[Federal Register Volume 66, Number 133 (Wednesday, July 11, 2001)]
[Rules and Regulations]
[Pages 36156-36162]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 01-17302]


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SECURITIES AND EXCHANGE COMMISSION

17 CFR Parts 270 and 274

[Release No. IC-25058; File No. S7-21-99]
RIN 3235-AH56


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

AGENCY: Securities and Exchange Commission.

ACTION: Final rule.

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SUMMARY: The Securities and Exchange Commission is adopting a new rule 
and related rule amendments under the Investment Company Act of 1940 
that affect the ability of investment companies to invest in repurchase 
agreements and pre-refunded bonds under the Act. The final rule 
codifies and updates staff positions that have permitted investment 
companies to ``look through'' counterparties to certain repurchase 
agreements and issuers of municipal bonds that have been ``refunded'' 
with U.S. government securities and treat the securities comprising the 
collateral as investments for certain purposes under the Act.

EFFECTIVE DATE: August 15, 2001.

FOR FURTHER INFORMATION CONTACT: Hugh Lutz, Attorney, or Martha B. 
Peterson, Special Counsel, Office of Regulatory Policy, at (202) 942-
0690, Division of Investment Management, Securities and Exchange 
Commission, 450 5th Street, N.W., Washington, D.C. 20549-0506.

SUPPLEMENTARY INFORMATION: The Securities and Exchange Commission today 
is adopting new rule 5b-3 [17 CFR 270.5b-3] and conforming amendments 
to rules 2a-7 [17 CFR 270.2a-7] and 12d3-1 [17 CFR 270.12d3-1] under 
the Investment Company Act of 1940 [15 U.S.C. 80a] (``Investment 
Company Act'' or ``Act'').\1\
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    \1\ Unless otherwise noted, all references to rule 2a-7 or rule 
12d3-1, or to any paragraph of those rules, will be to 17 CFR 
270.2a-7 and 17 CFR 270.12d3-1, respectively.
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Table of Contents

Executive Summary

I. Background
II. Discussion
    A. Qualifying Repurchase Agreements
    1. Acceptable Types of Collateral
    2. Bankruptcy Treatment
    3. Evaluating the Creditworthiness of Counterparties
    B. Treatment of Pre-Refunded Bonds
    C. Availability of Rule 12d3-1 for Repurchase Agreements
    D. Conforming Amendments to Rule 2a-7
III. Effective Date
IV. Cost-Benefit Analysis
V. Effects on Efficiency, Competition, and Capital Formation
VI. Summary of Final Regulatory Flexibility Analysis
    A. Need for and Objectives of the Rule Amendments
    B. Significant Issues Raised by Public Comments
    C. Small Entities Subject to the Rules
    D. Projected Reporting, Recordkeeping, and Other Compliance 
Requirements
    E. Agency Action to Minimize Effects on Small Entities
VII. Statutory Authority
Text of Rules and Form Amendments

Executive Summary

    Repurchase agreements provide investment companies (``funds'') with 
a convenient means to invest excess cash on a secured basis, generally 
for short periods of time. In a typical fund repurchase agreement, a 
fund enters into a contract with a broker, dealer, or bank (the 
``counterparty'' to the transaction) for the purchase of securities. 
The counterparty agrees to repurchase the securities at a specified 
future date, or on demand, for a price that is sufficient to return to 
the fund its original purchase price, plus an additional amount 
representing the return on the fund's investment.
    The Commission is adopting rule 5b-3, which permits a fund, subject 
to certain conditions, to treat a repurchase agreement as an 
acquisition of the underlying collateral in determining whether it is 
in compliance with (i) the investment criteria for diversified funds 
set forth in section 5(b)(1) of the Act\2\ and (ii) the prohibition on 
fund acquisition of an interest in a broker-dealer in section 12(d)(3) 
of the Act.\3\ Rule 5b-3 also provides for similar ``look-through'' 
treatment for purposes of section 5(b)(1) of the Act in the case of an 
investment in state or municipal bonds, the payment of which has been 
fully funded by escrowed U.S. government securities.
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    \2\ 15 U.S.C. 80a-5(b)(1).
    \3\ 15 U.S.C. 80a-12(d)(3).
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    The new rule codifies and updates staff interpretive and no-action 
letters. It is intended to adapt the Act to economic realities of 
repurchase agreements and pre-refunded bonds and reflects recent 
developments in bankruptcy law protecting parties to repurchase 
agreements.

[[Page 36157]]

