- Overview of the SEC's Proposed Money Market Reforms
- July 16, 2009 | Authors: Lea Anne Copenhefer; Roger P. Joseph; Joshua B. Sterling
- Law Firms: Bingham McCutchen LLP - Boston Office; Bingham McCutchen LLP - Washington Office
On June 30, 2009, the Securities and Exchange Commission published its proposed amendments to Rule 2a-7 and certain other rules under the Investment Company Act of 1940 concerning the operation and regulation of money market funds.1 As the rule release makes plain, the Commission’s proposals have been shaped by its experience in dealing with the credit crisis over the past two years – an unprecedented period in which one fund “broke the buck” and many more relied upon billions of dollars in support from their sponsors, as well as a Treasury Department guarantee and certain lending programs sponsored by the Federal Reserve Board, to help support their stable net asset values. In addition, the release reflects concepts raised by the Investment Company Institute and in the Obama Administration’s recent white paper concerning financial regulatory reform.2
The Commission’s proposed amendments would, in the main:
- Amend the liquidity, maturity, and quality requirements of Rule 2a-7 to require money market funds to maintain a percentage of their portfolio holdings in instruments that can be readily converted to cash, to reduce the weighted average maturity of their holdings, and to limit their investments to “first-tier” portfolio securities;
- Implement a monthly reporting requirement concerning money market funds’ portfolio holdings;
- Permit a money market fund that has broken the buck to suspend redemptions to allow for its orderly liquidation;
- Require money market funds and their administrators to adopt and implement procedures to facilitate the orderly processing of purchases and redemptions of money market fund shares at different prices than $1.00 per share; and
- Permit affiliates to purchase distressed assets from money market funds before a ratings downgrade or a default on those securities.
In addition to the proposed amendments, the Commission is soliciting comments on a variety of concepts, including most notably:
- Whether money market funds should no longer be permitted to use the amortized cost method of valuation or maintain a stable net asset value; and
- Whether the Commission should require money market funds to have the ability to redeem investors in kind.
Comments on the Commission’s proposals are due by September 8, 2009. Below we discuss those proposals and the broader concepts that the Commission has raised for further consideration.
Proposed Amendments. As explained in the proposing release, the Commission’s proposed rule amendments are animated by two central purposes: first, to reduce the likelihood that any money market fund will break the buck; and second, to facilitate an orderly liquidation of any fund that does so. We address each proposal in turn.
Limits on Acquisition of Illiquid Securities. The Commission’s proposal would prohibit money market funds from acquiring a security unless, at the time acquired, the security could be sold or disposed of in the ordinary course of business at its approximate amortized cost value within seven days. This prohibition on acquiring illiquid securities would build on earlier Commission interpretations indicating that a money market fund should not hold more than 10 percent of its assets in illiquid securities.3 Because of the possibility that securities already in a fund’s portfolio could themselves become illiquid, the Commission considers it appropriate to prohibit funds from acquiring securities that already are in that condition.
Cash and Securities Readily Convertible into Cash. The Commission is proposing that money market funds be required to hold specific percentages of their assets in cash and securities readily convertible into cash. As the proposing release explains, the Commission has proposed these requirements because money market funds often promise same-day or next-day redemptions, and those promises placed severe liquidity pressure on certain funds during the credit crisis. Accordingly, the proposed liquidity tests are based on the legal right of funds to receive cash rather than their ability to find purchasers of their portfolio securities; in addition, the tests attempt to differentiate among categories of funds based on the redemption demands that each is likely to face.
Minimum Daily Liquidity Requirement. A taxable retail fund would be required to invest at least five percent of its total assets in “daily liquid assets” – i.e., cash, U.S. Treasury securities, and securities that the fund can reasonably expect to convert to cash within a day. The Commission also is proposing that a taxable institutional fund be required to hold at least 10 percent of its assets in daily liquid assets, and is soliciting comment on whether that level should be 15 or 20 percent. The Commission is not seeking to apply a daily minimum liquidity requirement to tax-exempt money market funds.
Minimum Weekly Liquidity Requirement. The Commission is proposing that both taxable and tax-exempt money market funds be subject to a minimum weekly liquidity requirement. This proposed requirement would prohibit a retail money market fund from acquiring securities other than “weekly liquid assets” if, immediately after the acquisition, the fund would have invested less than 15 percent of its total assets in assets of that kind. Institutional money market funds would be subject to a 30 percent requirement. The term “weekly liquid assets” would be defined to include cash, U.S. Treasury securities, and securities (including repurchase agreements) that mature or are subject to a demand feature exercisable and payable within five business days.
