In response to the outbreak of the COVID-19 coronavirus disease, the Securities and Exchange Commission took extraordinary action to bolster liquidity for registered investment companies through at least June 30, 2020. In an Order dated March 23, 2020, the Commission exempts most open-end funds from restrictions that limit their ability to borrow money from affiliates or engage in interfund lending (IFL) arrangements. The order applies to open-end funds, other than money market funds, and insurance company separate accounts registered as unit investment trusts (collectively "funds" or "open-end funds") that seek short-term financing.
The following summarizes the exemptions and their implications:
Borrowings from affiliated persons and the ability of affiliated persons to make collateralized loans.
The Commission exempts open-end funds from the restrictions of Section 18(f)(1) and Sections 17(a) and 17(b) the Investment Company Act of 1940 (the "1940 Act")—each further described below—to allow an open-end fund to borrow money from any affiliated person that is not itself a bank or an investment company, provided that:
- The fund's board, including a majority of the independent trustees, reasonably determines that the borrowing:
- Is in the best interest of the fund and its shareholders; and
- Will be used for the purpose of satisfying shareholder redemptions; and
- Prior to relying on this relief for the first time, the fund notifies the Commission staff via email at IM-EmergencyRelief@sec.gov stating that it is relying on the Order.
Analysis: Section 17(a) of the 1940 Act generally prohibits an affiliated person (which includes an affiliated person of an affiliated person, commonly called a second-tier affiliate) from buying or selling property from a registered investment company. This section is read to prohibit an affiliate from making a collateralized loan to a fund, because foreclosing on the collateral would be the equivalent of a purchase of an asset from the fund.
Section 18f(1) of the 1940 Act generally prohibits an open-end fund from issuing a "senior security," but allows a fund to borrow from a bank provided that the fund maintains "300 percent asset coverage." This means that a fund generally must have on its books $3 in total assets, including the amount borrowed, for every $1 it borrows, effectively limiting the fund's ability to leverage its assets. The term "senior security" does not include a "promissory note or other evidence of indebtedness" when a loan is for "temporary purposes only" and does not exceed 5% of the value of the fund's total assets at the time the loan is made.1
The Order exempts funds from these limitations if the open-end fund complies with the Order's conditions. Thus, an affiliated person, such as the fund's investment adviser or sponsor, can now make a collateralized loan to an open-end fund through at least June 30, 2020. This element of the exemption is especially significant for fund affiliates that are bank holding companies and certain of their affiliates, because the Federal Reserve Act generally limits their ability to lend money to fund affiliates without taking collateral.
We note that under current law a non-bank fund affiliate can lend a fund up to 5% of the fund's total assets on an unsecured basis for "temporary purposes" (typically understood not to exceed 60 days). In addition, regardless of the terms of the Order (and implicit in the required "best interest" finding), the fund's board, as a fiduciary, should evaluate the proposed transaction to ensure that the loan is in the best interests of the fund and does not involve overreaching on the part of the affiliate.
The Order also does not specify whether or how a fund must disclose lending arrangements with affiliates, in contrast with other parts of the Order that require disclosure when a fund relies on the Order, among other things, to enter into or expand upon IFL arrangements or to exceed a fundamental limitation contained in its registration statement.
IFL arrangements for funds with existing IFL orders. The Commission exempts open-end funds from certain common limitations in their IFL orders. Specifically:
- Funds with existing IFL orders can make loans to other funds up to 25% of current assets at the time of the loan, even the IFL order provides a lower limit;
- Funds may borrow money for any term notwithstanding any conditions in the IFL order that otherwise limit the term, provided:
- The term of the interfund loan made in reliance on the Order does not extend beyond June 30, 2020 at the earliest;
- The board, including a majority of the independent trustees, determines that the maximum term for interfund loans made in reliance on the Order is appropriate; and
- The loans will remain callable and subject to early repayment on the terms contained in the IFL order.
- Funds can rely on the Order even if the fund's IFL order incorporates otherwise inconsistent fundamental restrictions, limitations or non-fundamental policies from its registration statement (see below);Funds with existing IFL orders can rely on the Order provided they comply with the following conditions in addition to those above:
- Any loan under the facility is otherwise made in accordance with the terms and conditions of the existing IFL order;
- Prior to relying on this relief for the first time, the fund notifies the Commission staff via email at IM-EmergencyRelief@sec.gov stating that it is relying on the Order; and
- Prior to relying on this relief for the first time, the fund discloses on its public website that it is relying on the Order and modifying the terms of existing IFL order to permit additional flexibility to provide or obtain short-term funding from its IFL facility.
