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Our Ref. No. 93-523-CC
 

RESPONSE OF THE OFFICE OF CHIEF COUNSEL Brown & Wood
 

DIVISION OF INVESTMNT MAAGEMENT File No. 132-3
 

Your letter of August 17, 1993, requests our concurrence
 

wi th your views on several interpretive issues concerning Rule


3a- 7 under the Investment Company Act of 1940 (" 1940 Act"). 1./ 

Specifically, you request our concurrence with the following:


(1) cumulative preferred stock that has no dete~inable liquidation date is an "eligible asset" within the meaning of


Rule 3a-7 (b) (1); (2) when a structured financing program issues 

two or more types of securities that are not redeemable alone,
 

but which give investors direct withdrawal rights if combined,
 the program does not issue redeemable securities wi thin the 

meaning of Section 2(a) (32) of the 1940 Act; and (3) the term
 

"trustee" in Rule 3a-7(a) (4) includes a custodian.
 

1. Is cumulative preferred stock that has no predetermined
 

liquidation date an "eligible asset? "
 

Rule 3a- 7 (at requires an issuer relying on the rule to be
 

engaged in the business of purchasing, or otherwise acquiring,
 and holding "eligible assets." Rule 3a- 7 (b) (1) defines "eligible 

assets" as 
 "financial assets, either fixed or revolving, that by
 

their termsconvert-'iñtb cash within a finite time period plus
 

any rights or 'other assets designed to assure the servicing or
 timely.-disltributionof. proceeds to security 'holders." You state 

that cumulative preferred stock should be considered an eligible
 

asset even though the stock' spar, stated, or liquidation value
 

may have no predetermined payment date, and therefore the stock
 does not, by its terms, convert into cash withiri a finite period 

of time. ~/ You believe that, notwithstanding the absence of a
 

self-liquidating feature, cumulative preferred stock should be
 

considered an eligible asset because it was included in a nonexclusive list of eligible assets that appeared in subparagraph
 

(b) (1) of proposed Rule 3a-7. 'J/ 

In the release adopting Rule 3a- 7, the Commission stated
 

that eligible assets must be self - liquidating, and chose not to
 

include a list of eligible 
 assets in the final rule. ~/ The
 

1./ Rule 3a- 7 excludes from the definition of "investment
 

company" any issuer that pools certain financial assets and
 

issues securities backed by those 'assets.
 

~/ You contrast the preferred stock with its dividends, which,
 

you state, do convert into cash within a finite time period.
 

'J/ Investment Company Act ReI. No. 18736 (May 29, 1992).
 

~/ Investment Company Act ReI. No. 19105 (Nov. 19, 1992).
 
Commission clearly indicated that the characteristics of a
 

security, and not its label, are determinative. ~/ Therefore, if
 

cumulative preferred stock has no predetermined liquidation date,
 

it would not be an eligible asset within the meaning of .'
 

Rule 3a-7 (b) (1). Q/ 

2. Does a structured financing program that issues two or
 

more types of securities that are not redeemable alone.
 

but which give investors direct withdrawal rights if
 

combined. issue redeemable securities within the
 

meaning of Section 2 (a) (32) of the 1940 Act? 

Rule 3a- 7 (a) excepts a structured financing program from the 

definition of investment company if, among other things, the
 issuer does not issue redeemable securities. 2/ Section 2 (a) (32) 

defines a redeemable security as "any security, . . . under the
 

terms of which the holder, upon presentation to the issuer or a
 

person the issuer designates, is entitled (absolutely or only out
 

of surplus) to receive approximately its proportionate share of
 

the issuer's current net assets or the cash equivalent. "
 

You state that certain structured financing programs issue
 two classes of securities and that the holders of one class of. 

securities ("Class B") may have the absolute or conditional right
 

to withdraw portfolio securities from the program, upon
 

acquisition and presentation of an appropriate amount of the
 

other class of securities ("Class A"). Class B holders may
 

acquire Class A securities directly (by purchasing the Class A
 

securities) or through, payment of a stipulated amount to 
 the sponsor. ~/ You bel ieve that, notwithstanding these direct 

~/ Id. at nn.13-21 and accompanying text.
 