I. Background

    Repurchase agreements provide funds with a means to invest idle 
cash at competitive rates for short periods. While a repurchase 
agreement has legal characteristics of both a sale and a secured 
transaction, economically it functions as a loan from the fund to the 
counterparty, in which the securities purchased by the fund serve as 
collateral for the loan and are placed in the possession or under the 
control of the fund's custodian during the term of the agreement.\4\
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    \4\ See Treatment of Repurchase Agreements and Refunded 
Securities as an Acquisition of the Underlying Securities, 
Investment Company Act Release No. 24050 (Sept. 23, 1999) [64 FR 
52476 (Sept. 29, 1999)] (``Proposing Release''), at n.4 and 
accompanying text.
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    Two provisions of the Act may affect a fund's ability to invest in 
repurchase agreements. Section 12(d)(3) of the Act generally prohibits 
a fund from acquiring an interest in a broker, dealer, or underwriter. 
Because a repurchase agreement may be considered to be the acquisition 
of an interest in the counterparty, section 12(d)(3) may limit a fund's 
ability to enter into repurchase agreements with many of the firms that 
act as counterparties.\5\ Section 5(b)(1) of the Act limits the amount 
that a fund that holds itself out as being a diversified investment 
company may invest in the securities of any one issuer (other than the 
U.S. Government). This provision may limit the amount of repurchase 
agreements that a diversified fund may enter into with any one 
counterparty.
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    \5\ With minor exceptions, section 12(d)(3) prohibits an 
investment company from purchasing or otherwise acquiring ``any 
security issued by or any other interest in the business of any 
person who is a broker, a dealer, [or] is engaged in the business of 
underwriting.'' The staff has taken the position that fund 
repurchase agreements with banks that are engaged in a securities-
related business, including dealing in government securities, may be 
subject to the prohibitions of section 12(d)(3). See Letter from 
Gerald Osheroff, Associate Director, Division of Investment 
Management, to Matthew Fink, General Counsel, Investment Company 
Institute (May 7, 1985).
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    A fund investing in a properly structured repurchase agreement 
looks primarily to the value and liquidity of the collateral rather 
than the credit of the counterparty for satisfaction of the repurchase 
agreement. In two separate no-action positions issued in 1979 and 1980, 
the staff stated that, for purposes of sections 12(d)(3) and 5(b)(1) of 
the Act, a fund may treat a repurchase agreement as an acquisition of 
the underlying collateral if the repurchase agreement is 
``collateralized fully.''\6\ Because most repurchase agreements are 
collateralized fully by highly liquid U.S. government securities, this 
``look-through'' treatment allowed funds to treat repurchase agreements 
as investments in government securities. As a result, a fund could 
invest in repurchase agreements with the same counterparty without the 
limitations of section 12(d)(3) or 5(b)(1).\7\
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    \6\ In 1979, the staff announced that it would not recommend 
enforcement action under section 12(d)(3) if the repurchase 
agreement was ``structured in a manner reasonably designed to 
collateralize fully the investment company loan.'' Investment 
Company Act Release No. 10666 (Apr.18, 1979) [44 FR 25128 (Apr. 27, 
1979)] (``Release 10666''). The following year, the staff applied 
this no-action position to a fund's compliance with the 
diversification requirements of section 5(b)(1) of the Act. 
MoneyMart Assets, Inc., SEC No-Action Letter (Sept. 3, 1980).
    \7\ Repurchase agreements with broker-dealers affiliated with 
the fund would, of course, continue to raise serious questions under 
sections 17(a) and 17(d) of the Act [15 U.S.C. 80a-17(a), 15 U.S.C. 
80a-17(d)]. See Release 10666, supra note 6, at n.24.
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    On September 23, 1999, the Commission issued a release proposing to 
codify and update these staff no-action positions.\8\ We proposed new 
rule 5b-3 that would permit a fund, under certain circumstances, to 
look through repurchase agreements to the underlying securities for 
purposes of sections 5(b)(1) and 12(d)(3) of the Act. The proposed rule 
included conditions for looking through a repurchase agreement that 
were substantially similar to the conditions governing ``look-through'' 
treatment for money market funds under rule 2a-7 for purposes of 
complying with the rule's diversification requirements.\9\ We also 
proposed to codify a 1993 staff no-action position that permits funds, 
under certain conditions, to look through pre-refunded bonds to the 
escrowed government securities for purposes of the section 5(b)(1) 
diversification requirements.\10\ Finally, we proposed to eliminate a 
note to rule 12d3-1, which makes the rule's limited exemption from 
section 12(d)(3) of the Act unavailable for repurchase agreements, 
including those that were not collateralized fully.
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    \8\ See Proposing Release, supra note 4.
    \9\ In 1996, when the Commission amended rule 2a-7, we tied the 
availability of ``look-through'' treatment to the preferred 
treatment given to repurchase agreements under the Bankruptcy Code 
and related insolvency statutes. See Revisions to Rules Regulating 
Money Market Funds, Investment Company Act Release No. 21837 (Mar. 
21, 1996) [61 FR 13956 (Mar. 28, 1996)]. Proposed rule 5b-3 included 
similar requirements. In addition, we proposed conforming amendments 
to rule 2a-7 so that it would be consistent with rule 5b-3.
    \10\ T. Rowe Price Tax-Free Funds, SEC No-Action Letter (June 
24, 1993). In the letter, the Division of Investment Management 
agreed not to recommend any enforcement action if a fund treated an 
investment in municipal bonds refunded with escrowed government 
securities as an investment in the government securities for 
purposes of section 5(b)(1). This no-action position was based on 
certain representations, including that (1) the deposit of the 
government securities was irrevocable and pledged only to the debt 
service on the original bonds, (2) payments from the escrow would 
not be subject to the preference provisions or automatic stay 
provisions of the Bankruptcy Code, and (3) no fund would invest more 
than 25 percent of its assets in the pre-refunded bonds of any 
single municipal issuer.
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    The Commission received letters from four commenters on the 
Proposing Release, including the Investment Company Institute, which 
supported adoption of the rule.\11\ We are adopting rule 5b-3, 
amendments to rule 2a-7, and amendments to rule 12d3-1, with certain 
changes suggested by these commenters.
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    \11\ The commenters included two trade associations, one 
investment adviser, and a bank. The comment letters are available in 
the Commission's Public Reference Room, 450 5th Street, N.W., 
Washington, D.C. (File No. S7-21-99).
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II. Discussion

