The Securities and Exchange Commission (SEC) at its open meeting on January 27th voted 4-1 (with Commissioner Casey dissenting) to adopt new rules to enhance the current regulatory framework for money market funds. These new rules are designed to increase the resiliency of money market funds to market stresses, reduce the risks of runs on the funds (such as when the Reserve Primary Fund “broke the buck” ), and protect investors if a fund does break the buck. The new rules are similar to those proposed in June with some significant differences as discussed below. Importantly, the SEC did not propose any rulemaking yesterday with respect to a floating rate net asset value but explained that the concept was still under consideration. The SEC also indicated that money market reform will be an ongoing process and that we should expect additional rule proposals as part of a fundamental re-evaluation of the regulatory structure of money market funds. Most of the Commissioners supported the new rules; however, Commissioner Casey did not. She explained that absent more fundamental changes, money market funds were still susceptible to runs and that she supported a move away from reliance on credit ratings.
The new rules will be effective 60 days after publication in the Federal Register. Mandatory compliance will be phased in during the year.
The new rules adopted yesterday would:
- enhance the risk-limiting requirements of Rule 2a-7 by adding new liquidity requirements and tightening existing requirements regarding maturity and quality of a money market portfolio;
- add stress-testing and “know your investor” requirements;
- require greater fund board participation with respect to reliance on ratings issued by nationally recognized statistical rating organizations (NRSROs);
- require additional disclosure of portfolio holdings information to investors and the SEC; and
- facilitate an orderly liquidation if a money market fund breaks the buck.
These changes are discussed in more detail below.
Certain enhancements to Rule 2a-7’s risk-limiting requirements. The new rules add the same minimum daily and weekly liquidity standards for all funds. All money market funds would be required to hold 10 percent of their assets in cash, U.S. Treasury securities or securities that convert to cash within one day. In addition, money market funds would be required to have at least 30 percent of their assets in cash, U.S. Treasury securities, certain government securities with remaining maturities of 60 days or less, or securities that convert to cash in a week. Under the new rules, fund boards do not need to make a determination that the money market funds they oversee are institutional or retail. The SEC staff indicated at the open meeting that they would be interested in revisiting this area if the industry arrived at a workable model for making an institutionalretail distinction. Money market funds would also be restricted from purchasing illiquid securities if, after the purchase, more than 5 percent of the fund’s portfolio would consist of illiquid securities (currently the limit is 10 percent). As amended, the term “illiquid” means any security that cannot be sold or disposed of within seven days at current carrying value.
The new rules enhance quality standards by limiting, instead of prohibiting as proposed, the acquisition of second-tier securities. Money market funds would be limited to investment of 3 percent (reduced from 5 percent) of their assets in second-tier securities, and no second-tier security could represent more than ½ of one percent of the fund’s assets (reduced from the greater of 1 percent or $1 million). Also as adopted, the maturity of a second-tier security may not exceed 45 days, which is much shorter than the current 397-day limit.
The new rules would help protect against interest rate risk and enhance the ability of funds to withstand market pressures by shortening maturity standards. In particular, the SEC is, as proposed, shortening the maximum weighted average maturity requirement from 90 days to 60 days. The SEC staff said at the open meeting that a 60-day weighted average maturity provided funds with more resiliency against market stresses than 75 days, and was a better reflection of current industry practice. The SEC also instituted a new standard, which limits the maximum weighted average life of a fund’s portfolio to 120 days, which affects investments in long-term floating rate securities.
Stress testing and “know your investor” procedures. Another aspect of the amendments would require that funds undergo periodic stress testing to determine whether the fund can maintain a $1 net asset value under a variety of scenarios, including changes in credit quality of portfolio securities, interest rate changes or a high number of redemptions. Funds would also be required to hold sufficiently liquid securities to meet foreseeable redemptions. As a result, funds will need procedures to identify investors whose redemption risks may pose risks and to anticipate the likelihood of large redemptions.
Board evaluation of NRSROs. The amendments would require funds to designate each year at least four NRSROs whose ratings the fund’s board considers to be reliable for purposes of determining those securities that are rated in the top two rating categories and eligible investments for the funds.
Additional disclosure requirements. The SEC has adopted requirements that funds disclose their portfolio holdings on a monthly basis on their website, as well as file more detailed disclosures with the SEC, including the mark-to-market value of a fund’s net assets (or shadow NAV), on a monthly basis on new Form N-MFP, both as of five business days after month end. Form N-MFP would be made public after a 60-day delay.
Facilitation of orderly liquidation. The new rules provide that funds and their administrators would be required to be able to electronically process purchases and redemptions in amounts other than $1 in the event that a fund broke the buck. Boards of directors of money market funds would be permitted to suspend redemptions from the fund if the fund breaks the buck, allowing for a more orderly liquidation of fund assets.
Purchases by affiliates. The new rules allow affiliates of a money market fund to purchase distressed assets from a fund to protect the fund from losses under certain conditions without prior approval by the SEC.
Repurchase agreements. The SEC has also amended the requirements for allowing a money market fund to “look through” the repurchase issuer to the underlying collateral securities for diversification purposes. The amendments would require that the collateral be cash items or government securities, and that the fund board (or its delegate) evaluate the creditworthiness of the repurchase counterparty.
* * * * *
The SEC determined to postpone rulemaking on whether to substitute a floating NAV for the current stable NAV and whether to require money market funds to redeem in-kind certain types of redemptions. The SEC indicated that it will continue to consider those areas as well as others, including: requiring public disclosure of mark-to-market pricing on a real-time basis; establishing a private liquidity facility; and creating a two-tiered money market fund regulatory structure with a stable NAV only for money market funds subject to greater risk-limiting conditions and possible liquidity facility requirements.
Please note that this information is based on the January 27, 2010 SEC Open Meeting, and that the new rules have not been released yet.