, Q/ This position is consistent with that of the Division of
 Corporation Finance. See Securities Act ReI. No. 6964 (Oct. 

29, 1992) (adopting revisions to Form S -3).
 

2/ Rule 3a- 7 requires structured financing programs to issue
 

only non- redeemable securities in order to "preclud (e)
 

(those) issuers from acting in a manner similar to mutual
 

funds," which might lead to investor confusion between
 

unregistered structured financings and registered investment
 

companies. See Investment Company Act ReI.: Nos. 19105
 

(adopting Rule 3a-7) at n.24 and accompanying text and 18736
 

(proposing Rule 3a-7) at n.61 and accompanying text.
 

~/ The staff understands that some issuers may conduct periodic
 

auctions of Class A securities to enable Class B holders to
 

acquire sufficient Class A securities to effect a
 

withdrawal. Moreover, in some programs, Class A securities
 

(continued. . . ) 

- 2 ­
withdrawal rights, the structured financing program does not
 

issue "redeemable securities." ~/
 

Whether a structured financing program issues redeemable
 

securities in the circumstances you describe will depend on
 

whether there are substantial enough restrictio~s on an
 

investor's ability to withdraw portfolio securities. The
 

Division considers the following factors to be important to this
 

determination: (1) whether an investor's withdrawal right is
 

conditional or absolute, 10/ (2) whether the issuer offers the
 

matching securities for sale to investors at the 'same time or
 

only at different times, (3) whether and how often the issuer
 

sponsors activities (such as auctions and mandatory tender
 

features) designed to facilitate an investor's ability to acquire
 

the matching security or securities and present them for
 

withdrawal, (4) whether the amount of portfolio securities that
 

an investor can withdraw from the program at anyone time is
 

limited or unlimited, 11/ (5) how often an investor can withdraw
 

~/ ( . . . continued) 

are subj ect to a mandatory tender; that is, if a Class B
 

holder's auction bid is unsuccessful, it can require that
 

the issuer call an appropriate amount of Class A securities.
 

The Class B holder, upon payment of the face amount of the
 

called Class A securities, then may present both securities
 

to the issuer-t'o'-effect the withdrawal.
 

also 'stateth~t the structured':finanCi~ilg program does
 

not issue redeemable securities even if the Class A and
 ~/ You 


Class B securities, once combined, are viewed as redeemable.
 

Because the decision to combine is the investor's and is not
 

dictated by the terms of the offering, you do not believe
 

that the program is the "issuer" of the combined security.
 

We disagree. Although the decision to combine is the '
 

investor's, the structured financing program will define all
 

of the rights attributable to the Class A and Class B
 

securities, and will register the securities under the
 

Secùrities Act of 1933. Further, the' program, not the
 

investor, is the obligor of the recombined security. See
 

The SuperTrust Trust for Capital Market Fund, Inc. Shares,
 

Investment Company Act ReI. No. 17613 (Jul. 25, 1990) (unit
 

investment trust was issuer of redeemable security as well
 

as its non-redeemable components) .
 

10/ See United States Property Investments, N.V. (pub. avail.
 

May 1, 1989) (no obligation on part of issuer to redeem any
 

or all of the securities tendered).
 

11/ In an effort to distinguish closed- end interval funds from
 issuers of redeemable securities, the Commi.:ision limits the 

(continued. . . ) 

- 3 ­
portfolio securities from the program, 12/ (6) whether or not
 

there is a holding period requirement ,13 / (7) the denomination
 

of'the securities and the minimum amount needed to withdraw
 

portfolio securities, 14/and (8) how the withdrawal right
 

feature is presented to investors.
 

Your letter does not contain sufficiently specific facts

about the structured financing programs and the withdrawal rights 

to enable the staff to determine whether or not the programs 

should be deemed to be issuing redeemable securities. Therefore, 

we cannot concur in your opinion that these arrangements would 

not cause Rule 3a- 7 to be unavailable. 

3. Does the term "trustee" in Rule 3a-7(a) (4) include a

custodian? 