A. Qualifying Repurchase Agreements

    New rule 5b-3(a) allows funds to treat the acquisition of a 
repurchase agreement as an acquisition of the underlying securities for 
purposes of sections 5(b)(1) and 12(d)(3) of the Act if the obligation 
of the seller to repurchase the securities from the fund is 
``collateralized fully.''\12\ A repurchase agreement is 
``collateralized fully'' if: (i) The value of the underlying securities 
(reduced by the costs that the fund reasonably could expect to incur if 
the counterparty defaults) is, and at all times remains, at least equal 
to the agreed resale price;\13\ (ii) the fund has perfected its 
security interest in the collateral; (iii) the collateral is maintained 
in an account of the fund with its custodian or a third party that 
qualifies as a custodian under the Act;\14\ (iv) the collateral for the 
repurchase agreement consists entirely of: (A) Cash items; (B) U.S. 
government securities; (C) securities that at the time the repurchase 
agreement is entered into are rated in the highest category by the

[[Page 36158]]

``Requisite NRSROs';\15\ or (D) unrated securities that are of 
comparable quality to securities that are rated in the highest rating 
category by the Requisite NRSROs, as determined by the fund's board of 
directors or its delegate; and (v) the repurchase agreement qualifies 
for an exclusion from any automatic stay of creditors' rights against 
the counterparty under applicable insolvency law in the event of the 
counterparty's insolvency.
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    \12\ Rule 5b-3(a). A fund may only look through only that 
portion of the repurchase agreement that is collateralized fully. 
Any agreement or portion of an agreement that is not collateralized 
fully would be treated as a loan by the fund to the counterparty. 
Use of rule 5b-3(a) is optional: even if a fund can look through the 
repurchase agreement, it may choose to look to the counterparty 
rather than the underlying securities in meeting the diversification 
requirements of section 5(b)(1).
    \13\ The term ``resale price'' is defined in rule 5b-3(c)(7) as 
the acquisition price paid to the seller plus the accrued resale 
premium, i.e., the return on investment specified in the agreement.
    \14\ We have revised this element of the rule to clarify that 
the collateral would have to be held by a custodian, or third party, 
in an account of the fund.
    \15\ The term ``Requisite NRSROs'' is defined in rule 5b-3(c)(6) 
as any two NRSROs, or, if only one NRSRO has issued a rating at the 
time the fund acquires the security, that NRSRO. ``NRSRO'' is 
defined in rule 5b-3(c)(5) as any nationally recognized statistical 
rating organization, as that term is used in paragraphs 
(c)(2)(vi)(E), (F) and (H) of rule 15c3-1 [17 CFR 240.15c3-1] under 
the Securities Exchange Act of 1934 [15 U.S.C. 78a-mm], that is not 
an ``affiliated person,'' as defined in section 2(a)(3)(C) of the 
Act [15 U.S.C. 80a-2(a)(3)(C)], of the issuer of, or any insurer or 
provider of credit support for, the security.
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1. Acceptable Types of Collateral
    New rule 5b-3 specifies the types of collateral that may be used to 
``collateralize fully'' a repurchase agreement eligible for ``look-
through'' treatment under the rule. We have expanded acceptable 
collateral to include unrated securities that are of comparable quality 
to securities that are rated in the highest rating category by the 
Requisite NRSROs, as determined by the investment company's board of 
directors or its delegate.\16\ We are not, however, adopting a 
recommendation by two commenters that we altogether eliminate the 
rule's requirements regarding the credit quality of the collateral. A 
requirement that the underlying collateral be of highest quality limits 
a fund's exposure to the ability of the counterparty to maintain 
sufficient collateral. As we noted in the Proposing Release, securities 
of lower quality may be subject to greater price fluctuation. In the 
event of a steep drop in the market value of the collateral, the 
counterparty would have to deliver additional securities sufficient to 
ensure that the repurchase agreement remains fully collateralized. If 
the counterparty does not deliver sufficient additional securities and 
thus defaults, the fund may be unable to realize the full value of the 
repurchase agreement upon liquidation of the collateral. In addition, 
high quality securities are more readily liquidated than lower quality 
securities, in the event of a counterparty default.
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    \16\ Rule 5b-3(c)(1)(iv)(D).
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2. Bankruptcy Treatment
    Rule 5b-3 extends ``look-through'' treatment only to repurchase 
agreements that qualify for an exclusion from any automatic stay of 
creditors' rights under applicable bankruptcy laws.\17\ Most comments 
supported this provision, which we are adopting as proposed. Failure of 
a repurchase agreement to qualify for an exclusion from an automatic 
stay would make ``look-through'' treatment inappropriate because the 
credit and liquidity risks assumed by the fund would be tied directly 
to the counterparty rather than the issuer of the underlying 
collateral.
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    \17\ Rule 5b-3(c)(1)(v). See sections 101(47) of the Federal 
Bankruptcy Code (``Bankruptcy Code'') (defining ``repurchase 
agreement'') and 559 (protecting repurchase agreement participants 
from the Bankruptcy Code's automatic stay provisions). The 
Bankruptcy Code currently defines a repurchase agreement as:
    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.
    As a result, funds are limited in the collateral they can accept 
by both paragraph (c)(1)(iv)(D) of the rule and the provisions of 
the Bankruptcy Code (and other applicable insolvency laws) providing 
preferred treatment to qualifying repurchase agreements.
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3. Evaluating the Creditworthiness of Counterparties
    We are eliminating the requirement, included in the staff no-action 
positions, and our proposal, that the fund's board of directors or its 
delegate evaluate the creditworthiness of the counterparty to a 
repurchase agreement. As one commenter observed, the creditworthiness 
assessment was required under the staff no-action letters because, at 
the time the letters were written, it was not clear whether a 
repurchase agreement would be subject to the automatic stay provision 
in the Bankruptcy Code, in the event that the counterparty became 
insolvent.\18\ In light of subsequent amendments to the Code protecting 
the parties to repurchase agreements and our requirement that funds 
relying on the rule qualify for Bankruptcy Code protection,\19\ we 
conclude that it is not necessary for the rule to contain a specific 
requirement that the fund's directors or their delegate assess the 
creditworthiness of the counterparty.\20\
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    \18\ See Proposing Release supra note 4 at nn.12-16 and 
accompanying text.
    \19\ Rule 5b-3(c)(1)(v).
    \20\ By omitting this requirement, we are not suggesting that it 
might not be prudent for an adviser to a fund to take precautions, 
including evaluating the creditworthiness of the counterparty, when 
entering into repurchase agreements on behalf of the fund.
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B. Treatment of Pre-Refunded Bonds