General Liquidity Requirement. The Commission has emphasized that the minimum daily and weekly liquidity requirements should not be regarded as substitutes for a money market fund’s own analysis of its liquidity needs. In this vein, the Commission is proposing to require that a money market fund hold highly liquid securities sufficient to meet reasonably foreseeable redemptions and any commitments that the fund has made to shareholders (e.g., undertaking to pay redemptions in less than seven days).
The Commission explained that it would expect money market funds to consider a variety of factors, including the characteristics of its investors and their likely liquidity needs (e.g., whether there are any large investors that are likely to make significant redemptions). The Commission also explained that funds should adopt "know your investor" policies to ensure that appropriate efforts are undertaken to identify risk characteristics of their shareholders. In particular, the Commission highlighted risks associated with investors holding money market fund shares through omnibus accounts and other portals, which may tend to have the effect of limiting a fund’s understanding of those investors’ liquidity needs.
Stress Testing. The Commission is proposing to amend Rule 2a-7 to require that the board of directors for each money market fund using the amortized cost method adopt procedures providing for periodic stress testing of the money market fund’s portfolio. The testing would be required to take place at intervals that the board of directors determines to be appropriate and reasonable in light of market conditions.
In general terms, this proposal would require testing of a fund’s ability to maintain a stable net asset value per share based upon certain hypothetical scenarios. Those scenarios would include:
- an increase in short-term interest rates;
- an increase in shareholder redemptions;
- a downgrade of or default on a portfolio security; and
- the widening or narrowing of yield spreads on a benchmark for overnight interest rates (selected by the fund) and commercial paper and other securities held in the fund’s portfolio.
The precise details of those scenarios would be left to each fund, although the Commission has suggested that these tests should include concurrent hypothetical scenarios (e.g., rising interest rates and multiple redemptions). Fund management would be required to report to the board on the results of the stress tests, and in particular would be required to identify the dates of the tests and the magnitude of each event tested that would cause the fund to break the buck. The results of the stress tests would be required to be maintained as part of the fund's books and records.
Reduction in Weighted Average Maturity. The Commission is proposing to shorten the maximum dollar-weighted average portfolio maturity of money market funds to 60 days, from the current 90-day limit. In the proposing release, the Commission acknowledged that the ICI recently proposed a lesser reduction, to 75 days. However, the Commission explained that a 60-day limit would be more appropriate in light of recent statistics indicating that average weighted maturities of taxable money market funds have not exceeded 58 days in the last 20 years, and that the figure is currently around 53 days.
Weighted Average Life. The Commission is proposing a new limitation of 120 days for the “weighted average life” of money market funds, which is designed to address certain risks that the ICI highlighted concerning the “maturity shortening” provisions of Rule 2a-7 for short-term variable- and floating-rate securities.4 (In its report, the ICI expressed concern that a variable- or floating-rate security generally would be more sensitive to credit and interest rate spreads than would be a short-term security with a final maturity equal to the former’s reset date.) Accordingly, the weighted average life of a portfolio would be measured without regard to a security’s interest rate reset dates. The release explains, however, that a security’s demand features could be used for calculating a portfolio’s weighted average life.
Maturity Limits for Portfolio Securities. The Commission is requesting comment on whether the 397-day limit for a security to be deemed eligible under Rule 2a-7 should be reduced, and offered 270 days as a possible alternative. In addition, the Commission is proposing to eliminate a provision of Rule 2a-7 that permits a money market fund relying exclusively on the penny-rounding method of pricing to acquire government securities with remaining maturities of up to 762 days. As a result, investments in government securities by those funds would be subject to the 397-day limit otherwise provided by Rule 2a-7. This amendment may have little practical effect because, as the Commission noted in the release, there appear to be no money market funds that rely exclusively on the penny rounding method.
Elimination of Second-Tier Securities. The Commission is proposing to allow money market funds to invest only in securities that have received the highest short-term debt ratings from the requisite nationally recognized statistical ratings organizations (“NRSROs”). These first-tier securities would be the only “eligible securities” in which a money market fund would be permitted to invest. In other words, the Commission would no longer allow money market funds to make investments in second-tier securities. (Currently, a money market fund may hold up to five percent of its total assets in second-tier securities.) If an eligible security is downgraded, the fund would have to dispose of the security as soon as practicable consistent with achieving an orderly disposition of that security, unless the fund’s board found that disposing of the security would not be in the best interest of the fund.
