orange County, Mired in Investment Mess, Files for 
Bankruptcy,'' Wall St. J., Dec. 7, 1994 at A1, A6; Michael Utley, 
``Judge Rules Pool's Bankruptcy Filing Invalid, But Impact is Mostly 
Academic,'' Bond Buyer, May 26, 1995 at 1, 36.
    \23\ The Division of Investment Management addressed analogous 
issues raised by the Orange County bankruptcy in July 1991, when New 
Jersey regulators seized Mutual Benefit Life Insurance Company 
(``MBLI''). A number of securities held by tax exempt funds were 
subject to demand features provided by MBLI. After its seizure by 
the New Jersey insurance regulators, MBLI could no longer honor its 
obligations under the terms of the demand features it provided. 
Advisers to funds holding MBLI-backed securities took various 
actions to prevent shareholder losses that would have occurred had 
the funds been required to break a dollar. The advisers either 
repurchased the MBLI-backed instruments from the funds at their 
amortized cost or obtained a replacement guarantor.
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II. Amendments to Rule 2a-7

A. Preliminary Matters

    The Commission is today adopting the second of two sets of 
amendments to rule 2a-7 under the 1940 Act designed to tighten the 
risk-limiting conditions of the rule. These amendments primarily deal 
with tax exempt funds; they are intended to provide investors in tax 
exempt money market funds with protections similar to those provided to 
investors in taxable funds by the 1991 Amendments. The Commission 
believes that these amendments are necessary to provide greater 
assurance that tax exempt money market funds meet investors' 
expectations for safety and convenience by reducing the likelihood that 
these funds will not be able to maintain a stable net asset value using 
pricing procedures permitted by rule 2a-7.
    The amendments to rule 2a-7 adopted in 1991, while not insulating 
funds from all events that could threaten their net asset values, 
appear to have reduced the riskiness of money market funds at a modest 
cost to money fund investors in terms of reduced yield.24 The 
Commission acknowledges that none of its rules can eliminate completely 
the risk that a money market fund will break a dollar as a result of a 
decrease in value of one or more of its portfolio securities. Thus, in 
adopting these amendments, the Commission is prescribing minimum 
standards designed not to ensure that a fund will not break a dollar, 
but rather to require the management of funds in a manner consistent 
with the investment objective of maintaining a stable net asset value.

    \24\ See ``Has the SEC Reduced the Riskiness of Money Market 
Funds? An Assessment of the Recent Changes to Rule 2a-7,'' S. 
Collins and P. Mack (Nov. 1993)(study by economists for the Board of 
Governors of the Federal Reserve System of money fund data indicated 
decrease in risk and 20 basis point reduction in yields due to 1991 
Amendments).
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    A money fund's board of directors has oversight responsibility for 
the sound management of the fund.25 The fund's adviser is 
typically delegated responsibility for selecting appropriate 
investments for the fund. Rule 2a-7 requires that fund investments 
should be made in accordance with procedures ``reasonably designed'' to 
maintain a stable net asset value or share price.26 In addition, 
investments made in accordance with such procedures should be 
consistent with maintaining a stable net asset value or share price. 
Rule 2a-7 provides an analytical framework for fund advisers to follow 
when making such investment decisions, including decisions regarding 
new types of securities not specifically addressed by the rule, 
Commission releases, or staff interpretive letters. As the Commission 
stated in 1991, that a particular security is technically eligible for 
fund investment under rule 2a-7 is not itself an adequate basis for an 
investment in the security.27 For example, a number of money funds 
recently invested in certain structured notes that were Government 
securities on the asserted belief that the provisions of rule 2a-7 
dealing with adjustable rate Government securities would permit such an 
investment. When short-term interest rates increased in early 1994, the 
values of these securities decreased and many became illiquid.28 
These and other types of losses are more likely to be avoided if a fund 
has in place, and operates in accordance with, procedures designed to 
determine whether investment in the security is consistent not only 
with the technical requirements of rule 2a-7, but with the rule's 
analytical framework and with the fund's investment objective of 
maintaining a stable net asset value.

    \25\ See Investment Company Act Rel. No. 13380, supra note 7, at 
nn. 40-42 and accompanying text.
    \26\ Paragraphs (c)(6)(i) and (c)(7) of rule 2a-7, as amended.
    \27\ Release 18005, supra note 11, at Section II.A.
    \28\ See infra Section II.F.4.a. of this Release.
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    In preparing these rules for adoption, the Commission has weighed 
carefully the need to provide a similar level of safety for investors 
in tax exempt and taxable money funds and the need, frequently 
expressed by fund commenters, to allow tax exempt funds sufficient 
flexibility to cope with a limited supply of high quality municipal 
securities. For example, while the amendments adopted today limit all 
funds to investing not more than five percent of assets in the 
securities of any one issuer, the amendments limit the application of 
this standard to only seventy-five percent of single state fund assets 
and exclude from the diversification requirements for all funds 
securities subject to certain types of demand features, refunding 
agreements, and issuer-provided puts.29

    \29\ See infra Sections II.B.1.b., II.C.1.c. and II.D.2. of this 
Release, and paragraphs (c)(4) (i) and (ii), (c)(4)(vi)(A)(2) and 
(c)(4)(vi)(B)(1) of rule 2a-7, as amended.
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    In response to comment letters, the Commission has simplified the 
operation of the rule in several respects. Where possible, the same 
provisions are applied to all types of funds, separate diversification 
tests for issuers of conditional and unconditional puts have been 
eliminated, and fund board involvement is no longer required regarding 
matters with which directors can be expected to have little expertise. 
Wherever possible, headings and cross-references have been added to the 
rule to assist a reader in understanding how its provisions 
interrelate.

B. Portfolio Quality and Diversification

1. Five Percent Diversification Test
    a. Application to Tax Exempt Funds. As discussed above, taxable 
funds are subject to the Five Percent Diversification Test, that is, no 
more than five percent of the total assets of a taxable money fund may 
be invested in securities of a single issuer. In proposing to extend 
diversification standards to tax exempt funds, the Commission took into 
account the differences between national and single state funds. Most 
national funds elect to meet the diversification requirements of 
section 5(b)(1) of the 1940 Act,30 and

[[Page 13960]]
choose not to use the ``twenty-five percent basket'' (the portion of a 
diversified fund's assets that is not required to be diversified) to 
invest more than five percent of their assets in a single issuer. Most 
commenters, including most mutual fund commenters, supported the 
extension of the Five Percent Diversification Test to national funds, 
which the Commission is adopting as proposed.31

    \30\ Section 5(b)(1) provides that a diversified investment 
company may not, with respect to seventy-five percent of its assets, 
invest more than five percent of its assets in instruments of any 
one issuer, other than cash, cash items, Government securities (as 
defined in section 2(a)(16) of the 1940 Act [15 U.S.C. 80a-
2(a)(16)]) and securities of other investment companies. The 
remaining twenty-five percent of its assets (the ``twenty-five 
percent basket'') may be invested in any manner. If an investment 
company invests more than five percent of its assets in a single 
issuer, the entire investment is placed in the twenty-five percent 
basket, and then aggregated with other investments that are greater 
than five percent to determine whether the fund is in compliance 
with section 5(b)(1). The investment company may not invest more 
than twenty-five percent of its assets in a single issuer by 
splitting its investment into two lots between the twenty-five 
percent basket and the diversified portion of its portfolio. See 
Lybrand, Ross Bros. & Montgomery (Oct. 24, 1941) (pub. avail. Nov. 
22, 1991). Section 5(b)(1) also prohibits a diversified fund, with 
respect to seventy-five percent of its assets, from investing in 
securities that comprise more than ten percent of the outstanding 
voting securities of an issuer.
    \31\ Paragraph (c)(4)(i) of rule 2a-7, as amended.
---------------------------------------------------------------------------

    Unlike national funds, many single state funds are not diversified 
under section 5(b)(1), and could not satisfy the Five Percent 
Diversification Test because their investment objectives provide them 
with a much narrower range of high quality investment 
alternatives.32 Although the Commission expressed concern about 
the risks involved in a non-diversified portfolio of a money fund, it 
was unclear to the Commission that it would be possible for single 
state funds to satisfy the Five Percent Diversification Test. 
Accordingly, the proposed amendments would not have required single 
state funds to comply with any issuer diversification test under the 
rule. To reduce the risks associated with a non-diversified portfolio, 
the Commission proposed to limit single state funds to investing in 
first tier securities, and proposed additional disclosure requirements 
to inform investors of the risks of an undiversified single state 
fund.33 The Commission also asked commenters to consider whether 
single state funds should be required to satisfy a diversification 
standard under the rule.34

    \32\ Proposing Release, supra note 20, at Sections II.A. and 
II.A.2.
    \33\ Proposed amendments to Form N-1A would have required a 
single state fund to disclose in its prospectus risks related to 
lack of diversification. Proposing Release, supra note 20, at 
Section III.A.
    \34\ Proposing Release, supra note 20, at Section II.A.2.
---------------------------------------------------------------------------

    Most commenters supported the exception from the Five Percent 
Diversification Test for single state funds. Many of these commenters, 
however, opposed the proposed first tier securities restriction, and 
asserted that this requirement would exacerbate the supply problem 
without making funds more safe by forcing single state funds to be less 
diversified. Other commenters maintained that the rule should mandate 
some diversification with respect to single state funds, which they 
asserted present greater risks than other types of money funds. One 
commenter suggested that single state funds offering securities from 
``large'' states should be subject to the same diversification 
standards as national funds. Another commenter went even further, 
stating that the rule should impose the diversification standards 
applicable to national funds to all single state funds. The views of 
these commenters, as well as the Commission's experience in 
administering rule 2a-7 since the amendments were proposed, have led 
the Commission to reconsider its proposal to exempt single state funds 
entirely from a diversification test.
    In proposing the 1991 Amendments, the Commission noted that a 
fund's ability to maintain a stable net asset value under the rule may 
be impaired to the extent it invests heavily in one or more issuers 
that subsequently experience credit problems or default on their 
securities.35 The validity of that observation has been proven by 
many of the incidents of the past two years in which advisers to funds 
have taken steps to prevent the fund from breaking a dollar as a result 
of holding a distressed security.36 In each case, the smaller the 
position, the less of an effect the distressed security had on the 
fund.

    \35\ Release 17589, supra note 2, at Section II.1.
    \36\ Transactions of this type occurred within the last two 
years because funds held either long-term adjustable rate securities 
whose market values declined when short-term interest rates were 
increased, or notes issued by Orange County. Twenty-five advisers or 
related persons purchased adjustable rate securities from their 
funds at the securities' amortized cost values to avoid any fund 
shareholder losses. Thirty-eight advisers or related persons either 
purchased Orange County notes from, or entered into credit support 
arrangements with their affiliated funds in order to maintain the 
funds' stable share price of $1.00. These transactions are 
prohibited by section 17 of the 1940 Act [15 U.S.C. 80a-17] in the 
absence of a Commission exemption. See infra Section IV. of this 
Release.
---------------------------------------------------------------------------

    In the case of the bankruptcy of Orange County, most of the funds 
holding the notes held a fairly small portion of their assets in Orange 
County notes.37 As a result, in some cases, the fund could 
maintain its share price without any assistance from the fund's 
adviser; in other cases, the adviser was in a position to take steps to 
prevent the fund from breaking a dollar only because the fund's Orange 
County Note position was relatively small. While, as the Commission has 
stated several times, no adviser is required to guarantee its fund 
against the possibility of breaking a dollar,38 experience has 
demonstrated that diversification may not only limit investment risk, 
but also may place the fund in a better position to address (or avoid) 
significant deviation between a fund's market-based and amortized cost 
values.

    \37\ The thirty-eight funds that sought and were granted ``no-
action'' relief from the Division of Investment Management either to 
sell the Orange County notes to affiliated persons, or to arrange 
for affiliated persons to provide some type of credit support for 
the benefit of the funds, are illustrative. Most of these funds had 
no more than five percent of their assets invested in notes issued 
by Orange County, or one of the participants in the Orange County 
Investment Pools. Within this group, the fund (a single state fund) 
that had the greatest concentration of its assets in securities 
issued by a single issuer had 8.7 percent of its assets invested in 
that issuer.
    \38\ See, e.g., Release 18005, supra note 11, at Section II.H.; 
Testimony of Arthur Levitt, Chairman, U.S. Securities and Exchange 
Commission, Concerning Issues Affecting the Mutual Fund Industry 
Before the Subcommittee on Telecommunications and Finance, Committee 
on Energy and Commerce, U.S. House of Representatives, 23-25 (Sept. 
27, 1994); Testimony of Arthur Levitt, Chairman, U.S. Securities and 
Exchange Commission, Concerning Municipal Bond and Government 
Securities Markets Before the Committee on Banking, Housing and 
Urban Affairs, U.S. Senate, 10-11 (Jan. 5, 1995).
---------------------------------------------------------------------------

    The Commission recognizes that single state funds face a limited 
choice of very high quality issuers in which to invest, and that the 
number of first tier issuers in several states is especially limited. 
Application of the Five Percent Diversification Test to one hundred 
percent of the assets of these funds could force some funds to invest 
in lower quality issuers than those in which they would otherwise 
invest. While greater diversification provides an additional measure of 
safety for investors where there are many issuers to choose from, the 
Commission is concerned that too stringent a diversification standard 
could result in a net reduction in safety for certain single state 
funds. As a result, the Commission has decided to require single state 
funds to be diversified at the five percent level only as to seventy-
five percent of their assets; the remaining twenty-five percent basket 
may be invested only in the first tier securities of one or more 
issuers. The availability of the twenty-five percent basket will 
provide single state funds with the flexibility to retain several 
positions of over five percent in very high quality investments.39

    \39\ Application of the non-diversified basket will track the 
comparable provision of section 5(b)(1) of the 1940 Act [15 U.S.C. 
80a-5(b)(1)]. See supra note 30.
---------------------------------------------------------------------------

    The Commission has decided to exclude from the application of the

[[Page 13961]]
diversification requirement securities that are subject to an 
unconditional demand feature from a non-controlled person, as defined 
in the rule.40 This approach will be applicable to all money 
funds, not only single state funds. The Commission believes that this 
approach, described in more detail below, will provide the advantages 
of diversification while permitting funds sufficient flexibility to 
respond to the available supply of eligible securities.

    \40\ Paragraphs (c)(4)(i) and (ii) of rule 2a-7, as amended.
---------------------------------------------------------------------------

    b. Scope of the Diversification Standards. A large percentage 
(sixty to seventy percent) of the securities currently held in tax 
exempt fund portfolios consist of long-term adjustable rate securities 
that are subject to unconditional demand features.41 The provider 
of an unconditional demand feature assumes the credit risks presented 
by a particular issuer by agreeing to provide principal and interest 
payments in the event the issuer of the underlying security is unable 
to do so. Funds generally rely on the credit quality of the issuer of 
an unconditional demand feature to satisfy the rule's quality 
standards.42 In light of this reliance, two commenters questioned 
the necessity of requiring a fund to satisfy the rule's issuer 
diversification and quality standards with respect to the issuer of the 
underlying security.43

    \41\ Proposing Release, supra note 20, at Section I.B.
    \42\ Paragraph (c)(3)(ii) of rule 2a-7, as amended, permits a 
fund to rely on the credit quality of the unconditional demand 
feature in determining whether the underlying security is an 
eligible security or a first tier security.
    \43\ The commenters discussed this issue within the context of 
the rule's put diversification standards. See infra Section II.C.2. 
of this Release.
---------------------------------------------------------------------------

    If a security subject to an unconditional demand feature was in 
default or otherwise became distressed, a money fund normally would be 
expected to exercise the demand feature and receive the entire 
principal amount of the security and any interest payments due or 
accrued.44 Thus, lack of diversification in the underlying 
security may be less important to a money fund's ability to maintain a 
stable net asset value than the ability to exercise the demand feature. 
Demand features are subject to a separate diversification requirement 
under the rule and, thus, excessive reliance on the credit of a single 
issuer is already addressed by the rule.45

    \44\ Paragraph (c)(5)(ii) of rule 2a-7, as amended, requires a 
money fund to dispose of a defaulted or distressed security (e.g., 
one that no longer presents minimal credit risks) ``as soon as 
practicable,'' absent a finding by the board of directors that 
disposal would not be in the best interests of the fund.
    \45\ Demand features and other types of puts that enhance 
underlying securities continue to be subject to the rule's put 
diversification requirements. See infra Section II.C.1. of this 
Release.
---------------------------------------------------------------------------

    Based on these considerations, and in light of the greater 
flexibility that would be afforded to single state funds, the 
Commission has decided to amend the rule so that the issuer 
diversification requirement--for all money funds--excludes securities 
subject to an ``unconditional demand feature issued by a non-controlled 
person,'' as defined in the rule.46 The Commission is limiting 
this exclusion to securities whose unconditional demand features are 
issued by non-controlled persons to reduce a fund's exposure to the 
credit risks presented by a single economic enterprise.47 
Securities subject to other types of puts, including conditional demand 
features, would continue to be subject to the rule's issuer 
diversification standard.

    \46\ An ``unconditional demand feature issued by a non-
controlled person'' is defined in the rule to mean an 
``unconditional put'' that is also a ``demand feature issued by a 
non-controlled person.'' Paragraph (a)(26) of rule 2a-7, as amended. 
A ``demand feature issued by a non-controlled person'' is defined to 
mean ``a demand feature issued by a person that, directly or 
indirectly, does not control, and is not controlled by or under 
common control with the issuer of the security subject to the Demand 
Feature. Control shall mean `control' as defined in section 2(a)(9) 
of the Act.'' Paragraph (a)(8) of rule 2a-7, as amended.
    \47\ Similarly, the twenty-five percent put basket will not be 
available for puts that do not meet the definition of a put issued 
by a non-controlled person. See infra Section II.C.1.b. of this 
Release.
---------------------------------------------------------------------------

2. Quality Limitations on Portfolio Securities
    Rule 2a-7 limits both taxable and tax exempt funds to investing 
only in eligible securities--securities receiving at least the second 
highest rating from the requisite NRSROs (as defined in the rule) or 
comparable unrated securities.48 Taxable funds must comply with 
the Second Tier Securities Tests--investment in second tier securities 
is limited to five percent of fund assets, and investment in the second 
tier securities of any one issuer is limited to the greater of one 
percent of fund assets or one million dollars. The proposed amendments 
to the rule would have established different quality standards for 
national and single state funds.

    \48\ See supra nn. 12 and 13 and accompanying text and paragraph 
(a)(19) of rule 2a-7, as amended.
---------------------------------------------------------------------------

    a. Proposed Limitations for Single State Funds. The proposed 
amendments would have limited single state fund investment to first 
tier securities. The Commission stated in the Proposing Release that 
the first tier securities restriction was designed to reduce the 
additional risks that may accompany lower levels of diversification as 
a result of the Commission's proposal not to extend the Five Percent 
Diversification Test to single state funds. As noted above, most fund 
commenters objected to this limitation. In light of the requirement 
that single state funds be diversified as to seventy-five percent of 
their assets,49 the Commission has decided not to adopt the 
proposed first tier securities restriction.

    \49\ See supra Section II.B.1.a. of this Release and paragraph 
(c)(4)(iii) of rule 2a-7, as amended.
---------------------------------------------------------------------------

    b. Application of the Second Tier Securities Tests to Conduit 
Securities. The proposed amendments to the rule would have extended the 
Second Tier Securities Tests only to national fund investment in 
``conduit securities.'' The Proposing Release explained that, in 
contrast to traditional state and municipal securities, conduit 
securities are issued to finance non-governmental private projects, 
such as retirement homes, private hospitals, local housing projects, 
and industrial development projects, with respect to which the ultimate 
obligor is not a governmental entity. Conduit securities are not backed 
by a revenue source from any essential public facility or by the taxing 
authority of any state or municipality. As a result, the risk of 
default for conduit securities is significantly higher than it is for 
traditional state or municipal securities.50 Therefore, the 
Commission proposed to treat a national fund's investment in conduit 
securities no differently than a taxable fund's investment in 
securities typically issued by a private concern.