    We are adopting, as proposed, new rule 5b-3(b) which codifies, for 
purposes of section 5(b)(1), the conditions specified in the staff's 
no-action position permitting a fund to treat an investment in a 
``refunded security'' as an investment in the escrowed U.S. government 
securities.\21\ Under the rule, a ``refunded security'' is defined as a 
debt security the principal and interest payments of which are to be 
paid by U.S. government securities that have been irrevocably placed in 
an escrow account and are pledged only to the payment of the debt 
security.\22\ The escrowed securities must not be redeemable prior to 
their final maturity, and the escrow agreement must prohibit the 
substitution of the escrowed securities unless the substituted 
securities are also U.S. government securities.\23\ Finally, an 
independent certified public accountant must have certified to the 
escrow agent that the escrowed securities will satisfy all scheduled 
payments of principal, interest and applicable premiums on the refunded 
securities.\24\ This treatment corresponds to the treatment that has 
been given to pre-refunded bonds in rule 2a-7.\25\
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    \21\ Rule 5b-3(b). Unlike the no-action position, the rule does 
not limit the amount of pre-refunded bonds of any one issuer that a 
fund can acquire. See T. Rowe Price Tax-Free Funds, supra note 10.
    \22\ Rule 5b-3(c)(4).
    \23\ Rule 5b-3(c)(4)(i), (ii).
    \24\ Rule 5b-3(c)(4)(iii). The rule makes an exception to the 
certification requirement if the refunded security has received the 
highest rating from an NRSRO. Id.
    \25\ See rule 2a-7(c)(4)(ii)(B). Technical amendments that we 
are adopting today will replace the definition of ``refunded 
security'' in rule 2a-7(a)(20) with a reference incorporating the 
definition that we are adopting in rule 5b-3(c)(4).
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    Commenters expressed support for the changes made by rule 5b-3(b), 
and we are adopting this provision as proposed.

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

    We are adopting, as proposed, an amendment to rule 12d3-1 that 
eliminates a note appended to the rule. Rule 12d3-1 provides limited 
exemptive relief from the prohibition in section 12(d)(3) of the Act 
against a fund acquiring an interest in a broker-dealer or a bank 
engaged in a securities-related business.\26\ As discussed above, a 
fund

[[Page 36159]]

that enters into a repurchase agreement with a broker-dealer or other 
counterparty that is engaged in securities related activities may be in 
violation of section 12(d)(3) of the Act, unless it is permitted to 
look through the agreement to the underlying collateral. The note 
appended to rule 12d3-1 has made the rule unavailable for repurchase 
agreements. With the elimination of this note, funds may rely on rule 
12d3-1 even if the repurchase agreement does not meet the requirements 
for ``look-through'' treatment in rule 5b-3.\27\
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    \26\ Rule 12d3-1 provides an exemption for purchases of 
securities of any entity that derived fifteen percent or less of its 
gross revenues from securities related activities in its most recent 
fiscal year, unless the acquiring company would control the entity 
after the purchase. If the entity derived more than fifteen percent 
of its gross revenues from securities related activities, the rule 
provides a limited exemption based on the amount and value of the 
securities purchased. The note to the rule stated: ``NOTE: It is not 
intended that this rule should supersede the requirements prescribed 
in Investment Company Act Release No. 13005 (Feb. 2, 1983) with 
respect to repurchase agreements with brokers or dealers.''
    \27\ By eliminating this note, we do not intend in any way to 
alter an adviser's duty of care with respect to the advice it 
provides a mutual fund, including the advice to enter into a 
repurchase agreement.
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D. Conforming Amendments to Rule 2a-7

