Rules Governing the Acquisition of Securities by Money Market Funds

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1 January 2007 Rules Governing the Acquisition of Securities by Money Market Funds Diversification If you have questions or would like additional information on the material covered in this text, please contact one of the authors: Stephen A. Keen (Pittsburgh) Leslie K. Ross (Pittsburgh) or the Reed Smith attorney with whom you regularly work. The diversification requirements of Rule 2a-7 are without question the most complex aspects of a complicated regulation. A number of factors contribute to this complexity. First, Rule 2a-7 imposes more stringent diversification requirements on funds paying taxable dividends (which we refer to as Taxable Funds ) than on funds paying dividends exempt from Federal income tax (which we refer to as National Funds ) or exempt from both Federal and state income tax (defined in (a)(23) as Single State Funds ). Second, the rule contains two diversification regimes. One limits the percentage of Total Assets that a money market fund may invest in securities of a single Issuer (which we will call Issuer Diversification ). The other limits the percentage of Total Assets that a money market fund may invest in securities issued or Guaranteed by, or having Demand Features to, one entity (which we will refer to as Demand Feature & Guarantee Diversification ). Rule 2a-7(a)(25) defines Total Assets as the total amortized cost value of a Fund s assets. We will refer to the amount a Fund invests in securities issued or Guaranteed by, or having Demand Features to, a Credit Party as the Fund s exposure to the Credit Party. Some types of securities only need to comply with Issuer Diversification. Securities with Guarantees Issued By Non- Controlled Persons only need to comply with Demand Feature & Guarantee Diversification. Securities with other forms of Demand Features and Guarantees must comply with both Issuer and Demand Feature & Guarantee Diversification. Third, the rule applies different limits to different types of securities. Second Tier Securities, Demand Features and Guarantees must adhere to stricter limits than First Tier Securities, Guarantees and Demand Features. In the case of National and Single State Funds, however, these stricter limits apply only to Conduit Securities. In contrast, the rule allows more latitude for investment in First Tier Demand Features and Guarantees Issued By A Non-Controlled Person than investments in other First Tier Securities. This text is presented for informational purposes and is not intended to constitute legal advice. Reed Smith LLP All Rights Reserved. Reed Smith refers to Reed Smith LLP, a limited liability partnership formed in the state of Delaware. Fourth, the rule requires different percentages of the portfolio to comply with the limitations on certain types of securities. For most types of securities and Funds, all securities of a given type must comply with a diversification limit. For certain types of securities, however, only seventy-five percent of the money market fund s Total Assets must comply with the limitation. This means that, so long as at least seventy-five percent of the Total Assets meet Rule 2a-7 s various diversification limits, the Fund may invest the remainder of the portfolio in the specified type of security without regard for diversification. The undiversified portion of the portfolio is frequently referred to as the 25% basket. Single State Funds NEW YORK LONDON PARIS LOS ANGELES WASHINGTON, D.C. SAN FRANCISCO PHILADELPHIA PITTSBURGH OAKLAND MUNICH ABU DHABI PRINCETON N. VIRGINIA WILMINGTON BIRMINGHAM DUBAI CENTURY CITY RICHMOND GREECE r e e d s m i t h. c o m

2 have a 25% basket for Issuer Diversification of First Tier Securities. All money market funds have a 25% basket for Demand Feature & Guarantee Diversification of First Tier Demand Features and Guarantees Issued By A Non-Controlled Person. Finally, the rule contains special instructions for diversification of repurchase agreements Collateralized Fully, Refunded Securities, Conduit Securities and Asset Backed Securities. These special provisions are reviewed at the end of this section. The rule also recognizes that securities may have multiple Guarantees and Demand Features, each of which must comply with the diversification limits. The combination of these factors leads to the daunting complexity of Rule 2a-7 s diversification requirements. Indeed, in many cases you must analyze the diversification of the entire portfolio in order to determine whether a particular Acquisition complies with the rule. In this section, we will describe an approach that should make the process of diversifying a Fund in compliance with Rule 2a-7 more manageable. Diversification Limitations The following tables show the diversification limitations of Rule 2a-7 for each type of Fund and each type of security. The first table shows the limitations for Issuer Diversification. RULE 2a-7 ISSUER DIVERSIFICATION Type of Security Taxable National Single State Government Securities No Limit No Limit No Limit Repurchase Agreements Collateralized Fully by Government Securities No Limit No Limit No Limit Refunded Securities No Limit No Limit No Limit Securities Subject to Guarantees Issued By A Non-Controlled Person See Next Table See Next Table See Next Table First Tier Securities 5% x 100% 5% x 100% 5% x 75% Second Tier Conduit Securities 1% x 100%* 1% x 100%* 1% x 100%* Other Second Tier Securities 1% x 100%* 5% x 100% 5% x 100% The first number represents the maximum percentage of Total Assets that the specified type of fund may invest in the specified type of security. The second number represents the minimum percentage of Total Assets that must comply with these limitations. Securities marked with an * cannot exceed five percent of Total Assets in the aggregate. For example, except for the first four types of securities, a Taxable Fund may not invest more than five percent of its Total Assets in First Tier Securities, or more than one percent of Total Assets in Second Tier Securities, of a single Issuer. These limitations apply to one-hundred percent of the Fund s Total Assets, so the Fund may not Acquire any securities in excess of the limits. In contrast, the limitations on First Tier Securities for a Single State Fund apply to only seventy-five percent of its Total Assets. This means that the Fund may invest up to twenty-five percent of its Total Asset in excess of the five percent limit. For example, a Single State Fund may invest fifteen percent of its Total Assets in First Tier securities of one Municipal Issuer and ten percent in First Tier Conduit Securities of another Issuer

