On June 30, 2009 the Securities and Exchange Commission (“SEC”) issued a proposed rule which, if adopted, would make significant amendments to the current regulatory framework for money market funds. According to the Release, the proposed amendments are designed to increase the resilience of money market funds to economic stresses and reduce the risks of runs on the funds. The proposed amendments, if adopted, would amend the principal rule governing money market funds, Rule 2a-7 under the Investment Company Act of 1940, as amended (the “Investment Company Act”), to address the following seven key areas:
- Tightening of existing liquidity requirements
- Shortening portfolio maturity limits;
- Increasing portfolio quality requirements;
- Requiring periodic stress testing of portfolios;
- Requiring “Know Your Investor” procedures to anticipate redemption risks to the fund;
- Requiring enhanced disclosure of portfolio holdings through monthly reporting; and
- Improving money market fund operations to increase the ability of a fund to effectively respond to market challenges.
Details of the SEC’s proposed amendments to Rule 2a-7 in these seven areas are summarized below.
Liquidity Requirements. The proposed amendments would add new liquidity requirements to Rule 2a-7 by:
- prohibiting all money market funds from acquiring securities unless they are liquid (i.e., securities that can be sold or disposed of in the ordinary course of business within seven days at approximately their amortized cost value);
- dividing money market funds into “institutional” and “retail” categories. The determination of a fund’s category would be made no less than once per calendar year by the fund’s board of directors based on its review of the:
- nature of the record owners of fund shares;
- minimum amount required to be invested to establish an account; and
- historical cash flows, and resulting or expected cash flows that would result, from purchases and redemptions of fund shares;
- requiring that money market funds have a minimum percentage of their assets in highly liquid securities so that those assets could be readily converted to cash:
- for retail money market funds, at least 5% of assets would be required to be in cash, U.S. Treasury securities, or securities readily convertible into cash (collectively, “liquid”) within one day, and at least 15% would be required to be liquid within one week.
- for institutional money market funds, which have experienced greater liquidity challenges than retail funds, at least 10% of assets would be required to be liquid within one day, and at least 30% would be required to be liquid within one week.
Shortened Maturity Limits. In an effort to limit the exposure of money market funds to certain risks, including interest rate risk, the proposed amendments would amend Rule 2a-7 to shorten the average maturity limits for securities held by money market funds. The proposed amendments would restrict the maximum “weighted average life” maturity of a fund’s portfolio to 120 days (currently there is no such limit) and restrict the maximum weighted average maturity of a fund’s portfolio to 60 days (currently the limit is 90 days). The weighted average life of a portfolio would be measured without regard to a security’s interest rate reset dates, and thus would limit the extent to which a money market fund could invest in longer term securities that may expose a fund to interest rate spread risk and credit spread risk.
The proposed amendments also seek to delete a provision of Rule 2a-7 that permits a money market fund that relies exclusively on the penny-rounding method of pricing to acquire government securities with remaining maturities of up to 762 days, rather than the 397-day limit otherwise provided by Rule 2a-7. Under the amended rule, money market funds could not acquire any security with a remaining maturity of more than 397 days, subject to the maturity shortening provisions for floating- and variable-rate securities and securities with a demand feature.
Increased Portfolio Quality. The proposed amendments would limit exposure to credit risk by generally requiring money market funds to only invest in “First Tier” securities, defined as “any eligible security that, if rated, has received the highest short-term debt ratings from the requisite nationally recognized statistical rating organization (“NRSRO”) or, if unrated, has been determined by the fund’s board of directors to be of comparable quality.” Money market funds would be prohibited from acquiring “Second Tier” securities (any eligible security that is not a “First Tier” security), as opposed to current regulation which permits most funds to invest up to 5% of their assets in “Second Tier” securities.
The proposed amendments would continue to permit money market funds to acquire long-term unrated securities (i.e., neither the security nor its issuer or guarantor has a short-term rating) with a remaining maturity of 397 calendar days or less, but would limit such purchases to securities that have received long-term ratings in the highest two NRSRO ratings categories. With respect to repurchase agreements (a popular investment for money market funds), the proposed amendments would limit money market funds to investing in repurchase agreements that are collateralized by cash items or government securities in order to obtain special treatment under the diversification provisions of Rule 2a–7. Moreover, the proposed amendments would require that the money market fund’s board of directors or its delegate evaluate the creditworthiness of the counterparty, regardless of whether the repurchase agreement is collateralized fully.
Periodic Stress Testing. The proposed amendments would require the board of directors of money market funds using the amortized cost method to adopt procedures providing for periodic stress testing of their portfolios. These procedures would require testing to examine a fund’s ability to maintain a stable net asset value (“NAV”) per share based upon certain hypothetical events, including an increase in short-term interest rates, an increase in shareholder redemptions, a downgrade of or default on a portfolio security, and widening or narrowing of spreads between yields on an appropriate benchmark selected by the fund for overnight interest rates and commercial paper and other types of securities held by the fund.