    We are also adopting conforming amendments to rule 2a-7. These 
amendments replace the definitions of ``collateralized fully,'' ``event 
of insolvency,'' and ``refunded security,'' currently set forth in rule 
2a-7, with cross-references to the corresponding definitions in rule 
5b-3.\28\
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    \28\ Rule 2a-7(a)(5), (11), and (20) (cross-referencing rule 5b-
3(c)(1), (2), and (4)). Rule 5b-3(c)(1) expands the types of 
collateral that may be used to collateralize fully a repurchase 
agreement to include certain high-quality, unrated securities. See 
supra note 16 and accompanying text. This expansion of acceptable 
collateral also applies to rule 2a-7.
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III. Effective Date

    The new rule and rule amendments will be effective August 15, 
2001.\29\
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    \29\ As we indicated in the Proposing Release, we are 
withdrawing all prior Commission and staff no-action and 
interpretive positions that are inconsistent with rule 5b-3. This 
withdrawal is effective [60 days after publication of the release in 
the Federal Register]. After this date, funds may ``look through'' 
repurchase agreements and pre-refunded bonds to the underlying 
collateral, for purposes of the Act, only if all of the requirements 
of rule 5b-3 are met.
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IV. Cost-Benefit Analysis

    The Commission is sensitive to the costs and benefits imposed by 
its rules. For the most part, rule 5b-3 codifies current staff 
positions, and therefore will result in few marginal costs or 
benefits.\30\ By codifying a number of staff no-action positions issued 
over a nearly twenty year period, the rule will give greater 
transparency to the Commission's rules in this area. In addition, the 
rule uses standards that are similar to those currently specified in 
rule 2a-7 for the treatment of repurchase agreements and pre-refunded 
bonds by money market funds. With this similar treatment, fund 
complexes that include money market funds may be more efficient in 
monitoring compliance with the requirements of the rules for all types 
of funds.
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    \30\ We received no response to the request for comment on the 
preliminary cost-benefit analysis that was included in the Proposing 
Release.
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    The rule is more restrictive than current requirements in two 
respects. First, as discussed above, rule 5b-3 is limited to repurchase 
agreements in which the underlying collateral consists of cash items, 
U.S. government securities, securities that are rated in the highest 
rating category by the Requisite NRSROs and unrated securities that are 
of comparable quality to securities that are rated in the highest 
rating category by the Requisite NRSROs, as determined by an investment 
company's board of directors or its delegate. This requirement is 
intended to ensure that the market value of the collateral will remain 
fairly stable and that the fund will be able to liquidate the 
collateral quickly in the event of a default. This limitation on 
collateral is more restrictive than the staff's position with respect 
to the treatment of repurchase agreements for purposes of section 
12(d)(3),\31\ but less restrictive than the staff's position with 
respect to section 5(b)(1).\32\ Since most repurchase agreements are 
collateralized by U.S. government securities, which clearly fall within 
the rule's limitations, it appears that the limitation will not have 
any significant impact on funds.
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    \31\ Investment Company Act Release No. 13005 (Feb. 2, 1983) [48 
FR 5894 (Feb. 9, 1983)] did not specify the type of collateral, 
merely noting that the ``securities most frequently used in 
connection with repurchase agreements are Treasury bills and other 
United States Government securities.''
    \32\ The staff's no-action position in MoneyMart Assets, supra 
note 6, was conditioned on the collateral consisting entirely of 
U.S. government securities.
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    Second, the rule is limited to repurchase agreements that qualify 
for an exclusion from any automatic stay under applicable insolvency 
law. Although this requirement is included in rule 2a-7, it was not a 
feature of the staff positions, which generally pre-dated the relevant 
changes in the Bankruptcy Code. Again, because most repurchase 
agreements qualify for an exclusion, this limitation should not have 
any significant impact on funds. The limitation will, however, provide 
important protections for investors by ensuring that a fund can 
liquidate the collateral quickly in the event of the counterparty's 
bankruptcy.
    The use of rule 5b-3 is optional: even if a fund can look through a 
repurchase agreement, it may choose to look to the counterparty rather 
than the underlying securities in meeting the diversification 
requirements in section 5(b)(1). Thus, a fund may choose not to use 
rule 5b-3 if it determines that the costs of complying with the rule's 
requirements outweigh the benefits of being able to look through the 
repurchase agreement to the underlying securities.
    The amendment to rule 12d3-1 eliminates the ``Note'' to the rule 
that renders the rule unavailable for repurchase agreements. This 
amendment will provide additional flexibility for funds without 
impairing investor protection.