The Commission has acknowledged that second-tier securities did not directly contribute to the stress on money market funds during the height of the credit crisis. Instead, the Commission has indicated that it is making this proposal based largely on the ICI’s recent report, which states that second-tier securities reflect an “imprudent” risk to stable net asset values. The Commission also has suggested that this amendment should not substantially disrupt money market fund operations, citing its staff’s September 2008 finding that second-tier securities comprise only 0.4 percent of money market fund assets.
Credit Reassessment. The proposing release clarifies that the definition of “eligible security” would include unrated securities that a money market fund’s board of directors (or its delegate) determined to be of comparable quality to a rated security.5 This concept is found in the current definition of “first-tier security” in Rule 2a-7.6 As a result, the Commission is proposing a conforming amendment that would require a board to reassess whether an eligible security that is unrated continues to present minimal credit risks if, following its acquisition by a money market fund, the fund’s investment adviser becomes aware that the security has received a rating from any NRSRO below the highest short-term rating category.
Eligible Securities – Use of NRSROs. The Commission is soliciting comment on whether the proposed definition of “eligible security” should refer to ratings from requisite NRSROs, as a follow-up to its July 2008 proposal to eliminate those references from Rule 2a-7.7 In soliciting further comments, the Commission explained that a vast majority of commenters on its earlier proposal indicated that they favored the continued use of credit ratings as a floor for assessing the credit quality of potential investments.
In addition, the Commission is seeking input on whether a money market fund’s board of directors should be required to designate three or more NRSROs to which the fund would look for all purposes under Rule 2a-7 and to evaluate annually whether those NRSROs have issued sufficiently reliable credit ratings. This concept may be intended to address concerns that portfolio managers at times “cherry-pick” the most favorable ratings when evaluating the credit quality of a security.
Asset-Backed Securities. The Commission is requesting comment on whether and how it should amend Rule 2a-7 to address risks posed by investments in asset-backed securities, particularly risks associated with investments in commercial paper issued by structured investment vehicles (“SIVs”). As explained in the proposing release, in 2007 money market funds were exposed to valuation pressures from their holdings of SIV-issued commercial paper, because SIVs generally lacked access to liquidity facilities that would have permitted them to roll over their commercial paper in the face of credit events and market disruptions. In this regard, the Commission has asked whether it should provide additional guidance on the required minimal credit risk evaluation with respect to all asset-backed securities, such as a requirement to consider whether a security includes any committed line of credit or other liquidity support.
Eligible Securities – “Stub” Securities. The Commission is proposing to restrict the type of “stub” securities in which money market funds may invest. (Stub securities are long-term unrated securities with remaining maturities of 397 calendar days or less.) Money market funds would be limited to investing in stub securities that have received long-term ratings in the highest two ratings categories – a change from the current requirement, which permits investments in stub securities if they are rated in the highest three categories.
Other Proposed Amendments.
Disclosure of Portfolio Information. The Commission is proposing that money market funds disclose portfolio holding information on their websites, and that they file with the Commission more detailed holdings information, within two business days after the end of each month. The Commission expects that it would make the reports filed with it publicly available two weeks after the date of filing. In light of these proposed monthly disclosures, the Commission is proposing to exempt money market funds from the requirement, under Rule 30b1-5 of the Investment Company Act, to file quarterly schedules of investments on Form N-Q. The Commission is not proposing to exempt money market funds from other requirements of Form N-Q (e.g., the requirement to disclose information about the fund’s controls and procedures), but it has sought comment on whether a broader exemption would be appropriate.
Investments in Repurchase Agreements. The Commission is proposing to amend the “look-through” treatment of repurchase agreements under Rule 2a-7, pursuant to which a money market fund may treat the acquisition of a fully-collateralized repurchase agreement as an acquisition of the underlying collateral for purposes of the rule’s diversification requirements. In particular, the Commission’s proposal would limit look-through treatment to repurchase agreements collateralized by cash items or government securities. The Commission also is proposing to require that a money market fund’s board of directors (or its delegate) evaluate the creditworthiness of the counterparty to a repurchase agreement – regardless of whether the agreement is fully collateralized. This last proposal would restore a provision to Rule 2a-7 that had been eliminated in 2001 due to certain bankruptcy law developments that protected funds from the automatic stay of creditors’ rights.8
Procedures for Processing Fund Transactions at Prices other than $1.00. The Commission is proposing to require that a money market fund’s board of directors determine in good faith, at least once each calendar year, that the fund or its transfer agent has the capacity to redeem and sell its securities at different prices than $1.00 per share. This proposal is intended to address problems in the processing of money market fund transactions that arose during the height of the credit crisis last fall, which the Commission has attributed to “hard-wired” procedures that allowed funds and their administrators to process purchases and redemptions exclusively at $1.00.
