Earlier this month, the US Securities and Exchange Commission (“SEC”) staff provided no-action assurances to certain registered management investment companies and series thereunder (collectively, the “Funds”) and their directors or officers with respect to the Funds, acting as self-custodians, maintaining certain loan interests without strict compliance with paragraphs (b) - (e) of Rule 17f-2 under the Investment Company Act of 1940 (“ICA”) and without compliance at all with paragraph (f) of rule 17f-2.
The loans at issue were term or delayed draw corporate loans (“Loans”) originated, negotiated and structured by one or more primary lenders, typically banks, insurance companies or other financial institutions. The Funds would purchase from the primary lenders interests in a Loan (“Loan Interests”)1. The Funds do not receive any securities certificate or other tangible evidence of ownership that could be custodied with its custodian or, that if endorsed and delivered to a subsequent purchaser or other third party, could be used by that third party to evidence its own right to a Fund’s Loan Interest. Settlement of purchases of Loan Interests involve a number of steps, and various documents are executed in connection with the settlement process (“Loan Documents”). Possession of the Loan Documents would be of no value to a purchaser or other purported transferee of a Fund’s Loan Interests. Instead, the Loan Interests are reflected on the records that are maintained on behalf of the borrower under the Loan (typically by an administrative agent) for the purpose of identifying the owners of all Loan Interests and the principal amount of the Loan attributable to each. The Funds had been providing the Loan Documents to their custodian for safekeeping under Section 17(f), but that posed a number of challenges. Accordingly, the Funds wanted to cease providing the Loan Documents to their custodians and instead rely on Rule 17f-2, the self-custody rule under the ICA, but with a number of modifications to address the particular attributes of this particular asset class.
Rule 17f-2 has a number of requirements that some view as burdensome. For example, the rule requires that: (1) fund investments (with limited exception) must be deposited in the safekeeping of a bank (often referred to as the “vaulting requirement,” which assumes certification or physical possession); (2) the fund’s board must designate no more than five “authorized persons” for the fund and adopt a resolution permitting access to the fund’s investments only by two persons acting together; (3) any person depositing or withdrawing investments from the depository or ordering their withdrawal and delivery from the safekeeping of the fund or other company must sign a specific notation; and (4) investments maintained by a fund must be verified by complete examination by an independent public accountant retained by the fund at least three times during the fiscal year, at least two of which must be on a “surprise” basis.
Drawing from prior staff no-action relief, the Funds proposed the following in lieu of the rule’s requirements:
- Only a limited number of authorized personnel of the Funds would provide instructions to the Funds’ custodian and the administrative agents;
- Passwords or other appropriate security procedures would be used to ensure that only properly authorized persons can transmit such instructions;
- The Funds would reconcile settled Loan Interests to the records of the administrative agents on a regular basis (i.e., at least monthly);
- Loan Interests would be titled or recorded at the administrative agents in the name of a Fund (not in the name of the Fund’s investment adviser);
- Neither the Funds nor their investment advisers would be affiliated with the administrative agents; and
- Each Fund would adopt policies and procedures reasonably designed to prevent violation of the above conditions, as part of the Fund’s compliance program under ICA Rule 38a-1.
In lieu of the rule’s verification requirement, each Fund would be subject to an annual audit during which the Fund’s independent public accountant confirms all of the Fund’s investments, including its investments in Loan Interests, and reconciles the Loan Interests to the Fund’s account records. The incoming letter noted that a single annual audit, such as that normally performed for mutual funds, provides sufficient custody protections to investors in pooled investment vehicles under Rule 206(4)-2 under the Investment Advisers Act of 1940 (“Advisers Act”). In the staff’s letter, the staff specifically noted the incoming letter’s representation that the Funds are complying with annual audit requirements.
This letter reflects the continuing interest in investments and trading in loans by non-banks, which in turn continues to raise interesting regulatory questions under the ICA and the Advisers Act2.
2 See, for example, our earlier Perspective, What Madison Capital Ruling Means For Investment Advisers.