V. Effects on Efficiency, Competition, and Capital Formation

    Section 2(c) of the Investment Company Act requires the Commission, 
when engaging in rulemaking that requires it to consider or determine 
whether an action is consistent with the public interest, to consider, 
in addition to the protection of investors, whether the action will 
promote efficiency, competition, and capital formation.\33\ Rule 5b-3 
and the amendments to rules 2a-7 and 12d-3 are being adopted pursuant 
to the authority in section 6(c) and 38(a) of the Act.\34\ Section 6(c) 
conditions rulemaking authority on the requirement that the rule be 
``necessary or appropriate in the public interest''; therefore, the 
requirements of section 2(c) apply to rule 5b-3 and the rule 
amendments.
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    \33\ 15 U.S.C. 80a-2(c).
    \34\ 15 U.S.C. 80a-6(c) and 80a-38(a).
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    The Commission has considered whether this rulemaking will promote 
efficiency, competition, and capital formation. The rule and rule 
amendments generally codify the requirements for looking through 
repurchase agreements and pre-refunded bonds to the underlying 
securities for purposes of complying with sections 5(b)(1) and 12(d)(3) 
of the Act. Consistent with staff no-action positions, funds have been 
looking through repurchase agreements and pre-refunded bonds for a 
number of years. The few changes made by the rule and rule amendments 
generally are intended to reflect recent developments in bankruptcy law 
protecting parties to repurchase agreements and to adapt the Act to 
economic realities of repurchase agreements and pre-refunded bonds. 
These changes should not have a significant impact on funds. In 
addition,

[[Page 36160]]

since the use of rule 5b-3 is optional, funds may choose to look to the 
repurchase agreement counterparty rather than the underlying securities 
in meeting the diversification requirements in section 5(b)(1). Given 
these factors, we believe that the rule and rule amendments will have 
no significant impact on efficiency, competition, and capital 
formation.

VI. Summary of Final Regulatory Flexibility Analysis

    The Commission has prepared a Final Regulatory Flexibility Analysis 
(``FRFA'') in accordance with 5 U.S.C. 604 regarding rule 5b-3, and the 
amendments to rules 2a-7 and 12d3-1. A summary of the Initial 
Regulatory Flexibility Analysis (``IRFA''), which was prepared in 
accordance with 5 U.S.C. 603, was published in the Proposing Release. 
The following is a summary of the FRFA.

A. Need for and Objectives of the Rule Amendments

    Rule 5b-3 generally codifies the staff's position that a fund may 
look through a fully collateralized repurchase agreement to the 
underlying securities for purposes of sections 5(b)(1) and 12(d)(3) of 
the Act. The rule also permits a fund to treat the acquisition of 
certain pre-refunded bonds as an acquisition of the escrowed securities 
for purposes of section 5(b)(1) of the Act. In addition, the amendment 
to rule 12d3-1 eliminates the ``Note'' appended to the rule in order to 
allow funds to rely on rule 12d3-1 even if the repurchase agreement is 
not collateralized fully. Finally, the amendments to rule 2a-7 are 
intended to simplify and update the provisions of that rule that 
address repurchase agreements and refunded securities.

B. Significant Issues Raised by Public Comments

    The Commission received no comments on the IRFA.

C. Small Entities Subject to the Rules

    For purposes of the Investment Company Act and the Regulatory 
Flexibility Act, a fund is a small entity if the fund, together with 
other funds in the same group of related funds, has net assets of $50 
million or less as of the end of its most recent fiscal year.\35\
---------------------------------------------------------------------------

    \35\ 17 CFR 270.0-10.
---------------------------------------------------------------------------

    Rule 5b-3 and the amendment to rule 12d3-1 will affect any fund 
that invests in a repurchase agreement with a broker, dealer, 
underwriter, or bank that is engaged in a securities-related business, 
when the investment may otherwise be prohibited by section 12(d)(3) of 
the Act. In addition, rule 5b-3 will affect any fund that holds itself 
out as a diversified investment company under section 5(b)(1) of the 
Act and that invests in repurchase agreements or pre-refunded bonds.
    As of December 31, 2000, there were approximately 4,145 registered 
funds that were not money market funds. The Commission staff estimates 
that 196 of these funds are small entities. We assume that all funds 
enter into repurchase agreements, and that many of these agreements are 
with broker-dealers or other counterparties that are engaged in a 
securities-related business. Therefore, we anticipate that all of the 
estimated 196 small entities will be affected by the rule's treatment 
of investments in repurchase agreements for purposes of section 5(b)(1) 
and 12(d)(3) of the Act, and the amendment to rule 12d3-1.
    The FRFA explains that rule 5b-3 should not have a significant 
economic impact on these funds. The rule would not effect significant 
changes to the current treatment of repurchase agreements and pre-
refunded bonds, but instead would generally codify and update a number 
of no-action positions that have been taken by the Commission staff. In 
addition, the amendment to rule 12d3-1 would benefit these funds by 
allowing them to rely on the rule even if the repurchase agreement does 
not meet the requirements for ``look-through'' treatment.
    The amendments to rule 2a-7 affect money market funds. As of 
December 31, 2000, there were approximately 300 registered funds with 
one or more portfolios that are money market funds. The Commission 
staff estimates that approximately six of these funds are small 
entities. The amendments replace the definitions of ``collateralized 
fully,'' ``event of insolvency,'' and ``refunded security'' in rule 2a-
7 with cross-references to the corresponding definitions in rule 5b-3. 
The cross-reference to the definition of ``collateralized fully'' in 
rule 5b-3 will allow money market funds to use unrated securities that 
are of comparable quality to securities that are rated in the highest 
rating category by the Requisite NRSROs to collateralize fully their 
repurchase agreements. This change will not have a significant impact 
on small entities because most repurchase agreements are collateralized 
fully by U.S. government securities. In addition, the cross-references 
to the definitions of ``event of insolvency'' and ``refunded security'' 
in rule 5b-3 will not have a significant impact on small entities 
because the cross-references do not involve any change in substantive 
requirements.