3 The second table shows the limitations for Demand Feature & Guarantee Diversification. RULE 2a-7 DEMAND FEATURE & GUARANTEE DIVERSIFICATION Type of Security Taxable National Single State Securities Not Subject to Demand Features or Guarantees See Prior Table See Prior Table See Prior Table Securities Guaranteed by a Government Issuer No Limit No Limit No Limit Securities Subject to First Tier Demand Features or Guarantees Issued By A Non-Controlled Person Securities Subject to Other First Tier Demand Features or Guarantees Conduit Securities Subject to Second Tier Demand Features or Guarantees Other Securities Subject to Second Tier Demand Features or Guarantees 10% x 75% 10% x 75% 10% x 75% 10% x 100% 10% x 100% 10% x 100% 5% x 100%* 5% x 100%* 5% x 100%* 5% x 100%* 5% x 100% 5% x 100% In this table, the first number represents the maximum exposure that a Fund may have to an entity providing a Demand Feature or Guarantee. The second number still represents the minimum percentage of Total Assets that must comply with these limitations. Securities marked with an * cannot exceed five percent of Total Assets in the aggregate. For example, a money market fund may not have an exposure of more than ten percent of its Total Assets to the provider of a First Tier Demand Feature or Guarantee. If the Demand Feature or Guarantee is Issued By A Non- Controlled Person, however, these limitations apply to only seventy-five percent of the Fund s Total Assets. For example, a fund may have thirteen percent of its Total Assets exposed to one Guarantor and twelve percent exposed to another entity providing Conditional Demand Features. Application of Diversification Limits to an Acquisition A Fund may not Acquire a security if it would result in a violation of Issuer Diversification or Demand Feature & Guarantee Diversification, whichever is applicable to the Acquired security. The following procedure will determine whether an Acquisition would violate applicable diversification limits. It relies on the credit analysis described above in the section on Minimal Credit Risk to identify and classify Credit Parties subject to diversification. You should base all calculations on the Amortized Cost of the relevant securities and the Fund s Total Assets. You must determine whether each Credit Party is subject to Issuer Diversification, Demand Feature & Guarantee Diversification, or both. You should follow the remaining steps separately for each Credit Party. If the security is subject to Issuer Diversification, you must calculate the amount currently invested in securities issued by the Credit Party. You should include in this calculation only securities subject to Issuer Diversification. If the security is subject to Demand Feature & Guarantee Diversification, you must calculate the current exposure to the Credit Party. You should include all securities to which an entity is a Credit Party in calculating this exposure, regardless of whether they are subject to Issuer or Demand Feature & Guarantee Diversification

4 You should then divide the calculated amount of securities (in the case of Issuer Diversification) or the calculated exposure (in the case of Demand Feature & Guarantee Diversification) by the Fund s Total Assets. You should use the resulting percentage to determine if the Fund s current positions comply with the diversification limit for that type of Fund and security. If the current positions comply with the applicable diversification limit, the Fund may Acquire the security so long as it would not cause the Fund to exceed the diversification limit. If the current positions exceed, or the Acquisition would cause the Fund to exceed, the applicable diversification limit, you should determine the percentage of Total Assets to which the diversification limit applies. If the diversification limit applies to one-hundred percent of Total Assets, then the Fund may not Acquire the security. If the diversification limit applies to seventy-five percent of Total Assets, you should calculate the percentage of Total Assets in compliance with all Issuer Diversification or Demand Feature & Guarantee Diversification limits, whichever are applicable to the security. If the result exceeds seventy-five percent of Total Assets, then the Fund may Acquire the security so long as it would not cause the percentage of Total Assets in compliance with all applicable Issuer Diversification or Demand Feature & Guarantee Diversification limits to fall below seventy-five percent. If the result does not exceed seventy-five percent of Total Assets, then the Fund may not Acquire the security. If a security has multiple Credit Parties, then the most restrictive result will control the Acquisition of the security. For example, if a Fund does not have any current investments in a security s Issuer, but has an exposure of nine percent to the provider of the security s Demand Feature, and only seventy-five percent of the Total Assets currently comply with the Demand Feature & Guarantee Diversification limits, then the Fund could invest