    \50\ See Municipal Bond Defaults--The 1980's: A Decade in Review 
(J.J. Kenny & Co., Inc. 1993). Bankruptcies and defaults by major 
municipal issuers, such as Orange County, California, are rare 
events. Of the approximately 120 municipal bankruptcies since 1979, 
most have involved small, local governments or special tax 
districts. See ``Banging a Tin Cup With a Silver Spoon,'' N.Y. 
Times, June 4, 1995 at F1.
---------------------------------------------------------------------------

    Most commenters supported the application of the Second Tier 
Securities Tests to national fund investment in conduit securities. 
These commenters generally agreed that this limited application of the 
Second Tier Securities Tests would allow national funds maximum 
flexibility to invest in the type of tax exempt securities that present 
the least risk of default. A smaller group of commenters, however, 
asserted that the proposed limitation would further limit the supply of 
eligible securities.51 Many conduit securities in which money 
funds invest are subject to unconditional demand features. Because the 
Second Tier

[[Page 13962]]
Securities Tests will not be applied to conduit securities with 
unconditional demand features issued by non-controlled persons, the 
application of the Second Tier Securities Tests to these securities 
should have a limited effect on the supply of tax exempt 
securities.52

    \51\ See supra note 29 and accompanying text.
    \52\ As adopted, the rule exempts from the Second Tier 
Securities Tests any conduit security subject to an unconditional 
demand feature issued by a non-controlled person, whether the demand 
feature is first or second tier. Paragraph (c)(4)(iv)(B) of rule 2a-
7, as amended.
---------------------------------------------------------------------------

    The Commission has decided to extend the Second Tier Securities 
Tests to national and single state fund investment in conduit 
securities. Under amendments to the rule being adopted, the non-
governmental entity ultimately responsible for the payment of principal 
and interest is treated as the issuer of the conduit security for 
purposes of the rule's issuer diversification requirements.53 
Credit quality determinations for a conduit security must be made by 
reference to the underlying corporate or project issuer, unless the 
conduit security is subject to an unconditional demand feature, in 
which case the conduit security will not be subject to the Second Tier 
Securities Tests.54 Credit quality determinations for conduit 
securities subject to conditional demand features must be made by 
reference to the provider of the demand feature and the long-term 
rating of the underlying corporate or project issuer.55 In 
addition, for purposes of calculating compliance with the one percent 
limit on second tier securities of a single issuer, the issuer of the 
conduit is the corporation or project.56

    \53\ Paragraph (c)(4)(vi)(A)(3) of rule 2a-7, as amended.
    \54\ Paragraph (c)(4)(iv)(B) of rule 2a-7, as amended.
    \55\ See infra Section II.B.2.b. of this Release and paragraph 
(c)(3)(iii) of rule 2a-7, as amended.
    \56\ See paragraph (c)(4)(vi)(A)(3) of rule 2a-7, as amended. 
For example, a municipal security issued to finance a private 
hospital that meets the definition of a conduit security would be 
considered--for diversification purposes--to have been issued by the 
hospital, not the municipality.
---------------------------------------------------------------------------

    c. Definition of the Term ``Conduit Security''. The proposed 
amendments would have defined the term ``conduit security'' to mean a 
security issued through a state or territory of the United States, or 
any political subdivision or instrumentality thereof, which is not: (1) 
payable from the revenues of such governmental unit (``Revenue 
Clause''); (2) unconditionally guaranteed by such governmental unit; 
(3) related to a project or facility owned and operated by such 
governmental unit; or (4) related to a facility leased to and under the 
control of an industrial or commercial enterprise that is part of a 
public project owned and under the control of such governmental unit. 
The definition was intended to exclude securities for which the 
ultimate obligor is a governmental unit.
    Several commenters advised the Commission that portfolio managers 
would be able to identify conduit securities more readily and without 
obtaining legal and other expert opinions if the rule affirmatively 
stated what a conduit security is, instead of what it is not. Several 
commenters also urged that the Revenue Clause be deleted because it 
might result in excluding from the Second Tier Securities Tests a 
security for which the ultimate obligor is a private entity.57 The 
Commission has modified the definition of the term ``conduit security'' 
to reflect some of these concerns.58

    \57\ For example, a governmental unit could issue bonds on 
behalf of a private firm for the purpose of raising funds to 
construct facilities for a company, such as a plant or a residential 
real estate project. The payment of principal or interest on the 
bonds would be secured through a lease arrangement under which the 
private firm makes periodic payments to the governmental unit. If 
these payments were characterized as ``revenue,'' then the bonds 
issued by the governmental unit would not be treated as conduit 
securities under the proposed definition.
    \58\ In the Proposing Release, the Commission asked commenters 
whether the rule's definition of a conduit security should reference 
the provisions of the Internal Revenue Code (``IRC'') governing the 
treatment of private activity bonds, IRC sections 141-174 [26 U.S.C. 
141-147]. Most commenters discussing the definition of a conduit 
security strongly opposed this approach, generally observing that it 
would have the effect of treating certain general obligation bonds, 
and bonds issued to finance property owned by a governmental unit, 
as conduit securities that are subject to the Second Tier Securities 
Tests, which would be inconsistent with the Commission's objective 
of subjecting only obligations of non-governmental issuers to the 
Second Tier Securities Tests. The Commission has decided not to 
reference the IRC's private activity bond rules in defining the term 
``conduit security.''
---------------------------------------------------------------------------

    The term ``conduit security'' is defined as a security issued by a 
municipal issuer involving an arrangement or agreement entered into, 
directly or indirectly, with an issuer other than a municipal issuer, 
which arrangement or agreement provides for or secures repayment of the 
security.59 The term ``conduit security'' does not include a 
security that is: (1) unconditionally guaranteed by a municipal issuer; 
(2) payable from the general revenues of the municipal issuer (other 
than revenues derived from an agreement or arrangement with a person 
who is not a municipal issuer that provides for or secures repayment of 
the security); (3) related to a project owned and operated by a 
municipal issuer; or (4) related to a facility leased to and under the 
control of an industrial or commercial enterprise that is part of a 
public project which, as a whole, is owned and under the control of a 
municipal issuer.60

    \59\ Paragraph (a)(6) of rule 2a-7, as amended. The rule 
amendments, as adopted, define the term ``municipal issuer'' to mean 
a state or territory of the United States, or any political 
subdivision or instrumentality thereof. The term ``state'' is 
defined in the 1940 Act to mean any state, the District of Columbia, 
Puerto Rico, the Virgin Islands, or any other possession of the 
United States [15 U.S.C. 80a-2(a)(39)].
    \60\ Paragraph (a)(6) of rule 2a-7, as amended.
---------------------------------------------------------------------------

C. Diversification and Quality Standards for Put Providers

    A substantial portion of securities held by tax exempt funds are 
subject to puts and demand features.61 A ``put'' is the right to 
sell a specified underlying security within a specified period of time 
and at a specified exercise price that may be sold, transferred, or 
assigned only with the underlying security.62 A demand feature is 
a put that may be exercised at specified intervals not exceeding 397 
calendar days and upon no more than thirty days' notice.63 Demand 
features can serve three different purposes: (1) to shorten the 
maturity of a variable or floating rate security; 64 (2) to 
enhance the security's credit quality; and (3) to provide liquidity 
support for the security. If the demand feature can be exercised on 
seven days' notice, then the security will be treated as a liquid 
security under the appropriate guidelines.65

    \61\ Proposing Release, supra note 20, at Section I.B.
    \62\ Paragraph (a)(16) of rule 2a-7, as amended.
    \63\ Paragraph (a)(7) of rule 2a-7, as amended.
    \64\ Paragraphs (d)(3) and (d)(5) of rule 2a-7, as amended. 
Initially, rule 2a-7 provided that only demand features that ran to 
the issuer of the security could be used to shorten maturities. See 
Release 13380, supra note 7, at n.9. This was changed by the 
amendments to rule 2a-7 adopted in 1986. Investment Company Act Rel. 
No. 14983 (Mar. 12, 1986) [51 FR 9773 (Mar. 21, 1986)] (``Release 
14983'').
    \65\ A money fund is limited to investing no more than ten 
percent of its assets in illiquid securities. See Release 13380, 
supra note 7, at nn.37-38 and accompanying text. See also Investment 
Company Institute (pub. avail. Dec. 9, 1992). The Division of 
Investment Management has provided guidance concerning the 
implementation of three business days as the standard settlement 
period for trades effected by brokers and dealers, and a fund's 
determination of whether securities it holds should be deemed liquid 
for purposes of complying with the ten percent restriction. Letter 
from Jack W. Murphy, Associate Director and Chief Counsel, Division 
of Investment Management, to Paul Schott Stevens, General Counsel, 
Investment Company Institute (May 26, 1995) (``T+3 Letter'').
---------------------------------------------------------------------------

    Demand features may be conditional or unconditional.66 Under 
rule 2a-7, a demand feature used as a substitute for

[[Page 13963]]
the credit quality of the underlying security must be an 
``unconditional put,'' defined to include any guarantee, letter of 
credit (``LOC'') or similar unconditional credit enhancement that by 
its terms would be readily exercisable in the event of a default in 
payment of principal or interest on the underlying security.67 A 
demand feature that is not an ``unconditional put'' may serve as the 
basis for determining whether a security is an eligible security and 
categorizing it as a first or second tier security; however, the long-
term credit quality of the security subject to a conditional demand 
feature must also be analyzed.68

    \66\ Both conditional and unconditional puts may operate as 
demand features to shorten the maturities of adjustable rate 
securities. As discussed in Section II.C.3. of this Release, infra, 
amendments to rule 2a-7 limit the types of conditions to which 
exercise of a demand feature can be subject. Paragraph 
(c)(3)(iii)(B) of rule 2a-7, as amended.
    \67\ Paragraph (a)(27) of rule 2a-7, as amended.
    \68\ Paragraph (c)(3)(iii)(B) of rule 2a-7, as amended.
---------------------------------------------------------------------------

    The Commission is adopting several amendments to the provisions of 
the rule relating to puts and demand features.
1. Put Diversification Standards
    Under rule 2a-7, a taxable money fund may not invest more than five 
percent of its assets in securities subject to conditional puts from, 
or securities directly issued by, the same institution. The percentage 
limitation applicable to unconditional puts is ten percent. A tax 
exempt fund is required to comply with these two requirements with 
respect to seventy-five percent of its assets; there is no 
diversification requirement with respect to the remaining twenty-five 
percent (``twenty-five percent put basket''). The Commission proposed 
to apply a uniform ten percent limitation on all puts issued by the 
same institution and to eliminate the twenty-five percent put basket 
for tax exempt funds.69

    \69\ See Proposing Release, supra note 20, at Section II.C.2.
---------------------------------------------------------------------------

    a. Uniform Diversification Standards for Conditional and 
Unconditional Puts. Under the proposed amendments, a fund could not 
have invested more than ten percent of its assets in securities subject 
to conditional and unconditional puts, and securities directly issued 
by, the same issuer. A fund would have been required to aggregate 
conditional and unconditional puts issued by the same issuer in 
applying the ten percent restriction. Most of the commenters who 
addressed these aspects of the proposal supported the aggregation of 
conditional and unconditional puts in applying a uniform percentage 
restriction. Other commenters disagreed, either urging that the ten 
percent limit be raised or that the rule's put diversification 
standards continue to distinguish between puts that provide liquidity 
support (conditional puts) and puts that provide credit support 
(unconditional puts).
    The Commission has decided to adopt the uniform ten percent 
limitation as proposed, and eliminate the current distinction between 
conditional and unconditional puts under the rule's put diversification 
standards.70 Although there are differences between the risks 
incurred by the put provider and the nature of the reliance by the 
investor in each case, the Commission does not believe that these 
differences are significant enough to warrant continued disparate 
treatment under the rule. Moreover, aggregating conditional and 
unconditional puts and applying a single put diversification standard 
to the aggregate number should simplify compliance with the rule.

    \70\ Paragraph (c)(4)(v)(B) of rule 2a-7, as amended.
---------------------------------------------------------------------------

    b. The Twenty-Five Percent Put Basket. The proposed amendments to 
the rule would have eliminated the twenty-five percent put basket so 
that a tax exempt fund would have been required to meet the rule's put 
diversification standards with respect to one hundred percent of its 
assets. The Commission explained that extensive reliance on a single 
put provider or a few providers could present considerable risks, 
particularly for a single state fund which, under the amendments as 
proposed, would not have been required to be diversified with respect 
to underlying securities.71

    \71\ Proposing Release, supra note 20, at Section II.C.2.b.
---------------------------------------------------------------------------

    Most commenters urged the Commission to retain the twenty-five 
percent put basket in some form. Many concluded that eliminating the 
twenty-five percent put basket would increase reliance by funds on less 
creditworthy put providers and decrease the flexibility currently 
afforded funds in enhancing the credit quality and liquidity of 
securities. The commenters disagreed with the Commission's assumption 
that one probable effect of the elimination of the twenty-five percent 
put basket would be new entrants to the market as put providers.
    A number of commenters suggested that, in light of the Commission's 
proposal to require that when a fund invests more than five percent of 
its assets in securities subject to puts from a single put provider, 
the puts be first tier securities,72 it would be appropriate to 
retain the twenty-five percent put basket. The Commission has decided 
to incorporate this approach in amendments to the rule's put 
diversification standards.

    \72\ See infra Section II.C.2.b. of this Release.
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    The amendments provide that the twenty-five percent put basket is 
available to all money funds for first tier puts, but only if the put 
is a ``put issued by a non-controlled person''--a put issued by a 
person that does not directly or indirectly control, and is not 
controlled by or under common control with the issuer of the security 
subject to the put.73 The Commission is restricting fund use of 
the twenty-five percent put basket to non-controlled persons to 
minimize a fund's concentration of assets in a single economic 
enterprise.

    \73\ Paragraphs (a)(17) (definition of ``put issued by a non-
controlled person'') and (c)(4)(v) of rule 2a-7, as amended. The 
Commission is adopting amendments that limit fund investment in puts 
that are second tier securities to five percent of fund assets. See 
infra Section II.C.2.b. of this Release and paragraph (c)(4)(v)(B) 
of rule 2a-7, as amended. Further, a fund that has invested more 
than ten percent of its assets in securities subject to puts and in 
securities directly issued by a single issuer must count the total 
amount invested towards the twenty-five percent undiversified put 
basket. In other words, a fund may not use all or a portion of its 
twenty-five percent put basket and an additional amount of its 
diversified assets to invest more than twenty-five percent of its 
assets in a single issuer. See supra, note 30.
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    c. Issuer-Provided Demand Features. The put diversification 
standards under rule 2a-7 apply to ``securities issued by or subject to 
Puts from the institution that issued the Put.'' 74 In the 
Proposing Release, the Commission requested comment on the treatment of 
puts by the issuer of the underlying securities (``issuer-provided 
demand features'').75 Some commenters asserted that funds should 
be permitted to exclude issuer-provided demand features from the put 
diversification requirements because issuer-provided demand features 
can be viewed as the functional equivalent of short-term securities 
that are ``rolled over'' periodically. The commenters also suggested 
that including issuer-provided demand features as puts in determining 
compliance with the rule's put diversification standards amounts to 
``double counting.'' The Commission agrees and has added language to 
the rule to clarify that a fund is not required to aggregate an issuer-
provided put with the security subject to the put for purpose of 
determining compliance with the put diversification requirement of the 
rule.76

    \74\ Paragraph (c)(4)(v)(A) of rule 2a-7, as amended.
    \75\ See Proposing Release, supra note 20, at Section 
II.C.2.d.(3). The Commission noted that rule 2a-7, as originally 
adopted, provided that only issuer-provided demand features could be 
used to shorten the maturity of a security. See Release 13380, supra 
note 7, at n.10 and accompanying text.
    \76\ Paragraph (c)(4)(vi)(B)(1) of rule 2a-7, as amended. Under 
this paragraph, a put issued by the same institution that issued the 
underlying security would not be subject to the rule's put 
diversification requirements, and would be subject only to the 
rule's issuer diversification requirements. For example, a security 
representing four percent of a fund's total assets that had an 
issuer-provided demand feature would be treated as a four percent 
position in ``securities issued by or subject to Puts from the 
institution that issued the Put,'' not eight percent [quoting 
paragraph (c)(4)(iv)(A) of rule 2a-7, as amended].

[[Page 13964]]

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    d. Multiple Puts and Guarantees. The proposed amendments would have 
amended rule 2a-7's put diversification standards to address how put 
diversification calculations should be made when a security is subject 
to several puts (``multiple puts''). Under the proposed amendments, 
different calculation methods would have been applied when: (i) each 
multiple put provider had contractually agreed to guarantee only a 
portion of the total principal value of the underlying security 
(``fractional puts''), and (ii) each multiple put provider had an 
obligation that was not limited contractually (``layered puts''). The 
proposed amendments would have clarified that an institution that 
provides a fractional put would be treated as guaranteeing only that 
portion of the principal value of the security that it contractually 
agreed to provide.77 An institution providing a layered put would 
have been deemed to cover the entire principal amount of the security, 
notwithstanding that the security is subject to puts from other 
institutions.

    \77\ For example, if two banks issued puts on the same VRDN and 
each agreed to absorb fifty percent of the losses, then each would 
be deemed to guarantee no more than fifty percent of the VRDN under 
the rule's put diversification standards.
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    Most commenters who discussed these issues supported the proposed 
treatment of fractional puts. These commenters stated that it was 
appropriate to allocate exposure among put providers for 
diversification purposes in accordance with the put providers' 
contractual obligations. The Commission has decided to adopt these 
amendments to the rule as proposed.78

    \78\ Paragraph (c)(4)(vi)(B)(2) of rule 2a-7, as amended.
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    Most commenters opposed treating each put provider in a layered put 
structure as the guarantor of the entire amount guaranteed because, 
they argued, the approach ignored the fact that the fund may be relying 
only on the guarantee of one of the put providers. The Commission has 
decided to adopt amendments to the rule that reflect these comments. 
For a security subject to layered puts, the rule permits a fund that is 
not relying on a particular put for satisfaction of the rule's credit 
quality 79 or maturity standards,80 or for liquidity, to 
exclude that put when determining its compliance with the rule's put 
diversification standards.81 The fund must document this 
determination in its records.82

    \79\ Under the rule, a fund holding a security that is subject 
to an unconditional demand feature may satisfy the rule's credit 
quality standards with respect to the underlying security based 
solely on the short-term rating of the demand feature provider. 
Paragraph (c)(3)(ii) of rule 2a-7, as amended.
    \80\ Rule 2a-7 generally permits a fund to measure the maturity 
of an adjustable rate security subject to a demand feature by 
reference to the date on which principal can be recovered through 
demand. See infra Sections II.F.1. and II.F.2. of this Release and 
paragraphs (d)(3) and (d)(5) of rule 2a-7, as amended.
    \81\ Paragraph (c)(4)(vi)(B)(4) of rule 2a-7, as amended. This 
paragraph of the rule also permits a fund holding a security subject 
to a single put that it is not relying on to satisfy the rule's 
credit quality or maturity standards, or for liquidity, to disregard 
that put in determining its compliance with the rule's put 
diversification standards. If a fund is relying on separate puts for 
each of these purposes (e.g., a conditional demand feature for 
purposes of liquidity and maturity, and an unconditional put for 
purposes of credit quality), then each put would have to satisfy the 
rule's put diversification standards.
    \82\ Paragraphs (c)(8)(ii) and (c)(9)(vi) of rule 2a-7, as 
amended. A fund would document this determination when it acquires 
the security. The fund may subsequently determine that it is or is 
not relying on a particular put, but must reflect the change in its 
written records.
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    In the context of describing the proposed amendments regarding 
treatment of multiple puts under the rule's diversification standards, 
the Commission indicated that bond insurance was a type of put under 
rule 2a-7.83 A number of commenters disagreed with this analysis 
of bond insurance, arguing that bond insurance does not provide 
liquidity and is not viewed by the market as a substitute for the 
credit of the underlying issuer. Because bond insurance guarantees the 
timely payment of principal and interest by the insured issuer,84 
it meets the rule's definition of an unconditional put, permitting 
credit substitution in the eligibility determination. The Commission 
has amended the rule to clarify this matter.85

    \83\ Proposing Release, supra note 20, at note 81.
    \84\ Eli Nathans, Municipal Bond Insurance--The Economics of the 
Market, 13 Mun. Fin. J., No.2 (Summer 1992) 1, 2.
    \85\ Paragraph (a)(27) of rule 2a-7, as amended. A bond 
insurance policy that permits the holder of the security to receive 
all principal and interest payments at the time of the default of 
the insured obligation would also be an unconditional demand 
feature. By contrast, a policy under which the fund would only 
receive periodic payments of principal and interest as those 
payments came due under the terms of the insured obligation would be 
an unconditional put, but not an unconditional demand feature.
---------------------------------------------------------------------------

    The Commission recognizes, however, that bond insurance may not be 
relied upon by a fund when determining a security's eligibility under 
the rule. One commenter argued that, in the case of a security subject 
to a guarantee, such as bond insurance, and a demand feature, the fund 
is very likely to look only to the issuer of the demand feature if it 
needs to sell the security and thus, as a practical matter, to the 
issuer of the demand feature for credit support. Therefore, this 
commenter concluded, the guarantee should not be counted for purposes 
of rule 2a-7's diversification requirements. The Commission agrees, and 
has amended the rule to permit a fund holding a security subject to a 
put (including bond insurance) and an unconditional demand feature to 
count only the demand feature for purposes of the put diversification 
calculation.86 A fund relying on this provision of the rule is not 
required to maintain contemporaneous records of its determination that 
the fund is not relying on the guarantee to determine credit quality.