D. Projected Reporting, Recordkeeping, and Other Compliance 
Requirements

    Rule 5b-3 and the amendments to rule 2a-7 and 12d-3 will not impose 
any new reporting or recordkeeping requirements. These provisions do 
not involve major changes in compliance requirements because they 
mainly codify existing Commission staff positions. There are no rules 
that duplicate, overlap or conflict with the rule and rule amendments.

E. Agency Action to Minimize Effects on Small Entities

    The Regulatory Flexibility Act directs the Commission to consider 
significant alternatives that would accomplish the stated objective, 
while minimizing any significant economic impact on small entities. In 
connection with rule 5b-3 and the rule amendments, the Commission 
considered the following alternatives: (i) The establishment of 
differing compliance or reporting requirements or timetables that take 
into account the resources available to small entities; (ii) the 
clarification, consolidation, or simplification of compliance and 
reporting requirements under the rule for small entities; (iii) the use 
of performance rather than design standards; and (iv) an exemption from 
coverage of the rule, or any part thereof, for small entities. The FRFA 
notes that rule 5b-3 and the rule amendments are not intended to effect 
major substantive changes to the current treatment of repurchase 
agreements and pre-refunded bonds, but would essentially codify a 
number of no-action positions taken by the Commission staff. Because 
rule 5b-3 and the rule amendments are designed to clarify the 
appropriate treatment of investments by funds in repurchase agreements 
and pre-refunded bonds for various purposes of the Act, and to provide 
investment flexibility for funds of all sizes, it would be inconsistent 
with the purposes of the Regulatory Flexibility Act to propose to 
exempt small entities from their coverage. Further clarification, 
consolidation, or simplification of the rules, or specification of 
different compliance standards for small entities, would not be 
appropriate, because the rules set forth the minimum standards 
consistent with investor protection. For the same reasons, the use of 
performance standards would be inappropriate. Overall, rule 5b-3 and 
the rule amendments will not have an adverse effect on small entities.
    The FRFA is available for public inspection in File No. S7-21-99, 
and a

[[Page 36161]]

copy may be obtained by contacting Hugh Lutz, Attorney, at (202-942-
0690), Office of Regulatory Policy, Securities and Exchange Commission, 
450 5th Street, N.W., Washington, D.C. 20549-0506.

VII. Statutory Authority

    The Commission is adopting new rule 5b-3, and amending rule 2a-7 
and rule 12d3-1, pursuant to the authority set forth in sections 6(c) 
and 38(a) of the Act [15 U.S.C. 80a-6(c) and 80a-37(a)]. The Commission 
is amending Form N-SAR pursuant to authority set forth in sections 13, 
15(d) and 23(a) of the Securities Exchange Act of 1934 [15 U.S.C. 78m, 
78o(d), and 78w(a)] and sections 8, 30 and 38 of the Investment Company 
Act of 1940 [15 U.S.C. 80a-8, 80a-29 and 80a-37].

List of Subjects in 17 CFR Parts 270 and Part 274

    Investment companies, Reporting and recordkeeping requirements, 
Securities.

Text of Rule and Form Amendments

    For the reasons set out in the preamble, Title 17, Chapter II of 
the Code of Federal Regulations is amended as follows:

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

    1. The authority citation for Part 270 continues to read, in part, 
as follows:

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

    2. Section 270.2a-7 is amended by revising paragraphs (a)(5), 
(a)(11), and (a)(20) to read as follows:


Sec. 270.2a-7  Money market funds.

    (a) Definitions.
* * * * *
    (5) Collateralized Fully means ``Collateralized Fully'' as defined 
in Sec. 270.5b-3(c)(1).
* * * * *
    (11) Event of Insolvency means ``Event of Insolvency'' as defined 
in Sec. 270.5b-3(c)(2).
* * * * *
    (20) Refunded Security means ``Refunded Security'' as defined in 
Sec. 270.5b-3(c)(4).
* * * * *

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


Sec. 270.5b-3  Acquisition of repurchase agreement or refunded security 
treated as acquisition of underlying securities.