only an additional one percent of Total Assets in the security. The Three-Day Safe Harbor Rule 2a-7 provides Taxable and National Funds with some leeway in complying with Issuer Diversification, although short of the 25% basket for Issuer Diversification provided to Single State Funds. Rule 2a-7 permits Taxable and National Funds to invest up to twenty-five percent of their Total Assets in securities of a single Issuer subject to three conditions. The securities are First Tier Securities. The Fund Acquires securities of only one Issuer in excess of the five percent limit at any one time. The Fund exceeds the five percent limit for not more than three business days. The SEC has explained that they created this temporary exception to Issuer Diversification: in response to commenters who asserted that the twenty-five percent basket often is useful in managing portfolio liquidity and large cash inflows; they urged that the ability to invest a large percentage of fund assets in a single high quality issuer on a temporary basis is an efficient way to assure liquidity in the event of unexpected redemptions by shareholders or to invest unanticipated cash inflows. The [SEC] believes that a three-day limit will permit a fund to realize these efficiencies without being exposed to the risks associated with investing more than five percent of fund assets in a single issuer for an indefinite period of time. For example, a fund that holds First Tier Securities that will mature in three business days may avail itself of an opportunity to purchase additional securities of the same issuer rather than disposing of the securities it holds or waiting for them to mature. 1 Clearly, the SEC did not intend to permit a Fund to invest continuously up to twenty-five percent of its Total Assets in First Tier Securities of a single Issuer that roll over every three days. Such a practice would expose a Fund to the risks associated with investing more than five percent of fund assets in a single issuer for an - 4 -

5 indefinite period of time. Funds should therefore only rely upon this safe harbor to respond to unanticipated cash flows or to roll over large positions, as suggested in the SEC s example. Guarantees From Affiliated Persons and Conditional Demand Features As indicated in the diversification tables, the Issuer Diversification does not apply to a security Guaranteed By A Non-Controlled Person. Moreover, Demand Feature & Guarantee Diversification applies only to securities having a Demand Feature or Guarantee. Therefore, most securities will need to comply with only one diversification limit under Rule 2a-7. However, in two circumstances a security will need to comply with both limitations. First, if a security has a Guarantee from an entity that controls, is controlled by or is under common control with the Issuer. Such a Guarantee does not qualify as Issued By A Non-Controlled Person. As a result, the security must comply with both Issuer and the Demand Feature and Guarantee Diversification. The Fund will need to comply with Issuer Diversification regardless of whether the Issuer is a Credit Party. This reflects the SEC s concern that a Guarantee from an affiliated person of the Issuer does not provide as complete a credit substitution as a third-party Guarantee. However, the Fund may still elect not to treat the affiliated Guarantor as a Credit Party, in which case Demand Feature & Guarantee Diversification would not apply to the security. The second circumstance involves securities with Conditional Demand Features. Such securities must have at least two Credit Parties the provider of the Demand Feature and the Issuer or Guarantor whose payment default will terminate the Demand Feature. Consequently, the security must comply with the diversification limits applicable to both the provider of the Demand Feature and the Issuer or Guarantor. For example, if a security has a First Tier Demand Feature conditioned upon the performance of the Issuer, then a Fund would have to limit investments in the Issuer s securities to five percent of Total Assets. A Fund would also have to limit its exposure to the Demand Feature provider to ten percent of Total Assets. However, a Fund s exposure to the Demand Feature provider could exceed ten percent to the extent room is available in the 25% basket permitted by Demand Feature & Guarantee Diversification. A Single State Fund could also include the Issuer s securities in its 25% basket permitted by Issuer Diversification. In contrast, Issuer Diversification would not apply to a security that has a First Tier Demand Feature conditioned upon the performance of a Guarantee. However, the security would have to comply with Demand Feature & Guarantee Diversification for both the provider of the Demand Feature and the Guarantor. In such a case, assuming both the Demand Feature and the Guarantee are Issued By A Non-Controlled Person, you will need to determine either that: Acquisition of the security would not increase the Fund s exposure to the provider of the Demand Feature or the Guarantor to more than ten percent of Total Assets, or Acquisition of the security would not cause the percentage of the Fund s Total Assets meeting Demand Feature & Guarantee Diversification limits to fall below seventy-five percent. If, for example, a Fund wanted to invest five percent of Total Assets in the security, it could do so if the Fund s existing exposure to both the provider of the Demand Feature and the Guarantor did not exceed five percent. In this case, neither Credit Party s exposure would exceed ten percent. The Fund could also invest five percent if the existing exposure to either the provider of the Demand Feature or the Guarantor exceeded five percent and the resulting exposure did not exceed the amount available in the 25% basket. In this case, seventy-five percent of the Total Assets would still comply with Demand Feature & Guarantee Diversification. However, the Fund could not invest five percent if the existing exposure to both the provider of the Demand Feature and the Guarantor exceeded ten percent. In this last case, the sum of the existing exposures and five - 5 -

