Money Market Fund Reform: SEC Proposes Rule Amendments and Seeks Comment on Fundamental Issues

On June 24, 2009, the SEC voted to propose amendments to Rule 2a-7, the money market fund rule under the Investment Company Act of 1940, designed to strengthen the regulatory requirements governing money market funds to increase their resilience to economic stresses and reduce the risks of runs on the funds. The SEC also voted to seek public comment on some possible fundamental reforms relating to money market funds, including whether the stable $1.00 share price should be abandoned in favor of a floating net asset value per share (NAV) and whether money market funds should be required to satisfy redemption requests in excess of a certain size through in-kind redemptions. The SEC did not include those more fundamental reforms as formal proposals.

The proposed amendments largely track the proposals issued by the Investment Company Institute (ICI) in its Report of the Money Market Working Group (the ICI Report) released March 17, 2009, and also echo the Obama administration’s money market fund proposals set forth in the Report on Financial Regulatory Reform released June 17, 2009 (Administration Report). The Administration Report states that the President’s Working Group on Financial Markets (PWG) should complete a report by Sept. 15, 2009 addressing the more fundamental aspects of money market fund reform, which “could include” abandoning the stable NAV or requiring access to private emergency liquidity facilities. The SEC is a member of the PWG, and SEC Chairman Mary Shapiro said that the SEC will share with the PWG the comments submitted to the SEC on the Proposals during the comment period.

The proposed amendments for money market funds would:

• tighten liquidity requirements

• shorten portfolio maturity limits

• increase credit quality requirements (by prohibiting the purchase of Second Tier Securities)

• require stress testing of portfolios

• require “Know Your Investor” procedures to anticipate redemptions that may pose risks to the fund

• enhance disclosure of portfolio holdings

• address issues that arise when money market funds experience market challenges

Limited information on the proposed rule amendments and possible fundamental reforms is publicly available at this time, although the SEC staff has said the full text will be posted to the SEC Web site “as soon as possible.” The full text may include additional proposals, and certainly will include detail beyond what is summarized below. Public comments must be received within 60 days after publication of the proposals in the Federal Register.

The proposals and possible reforms are described below, along with a statement of how the particular proposal compares to those in the ICI Report and the Administration Report.

PROPOSED AMENDMENTS

Liquidity/ Customer Liquidity Needs

No Illiquid Securities (Not addressed in ICI Report or Administration Report) – The proposed amendments would prohibit money market funds from purchasing illiquid securities. Money market funds currently are permitted to invest up to 10% of net assets in illiquid securities. Illiquid securities currently are defined as those that “may not be sold or disposed of in the ordinary course of business within seven days at approximately the value at which the mutual fund has valued the asset.” The proposed amendments would have the effect of forbidding investment in securities with no secondary market that are currently sometimes used by money market funds unless they are payable on demand or mature within seven days.

One Day and Seven Day Liquidity – Different Requirements for Retail and Institutional Funds (More restrictive than ICI Report. Addressed only generally in Administration Report) – The Proposed Amendments would require money market funds to have a minimum percentage of their assets in cash or highly liquid securities so that these assets could be readily converted into cash.

Retail money market funds would be required to keep at least 5% of assets in cash, U.S. Treasury securities, or securities readily convertible into cash within one day, and at least 15% of assets must satisfy this standard for payment within one week. This standard for liquidity differs from the existing standard set forth under the prior caption. Although it is not completely clear from the information publicly available at this time, it appears that “convertible into cash” may refer to a right to receive cash within one day or one week as opposed to the existing definition of liquidity which includes the ability to dispose of (e.g., sell) a security.

Under the proposed amendments, institutional money market funds would be required to keep at least 10% of assets in cash or securities that meet the new liquidity standard for payment within one day, and at least 30% of assets in cash or securities that meet the standard for payment within one week.

The one-day requirements would not apply to tax-exempt money market funds. The ICI had recommended that the same liquidity standard apply to retail and institutional money market funds: 5% daily liquidity for taxable money market funds and 20% weekly liquidity for all money market funds. The ICI’s 5% daily requirement would be the same as the SEC proposal for retail funds, but significantly less than the SEC proposes for institutional funds. The ICI’s 20% weekly requirement would be a greater percentage than the SEC proposes for retail funds, but significantly less than the SEC proposes for institutional funds.