Analysis: This provision creates immediate, but temporary, liquidity for open-end funds by letting them exceed the limits that apply to the amount of cash that a fund can borrow (or lend) or the term of the loan, in each case as otherwise required by an existing IFL order. Note that some IFL orders may incorporate fundamental restrictions of funds that reflect these limits. Subject to the notification and disclosure provisions described below, the Commission has exempted funds from these limitations as well (see below).
As with consideration of affiliate lending arrangements, the fund's board should evaluate the proposed transaction to ensure that the loan is in the best interests of the fund and does not involve overreaching on the part of the affiliate, taking into account that the interests of a borrowing fund will differ from the interests of a lending fund.
A fund relying on the Order to expand its IFL order must post prior notice to the fund's website. Depending on the circumstances a fund also may be required to amend its registration statement to reflect the new arrangements.
IFL arrangements for registered investment companies without existing IFL orders.
The Commission will allow any open-end fund to participate in IFL arrangements by relying on any IFL order that the Commission has issued within the 12 months preceding the Order, provided:
- The fund satisfies the conditions in the order it chooses to rely on, except that:
- The fund may also rely on the exemptions provided by the Order to funds that have existing IFL orders (that is, a fund can lend up to 25% of its assets and without regard to the maximum term of a loan contained in the existing IFL order);
- The fund does not have to comply with a condition in the IFL order requiring prior disclosure in its registration statement or shareholder report; and
- Money market funds may not participate as borrowers in the IFL facility;
- Prior to relying on the Order for the first time, the fund notifies the Commission staff via email at IM-EmergencyRelief@sec.gov stating that it is relying on the Order, and identifying the recent IFL order on which it chooses to rely; and
- The fund:
- Discloses on its website, prior to participating in an IFL program, that it is relying on the Order; and
- To the extent that it files a prospectus supplement, amends its registration statement or files a shareholder report, it updates disclosures about the material facts of its participation or intended participation in the IFL facility.
Analysis: With the stroke of a pen, the Commission short-circuited the lengthy, cumbersome and costly exemptive application process, giving funds an "instant IFL order," which they can rely on at least through June 30, 2020. The condition states that before relying on the instant IFL order, a fund must disclose this fact on its website, but it stops short of requiring a fund to file a prospectus supplement right away. Rather, it requires funds to disclose the instant IFL order "to the extent it files" a supplement, amended registration statement or shareholder report. This requirement should be read together with the requirement to supplement or amend a fund's registration statement if the borrowing or lending activity would otherwise violate a fundamental investment policy or restriction (see below). Note that the Order's other disclosure requirements appear to be triggered only when actual reliance on the Order is imminent, whereas this disclosure condition is triggered when a fund intends to rely on the Order to participate in an IFL facility.
In addition, a fund firm electing to rely on an instant IFL order should document that the merits and alternatives to the IFL arrangement were carefully thought through. Funds will require internal policies and procedures to implement their IFL terms.
The Order clearly states money market funds cannot participate in an IFL facility as a borrower, which suggests they may be lenders.
Deviating from a fund's fundamental policy with respect to borrowing or lending.
The Order allows an open-end fund to deviate from any "relevant policy" in its registration statement without prior shareholder approval to the extent necessary to allow it to enter into any "otherwise lawful lending or borrowing transaction" (i.e., in all respects as contemplated by the relief above or otherwise), provided:
- The board of the fund, including a majority of the independent trustees, "reasonably determines" that the lending or borrowing is in the best interests of the fund and its shareholders;
- The fund promptly notifies its shareholders of the deviation by filing a prospectus supplement and including a statement on the fund's public website; and
- Prior to relying on the Order for the first time, the fund notifies the Commission staff via email at IM-EmergencyRelief@sec.gov, stating that it is relying on the Order.
Analysis: With another stroke of the pen, the Commission lifted a broad set of potentially significant limitations that, in the ordinary course, often require the time and expense of a shareholder vote to change.
As with other elements of relief under the Order, the board plays a significant role in evaluating whether it is in the best interests of the fund and its shareholders to exceed fundamental investment policies or restrictions. In its evaluation, boards should also consider implications under state law.
To rely on this exemption, a fund must "promptly" notify shareholders "of the deviation" in a supplement or amendment to the fund's registration statement and through notice on the fund's website. This standard leaves some room for interpretation.
Timing of reliance on the Order.
The relief under the Order is available immediately and through an unspecified date to be set by the Commission staff in a later public notice. That date will be at least two weeks from the date of the notice but no earlier than June 30, 2020.
1. Section 18 provides that a loan shall be presumed to be for temporary purposes if it is repaid within 60 days and is not extended or renewed; otherwise it shall be presumed not to be for temporary purposes. This presumption may be rebutted by evidence.
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