    \86\ Paragraph (c)(4)(vi)(B)(3) of rule 2a-7, as amended.
---------------------------------------------------------------------------

2. Quality Standards
    a. Rating Requirement for Demand Features. The proposed amendments 
to the rule would have limited funds to investing in demand features 
(other than standby commitments) that are rated, or provided by 
institutions that are rated, by NRSROs. Most commenters discussing this 
issue opposed the proposed rating requirement for demand features and 
suggested that the rule should permit a fund to purchase a security 
subject to an unrated demand feature if it can make a comparability 
determination similar to the determination permitted under the rule in 
connection with the purchase of unrated securities.87 Other 
commenters asserted that the fund manager's obligation under the rule 
to determine that all portfolio securities present minimal credit risk 
obviated the need for the proposed rating requirement.88

    \87\ Paragraph (a)(9)(iii) of rule 2a-7, as amended, permits a 
fund to treat an unrated security as an eligible security if the 
fund's board of directors determines that the unrated security is of 
comparable quality to a rated security.
    \88\ Paragraph (c)(3) of rule 2a-7, as amended, limits fund 
investment to securities that its ``board of directors determines 
present minimal credit risks.'' This determination must be based on 
factors pertaining to credit quality ``in addition to any rating 
assigned to such securities by an NRSRO'' (emphasis added).
---------------------------------------------------------------------------

    The Commission explained in the Proposing Release that NRSRO 
ratings assigned to demand features or the issuer of demand features 
may provide additional protection by ensuring input into the minimal 
credit risk determination by an outside source. This extra source of 
protection may be particularly important in light of the

[[Page 13965]]
Commission's decision to preserve the twenty-five percent 
diversification basket for put providers, and to eliminate the 
applicability of rule 2a-7's diversification requirements to securities 
subject to certain unconditional demand features.89 In addition, 
funds may have limited ability to monitor the credit quality of some 
demand feature providers, such as foreign banks.90 The Commission 
is adopting the rating requirement for demand features as 
proposed.91

    \89\ See supra Section II.B.1.b. of this Release.
    \90\ Proposing Release, supra note 20, at Section II.C.2.d.(2).
    \91\ Paragraph (a)(9)(iii)(D)(1) of rule 2a-7, as amended. The 
amendments remove from the definition of eligible security unrated 
securities that are subject to demand features. Thus, in order for a 
security subject to a demand feature to be eligible for fund 
investment, the demand feature must be rated.
---------------------------------------------------------------------------

    b. Providers of Puts in Excess of Five Percent of Fund Assets. The 
proposed amendments would have prohibited a money fund from investing 
more than five percent of its assets in securities subject to a put 
from a single put provider that is not a first tier put. Compliance 
with this provision would be measured at the time the put was acquired 
by the fund. All the commenters discussing this aspect of the proposal 
agreed that it is appropriate to limit fund investment in puts that are 
not first tier securities (``second tier puts''), and the Commission is 
adopting the limit as proposed.92

    \92\ Paragraph (c)(4)(v)(B) of rule 2a-7, as amended.
---------------------------------------------------------------------------

    If more than five percent of a fund's assets were subject to a 
demand feature from a single institution that was no longer a first 
tier put, the proposed amendments also would have required the fund to 
reduce the amount of the securities subject to the demand feature to 
not more than five percent of the fund's assets by exercising the 
demand feature at the next succeeding exercise date. Most commenters 
were critical of this proposed requirement and suggested that it might 
be in the best interests of fund shareholders for the fund either to 
retain the securities subject to the demand features or dispose of the 
securities in an orderly manner. Because there may be some 
circumstances during which it may be in the best interest of the fund 
to continue to hold the securities subject to the put, the Commission 
is adopting the amendment with the express provision that a fund's 
board of directors may determine that disposal of the securities is not 
in the best interest of the fund, and determine to permit the fund to 
continue to hold the securities.93

    \93\ Paragraph (c)(5)(i)(C) of rule 2a-7, as amended. This 
determination may not be delegated. Paragraph (e) of rule 2a-7, as 
amended. If the demand feature is no longer an eligible security, 
paragraph (c)(5)(ii) of rule 2a-7 requires the fund to obtain a new 
demand feature or dispose of the underlying security (unless the 
board of directors finds that it would be in the best interest of 
the fund not to dispose of the security). See Release 18005, supra 
note 11 at Section II.E.1. for a discussion of securities held by a 
money fund that are in default, are no longer eligible securities, 
or no longer present minimal credit risks.
---------------------------------------------------------------------------

    c. Certain Unrated Securities. Rule 2a-7 currently provides that an 
unrated security that, when issued, was a long-term security but when 
purchased by the fund has a remaining maturity of less than 397 
calendar days may be considered to be an eligible security based on 
whether the security is comparable in quality to a rated security, 
unless the security has received a long-term rating from any NRSRO that 
is not within the two highest categories of long-term ratings. Under 
this provision, a long-term rating from an NRSRO below the top two 
rating categories results in the security becoming ineligible for 
investment by a money market fund. One commenter stated that, because 
many issuers with long-term ratings in the third highest ratings 
categories have first tier short-term ratings, the rule was 
unnecessarily restrictive. The Commission agrees, and has expanded this 
provision to accommodate long-term ratings within the top three ratings 
categories.94 Funds will continue to be required to determine that 
such a security is of ``comparable quality'' to rated eligible 
securities.95

    \94\ Paragraph (a)(9)(iii)(B) of rule 2a-7, as amended.
    \95\ Paragraph (a)(9)(iii) of rule 2a-7, as amended.
---------------------------------------------------------------------------

3. Conditional Demand Features
    Rule 2a-7 does not currently restrict the types of conditions to 
which a demand feature may be subject. The inability of a fund to 
exercise a demand feature because of the occurrence of a condition 
precluding exercise would likely result in violations of the maturity 
limitations of rule 2a-7, the liquidity requirements of the 1940 
Act,96 and a loss of value of the underlying security, when, for 
example, a short-term security paying interest at short-term rates is 
transformed into a long-term security. Therefore, the proposed 
amendments would have limited the permissible conditions with respect 
to conditional puts to the following: (1) default in the payment of 
principal or interest on the underlying security; (2) the bankruptcy, 
insolvency, or receivership of the issuer or a guarantor of the 
underlying security; (3) the downgrading of either the underlying 
security or a guarantor by more than two full rating categories; and 
(4) in the case of a tax exempt security, a determination by the 
Internal Revenue Service of taxability with respect to the interest on 
the security.97 These conditions were designed to permit the fund 
to monitor the continued availability of a demand feature and to take 
steps to sell the security or replace the demand feature if it appears 
that conditions are likely to occur that would limit the ability of the 
fund to exercise the demand feature.98

    \96\ The money fund could lose liquidity at a time when it is 
most necessary. A money fund is limited to investing no more than 
ten percent of its assets in illiquid securities. See supra note 65 
and accompanying text and infra Section II.C.4.c. of this Release.
    \97\ The proposed amendments to the rule incorporated 
recommendations of Fidelity Management & Research Company 
(``Fidelity'') and the Investment Company Institute (``ICI''). See 
Letter from Matthew Fink, Senior Vice President and General Counsel, 
ICI, to Marianne Smythe, Director, Division of Investment Management 
(Mar. 25, 1991); Letter from Thomas D. Maher, Associate General 
Counsel, Fidelity, to Jonathan G. Katz, Secretary, U.S. Securities 
and Exchange Commission (Sept. 24, 1990), in File No. S7-13-90.
    \98\ Proposing Release, supra note 20, at Section II.C.3.
---------------------------------------------------------------------------

    Many commenters objected to the proposed definition of the term 
``conditional put.'' These commenters stated that the current market 
has few, if any, variable rate demand notes (``VRDNs'') with 
conditional puts that would satisfy the proposed definition. Even the 
commenters who recommended the proposed conditions conceded that 
although most put providers have conditions similar to those included 
in the proposed amendments, every provider uses somewhat different, 
often broader, language.99 As a result, modifying the scope of one 
or more of the four conditions would not address this concern.

    \99\ See Letter from Thomas D. Maher, Associate General Counsel, 
Fidelity, to Jonathan G. Katz, Secretary, U.S. Securities and 
Exchange Commission (May 5, 1994); Letter from Thomas D. Maher, 
Associate General Counsel, Fidelity, to Kenneth J. Berman, Deputy 
Office Chief, Office of Disclosure and Investment Adviser 
Regulation, Division of Investment Management, U.S. Securities and 
Exchange Commission (June 17, 1994); Letter from Paul Schott 
Stevens, General Counsel, ICI, to Jonathan G. Katz, Secretary, U.S. 
Securities and Exchange Commission (May 5, 1994), in File No. S7-34-
93.
---------------------------------------------------------------------------

    The Commission has decided to adopt an alternative approach 
suggested by several commenters by revising the rule to provide general 
guidance concerning the types of conditions that are appropriate for 
money fund investment. Rule 2a-7, as amended, provides that a security 
subject to a conditional demand feature is an eligible security only if 
the fund's board of directors (or its delegate) determines that there 
is ``minimal risk'' of occurrence of the conditions that

[[Page 13966]]
would result in the demand feature not being exercisable.100 The 
fund's board of directors (or its delegate) also must determine that: 
(1) the conditions limiting exercise can be monitored readily by the 
fund, or relate to the taxability, under federal, state or local law, 
of the interest payments on the security; or (2) the terms of the 
demand feature require that the fund receive notice of the occurrence 
of the condition and the opportunity to exercise the demand 
feature.101

    \100\ Paragraph (c)(3)(iii)(B) of rule 2a-7, as amended.
    \101\ Id.
---------------------------------------------------------------------------

    Rule 2a-7 currently provides that a security subject to a 
conditional demand feature (``underlying security'') is an eligible 
security only if the demand feature is an eligible security and the 
underlying security has received a long-term rating from the Requisite 
NRSROs in one of the two highest long-term ratings categories or, if 
unrated, is determined to be of comparable quality. The rule thus 
assumes securities subject to conditional demand features are always 
long-term securities. The Commission is amending rule 2a-7 to provide 
that, in the case of an underlying security that has a remaining 
maturity of 397 days or less, the underlying security is an eligible 
security only if the demand feature is an eligible security and the 
underlying security has received a short-term rating from the requisite 
NRSROs in one of the two highest short-term ratings categories or, if 
unrated, is determined to be of comparable quality.102

    \102\ Paragraph (c)(3)(iii)(C)(1) of rule 2a-7, as amended.
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    4. Other Issues Applicable to Put Providers
    a. Accrued Interest. The Commission proposed amendments to the 
definition of the term ``put'' and also requested comment whether 
additional amendments to the rule were necessary to restrict fund 
investment to certain types of credit and liquidity enhancements. The 
proposed amendments would have amended the definition of a ``put'' to 
specify that the put must enable the holder to receive not only the 
amortized cost of the securities, but also accrued interest. The 
Commission is adopting these amendments as proposed.103

    \103\ Paragraph (a)(16) of rule 2a-7, as amended.
---------------------------------------------------------------------------

    b. Notice of Substitution of Put Provider. The Commission stated in 
the Proposing Release that it is aware of several instances in which a 
money fund had invested in a security backed by a LOC or other credit 
or liquidity enhancement that was replaced during the life of the 
underlying security without notice to the fund.104 A fund must 
know the identity of the put provider for a number of reasons, which 
include a determination of whether the fund is in compliance with the 
rule's put diversification and credit quality provisions. The Proposing 
Release asked commenters to consider whether the rule should be amended 
to limit fund investment in puts that obligate the issuer of the 
underlying security (or the trustee under any applicable indenture) to 
inform investors of the substitution of the put provider. All the 
commenters responding to this question agreed with the Commission that 
it is essential for the control of credit risk and for compliance with 
the rule that funds be aware of the identity of their put providers at 
all times, and that rule amendments would be appropriate.105

    \104\ Proposing Release, supra note 20, at Section II.D.1.c.
    \105\ A number of these commenters discussed the problems a fund 
may encounter in obtaining notice of the substitution of a put 
provider when the securities are held by an intermediary, such as a 
securities depository. The Commission was advised that 
intermediaries employ methods to transmit notice of this type to 
their participants.
---------------------------------------------------------------------------

    The Commission is adopting amendments to address these concerns. 
Under the amendments, a security subject to a demand feature is not 
eligible for fund investment unless arrangements are in place to notify 
the fund holding the security in the event that there is a change in 
the identity of the issuer of a demand feature.106

    \106\ Paragraph (a)(9)(iii)(D)(2) of rule 2a-7, as amended. The 
obligation to provide notice may be the obligation of the issuer of 
the underlying security, the issuer of the demand feature, or a 
third party, such as the dealer from which the fund wishes to 
purchase the security.
---------------------------------------------------------------------------

    c. Liquidity Requirements for Money Funds and the Three Business 
Day Settlement Cycle. Section 22(e) of the 1940 Act provides, with 
certain exceptions, that no registered investment company may postpone 
the date of payment upon redemption of a redeemable security for more 
than seven days after the security is tendered for redemption. The 
Commission has stated that all mutual funds should limit their holdings 
of illiquid securities to ensure that they can satisfy all redemption 
requests within the seven day period. The Commission considers a 
security to be illiquid if it cannot be disposed of within seven days 
in the ordinary course of business at approximately the price at which 
the fund has valued it.107 The limit on money fund holdings of 
illiquid securities is ten percent of fund assets.108

    \107\ Release 14983, supra note 64; Securities Act Rel. No. 6862 
(Apr. 23, 1990) [55 FR 17933 (Apr. 30, 1990)] (adopting Rule 144A 
under the Securities Act of 1933 (discussing the definition of 
``liquid'' and citing Release 14983).
    \108\ Release 14983, supra note 64 at Section A.4.; Investment 
Company Institute (pub. avail. Dec. 9, 1992).
---------------------------------------------------------------------------

    Rule 15c6-1 under the Securities Exchange Act of 1934, which 
recently became effective, established three business days (``T+3'') as 
the standard settlement period for securities trades effected by a 
broker or dealer.109 The Division of Investment Management 
provided advice regarding the implications of the T+3 standard in 
determining whether a security held by a fund should be deemed liquid 
for purposes of the restrictions described above.110 This issue is 
significant for money funds, because a large percentage of money fund 
assets consist of securities with a seven day demand feature.111

    \109\ Rule 15c6-1 [17 CFR 240.15c6-1] generally provides that 
``a broker or dealer shall not effect or enter into a contract for 
the purchase or sale of a security (other than an exempted security, 
government security, municipal security, commercial paper, bankers' 
acceptances, or commercial bills) that provides for payment of funds 
and delivery of securities later than the third business day after 
the date of the contract unless otherwise expressly agreed to by the 
parties at the time of the transaction.'' Securities Exchange Act 
Rel. No. 33023 (Oct. 6, 1993) [58 FR 52891 (Oct. 13, 1993)].
    \110\ See T+3 Letter, supra note 65.
    \111\ Id.
---------------------------------------------------------------------------

    The Division noted that, because rule 15c6-1 applies to brokers and 
dealers and does not apply directly to funds, its implementation does 
not change the standard for determining liquidity, which is based on 
the requirements of section 22(e) of the 1940 Act. As a practical 
matter, however, many funds (including money funds) will have to meet 
redemption requests within three days because a broker or dealer will 
be involved in the redemption process. Many of these funds hold 
portfolio securities that do not settle within three days. In light of 
the T+3 standard, the Division recommended that funds should assess the 
mix of their portfolio holdings to determine whether, under normal 
circumstances, they will be able to facilitate compliance with the T+3 
standard by brokers or dealers. Factors the funds should consider 
include the percentage of the portfolio that would settle in three days 
or less, the level of cash reserves, and the availability of lines of 
credit or interfund lending facilities. The Commission shares the 
Division's concerns and urges money funds to monitor carefully their 
liquidity needs in light of the shorter settlement period.
    5. Short-Term Ratings
    Rule 2a-7 currently distinguishes between short-term and long-term

[[Page 13967]]
securities based on whether the security has a remaining maturity of 
366 days--primarily for the purpose of distinguishing between 
securities that have short-term and long-term ratings. NRSROs do not 
always draw such a line when assigning ratings.112 Therefore, the 
Commission has revised the rule to replace references to ``short-term 
securities'' and ``long-term securities'' in various sections of the 
rule with references to securities that have received short-term and 
long-term ratings from a NRSRO.113 Whether a security has received 
a long- or a short-term rating from a NRSRO will depend upon how the 
NRSRO has characterized its rating.

    \112\ See, e.g., Fitch Ratings Book (May 1995) (short-term 
ratings apply to debt payable on demand or to securities with 
original maturities of up to three years), and Orrick, Herrington & 
Sutcliffe (pub. avail. July 20, 1994) (synthetic warrants maturing 
in twenty-two months given short-term ratings by NRSROs).
    \113\ Paragraphs (a)(9) (definition of ``eligible security''), 
(a)(11) (definition of ``first tier security''), (a)(29) (definition 
of ``unrated security''), and (c)(3)(iii)(C) (requirements for 
security subject to conditional demand feature) of rule 2a-7, as 
amended. In addition, the Commission has eliminated the definitions 
of ``short-term'' and ``long-term'' from the rule.
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D. Other Diversification and Quality Standards

1. Repurchase Agreements
    Rule 2a-7 allows a fund to ``look through'' a repurchase agreement 
(``repo'') to the underlying collateral for diversification purposes 
when the obligation of the counterparty is ``collateralized fully.'' 
114 Under the current rule, a repo is collateralized fully if, 
among other things, the collateral consists entirely of Government 
securities or securities that, at the time the repo is entered into, 
are rated in the highest rating category by the requisite 
NRSROs.115 The Commission is adopting, as proposed, amendments to 
permit a fund to treat the repo as collateralized fully only if it is 
collateralized by securities that would qualify the repo for 
preferential treatment under the Federal Deposit Insurance Act 116 
or the Federal Bankruptcy Code.117 The Proposing Release noted 
that if the collateral does not qualify for special treatment under 
either of these statutes, a fund could encounter significant liquidity 
problems if a large percentage of its assets were invested in a repo 
with a bankrupt counterparty.118 Although some commenters argued 
that the rule should encompass types of collateral that fall outside 
the repo specific provisions of the Bankruptcy Code, the Commission 
believes that the ``look through'' provisions of the rule would be 
inappropriate in these circumstances because the credit and liquidity 
risks assumed by the fund would be tied directly to the counterparty 
rather than the issuers of the underlying collateral.119

    \114\ Paragraph (c)(4)(vi)(A)(1) of rule 2a-7, as amended. A 
money fund investing in a repurchase agreement that does not meet 
the requirements of this paragraph may not ``look through'' and must 
instead treat the counterparty to the agreement as the issuer.
    \115\ See Proposing Release, supra note 20, at Section II.D.3.
    \116\ See also 12 U.S.C. 1821(e)(8) (A) and (C) (affording 
preferential treatment to ``qualified financial contracts''), 12 
U.S.C. 1821(e)(8)(D)(i) (defining qualified financial contract to 
include repurchase agreements) and 12 U.S.C. 1821(e)(8)(D)(v) 
(defining repurchase agreement).
    Not all collateral that would qualify a repo for preferential 
treatment under the Federal Deposit Insurance Act would be 
permitted. Of the mortgage-related securities referred to in 12 
U.S.C. 1821(e)(8)(D)(c), only ``mortgage related securit[ies]'' as 
defined in Section 3(a)(41) of the 1934 Act [15 U.S.C. 78c(a)(41)] 
would be permitted.
    See sections 101(47) of the Federal Bankruptcy Code 
(``Bankruptcy Code'') (defining ``repurchase agreement''), and 559 
(protecting repo participants from the Bankruptcy Code's automatic 
stay provisions) [11 U.S.C. 101(47), 559]. The Bankruptcy Code 
defines a repurchase agreement as follows:
    An agreement, including related terms which provides for the 
transfer of certificates of deposit, eligible bankers' acceptances, 
or securities that are direct obligations of, or that are fully 
guaranteed as to principal and interest by, the United States or any 
agency of the United States against the transfer of funds by the 
transferee of such certificates of deposit, eligible bankers' 
acceptances, or securities with a simultaneous agreement by such 
transferee to transfer to the transferor thereof certificates of 
deposit, eligible bankers' acceptances, or securities as described 
above, at a date certain no later than one year after such transfer 
or on demand, against the transfer of funds.
    \117\ Paragraph (a)(4) of rule 2a-7, as amended. Depository 
institutions are not eligible for protection under the Bankruptcy 
Code. Section 109 of the Bankruptcy Code [11 U.S.C. 109]. Instead, 
the bank regulatory laws provide for the establishment of 
conservatorship and receiverships of depository institutions in 
default. See, e.g., section 11 of the Federal Deposit Insurance Act 
[12 U.S.C. 1821].
    \118\ Proposing Release, supra note 20, at n. 172.
    \119\ Id.
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2. Pre-Refunded Bonds
    The Proposing Release noted that a significant portion of tax 
exempt fund assets consist of pre-refunded bonds--bonds the payment of 
which are funded by and secured by escrowed Government 
securities.120 The proposed amendments to the rule would have 
allowed funds to ``look through'' the pre-refunded bonds to the 
escrowed securities for diversification purposes if the underlying 
securities are Government securities and the escrow arrangement 
satisfies certain conditions designed to assure that the bankruptcy of 
the issuer of the pre-refunded bonds would not affect payments on the 
bonds from the escrow account. The proposed amendments would have 
limited fund investment in pre-refunded bonds issued by the same issuer 
to twenty-five percent of its assets. Because these securities would, 
in effect, be treated as Government securities, they would not be 
subject to a diversification limitation.

    \120\ Id.
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    Most commenters supported the proposed treatment of pre-refunded 
bonds. A few of these commenters suggested that the twenty-five percent 
limitation per issuer was not necessary since the issuer's credit 
typically does not secure such bonds.121 The Commission agrees, 
and has eliminated this limitation.122 The Commission has decided 
to make additional technical modifications to the conditions applicable 
to the escrow arrangements that were suggested by the 
commenters.123 The Commission is also amending the rule to include 
within the definition of an ``unrated security'' a rated security that 
subsequently was made subject to a refunding agreement.124 This 
amendment clarifies that a fund must disregard ratings given to a 
security before the security became a ``refunded security'' (as that 
term is defined in the rule) in determining whether the security is an 
eligible security (as that term is also defined in the rule).

    \121\ The twenty-five percent limitation was a condition 
specified in a ``no-action'' position taken by the Division of 
Investment Management in T. Rowe Price Tax-Free Funds (pub. avail. 
June 24, 1993) regarding the treatment of these securities for 
purposes of section 5(b)(1) of the 1940 Act. See Proposing Release, 
supra note 20, at n. 38 and accompanying text.
    \122\ The Commission is also eliminating the limitation for 
funds other than money funds that otherwise rely on the staff no-
action position set forth in T. Rowe Price Tax-Free Funds.
    \123\ Paragraphs (a)(18) and (c)(4)(vi)(A)(2) of rule 2a-7, as 
amended. The proposed amendments would have permitted a fund to 
``look through'' the pre-refunded bonds to the escrowed securities 
for diversification purposes if: (1) the escrowed securities were 
Government securities; (2) the escrowed securities were pledged only 
with respect to the payment of principal, interest and premiums on 
the pre-refunded bonds; and (3) either an independent certified 
public accountant or a NRSRO certified that the escrowed securities 
would satisfy all scheduled payments of principal, interest and 
premiums on the pre-refunded bonds. Commenters urged the Commission 
to clarify condition (2) by stating that excess proceeds could be 
remitted to the issuer or a third party. Commenters also noted that 
NRSROs rarely provide the certification described in condition (3), 
and requested that the reference to a NRSRO be deleted from the 
text. The rule reflects these comments; only independent certified 
public accountants may provide the certification.
    \124\ Paragraph (a)(29)(iii) of rule 2a-7, as amended. If the 
security has a NRSRO rating that does reflect the existence of the 
refunding agreement, then the security would not be considered 
unrated. Id.