6 percent would necessarily exceed twenty-five percent. Of course, this assumes that the existing exposure does not include any other securities to which both the provider of the Demand Feature and the Guarantor are Credit Parties. Second Tier Securities; Conduit Securities In addition to limiting investments in any single Issuer of Second Tier Securities or exposure to any provider of Second Tier Demand Features or Guarantees, Rule 2a-7 also limits a money market fund s aggregate exposure to Second Tier Securities. Thus, a Taxable Fund may only invest up to: five percent of its Total Assets in Second Tier Securities; five percent of its Total Assets in securities having Second Tier Guarantees or Demand Features from a single provider; and one percent of its Total Assets in Second Tier Securities of a single Issuer that are subject to Issuer Diversification. (However, if the Taxable Fund has Total Assets of less than $100 million, it may invest up to $1 million in an Issuer s Second Tier Securities.) Rule 2a-7 subjects National and Single State Funds to similar limitations, but only for Conduit Securities. This subsection explains the difference between Municipal and Conduit Securities. 1. Municipal Securities. Rule 2a-7 does not use the term Municipal Securities. However, the definition of Conduit Security excludes the following types of securities. Securities fully Guaranteed by a Municipal Issuer. Securities payable from the general revenues of a Municipal Issuer. Securities issued to finance a public project owned and operated by a Municipal Issuer, or a privately operated facility that is part of such a public project. In addition, the SEC s release adopting revision to Rule 2a-7 stated that [c]onduit securities are not backed by a revenue source from any essential public facility or by the taxing authority of any state or municipality. 2 We will use the term Municipal Securities to refer to all securities that have a Municipal Issuer but are not Conduit Securities. For example, Municipal Securities include any securities ultimately backed by the taxing authority of a Municipal Issuer, such as TANs and BANs. Securities backed by revenues from other Municipal Issuers 3, such as RANs and GANs, also qualify as Municipal Securities. Finally, Municipal Securities should include securities backed by fees and tolls charged by a Municipal Issuer for a public facility. Rule 2a-7 does not limit the aggregate amount of Total Assets a National or Single State Fund may invest in Second Tier Municipal Securities. Moreover, National and Single State Funds may invest up to five percent of their Total Assets in Second Tier Municipal Securities of a single Municipal Issuer. For purposes of Rule 2a-7, a single Municipal Issuer includes an agency, authority, instrumentality or other political subdivision, if its assets and revenues are separate from those of the government creating the subdivision. 4 Thus, Rule 2a-7 would treat a state turnpike authority as a separate Municipal Issuer from the state itself. However, the rule would not treat securities issued by the authority but secured by tolls from different turnpikes as having separate Municipal Issuers. 2. Conduit Securities. In its release, the SEC explained that conduit securities are issued to finance nongovernmental private projects, such as retirement homes, private hospitals, local housing projects, and industrial development projects, with respect to which the ultimate obligor is not a governmental entity. 5 As - 6 -

7 shown in the table at the end of the Minimal Credit Risk section, a Conduit Security is a security with a Municipal Issuer payable solely from an Underlying Obligation from a non-municipal Issuer. 3. For all purposes under Rule 2a-7, a Fund should ignore a conduit Municipal Issuer and treat the Issuer of the Underlying Obligation as the Issuer of a Conduit Security. The Issuer Diversification limits for First Tier Conduit Securities are the same as for First Tier Municipal Securities. Therefore, a Single State Fund may also include such Conduit Securities in its 25% basket for Issuer Diversification. 4. For Second Tier Securities subject to Issuer Diversification, a National or Single State Fund may not invest more than one percent of its Total Assets in Conduit Securities backed by Underlying Obligations of a single Issuer. Funds with Total Assets of less than $100 million may invest up to $1 million in such Conduit Securities. In addition, a National or Single State Fund s exposure to a provider of a Second Tier Demand Feature or Guarantee cannot exceed five percent. Finally, a National or Single State Fund must limit it aggregate exposure to Second Tier Conduit Securities to not more than five percent of its Total Assets. Asset Backed Securities and Ten Percent Obligors Generally, Rule 2a-7 treats a Special Purpose Entity as the Issuer of its Asset Backed Securities. However, the rule makes an exception for any Ten Percent Obligor of the Special Purpose Entity. A Ten Percent Obligor under (c)(4)(ii)(d) includes any Issuer of ten percent or more of the Qualifying Assets supporting an Asset Backed Security. The rule treats a Ten Percent Obligor as the issuer of its pro rata share of the Asset Backed Security. For example, if a Fund invested five percent of its Total Assets in Asset Backed Securities issued by a Special Purpose Entity, and if obligations of Motor Corp. comprised twenty percent of the Qualifying Assets held by the Special Purpose Entity, then Rule 2a-7 would treat the Fund has having invested: one percent (20% x 5%) of its Total Assets in Motor Corp., and