4000 - Advisory Opinions
Nondiscretionary Advances to a Unit Investment Trust by Insured Nonmember Bank Serving as Trustee
September 16, 1985
Gerald J. Gervino, Senior Attorney
This is in response to your letter of April 23, 1985, which is supplemented by a letter of June 24, 1985. You request our confirmation that section 337.4(e)(4) of our regulations does not prohibit an insured nonmember bank which serves as trustee to a unit investment trust ("trust") from making nondiscretionary advances to the trust that are required by a trust agreement entered into prior to an underwriting or distribution of units in the trust by an affiliate of the bank.
Section 337.4(e)(4) prohibits an insured nonmember bank which has a subsidiary or affiliate that engages in the sale, distribution, or underwriting of stocks, bonds, debentures, notes, or other securities, or acts as an investment adviser to any investment company from extending credit or making any loan directly or indirectly to any investment company whose shares are currently underwritten or distributed by such subsidiary or affiliate of the bank.
Where a subsidiary or affiliate of an insured nonmember bank acts as trustee to an investment company, the above regulatory provision would appear to prohibit extensions of credit to that investment company at a time when the securities of that investment company are being underwritten by the subsidiary or the affiliate of the bank.
You suggest that a unit investment trust issuing units representing an undivided fractional interest in an unmanaged portfolio of securities presents a different situation from that found with respect to managed investment portfolios of other types of investment companies. You point out that a unit investment trust has no investment adviser, normally consists of high grade bonds with a fixed debt return, and is subject to extremely limited discretion on the part of the sponsor and trustee of the fund. The trustee of the unit investment trust primarily issues units, collects interest from the various issuers of the securities in the fund, and distributes the pro rata share of the interest payments to the various security holders of the fund.
Because of timing differences in the interest payments received from the issuers of the securities and the distribution dates elected by the various security holders of the fund, the trustee encounters cash shortfalls in its custodial account. The trust agreement normally provides that the trustee advance funds to the trust subject to repayment upon receipt of interest payments from the issuers of the securities. After an initial period of perhaps 30 months, the trustee is unlikely to experience cash shortfalls for more than a brief period. The trustee is not required to bear any practical risk of loss with respect to these shortfalls since it can recover monies advanced from subsequent interest payments. The trustee is protected from most liability and loss by the terms of the trust agreement. At any rate, the commitment to extend credit is made at the time that the trustee accepts the trust rather than at the time that the need for extending credit to the trust arises.
You note that section 337.4(e)(3) contains an interpretive footnote that makes it clear that the prohibition in that paragraph against extensions of credit should not be construed to prohibit a bank from honoring a loan commitment entered into prior in time to an underwriting or distribution. You suggest that, in the case of a unit investment trust, the bank's commitment to extend credit was arranged prior to any bank affiliate underwriting or distributing of the securities. Thus, you suggest that the danger of the bank overextending itself to unit investment trusts underwritten or distributed by an affiliate is not apparent.
Section 337.4 in general was designed in great part to prevent a bank from improvidently extending credit to assist securities affiliates or to issuers in which securities affiliates were strongly involved. Subparagraph (e)(4) in particular was designed to prevent a bank from improvidently lending to investment companies in which its securities affiliates were involved in order to save such investment companies from liquidity crises which can arise.
Under the facts you have presented to us, the commitment of the bank as trustee is not definite but appears limited and is apparently collateralized. You mention that the bank is primarily required to meet cash flow shortages with respect to the collection and payment of interest to security holders and other administrative costs. You indicate that these advances may be reimbursable from the assets in the custody of the trustee. You further indicate that the trustee is protected by the terms of an agreement against most liabilities. We are satisfied based upon the particular nature of the relationship described in your letter that the advances in question do not pose the type of indeterminate risk section 337.4(e)(4) was primarily designed to meet. We are therefore prepared to conclude that section 337.4(e)(4) does not extend to a bank (as trustee for a unit trust distributed by the bank's affiliate) making advances to the trust in accordance with the trust agreement to cover accrued but unpaid interest due to unit holders provided that the following circumstances are met:
1. Accrued interest advances or extension of credit must be reimbursable from assets in the actual or constructive possession of the bank trustee in such a fashion as to constitute a perfected security interest under local law and in sufficient amounts to equal or exceed the collateral requirements that would be required by Section 23A of the Federal Reserve Act.
2. The trustee bank must not be required to lend funds with respect to the redemption of outstanding securities. Even though not required by the trust agreement, the trustee must not in fact lend funds, in substantial quantity, for the redemption of securities.
We assume that the trustee bank will not lend funds for the purchase of the trust's securities by any other person or issue letters of credit with respect to the obligations of or otherwise extend credit to portfolio issuers or their affiliates.