If this rule proposal relating to liquidity is adopted, the SEC and the industry will need to address the method of identifying retail and institutional funds. The ICI Report had objected to the distinction between retail and institutional funds, on the basis that it would be difficult to draw a distinction between the two types of shareholders and funds might have a mix of the shareholder types. Further, the retail funds likely would perform better, since they could hold less cash and highly liquid securities, and therefore might be more appealing to some shareholders. It could be a challenge to police adequately the assignment of shareholders to one or the other category.

“Know Your Customer” Procedures (Consistent with ICI Report, but ICI adds an additional related requirement. Not addressed in Administration Report) – The proposed amendments, like the ICI Report, would require each money market fund to develop procedures to identify investors whose redemption requests may pose risks for the fund. The procedures would require the fund to anticipate the likelihood of large redemptions. The ICI Report, in addition, would require money market funds to provide monthly Web site disclosure about client concentration levels and the risks, if any, that such concentration may pose to the fund. Developing procedures for this disclosure may involve operational challenges. Also, some funds may believe that the disclosure could unfairly disadvantage them.

More Conservative Portfolios

Average Portfolio Maturity (More restrictive than ICI Report. Addressed only generally in Administration Report) – The proposed amendments would shorten the maximum average portfolio maturity for money market funds from 90 days to 60 days. The ICI had recommended a less restrictive reduction in the maximum portfolio maturity to 75 days. Average portfolio maturity of money market funds currently is well within the SEC’s proposed more restrictive limit, according to Robert Plaze, the Associate Director of the SEC’s Division of Investment Management, who spoke in a question and answer session with the SEC Commissioners at the meeting at which the proposals were adopted. Nevertheless, the SEC staff felt the rule change is warranted, because money market funds might seek to extend average portfolio maturities in the future, as memories of the current market turmoil fade and portfolios become less conservative.

Weighted Average Life Maturity (Consistent with ICI Report. Addressed only generally in Administration Report) – The Proposed Amendments would impose on money market funds a “weighted average life” portfolio maturity of no more than 120 days. The SEC has not explained the meaning of “weighted average life” maturity, but has said that the concept differs from the existing weighted average maturity (WAM) requirement currently included in Rule 2a-7. The ICI Report had suggested that a maximum “spread WAM” of 120 days be imposed on each money market fund portfolio, and it is possible that this is the concept the SEC refers to as the “weighted average life” portfolio maturity. A “spread WAM” would be a new, more restrictive method of calculating WAM. Currently under Rule 2a-7, a fund is permitted to deem the maturity of certain variable rate instruments to be “shortened” to less than their nominal maturity, based on the next date the interest rate on the instruments is readjusted. The “spread WAM” would forbid a money market fund from using that type of “maturity shortening” approach when calculating WAM. As a result, under the “spread WAM” method, the maturity of a portfolio is calculated to be longer than it otherwise would be. The ICI has said that the purpose of this more stringent method of calculating maturity is to assure that money market funds can maintain a high degree of stability even during periods of market volatility.

Credit Quality (Consistent with ICI Report. Addressed only generally in Administration Report) – The proposed amendments would forbid money market funds from investing in Second Tier Securities (in summary, securities rated in the second short term rating category by rating agencies). Currently, in general, money market funds are permitted to invest up to 5% of their assets in Second Tier Securities. Mr. Plaze noted that the depth of the market for Second Tier Securities has reduced since the SEC adopted the existing permission for Second Tier holdings. He also noted that some money market funds do not have the ability to perform adequate risk analysis on Second Tier Securities. Further, offerings of Second Tier Securities are generally smaller, so are proportionally more costly for a fund to subject to credit analysis. Certain of the Commissioners questioned or voiced reservations about whether the elimination of Second Tier Securities is advisable.

Periodic Stress Tests (Consistent with ICI Report. Addressed only generally in Administration Report) – The proposal, like the ICI Proposal, would require money market fund managers to examine the fund’s ability to maintain a stable NAV in the event of shocks such as interest rate changes, higher redemptions and changes in credit quality of the portfolio. Neither the ICI Report nor the material publicly available to date describing the proposed amendments provides detail on the nature of the stress tests.

Transparency/Reporting

Monthly Web site Posting (Consistent with ICI Report. Not addressed in Administration Report) – Both the proposed amendments and the ICI Report would require money market funds to post their portfolio holdings on their Web sites monthly. The ICI Report suggests a two-day lag in reporting time. The lag time for the proposals is not available in the information made public to date.