[[Page 13968]]

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3. Diversification Safe Harbor
    A money fund that elects to be diversified must comply with the 
requirements of section 5(b)(1) of the 1940 Act and the rules under 
that section.125 These requirements are applicable to most taxable 
and many tax exempt money funds, since most elect to be diversified. 
Although rule 2a-7's diversification requirements are more strict, 
under certain circumstances a money fund may be in compliance with rule 
2a-7, but not in compliance with section 5(b)(1).126 The proposed 
amendments would have provided that money funds complying with rule 2a-
7's diversification requirements are deemed to be diversified under 
section 5(b)(1) (``diversification safe harbor''). Commenters 
discussing this aspect of the proposal supported the diversification 
safe harbor, and the Commission is adopting the amendments as 
proposed.127

    \125\ See supra note 30; Proposing Release, supra note 20, at n. 
29 and accompanying text.
    \126\ One difference that may cause this to occur is the timing 
of the measurement of diversification. Compliance with section 
5(b)(1) of the 1940 Act is measured at the time of a purchase based 
on the value of the fund's total assets as of the end of the 
preceding fiscal quarter. See rule 5b-1 [17 CFR 270.5b-1]). For 
purposes of rule 2a-7, both the fund's total assets (as defined in 
the rule) and compliance with the rule's diversification 
requirements are measured at the time a purchase is made. See 
paragraph (c)(4)(i) of rule 2a-7, as amended.
    \127\ Paragraph (c)(4)(vii) of rule 2a-7, as amended.
---------------------------------------------------------------------------

4. Three-Day Safe Harbor
    Rule 2a-7 currently permits a fund to invest more than five percent 
of its assets in the first tier securities of a single issuer for up to 
three business days (the ``three-day safe harbor'') and does not 
contain any limitation on the percentage of fund assets that can be 
invested in accordance with this provision. Since the provision is 
primarily applicable to taxable funds, which typically are diversified 
companies within the meaning of section 5(b)(1), funds could not use 
this provision to invest more than twenty-five percent of their assets 
in the securities of a single issuer. The Commission proposed to extend 
the availability of the three-day safe harbor to national funds. To 
assure that the three-day safe harbor could not have the effect of 
allowing funds that are not diversified to invest an inordinate portion 
of their assets in a single issuer at any time, the proposed amendments 
would have limited to twenty-five percent the percentage of fund assets 
that may be invested under the safe harbor at any one time. The 
Commission is adopting this amendment substantially as 
proposed.128

    \128\ Paragraph (c)(4)(iii) of rule 2a-7, as amended. Because 
single state funds are required to be diversified only as to 
seventy-five percent of their assets, they have available a twenty-
five percent basket to accommodate purchases in excess of five 
percent. Paragraph (c)(4)(i) of rule 2a-7, as amended. As a result, 
the three-day safe harbor of paragraph (c)(4)(ii) of the amended 
rule is not extended to them.
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E. Asset Backed Securities and Synthetic Securities

1. Background
    The proposed amendments would have amended rule 2a-7 to clarify the 
application of the rule to ``synthetic'' tax exempt securities and 
ABSs. Both types of securities rely on demand features and complex 
liquidity arrangements that are designed to meet the risk-limiting 
conditions of the rule.
    An ABS represents an interest in a pool of financial assets, such 
as credit card or automobile loan receivables. Typically, an ABS is 
sponsored by a bank or other financial institution to pool financial 
assets and convert them into capital market instruments, thereby 
enabling the sponsor to transform illiquid assets into cash and 
increase balance sheet liquidity.129 The ABS is structured to 
assure that the issuer of the ABS will not be affected by the 
bankruptcy of the sponsor. In addition, the structure of the ABS 
affects the nature and amount of the credit enhancement. While 
structural issues affect the risks associated with many types of 
securities, they are particularly important in evaluating ABSs.130

    \129\ For a detailed discussion of ABSs, see U.S. Securities and 
Exchange Commission Division of Investment Management, Protecting 
Investors: A Half Century of Investment Company Regulation, May 
1992, at 1-103 and Investment Company Act Rel. No. 18736 (May 29, 
1992) [57 FR 23980 (June 5, 1992)] and Investment Company Act Rel. 
No. 19105 (Nov. 19, 1992) [57 FR 56248 (Nov. 27, 1992)] respectively 
proposing and adopting rule 3a-7 under the 1940 Act [17 CFR 270.3a-
7], the rule excluding the issuers of certain ABSs from the 
definition of investment company.
    \130\ While the structure of ABSs vary, the ABSs that have been 
marketed to money funds have generally involved: (i) the trust, 
which issues the ABSs; (ii) the sponsor, which contributes the 
assets to the trust; (iii) the servicer, which is responsible for 
administering the assets in the pool; (iv) the trustee, which 
monitors the activities of the servicer, and (v) the bank, which 
provides some form of liquidity and/or credit enhancement to assure 
that the trust will have sufficient funds to meet interest and 
amortization payments in the event that cash flow from the 
underlying assets is insufficient to meet the payment schedule of 
the ABSs.
---------------------------------------------------------------------------

    Synthetic securities are another form of ABSs that have been 
developed to address the shortage in the supply of short-term tax 
exempt securities.131 While a variety of synthetic structures 
exist, all involve trusts and partnerships that, in effect, convert 
long-term fixed-rate bonds into variable or floating rate demand 
securities. Typically, one or two long-term, high quality, fixed-rate 
bonds of a single state or municipal issuer (the ``core securities'') 
are deposited in a trust by the sponsor. Interests in the trust may be 
distributed through an offering of securities to the public registered 
under the 1933 Act, or through an offering exempt from the Act's 
registration requirements, such as a ``private placement.'' Holders of 
interests in the trust receive interest at the current short-term 
market rate and the sponsor receives the difference (after 
administrative expenses) between the current market interest rate and 
the long-term rate paid by the core securities. An affiliate of the 
sponsor or a third party (usually a bank) issues a conditional demand 
feature permitting holders to recover principal at par within a 
specified period. The demand features are conditional to address tax-
related concerns.

    \131\ See, e.g., Peter Heap, ``Inside Derivatives Price and 
Demand Are Guide in Building Secondary Market Derivatives,'' Bond 
Buyer, Mar. 14, 1995 at 4; ``Portfolio Manager Paints Derivatives 
with a Broad Brush,'' The Guarantor, Oct. 10, 1994 at 3.
---------------------------------------------------------------------------

    The proposed amendments to the rule would have established specific 
criteria for fund investment in ABSs, and would have addressed issues 
concerning the diversification, maturity and quality standards 
applicable to these types of securities. Most commenters argued that it 
was not necessary to amend the rule in order to provide for the 
treatment of ABSs because the diversification, quality, and maturity 
standards applicable to ABSs could be addressed within the existing 
framework of the rule. Questions were raised, however, concerning the 
applicability of the rule to ABSs both prior to and after the 
publication of the Proposing Release,132 and commenters presented 
widely divergent and, sometimes, conflicting views on how ABSs should 
be treated. The Commission therefore has concluded that amendments are 
necessary to reduce uncertainty concerning the application of the rule 
to these securities.

    \132\ See, e.g., Donaldson, Lufkin & Jenrette Securities 
Corporation (pub. avail. Sept. 23, 1994); Orrick, Herrington & 
Sutcliffe (pub. avail. July 27, 1994).
---------------------------------------------------------------------------

2. Definitions
    The Commission is adopting, substantially as proposed, certain 
definitions used in the rule. The term ``asset backed security'' is 
defined as a fixed-income security issued by a ``special purpose 
entity,'' substantially all the assets of which consist of

[[Page 13969]]
``qualifying assets.'' 133 The term ``special purpose entity'' is 
defined as a trust, corporation, partnership or other entity organized 
for the sole purpose of issuing fixed-income securities, which 
securities entitle their holders to receive payments that depend 
primarily on the cash flow from qualifying assets.134 Finally, the 
term ``qualifying assets'' is defined as financial assets, either fixed 
or revolving, that by their terms convert to cash within a finite time 
period, plus any rights or other assets designed to assure the 
servicing or timely distribution of proceeds to security 
holders.135

    \133\ Paragraph (a)(2) of rule 2a-7, as amended.
    \134\ This term excludes investment companies. Id.
    \135\ Id. The Division of Investment Management has received 
requests for interpretive guidance under rules 2a-7 and 3a-7 under 
the 1940 Act regarding trusts that hold assets that may not be 
redeemed or mature within a ``finite time period.'' See, e.g., 
Donaldson, Lufkin & Jenrette Securities Corp. (pub. avail. Sept. 23, 
1994) (auction rate preferred stock issued by closed-end fund that 
remains outstanding after sale at auction); Brown & Wood (pub. 
avail. Feb. 24, 1994) (cumulative preferred stock with no 
determinable liquidation date). The Commission welcomes requests for 
interpretive guidance or exemptive relief concerning such 
instruments. Rule 2a-7, as amended, should not be interpreted to 
permit investments in ABSs that hold assets that are not 
``qualifying assets'' if the rule's conditions applicable to 
investment in ABSs (e.g., the rating requirement) are not complied 
with.
---------------------------------------------------------------------------

3. Diversification Standards
    a. Diversification: General. The proposed diversification standards 
would have distinguished between qualifying assets that consist of the 
securities of ten or fewer issuers, and qualifying assets that consist 
of the securities of more than ten issuers. In the case of qualifying 
assets that consist of securities issued by ten or fewer issuers (e.g., 
most tax exempt tender option bond structures),136 the issuer of 
each core security would have been treated as the issuer for issuer 
diversification purposes. The sponsor of the ABS would have been 
treated as the issuer when the ten issuer limit was exceeded.

    \136\ See Proposing Release, supra note 20, at Section II.C.4.d.
---------------------------------------------------------------------------

    (1) Special Purpose Entity as Issuer. In proposing to treat the 
sponsor of the special purpose entity as the issuer of the ABS, the 
Commission assumed that the credit quality of the ABS reflects the 
asset origination practices of the sponsor.137 While some 
commenters agreed with the Commission's analysis, most commenters 
addressing the subject strongly opposed treating the sponsor of the ABS 
as the issuer for diversification purposes. They argued that the 
special purpose entity is protected in the event of the sponsor's 
bankruptcy so that an investment in an ABS does not reflect the credit 
risks associated with an investment in the sponsor. The commenters 
pointed out that the NRSRO ratings assigned to ABSs are premised on the 
integrity of the structure of the special purpose entity. These 
commenters urged that the rule treat the special purpose entity as the 
issuer of the ABS. Commenters also pointed out that the proposed 
treatment of the sponsor as the issuer of the ABS was inconsistent with 
the approach of the Commission elsewhere in the securities 
laws.138

    \137\ Id.
    \138\ One commenter stated that a test different from the one 
proposed--that is, one based on asset concentration, would be 
consistent with certain positions taken by the Division of 
Corporation Finance. An asset concentration in excess of ten percent 
may elicit staff comments requesting disclosure of financial 
information regarding the obligor of the assets. See Staff 
Accounting Bulletins 71 and 71A (``SAB 71/71A'').
---------------------------------------------------------------------------

    The Commission has decided to modify the proposal to conform with 
its treatment of the special purpose entity as the sponsor of the ABS 
in other contexts. The diversification standards adopted treat the 
special purpose entity as the issuer of the ABS, subject to the 
exception described below.139

    \139\ Paragraph (c)(4)(vi)(A)(4) of rule 2a-7, as amended.
---------------------------------------------------------------------------

    (2) Looking through the Special Purpose Entity. Several commenters 
agreed that in some circumstances it would be appropriate to ``look 
through'' the special purpose entity and treat the obligor of the 
qualifying assets as the issuer of a portion of the ABS. These 
commenters asserted that whether to look through the special purpose 
entity should not turn on the number of qualifying assets, as the 
Commission proposed, but the extent to which the special purpose entity 
is concentrated in the assets of a single obligor.
    The Commission believes that the approach recommended by the 
commenters has advantages over that included in the proposal. The 
proposed approach was designed primarily to require a fund to look 
through the special purpose entity in the case of a tender option bond 
or other synthetic security that tends to have few underlying 
securities. These structures may have more underlying securities, but 
it would be appropriate to continue to look to the ultimate obligor of 
the underlying security if the security constitutes a sufficiently 
large portion of the obligations underlying the ABS. Moreover, it would 
be appropriate to treat an obligor in a more traditional ABS as the 
issuer of a proportionate portion of the ABS when the security 
represents a sufficiently large portion of the ABS.
    Based on these considerations, the Commission has revised the rule 
to provide that the special purpose entity generally is treated as the 
issuer of the ABS; however, any entity whose obligations constitute ten 
percent or more of the principal amount of the qualifying assets 
backing the ABS is deemed to be the issuer of that portion of the ABS 
equal to the percentage of the qualifying assets represented by all of 
the obligations of the entity included in the pool.140 As amended, 
the rule provides that a special purpose entity whose qualifying assets 
are themselves ABSs (``secondary ABSs'') will be treated as the issuer 
of the secondary ABSs.141 A fund holding ABSs is required to make 
the calculations necessary to determine the issuer of the ABSs for 
diversification purposes on a periodic basis.142

    \140\ Id. A diversification test of this type is consistent with 
a no-action position taken by the Division of Investment Management 
under section 5(b)(1) of the 1940 Act (Hyperion Capital Management, 
Inc. (pub. avail. Aug. 1, 1994)) and accounting positions taken by 
the Division of Corporation Finance (SAB 71/71A, supra note 136). 
See also Securities Exchange Act Release No. 34961 (Nov. 10, 1994) 
[59 FR 59590 (Nov. 17, 1994)] at n.80 and accompanying text.
    \141\ Paragraph (c)(4)(vi)(A)(4) of rule 2a-7, as amended.
    \142\ Paragraphs (c)(8)(iv) and (c)(9)(v) of rule 2a-7, as 
amended. The calculations are required to be made periodically 
because of the revolving nature of many ABSs' assets.
---------------------------------------------------------------------------

    b. Diversification: First Loss Guarantees. The Proposing Release 
noted that some ABSs are issued with guarantees as to first losses, in 
which an institution guarantees all losses up to a specified percentage 
(e.g., ten percent of the assets of the pool).143 Because the loss 
coverage is usually a multiple of the likely losses to be experienced, 
the possibility of the losses exceeding the coverage generally is 
considered to be remote. Because a first loss guarantee exposes the 
guarantor to essentially the same risk as a guarantor of the entire 
value of the security, the Commission proposed that a first loss 
guarantor be treated as guarantor of the entire principal amount of the 
security for purposes of the put diversification standards.

    \143\ Proposing Release, supra note 20, at Section II.C.4.e.
---------------------------------------------------------------------------

    Only one commenter supported this aspect of the Commission's 
proposal. The remaining commenters opposed the proposed amendment, and 
generally argued that the proposed treatment of first loss guarantors 
was inconsistent with the proposed treatment of put providers whose 
obligations are limited

[[Page 13970]]
by contract.144 One commenter objected because the amendment 
appeared to be addressing the guarantor's exposure to losses, rather 
than the fund's. Another commenter noted that, because of the 
contractual limit on the first loss guarantor's obligations, that 
guarantor is only required to make payment for losses experienced by 
the pool to the extent of its guarantee, and additional losses would 
have to be borne by the holder of the ABS.

    \144\ Under proposed amendments to the rule's put 
diversification provisions, the issuer of a fractional put would 
have been treated as guaranteeing only that portion of the value of 
the security which it contractually agreed to provide. See Proposing 
Release, supra note 20, at Section II.C.2.c. The Commission is 
adopting these amendments as proposed. See supra Section II.C.1.d. 
of this Release and paragraph (c)(4)(vi)(B)(2) of rule 2a-7, as 
amended.
---------------------------------------------------------------------------

    Rule 2a-7 diversification requirements are designed to limit the 
exposure of the fund to any single issuer or credit enhancer.145 
Because the exposure of a first loss guarantor to losses the pool may 
incur is substantially greater than the exposure of a fractional 
guarantor, the exposure of the fund to the first loss guarantor is also 
substantially greater.146 Therefore, the Commission believes that 
it is appropriate to treat first loss guarantees differently from 
fractional guarantees. Because first loss guarantees typically are 
designed to cover likely losses to be experienced, a statement made in 
the Proposing Release no commenter contradicted, it seems appropriate 
to treat the first loss guarantor as guaranteeing the entire value of 
the security. The Commission is adopting this amendment as 
proposed.147

    \145\ See Proposing Release, supra note 20, at Section II.A.
    \146\ For example, if a fractional put provider guarantees ten 
percent of the losses experienced by a $1 million pool, and the pool 
has losses of seven percent, the put provider's exposure is $7,000. 
By contrast, if a first loss guarantor guarantees the first ten 
percent of losses experienced by a $1 million pool, and the pool has 
losses of seven percent, the guarantor's exposure is $70,000--an 
amount ten times greater than the fractional put provider's 
exposure.
    \147\ Paragraph (c)(4)(vi)(B)(2) of rule 2a-7, as amended. The 
Commission also notes that the proposed treatment of first loss 
guarantees under rule 2a-7 is consistent with a notice of proposed 
rulemaking issued by the Department of the Treasury, the Federal 
Reserve System, and the Federal Deposit Insurance Corporation. 
``Risk-Based Capital Requirements--Recourse and Direct Credit 
Substitutes; Proposed Rule,'' 59 FR 27115 (May 25, 1994). As 
described in that release, the Office of the Comptroller of the 
Currency, Department of the Treasury, The Board of Governors of the 
Federal Reserve System, the Federal Deposit Insurance Corporation 
and the Office of Thrift Supervision, Department of the Treasury 
proposed revisions to their risk-based capital standards that would 
treat certain first loss guarantees as a guarantee of the entire 
principal amount of the assets enhanced.
---------------------------------------------------------------------------

4. Quality Standards
    The proposed amendments to rule 2a-7 would have limited funds to 
investing only in an ABS that has a short-term rating from a NRSRO and, 
when the final maturity of the ABS exceeds 397 days, a long-term debt 
rating from a NRSRO. Many commenters opposed this proposed requirement, 
arguing that it would be redundant because the rule currently requires 
fund managers to perform a thorough legal, structural and credit 
analysis with respect to all securities. The Commission notes that the 
legal, structural and credit analysis required by rule 2a-7 is to be 
conducted independently of any determination of a security's credit 
quality made by a NRSRO.148 In addition, the Commission continues 
to believe that, in view of the role NRSROs have played in the 
development of the structured finance markets, a rating requirement 
should not be burdensome.149 Because both short- and long-term 
debt ratings from NRSROs reflect the NRSROs' legal, structural, and 
credit analyses, the rule requires that an ABS be rated in order to be 
eligible for fund investment, but does not specify whether the rating 
received must be short- or long-term.150

    \148\ Paragraph (c)(3)(i) of rule 2a-7, as amended; Release 
18005, supra note 11, at Section II.A. (adopting amendments to 
paragraph (c)(2) of rule 2a-7); Letter to Registrants (pub. avail. 
May 8, 1990). For a discussion of the limitations of NRSRO ratings 
for evaluating certain aspects of ABSs, see Investment Company Act 
Rel. No. 20509 at Sec. I.B.1 (Aug. 31, 1994) [59 FR 46304 (Sept. 7, 
1994)].
    \149\ Proposing Release, supra note 20, at Section II.C.4.b.
    \150\ Paragraph (a)(9)(iii)(C) of rule 2a-7, as amended.
---------------------------------------------------------------------------

5. Maturity Standards
    The proposed maturity standards for ABSs would have taken into 
account the difference between ``pay-through'' ABSs and ``pass-
through'' ABSs. A pay-through ABS has a maturity and payment schedule 
different from that of its underlying assets. A pass-through ABS is one 
in which the cash generated by the underlying assets passes through 
directly to the ABS holders. Pass-through ABSs held by funds generally 
are not scheduled to return a holder's principal for three to five 
years. They typically provide for periodic interest rate resets and for 
principal to be returned after some period (not exceeding thirteen 
months) after a demand for payment has been made.
    The proposed amendments would have provided that the final maturity 
of an ABS is the date on which principal is scheduled to be returned to 
the holder, regardless of whether demand has been made. The proposed 
amendments also would have permitted a fund to measure the maturity of 
an ABS with an adjustable rate of interest subject to a demand feature 
by reference to the time principal is scheduled to be repaid once 
demand is made, but only if the holder is entitled to receive principal 
and interest within thirteen months of making demand.
    Several commenters expressed concern regarding the treatment of a 
pass-through ABS with a ``scheduled'' maturity. The commenters noted 
that the effect of the proposed amendments would be to allow funds to 
determine the maturity of an ABS by relying on the date on which 
principal is scheduled, but not necessarily required, to be repaid. 
These commenters concluded that the proposed amendments' reference to a 
scheduled principal repayment is troublesome because on that date there 
is no binding obligation under which the fund would receive payment. In 
light of the comments, the Commission has decided to modify the ABS 
maturity determination by amending the definition of ``demand feature'' 
to include a feature of an ABS permitting the fund unconditionally to 
receive principal and interest within thirteen months of making 
demand.151

[[Page 13971]]
The maturity of an ABS with a final maturity in excess of 397 days may 
be determined by reference to a demand feature only if the ABS also 
meets the definition of a floating or variable rate security.152

    \151\ Paragraph (a)(7)(ii) of rule 2a-7, as amended. For 
example, prior to the fund's election to receive principal payments, 
the maturity of an adjustable rate ABS with a five year final 
maturity and a demand feature permitting the fund to obtain 
principal and interest within thirteen months would be considered a 
thirteen month instrument at all times (i.e., on a rolling basis). 
After the election is made, a fund could treat such an instrument as 
having a maturity equal to the date when principal will be returned 
(i.e., each day that the fund holds the instrument after election, 
the fund could reduce the security's maturity by one day).
    This amendment supersedes an interpretive position taken by the 
Division of Investment Management in Merrill, Lynch, Pierce, Fenner 
& Smith (pub. avail. Apr. 6, 1987). In Merrill, Lynch, the Division 
addressed the maturity determination for a type of variable rate 
coupon note. A holder of the notes was required to satisfy certain 
conditions in order to receive principal on ``the date noted on the 
face of the instrument'' (quoting paragraph (d)(1) of rule 2a-7, 
prior to amendment), and, so long as the notes continued to be held, 
their maturity was automatically extended at the end of each 
interest rate reset period by one additional such period. The 
Division concluded that, subject to certain conditions, a money fund 
could treat such a security as having a maturity equal to the date 
specified on the face of the instrument, as automatically extended 
by an additional interest payment period. The Merrill, Lynch 
position is inconsistent with paragraph (d) of rule 2a-7, as 
amended, which provides that an instrument's maturity is the date on 
which ``the principal amount must unconditionally be paid'' and with 
the maturity determination requirements for ABS discussed in the 
text of this release. Money funds may, however, continue to treat a 
``mandatory tender'' feature as an unconditional right to receive 
principal, provided that the issuer's obligation to pay is not 
dependent on the fund taking any action (such as giving notice to 
the issuer of the intent to redeem), other than physically 
delivering the notes or bonds for redemption.
    \152\ Paragraphs (d)(3) and (d)(5) of rule 2a-7, as amended. The 
maturity of a floating or variable rate ABS may also be determined 
by reference to a demand feature meeting the requirements of 
paragraph (a)(7)(i) of the amended rule.
---------------------------------------------------------------------------

F. Variable and Floating Rate Securities

    Rule 2a-7 generally prohibits a money fund from acquiring a 
security with a remaining maturity of more than 397 calendar days. The 
purpose of this requirement and the other maturity provisions of the 
rule is to limit a fund's exposure to interest rate risk.153 The 
rule generally requires a fund to measure the maturity of a portfolio 
security by reference to the security's final maturity date. A fund, 
however, may measure the maturity of a ``variable rate security'' or a 
``floating rate security'' (collectively, ``adjustable rate 
securities'') by reference to a date that is earlier than the final 
maturity date.

