SEC Denies No-Action Treatment for Combinable Certificates

Many structured finance transactions rely on Securities and Exchange Commission Rule 3a-7 for their exemption from the Investment Company Act of 1940. Rule 3a-7 provides a "safe harbor" from the 1940 Act for such transactions subject to various conditions, including a requirement that the securities issued not be redeemable by the investors.

The Staff of the SEC recently refused to take a no-action position under Rule 3a-7 for a program under which U.S. Treasury inflation-indexed bonds would be deposited in a trust and two classes of certificates would be issued. The Treasury bonds pay interest at a fixed rate on a CPI-adjusted balance. One class of certificates would pay interest at a fixed rate on the initial bond balance. The other class would pay the fixed rate on any increased portion of the bond balance. Certificate denominations would be $500,000. Investors could withdraw their investments by combining like amounts of both classes of certificates and surrendering them for their share of the underlying bonds, but only with a certification of an investment bank that the market value of the certificates was less than that of the underlying Treasury bonds. Further, if they surrendered less than all of their certificates, they must have at least $500,000 remaining.

At issue was whether the withdrawal feature rendered the certificates redeemable. The Staff stated that whether the certificates were redeemable turned on whether there would be substantial restrictions on withdrawal — specifically, whether the market value condition constituted such a restriction. It is clear that, at original issuance, the certificates would have a market value greater than the Treasury bonds or the transaction would not be initiated. However, a number of factors might influence their relative values in the future. The Staff denied no-action treatment because, based on the facts before it, it was unable to determine the likelihood that the market value condition would or would not be satisfied. Therefore, it was unable to conclude that the market value condition constituted a substantial restriction on withdrawals and that the certificates should not be regarded as redeemable.