On June 5, 2013, the U.S. Securities and Exchange Commission (the "SEC") issued a set of sweeping proposals (the "Proposed Rules") that would, if adopted, significantly alter the characteristics of many types of money market funds ("MMFs") in the United States.1 The Proposed Rules were issued pursuant to the Financial Stability Oversight Council's recommendation that the SEC enact structural reforms of MMFs in response to the financial crisis of 2007-2008.2
The SEC seeks to achieve two primary goals with the Proposed Rules. First, the Proposed Rules are intended to make MMFs less susceptible to heavy redemptions and to improve the ability of MMFs to manage and mitigate potential contagion from such redemptions. Second, the Proposed Rules are intended to increase the transparency of MMF risk and risk-management practices. The SEC believes that the Proposed Rules achieve these goals while generally preserving the current benefits of MMFs.
The implications of the Proposed Rules are widespread, as MMFs play a very large role in the U.S. capital markets, including securitization. MMFs are major investors in asset-backed commercial paper ("ABCP") and other types of short-term asset-backed securities ("ABS"). In addition, securitization structures often utilize MMFs to invest cash on deposit in collection accounts, reserve accounts and other types of accounts used in securitization structures.
This newsletter provides a detailed summary of the Proposed Rules and identifies some of the potential implications for securitizations. For a more general discussion of the Proposed Rules and their potential implications, see our Client Alert SEC Money Market Fund Reforms Could Significantly Affect Corporate Cash Management.
Alternatives for Management of Heavy Redemptions
The most notable reform contemplated by the Proposed Rules deals with the management of liquidity risks and pricing issues associated with heavy redemptions. The Proposed Rules offer three alternative approaches to better manage those risks:
- Floating NAV Alternative: MMFs (other than government MMFs and retail MMFs) would be required to price their shares based on a "floating" net asset value per share, rather than the traditional fixed $1.00 per share; or
Liquidity Fee and Gates Alternative: In the event that the weekly liquid assets of an MMF (other than a government MMF) fall below 15% of its total assets, that MMF would be:
- required to impose a liquidity fee of 2% (or a lesser fee as determined by the MMF's board) on all redemptions unless the MMF's board determines that imposing such a fee is not in the best interest of the MMF; and
- permitted to suspend redemptions temporarily if the MMF's board determines that doing so is in the MMF's best interest; or
- Combination Alternative: A combination of the Floating NAV Alternative and the Liquidity Fee and Gates Alternative.
One possible effect of these proposals is that investors may allocate funds away from the types of MMFs affected by the alternative that is ultimately adopted. This could lead to a reduction in the very robust demand that MMFs currently have for ABCP and short-term ABS. In addition, these alternatives could make MMFs a less effective cash management tool within securitization structures, as a floating net asset value and/or liquidity fees and gates could render them less desirable for highly-rated transactions. Finally, these alternatives will likely lead to lower yields on MMFs due to increased costs, thus further diminishing the attractiveness of MMFs as a cash management tool.
Amendments to Diversification Requirements
In addition to these alternatives, the Proposed Rules amend the diversification requirements of Rule 2a-7 under the Investment Company Act ("Rule 2a-7"). This amendment would generally require MMFs to look to the securitization sponsor, rather than the issuing special purpose entity ("SPE"), when determining whether the MMF complies with the issuer diversification requirements of Rule 2a-7. As a result, this amendment could limit the ability of a MMF to invest in ABCP or other short-term ABS of larger securitization sponsors.
Among the other reforms contemplated by the Proposed Rules are:
- amendments to the stress testing requirements of Rule 2a-7; and
- amendments to the disclosure requirements and forms under Rule 2a-7.
Deadline for Comments
Comments on the Proposed Rules are due on September 17, 2013. Comments that have been submitted to the SEC are available for review on the SEC's website.3
- If the Floating NAV Alternative is adopted, the Proposed Rules specify a compliance date of two years following the effective date of the final rules.
- If the Liquidity Fee and Gates Alternative is adopted, the Proposed Rules specify a compliance date of one year following the effective date of the final rules.
- With respect to all of the other reforms set out in the Proposed Rules, the Proposed Rules specify a compliance date of nine months following the effective date of the final rules.
Overview of the Existing Accommodations and Risk Limiting Conditions in Rule 2a-7
MMFs are popular cash management vehicles for both retail and institutional investors, including servicers and trustees in securitization transactions. This popularity can be attributed in large part to the ability of MMFs to maintain a $1.00 stable share price. Among other benefits, the $1.00 stable share price makes an investment in a MMF both tax efficient and administratively convenient.
The $1.00 stable share price is made possible by various accommodations and safeguards under Rule 2a-7. The two most important accommodations provided by Rule 2a-7 are:
- Amortized Cost Method. A MMF may use the amortized cost method of accounting when valuing the securities in its portfolio. Under this method of accounting, a MMF's net asset value is calculated by reference to the MMF's acquisition cost of its portfolio securities, as adjusted for amortization of premium or accretion of discount, rather than by reference to the value of the portfolio securities based on current market factors.
- Penny-Rounding Method of Pricing. A MMF may compute its price per share for purposes of distribution, redemption and repurchase such that the current net asset value per share is rounded to the nearest one percent (i.e., rounded to the nearest penny). Thus, a MMF with a net asset value per share of $0.9975 may continue to quote its price per share at $1.00.