Rule 3a- 7 (a) (4) requires an issuer relying on the rule to


appoint a trustee that meets the requirements of Section 26 (a) (1) 

of the 1940 Act. Section 26 (a) (1) requires the trustee or
 

custodian of a unit investment trust to be a bank with aggregate
 

capital, surplus, and undivided profits of at least $500,000.
 

11/ ( . . . continued) 

size 'of repurchase offers by closed-end management
 

investment companies to not 
 more than 25% of the company's
 outstanding cOrróñ'st()ck.BeeRule 23c-3 (a) (3) and 

Investment CompanY;dActRel . 
 Nos .'18869 (Jul. 28, 1992)


(proposing' Rule':23'ç¥'3):and19399.(Apr.7, 1993) (adopting

Rule 23c-3). Seeå.lso California Dentists' Guild Real
 

Estate Mortgage Funa II (pub. avail. Jan. 4, 1990)
 

(withdrawals limited to the lesser of $100,000 or 25% of the
 

investor's account per quarter); Redwood Mortgage Investors
 

VII (pub. avail. Jan. 5, 1990) (total withdrawals limited to
 

20% 'of outstanding accounts per year) .
 

12/ See, e. g., California Dentists' Guild Real Estate Mortgage
 

Fund II (quarterly withdrawals with 90 days' notice
 

required); Redwood Mortgage Investors VII (quarterly
 

withdrawals with three months' notice required); United


States Property Investments, N. V. (annual withdrawals with four months' notice required) . 

13/ See, e.g., California bentists' Guild Real Estate Mortgage
 

Fund II (one year holding period); Redwood Mortgage
 

Investors VII (one year holding period); United States


Property Investments, N. V. (two year holding period) . 

14/ See SPDR Trust, Series 1, Investment Company Act ReI. No.
 

18959 (Sept. 17, 1992) (substantial dollar amount required
 

to aggregate non-redeemable securities into redeemable


uni t) . 

- 4 ­
You state that Section 26 (a) (1) expressly contemplates the
 

use of a custodian bank, and that many structured financing
 

programs use custodians rather than trustees. You also state
 

that the Commission, in proposing and adopting the rule, never
 

expressly precluded the use of a custodian bank. Finally, you
 

state that a custodian bank is able to perform the same functions
 

and comply with the same requirements required of a trustee bank.
 

Rule 3a- 7 (a) (4) specifically requires an issuer to appoint a
 

trustee. Therefore, we cannot concur in your opinion that the
 

term "trustee" in Rule 3a-7(a) (4) includes a custodian.
 ~t- 6­

Monica L. Parry 

Senior Counsel 

- 5 ­
,.~ 

555 CAI.IFORNI~ ,STREET'
 BROWN & WOO.O
 815 CONNECTICUT AVENUE. N.W.

SAN FRANCISCO,CA,SJ4104:1 7 15 WA5HINGTON, D.C. 20006-4004


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'012 

ACT ICiYLJ c.1\ 

SECTION Investment Company Act of 1940


Rule 3a-7
 RULE So. -7 

PUBLIC .. l~ i I I 0. II ,:, AVAILABILIT~ 

August 17, 1993
 

Division of Investment Management
 

Securities and Exchange Commission
 

Washington, D.C. 20549
 

Attention: Officeof__Chief Counsel

... ,. "",~,,,..-, 

,;tadies, and . 
 Gentlemen : 

Reference is made to Investment Company Act Release No. IC19105, dated November 19, 1992 (the "Release"), relating to the
 

adoption of Rule 3a-7 (the "Rule") under the Investment Company
 

Act of 1940 (the "Act"). The Rule, which provides that
 

structured financing arrangements meeting certain requirements
 

are not subject to registration under the 
 Act, is designed to
 

remove "an unnecessary and unintended barrier to the use of
 

structured financings." We believe 
 that this goal has been
 substantially achieved; howeve~, as 
 wi th any important 

initiative, certain technical issues are presented by the
 

language of the Rule in its final form. We have been requested
 

to give advice respecting the application of the Rule to certain
 

structu~ed financing arrangements which appear to fall within the
 

intent of the Rule but are not clearly reconcilable to its actual
 

text. Based upon informal conversations with certain staff
 

members, we understand thát resolution of these issues should be
 

pursued through the no-action letter process. Accordingly, the
 

purpose of this letter is to request that the staff recommend
 

that the Commission take no enforcement action if transactions
 

are effected based on our view as to the proper resolution of the
 

following issues. Terms used but not defined in this letter have
 

the meanings assigned to them in the Release.
 
