Banks are witnessing a booming business in lending to mutual fund complexes so these firms can cover redemptions by shareholders.

Now, as potential lenders position themselves to take advantage of the growing market for this type of bank financing, is a good time to review various pitfalls a lender may encounter in this type of transaction.

A redemption credit facility involves the commitment of one or more lenders to fund an advance to an open-end mutual fund borrower. The fund complex needs the financing for redeeming investors' shares.

Because of the transaction costs involved in documenting a transaction of this type, it is generally more cost effective for an entire family of mutual funds to become party to a redemption credit facility as "co- borrowers."

Also, because the credit facility must be large enough to allow for the redemption of a significant portion of the funds' shares, most lenders prefer to syndicate redemption credit facilities.

In addition to the many considerations common to all credit facilities, redemption credit facilities for mutual funds involve important legal concerns that need to be carefully considered during the underwriting and documentation process.

These can be summarized as follows:

*Each mutual fund that borrows funds must be responsible only for its own borrowings.

*A default by a single mutual fund should not trigger cross-defaults for each of its co-borrowers, usually other funds in the complex.

*Each mutual fund may borrow only to the extent permitted by the Investment Company Act of 1940 and its own Registration Statement.

*The credit facility should demonstrate compliance with a host of federal regulations.

The parties' preeminent concern should be to structure the facility in compliance with the 1940 act. A recent Securities and Exchange Commission ruling suggests several criteria which all such redemption credit facilities should satisfy.

Each mutual fund should be liable only for its own borrowings and the costs and expenses related to its own involvement in the facility.

Federal law generally prohibits a fund from using its assets for the benefit of anyone other than shareholders of that fund. Thus, for example, the law would prohibit a fund from giving its guarantee, or becoming otherwise obligated in respect of, the indebtedness of another fund.

In a recent SEC no-action letter, the SEC indicated that common obligations may be payable pro rata in accordance with the net asset values of the funds.

Parties to these transactions will often find it useful to specify a formula in the credit agreement for allocating among the borrowers any obligations not specifically associated with a particular fund. Often, the co-borrowers will allocate the obligations among themselves on a pro rata basis in accordance with their respective net asset values.

Although a default by a single borrower may cause its obligations to accelerate, the credit agreement should be structured so that a default by a single borrower will not penalize its co-borrowers.

Lenders should also be careful to comply with Regulation U. This regulation and its counterparts - G, T, and X - impose reporting and asset coverage obligations on purpose credits, which are loans used to purchase and carry publicly traded stocks.

In substance, although they apply to different types of entities, the substance of regulations G, T, or U will apply to any lender and Regulation X will apply to any borrower. (For reasons of simplicity, we will refer to this entire body of law collectively as Regulation U).

If Regulation U applies to a credit, the lender will need to confirm, and document that the borrower's net assets will exceed at all times the amount of the loan by at least a 2-1 margin.

Specialty funds that do not invest in stock ( e.g. money market funds, bond funds, fixed-income funds, and so on) may escape this generalization. Regulation U, however, would apply to a redemption credit facility for a typical common stock fund.

Whether purpose credit is secured directly or indirectly is a complicated question in many transactions. For redemption credit facilities, however, the Federal Reserve has stated that nearly every loan to a mutual fund can be deemed to be either directly or indirectly secured by margin stock.

Thus, a prudent lender will usually wish to confirm that the redemption credit facility will comply with the asset coverage requirements of Regulation U.

Most redemption credit facilities will place a limit on a borrower's loans based on its net asset value. Mutual funds are limited by Section 18 of the 1940 act from borrowing more than 33 1/3% of their net asset value.

Placing a limit on a mutual fund's borrowings that is more stringent that the 2-1 limit created by Regulation U is the best way a lender can demonstrate its compliance with Regulation U.

Lenders who can efficiently negotiate their way through the maze of existing laws will be those who will most effectively capitalize on these new opportunities.

Mr. Molen is a partner and Mr. Wilson is an associate in the Atlanta office of Paul, Hastings, Janofsky & Walker.

Subscribe Now

Access to authoritative analysis and perspective and our data-driven report series.

14-Day Free Trial

No credit card required. Complete access to articles, breaking news and industry data.