the balance (four percent) of its Total Assets in the Special Purpose Entity. Ten Percent Obligors occur most frequently in synthetic adjustable rate demand instruments. Dealers typically create these instruments by depositing a single long-term, fixed rate bond into a trust. The trust issues certificates that pass through interest at a rate determined by an Index Rate or a Remarketing Agent. The certificates also have Demand Features. This structure effectively converts the underlying bond into a Floating or Variable Rate Security with a Demand Feature, thereby satisfying the maturity requirements of Rule 2a-7. For diversification purposes, however, a Fund should ignore the trust (which serves as a Special Purpose Entity) and treat the Issuer of the bond (as a Ten Percent, indeed one-hundred percent, Obligor) as the Issuer of the certificates. In contrast, a master trust may issue a billion dollars of Asset Backed Securities supported by tens of thousands of retail automobile loans. In such circumstances, it is unlikely that one person could have liability for the $100 million of loans necessary to qualify as a Ten Percent Obligor. In this case, Rule 2a-7 would require a Fund to treat the master trust (as a Special Purpose Entity) as the Issuer of the entire amount of Asset Backed Securities. The remainder of this subsection explains additional complications that may result when Ten Percent Obligors have Demand Features or Guarantees, or are Special Purpose Entities themselves. 1. Demand Feature & Guarantee Diversification. Rule 2a-7 also requires a Fund to account for Ten Percent Obligors for purposes of Demand Feature & Guarantee Diversification. Generally, a Fund must include a direct Demand Feature or Guarantee for an Asset Backed Security in calculating its exposure under Demand Feature & Guarantee Diversification. In addition, if the Qualifying Assets of a Ten Percent Obligor have a Guarantee, or are subject to a Demand Feature, then a Fund must also include a pro rata share of any Asset Backed Security supported by the Ten Percent Obligor s Qualifying Assets in calculating its exposure to the provider of the Guarantee or Demand Feature

8 To use our first example, suppose that Parent Co. guaranteed the Qualifying Assets of Motor Corp. Then the Fund would also have to include one percent of its Total Assets in its exposure to Parent Co. Moreover, if Parent Co. controlled Motor Corp. and was not the sponsor of the Special Purpose Entity, then the Guarantee would not be Issued By A Non-Controlled Person. Thus, the Fund could not include Parent Co. s exposure in its 25% basket for Demand Feature & Guarantee Diversification. However, Demand Feature & Guarantee Diversification only applies to Credit Parties. If, in our example, the Fund does not rely on the Parent Co. s Guarantee for credit support, maturity or liquidity, it may still ignore the Guarantee for purposes of Demand Feature & Guarantee Diversification. Also, if the Asset Backed Securities has a full Guarantee Issued By A Non-Controlled Person, the Fund will not need to subject either the Special Purpose Entity or Motor Corp. to Issuer Diversification when it Acquires the Asset Backed Security. Many Asset Backed Securities have Guarantees covering the first losses incurred on the Qualifying Assets up to an amount that is less than the full amount of the Asset Backed Securities. This type of first loss coverage will not exempt the issuing Special Purpose Entity or any Ten Percent Obligor from Issuer Diversification. However, the rule requires the Fund to include only the portion of the Asset Backed Security covered by the partial Guarantee in its exposure to the Guarantor. For example, if an Asset Backed Security has a Guarantee covering first losses up to twenty percent of the Qualifying Assets, and a Fund invests five percent of its Total Assets in the Asset Backed Security, then the Fund would have an exposure of one percent (5% x 20%) to the Guarantor. 2. Qualifying Assets Subject to Guarantees Issued By A Non-Controlled Person. In some cases, a portion of the Qualifying Assets held by a Special Purpose Entity may be subject to direct Guarantees. Unlike first loss coverage, which covers losses regardless of which Qualifying Assets default, such Guarantees only cover defaults on specific Qualifying Assets. If the Qualifying Assets of a Ten Percent Obligor are subject to such a Guarantee By A Non-Controlled Person, we might expect the pro rata share of the ABS attributed to the Ten Percent Obligor to be excluded from the Issuer Diversification limitations. Rule 2a-7(c)(4) is not clear on this point, however. As we just explained, (c)(4)(ii)(d)(1) treats the Ten Percent Obligor as the issuer of a portion of the ABS. However, (c)(4)(ii)(d)(3) does not treat a Guarantee of Qualifying Assets as a Guarantee of a portion of the ABS; the subparagraph simply requires the Guarantee to comply with the Demand Feature & Guarantee Diversification limitations. Thus, a literal reading of (c)(4)(i) would not appear to exclude the portion of the ABS deemed to be issued by the Ten Percent Obligor from the Issuer Diversification limitations, because (c)(4)(ii)(d)(3) does not expressly deem the ABS to be subject to a Guarantee By A Non-Controlled Person. However, such a literal reading of Rule 2a-7 places too much emphasis on how the SEC chose to calculate exposure to Ten Percent Obligors, and too little emphasis on the reasons that the SEC excluded securities Guaranteed By A Non-Controlled Person from the Issuer Diversification limitations. The SEC provided the following explanation for this exclusion. If a security subject to an unconditional demand feature was in default or otherwise became distressed, a money fund normally would be expected to exercise the demand feature and receive the entire principal amount of the security and any interest payments due or accrued. Thus, lack of diversification in the underlying security may be less important to a money fund s ability to maintain a stable net asset value than the ability to exercise the demand feature. Demand features are subject to a separate diversification requirement under the rule and, thus, excessive reliance on the credit of a single issuer is already addressed by the rule. 6 In the version of Rule 2a-7 adopted in this Release, guarantees were included in the definition of an Unconditional Put. When the SEC amended Rule 2a-7 to include the defined term Guarantee, the SEC - 8 -

