On March 23, 2020, in response to business disruptions caused by the spread of the coronavirus (“COVID-19”), the Securities and Exchange Commission (“SEC”) issued an exemptive order (the “Order”) under the Investment Company Act of 1940 (“1940 Act”) granting registered investment companies and insurance company separate accounts registered as unit investment trusts (“separate accounts”) regulatory flexibility to obtain short term funding by (1) borrowing money from affiliated persons, (2) engaging in interfund lending outside the scope of existing interfund lending orders, and (3) deviating from fundamental policies. The Order provides this relief until at least June 30, 2020, but the SEC may extend the time period if necessary (the “relief period”).
Affiliated Person Borrowing and Collateralized Loans
The Order provides temporary relief from the following provisions of the 1940 Act that generally prohibit lending between affiliated parties, including “second tier” affiliates):
- Section 12(d)(3), which prohibits registered investment companies (“Funds”) and any companies they control from purchasing securities issued by broker-dealers or investment advisers, unless (a) one or more Funds own all the outstanding shares of a broker-dealer, and (b) the broker-dealer is primarily engaged in the business of market-making.
- Section 17(a), which generally prohibits persons affiliated with a Fund from (a) knowingly buying or selling anything of value to or from that Fund or any company it controls, or (b) borrowing or loaning anything of value to or from that Fund or the companies it controls.
- Section 18(f)(1), which generally prohibits open-end Funds from issuing or selling bonds or notes unless they are collateralized at 300 percent.
Importantly, the Order does not exempt all activities prohibited by sections 12(d)(3), 17(a), and 18(f)(1), only those activities necessary to facilitate borrowing from affiliates and second tier affiliates. As a condition of the relief, a Fund’s board of trustees, or the insurance company on behalf of the separate accounts, must reasonably determine that such borrowing is in the best interests of the Fund or the separate account and that the money borrowed will be used to satisfy shareholder redemptions. Prior to relying on the Order, Funds and separate account must notify the SEC’s Division of Investment Management (via email at IM-EmergencyRelief@sec.gov) of their intent to do so.
Interfund Lending Arrangements (Funds With Existing Interfund Lending Orders)
Section 17(d) of the 1940 Act, and Rule 17d-1 thereunder, generally prohibit joint transactions between Funds and their affiliated persons. However, Section 17(b) of the 1940 Act gives the SEC the authority to grant an order exempting certain classes of transactions. In recent years, the SEC has issued orders to many Fund complexes to allow them to loan assets among different Funds. The Order expands existing relief by allowing Funds that currently rely on an interfund lending order to:
- Make loans through an interfund lending facility in an aggregate amount that does not exceed 25 percent of its current net assets at the time of the loan, notwithstanding any lower limit set forth in a Fund’s existing interfund lending order; and
- Borrow or make loans permitted by a Fund’s existing interfund lending order for any term, provided that: (i) the term of any interfund loan made in reliance on the Order does not extend beyond the expiration of the relief period; (ii) the Fund’s board of trustees reasonably determines that the maximum term for such loans is appropriate; and (iii) the loans remain callable and subject to early repayment on the terms described in the Fund’s existing interfund lending order;
To rely on the relief above, Funds must ensure that any loan made in reliance on the Order is otherwise in accordance with the terms and conditions of their existing interfund lending order. They must also notify the SEC’s Division of Investment Management (via email at IM-EmergencyRelief@sec.gov) before relying on the Order, and disclose on their public website that they are relying on the Order, and that the Order modifies the terms of their existing interfund lending order to permit additional flexibility to provide or obtain short-term funding from an interfund lending and borrowing facility.
Interfund Lending Arrangements (Funds Without Existing Interfund Lending Orders)
In addition to providing relief to Funds that already rely on interfund lending orders, the Order enables Funds without existing interfund lending orders to engage in interfund lending provided that any such Fund:
- Satisfy the terms and conditions for relief contained in SEC interfund lending orders issued in the prior 12 months (including with respect to whether a Fund may participate as a borrower), except that:
- the Fund may rely on the same relief, including the conditions, provided to Funds and separate accounts with existing interfund lending orders, as described above;
- the Fund need not satisfy the condition in recent SEC interfund lending orders that requires prior disclosure of reliance on interfund lending relief in the Fund’s registration statement or shareholder reports; and
- money market funds may not participate as borrowers in the any interfund facility.
- Notify the SEC’s Division of Investment Management (via email at IM-EmergencyRelief@sec.gov) before relying on the Order and identify the recent SEC interfund lending orders upon which the Fund is relying as precedent.
- Disclose that it is relying on the Order for the first time to utilize an interfund lending and borrowing facility, and update any prospectus supplement, registration statement or shareholder report, while relying on the Order, to include the material facts about the Fund’s participation or intended participation in interfund lending.
Fundamental Policy Deviation
Finally, the Order provides relief from Sections 13(a)(2)-(3) of the 1940 Act, which prohibit Funds from (a) borrowing/lending money, issuing bonds and notes, underwriting securities, or purchasing or selling real estate and commodities, or (b) deviating from policies concerning the concentration of investments in any particular industry or group of industries as contained in their registration statement, unless authorized by the vote of a majority of their outstanding voting securities. The Order allows funds to enter into lending and borrowing transactions that deviate from their stated policies without obtaining prior shareholder approval, provided that:
- A participating Fund’s board of trustees reasonably determines that such lending or borrowing is in the best interests of the fund and its shareholders;
- The participating Fund promptly notifies its shareholders of the deviation by filing a prospectus supplement and including disclosure on its public website; and
- Prior to relying on the relief for the first time, the Fund notifies the SEC’s Division of Investment Management (via email at IM-EmergencyRelief@sec.gov) that it is relying on the Order
Conclusion
The SEC, like other federal and state regulators, will continue monitoring the current situation and may, if necessary, extend the time period for this and other relief granted under the 1940 Act. Registered investment companies and insurance company separate accounts registered as unit investment trusts should consider how COVID-19 is affecting their operations and whether their reliance on the relief provided in the Order is in the best interest of the Fund or separate account and its shareholders.
Morrison & Foerster associate Kristofer Readling contributed to the writing of this alert.
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