    \153\ See Release 13380, supra note 7, at n.14 and accompanying 
text; State of Wisconsin (pub. avail. Mar. 3, 1983).
---------------------------------------------------------------------------

    Rule 2a-7 defines a ``variable rate security'' as an instrument the 
terms of which provide for the adjustment of the interest rate on 
specified dates and that, upon adjustment, can reasonably be expected 
to have a market value that approximates par value. A ``floating rate'' 
security is defined as an instrument the terms of which provide for the 
adjustment of its interest rate whenever a specified benchmark changes 
and that, at any time, can reasonably be expected to have a market 
value that approximates par value. Rule 2a-7 allows certain adjustable 
rate securities to be treated as having maturities shorter than their 
final maturities; however, the manner in which an adjustable rate 
instrument is treated depends upon whether it has a demand feature, the 
final maturity of the instrument and whether the instrument is a 
Government security.
1. Maturity Determinations: Floating Rate Securities
    Under the current rule, the maturity of a floating rate security 
subject to a demand feature is the period remaining until principal can 
be recovered through demand. The same test is generally applicable in 
determining the maturity of a variable rate security subject to a 
demand feature, the principal amount of which is scheduled on the 
instrument's face to be paid in more than 397 days. In contrast, a 
variable rate security (without a demand feature) scheduled to be paid 
in 397 days or less may be treated as having a maturity equal to the 
period remaining until the next readjustment of the interest rate. 
There is no parallel provision for floating rate securities with final 
maturities of 397 days or less.
    Because variable and floating rate securities expose funds to 
similar types of interest rate risk, the Commission proposed to amend 
the rule to permit funds to determine the maturity of floating rate 
securities with final maturities of 397 days or less by referring to 
the interest rate reset. Commenters supported the proposed amendment, 
which the Commission is adopting substantially as proposed.154 The 
interest rate of a floating rate security moves in tandem with changes 
in the interest rate to which it is linked, and the amendments will 
permit funds to treat these instruments as having one-day maturities.

    \154\ Floating rate securities with final maturities of more 
than 397 days that are subject to demand features are deemed to 
having maturities equal to the period remaining until principal can 
be recovered through demand. Paragraph (d)(5) of rule 2a-7, as 
amended.
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2. Maturity Determinations: Variable Rate Securities
    Under the current rule, when the period remaining until the final 
maturity of a variable rate demand instrument (i.e., its maturity 
without reference to the demand feature) is less than 397 days, its 
maturity under rule 2a-7 is the longer of the period remaining until 
the next interest rate readjustment or the date on which principal can 
be recovered on demand. A variable rate security with the same final 
maturity that does not have a demand feature is treated as having a 
remaining maturity equal to the period remaining until the next 
readjustment in the interest rate. The effect of these provisions is 
that a variable rate security with a final maturity of less than 397 
days will have a longer maturity when a demand feature is added to it.
    To correct this anomaly, the Commission proposed that only a 
variable rate demand security with a final maturity in excess of 397 
days would have its maturity measured by the longer of the period 
remaining until its next interest rate adjustment or the date on which 
principal can be recovered on demand; the maturities of securities with 
final maturities of 397 days or less would be measured by reference to 
the earlier of the date on which the interest rate next readjusts or 
the date on which principal can be recovered on demand. Commenters 
supported the proposed amendment, which the Commission is adopting as 
proposed.155

    \155\ Paragraph (d)(2) of rule 2a-7, as amended.
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3. Adjustable Rate Government Securities
    Rule 2a-7 provides that ``an instrument that is issued or 
guaranteed by the United States government or any agency thereof which 
has a variable rate of interest adjusted no less frequently than every 
762 days'' is deemed to have a maturity equal to the period remaining 
until the next readjustment of the interest rate.156 The 
Commission is adopting two amendments to clarify the scope of this 
provision.

    \156\ Paragraph (d)(1) of rule 2a-7, as amended. Generally, the 
readjustment must occur every 397 days to reflect the rule's 
maturity requirements. For certain funds that mark-to-market, 
however, readjustment may occur every 762 days. Paragraph (c)(2)(ii) 
of rule 2a-7, as amended.
---------------------------------------------------------------------------

    First, the amendments clarify that the maturity of the security may 
only be determined by reference to the interest readjustment date if, 
upon readjustment, the security can reasonably be expected to have a 
market value that approximates par value.157 This change makes 
explicit that Government securities are treated the same way as other 
adjustable rate securities under the rule.158

    \157\ This codifies the interpretation of the current rule. See 
Investment Company Institute (pub. avail. June 16, 1993); Morgan 
Keegan & Company, Inc. (pub. avail. July 24, 1992) at n.7.
    \158\ The amendments also make clear that this provision applies 
to floating rate Government securities. Paragraph (d)(1) of rule 2a-
7, as amended.
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    Second, the reference to Government securities in paragraph (d)(1) 
of rule 2a-7 is being conformed to other provisions of the rule 
relating to Government securities. As amended, the provision applies to 
all Government securities, including securities issued by persons 
controlled or supervised by and acting as instrumentalities of the U.S. 
Government.159

    \159\ The amendment reflects a no-action position taken by the 
Division of Investment Management with respect to securities issued 
by instrumentalities of the U.S. government. See Student Loan 
Marketing Association (pub. avail. Jan. 18, 1989).
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4. Other Issues Concerning Adjustable Rate Securities
    a. Background. Rule 2a-7 allows the maturity of adjustable rate 
securities to be determined by reference to interest rate adjustment 
dates if the security ``can reasonably be expected to have a market 
value that approximates its par value'' upon adjustment of the interest

[[Page 13972]]
rate.160 The Commission proposed to clarify that the board of 
directors or its delegate must have a reasonable expectation that, upon 
each adjustment of the interest rate until the final maturity of the 
security or until the principal amount can be recovered through demand, 
the security will have a market value approximating its amortized 
cost.161

    \160\ Paragraphs (a)(7) and (a)(21) of rule 2a-7 [17 CFR 270.2a-
7(a)(7) and (a)(21)], prior to amendment. Adjustable rate securities 
may be priced at a premium to par value when the security pays 
interest above market rates. A fund may treat the security as an 
adjustable rate security for purposes of rule 2a-7's maturity 
provisions if the fund reasonably expects that upon readjustment of 
the interest rate, the market value of the security will approximate 
its amortized cost. The premium generally would be amortized over 
the life of the security. It is critical that the fund carefully 
consider all factors involved in the valuation of the security, 
particularly the likelihood of prepayment before the premium is 
fully amortized. An accelerated return of principal will require the 
fund to write off the premium before it is amortized, and could 
result in a significant deviation between the amortized cost and 
market value of the security.
    \161\ Paragraphs (a)(12) and (a)(30) of rule 2a-7, as amended.
---------------------------------------------------------------------------

    Several commenters discussed the proposed amendments to the 
maturity determination provisions of the rule as they relate to 
adjustable rate Government securities. Commenters opposing this aspect 
of the proposed amendments emphasized that the amendments should 
exclude adjustable rate Government securities ``based on the lack of 
credit risk'' inherent in these instruments. The maturity determination 
provisions of the rule, however, are designed to limit a fund's 
exposure to interest rate, rather than credit, risk and recent history 
demonstrates that an investment in a Government security can expose the 
fund to substantial interest rate risk.162 The Commission is, 
therefore, adopting the amendment as proposed.

    \162\ In the Proposing Release, the Commission noted that a 
number of adjustable rate securities developed specifically for 
money market funds had interest rate readjustment formulas that 
could not be expected to reflect short-term interest rates under 
certain conditions. At that time, the Commission expressed the 
concern that changes in interest rates or other conditions that 
could reasonably be foreseen to occur during the life of the 
securities could result in their market values not returning to par 
at the time of an interest rate readjustment. The Commission 
identified securities that displayed this characteristic, and 
concluded that such securities presented risks that were not 
appropriate for money market funds to assume. See Proposing Release, 
supra note 20, at nn.161-164 and accompanying text.
    In June 1994, the Division of Investment Management provided 
money market funds and their advisers with additional guidance 
concerning investments in adjustable rate securities. The Division 
reminded fund managers of their general obligations under rule 2a-7 
to ensure that money market funds invest only in securities that are 
consistent with maintaining stable net asset values, and directed 
money market funds that held these securities to work with their 
advisers in developing plans for their orderly disposition. See 
Letter from Barry P. Barbash, Director, Division of Investment 
Management, to Paul Schott Stevens, General Counsel, Investment 
Company Institute (June 30, 1994). Money market funds holding 
adjustable rate securities of the type described in the Proposing 
Release experienced problems when short-term interest rates 
increased last year. To maintain their funds' stable net asset 
values, a number of fund advisers took actions which included 
purchasing certain adjustable rate securities from their money 
market funds at their amortized cost value (plus accrued interest), 
or contributing capital to the funds. One fund holding notes of this 
type, the U.S. Government Money Market Fund, a series of Community 
Bankers Mutual Fund, Inc., announced in September 1994 that it would 
liquidate and distribute less than $1.00 per share to its 
shareholders. Press reports generally treated this liquidation as 
the first instance in which a money market fund had ``broken a 
dollar.'' See Brett D. Fromson, ``Losses on Derivatives Lead Money 
Fund to Liquidate,'' Washington Post, Sept. 28, 1994 at F1; Leslie 
Wayne, ``For Money Market Fund Investors, New Cautions,'' N.Y. 
Times, Sept. 29, 1994 at D1, D8.
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    The effect of the new provision is to prohibit funds from 
purchasing an adjustable rate Government security with a remaining 
maturity of more than 397 days unless the interest rate readjustment 
mechanism can reasonably be expected to return the instrument to par 
upon all interest rate adjustment dates during the life of the 
instrument. A fund could purchase an adjustable rate Government 
security with a remaining maturity of 397 days or less, the value of 
which the fund does not expect to return to par on all interest rate 
adjustment dates, but would have to treat the security as a fixed rate 
security and measure its maturity by reference to its final maturity. 
Adjustable rate securities with demand features generally would not be 
affected by the proposed changes because if a discount develops or is 
likely to develop a fund could exercise the demand feature and receive 
the amortized cost value of the instrument.
    b. Recordkeeping Requirement. The Commission proposed to require a 
money market fund to maintain a written record of its determination 
that an adjustable rate security, the maturity of which is determined 
by reference to its interest rate readjustment date, will either 
maintain a value of par or return to par on each interest rate 
readjustment date through the life of the security. A number of 
commenters who opposed this requirement stated that further guidance 
regarding the definition of the term ``approximates par'' was necessary 
or that the rule should specifically state the amount of deviation that 
would be permissible. The Commission believes that this approach would 
be rigid and unnecessary, absent an indication that decisions reached 
in this area by funds are inconsistent with the purposes of the rule.
    Other commenters asserted that the paperwork burden this 
requirement could entail might outweigh benefits to shareholders, and 
might have the effect of forcing funds to purchase higher proportions 
of fixed rate securities that may have a higher degree of price 
volatility than adjustable rate securities. The Commission is not 
persuaded by this argument. One of these commenters suggested that if 
the determination regarding the return to par would be common to a 
group of securities, a single documentation of the analysis should be 
sufficient. The Commission agrees. The amendments do not require a 
fund's board of directors to maintain a written determination for each 
individual adjustable rate security in the fund's portfolio--it is 
sufficient for the fund to maintain the required record for each type 
of security (e.g., one record could be maintained for several different 
adjustable rate securities of similar credit quality whose interest 
rate readjustment mechanisms are tied to LIBOR plus or minus a number 
of basis points that make the securities similarly sensitive to 
interest rate changes). The Commission has decided to adopt the 
amendments as proposed.163

    \163\ Paragraphs (c)(8)(iii) and (c)(9)(iv) of rule 2a-7, as 
amended.
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G. Other Amendments to Rule 2a-7

1. U.S. Dollar Denominated Instruments
    To avoid exposure to foreign currency risk, rule 2a-7 limits fund 
investment to ``United States dollar-denominated securities.'' 164 
The proposed amendments would have defined the term ``United States 
dollar-denominated'' to clarify that it means: (a) the payment of 
interest and principal must be made in U.S. dollars at all times; and 
(b) an eligible security's interest rate may not vary or float with a 
rate tied to foreign currencies, foreign interest rates, or any index 
expressed in a currency other than U.S. dollars.

    \164\ Paragraph (c)(3)(i) of rule 2a-7, as amended.
---------------------------------------------------------------------------

    Several commenters were critical of the proposed definition and 
recommended that the rule permit fund investment in securities on which 
the amount of interest payable is based on changes in the value of a 
foreign currency as long as principal and interest are payable in full 
in U.S. dollars. The Commission believes that amending the rule in this 
manner would have the effect of exposing the fund to currency 
fluctuations. The Commission has decided to adopt the definition of

[[Page 13973]]
``United States dollar-denominated'' as proposed.165

    \165\ Paragraph (a)(28) of rule 2a-7, as amended.
---------------------------------------------------------------------------

2. Investment in Other Money Funds
    The Commission is adopting, as proposed, amendments to rule 2a-7 to 
clarify that shares in other money funds that comply with the rule: (a) 
are first tier securities;166 and (b) should be treated as having 
a rolling maturity equal to the period of time within which the 
acquired fund is required to make payment upon redemption under 
applicable law.167 A shorter maturity may be used if the fund 
making the investment has a contractual arrangement with the other 
money fund for more rapid receipt of redemption proceeds.168

    \166\ Paragraph (a)(11)(iv) of rule 2a-7, as amended.
    \167\ Paragraph (d)(8) of rule 2a-7, as amended. See also 
Proposing Release, supra note 20, at n.182 and accompanying text; 
T+3 Letter, supra note 65.
    \168\ Id.
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    For diversification purposes, an investment in another money fund 
generally may be treated as an investment in any other issuer (and 
therefore generally cannot exceed five percent of a fund's 
assets).169 An exception to this treatment is made for funds that 
invest substantially all of their assets in shares of another money 
fund (the ``underlying fund'') in which case the fund is permitted to 
``look through'' the shares to the assets of the underlying 
fund.170 These include funds in ``master-feeder'' arrangements and 
certain separate accounts offering variable insurance products. Such a 
fund will be deemed to be in compliance with rule 2a-7 for 
diversification and other purposes if the board of directors reasonably 
believes that the underlying money fund is in compliance with the 
rule.171 The board of directors of the fund is not required to 
monitor every investment decision made by the underlying fund. Rather, 
the board could review the underlying fund's procedures and obtain 
regular reports concerning the underlying fund's compliance with the 
rule.172

    \169\ Investment by one fund in another is limited by section 
12(d)(1)(A) of the 1940 Act [15 U.S.C. 80a-12(d)(1)(A)]. Section 
12(d)(1)(A) provides that a fund may not invest more than ten 
percent of its assets in securities issued by other investment 
companies, invest more than five percent of its assets in any single 
investment company, or acquire more than three percent of the voting 
securities of another investment company.
    \170\ Paragraph (c)(4)(vi)(A)(5) of rule 2a-7, as amended. The 
restrictions of section 12(d)(1)(A) do not apply if the fund making 
the investment invests all of its assets in shares of another fund, 
subject to certain conditions. Section 12(d)(1)(E) [15 U.S.C. 80a-
12(d)(1)(E)].
    \171\ Paragraph (c)(4)(vi)(A)(5) of rule 2a-7, as amended. The 
responsibility for making this determination may be delegated by the 
board to the fund's adviser. Paragraph (e) of rule 2a-7, as amended.
    \172\ In addition, the investment objectives and policies of the 
two funds should not be inconsistent. See Guide 34 to Form N-1A and 
Guide 38 to Form N-3.
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3. Board Approval and Reassessment of Certain Securities
    Rule 2a-7 currently requires the board of directors of a taxable 
fund to approve or ratify purchases of unrated securities and 
securities that are rated by only one NRSRO. The amendments eliminate 
this requirement.173

    \173\ Paragraph (c)(3) of rule 2a-7, as amended.
---------------------------------------------------------------------------

    Rule 2a-7 also requires funds to limit portfolio investments to 
securities determined to present minimal credit risks. In compliance 
with this requirement, the fund's board of directors must reassess 
promptly whether a security presents minimal credit risks when the 
fund's investment adviser becomes aware that an unrated security or a 
second tier security has been given a rating by any NRSRO below the 
NRSRO's second highest rating category. The Proposing Release requested 
comment on whether to permit delegation of the reassessment 
requirement.174 All the commenters who responded to this request 
suggested that the rule should permit delegation of the reassessment 
requirement to the fund's investment adviser. These commenters stated 
that the investment adviser is in a better position to make credit 
determinations given its staff and analytical and information 
resources. The Commission agrees, and is amending the rule as 
suggested.175

    \174\ Proposing Release, supra note 20, at Section II.D.6.
    \175\ Paragraphs (c)(5)(i)(A) and (e) of rule 2a-7, as amended.
---------------------------------------------------------------------------

4. Recordkeeping
    Amendments to rule 2a-7 require a fund to maintain a written record 
of the determination that a portfolio security presents minimal credit 
risks and to maintain a record of NRSRO ratings (if any) used to 
determine the status of a security under the rule.176 The 
Commission is also adopting, as proposed, amendments to rule 31a-1 
under the 1940 Act that require money funds to maintain in their 
portfolio investment records information identifying: (a) each security 
by its legal name; (b) any liquidity or credit enhancements associated 
with each security; and (c) any coupons, accruals, maturities, puts, 
calls or any other information necessary to identify, value and account 
for each security.

    \176\ Paragraph (c)(9)(iii) of rule 2a-7, as amended.
---------------------------------------------------------------------------

5. Defaulted Securities
    Rule 2a-7 imposes certain obligations regarding defaulted 
securities.177 The Commission proposed amending the rule to 
include ``events of insolvency'' as events that would trigger these 
obligations, and is adopting those amendments substantially as they 
were proposed.178 The Commission is adopting as proposed an 
amendment to the rule that would require a fund to notify the 
Commission of the default of a security subject to a credit enhancement 
or demand feature only in the event that the provider of the 
enhancement or demand feature failed to fulfill its obligations to the 
fund.179

    \177\ See Proposing Release, supra note 20, at Section II.D.8.
    \178\ Paragraphs (a)(10) and (c)(5)(ii) of rule 2a-7, as 
amended.
    \179\ Paragraph (c)(5)(iv) of rule 2a-7, as amended.
---------------------------------------------------------------------------

6. Technical Amendments
    The Commission is adopting technical amendments to rule 2a-7 to 
clarify its terminology. References to ``instruments'' are being 
changed to ``securities.'' In addition, references to the requirement 
that the market value of an adjustable rate security must reasonably 
approximate its par value are being changed to clarify that the 
security's market value must reasonably approximate its amortized 
cost.180 The definition of ``unrated security'' also is being 
revised to clarify that if an unrated security becomes rated while held 
by the fund, the fund may continue to treat it as an unrated security, 
in the same manner as a fund may continue to determine whether a 
security rated by a single NRSRO is first or second tier if a second 
NRSRO rates the security after it is acquired by the fund.181 The 
definition of ``first tier security'' is also being amended to include 
government securities.182

    \180\ Paragraphs (a)(12), (a)(30), and (c)(8)(iii) of rule 2a-7, 
as amended. See supra Section II.F.4.a. (discussion of determination 
that par will be approximated).
    \181\ Paragraph (a)(29) of rule 2a-7, as amended.
    \182\ Paragraphs (a)(11)(v) and (a)(13) of rule 2a-7, as 
amended. Prior to the adoption of today's amendments, a fund 
purchasing a government security would have been required to treat 
the security as an unrated first tier security (paragraph 
(a)(11)(iii) of rule 2a-7, as amended), because NRSROs do not rate 
government securities. As a result, the fund would have been 
required to perform a comparability analysis. Under the amended 
definition of ``first tier security,'' a fund may treat a government 
security as first tier without conducting a comparability analysis, 
even though the security has not received a rating from an NRSRO.
---------------------------------------------------------------------------

III. Amendments to Disclosure Rules

    The Commission is adopting amendments to the forms and advertising 
rules used by tax exempt

[[Page 13974]]
funds and is publishing a Staff Guide designed to elicit disclosures 
concerning the specific risks of investing in tax exempt funds.