9 extend[ed] these provisions [exempting securities from Issuer Diversification limitations] to other types of guarantees commonly held by funds, such as bond insurance, letters of credit and similar unconditional guarantees. 7 The SEC s rationale for excluding Guaranteed securities from the Issuer Diversification limitations also applies to Guaranteed Qualifying Assets. A Ten Percent Obligor is obligated to make payments on the Qualifying Assets, not the ABS. If the Ten Percent Obligor default[s] or otherwise [becomes] distressed, the SPE will rely on the provider of the Guarantee for payment. This means that the Fund relies indirectly on the provider of the Guarantee, not the Ten Percent Obligor, for payment of this portion of ABS. Paragraph (c)(4)(ii)(d)(3) make certain that the provider of the Guarantee is subject to the Demand Feature & Guarantee Diversification limitations. Thus, excessive reliance on the credit of a single issuer is already addressed by the rule, and there is no need to limit exposure to a Ten Percent Obligor upon whom the Fund will not rely. The fact that (c)(4)(ii)(d)(1) treats Ten Percent Obligors as if they were part issuers of the ABS should not change this conclusion. Clause (ii) of (c)(4) clearly states that its provisions (including the provisions of subclause (D) dealing with ABSs) are solely [f]or purposes of making calculations under [the Issuer Diversification limitations]. In other words, clause (ii) explains, rather than changes, the application of the Issuer Diversification limitations, to various securities. The SEC had two alternatives in dealing with diversification of Ten Percent Obligors: either it could treat the Ten Percent Obligor as the issuer of a portion of the ABS, or it could treat the Fund as owning the Qualifying Assets of the Ten Percent Obligor. Either alternative is a legal fiction. The fact that the SEC chose the simpler fiction of treating the Ten Percent Obligor as an issuer (rather than requiring Funds to track information regarding Qualifying Assets) does not suggest that the SEC intended to treat Ten Percent Obligors differently for purposes of the Issuer Diversification limitations. Interpreting (c)(4)(ii)(d)(3) literally would imply that the SEC arbitrarily chose the second approach (effectively treating a Fund has owning the Guaranteed Qualifying Assets) for purposes of calculating Demand Feature & Guarantee Diversification. There is no reason to think that the SEC intended to act so inconsistently in its treatment of Ten Percent Obligors. Therefore, it makes more sense to interpret Rule 2a-7 to treat the provider of such a Guarantee has having Guaranteed the portion of the ABS that the rule treats the Ten Percent Obligor as having issued. Following this interpretation, if the Ten Percent Obligor s Qualifying Assets are fully Guaranteed By A Non-Controlled Person, the Ten Percent Obligor s portion of the ABS will be subject to a Guarantee By A Non-Controlled Person and therefore excluded from the Issuer Diversification limitations. 3. Secondary ABSs. A further complication may arise if ten percent or more of the Qualifying Assets supporting an Asset Backed Security (a Primary ABS) consist of another Asset Backed Security (a Secondary ABS). Generally, a Fund must treat the Special Purpose Entity issuing the Secondary ABS as a Ten Percent Obligor. Moreover, a Fund must treat any Ten Percent Obligor of a Secondary ABS as a Ten Percent Obligor of the Primary ABS. The Fund must do so even if the secondary Ten Percent Obligor s share of the total Qualifying Assets supporting the Primary ABS is ultimately less than ten percent. The SEC provided the following example of how these diversification rules should apply. A fund invests 10% of its assets directly in an ABS ( Primary ABS ) issued by an SPE. The fund also invests 4% of its assets directly in securities issued by Obligor C. Obligor C is not an SPE issuing ABSs. 25% of the Primary ABS s qualifying assets is [sic] invested in Obligor A and 50% of the Primary ABS s qualifying assets is [sic] invested in Obligor B. Obligor A is an SPE with 30% of its qualifying assets invested in securities issued by Obligor C. Obligor B is an SPE with 20% of its qualifying assets invested in securities issued by Obligor C. In this example, Obligors A and B are both Ten Percent Obligors of the Primary ABS. Obligor C is also a Ten Percent Obligor of the Secondary ABS issued by Obligors A and B. This means that the Fund must also treat - 9 -