1. Is cumulative preferred stock an "eligible' asset"? The
 form of proposed 
 Rule 3a-7 as set forth in -InvestmèntCompany Act


29, 1992 (the "Proposing Release"),
 

contained a non-exclusive list of eligible assets (defined in the
 

proposed rule to mean "obligations that require scheduled cash
 

payments") which included "cumulative preferred stock." The
 

Rule, however, requires that eligible assets "by their terms
 

convert into cash within a finite time period". This definition
 

clearly encompasses the dividends payable on cumulative preferred
 

stock, which can be valued, statistically analyzed and
 

securitized. However, the par, stated or liquidation value of a
 

share of cumulative preferred stock may have no determinable
 

payment date and it would not, therefore, appear to be a "selfliquidating" asset. Because the Release states that the
 

definition of eligible assets "is intended to include all of the
 

assets provided as examples in the proposed paragraph" and does
 

not otherwise indicate an intent to exclude cumulative preferred
 

stock, we believe that the term "eligible assets" should be


Release No. 18736,' dated May 

understood to include cumulative preferred stock. 

2. Do certain types of withdrawal rights create redeemable
 

securities? A number of structured financings involve the
 

deposit of securities with a non-affiliated bank, acting as
 

depositary or custodian,! and the issuance by the bank of
 

in the eligible assets so
 

'deposited. For example, if fixed rate securities are deposited,
 

receipts evidencing ,interests 

oneclass.of receipt ("Class ,A.,Receipts") 'may entitle the holder
 tòdistribütions at a floating or 'adjustable rate, with the
 

residual class of receipt ("Class B Receipts" ) receiving any
 

remaining cash flow. In many cases, however, a holder of the
 

Class B Receipts may have the absolute or con~itional right to
 

withdraw deposited securities, upon acquisition and presentation
 

of an appropriate amount pf the Class A Receipts (which
 

acquisition may be effected directly or through payment of a
 

stipulated amount which is then distributed to effect retirement
 

of the related Class A Receipts) .. We believe that these direct
 

withdrawal rights do not constitute the issuance of "redeemable
 

securities" as prohibited by Rule 3a-7.
 

the Proposing Release that Rule
 

3a-7 would be unavailable to structured financings issuing
 

redeemable securities in order to preclude such "issuers from
 

acting in a manner similar to registered investment companies."
 

The Rule's prohibition on the issuance of redeemable securities
 

is based on the same concern that led Congress in 1970 to
 

incorporate a virtually identical prohibition for entities
 

seeking to rely on the exception from the Act set forth in
 

The Commission stated in 


See question 3 below.
 

2 
. '
 

.",-' , ,
 . ,,- .. ;., -. - - -'--,-,' ',' séCtiÓIli3 (C), ( 51:"theJ:eo:f..see~Reportof,the ,',securities and, 

'ExChangè'còníission . önthe'Public' Policy Implications of
 

Investment company'Growth, H.R.Rep. No. 2337, 89th Cong., 2d


Sess. 328-9 (1966). See also S. Rep. No. 184, 91st Cong., 1st

Sess. 37 (1969);' H.R. Rep. No. 1382, 91st Cong., 2d Sess. 17 

(1970) ~ Accordingly, the Release instructs counsel to look to


Commission staff no-action letters under Section 3 (c) (5) for
 

guidance on whether particular types of securities may be
 

considered redeemable.
 

We do not believe the withdrawal rights discussed above are
 

redeemable securities either under the literal wording of the
 

Act's definition of a "redeemable security" or under staff no-


action letters. Under section 2 (a) (32) of the Act, a redeemable
 secur i ty is def ined as: 

any security, other than short term paper, under the terms
 

of which the holder, upon its presentation to the issuer or
 

to a person designated by the issuer, is entitled (whether
 

absolutely or only out of surplus) to receive approximately
 

his proportionate share of the issuer's current net assets,
 

or the cash equivalent thereof.
 

