SECTION 2. BACKGROUND

.01 A repo is a written agreement that provides for a “sale” and “repurchase” of a security or securities (the “underlying securities,” or the “collateral”. The purchaser agrees to purchase the underlying securities at a specific price and the seller, or “counterparty,” agrees to repurchase the same securities on a specific date for a specified price, plus an additional amount that reflects the time value of the purchaser’s investment from the date of purchase of the underlying securities to the date of their repurchase by the seller.

.02 RICs purchase securities in repo transactions as a convenient means to invest idle cash at competitive rates on a secured basis, generally for short periods of time. See Securities and Exchange Commission (SEC) Release No. IC–25058, 66 FR 36156, 36156–57 (July 11, 2001):

While a repurchase agreement has legal characteristics of both a sale and a secured transaction, economically it functions as a loan from the fund to the counterparty, in which the securities purchased by the fund serve as collateral for the loan and are placed in the possession or under the control of the fund’s custodian during the term of the agreement. . . .

. . . . A fund investing in a properly structured repurchase agreement looks primarily to the value and liquidity of the collateral rather than the credit of the counterparty for satisfaction of the repurchase agreement. Id . at 36157 (footnote omitted).

.03 Section 851(b) provides that certain requirements must be satisfied for a domestic corporation to be taxed as a RIC under subchapter M, part I. Section 851(b)(3) imposes certain asset diversification requirements with respect to a RIC’s total assets that must be satisfied as of the close of each quarter of the RIC’s taxable year.

.04 Section 851(b)(3)(A) requires that at least 50 percent of the value of a corporation’s total assets be represented by cash and cash items (including receivables), Government securities, securities of other RICs, and other securities generally limited in respect of any one issuer to an amount not greater in value than 5 percent of the value of the total assets of the RIC and to not more than 10 percent of the outstanding voting securities of such issuer.

June 1, 2004 984 2004-22 I.R.B.

.10 Section 851(c)(5) provides that, for purposes of section 851(b)(3), all terms not specifically defined in section 851(c) shall have the same meaning as when used in the 1940 Act, as amended. The term “Government security” is not specifically defined in section 851(c).

.11 Section 2(a)(16) of the 1940 Act defines the term “Government security” for purposes of the 1940 Act without specific reference to funds investing in repos for which Government securities serve as collateral.

.12 The RIC diversification rules of subchapter M are substantially similar in structure and purpose to those of section 5(b)(1) of the 1940 Act. Both sets of rules impose numerical limitations on the percentages and types of assets that may be held by an investment company. Both sets of rules are intended to protect the investor from the risks of loss and of illiquidity inherent in the concentration of assets in the securities of a single or a small number of issuers. See H.R. Rep. No. 2020, 86 ^th

Cong., 2 ^d Sess. 820–26. In view of the commonality of structure and purpose of both sets of rules and in view of the need for RICS simultaneously to comply with both, the RIC diversification provisions of the Code and those of the1940 Act should be interpreted consistently.