October 10, 2011

The back-and-forth between the industry and regulators over whether money market funds should be required to use floating net asset values misses the point, according to a recent academic paper.

A bigger concern for the Securities and Exchange Commission should be what requirements are in place in the event that another money fund does break the buck, write co-authors Jill Fisch, a University of Pennsylvania law professor, and Eric Roiter, a Boston University law professor who was general counsel at Fidelity from 1997 to June 2008.

Fisch and Roiter propose several changes for money funds if they breach the $1-per-share NAV. First, they recommend allowing a money fund that has broken the buck to convert to a floating NAV. Second, if the fund chooses to liquidate instead of converting, they propose allowing investors to redeem the bulk of their shares without waiting for liquidation to finish. The co-authors would also require better fund disclosure about the circumstances under which a particular money fund might be unable to maintain a stable NAV.

These changes, Fisch and Roiter say, would provide flexibility for fund managers and predictability for investors when funds break the buck. Meanwhile, the added disclosure would boost liquidity, counteract the factors that might lead to a run on the fund, and make money funds more economically viable, according to the paper.

Fisch explains that "the real issue with breaking the buck now is that people don't know what's going to happen."

In the co-authors' view, the lesson from the Reserve Primary Fund's breaking the buck in September 2008 wasn't the need for a floating NAV, which the paper calls "a red herring," but the lack of effective liquidation procedures for money funds — and neither SEC rulemaking nor industry proposals have filled in the gap.

The paper comes as the industry awaits additional regulatory changes promised by the SEC when it passed new money fund rules in January 2010. Among the options the SEC has said it is considering are capital buffers, where money would be set aside in an account holding a certain amount of liquid assets that could be tapped to cover investment losses. Also on the table is requiring funds to use a floating NAV, an idea that has sparked intense industry opposition.

"It's aimed at preventing a run, but from a different standpoint than the capital buffer," says Joan Ohlbaum Swirsky, of counsel at Stradley Ronon, regarding the proposal by Fisch and Roiter. "I think it's a little less onerous on the industry, in a way, than the capital buffer, because there's no mandatory reserve. The fund would have a choice."

The SEC's amendments early last year to Rule 2a-7 included a few provisions addressing what happens when a fund breaks the buck. Money funds or their transfer agents now must be able to process purchases and redemptions at prices other than $1 per share. A money market fund's board also now has the power to suspend redemptions, provided the board has "irrevocably" approved liquidation of the fund and also given the SEC prior notice of its plans. The rule changes also gave affiliates greater ability to purchase distressed securities from a money fund.

Still, existing money fund rules don't explicitly lay out a set of consequences for a money fund that breaks the buck, Fisch and Roiter say. That's what their paper proposed to do. Specifically, they propose amending Rule 2a-7 so that the board of a money fund that breaks the buck would be required to take one of three actions.

First, the board could raise capital from the fund's advisor or another source to restore the $1 NAV. Second, the board could close and liquidate the fund. Third, the board could continue operating the fund, but with a floating NAV. The paper proposes allowing one business day after the fund has broken the buck for the board to restore the $1 NAV, and two business days for the board to choose between the two remaining alternatives.

Converting a money fund to a floating NAV should be fairly simple in light of the 2010 rule change requiring that the funds be able to make such conversions, the paper notes. However, the co-authors say that because few funds would likely be able to operate after converting to a floating NAV, liquidation is the more probable result.

It's difficult to predict how investors might respond to the prospect that a money fund could convert to a floating NAV. "Will they feel protected enough by the procedure that would be put in place by this proposal, or would they at the first sign of trouble be worried that the fund is going to float the NAV?" says Swirsky, the Stradley Ronon attorney.

The paper's second proposal would amend the 2010 rule change granting a money fund board the power to suspend redemptions when a fund is being liquidated. Fisch and Roiter would limit the board's power to suspend redemptions completely to two business days. Boards that choose to liquidate would then, for the next three business days, be permitted to suspend redemptions of no more than 50% of a shareholder's interest in the fund, and then, after the fifth business day, no more than 10% of a shareholder's holdings.

"Money in the Reserve Primary Fund was tied up for a year with no particularly good reason," Fisch says. "So part of our proposal is that there should be limits on that tie-up period and the amount of money that the board of directors can set aside during the period when they're resolving these issues, so there's some predictability in the market."

Notably, the SEC solicited comments on the suspension of redemptions in its 2009 money fund rule proposal. "Should there be a limit on the suspension period so that shareholder assets are not 'locked up' for an unduly lengthy period?" the proposal asks, among other questions. "If so, what should be the maximum length of the suspension period (e.g., 60 or 90 days)?"

Stephen Keen, of counsel at Reed Smith, says that while he agrees with the current proposal on the need to develop a clear understanding of what is expected when a fund breaks the buck, he would not fully agree with the paper's recommendations. In an e-mail response to questions, Keen says the proposed requirement that a board take action whenever a fund's shadow price falls below $0.995 "could create systemic risk." He would favor requiring action only if the deviation is due to a default, not a possibly temporary blip in market values.

"My disagreements are minor, however, compared to the problems posed by imposing a capital requirement on money market funds," Keen says. "It's hard to fault someone else who has pointed out to the regulators that they are heading the wrong way."

John Hunt, partner at McLaughlin & Hunt, questions whether the proposal would effectively stop runs. "The biggest problem for most firms when they were dealing with all the toxic assets was how do you put a price on them," he says.

Meanwhile, it seems that support for the capital buffer concept is growing. Boston Fed president Eric Rosengren recently came out in favor of the idea. In a speech prepared for delivery on September 29 in Stockholm, he said, "My own preferred approach would be to require [money funds] to have a meaningful capital-like buffer that exceeds, for example, their single-issuer concentration exposure limits — perhaps on the order of 2% to 3% — that, if violated, automatically leads to a fund’s conversion to a floating net asset value."