On June 24, 2009, the Securities and Exchange Commission (the "SEC") approved a release regarding proposed changes in Rule 2a-7 under the Investment Company Act of 1940 (as amended, the "1940 Act"), and requesting comments on a number of related issues. The press release announcing the proposed changes (www.sec.gov/news/press/2009/2009-142.htm) provided far less detail regarding these proposals than the presentation made by the Division of Investment Management (the "Division") at the Open Meeting of the SEC ("Meeting"). This Alert is therefore based on the Division's presentation and response to the Commissioners' questions. In light of the repeated references to the draft release during the Meeting, we anticipate that the release will be posted fairly soon. Clearly the Division has devoted its full efforts to meet the June deadline for proposed changes previously set by Chairman Shapiro.
We remind readers of this Alert that the devil remains in the detail, so we cannot fully evaluate the proposal until we see the release itself. Subject to this major qualification, here are the specific revisions and comment requests discussed at the Meeting that do not appear to correspond to any of the recommendations made in the Investment Company Institute's Money Market Working Group Report (www.ici.org/pdf/ppr_09_mmwg.pdf) (the "Brennan Report").
- Money market funds would not be permitted to invest in illiquid securities.
- Money market funds would be required to have the ability to process transactions at prices other than $1 per share.
- The SEC will request comment on whether to impose additional restrictions on investments in asset-backed securities by money market funds.
- The SEC will request comment on whether money market funds should be required to maintain the ability to redeem large redemptions in-kind.
- The SEC will request comment on whether money market funds should be required to operate using a floating NAV.
The SEC will request comment on whether money market funds should be required to publish their shadow (i.e., market value based) NAV whenever they disclose their portfolio holdings. In addition, it appears that the following Brennan Report recommendations will be proposed in a modified form:
- The weighted average maturity limitation would be reduced from 90 to 60 days. (The Brennan Report recommended 75 days.)
- Eligible Securities would be limited to First Tier Securities. (The Brennan Report recommended that money market funds should no longer be permitted to invest in Second Tier Securities, but would not have treated securities downgraded to Second Tier as "ineligible.")
- Money market funds would be required to disclose their schedule of investments within two business days after the close of each month. Disclosure would be made on their website and filed with the SEC. (The Brennan Report recommended only website disclosure.)
- The board of directors of a money market fund would be permitted to suspend redemptions after determining to break a dollar and to liquidate the fund. The SEC is asking for comments regarding whether to permit boards to suspend redemptions under other circumstances. (The Brennan Report also recommended allowing boards to suspend redemptions for up to five days if the fund was near breaking a dollar.)
- The SEC will request comment on whether to require the board of directors to designate three or more NRSROs that would be relied upon for purposes of determining whether a security was and remained an "Eligible Security." The release also reiterates the request for comments on whether to eliminate references to NRSROs in Rule 2a-7. (The Brennan Report recommended the continued use of NRSRO ratings in defining Eligible Securities and the designation of three or more NRSROs)
Finally, it appears that the proposed revisions to Rule 2a-7 will include the following recommendations from the Brennan Report:
- Money market funds would be subject to a weighted average life limitation ("WAL") of 120 days, which would be based on the remaining time until repayment of the security, without regard to interest rate adjustment features. (This corresponds to the "Spread WAM" requirement proposed in the Brennan Report.)
- Money market funds would be subject to daily and weekly liquidity requirements (e.g., a minimum percentage of securities that mature in one day, or seven days or less, or highly liquid securities).
- Money market funds would be required to stress-test their portfolios.
- Money market funds would be required to adopt "know your investor" procedures and to assess liquidity risks.
- Rule 17a-9 would be expanded to permit acquisitions of distressed securities that are still technically "Eligible Securities" under Rule 2a-7.
Of the novel recommendations, the prohibition on "illiquid securities" was most surprising. Last year, the SEC proposed codifying the 90 percent liquid security requirement in Rule 2a-7 as part of a proposal to remove references to NRSROs from SEC regulations (www.sec.gov/rules/proposed/2008/ic-28327.pdf). Superficially, permitting money market funds to invest in illiquid securities appears inconsistent with their role in providing daily liquidity. However, as we have seen time and again over the past two years, a security that is readily traded when purchased may become completely illiquid under adverse market conditions. The change may also affect product innovation, as money market funds frequently use their illiquid securities basket to test new products before they gain the wide acceptance necessary to support market liquidity. In any event, we would argue that the last two years demonstrate that a reconsideration by the Division of what "liquidity" means for any fixed-income fund (not just money market funds) is now long overdue.
The request for comments on asset-backed securities was somewhat less surprising. We remember the debates during the 1996/97 amendments to Rule 2a-7 regarding asset-backed securities, some of which anticipated problems experienced by structured investment vehicles in 2007 (e.g., reliance on market liquidity to repay obligations), and were anticipating that the Division might reexamine their conclusions. We will not be able to tell if the SEC has anything specific in mind until it publishes the release, but it will be interesting to see if any recommendations are forthcoming from the market.
Consideration of forcing funds to a floating NAV (which we think is more honestly stated as "outlawing money market funds") was openly discussed in SEC speeches and in the administration's White Paper on financial reform, so the request for comments was expected. The request regarding disclosure of the shadow NAV appears to search for a middle ground between the status quo and outlawing money market funds, although the result (if it leads to more frequent runs) may not be much different than outlawing the funds.
Regarding the remaining novel recommendations—the ability to trade at a fluctuating NAV and execute redemptions in-kind—our firm has been working with industry members for some time on developing these procedures. The proposals are also consistent with the Brennan Report's emphasis on the need for contingency planning, even though they do not correspond to any specific recommendation made in the Brennan Report.
Comments will be due 60 days after publication of the release, and we doubt the current Chairman will be inclined to extend the comment period. Although we had not previously anticipated the SEC acting so quickly, there is now a strong chance that final revisions could be adopted by year's end.