On March 17, 2009, the Money Market Working Group ("MMWG") of the Investment Company Institute (the "ICI") submitted a 216-page Report to the ICI's Board of Governors.1 John Brennan, Chairman of The Vanguard Group, Inc., chaired the MMWG, so the ICI refers to the report as the "Brennan Report." Although the Brennan Report is most noteworthy for its recommendations regarding the reform of money market mutual funds ("money funds"), the Brennan Report also contains a wealth of information for in-house counsel, compliance officers and risk managers who work with money funds. Therefore, in addition to summarizing the recommended reforms, this client bulletin highlights various Appendices to the Brennan Report that we believe our clients will find useful.
1. Recommendations of the MMWG
Section 7 of the Brennan Report includes a table summarizing the various recommendations made by the MMWG, which can be grouped into the following categories:
a. Liquidity Risk
The Brennan Report recommends the adoption of several rules designed to address liquidity risks faced by money funds. In keeping with the historical approach of Rule 2a-7, the rules would require a money fund's adviser to assess the liquidity risks presented by different types of shareholders, and would impose quantitative requirements for daily and weekly liquidity. The Brennan Report also calls for augmented disclosure. Specifically, regulations would require:
- All money funds to develop procedures for admitting shareholders to ensure, to the extent possible, that funds either (1) understand the expected liquidity needs of the shareholder or (2) when such information is not available, mitigate the adverse effects of unpredictable redemptions by such shareholders.
- Taxable money funds to meet a minimum 5 percent daily liquidity standard.
- All money funds to meet a minimum 20 percent weekly liquidity standard.
- All money funds to make monthly disclosures of client concentration levels by client type, and also disclose any risk of client concentration.
The liquidity standards would differ significantly from the current 10 percent limitation on "illiquid" securities. In addition to regulating the money funds' ability to sell securities in the market, the new standards would require "structural" liquidity in the form of securities that mature or are subject to Demand Features exercisable within the relevant time frame. For example, except as noted in the next paragraph, only overnight investments would count toward the 5 percent daily liquidity standard for taxable money funds. The absence of a significant supply of overnight municipal securities accounts for why this standard would not apply to tax-free funds.
Treasury securities and fixed-rate Agency notes issued with maturities of three months or less also would count toward the liquidity standards. The markets for these securities held up well during the financial turmoil, and tend to be buoyed by a flight to quality. Moreover, these securities trade on a cash settlement basis, so the money fund can obtain same-day liquidity upon sale of the securities. These factors led the MMWG to conclude that money funds could still rely on their ability to sell these securities to generate needed liquidity, even during times of market disruption.
The "know your client" requirements and disclosures of client concentrations get to the root cause of liquidity risk—the propensity of certain shareholders to redeem in response to changes in yield or perceived risks. Many managers routinely seek to assess their shareholders' liquidity needs and to discourage large investments of "hot money" (i.e., shareholders who have volatile cash flows in and out of the money fund). The recommended changes would require money funds to formalize their procedures for assessing the potential demand of their shareholders for redemptions, and would provide investors with a means of gauging a money fund's susceptibility to large outflows because of client concentrations.
b. Interest Rate Risk
Money funds have always been subject to limitations on their weighted average maturity ("WAM"), initially 120 days and then reduced to 90 days by the 1991 amendments to Rule 2a-7. However, even before the 90-day limit was imposed, money funds rarely maintained WAMs close to the 90-day limit. The Brennan Report therefore takes the next step, and recommends a further reduction in the WAM limit to 75 days.
The Brennan Report also recommends establishing a secondary WAM limit, termed a "spread WAM," of 120 days. This recommendation addresses the potential "spread duration" of adjustable rate securities without Demand Features. For purposes of the 90-day (and the proposed 75-day) WAM limitation, these securities are generally treated as maturing on the date of their next interest rate change. However, if interest spreads (i.e., the difference between the rate charged for a type of obligation and the risk free rate of return) change significantly, the impact of the change is the same as for a fixed rate security. The spread WAM calculation would therefore treat all securities as maturing on their scheduled maturity date, or the date principal could be recovered through exercise of a Demand Feature, whichever is earlier. In order to accommodate the longer maturity of adjustable rate securities, the spread WAM limit would be extended to the original 120 days.
c. Credit Risk
Rule 2a-7 has always required money funds to determine the minimal credit risk of their investments. However, no one has provided any guidance as to how to make this determination since an exchange of letters between the ICI and the Director of the Division of Investment Management in early 1990. The Brennan Report augments this guidance by including in Appendix I recommended best practices for determining minimal credit risks.