_ ,We ,rec:ognizethat Section. 
 2 (a) (32) encompasses redemptions in ,kind '(i~e~i'J:ëaellpti-ons:for secur ities',hela.:by .,'" the issuer) as wel las"r,:#~inpti9ns ".r or:..gash "anci ,."t,p.at-',t,he to "tight, VI ithdraVl.' ,,_ , ,'depQs1 fed 'd's'ë'Òù.'rltìés tmay'.?at'.,'"f irst..t'â'pÍ)eå.f-šïm-iiârtÓ~'a~:~rêaémption :.... '".:....',;., :.,'..-. ',., :.,~,'.... ; _ "::_..'.. ," .... '. ,'...... ",I.. '''''' _.... ,:, -'. _,......:,' ,: _',,~ .... " .. ._',,' ."C _, _..: .. ';'. : :_".." '_ _"C, ....' ._-_~.", ,:. .. '," "._,.' .. .~. : ~"""'.-_~""'."_:"~-: "".. -.. '.;,~:_ .. ,'~ .. '., ... ,_ .-,,_ ': 

however /1 t' is apparëntthat
 

those withdrawal rights fall outside the section. Neither the
 

Class A Receipt holders nor the Class B Receipt holders have the
 

right to require withdrawal upon mere presentation of a Receipt
 

-to the issuer. A Class A Receipt holder has no withdrawal right
 

at all. Moreover, a Class B Receipt holder may exercise its
 

inkirid. upoh\'6loserdex~ñiinatioii, : 


withdrawal right 
 only . if such holder first acquires Class A

Receipts (ei therdirectly or by making payment of an amount
 

sufficient to. retire a stipulated principal amount of Class A
 

unencumbered right tò redeem withïn
 

the meaning of the section.
 

Receipts). Thus, there is no 


In addition, the amount of securities withdrawn do not
 

correspond to a "proportionate share .ofthe issuer's current net
 

assets" under the section. That is, the withdrawal rights
 

attached to Clas~ B Receipts require the presentation or
 

retirement of a stipulated amount of Class A Receipts; the Class
 

B Receipt holder does not, in effect, realize fully the value of
 

the withdrawn securities.
 

The actions required of a Class B Receipt holder in order to
 

withdraw deposited securities also constitute "substantial
 

restrictions" on the right to redeem in accordance with prior
 

3 
l :
 

-. 

, ,

,Çollie;sion staff no-action letters under Section 3 (c) (5). As
 

recogrlized irìthe Release, where such restrictions exist with
 

respect to a security, the security should not be considered
 

redeemable so as to render the issuer ineligible to rely on the


Rule. 

We are unaware of any no-action letters precisely on point.
 

However, certain principles evidenced in the letters support the
 

conclusion that the conditions to withdrawal of deposited
 

securities constitute "substantial restrictions. II The staff has
 

found substantial restrictions to exist where there are
 

restrictions on either the amount or frequency of redemptions, or
 

both. See,~, California Dentists' Guild Real Estate Mortqaqe
 

Fund II (pub. avail. January 4, 1990) (security redeemable only
 

at quarterly intervals commencing one year after purchase, then
 

up to a maximum of $100,000 or 25% of the investor's account);
 

Redwood Mortgaqe Investors VII (pub. avail. January 5, 1990) (one
 

year holding period and quarterly redemptions of limited amount);
 

United States Property Investment. NV (pub. avail. May 1, 1989)
 