A. Single State Funds

    To alert investors to the greater risks of investing in single 
state funds, proposed amendments to Form N-1A would have a required a 
single state fund to disclose in its prospectus that: (1) its 
investments are concentrated geographically; (2) for a single state 
fund that does not meet the Five Percent Diversification Test, that the 
fund may invest a significant percentage of its assets in the 
securities of a single issuer; and (3) that an investment in the fund 
therefore may be riskier than an investment in other types of money 
funds.
    Several commenters, while generally supporting additional 
disclosure, expressed concern that the proposed disclosure for single 
state funds might exaggerate the risk of investing in these funds, 
leading to investor confusion. These commenters urged the Commission 
not to require a single state fund to disclose that an investment in it 
may be riskier than an investment in another type of money fund. The 
amendments to rule 2a-7 require single state funds to be diversified at 
the five percent level as to seventy-five percent of their assets, but 
these funds are less diversified than other types of money market funds 
and are still dependent on the financial health of a particular 
state.183 Because of the importance of diversification in 
protecting a fund from exposure to a particular issuer, the Commission 
has decided to require a single state fund that is not diversified as 
to 100% of assets to disclose on the cover page of the prospectus that 
it may invest a significant percentage of its assets in the securities 
of a single issuer, and that an investment in the fund may therefore be 
riskier than investment in other types of money funds. The Commission 
has also decided to adopt the disclosure requirement regarding 
geographic concentration, which may be placed in the text of the 
prospectus, substantially as proposed.184

    \183\ See supra Section II.B.1.a. of this Release and paragraph 
(c)(4)(ii) of rule 2a-7, as amended.
    \184\ Item 4(c) of Form N-1A, as amended.
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B. Disclosure Concerning Exposure to Put Providers

    The Commission is publishing an amendment to Staff Guide 21 to Form 
N-1A. The amendment interprets the form as requiring a money fund 
having more than forty percent of its portfolio subject to third party 
credit enhancements to disclose that the safety of its portfolio (and 
the ability of the fund to maintain a stable share price) is largely 
dependent upon guarantees from foreign and domestic banks and that 
these arrangements are not subject to federal deposit insurance. The 
wording of the guide has been changed somewhat from the draft published 
in the Proposing Release 185 to reflect the approach taken by the 
Commission in proposing to simplify money market fund 
prospectuses.186

    \185\ Guide 21 to Form N-1A, as amended.
    \186\ Investment Company Act Rel. No. 21216 (July 19, 1995) [60 
FR 38454 (July 26, 1995)].
---------------------------------------------------------------------------

    Under the proposed amendments, money fund portfolio schedules would 
have been required to include information regarding put 
providers.187 Those amendments are not being adopted at this time. 
The Commission is currently examining portfolio schedule requirements 
for investment companies generally and will continue to consider the 
proposed amendments in connection with that project.

    \187\ Proposing Release, supra note 20, at Section III.C.
---------------------------------------------------------------------------

C. Risk Disclosure in Certain Communications

    Money funds are required to include in certain advertisements and 
sales literature a statement that an investment in a money fund is not 
insured or guaranteed by the U.S. Government and there can be no 
assurance that the fund will maintain a stable net asset value.188 
The amendments extend this requirement to ``tombstone'' advertisements 
under rule 134 of the 1933 Act.189

    \188\ See paragraph (a)(7) of rule 482 [17 CFR 230.482(a)(7)] 
and introductory paragraph of rule 34b-1 [17 CFR 270.34b-1].
    \189\ Paragraph (e) or rule 134, as amended [17 CFR 230.134(e)].
---------------------------------------------------------------------------

IV. Exemptive Rule Governing Purchases of Certain Portfolio Securities 
by Affiliated Persons

    The Proposing Release noted that when money funds have held a 
security that is no longer eligible for fund investment, fund advisers 
or related persons frequently have repurchased the security from the 
fund at the security's amortized cost value to avoid any fund 
shareholder loss.190 These transactions came within section 
17(a)(2) of the 1940 Act [15 U.S.C. 80a-17(a)(2)], which prohibits an 
affiliated person of a fund, or an affiliated person of such a person, 
from knowingly purchasing a security from the fund in the absence of a 
Commission exemption. Nevertheless, the transactions appeared to be 
reasonable, fair, in the best interests of fund shareholders, and 
consistent with the actions that a fund should take in the event of a 
default of a portfolio security.191 Thus, the staff of the 
Division of Investment Management advised parties to these transactions 
that the staff would not recommend enforcement action to the Commission 
if these transactions were consummated.

    \190\ Proposing Release, supra note 20, at nn.12 and 28 and 
accompanying text.
    \191\ Paragraph (c)(5)(ii) of rule 2a-7, as amended, requires a 
fund holding a defaulted security to dispose of the security as soon 
as practicable consistent with achieving an orderly disposition of 
the security, unless the fund's board of directors concludes that 
disposal would not be in the best interests of the fund.
---------------------------------------------------------------------------

    Based upon the Commission's experience with actions taken by funds 
and their affiliates to dispose of portfolio securities that were no 
longer eligible under rule 2a-7,192 the Commission proposed new 
rule 17a-9 to exempt from section 17(a) of the 1940 Act the purchase of 
a security that is no longer an eligible security. Several commenters, 
including the ICI, opposed the adoption of rule 17a-9, asserting that 
its mere existence would cause investors to expect a fund's adviser to 
purchase ineligible securities from the fund, and guarantee that the 
fund will maintain a stable net asset value.

    \192\ See Testimony of Arthur Levitt, Chairman, U.S. Securities 
and Exchange Commission, Concerning Issues Affecting the Mutual Fund 
Industry Before the Subcommittee on Telecommunications and Finance, 
Committee on Energy and Commerce, U.S. House of Representatives, 23-
25 (Sept. 27, 1994); Testimony of Arthur Levitt, Chairman, U.S. 
Securities and Exchange Commission, Concerning Municipal Bond and 
Government Securities Markets Before the Committee on Banking, 
Housing and Urban Affairs, U.S. Senate, 10-11 (Jan. 5, 1995).
---------------------------------------------------------------------------

    The Commission believes that existing rules applicable to money 
funds already address this concern by requiring money fund prospectuses 
and sales literature to disclose prominently that there is no assurance 
or guarantee that a fund will be able to maintain a stable net asset 
value of $1.00 per share.193 Moreover, the Commission believes it 
unlikely that the existence of an exemptive rule alone will create any 
investor expectations.

    \193\ See Release 18005, supra note 11, at Section II.H. 
(adopting amendments to Item 1(a)(ix) of Form N-1A).
---------------------------------------------------------------------------

    The Commission has decided to adopt the rule as proposed. In doing 
so, the Commission is not suggesting that affiliated persons of funds 
have any legal obligation to enter into transactions covered by the new 
rule. The exemption applies to transactions where: (a) the purchase 
price is paid in cash; and (b) the purchase price is equal to the 
greater of the amortized cost of the security or its market price (in 
each

[[Page 13975]]
case, including accrued interest).194 The rule, as adopted, is 
available for transactions involving securities that are no longer 
eligible securities because they no longer satisfy either the credit 
quality or maturity limiting provisions of the rule (e.g., the 
securities are long-term adjustable rate securities whose market values 
no longer approximate their par values on the interest rate 
readjustment dates).

    \194\ See rule 17a-9, as adopted. A fund must notify the 
Commission in the event of default with respect to portfolio 
securities that account for one half of one percent or more of a 
fund's assets immediately before the occurrence of default. See 
paragraph (c)(5)(iii) of rule 2a-7, as amended.
---------------------------------------------------------------------------

V. Compliance Dates

A. General Compliance Date

    Money funds may comply with any of the amendments or rules adopted 
today upon publication of this release in the Federal Register. 
Beginning October 3, 1996, money funds must comply with all amendments 
and rules adopted today not specifically addressed below in paragraphs 
B. and C.195 The Commission is delegating to the Division Director 
the authority to address issues regarding compliance dates that are not 
addressed in this section, unless the Director believes that it is 
necessary in the public interest or in the interest of investors that 
the Commission consider the issue.

    \195\ To the extent these amendments involve clarification of 
Commission or staff interpretations of the current provisions of 
rule 2a-7, these compliance dates are not intended to suggest that 
non-compliance prior thereto does not involve a violation of rule 
2a-7.
---------------------------------------------------------------------------

    Rule 2a-7 requires funds to meet the rule's diversification 
requirements with respect to a particular issuer on the date the fund 
acquires a security of that issuer.196 Therefore, phase-in rules 
for the new diversification requirements for tax exempt funds are 
unnecessary. A tax exempt fund holding a greater percentage of its 
total assets in the securities of an issuer than the applicable 
diversification requirement permits as of October 3, 1996 may not 
purchase additional securities or ``roll over'' current holdings until 
such securities purchased or rolled over will not cause the fund to 
exceed the applicable diversification requirements immediately after 
the purchase or rollover. Funds are not required to exercise puts or 
otherwise dispose of portfolio holdings to meet the new diversification 
requirements.

    \196\ Paragraphs (c)(4) (i) and (ii) (with respect to 
diversification generally) and (c)(4)(v) (with respect to 
diversification of puts) of rule 2a-7, as amended.
---------------------------------------------------------------------------

B. Grandfathered Securities

    To minimize disruption to funds and markets as a result of adoption 
of these amendments, the Commission is ``grandfathering'' certain 
securities first issued on or before June 3, 1996 that do not meet the 
following requirements of the amended rule:
    (1) requirement that demand features be rated; 197

    \197\ Paragraph (a)(9)(iii)(D)(1) of rule 2a-7, as amended.
---------------------------------------------------------------------------

    (2) requirement that, in order for a security subject to a demand 
feature to be an eligible security, the fund must receive notice from 
the demand feature's issuer or another institution if there is a 
substitution of the provider of the demand feature; 198

    \198\ Paragraph (a)(9)(iii)(D)(2) of rule 2a-7, as amended.
---------------------------------------------------------------------------

    (3) new requirements for ABSs regarding maturity determinations and 
ratings; 199

    \199\ Paragraphs (a)(7)(ii) (definition of demand feature for 
ABS) and (a)(9)(iii)(C) (rating requirements) of rule 2a-7, as 
amended. Note, however, that funds are required to apply the 
diversification requirements for ABS in accordance with Section 
V.A., supra, of this Release. See also paragraph (c)(4)(vi)(A)(4) of 
rule 2a-7, as amended (diversification calculation for ABSs).
---------------------------------------------------------------------------

    (4) revised definition of ``put'' to include ability to recover 
principal and any accrued interest; 200 and

    \200\ Paragraph (a)(16) of rule 2a-7, as amended.
---------------------------------------------------------------------------

    (5) requirement that security subject to conditional demand feature 
is an eligible security only if board of directors or its delegate 
makes certain determinations regarding the demand feature's 
exercisability.201

    \201\ Paragraph (c)(3)(iii)(B) of rule 2a-7, as amended.
---------------------------------------------------------------------------

    A money fund may continue to hold these ``grandfathered'' 
securities or acquire such securities provided that they satisfy the 
other provisions of the rule, as amended, and are issued on or before 
June 3, 1996.
    C. Disclosure and Reporting
    The following amendments pertaining to disclosure and advertising 
will become effective as follows:
    (1) amendments to Form N-1A will be effective: (1) for investment 
companies whose registration statements become effective on or after 
June 3, 1996 upon use of any prospectus on or after June 3, 1996; and 
(2) for all other investment companies, upon use of any prospectus 
contained in any post-effective amendment filed on or after June 3, 
1996;
    (2) amendments to Form N-SAR will be effective for any report 
required by rules 30a-1 and 30b1-1 [17 CFR 270.30a-1 and 270.30b1-1] 
filed on or after July 3, 1996; and
    (3) the amendment to rule 134 under the Securities Act of 1933 will 
be effective for ``tombstone'' advertisements used after June 3, 1996.

VI. Regulatory Flexibility Analysis

    A summary of the Initial Regulatory Flexibility Analysis regarding 
the proposed rule and form amendments was published in the Proposing 
Release. No comments were received. The Commission has prepared a Final 
Regulatory Flexibility Analysis in accordance with 5 U.S.C. 604, a copy 
of which may be obtained by contacting Martha H. Platt, Senior 
Attorney, Mail Stop 10-6, Securities and Exchange Commission, 450 Fifth 
Street, N.W., Washington, D.C. 20549.

VII. Statutory Authority

    The Commission is amending rule 2a-7 under the exemptive and 
rulemaking authority set forth in sections 6(c) [15 U.S.C. 80a-6(c)], 
8(b) [15 U.S.C. 80a-8(b)], 22(c) [15 U.S.C. 80a-22(c)], 34(b) [15 
U.S.C. 80a-34(b)], and 38(a) [15 U.S.C. 80a-37(a)] of the Investment 
Company Act of 1940. The Commission is adopting rule 17a-9 under the 
exemptive and rulemaking authority set forth in sections 6(c) [15 
U.S.C. 80a-6(c)] and 38(a) [15 U.S.C. 80a-37(a)] of the Investment 
Company Act of 1940. The authority citations for the amendments to the 
rules and forms precede the text of the amendments.

VIII. Text of Rule and Form Amendments

List of Subjects in 17 CFR Parts 230, 239, 270 and 274

    Investment companies, Reporting and recordkeeping requirements, 
Securities.

    For the reasons set out in the preamble, the Commission is amending 
chapter II, title 17 of the Code of Federal Regulations as follows:

PART 230--GENERAL RULES AND REGULATIONS, SECURITIES ACT OF 1933

    1. The authority citation for Part 230 continues to read in part as 
follows:

    Authority: 15 U.S.C. 77b, 77f, 77g, 77h, 77j, 77s, 77sss, 78c, 
78d, 78l, 78m, 78n, 78o, 78w, 79ll(d), 79t, 80a-8, 80a-29, 80a-30, 
and 80a-37, unless otherwise noted.
* * * * *
    2. Section 230.134 is amended by adding paragraph (e) to read as 
follows:


Sec. 230.134  Communications not deemed a prospectus.

* * * * *
    (e) In the case of an investment company registered under the 
Investment Company Act of 1940 that holds itself out as a ``money 
market fund,'' a communication used under

[[Page 13976]]
this section shall contain the disclosure required by 
Sec. 230.482(a)(7).

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

    3. The authority citation for Part 270 is amended by removing the 
third paragraph in the sub-authority to read as follows:

    Authority: 15 U.S.C. 80a-1 et seq., 80a-37, 80a-39 unless 
otherwise noted;
* * * * *
    4. Section 270.2a-7 is revised to read as follows:


Sec. 270.2a-7  Money market funds.

    (a) Definitions.
    (1) Amortized Cost Method of valuation shall mean the method of 
calculating an investment company's net asset value whereby portfolio 
securities are valued at the fund's acquisition cost as adjusted for 
amortization of premium or accretion of discount rather than at their 
value based on current market factors.
    (2) Asset Backed Security shall mean a fixed income security (other 
than a Government security) issued by a Special Purpose Entity (as 
hereinafter defined), substantially all of the assets of which consist 
of Qualifying Assets (as hereinafter defined). Special Purpose Entity 
shall mean a trust, corporation, partnership or other entity organized 
for the sole purpose of issuing fixed income securities which entitle 
their holders to receive payments that depend primarily on the cash 
flow from Qualifying Assets, but does not include a registered 
investment company. Qualifying Assets shall mean financial assets, 
either fixed or revolving, that by their terms convert into cash within 
a finite time period, plus any rights or other assets designed to 
assure the servicing or timely distribution of proceeds to security 
holders.
    (3) Business Day shall mean any day, other than Saturday, Sunday, 
or any customary business holiday.
    (4) Collateralized Fully in the case of a repurchase agreement 
shall mean that:
    (i) The value of the securities collateralizing the repurchase 
agreement (reduced by the transaction costs (including loss of 
interest) that the money market fund 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 (as 
defined hereinafter) provided in the agreement; and
    (ii) The money market fund or its custodian either has actual 
physical possession of the collateral or, in the case of a security 
registered on a book entry system, the book entry is maintained in the 
name of the money market fund or its custodian; and
    (iii) The money market fund retains an unqualified right to possess 
and sell the collateral in the event of a default by the seller; and
    (iv) The collateral consists entirely of securities that are direct 
obligations of, or that are fully guaranteed as to principal and 
interest by, the United States or any agency thereof, and/or 
certificates of deposit, bankers' acceptances which are eligible for 
acceptance by a Federal Reserve Bank, and, if the seller is a 
depositary institution as defined in 12 U.S.C. 1813(c), mortgage 
related securities (as such term is defined in section 3(a)(41) of the 
Securities Exchange Act of 1934 [15 U.S.C. 78c(a)(41)]) that, at the 
time the repurchase agreement is entered into, are rated in the highest 
rating category by the Requisite NRSROs.
    (v) Resale Price shall mean the purchase price paid to the seller 
of the securities plus the accrued resale premium on such purchase 
price. The accrued resale premium shall be the amount specified in the 
repurchase agreement or the daily amortization of the difference 
between the purchase price and the resale price specified in the 
repurchase agreement.
    (5) Conditional Demand Feature shall mean a Demand Feature that is 
not an Unconditional Demand Feature.
    (6) Conduit Security shall mean a security issued by a Municipal 
Issuer (as hereinafter defined) involving an arrangement or agreement 
entered into, directly or indirectly, with a person other than a 
Municipal Issuer, which arrangement or agreement provides for or 
secures repayment of the security. Municipal Issuer shall mean a state 
or territory of the United States (including the District of Columbia), 
or any political subdivision or public instrumentality of a state or 
territory of the United States. A Conduit Security does not include a 
security that is:
    (i) Fully and unconditionally guaranteed by a Municipal Issuer; or
    (ii) Payable from the general revenues of the Municipal Issuer or 
other Municipal Issuers (other than those revenues derived from an 
agreement or arrangement with a person who is not a Municipal Issuer 
that provides for or secures repayment of the security issued by the 
Municipal Issuer); or
    (iii) Related to a project owned and operated by a Municipal 
Issuer; or
    (iv) Related to a facility leased to and under the control of an 
industrial or commercial enterprise that is part of a public project 
which, as a whole, is owned and under the control of a Municipal 
Issuer.
    (7) Demand Feature shall mean:
    (i) A Put that may be exercised either:
    (A) At any time on no more than 30 days' notice; or
    (B) At specified intervals not exceeding 397 calendar days and upon 
no more than 30 days' notice; or
    (ii) A feature permitting the holder of an Asset Backed Security 
unconditionally to receive principal and interest within thirteen 
months of making demand.
    (8) Demand Feature Issued By A Non-Controlled Person shall mean a 
Demand Feature issued by a person that, directly or indirectly, does 
not control, and is not controlled by or under common control with the 
issuer of the security subject to the Demand Feature. Control shall 
mean ``control'' as defined in section 2(a)(9) of the Act [15 U.S.C. 
80a-2(a)(9)].
    (9) Eligible Security shall mean:
    (i) A security with a remaining maturity of 397 calendar days or 
less that has received a short-term rating (or that has been issued by 
an issuer that has received a short-term rating with respect to a class 
of debt obligations, or any debt obligation within that class, that is 
comparable in priority and security with the security) by the Requisite 
NRSROs in one of the two highest short-term rating categories (within 
which there may be sub-categories or gradations indicating relative 
standing); or
    (ii) A security:
    (A) That at the time of issuance had a remaining maturity of more 
than 397 calendar days but that has a remaining maturity of 397 
calendar days or less; and
    (B) Whose issuer has received from the Requisite NRSROs a rating 
with respect to a class of debt obligations (or any debt obligation 
within that class) that is now comparable in priority and security with 
the security, in one of the two highest short-term rating categories 
(within which there may be sub-categories or gradations indicating 
relative standing); or
    (iii) An Unrated Security that is of comparable quality to a 
security meeting the requirements of paragraphs (a)(9)(i) or (ii) of 
this section, as determined by the money market fund's board of 
directors; Provided, however, that:
    (A) The board of directors may base its determination that a 
Standby Commitment that is not a Demand Feature is an Eligible Security 
upon a finding that the issuer of the commitment presents a minimal 
risk of default;

[[Page 13977]]