The Brennan Report also reiterates the ICI's earlier position that Rule 2a-7 retain its Requisite NRSRO requirements, which establish a uniform credit risk floor for all money funds. The Brennan Report also recommends that money funds be required to identify and disclose at least three NRSROs that they will rely on for the Requisite NRSRO requirements. This would serve at least two purposes. First, it would relieve money funds from any obligation to follow every action taken by every NRSRO. Second, it would prevent money funds from opportunistically relying on different NRSROs for the purpose of determining whether a security is "Eligible" under Rule 2a-7, without disclosure to the board and shareholders.
In addition, the Brennan Report recommends reconsideration of the ability of money funds to invest in Second Tier Securities. Few money funds currently take advantage of the limit ability to acquire Second Tier Securities (Rule 2a-7 limits Second Tier Securities to 5 percent of a money fund's total assets). The Brennan Report recommends that money funds no longer be permitted to acquire any Second Tier Securities, although they could continue to hold portfolio securities after they had been downgraded to Second Tier.
Finally, the MMWG recommends revising the minimal credit risk requirement of Rule 2a-7 to clarify that the board's role is to oversee the credit process, and not to have primary responsibility for determining minimal credit risks. Rule 2a-7 has always specified that a money fund's board must determine minimal credit risks, while leaving other determinations (such as what WAM is "appropriate [for] maintaining a stable net asset value") up to the fund's adviser. The proposed change would dispense with the legal fiction that a money fund's board is capable of independent credit analysis.
d. General Risk Management
Although discussed under different headings, the Brennan Report includes two recommendations that would require money funds to adopt more general risk management procedures. First, money fund advisers would have to "stress test" their portfolios' ability to meet shareholder redemptions in conjunction with increased credit and interest rate risks. The money fund's board would adopt procedures defining the nature and frequency of the stress tests, similar to the procedures already required for shadow pricing and minimal credit risk determinations.
Second, the Brennan Report recommends that advisers establish a "New Products" committee to review novel investments before they are acquired by a money fund. The New Products committee would be multidisciplinary, so that it could assess operational, legal, tax, accounting and systemic risks. The committee would not have to review every investment, just new investment structures or techniques. For example, a New Products committee might review a decision to expand the type of securities that their money funds would accept in repurchase agreements. Once the ability to accept such securities is approved, however, the committee would not need to review each subsequent repurchase agreement (although Rule 2a-7 would still require a determination that the repurchase agreements continued to present minimal credit risk).
e. Dealing with a "Run on the Fund"
The liquidation of the Reserve Primary Fund and the subsequent wave of money fund redemptions have demonstrated that boards may sometimes need to suspend redemptions in order to prevent unfair results to the remaining shareholders. The SEC has adopted temporary regulations permitting money fund boards to suspend redemptions in conjunction with the liquidation of a money fund under the U.S. Treasury Department's Guarantee Program for Money Market Funds (the "Treasury Guarantee Program"). The Brennan Report recommends making these regulations permanent, and also permitting boards to temporarily suspend redemptions under limited circumstances. Specifically, the recommended regulations would permit a board to suspend redemptions for up to five business days if the board determined there was a significant risk that the money fund might break a dollar. This would give the board a limited time to assess the money fund's condition and explore alternatives before determining whether to continue maintaining a stable net asset value. In addition, if the board determines that the money fund should be liquidated after breaking a dollar, the board could continue to suspend redemptions and require all shareholders to wait for distributions under the plan of liquidation.
The Brennan Report recommends that the Federal Reserve and the Treasury Department keep at hand the alphabet soup of programs that were used to address the liquidity crisis following the Lehman Brothers bankruptcy. The report also suggests that the SEC may need to permit money funds to shadow price holdings with maturities of 60 days or less at their amortized cost value, if credit markets lock up again (which is to say, that money funds would not be required to shadow price such securities). In addition, the Brennan Report recommends extending the Treasury Guarantee Program to its final end date of Sept. 18, 2009.
f. Disclosure Requirements
As might be expected, the Brennan Report recommends that money funds reassess their risk disclosure in light of recent circumstances. The Brennan Report also notes that adoption of some of the recommendations (such as the right to suspend redemptions) would require additional disclosure in a money fund's registration statement. Finally, the Brennan Report recommends codifying the practice currently followed by most money funds of posting monthly portfolio holdings on their websites.