(ini tial two year holding period requirement). The withdrawal


rights at issue here impose similar types of restrictions on the
 

withdrawal of deposited securities. A Class B Receipt holder
 

cannot simply present such Receipt for withdrawal; a Class B
 

Receipt holder must expend funds to realize the value of such
 

securities. ,Specif,icaiiy, such Class B Receipt holder must
 

Edth~r - undertake 
 the expense of acquiring the necessary amount of


-'Cla;;s.d.A'Reaeipts in th~ secondary. market or pay the stipulated 

the deposited
 

securities. We believe these restrictions are substantial and
 

readily distinguish these withdrawal rights from the types of
 

,freely redeemable securities issued by registered open-end
 

investment, companies. 2
 

-amount befòre being permitted to withdraw 


Finally, we believe that even if the Class A Receipts and
 

Class B Receipts, once recombined by the Class B Receiptholder,
 

may be viewed as redeemable, the arrangement still would not
 

violate Rule 3a-7. The Rule is available to a structured
 

that the financing does not issue redeemable
 

securities. In accordance with that requirement, the structured
 

financings involved in our request never issue any security that
 

by itself is redeemable; a purchaser of Class B Receipts may also
 

choose initially to purchase Class A Receipts, but that is a
 

financing provided 


2 It is true that registered open-end investment companies may
 

charge redemption fees of up to two percent of the amount
 

redeemed to cover certain costs. Such charges, obviously,
 

are at a lower level and for very different purposes than
 

the types of expenses which must be incurred in connection
 

with the withdrawal rights.
 

4 
tiie,buY;Ea,r~ "") not dictated ," by,thet~rIls()f the. _:/d; :;~__:';:-::'~,...,,:
 -:',.'...- .... 

3. will a "custodian" bank satisfY oaraqraph (a) (4)? We
 

note that the Rule requires the use of a trustee bank meeting the
 

requirements of section 26 (a) (1) of the Act. That section
 

expressly contemplates the use of a "custodian" bank. For
 

reasons of precedent and custom, many structured financings
 

involving the deposit of securities use arrangements and
 

terminology customary for custody rather than trustee
 

relationships. Assuming the other requirements of Section
 26 (a) (1) are met, we believe that the term trustee in paragraph 

(a) (4) of the Rule should include a 
 custodian and we request your


concurrence in 
 this view. In support of our request we note that
 

neither the Proposing Release nor the Release reflect any
 

to preclude the use of a
 

custodian, rather than a technical trustee. To the contrary,
 

intention on the part of the Commission 


footnote 93 of the Proposing Release recognizes that ,a
 similar incorporation by reference of Section 26 (a) (1) of the Act exists 

in Section 17(f) of the Act, which governs the qualifications of
 

banks that may serve as custodians for ragistered investment
 companies.3 In addition, as noted above, Section 2 6 itself 

accommodates both ~rust and custodianship arrangements.
 

similarly, Section 4 (2) of the Act defines a unit investment
 

trustasaniinve.s;t.:nient'"c;oinpany . 
 which, amon,g othe.r~th.lng~,U (A) is

organizedunder:~LtrustindentÜre" contract of custodianship or 

agen9Y /orsimilardinstrument.. '"'' (emphasis "addèa)Kh~;':'\"F'AIla.iiý;,' thereisnoregùlatory'purpose to be served byrequiring:'å' '," 

trustee rather than a, custodian. An independent custodian' can
 

perform the same functions and meet the same requirements
 

required of a trustee by paragraph (a) (4) of the Rule. It is
 

those requirements that are important, not the particular form of


arrangement used. , 

In accordance with your request, this letter is intended to
 

restate our prior letter to the Division of Investment Management
 

dated March 9, 1993.
 

Section 17 (f) provides that "( e J very management investment
 

company shall place and maintain its securities and similar
 

investments in the custody of (1) a bank or banks having the
 

qualifications prescribed in (Section 26(a)(1)) for the
 

trustees of unit investment trusts."
 

5 

3 
l 

, 

.. 

:.~. ~"'~' ,::-.---'¡~~: .:.~-:-~- ?:.:~--~~¿-;),~~fj.:.~~l.~~~:'\:::;'.' .:?'::~~;'~',:. ".:;':;2:;,;'-S_tl'g~ldjyourequire any clarification or further information 

'cori6èrñlng~these issues, please do not hesitate to call the 

undersigned (212-839-5354) or Brian M. Kaplowitz (212-839-5370) 

of this office. 

Very truly yours,


I7'iC 

Kenneth T. Cote
 

cc: Thomas S. Harman
 

Monica L. Parry
 

6