The period for comments on the Securities and Exchange Commission’s proposed money market fund reforms ended September 17. The tone of the comment letters, as well as the large quantity of responses, should serve to remind the SEC that the views of investors matter most in the rulemaking process. Indeed, the outcome of this regulatory chapter needs to be about which reform best serves the shareholders of money market funds, and not which best pleases the Financial Stability Oversight Council ("FSOC"). Unfortunately, sometimes it seems as if the latter, not the former, is the party getting preferential treatment.
The SEC proposed two fundamentally different alternatives. Alternative 1 would force the prices of institutional prime and tax-exempt money market shares to "float" by requiring these funds to calculated their net asset values ("NAVs") using market-based prices and rounding the result to the nearest basis point. (A basis point is the fourth decimal following a price of $1—a hundredth of a cent). Retail money market funds could avoid this by imposing a $1 million limit on each shareholder’s daily redemptions. Alternative 2 would require all prime and tax-exempt money market funds to impose a 2 percent fee on redemptions if, at the end of the previous business day, its weekly liquid assets were less than 15 percent of its total assets. The fund’s board of directors would have the option of suspending redemptions for up to 30 days, imposing a lower redemption fee or calling off the redemption fee entirely.
As of October 9, 200 comment letters were available on the SEC’s website regarding the proposal, in addition to more than 1,200 form letters against Alternative 1. Additional letters will continue to trickle in, but the current docket already reflects a massive and predominantly negative response to the proposed alternatives. Contrary to earlier reports, JPMorgan did not support Alternative 1, arguing instead that a variation of Alternative 2 is "the best option for achieving the SEC’s objectives." Goldman Sachs’ support for Alternative 1 was tepid, insofar as it recommended rounding the NAV to only the nearest 10 basis points, which would not produce a floating price under most market conditions. Of the 10 largest money market fund managers, only the two predominantly retail managers (Schwab and Vanguard) commented in favor of Alternative 1, in each case subject to increasing the cap on daily redemptions and solving the tax and accounting issues inherent in using a floating share price for daily cash management.
Even before the comment period ended, unnamed sources at the Federal Reserve and the Treasury told the press that only Alternative 1 would be acceptable to FSOC. In November 2012, the FSOC proposed to use its power under section 120 of the Dodd-Frank Wall Street Reform and Consumer Protection Act to recommend structural reforms for money market funds to the SEC. Former Commissioner Walter was reported as saying that the threat of section 120 recommendations provided the impetus for the SEC’s reform proposals. These reports suggest that, unless the SEC adopts Alternative 1, FSOC will complete the section 120 process and force the SEC to require money market funds to float their NAVs.
If these reports are correct, FSOC is saying, in essence, that the views of other commenters on the SEC’s proposals are irrelevant. So much for FSOC’s statement in its Annual Report that "The SEC, by virtue of its institutional expertise and statutory authority, is best positioned to implement reforms to address the risk that MMFs present to the economy." Apparently, FSOC only respects the SEC’s expertise when it agrees with FSOC’s opinions.
According to conventional wisdom, the SEC’s safest path would be to adopt Alternative 1 and thereby avoid a section 120 recommend from FSOC. But this analysis overestimates the significance of section 120 and underestimates the risks of ignoring the comments received on the SEC’s proposals. A realistic balancing of the respective risks supports the conclusion that the SEC should exercise the independent authority Congress has given it to determine what will best promote investor protection, capital formation, competition and market efficiency.
All FSOC can do under section 120 is recommend that the SEC adopt structural reforms for money market funds. The SEC is free to reject the recommendation so long as it "explain[s] in writing to [FSOC] … why the agency has determined not to follow the recommendation." In the release for its reform proposals, the SEC already included a section explaining why it rejected FSOC’s proposed recommendations other than a floating NAV. If the SEC decides not to adopt Alternative 1, the release adopting the final rule could explain the reasons why the commissioners chose not to force money market funds to float their NAVs. This explanation would short-circuit the section 120 process, as it would inform FSOC of why the SEC will not follow the recommendation before FSOC has a chance to make it.
The potential consequences of ignoring the comments made in response to the SEC’s proposals are more serious than a section 120 recommendation. The notice and comment process for rulemaking is a constitutional underpinning of the SEC’s authority, insofar as it protects the right of citizens to due process of law. In addition, the Investment Company Act requires the SEC to "consider, in addition to the protection of investors, whether [a rule] will promote efficiency, competition, and capital formation." Finally, the SEC is required to weigh the costs and benefits of its rules and consider whether it could accomplish the same regulatory ends through less costly alternatives.
The SEC will find itself in court if it fails fully to comply with these constitutional, statutory and administrative requirements. Unlike FSOC, federal courts have the power to strike down the SEC’s regulations and have done so in the past. In the event of a challenge, the SEC will need to prove that it carefully analyzed the information provided in the comment letters and considered all of the proposed alternatives. A desire to appease FSOC would not provide a defense to claims that the SEC "cut corners" when assessing the costs and benefits of a floating NAV.
Dealing with the threat of an FSOC recommendation by adopting the recommendation will not defend the SEC’s independence and authority from encroachment by other federal agencies. At this important crossroads in the debate over money market fund reform, the SEC’s best course is, as always, to inform itself of the facts and possible consequences of the reform alternatives, and to adopt reforms that the SEC believes will best serve the interest of investors and of the capital markets. Whatever adverse publicity a section 120 recommendation may garner will pale in comparison to the publicity from a court’s finding that the SEC failed to take into proper account the comment letters (many from ordinary investors) waiting in its docket.