The proposed amendments also would require that the board of directors receive a report of the results of the stress testing at its next regularly scheduled meeting, which report must include:
- the date(s) on which the fund portfolio was tested; and
- the magnitude of each hypothetical event that would cause the money market fund to “break the buck.”
Under the proposed amendments, the records of a fund’s stress tests would be required to be maintained for six years, the first two years in an easily accessible place.
“Know Your Investor” and General Liquidity Requirement. The proposed amendments would also require money market funds to hold sufficiently liquid securities to meet reasonably foreseeable redemptions (referred to as “know your investor” requirements in an attachment to the SEC press release regarding the proposed amendments). In order to meet this requirement, the SEC expects that funds would develop procedures to identify the characteristics of their investors and the potential liquidity needs of their investors which may pose a risk (e.g., large redemptions). However, the SEC did not propose to amend Rule 2a-7 to require that funds adopt specific procedures, because it believes those procedures would be required by Rule 38a-1, the “Compliance Rule” under the Investment Company Act, if the proposed general liquidity requirement is adopted.
Enhanced Disclosure of Portfolio Holdings. To enhance disclosure regarding money market fund portfolio holdings, the proposed amendments would require funds to:
- post their portfolio holdings on their website no later than the second business day of the month, current as of the last business day of the previous month; and
- maintain the information on the website for at least twelve months.
In addition, the proposed amendments would also require money market funds to electronically file a new Form N-MFP with the SEC monthly. The proposed Form N–MFP would require the fund to report, with respect to each portfolio security held on the last business day of the prior month, among other things:
- identifying information for the issue, issuer and category of investment (e.g., Treasury debt, government agency debt, corporate commercial paper, structured investment vehicle notes, etc.);
- the current credit ratings of the issuer and the requisite NRSROs giving the ratings;
- maturity dates (under Rule 2a–7, final legal maturity date, and whether the maturity date is extendable);
- identity and current credit rating of enhancement provider, if applicable;
- the principal amount and amortized cost value;
- certain valuation information (i.e., whether the inputs used in determining the value of the securities are Level 1, Level 2 or Level 3, if applicable); and
- the percentage of the money market fund’s assets invested in the security.
In addition, the proposed Form N–MFP would require funds to report information about the fund’s risk characteristics, such as the fund’s dollar weighted average maturity of its portfolio and its 7-day gross yield, and include an ‘‘Explanatory Notes’’ item to permit funds to add miscellaneous information that may be material to other disclosure in the form. Since Form N–MFP would provide regular portfolio holdings information specific to money market funds, the SEC has proposed to amend Rule 30b1-5 to exempt money market funds from the portfolio holdings disclosure requirements of Form N-Q, although money market funds would remain subject to the controls and procedures and certification requirements of Form N-Q .
Improved Money Market Fund Operations. The Release also includes several proposed amendments to enhance money market fund operations. For example, the amendments would require a money market fund’s board of directors to determine, at least annually, that the fund (or its transfer agent) has the capacity to redeem and sell securities at a price other than $1.00 per share in order to facilitate share redemptions if the fund were to “break the buck.” The proposed amendments would also permit a money market fund to suspend redemptions if:
- the fund’s current price falls below $1.00 per share;
- the fund’s board of directors, including a majority of directors who are not interested persons, approves the liquidation of the fund; and
- the fund, prior to suspending redemptions, notifies the SEC of its decision to liquidate and suspend redemptions, by electronic mail directed to the attention of the SEC’s Director of the Division of Investment Management or the Director’s designee.
According to the Release, the SEC believes that these provisions would allow for an orderly liquidation of the portfolio in the event of a threatened run on a fund that has broken the buck. The proposed amendments include new proposed Rule 17a-9, which would expand the ability of affiliates of money market funds to purchase distressed assets from funds in order to protect a fund from losses. Currently, under Section 17 of the Investment Company Act, an affiliate ordinarily cannot purchase securities from the fund prior to a ratings downgrade or a default of the securities, unless it has received relief from the SEC. The proposed new rule would codify past no-action letter relief from the SEC staff.
Request for Comments
Throughout the Release, the SEC has requested comments on numerous questions about each of their proposed amendments, as well as related issues. In addition, the SEC requested comments on money market fund issues not specifically addressed by their proposed amendments, including, without limitation, the following:
- whether to substitute a floating NAV for the current stable NAV for money market funds;
- whether to require money market funds to satisfy redemptions requests in excess of a certain size through in-kind redemptions;
- determining what role credit rating agencies’ ratings should have in money market fund regulation;
- whether fund boards should designate certain rating agencies that they will use to evaluate securities for purchase, and to monitor securities after purchase;
- whether the “shadow pricing” NAV should be publicly disclosed; and
- whether Rule 2a–7 should be amended to address risks presented by special investment vehicles or asset-backed securities.
The proposed amendments discussed in this Legal Alert would represent a dramatic change in the regulatory landscape for money market mutual funds. We believe that the SEC will receive a large volume of responses to their requests for comments, and we expect those comments to come from individuals, small and large industry players and regular industry commentators. Since the SEC has invited comment on numerous issues, we believe they expect the same.