    (B) A security that at the time of issuance had a remaining 
maturity of more than 397 calendar days but that has a remaining 
maturity of 397 or less and that is an Unrated Security is not an 
Eligible Security if the security has received a long-term rating from 
any NRSRO that is not within the NRSRO's three highest long-term 
ratings categories (within which there may be sub-categories or 
gradations indicating relative standing);
    (C) An Asset Backed Security shall not be an Eligible Security 
unless it has a debt rating from an NRSRO; and
    (D) A security that is subject to a Demand Feature shall not be an 
Eligible Security unless:
    (1) The Demand Feature has received a short-term rating from an 
NRSRO (or the issuer of the Demand Feature has received from an NRSRO a 
short-term rating with respect to a class of debt obligations or any 
debt obligation within that class that is comparable in priority and 
security to the Demand Feature); and
    (2) The issuer of the Demand Feature, or another institution, 
undertakes to notify promptly the holder of the security in the event 
that the Demand Feature is substituted with a Demand Feature provided 
by another issuer.
    (10) Event of Insolvency shall mean, with respect to an issuer or 
guarantor:
    (i) An admission of insolvency, the application by the issuer or 
guarantor 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 issuer 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 issuer or guarantor; or
    (iii) The institution of similar proceedings by a government agency 
responsible for regulating the activities of the issuer or guarantor, 
whether or not contested by the issuer or guarantor.
    (11) First Tier Security shall mean any Eligible Security that:
    (i) Has received a short-term rating (or that has been issued by an 
issuer that has received a short-term rating with respect to a class of 
debt obligations, or any debt obligation within that class, that is 
comparable in priority and security with the security) by the Requisite 
NRSROs in the highest short-term rating category for debt obligations 
(within which there may be sub-categories or gradations indicating 
relative standing); or
    (ii) Is a security described in paragraph (a)(9)(ii) of this 
section whose issuer has received from the Requisite NRSROs a short-
term rating with respect to a class of debt obligations (or any debt 
obligation within that class) that now is comparable in priority and 
security with the security, in the highest short-term rating category 
for debt obligations (within which there may be sub-categories or 
gradations indicating relative standing); or
    (iii) Is an Unrated Security that is of comparable quality to a 
security meeting the requirements of paragraphs (a)(11)(i) and (ii) of 
this section, as determined by the fund's board of directors; or
    (iv) Is a security issued by a registered investment company that 
is a money market fund; or
    (v) Is a Government Security.
    (12) Floating Rate Security shall mean a security the terms of 
which provide for the adjustment of its interest rate whenever a 
specified interest rate changes and which, at any time until the final 
maturity of the instrument or the period remaining until the principal 
amount can be recovered through demand, can reasonably be expected to 
have a market value that approximates its amortized cost.
    (13) Government Security shall mean any Government Security as 
defined in section 2(a)(16) of the Act [15 U.S.C. 80a-2(a)(16)].
    (14) NRSRO shall mean 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, guarantor or provider of 
credit support for, the security.
    (15) Penny-Rounding Method of pricing shall mean the method of 
computing an investment company's price per share for purposes of 
distribution, redemption and repurchase whereby the current net asset 
value per share is rounded to the nearest one percent.
    (16) Put shall mean a right to sell a specified underlying security 
or securities within a specified period of time and at an exercise 
price equal to the amortized cost of the underlying security or 
securities plus accrued interest, if any, at the time of exercise, that 
may be sold, transferred or assigned only with the underlying security 
or securities. A Put will be considered to be from the party to whom 
the money market fund will look for payment of the exercise price.
    (17) Put Issued by a Non-Controlled Person shall mean a Put issued 
by a person that, directly or indirectly, does not control, and is not 
controlled by or under common control with the issuer of the security 
subject to the Put. Control shall mean ``control'' as defined in 
section 2(a)(9) of the Act [15 U.S.C 80a-2(a)(9)].
    (18) Refunded Security shall mean 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 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:
    (i) The deposited securities shall not be redeemable prior to their 
final maturity;
    (ii) At the time the deposited securities are placed in the escrow 
account, 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; and
    (iii) The escrow agreement shall prohibit the substitution of the 
deposited securities unless the substituted securities are Government 
Securities and, at the time of such substitution, the escrow agent 
shall have received a certification from an independent certified 
public accountant substantially the same as that required by paragraph 
(a)(18)(ii) of this section which certification shall give effect to 
the substitution.
    (19) Requisite NRSROs shall mean:
    (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 fund 
purchases or rolls over the security, that NRSRO.
    (20) Second Tier Security shall mean any Eligible Security that is 
not a First Tier Security. Second Tier Conduit Security shall mean any 
Conduit Security that is an Eligible Security that is not a First Tier 
Security.
    (21) Single State Fund shall mean a Tax Exempt Fund that holds 
itself out as primarily distributing income exempt

[[Page 13978]]
from the income taxes of a specified state or locality.
    (22) Standby Commitment shall mean a Put that entitles the holder 
to achieve same day settlement.
    (23) Tax Exempt Fund shall mean any money market fund that holds 
itself out as distributing income exempt from regular federal income 
tax.
    (24) Total Assets shall mean, with respect to a money market fund 
using the Amortized Cost Method, the total amortized cost of its assets 
and, with respect to any other money market fund, the total market-
based value of its assets.
    (25) Unconditional Demand Feature shall mean an Unconditional Put 
that is also a Demand Feature.
    (26) Unconditional Demand Feature Issued By A Non-Controlled Person 
shall mean an Unconditional Put that is also a Demand Feature Issued By 
A Non-Controlled Person.
    (27) Unconditional Put shall mean a Put (including any guarantee, 
financial guarantee (bond) insurance, letter of credit or similar 
unconditional credit enhancement) that by its terms would be readily 
exercisable in the event of a default in payment of principal or 
interest on the underlying security or securities.
    (28) United States Dollar-Denominated shall mean, with reference to 
a security, that all principal and interest payments on such security 
are payable to security holders in United States dollars under all 
circumstances and that the interest rate of, the principal amount to be 
repaid, and the timing of payments related to such security do not vary 
or float with the value of a foreign currency, the rate of interest 
payable on foreign currency borrowings, or with any other interest rate 
or index expressed in a currency other than United States dollars.
    (29) Unrated Security shall mean:
    (i) A security with a remaining maturity of 397 calendar days or 
less issued by an issuer that did not, at the time the security was 
acquired or rolled over by the fund, have a current short-term rating 
assigned by any NRSRO:
    (A) To the security; or
    (B) To the issuer of the security with respect to a class of debt 
obligations

(or any debt obligation within that class) that is comparable in 
priority and security with the security, or a Demand Feature with 
respect to the security; and
    (ii) A security:
    (A) That at the time of issuance had a remaining maturity of more 
than 397 calendar days but that has a remaining maturity of 397 
calendar days or less; and
    (B) Whose issuer had not at the time it was acquired or rolled over 
by the fund received from any NRSRO a short-term rating with respect to 
a class of debt obligations (or any debt obligation within that class) 
that now is comparable in priority and security with the security; and
    (iii) A security that is a rated security and is the subject of an 
external credit support agreement (including an arrangement by which 
the security has become a Refunded Security) that was not in effect 
when the security (or the issuer) was assigned its rating unless the 
security has a rating from an NRSRO reflecting the existence of the 
credit support agreement.
    (iv) A security is not an Unrated Security if any debt obligation 
(reference security) that is issued by the same issuer and is 
comparable in priority and security with that security has a short-term 
rating by an NRSRO. The status of such security as an Eligible Security 
or First Tier Security shall be the same as that of the reference 
security.
    (30) Variable Rate Security shall mean a security the terms of 
which provide for the adjustment of its interest rate on set dates 
(such as the last day of a month or calendar quarter) and which, upon 
each adjustment until the final maturity of the instrument or the 
period remaining until the principal amount can be recovered through 
demand, can reasonably be expected to have a market value that 
approximates its amortized cost.
    (b) Holding Out. It shall be an untrue statement of material fact 
within the meaning of section 34(b) of the Act [15 U.S.C. 80a-33(b)] 
for a registered investment company, in any registration statement, 
application, report, account, record, or other document filed or 
transmitted pursuant to the Act, including any advertisement, pamphlet, 
circular, form letter, or other sales literature addressed to or 
intended for distribution to prospective investors that is required to 
be filed with the Commission by section 24(b) of the Act [15 U.S.C. 
80a-24(b)] to:
    (1) Adopt the term ``money market'' as part of its name or title or 
the name or title of any redeemable securities of which it is the 
issuer; or
    (2) Hold itself out to investors as, or adopt a name which suggests 
that it is, a money market fund or the equivalent of a money market 
fund, unless such registered investment company meets the conditions of 
paragraphs (c)(2), (c)(3), and (c)(4) of this section. For purposes of 
this paragraph, a name which suggests that a registered investment 
company is a money market fund or the equivalent thereof shall include 
one which uses such terms as ``cash,'' ``liquid,'' ``money,'' ``ready 
assets'' or similar terms.
    (c) Share Price Calculations. The current price per share, for 
purposes of distribution, redemption and repurchase, of any redeemable 
security issued by any registered investment company (``money market 
fund''), notwithstanding the requirements of section 2(a)(41) of the 
Act [15 U.S.C. 80a-2(a)(41)] and of Secs. 270.2a-4 and 270.22c-1 
thereunder, may be computed by use of the Amortized Cost Method or the 
Penny-Rounding Method; Provided, however, That:
    (1) Board Findings. The board of directors of the money market fund 
shall determine, in good faith, that it is in the best interests of the 
fund and its shareholders to maintain a stable net asset value per 
share or stable price per share, by virtue of either the Amortized Cost 
Method or the Penny-Rounding Method, and that the money market fund 
will continue to use such method only so long as the board of directors 
believes that it fairly reflects the market-based net asset value per 
share.
    (2) Portfolio Maturity. The money market fund shall maintain a 
dollar-weighted average portfolio maturity appropriate to its objective 
of maintaining a stable net asset value per share or price per share; 
Provided, however, That the money market fund will not:
    (i) Except as provided in paragraph (c)(2)(ii) of this section, 
purchase any instrument with a remaining maturity of greater than 397 
calendar days; or
    (ii) In the case of a money market fund not using the Amortized 
Cost Method, purchase a Government Security with a remaining maturity 
of greater than 762 calendar days; or
    (iii) Maintain a dollar-weighted average portfolio maturity that 
exceeds ninety days.
    (3) Portfolio Quality.
    (i) General. The money market fund shall limit its portfolio 
investments, including Puts and repurchase agreements, to those United 
States Dollar-Denominated securities that the fund's board of directors 
determines present minimal credit risks (which determination must be 
based on factors pertaining to credit quality in addition to any rating 
assigned to such securities by an NRSRO) and which are at the time of 
acquisition Eligible Securities.
    (ii) Securities Subject to Unconditional Demand Features. A 
security that is subject to an Unconditional Demand Feature may be 
determined to be an Eligible Security or a First Tier Security based 
solely on

[[Page 13979]]
whether the Unconditional Demand Feature is an Eligible Security or 
First Tier Security, as the case may be.
    (iii) Securities Subject to Conditional Demand Features. A security 
that is subject to a Conditional Demand Feature (``Underlying 
Security'') may be determined to be an Eligible Security or a First 
Tier Security only if:
    (A) The Conditional Demand Feature is an Eligible Security or First 
Tier Security, as the case may be; and
    (B) At the time of the purchase of the Underlying Security, the 
money market fund's board of directors has determined that there is 
minimal risk that the circumstances that would result in the 
Conditional Demand Feature not being exercisable will occur; and
    (1) The conditions limiting exercise either can be monitored 
readily by the fund, or relate to the taxability, under federal, state 
or local law, of the interest payments on the security; or
    (2) The terms of the Conditional Demand Feature require that the 
fund will receive notice of the occurrence of the condition and the 
opportunity to exercise the Demand Feature in accordance with its 
terms; and
    (C) (1) If the Underlying Security has a remaining maturity of 397 
days or less, the Underlying Security (or the debt securities of issuer 
of the Underlying Security) has received a short-term rating by the 
Requisite NRSROs within the NRSROs' two highest short-term ratings 
categories (within which there may be sub-categories or gradations 
indicating relative standing) or, if unrated, is determined to be of 
comparable quality by the money market fund's board of directors; or
    (2) If the Underlying Security has a remaining maturity of more 
than 397 calendar days, the Underlying Security (or the debt securities 
of the issuer of the Underlying Security) has received a long-term 
rating by the Requisite NRSROs within the NRSROs' two highest long-term 
rating categories (within which there may be sub-categories or 
gradations indicating relative standing) or, if unrated, is determined 
to be of comparable quality by the money market fund's board of 
directors.
    (4) Portfolio Diversification.
    (i) Taxable and National Funds. Immediately after the acquisition 
of any security (other than a Government Security or a security subject 
to an Unconditional Demand Feature Issued By a Non-Controlled Person), 
a money market fund other than a Single State Fund shall not have 
invested more than five percent of its Total Assets in securities 
issued by the issuer of the security.
    (ii) Single State Funds. With respect to 75 percent of its Total 
Assets, immediately after the acquisition of any security (other than a 
Government Security or a security subject to an Unconditional Demand 
Feature Issued By a Non-Controlled Person), a Single State Fund shall 
not have invested more than five percent of its Total Assets in 
securities issued by the issuer of the security; Provided, however, 
That a Single State Fund shall not invest more than five percent of its 
Total Assets in securities issued by the issuer of the security unless 
the securities are First Tier Securities.
    (iii) Safe Harbor. Notwithstanding paragraph (c)(4)(i) of this 
section, a money market fund other than a Single State Fund may invest 
up to twenty-five percent of its Total Assets in the First Tier 
Securities of a single issuer for a period of up to three Business days 
after the purchase thereof.
    (iv) Second Tier Securities.
    (A) Taxable Funds. Immediately after the acquisition of any Second 
Tier Security, a money market fund that is not a Tax Exempt Fund shall 
not have invested more than:
    (1) The greater of one percent of its Total Assets or one million 
dollars in securities issued by that issuer which, when acquired by the 
money market fund (either initially or upon any subsequent roll over) 
were Second Tier Securities; and
    (2) Five percent of its Total Assets in securities which, when 
acquired by the money market fund (either initially or upon any 
subsequent roll over) were Second Tier Securities.
    (B) Tax Exempt Funds. Immediately after the acquisition of any 
Second Tier Conduit Security that is not subject to an Unconditional 
Demand Feature Issued By a Non-Controlled Person, a money market fund 
that is a Tax Exempt Fund shall not have invested more than:
    (1) The greater of one percent of its Total Assets or one million 
dollars in securities issued by that issuer which, when acquired by the 
money market fund (either initially or upon any subsequent roll over) 
were Second Tier Conduit Securities not subject to an Unconditional 
Demand Feature Issued By a Non-Controlled Person; and
    (2) Five percent of its Total Assets in Conduit Securities which, 
when acquired by the money market fund (either initially or upon any 
subsequent roll over) were Second Tier Conduit Securities not subject 
to an Unconditional Demand Feature Issued By a Non-Controlled Person.
    (v) Puts.
    (A) General. Immediately after the acquisition of any Put or 
security subject to a Put, with respect to seventy-five percent of the 
assets of a money market fund, no more than ten percent of the fund's 
Total Assets may be invested in securities issued by or subject to Puts 
from the institution that issued the Put, subject to sections 
(c)(4)(v)(B) and (C) of this section.
    (B) Second Tier Puts. Immediately after the acquisition of any Put 
(or a security after giving effect to the Put) that is a Second Tier 
Security, a money market fund shall not have invested more than five 
percent of its Total Assets in securities issued by or subject to Puts 
from the institution that issued the Put.
    (C) Puts Issued by Non-Controlled Persons. Immediately after the 
acquisition of any security subject to a Put, a money market fund shall 
not have invested more than ten percent of its Total Assets in 
securities issued by, or subject to Puts from the institution that 
issued the Put, unless, with respect to any security subject to Puts 
from that institution, the Put is a Put Issued By a Non-Controlled 
Person.
    (iv) Diversification Calculations.
    (A) General. For purposes of making calculations under paragraphs 
(c)(4)(i) through (iv) of this section:
    (1) Repurchase Agreements. The acquisition of a repurchase 
agreement may be deemed to be an acquisition of the underlying 
securities, provided that the obligation of the seller to repurchase 
the securities from the money market fund is Collateralized Fully.
    (2) Refunded Securities. The acquisition of a Refunded Security 
shall be deemed to be an acquisition of a Government Security.
    (3) Conduit Securities. A Conduit Security shall be deemed to be 
issued by the issuer (other than the Municipal Issuer) ultimately 
responsible for payments of interest and principal on the security.
    (4) Asset Backed Securities. An Asset Backed Security shall be 
deemed to be issued by the Special Purpose Entity that issued the Asset 
Backed Security, Provided, however, any person whose obligations 
constitute ten percent or more of the principal amount of the 
Qualifying Assets shall be deemed to be an issuer of the portion of the 
Asset Backed Security such obligations represent. For purposes of the 
foregoing, if the Qualifying Assets held by the Special Purpose Entity 
are themselves Asset Backed Securities (``Secondary Asset Backed 
Securities''), then the Special Purpose Entity shall be treated as 
holding directly the Secondary Asset Backed Securities.
    (5) Shares in Master Funds. A money market fund substantially all 
of the

[[Page 13980]]
assets of which consist of shares of another money market fund acquired 
in reliance on section 12(d)(1)(E) of the Act [15 U.S.C. 80a-
12(d)(1)(E)] shall be deemed to be in compliance with this section if 
the board of directors reasonably believes that the money market fund 
in which it has invested is in compliance with this section.
    (B) Put Diversification Calculations. In making calculations under 
the Put diversification requirements of paragraph (c)(4)(v) of this 
section, the following rules apply:
    (1) Issuer-Provided Puts. In the case of a security subject to a 
Put from the same institution that issued the underlying security, the 
value of the securities subject to the Put may be excluded from the Put 
diversification requirements of paragraph (c)(4)(v) of this section.
    (2) Fractional Puts. In the case of a security subject to a Put 
from an institution by which the institution guarantees a specified 
portion of the value of the security, the institution shall be deemed 
to guarantee the specified portion thereof, Provided, however, if the 
security is an Asset Backed Security and the Put is a guarantee of all 
or a portion of the first losses with respect to the security, the 
institution providing the Put shall be deemed to have guaranteed the 
entire principal amount of the security.
    (3) Layered Puts. In the case of a security subject to Puts from 
multiple institutions that have not limited the extent of their 
obligations as described in paragraph (c)(4)(vi)(B)(2) of this section, 
each institution shall be deemed to have guaranteed the entire 
principal amount of the security, Provided, however, in the case of a 
security subject to an Unconditional Demand Feature and a Put (or Puts) 
that is not a Demand Feature, the Put diversification requirements of 
paragraph (c)(4)(v) of this section need only be satisfied as to the 
institution issuing the Unconditional Demand Feature.
    (4) Puts Not Relied Upon. If the fund's board of directors 
determines that the fund is not relying on a Put to determine the 
quality (pursuant to paragraphs (c)(3)(ii) or (c)(3)(iii) of this 
section), or maturity (pursuant to paragraph (d) of this section), or 
liquidity of the portfolio security and maintains a record of this 
determination (pursuant to paragraphs (c)(8)(ii) and (c)(9)(vi) of this 
section), the Put diversification requirements of paragraph (c)(4)(v) 
of this section need not be satisfied as with respect to such put.
    (vii) Diversification Safe Harbor. A money market fund that 
satisfies the applicable diversification requirements of paragraph 
(c)(4) of this section shall be deemed to have satisfied the 
diversification requirements of section 5(b)(1) of the Act [15 U.S.C. 
80a-5(b)(1)] and the rules adopted thereunder.
    (5) Downgrades, Defaults and Other Events.
    (i) Downgrades.
    (A) General. Upon the occurrence of either of the events specified 
in paragraphs (c)(5)(i)(A)(1) and (2) of this section with respect to a 
portfolio security, the board of directors of the money market fund 
shall reassess promptly whether such security continues to present 
minimal credit risks and shall cause the fund to take such action as 
the board of directors determines is in the best interests of the money 
market fund and its shareholders:
    (1) A portfolio security of a money market fund ceases to be a 
First Tier Security (either because it no longer has the highest rating 
from the Requisite NRSROs or, in the case of an Unrated Security, the 
board of directors of the money market fund determines that it is no 
longer of comparable quality to a First Tier Security); and
    (2) The money market fund's investment adviser (or any person to 
whom the fund's board of directors has delegated portfolio management 
responsibilities) becomes aware that any Unrated Security or Second 
Tier Security held by the money market fund has, since the security was 
acquired by the fund, been given a rating by any NRSRO below the 
NRSRO's second highest rating category.
    (B) Securities To Be Disposed Of. The reassessments required by 
paragraph (c)(5)(i)(A) of this section shall not be required if, in 
accordance with the procedures adopted by the board of directors, the 
security is disposed of (or matures) within five Business days of the 
specified event and, in the case of events specified in paragraph 
(c)(5)(i)(A)(2) of this section, the board is subsequently notified of 
the adviser's actions.
    (C) Special Rule for Certain Securities Subject to Demand Features. 
In the event that after giving effect to a rating downgrade, more than 
five percent of the fund's Total Assets are invested in securities 
issued by or subject to Demand Features from a single institution that 
are Second Tier Securities, the board of directors (or its delegate) 
shall cause the fund to reduce its investment in securities issued by 
or subject to Demand Features from that institution to no more than 
five percent of its Total Assets by exercising the Demand Features at 
the next succeeding exercise date(s), absent a finding by the board of 
directors that disposal of the portfolio security would not be in the 
best interests of the money market fund.
    (ii) Defaults and Other Events. Upon the occurrence of any of the 
events specified in paragraphs (c)(5)(ii)(A) through (D) of this 
section with respect to a portfolio security, the money market fund 
shall dispose of such security as soon as practicable consistent with 
achieving an orderly disposition of the security, by sale, exercise of 
any Demand Feature or otherwise, absent a finding by the board of 
directors that disposal of the portfolio security would not be in the 
best interests of the money market fund (which determination may take 
into account, among other factors, market conditions that could affect 
the orderly disposition of the portfolio security):
    (A) The default with respect to a portfolio security (other than an 
immaterial default unrelated to the financial condition of the issuer);
    (B) A portfolio security ceases to be an Eligible Security;
    (C) A portfolio security has been determined to no longer present 
minimal credit risks; or
    (D) An Event of Insolvency occurs with respect to the issuer of or 
the provider of any Put with respect to a portfolio security other than 
a Put with respect to which a non-reliance determination has been made 
pursuant to paragraph (c)(4)(vi)(B)(4) of this section.
    (iii) Notice to the Commission. In the event of a default with 
respect to one or more portfolio securities (other than an immaterial 
default unrelated to the financial condition of the issuer) or an Event 
of Insolvency with respect to the issuer of the security or any Put to 
which it is subject, where immediately before default the securities 
(or the securities subject to the Put) accounted for \1/2\ of 1 percent 
or more of a money market fund's Total Assets, the money market fund 
shall promptly notify the Commission of such fact and the actions the 
money market fund intends to take in response to such situation. 
Notification under this paragraph shall be made telephonically or by 
means of a facsimile transmission, followed by letter sent by first 
class mail, directed to the attention of the Director of the Division 
of Investment Management.
    (iv) Defaults for Purposes of Paragraphs (c)(5)(ii) and (iii). For 
purposes of paragraphs (c)(5)(ii) and (iii) of this section, an 
instrument subject to a Demand Feature or unconditional credit 
enhancement shall not be deemed to be in default (and an Event of 
Insolvency with respect to the security