Monthly Reporting (Similar to ICI Report. Not addressed in Administration Report) – The proposed amendments would require money market funds each month to provide the SEC with detailed portfolio schedules in a format that could be used to create an interactive database through which the SEC could better oversee the activities of money market funds. This would replace the current quarterly reporting requirement that funds disclose holdings no more than 60 days after the close of the quarter. Mr. Plaze noted that the SEC would need to develop the operational capacity to create this interactive database, and the effectiveness of this provision might be delayed until the SEC develops that capacity.

The ICI Report included two recommendations for making more information available to the SEC, but using a different approach from that in the proposed amendments. First, the ICI proposed formalizing an SEC program to monitor money market funds whose returns significantly outperformed their peers, and proposed requiring the SEC to monitor another ten randomly selected money market funds each month. Second, the ICI proposed that a nonpublic reporting regime be developed for all institutional investors in the money markets, including money market funds.

Operational Matters for Money Market Funds under Stress

Processing Orders at Prices other than $1.00 per share (Not addressed in ICI Report nor Administration Report) – The proposed amendments would require all money market funds and their administrators to be able to process purchases and redemptions electronically at a price other than $1.00 per share. This proposal would address the operational difficulty of pricing share orders after a money market fund has broken the dollar, which became apparent when the Reserve Primary Fund broke the dollar in September.

Suspension of Redemptions (ICI Report would give fund Boards additional authority. Addressed only generally in Administration Report) – The proposed amendments would permit a money market fund board of directors to suspend redemptions if the fund were to break a dollar and liquidate. This would allow for the orderly liquidation of the portfolio. The fund would be required to notify the SEC when relying on this rule. The ICI Report went further, and would also give the board the authority to suspend redemptions for up to five days if a fund either has broken or reasonably believes it may be about to break the dollar. At the open meeting at which the proposals were voted, the SEC staff indicated that the staff had considered this proposal and rejected it, on the grounds that it would be difficult to create a standard to identify the point at which the Board could determine that a fund is about to break the dollar.

Expand permission for Affiliates to “Bail Out” Money Market Funds (Consistent with ICI Report. Not addressed in Administration Report) – The Investment Company Act forbids certain transactions between a fund and it affiliates, due to the potential for self-dealing and conflicts of interest. But, a transaction whereby an affiliate purchases a troubled security from its affiliated money market fund does not ordinarily raise these issues, and is permitted by an exemptive rule: Rule 17a-9. Rule 17a-9 currently is quite narrow, and is available only where a security has lost its status as an “Eligible Security” under Rule 2a-7 (a circumstance which generally relates to a reduction in the securities’ ratings). The proposed amendments and the ICI Report would expand the exemptive rule and permit an affiliate to purchase a security that is still an Eligible Security.

REFORM CONCEPTS FOR PUBLIC COMMENT

The SEC is seeking public comment on the following issues.

Floating NAV (Opposed in the ICI Report. Mentioned as a possible alternative in the Administration Report) – Should money market funds be required to sell and redeem shares at a floating share price rather than a stable share price? The ICI has strongly opposed this concept on various grounds, including the tax, accounting and operational complications of a floating share value for a product that is used for daily liquidity. Further, some have suggested, a money market fund with a floating NAV may, in fact, be a short term bond fund, rather than a money market fund – and short term bond funds already exist. A switch to a floating NAV may precipitate a flight from money market funds, which could exert downward pressure on commercial paper values.

Disclosure of market-based value per share, even if NAV does not float (Not addressed in ICI Report nor Administration Report) – Although it has not been included in the written materials available to date on the proposals, one of the SEC Commissioners has said that the full text of the proposal release requests industry comment on whether money market funds should be required to disclose their shadow price (their market-based NAV), even if the NAV does not float. Some have opposed this idea on the grounds that disclosure of market-based NAV may precipitate runs on money market funds from time to time as their shadow price fluctuates.