10 Obligor C as a Ten Percent Obligor of the Primary ABS. Therefore, for purposes of Issuer Diversification, assuming that there are no other Ten Percent Obligors for the Primary ABS or the Secondary ABS, the Fund would have invested: 1¾% of its assets indirectly in Obligor A, which is the product of (x) the percentage invested in the Primary ABS (10%) times (y) the percentage of Qualifying Assets comprised of Secondary ABS issued by Obligor A (25%) times (z) the percentage of Qualifying Assets from non-ten Percent Obligors underlying Obligor A s Secondary ABS (70%); 4% of its assets indirectly in Obligor B, which is the product of (x) the percentage invested in the Primary ABS (10%) times (y) the percentage of Qualifying Assets comprised of Secondary ABS issued by Obligor B (50%) times (z) the percentage of Qualifying Assets from non-ten Percent Obligors underlying Obligor B s Secondary ABS (80%); 5¾% of its assets in Obligor C, 4% directly, ¾% (10% x 25% x 30%) indirectly through the Secondary ABS issued by Obligor A, and 1% (10% x 50% x 20%) indirectly through the Secondary ABS issued by Obligor B; and 2½% of its assets in the SPE issuing the Primary ABS, which is the amount invested in the Primary ABS (10%) less the amount of underlying Qualified Assets attributed to Obligor A (1¾%), Obligor B (4%) and Obligor C (1¾%). In this example, the Fund would violate the Issuer Diversification requirements. The violation would not result from investing ten percent of the Fund s assets in Asset Backed Securities issued by a single Special Purpose Entity, however. When the various Ten Percent Obligors are taken into account, we would treat the Fund as investing only two and one-half percent of its assets in the Special Purpose Entity. Instead, the combination of direct and indirect investments in Obligor C would violate the five percent Issuer Diversification limit. This indirect violation illustrates why the SEC required funds to look for Ten Percent Obligors of Secondary ABSs. Finally, what if the Qualifying Assets of the Secondary ABS include Asset Backed Securities? Must we look down yet another level for Ten Percent Obligors. The answer is no. The SEC decided that the Qualifying Assets held by third level Special Purpose Entities are so attenuated that they are unlikely to affect diversification. Therefore, Rule 2a-7 does not to require a Fund to look beyond the Ten Percent Obligors of a Secondary ABS. 4. Restricted Special Purpose Entities. To further complicate matters, (c)(4)(ii)(d)(2) exempts a Restricted Special Purpose Entity from treatment as Ten Percent Obligor. To qualify as a Restricted Special Purpose Entity a Special Purpose Entity must satisfy three conditions. The Special Purpose Entity must issue Asset Backed Securities to only one other Special Purpose Entity. The Special Purpose Entity may only issue other securities (including other Asset Backed Securities) to it affiliated entities. None of the affiliated entities holding the Special Purpose Entity s securities may be a Special Purpose Entity. A Fund may ignore a Restricted Special Purpose Entity because the Fund cannot invest directly in Asset Backed Securities issued by the Restricted Special Purpose Entity. This eliminates any possible overlap between the Fund s indirect investment in the Restricted Special Purpose Entity and its investments in other Asset Backed Securities. Therefore, a Fund does not have to treat a Restricted Special Purpose Entity as a Ten Percent Obligor, regardless of the percentage of the Restricted Special Purpose Entity s Asset Backed Securities that support a Primary ABS or Secondary ABS. However, a Fund must still determine whether any Secondary ABS issued by a Restricted Special Purpose Entity includes Qualifying Assets of any Ten Percent

11 Obligor. For example, suppose Wholesale Inc. transfers its accounts receivables to a trust. Twenty percent of these receivables are obligations of Retail Co. The trust then sells senior pass-through certificates to a Special Purpose Entity, while Wholesale Inc. retains a subordinated interest in the receivables. If the trust does not issue any other securities, then it would qualify as a Restricted Special Purpose Entity. Therefore, a Fund would not have to treat the trust as a Ten Percent Obligor, even if the trust s certificates represented more than ten percent of the Special Purpose Entity s Qualifying Assets. However, under such circumstances, the Fund would still have to treat Retail Co. as a Ten Percent Obligor. 5. Credit Analysis of Asset Backed Securities. In order to verify proper diversification, any credit analysis of an Asset Backed Security must reflect: Whether the terms of the Asset Backed Security permit the issuing Special Purpose Entity to have any Ten Percent Obligors; If so, whether the amount and nature of the Qualifying Assets supporting the Asset Backed Security make the existence of a Ten Percent Obligor unlikely; If not, whether the issuing Special Purpose Entity has any Ten Percent Obligors or Secondary ABSs; and If the Special Purpose Entity holds a Secondary ABS, whether the Issuer is a Restricted Special Purpose Entity. The credit analysis must include the same information for each Secondary ABS supporting a Primary ABS. The credit analysis should obtain this information from a prospectus, offering memorandum, NRSRO report or from the documentation for the Asset Backed Security. Furthermore, unless the credit analysis determines that Ten Percent Obligors are not permitted or are unlikely, the analysis must be updated for any periodic information regarding the Asset Backed Security for changes in Ten Percent Obligors. Repurchase Agreements As shown in the first table, (c)(4)(ii)(a) imposes no limit on the percentage of a Fund s Total Assets invested in repurchase agreements with one seller, provided that it is Collateralized Fully by Government Securities. This is because, for purposes of diversification, the Rule 5b-3 treats a repurchase agreement that is Collateralized Fully by the underlying securities as an Acquisition of the underlying securities. To qualify as Collateralized Fully, a repurchase agreement must satisfy four requirements. 1. The underlying securities must consist exclusively of Government Securities or securities rated in the highest long-term or short-term category by the Requisite NRSROs. If the security is unrated, then the Credit Committee must determine that it is of comparable quality to securities that are rated in the highest rating category by the Requisite NRSROs. Cash collateral will also satisfy this condition. 2. If the underlying securities are maintained in a book entry system, they must be held in the name of the Fund or its custodian. The Fund or its custodian must have possession of any underlying certificated securities. Presumably, any cash must be held in an account with the Fund s custodian. A subcustodian, as agent for the Fund s custodian, may also hold the underlying securities on the Fund s behalf. 3. The value of the underlying securities (plus any cash collateral) must equal or exceed the Repurchase Price throughout the term of the repurchase agreement. The Fund must value the securities net of any transaction costs. 4. Applicable insolvency laws cannot impose an automatic stay upon the Fund s right to sell the underlying securities following the Seller s bankruptcy or insolvency