Permitting Affiliates to Purchase Distressed Assets from Money Market Funds. The Commission is proposing to amend Rule 17a-9 under the Investment Company Act, in order to expand the circumstances in which affiliated persons can purchase portfolio securities from money market funds. Currently, Rule 17a-9 permits the purchase of securities from an affiliated money market fund only if those securities are no longer eligible under Rule 2a-7. Under the proposal, a money market fund would be permitted to sell a portfolio security that has defaulted (other than an immaterial default unrelated to the financial condition of the issuer) to an affiliated person, even though the security continues to be an eligible security. Any such transaction would have to satisfy the other current requirements of Rule 17a-9.9
In addition, the Commission is proposing that Rule 17a-9 be amended to permit affiliated persons, for any reason, to purchase a portfolio security from an affiliated money market fund for cash at the greater of its amortized cost value or market value, provided that the affiliated person promptly remits to the fund any profit it realizes from the later sale of the security. This amendment would mean, for instance, that an affiliated person could purchase from a money market fund eligible securities that have not defaulted.
The proposing release also contains a related amendment to Rule 2a-7, which would require the prompt reporting of these affiliated transactions to the Commission by email. The notice must identify that the purchase has occurred and the reasons for the purchase.
Fund Liquidation and Suspension of Redemptions. The Commission is proposing new Rule 22e-3, which would enable boards of money market funds to suspend redemptions in circumstances where a money market fund has broken the buck and plans to liquidate.10 This new rule would be an exemption from the requirement, found in Section 22(e) of the Investment Company Act, that a mutual fund must redeem shares within seven days of a redemption request, and it is intended to shield money market fund investors from the ill effects of a run on a fund that has broken the buck.
- In particular, the proposed rule would permit a money market fund to suspend redemptions if:
- the fund’s current price per share is less than its stable net asset value per share;
- the fund’s board of directors, including a majority of the disinterested directors, approves the fund’s liquidation; and
- the fund, before suspending redemptions, notifies the Commission by email of its decision to liquidate and suspend redemptions.
The proposed rule also would give the Commission the authority to rescind or modify this exemption in certain circumstances, including where the fund has not devised or is not properly executing a plan of liquidation that protects fund shareholders. The Commission would have to give the fund notice and opportunity for hearing before issuing such an order. In addition, the proposed rule would allow a conduit fund – such as an insurance company separate account or a feeder fund in a master-feeder arrangement – to suspend redemptions where a money market fund in which it invests has suspended redemptions.
The Commission is seeking comment on a variety of issues relating to the proposed ability to suspend redemptions, including whether a suspension of up to five days should be permitted where a fund’s board determines that the fund’s net asset value is “materially impaired” and whether to include any conditions on the treatment of shareholders in a liquidation or the establishment of a reserve to cover expenses and potential liabilities.
Diversification. The Commission acknowledged in the proposing release that the diversification provisions of Rule 2a-7 generally did not figure in the money market turmoil last fall.11 However, the Commission is seeking comment on whether the issuer diversification requirement should be lowered from five percent, and has offered three percent as an alternative. At the same time, the Commission is soliciting comment on whether a lower diversification requirement would tend to reduce the quality of portfolio securities held by money market funds. In addition, the Commission is soliciting comment on whether money market funds should be subject to any industry concentration limits, in recognition of the fact that, at least last fall, many money market funds appeared to have had significant exposure to companies in the financial services sector.
Topics Open For Comment. The Commission regards the foregoing proposals as necessary to strengthen money market fund operations and oversight. But the Commission also has indicated that these proposals are merely first steps and that more changes may be coming. In this regard, the Commission highlighted – both in the release and during its June 24 open meeting – the following concepts as key subjects for consideration by commenters:
Floating Net Asset Values. The Commission is seeking comment on whether money market funds should no longer be permitted to use the amortized cost method of valuation and thus maintain a stable net asset value. This concept is plainly driven by the turbulence that money market funds suffered throughout the fall of 2008, during which time they were under pressure to handle a significant amount of redemptions – which led to increased sales of portfolio assets in a declining market – while seeking to maintain a stable net asset value of $1.00 per share. It also reflects the Commission’s view that money market funds have changed considerably since Rule 2a-7 was adopted in 1983. For instance, large institutional investors predominate today, whereas retail investors made up the majority of shareholders a quarter-century ago. Likewise, today money market funds are an integral part of the short-term credit market, but in 1983 they were principally an alternative to interest-bearing deposit accounts for retail investors.