    (a) Repurchase Agreements. For purposes of sections 5 and 12(d)(3) 
of the Act (15 U.S.C. 80a-5 and 80a-12(d)(3)), the acquisition of a 
repurchase agreement may be deemed to be an acquisition of the 
underlying securities, provided the obligation of the seller to 
repurchase the securities from the investment company is Collateralized 
Fully.
    (b) Refunded Securities. For purposes of section 5 of the Act (15 
U.S.C. 80a-5), the acquisition of a Refunded Security is deemed to be 
an acquisition of the escrowed Government Securities.
    (c) Definitions. As used in this section:
    (1) Collateralized Fully in the case of a repurchase agreement 
means that:
    (i) The value of the securities collateralizing the repurchase 
agreement (reduced by the transaction costs (including loss of 
interest) that the investment company reasonably could expect to incur 
if the seller defaults) is, and during the entire term of the 
repurchase agreement remains, at least equal to the Resale Price 
provided in the agreement;
    (ii) The investment company has perfected its security interest in 
the collateral;
    (iii) The collateral is maintained in an account of the investment 
company with its custodian or a third party that qualifies as a 
custodian under the Act;
    (iv) The collateral consists entirely of:
    (A) Cash items;
    (B) Government Securities;
    (C) Securities that at the time the repurchase agreement is entered 
into are rated in the highest rating category by the Requisite NRSROs; 
or
    (D) Unrated Securities that are of comparable quality to securities 
that are rated in the highest rating category by the Requisite NRSROs, 
as determined by the investment company's board of directors or its 
delegate; and
    (v) Upon an Event of Insolvency with respect to the seller, the 
repurchase agreement would qualify under a provision of applicable 
insolvency law providing an exclusion from any automatic stay of 
creditors' rights against the seller.
    (2) Event of Insolvency means, with respect to a person:
    (i) An admission of insolvency, the application by the person for 
the appointment of a trustee, receiver, rehabilitator, or similar 
officer for all or substantially all of its assets, a general 
assignment for the benefit of creditors, the filing by the person of a 
voluntary petition in bankruptcy or application for reorganization or 
an arrangement with creditors; or
    (ii) The institution of similar proceedings by another person which 
proceedings are not contested by the person; or
    (iii) The institution of similar proceedings by a government agency 
responsible for regulating the activities of the person, whether or not 
contested by the person.
    (3) Government Security means any ``Government Security'' as 
defined in section 2(a)(16) of the Act (15 U.S.C. 80a-2(a)(16)).
    (4) Refunded Security means a debt security the principal and 
interest payments of which are to be paid by Government Securities 
(``deposited securities'') that have been irrevocably placed in an 
escrow account pursuant to an agreement between the issuer of the debt 
security and an escrow agent that is not an ``affiliated person,'' as 
defined in section 2(a)(3)(C) of the Act (15 U.S.C. 80a-2(a)(3)(C)), of 
the issuer of the debt security, and, in accordance with such escrow 
agreement, are pledged only to the payment of the debt security and, to 
the extent that excess proceeds are available after all payments of 
principal, interest, and applicable premiums on the Refunded 
Securities, the expenses of the escrow agent and, thereafter, to the 
issuer or another party; provided that:
    (i) The deposited securities are not redeemable prior to their 
final maturity;
    (ii) The escrow agreement prohibits the substitution of the 
deposited securities unless the substituted securities are Government 
Securities; and
    (iii) At the time the deposited securities are placed in the escrow 
account, or at the time a substitution of the deposited securities is 
made, an independent certified public accountant has certified to the 
escrow agent that the deposited securities will satisfy all scheduled 
payments of principal, interest and applicable premiums on the Refunded 
Securities; provided, however, an independent public accountant need 
not have provided the certification described in this paragraph 
(c)(4)(iii) if the security, as a Refunded Security, has received a 
rating from an NRSRO in the highest category for debt obligations 
(within which there may be sub-categories or gradations indicating 
relative standing).
    (5) NRSRO means any nationally recognized statistical rating 
organization, as that term is used in paragraphs (c)(2)(vi)(E), (F) and 
(H) of Sec. 240.15c3-1 of this chapter, that is not an ``affiliated 
person,'' as defined in section 2(a)(3)(C) of the Act (15 U.S.C.

[[Page 36162]]

80a-2(a)(3)(C)), of the issuer of, or any insurer or provider of credit 
support for, the security.
    (6) Requisite NRSROs means:
    (i) Any two NRSROs that have issued a rating with respect to a 
security or class of debt obligations of an issuer; or
    (ii) If only one NRSRO has issued a rating with respect to such 
security or class of debt obligations of an issuer at the time the 
investment company acquires the security, that NRSRO.
    (7) Resale Price means the acquisition price paid to the seller of 
the securities plus the accrued resale premium on such acquisition 
price. The accrued resale premium is the amount specified in the 
repurchase agreement or the daily amortization of the difference 
between the acquisition price and the resale price specified in the 
repurchase agreement.
    (8) Unrated Securities means securities that have not received a 
rating from the Requisite NRSROs.

    4. Section 270.12d3-1 is amended by removing the note following 
paragraph (d)(8).

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

    5. The authority citation for Part 274 continues to read as 
follows:

    Authority: 15 U.S.C. 77f, 77g, 77h, 77j, 77s, 78c(b), 781, 78m, 
78n, 78o(d), 80a-8, 80a-24, and 80a-29, unless otherwise noted.


    Note: The text of Form N-SAR does not, and this amendment will 
not, appear in the Code of Federal Regulations.



    6. Form N-SAR (referenced in 17 CFR 274.101) is amended by revising 
the second sentence in the first paragraph of the Instructions to 
Specific Items 24 and 25 to read as follows:

FORM N-SAR

* * * * *

Instructions to Specific Items

* * * * *

ITEMS 24 and 25: Acquisition of securities of registrant's regular 
brokers or dealers

    * * * See Rule 12d3-1, Investment Company Act Release No. 14036, 
dated July 13, 1984, adopting Rule 12d3-1, and Investment Company Act 
Release No. 25058, dated July 5, 2001, amending Rule 12d3-1. * * *
* * * * *

    Dated: July 5, 2001.
By the Commission.
Margaret H. McFarland,
Deputy Secretary.
[FR Doc. 01-17302 Filed 7-10-01; 8:45 am]
BILLING CODE 8010-01-P