12 Refunded Securities Rule 5b-3 (as incorporated by reference in Rule 2a-7) also permits a money market fund to treat Refunded Securities as an investment in the Deposited Securities (as defined in Rule 5b-3(c)(4). To qualify as a Refunded Security, the security must satisfy three requirements. The Deposited Securities (and any securities substituted for Deposited Securities) must consist exclusively of non-callable Government Securities. The Issuer must irrevocably place the Deposited Securities in an escrow account with an unaffiliated escrow agent. The escrow agent must first apply any proceeds of the Deposited Securities to payments of principal, interest, and applicable premiums on the Refunded Securities. Only after full payment of the Refunded Security may the escrow agent apply proceeds of the Deposited Securities to its expenses or release them to the Issuer or another party An NRSRO must have rated the Refunded Security in its highest rating category based upon the escrow of Deposited Securities. Alternatively, an independent certified public accountant must have certified to the escrow agent that the Deposited Securities will satisfy all scheduled payments of principal, interest and applicable premiums on the Refunded Securities. The escrow agreement must also require such a certification before any substitution of Deposited Securities. The credit analysis must confirm compliance with each of these requirements of a Refunded Security. However, the analysis does not need to identify the Deposited Securities in the Fund s records. As Government Securities, Rule 2a-7 does not subject the Deposited Securities to any diversification limits. Thus, the composition of the Deposited Securities is irrelevant to Issuer Diversification, even though the rule treats Refunded Securities as Acquisitions of the Deposited Securities. Other Money Market Funds Rule 2a-7 does not impose any limitation on the percentage of Total Assets a Fund may invest in another money market fund. The rule simply requires a reasonable belief that the other fund has complied with the rule s diversification requirements. The portfolio manager or credit analyst should review the most recent annual or semiannual report of the other fund to confirm its diversification. However, 12(d)(1) of the 1940 Act generally prohibits an investment company from investing more than five percent of its assets in another investment company. This section also limits total investments by an investment company in other investment companies to ten percent of assets. 8 The 1940 act includes several exceptions to these limits. Many Funds have obtained exemptive orders from the SEC permitting investments in other investment companies to exceed these limits. The adviser should confirm that any proposed investment of more than five percent of a Fund s Total Assets in another money market fund complies with one of these exceptions or orders. * * * * * * Reed Smith is a top-20 global relationship law firm with more than 1,300 lawyers in 20 offices throughout the United States, the United Kingdom, Europe and the Middle East. Founded in 1877, the firm represents leading international businesses from Fortune 100 corporations to mid-market and emerging enterprises. Its attorneys provide litigation services in multi-jurisdictional matters and other high stake disputes, deliver regulatory counsel, and execute the full range of strategic domestic and cross-border transactions. Reed Smith is a preeminent advisor to industries including financial services, life sciences, health care, advertising and media, shipping, international trade and commodities, real estate, and education. For more information, visit reedsmith.com

13 Release No. IC-18005, Revisions to Rules Regulating Money Market Funds, 48 SEC-DOCKET (Feb. 20, 1991) (footnote omitted). Release No. IC-21837, Revisions to Rules Regulating Money Market Funds, 61 FED. REG , (Mar. 21, 1996). Although Government Issuers are technically not Municipal Issuers, the SEC probably intended to treat securities backed by Federated revenues and grants to Municipal Issuers as Municipal Securities. However, if the SEC did treat these securities as Conduit Securities, Rule 2a-7 would treat the securities as issued by the Government Issuer providing the revenues or grants. This would make the securities Government Securities, which are not subject to the limits on Second Tier Conduit Securities. Release No. IC-9785, Investment Companies Investments in Tax-Exempt Securities Regulatory and Disclosure Matters, 12 SEC-DOCKET 713, 713 (May 31, 1977). Although this release interprets the diversification requirements of Section 5(b)(1) of the 1940 Act, the SEC has never indicated that it would interpret the diversification requirements of Rule 2a-7 differently. Release No. IC-21837, supra n. 2, at Release No. IC-21837, supra n. 2, at Footnotes omitted. Release No. IC 22921, Technical Revisions to the Rules and Forms Regulating Money Market Funds, 62 Fed. Reg , (Dec. 9, 1997). Footnotes omitted. Section 12(d)(1) also prohibits an investment company from owning more than three percent of the voting securities of another investment company