Based on these developments, the Commission is concerned that, in money market funds with stable net asset values, smaller investors (who tend to hold their positions for a longer time) may bear a disproportionate amount of the costs imposed by larger shareholders. Those costs are likely to be exacerbated in a credit crisis or where the portfolio of a money market fund is otherwise deteriorating. The Commission has suggested that a floating net asset value could address this concern, both by making the risks of money market fund investments more transparent and by eliminating the possibility that shareholders could redeem their shares for more than the current market value per share of the fund’s portfolio.
Toward the end of its discussion, the Commission expressed its view that, in a stable market, “the other risk-limiting conditions” of Rule 2a-7 “would tend to promote a relatively stable net asset value per share,” even if money market funds could not use the amortized cost method. While it is important not to read too much into this statement, at the very least it suggests that the Commission is willing to consider seriously whether money market funds should have floating net asset values.
In-Kind Redemptions. The Commission is soliciting comment on whether, if it decides to retain a stable net asset value, to require money market funds to have the ability to redeem investors in kind. The goal of such a requirement would be to protect investors remaining in a fund who otherwise would bear the full cost of large redemptions that were paid in cash. Instead, the redeeming shareholders would bear some of those costs when selling the securities received in kind. The Commission has suggested that this requirement could be restricted to redemptions over a certain size. The Commission also has asked whether the imposition of a redemption fee, under Rule 22c-2 of the Investment Company Act, would be a better alternative to mandatory redemptions in kind.
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The Commission’s proposal is focused both on enhancing stability (through more stringent liquidity, maturity, and quality requirements) and on preparing investors and the Commission to handle any future instability (through more frequent reporting, stress-testing, more flexible transaction processing, and orderly redemption procedures in the case of fund liquidations). To achieve these ends, the Commission has drawn both from a variety of emergency measures that were implemented last fall and from recommendations by the ICI. The result is a wide-ranging package that contains a number of specific proposals and raises the possibility of more fundamental reforms.
Given the sheer scope of the proposal, it would be difficult to predict precisely what form the Commission’s final amendments will take. The views of industry participants and investors are likely to figure prominently in the Commission’s decisionmaking.
1SEC Release No. IC-28807 (June 30, 2009) (the "Proposing Release"). The full text of the Commission’s proposing release is available at http://www.sec.gov/rules/proposed/2009/ic-28807.pdf. The Commission approved the proposals at an open meeting held on June 24, 2009. For a discussion of that open meeting, please see our June 24, 2009 Alert, “SEC Proposes Significant but not Unexpected Amendments to Money Market Fund Regulations,” available at http://www.bingham.com/Media.aspx?MediaID=8822.
2See U.S. Treasury Department, Financial Regulatory Reform: A New Foundation – Rebuilding Financial Supervision and Regulation (June 2009); Investment Company Institute, Report of the Money Market Fund Working Group (March 17, 2009).
3See, e.g., SEC Release Nos. IC-13380 (July 11, 1983) & IC-14983 (March 12, 1986).
4See Rule 2a-7(d) under the Investment Company Act.
5See Proposing Release at n.88.
6See Rule 2a-7(a)(12) under the Investment Company Act.
7See SEC Release No. IC-28327 (July 1, 2008). The Commission raised a similar question in an earlier concept release. See SEC Release No. 33- 8236 (June 4, 2003).
8See SEC Release No. IC-25058 (July 5, 2001).
9Rule 17a-9 also requires that the purchase price must be paid in cash and must be equal to the greater of the market price or amortized cost value of the security.
10If adopted, proposed Rule 22e-3 would replace Rule 22e-3T, a temporary rule that provides a similar exemption for money market funds participating in the Treasury Department’s Temporary Guarantee Program.
11The Commission did indicate, however, that the guarantor and demand feature provisions of Rule 2a-7’s diversification requirements were implicated, as some money market funds were exposed to bond insurers and to securities firms that served as liquidity providers.