A more novel recommendation would apply to unregistered funds that hold themselves out as money fund equivalents or "money fund like." The Brennan Report recommends that the SEC prohibit advisers from representing that an unregistered fund is like a money fund, unless the unregistered fund also complies with the requirements of Rule 2a-7. This would effectively expand the current limitation in paragraph (b) of Rule 2a-7 to unregistered investment companies in order to prevent investor confusion.
g. Miscellaneous Recommendations
Several of the MMWG's recommendations defy easy classification. For example, the Brennan Report recommends expansion of Rule 17a-9 to permit the acquisition of Eligible Securities by affiliated persons of a money fund. Rule 17a-9 currently applies only to securities that become ineligible, i.e., securities downgraded below to Second Tier, or that have their remaining maturities extend beyond 397 days. In the past 18 months, the SEC's staff has issued scores of no-action letters permitting money fund affiliates to purchase securities that have defaulted or that have been determined to no longer present minimal credit risks prior to any downgrading that would cause the securities to become ineligible. Expansion of Rule 17a-9 would eliminate the need for a no-action letter prior to the affiliate's purchase of the security. The MMWG also recommends codifying what has become a standard practice of notifying the SEC's staff of any Rule 17a-9 transaction.
The Brennan Report also calls for enhanced surveillance of the money market by federal regulators. This would take two forms. First, all institutional investors in the money markets would have to report information on a nonpublic basis to an entity charged with monitoring markets as a whole. Second, the SEC's staff would monitor the gross returns of money funds and take appropriate actions if it notices unusually high performance from a fund. The staff would also monitor some funds on a random basis.
2. The Rest of the Brennan Report
The MMWG's recommendations comprise only a small part of the Brennan Report. Most of the Brennan Report provides background information supporting the recommendations and critiques of alternative proposals by other commenters, such as the Group of 30. The critiques, which include a response to proposals to abolish money funds by stripping them of the ability to maintain a stable net asset value, are contained in Section 8 of the Brennan Report. Earlier sections of the Brennan Report contain a wealth of statistical information about money funds and their relationship to the U.S. money market.
The Brennan Report also includes a number of appendices that should be of immediate use to in-house attorneys, compliance officers and risk managers who work with their complex's money fund managers. First, as noted, Appendix I provides recommended "best practices" for determining and monitoring the minimal credit risks of money fund investments. In addition, Appendix F provides a history of the SEC's and its staff's interpretation of the minimal credit risk requirement. Compliance officers and risk managers can use these "best practices" to evaluate their adviser's current minimal credit risk procedures and discuss possible enhancements with the investment management team. Attorneys and compliance officers can refer to Appendix F in advance of these discussions to refresh their understanding of the minimal credit risk requirement.
Second, Appendix J to the Brennan Report is a checklist of considerations and action items associated with suspending redemptions and liquidating a money fund. The Reserve Primary Fund liquidation and its aftermath have demonstrated the need for contingency planning by money funds—even for hitherto unthinkable events like "breaking a buck." We advise our clients to include contingency plans for substantial deviations in a money fund's shadow price, and for the events specified in Rule 2a-7(c)(6)(ii) within the amortized cost procedures adopted by the money fund's board of directors. Such procedures typically do not address what happens if the board determines to stop maintaining a stable net asset value. The checklist will help expand the contingency plan to the fund's bitter end.
Appendices E and G of the Brennan Report provide a general history of the regulation of money funds. Attorneys may find this a useful reference in their analysis and interpretation of Rule 2a-7. It should also help train the next generation of 2a-7 gurus.
The Brennan Report also contains two legal surveys. Appendix D provides a survey of current state laws that authorize 2a-7 compliant money market funds as permissible investments for government entities, banks and insurance companies. Appendix H provides a survey of regulations applicable to offshore money funds. Attorneys may also find these to be useful reference materials.
Finally, you may wish to read Appendix K for its entertainment value. The Appendix provides excerpts from a survey of institutional money managers conducted by Treasury Strategies, Inc. regarding the prospect of money funds losing their ability to maintain a stable net asset value. Most of the respondents found the prospect appalling.
Typically, the ICI would submit their recommendation to the SEC's staff and then wait for a rule proposal. The members of the MMWG, however, have undertaken to implement their recommendations before the Treasury Guarantee Program's final extension date of Sept. 18, 2009. The Executive Committee of the ICI has also recommended to all ICI members that they implement the recommendations by this date. This will put money fund managers in the novel position of having worked through the implementation of reforms before they are even proposed by the SEC. The upside of this approach is that the industry will be well-positioned to comment on the merits of the reform proposal; the downside is that managers may go through the expense and effort of developing compliance procedures for certain recommendations that are not ultimately adopted by the SEC.