At an open meeting held on January 27, 2010, the Securities and Exchange Commission (SEC) approved both new rules and amendments to the existing rules under the Investment Company Act of 1940, as amended (the “1940 Act”), that govern money market funds (the “Reforms”). These Reforms, considered by the SEC to be “a first step in the continuing effort to improve regulation” of money market funds, are designed to increase the protection of investors by restricting the risks posed by money market funds, enhance fund disclosure and improve fund operations.
Restriction of Risk
The Reforms revise the risk limiting restrictions of Rule 2a-7 under the 1940 Act as those restrictions relate to the quality, maturity and liquidity of money market fund portfolio holdings. The revisions mandated by the Reforms include:
Higher Credit Quality
- reducing the amount of assets that a money market fund is permitted to invest in second-tier securities from five percent of its total holdings to three percent;
- limiting a money market fund’s exposure to any single second-tier issuer to 0.5 percent;
- limiting investments in second-tier securities to those securities that have a maturity of no more than 45 days, rather than the current 397 day limit;
Shorter Maturity Limits
- reducing the maximum weighted average maturity limit of a money market fund’s portfolio from 90 days to 60 days;
- imposing a new weighted average life limit of 120 days for portfolio securities;
- imposing a new daily liquidity requirement mandating that 10 percent of assets held by taxable money market funds be in cash, U.S. Treasury securities or securities that can be converted into cash within one day;
- imposing a new weekly liquidity requirement mandating that 30 percent of the assets of all money market funds be in cash, U.S. Treasury securities, certain other government securities with remaining maturities of no more than 60 days or securities that can be converted into cash within one week;
- restricting money market funds from having more than five percent of their portfolios invested in illiquid securities, down from the current 10 percent limit, and redefining as “illiquid” any security that cannot be sold or disposed of within seven days at carrying value;
Know Your Investor Procedures
- imposing a new requirement that money market funds have in place “know your customer” procedures that will enable them to identify the potential for large redemptions and have enough liquid securities on hand to satisfy them;
Periodic Stress Tests
- imposing a new requirement that money market fund managers conduct periodic stress tests of their funds to evaluate the ability of the funds to maintain a stable net asset value (NAV) in the event of interest rate changes, increased redemptions, changes in the credit quality of the funds’ portfolios and other disruptive events;
Nationally Recognized Statistical Rating Organizations (NRSROs)
- imposing a new requirement that the board of directors of a money market fund designate each year at least four NRSROs whose ratings the fund’s board considers to be reliable (this requirement does not relieve money market funds of their duty to perform independent credit analyses of every security they purchase);
- eliminating the current requirement that funds invest only in those asset-backed securities that have been rated by an NRSRO; and
- permitting money market funds to “look through” issuers of repurchase agreements to the underlying collateral securities for diversification purposes only if (1) the collateral for such agreements is cash or government securities and (2) the money market fund has evaluated the creditworthiness of the repurchase counterparty.
Enhancement of Fund Disclosure
The Reforms require money market funds to increase disclosure of their portfolio holdings by posting on their Web sites and disclosing to the SEC, within five days of the end of the month, the composition of their portfolios. Such postings must be maintained on the funds’ Web sites for at least six months. In their reports to the SEC, money market funds must also disclose the mark-to-market value, or “shadow NAV,” of their assets. These reports must be filed in a format that can be used to create an interactive database that the SEC can use to better oversee the activities of money market funds. The contents of these reports will be made public 60 days after the date on which they are filed with the SEC.
Improvement of Fund Operations
The Reforms mandate several changes designed to make money market funds less vulnerable to “runs” and to lessen the negative impact on investors in money market funds that may break the buck (e.g., whose NAV has fallen below $1 per share). The changes include requiring money market funds and their administrators to be able to process transactions at prices other than $1 per share to facilitate redemptions should a fund break the buck, and permitting boards of directors of money market funds to suspend redemptions if a fund is about to break the buck and they decide to liquidate, so that liquidation may be conducted in an orderly fashion. The Reforms also expand the ability of affiliates of money market funds to purchase distressed assets from the funds in order to protect the funds from suffering losses without having to seek individual exemptive relief from the SEC.
Possible Future Reforms
SEC Chairman Mary Schapiro noted in her opening remarks at the meeting that additional reforms are possible and are under active consideration and review by the SEC and its staff, including:
- a move from the use of a stable NAV of $1 per share to a floating NAV;
- a requirement that large redemption requests be satisfied in-kind; and
- “real time” disclosure of shadow NAV.
Additional possible reforms include a private liquidity facility to provide liquidity to money market funds in times of stress and a “two-tiered” system of money market funds that requires a stable NAV for those funds that are subject to greater risk-limiting conditions and possible liquidity facility requirements, as well as several other proposals being discussed with the President’s Working Group. During the open meeting, the staff noted that many commenters expressed concern over these proposed changes, particularly the move to a floating NAV and the requirement for in-kind redemptions. Therefore, the staff is still considering how to proceed in these areas and will issue proposals related to them at a later time.
The text of the Reforms is not yet available. As such, the information contained in this alert is based upon statements made by the commissioners and staff of the SEC at the open meeting and upon the information contained in the press release issued by the SEC regarding the Reforms. The Reforms will become effective 60 days after they are published in the Federal Register and mandatory compliance with the provisions thereof will be phased in during the year.