[[Page 13981]]
shall not be deemed to have occurred) if:
    (A) In the case of an instrument subject to a Demand Feature, the 
Demand Feature has been exercised and the fund has recovered either the 
principal amount or the amortized cost of the instrument, plus accrued 
interest; or
    (B) The provider of the credit enhancement is continuing, without 
protest, to make payments as due on the instrument.
    (6) Required Procedures: Amortized Cost Method. In the case of a 
money market fund using the Amortized Cost Method:
    (i) General. In supervising the money market fund's operations and 
delegating special responsibilities involving portfolio management to 
the money market fund's investment adviser, the money market fund's 
board of directors, as a particular responsibility within the overall 
duty of care owed to its shareholders, shall establish written 
procedures reasonably designed, taking into account current market 
conditions and the money market fund's investment objectives, to 
stabilize the money market fund's net asset value per share, as 
computed for the purpose of distribution, redemption and repurchase, at 
a single value.
    (ii) Specific Procedures. Included within the procedures adopted by 
the board of directors shall be the following:
    (A) Shadow Pricing. Written procedures shall provide:
    (1) That the extent of deviation, if any, of the current net asset 
value per share calculated using available market quotations (or an 
appropriate substitute which reflects current market conditions) from 
the money market fund's amortized cost price per share, shall be 
calculated at such intervals as the board of directors determines 
appropriate and reasonable in light of current market conditions;
    (2) For the periodic review by the board of directors of the amount 
of the deviation as well as the methods used to calculate the 
deviation; and
    (3) For the maintenance of records of the determination of 
deviation and the board's review thereof.
    (B) Prompt Consideration of Deviation. In the event such deviation 
from the money market fund's amortized cost price per share exceeds \1/
2\ of 1 percent, the board of directors shall promptly consider what 
action, if any, should be initiated by the board of directors.
    (C) Material Dilution or Unfair Results. Where the board of 
directors believes the extent of any deviation from the money market 
fund's amortized cost price per share may result in material dilution 
or other unfair results to investors or existing shareholders, it shall 
cause the fund to take such action as it deems appropriate to eliminate 
or reduce to the extent reasonably practicable such dilution or unfair 
results.
    (7) Required Procedures: Penny-Rounding Method. In the case of a 
money market fund using the Penny-Rounding Method, in supervising the 
money market fund's operations and delegating special responsibilities 
involving portfolio management to the money market fund's investment 
adviser, the money market fund's board of directors undertakes, as a 
particular responsibility within the overall duty of care owed to its 
shareholders, to assure to the extent reasonably practicable, taking 
into account current market conditions affecting the money market 
fund's investment objectives, that the money market fund's price per 
share as computed for the purpose of distribution, redemption and 
repurchase, rounded to the nearest one percent, will not deviate from 
the single price established by the board of directors.
    (8) Specific Procedures: Amortized Cost and Penny-Rounding Methods. 
Included within the procedures adopted by the board of directors for 
money market funds using either the amortized cost or penny-rounding 
methods shall be the following:
    (i) Securities for Which Maturity is Determined by Reference to 
Demand Features. In the case of a security for which maturity is 
determined by reference to a Demand Feature, written procedures shall 
require ongoing review of the security's continued minimal credit 
risks, which review must be based on, among other things, financial 
data for the most recent fiscal year of the issuer of the Demand 
Feature and, in the case of a security subject to a Conditional Demand 
Feature, the issuer of the security, whether such data is publicly 
available or provided under the terms of the security's governing 
documentation.
    (ii) Securities Subject to Puts. In the case of a security subject 
to one or more Puts, written procedures shall require periodic 
evaluation of the determination described in paragraph 
(c)(4)(vi)(B)(4)(puts not relied upon) of this section.
    (iii) Adjustable Rate Securities Without Demand Features. In the 
case of a Variable Rate or Floating Rate Security that does not have a 
Demand Feature and for which maturity is determined pursuant to 
paragraphs (d)(1), (d)(2) or (d)(4) of this section, written procedures 
shall require periodic review of whether the security, upon 
readjustment of its interest rate, can reasonably be expected to have a 
market value that approximates its amortized cost.
    (iv) Asset Backed Securities. In the case of an Asset Backed 
Security, written procedures shall require the fund to periodically 
determine whether a person other than the Special Purpose Entity is the 
issuer of all or a portion of the Asset Backed Security for purposes of 
paragraph (c)(4)(vi)(A)(4) of this section.
    (9) Record Keeping and Reporting.
    (i) Written Procedures. For a period of not less than six years 
following the replacement of such procedures with new procedures (the 
first two years in an easily accessible place), a written copy of the 
procedures (and any modifications thereto) described in paragraphs 
(c)(5) through (c)(8) and (e) of this section shall be maintained and 
preserved.
    (ii) Board Considerations and Actions. For a period of not less 
than six years (the first two years in an easily accessible place) a 
written record shall be maintained and preserved of the board of 
directors' considerations and actions taken in connection with the 
discharge of its responsibilities, as set forth in this section, to be 
included in the minutes of the board of directors' meetings.
    (iii) Credit Risk Analysis. For a period of not less than three 
years from the date that the credit risks of a portfolio security were 
most recently reviewed in accordance with paragraph (c)(8)(i) of this 
section, a written record of the determination that a portfolio 
security presents minimal credit risks and the NRSRO ratings (if any) 
used to determine the status of the security as an Eligible Security, 
First Tier Security or Second Tier Security shall be maintained and 
preserved in an easily accessible place.
    (iv) Determinations With Respect to Adjustable Rate Securities. For 
a period of not less than three years from the date when the 
determination was most recently made, a written record shall be 
preserved and maintained, in an easily accessible place, of the 
determination required by paragraph (c)(8)(iii) of this section (that a 
Variable Rate or Floating Rate Security that does not have a Demand 
Feature and for which maturity is determined pursuant to paragraphs 
(d)(1), (d)(2) or (d)(4) of this section can reasonably be expected, 
upon readjustment of its interest rate at all times during the life of 
the instrument, to have a market value that approximates its amortized 
cost).

[[Page 13982]]

    (v) Determinations with Respect to Asset Backed Securities. For a 
period of not less than three years from the date when the 
determination was most recently made, a written record shall be 
preserved and maintained, in an easily accessible place, of the 
determination required by paragraph (c)(8)(iv) of this section (whether 
a person other than the Special Purpose Entity is the issuer of all or 
a portion of an Asset Backed Security pursuant to paragraph (c)(vi)(4) 
of this section). The written record shall include the identities of 
the issuers of the Qualifying Assets whose obligations constitute ten 
percent or more of the principal value of the Qualifying Assets, the 
percentage of the Qualifying Assets constituted by the securities of 
each such issuer and the percentage of the fund's Total Assets that are 
invested in securities of each such issuer.
    (vi) Evaluations with Respect to Securities Subject to Puts. For a 
period of not less than three years from the date when the evaluation 
was most recently made, a written record shall be preserved and 
maintained, in an easily accessible place, of the evaluation required 
by paragraph (c)(8)(ii) (regarding securities subject to one or more 
Puts) of this section.
    (vii) Inspection of Records. The documents preserved pursuant to 
this paragraph (c)(9) shall be subject to inspection by the Commission 
in accordance with section 31(b) of the Act [15 U.S.C. 80a-30(b)] as if 
such documents were records required to be maintained pursuant to rules 
adopted under section 31(a) of the Act [15 U.S.C. 80a-30(a)]. If any 
action was taken under paragraphs (c)(5)(ii) (with respect to defaulted 
securities and events of insolvency) or (c)(6)(ii) (with respect to a 
deviation from the fund's share price of more than \1/2\ of 1 percent) 
of this section, the money market fund will file an exhibit to the Form 
N-SAR [17 CFR 274.101] filed for the period in which the action was 
taken describing with specificity the nature and circumstances of such 
action. The money market fund will report in an exhibit to such Form 
any securities it holds on the final day of the reporting period that 
are not Eligible Securities.
    (d) Maturity of Portfolio Securities. For purposes of this section, 
the maturity of a portfolio security shall be deemed to be the period 
remaining (calculated from the trade date or such other date on which 
the fund's interest in the security is subject to market action) until 
the date on which, in accordance with the terms of the security, the 
principal amount must unconditionally be paid, or in the case of a 
security called for redemption, the date on which the redemption 
payment must be made, except as provided in paragraphs (d)(1) through 
(8) of this section:
    (1) Adjustable Rate Government Securities. A Government Security 
which is a Variable Rate Security where the variable rate of interest 
is readjusted no less frequently than every 762 days shall be deemed to 
have a maturity equal to the period remaining until the next 
readjustment of the interest rate. A Government Security which is a 
Floating Rate Security shall be deemed to have a remaining maturity of 
one day.
    (2) Short-Term Variable Rate Securities. A Variable Rate Security, 
the principal amount of which, in accordance with the terms of the 
security, must unconditionally be paid in 397 calendar days or less 
shall be deemed to have a maturity equal to the earlier of the period 
remaining until the next readjustment of the interest rate or the 
period remaining until the principal amount can be recovered through 
demand.
    (3) Long-Term Variable Rate Securities. A Variable Rate Security, 
the principal amount of which is scheduled to be paid in more than 397 
days, that is subject to a Demand Feature shall be deemed to have a 
maturity equal to the longer of the period remaining until the next 
readjustment of the interest rate or the period remaining until the 
principal amount can be recovered through demand.
    (4) Short-Term Floating Rate Securities. A Floating Rate Security, 
the principal amount of which, in accordance with the terms of the 
security, must unconditionally be paid in 397 calendar days or less 
shall be deemed to have a maturity of one day.
    (5) Long-Term Floating Rate Securities. A Floating Rate Security, 
the principal amount of which is scheduled to be paid in more than 397 
days, that is subject to a Demand Feature, shall be deemed to have a 
maturity equal to the period remaining until the principal amount can 
be recovered through demand.
    (6) Repurchase Agreements. A repurchase agreement shall be deemed 
to have a maturity equal to the period remaining until the date on 
which the repurchase of the underlying securities is scheduled to 
occur, or, where the agreement is subject to demand, the notice period 
applicable to a demand for the repurchase of the securities.
    (7) Portfolio Lending Agreements. A portfolio lending agreement 
shall be treated as having a maturity equal to the period remaining 
until the date on which the loaned securities are scheduled to be 
returned, or where the agreement is subject to demand, the notice 
period applicable to a demand for the return of the loaned securities.
    (8) Money Market Fund Securities. An investment in a money market 
fund shall be treated as having a maturity equal to the period of time 
within which the acquired money market fund is required to make payment 
upon redemption, unless the acquired money market fund has agreed in 
writing to provide redemption proceeds to the investing money market 
fund within a shorter time period, in which case the maturity of such 
investment shall be deemed to be the shorter period.
    (e) Delegation. The money market fund's board of directors may 
delegate to the fund's investment adviser or officers the 
responsibility to make any determination required to be made by the 
board of directors under this section (other than the determinations 
required by paragraphs (c)(1), (c)(5)(i)(C), (c)(5)(ii), (c)(6)(i), 
(c)(6)(ii)(A), (B), and (C), and (c)(7) of this section) provided:
    (1) Written Guidelines. The Board shall establish and periodically 
review written guidelines (including guidelines for determining whether 
securities present minimal credit risks as required in paragraph (c)(3) 
of this section) and procedures under which the delegate makes such 
determinations:
    (2) Oversight. The Board shall exercise adequate oversight (through 
periodic reviews of fund investments and the delegate's procedures in 
connection with investment decisions and prompt review of the adviser's 
actions in the event of the default of a security or Event of 
Insolvency with respect to the issuer of the security or any Put to 
which it is subject that requires notification of the Commission under 
paragraph (c)(5)(iii) of this section) to assure that the guidelines 
and procedures are being followed.
    5. Section 270.2a41-1 is amended by revising paragraph (a) 
introductory text to read as follows:


Sec. 270.2a41-1  Valuation of standby commitments by registered 
investment companies.

    (a) A standby commitment as defined in Sec. 270.2a-7(a)(22) may be 
assigned a fair value of zero, Provided, That:
* * * * *
    6. Section 270.12d3-1 is amended by revising paragraph (d)(7)(v) to 
read as follows:


Sec. 270.12d3-1  Exemption of acquisitions of securities issued by 
persons engaged in securities related businesses.

* * * * *
    (d) * * *
    (7) * * *
    
[[Page 13983]]

    (v) Acquisition of Puts, as defined in Sec. 270.2a-7(a)(16), 
provided that, immediately after the acquisition of any Put, the 
company will not, with respect to 75 percent of the total value of its 
assets, have invested more than ten percent of the total value of its 
assets in securities underlying Puts from the same institution. For the 
purposes of this section, a Put will be considered to be from the party 
to whom the company will look for payment of the exercise price.
* * * * *
    7. Section 270.17a-9 is added to read as follows:


Sec. 270.17a-9  Purchase of certain securities from a money market fund 
by an affiliate, or an affiliate of an affiliate.

    The purchase of a security that is no longer an Eligible Security 
(as defined in paragraph (a)(9) of Sec. 270.2a-7) from an open-end 
investment company holding itself out as a ``money market'' fund shall 
be exempt from section 17(a) of the Act [15 U.S.C. 80a-17(a)], provided 
that:
    (a) The purchase price is paid in cash; and
    (b) The purchase price is equal to the greater of the amortized 
cost of the security or its market price (in each case, including 
accrued interest).
    8. Section 270.31a-1 is amended by adding a sentence to the end of 
paragraph (b)(1) to read as follows:


Sec. 270.31a-1  Records to be maintained by registered investment 
companies, certain majority-owned subsidiaries thereof, and other 
persons having transactions with registered investment companies.

* * * * *
    (b) * * *
    (1) * * * In the case of a money market fund, also identify the 
provider of any put (as defined in Sec. 270.2a-7(a)(16)) or guarantee 
with respect to a portfolio security and give a brief description of 
the nature of the put (e.g., unconditional demand feature, conditional 
demand feature, guarantee, letter of credit, or bond insurance) and, in 
a subsidiary portfolio investment record, provide the complete legal 
name and accounting and other information (including sufficient 
information to calculate coupons, accruals, maturities, puts, and 
calls) necessary to identify, value, and account for each investment.
* * * * *

PART 239--FORMS PRESCRIBED UNDER THE SECURITIES ACT OF 1933

PART 274--FORMS PRESCRIBED UNDER THE INVESTMENT COMPANY ACT OF 1940

    9. The authority citation for part 239 continues to read, in part, 
as follows:

    Authority: 15 U.S.C. 77f, 77g, 77h, 77j, 77s, 77sss, 78c, 78l, 
78m, 78n, 78o(d), 78w(a), 78ll(d), 79e, 79f, 79g, 79j, 79l, 79m, 
79n, 79q, 79t, 80a-8, 80a-29, 80a-30 and 80a-37, unless otherwise 
noted.
* * * * *
    10. The authority citation for Part 274 continues to read as 
follows:

    Authority: 15 U.S.C. 77f, 77g, 77h, 77j, 77s, 78c(b), 78l, 78m, 
78n, 78o(d), 80a-8, 80a-24, and 80a-29, unless otherwise noted.

    Note: Form N-1A does not and the amendments will not appear in 
the Code of Federal Regulations.


Secs. 239.15A and 274.11A  [Amended]

    11. Form N-1A (referenced in 17 CFR 239.15A and 274.11A) is amended 
by redesignating paragraph (a)(vii) as paragraph (a)(viii) and by 
adding paragraph (a)(vii) and an instruction to the end of paragraph 
(a)(vii) of Part A, Item 1 to read as follows:
FORM N-1A
* * * * *

PART A--INFORMATION REQUIRED IN A PROSPECTUS

* * * * *
Item 1. Cover Page
* * * * *
    (vii) In the case of a Registrant that holds itself out as a money 
market fund primarily distributing income exempt from the income taxes 
of a specified state or locality (``single state fund''), a prominent 
statement that the registrant may invest a significant percentage of 
its assets in a single issuer, and that therefore investment in the 
Registrant may be riskier than an investment in other types of money 
market funds.
    Instruction: The disclosure required for money market funds by Item 
1(a)(vii) may be omitted if the registrant limits investment in a 
single issuer to five percent of fund assets as to 100 percent of 
assets.
* * * * *


Secs. 239.15A and 274.11A  [Amended]

    12. Form N-1A (referenced in 17 CFR 239.15A and 274.11A) is amended 
by adding a sentence and an Instruction to the end of paragraph (c) of 
Part A, Item 4 to read as follows:
FORM N-1A
* * * * *

PART A--INFORMATION REQUIRED IN A PROSPECTUS

* * * * *
Item 4. General Description of Registrant
* * * * *
    (c) * * * In the case of a Registrant that holds itself out as a 
money market fund primarily distributing income exempt from the income 
taxes of a specified state or locality (``single state fund''), a 
prominent statement that the registrant is concentrated in securities 
issued by the state or entities within the state and that therefore 
investment in the Registrant may be riskier than an investment in other 
types of money market funds.
* * * * *
    Note: Form N-3 does not and the amendments will not appear in 
the Code of Federal Regulations.


Secs. 239.17a and 274.11b  [Amended]

    13. Form N-3 (referenced in 17 CFR 239.17a and 274.11b) is amended 
by adding Instruction 11.e. to Part A, paragraph (a) of Item 4 to read 
as follows:
FORM N-3
* * * * *

PART A--INFORMATION REQUIRED IN A PROSPECTUS

* * * * *
Item 4. Condensed Financial Information
    (a) * * *

Instructions

    11. The portfolio turnover rate to be shown at caption 10 shall be 
calculated as follows:
* * * * *
    e. A registrant that holds itself out as a money market fund is not 
required to provide a portfolio turnover rate in response to this Item.
* * * * *
    Note: Form N-SAR does not and the amendments will not appear in 
the Code of Federal Regulations.


Sec. 274.101  [Amended]

    14. Form N-SAR (referenced in 17 CFR 274.101) is amended by 
revising the definition of ``Money Market Fund'' in General Instruction 
G to read as follows:
FORM N-SAR
* * * * *

[[Page 13984]]

GENERAL INSTRUCTIONS
* * * * *
G. Definitions
* * * * *
    Money Market Fund: The term ``money market fund'' shall mean any 
open-end fund that meets the maturity, quality and diversification 
conditions of paragraphs (c)(2), (c)(3), and (c)(4) of rule 2a-7 [17 
CFR 270.2a-7].
* * * * *
    15. Form N-SAR (referenced in 17 CFR 274.101) is amended by 
revising the last sentence of the Instruction to Item 63 to read as 
follows:
FORM N-SAR
* * * * *
Instructions to Specific Items
* * * * *
ITEM 63: Dollar weighted average maturity
    * * * A money market fund shall determine the weighted average 
portfolio maturity in the same manner as it would in monitoring 
compliance with the average portfolio maturity provisions of rule 2a-7.
    16. Form N-SAR (referenced in 17 CFR 274.101) is amended by adding 
a sentence at the end of the first paragraph of the Instruction to Item 
71 to read as follows:
FORM N-SAR
* * * * *
Instructions to Specific Items
* * * * *
ITEM 71: Portfolio turnover rate
    * * * A money market fund should enter a portfolio turnover rate of 
``0'' even if it owns securities that have maturities in excess of one 
year.
* * * * *
    17. Guide 21 (Disclosure of Risk Factors) to Form N-1A (referenced 
in 17 CFR 239.15A and 274.11A) is amended by adding a paragraph to the 
end of the Guide to read as follows:

Guide 21. Disclosure of Risk Factors

* * * * *
    In many cases, a substantial portion of the portfolio securities 
held by tax exempt money market funds is supported by credit and 
liquidity enhancements from third parties, generally letters of credit 
from foreign or domestic banks. These securities include variable rate 
demand notes, tender or ``put'' bonds and similar securities. Where 
more than forty percent of a money market fund registrant's portfolio 
consists, or is likely to consist, of securities subject to these 
features, the registrant should, in response to Item 4, state that, 
because the fund invests in securities backed by banks and other 
financial institutions, changes in the credit quality of these 
institutions could cause losses to the fund and effect its share price.


Secs. 239.15A and 274.11A  [Amended]

    18. Guide 35 is added to Form N-1A (referenced in 17 CFR 239.15A 
and 274.11A] to read as follows:

Guide 35. Money Market Fund Investments in Other Money Market Funds.

    Money market funds are permitted to invest in the securities of 
other money market funds in accordance with the provisions of rule 2a-7 
and section 12(d)(1) of the 1940 Act. Except when a fund has invested 
substantially all of its assets in the other money market fund, the 
investing fund does not need to ``look through'' the shares of the 
fund(s) in which it is investing in order to determine compliance with 
the diversification or Second Tier Security limitations of rule 2a-
7.45 However, the investment objectives and policies of the money 
market fund making the investment and the money market fund(s) in which 
it is investing should not be inconsistent. Paragraph (c)(4)(iv)(A)(5) 
of rule 2a-7 describes the obligations of a fund that invests 
substantially all of its asset in another money market fund.

    \45\ See Investment Company Act Rel. No. 21837 (March 21, 1996) 
at Section II.G.2.
---------------------------------------------------------------------------


Secs. 239.17a and 274.11b  [Amended]

    19. Guide 38 is added to Form N-3 (referenced in 17 CFR 239.17a and 
274.11b) to read as follows:

Guide 38. Money Market Fund Investments in Other Money Market Funds

    Money market funds are permitted to invest in the securities of 
other money market funds in accordance with the provisions of rule 2a-7 
and section 12(d)(1) of the 1940 Act. Except when a fund has invested 
substantially all of its assets in the other money market fund, the 
investing fund does not need to ``look through'' the shares of the 
fund(s) in which it is investing in order to determine compliance with 
the diversification or Second Tier Security limitations of rule 2a-
7.45 However, the investment objectives and policies of the money 
market fund making the investment and the money market fund(s) in which 
it is investing should not be inconsistent. Paragraph (c)(4)(v)(A)(5) 
of rule 2a-7 describes the obligations of a fund that invests 
substantially all of its assets in another money market fund.

    \45\ See Investment Company Act Rel. No. 21837 (March 21, 1996) 
at Section II.G.2.
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    By the Commission.

Margaret H. McFarland,
Deputy Secretary.
    Dated: March 21, 1996.
[FR Doc. 96-7334 Filed 3-27-96; 8:45 am]
BILLING CODE 8010-01-P