Credit Rating Agencies (ICI Report supports continued role for rating agencies. Not addressed in Administration Report) – What role should credit rating agencies’ ratings have in money market regulation? Should fund boards designate certain rating agencies that they will use to evaluate securities for purchase, and to monitor securities after purchase? The ICI has recommended that ratings in the top two short-term tiers continue to be included in Rule 2a-7 as a quality “floor” for money market funds. Also, the ICI has proposed that money market funds designate a minimum of three credit rating agencies that the adviser will monitor, to encourage credit rating agencies to compete for this designation by improving their ratings systems for short-term debt. The SEC proposed last year that references to ratings be removed from Rule 2a-7 – a proposal that was roundly criticized in the industry. Some argued that one of the strengths of money market funds is that Rule 2a-7 requires an independent third party (a rating agency) to analyze credit quality in addition to requiring minimal credit risk analysis by the fund adviser. SEC Commissioner Aguilar pointed out in a question and answer session relating to the proposals that the SEC had already sought comment on the concept of removing ratings references from Rule 2a-7, and he noted that the comments were overwhelmingly in favor of retaining a ratings requirement.

Asset-Backed Securities (Not addressed in ICI Report or Administration Report) – Should the SEC amend the money market fund rules with respect to investment in asset-backed securities and the attendant risks? The downgrade of structured investment vehicles during 2007 brought attention to the structural risks of certain asset-backed securities and to the fact that rating agencies can make mistakes about the credit quality of these securities. Currently, Rule 2a-7’s provisions relating to asset-backed securities focus on diversification analysis of asset-backed securities, rather than on the structural or other risks of asset-backed securities.

In-Kind Redemptions (Opposed in ICI Report. Not addressed in Administration Report) – Should funds be required to satisfy redemption requests in excess of a certain size through in-kind redemptions? Such a requirement would protect funds from the need to sell assets into a down market to generate cash to honor redemptions. The ICI has noted that redemptions in kind are unpopular with investors.


CERTAIN ICI SUGGESTIONS NOT ADDRESSED IN THE PROPOSALS

The ICI Report included several proposals that are not addressed in the Proposal:

• money market fund advisers should establish a “new products committee” to analyze new investment structures

• money market funds and their advisers should be encouraged to follow specified “best practices” for determining minimal credit risk

• risk disclosures in money market fund prospectuses and marketing materials should be enhanced

• the SEC should adopt a rule under the Investment Advisers Act designed to reduce investor confusion about funds that appear to be similar to money market funds, but which do not comply with the risk-limiting provisions of Rule 2a-7

• the SEC staff should have authority to reinstate a no-action letter that was issued in 2008, and which expired in January, which eased the shadow pricing process for money market funds

• the SEC should modernize Rule 2a-7 to clarify that Board responsibilities reflect oversight duties, rather than responsibilities for day-to-day operations of money market funds


ADDITIONAL IDEAS NOT ADDRESSED IN THE PROPOSALS

The Proposals do not address certain proposals that have been proffered by others recently, such as:

• moving to a $10.00 NAV

• requiring continuation of federal insurance or private insurance

• requiring capital reserves for funds or advisers

• requiring a private liquidity source (as suggested in the Administration Report; the SEC may have decided to leave this issue for review by the PWG).

The Proposals also did not suggest creating a bank-like product to replace money market funds. This idea was floated by the Group of Thirty in the report of its working group titled, “Financial Reform: A Framework for Financial Stability” (Jan. 15, 2009). The Group of Thirty is a private, nonprofit, international body composed of very senior representatives of the private and public sectors and academia, including several advisers to President Obama, including Paul Volcker, former chairman of the Federal Reserve Board and chairman of Obama’s Economic Recovery Advisory Board, Lawrence Summers, a senior economic adviser to the Obama administration and Treasury Secretary Timothy Geithner. The Group had said that the bank-like product would have access to central bank lender of last resort facilities and would be subject to appropriate prudential regulation and supervision and government insurance.

It is possible that any of the ideas which have not been addressed in the materials publicly available to date may be included in the final text of the proposals.

At the meeting at which the SEC adopted the proposals, there was a spirited question and answer session during which, at times, various SEC Commissioners voiced reservations about certain of the proposals, and indicated that they would welcome and carefully consider industry comments. Chairman Shapiro noted that the SEC wanted to be aware of how the changes would affect the industry, and whether any of the changes would limit the use of money market funds as an important liquidity source. Mr. Plaze said the SEC staff did not think “investors will notice a change” if and when money market funds operate under the rule proposals. Industry participants will have the chance to voice their views on that conclusion during the 60 day comment period.

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