While discrepancies can develop between the value of a portfolio security based on its amortized cost and the value of that portfolio security based on market factors,4 those values will converge as that portfolio security reaches maturity. However, this eventual convergence of values does not eliminate volatility in the market value of a portfolio security prior to maturity and thus does not eliminate all of the risks that could threaten the maintenance of a $1.00 stable share price. To mitigate such risks, Rule 2a-7 imposes the following important risk limiting conditions:
Click here to view table.
While the accommodations and countervailing risk limiting conditions provided by Rule 2a-7 have led to the rapid growth of MMFs in the United States, the financial crisis of 2007-2008 has led the SEC to re-examine not only the existing safeguards provided by Rule 2a-7, but also the accommodations in Rule 2a-7 that facilitate the $1.00 stable share price convention. Of particular concern to the SEC are the effects of severe economic downturns on MMFs. Most notable of these concerns are:
- incentives that can lead to a "run" on MMFs (i.e., extraordinarily heavy redemptions);
- liquidity issues that can arise during periods of heavy redemptions; and
- imperfect transparency that can exacerbate the foregoing conditions.
The SEC's commentary accompanying the Proposed Rules contains an extensive discussion of these concerns. A summary of that discussion is presented below.
Click here to view table.
Overview of the Proposed Rules
Alternative Proposals for Mitigating the Risks of Heavy Redemptions
Alternative 1: Floating Net Asset Value
The first alternative set forth in the Proposed Rules is the floating net asset value alternative ("Floating NAV Alternative"). Under that alternative:
- the share prices of MMFs would "float"; i.e., share prices would correspond to each MMF's net asset value, calculated in accordance with market-based factors rather than the amortized cost method;12
- the share prices of MMFs would be calculated using basis-point rounding rather than penny rounding; i.e., MMFs would round to the nearest 1/100th of one percent ($1.0000) rather than to the nearest one percent ($1.00); and
- government13 and retail14 MMFs are exempt from the foregoing requirements and may continue to use the amortized cost method of valuation and the penny-rounding method of pricing.
The SEC identifies two primary benefits of the Floating NAV Alternative. First, the SEC believes that a floating share price will reduce the incentive that investors have to redeem their MMF shares quickly in times of financial distress, as there would be no rush to redeem shares for the stable $1.00 price (while it is still available) and no corresponding concentration of losses among those investors who are slower to redeem their shares. Second, the SEC believes that the Floating NAV Alternative would improve transparency and reinforce the reality that MMFs are not risk free by making gains and losses on the portfolio securities a more regular and observable occurrence. The use of basis-point rounding, rather than penny rounding, would further increase transparency by providing investors with a more sensitive measure of changes in the value of the portfolio securities.
The SEC recognizes that the are potential drawbacks associated with the Floating NAV Alternative. For example, with respect to taxable MMFs, the Floating NAV Alternative will lead to realized gains and losses, thus producing tax liability and tax benefits, respectively. However, the SEC anticipates relatively small fluctuations in net asset values and it concludes that any tax burden would be minimal.
Another potential drawback identified by the SEC is whether entities who prepare financial statements in accordance with U.S. GAAP will continue to be able to treat their MMF shares as "cash equivalents" on their balance sheets.15 Under U.S. GAAP, cash equivalents are short-term, highly liquid investments that are readily convertible to known amounts of cash and that are so near to maturity that they present insignificant risk of changes in value due to changes in interest rates.16 The SEC states that the use of the Floating NAV Alternative would not preclude investors in MMFs from classifying their MMF shares as cash equivalents because (a) fluctuations in the share price would likely be insignificant and thus not inconsistent with the U.S. GAAP requirement that MMF shares be "convertible to a known amount of cash" and (b) the Floating NAV Alternative is not expected to change the risk profile of MMFs.17
The SEC decided to exempt government MMFs because such MMFs are less susceptible to the risks of heavy investor redemptions during times of financial distress. In addition, in the SEC's view, the credit risk associated with the portfolio securities held by government MMFs are particularly low and more transparent to investors than the credit risk associated with other types of MMFs.
Similarly, the SEC decided to exempt retail MMFs because the SEC perceives that retail investors are less likely to engage in mass redemptions than are commercial investors during times of financial distress. However, the SEC acknowledges the possibility that the introduction of the Treasury Temporary Guarantee Program in September 2008 may have played a large role in suppressing what might have otherwise been heavier redemptions by retail investors.
Alternative 2: Standby Liquidity Fee and Gates
The second alternative set forth in the Proposed Rules is the standby liquidity fee and gates alternative ("Liquidity Fee and Gates Alternative"). Under that alternative:
In the event that a MMF's weekly liquid assets18 fall below 15% of its total assets as of the end of any business day (the "Liquidity Threshold"):
- the MMF must impose a liquidity fee of 2% on all redemptions as of the next business day (or such lower fee that the board determines is in the best interest of the MMF) unless the board of the MMF determines that imposing such a fee would not be in the best interest of the fund;
- the MMF may impose a suspension of redemptions (i.e., a "gate") for a period up to 30 days if the MMF's board determines that a gate is in the best interest of the MMF (but may not maintain gates totaling more than 30 days during any 90-day period);19
- any such liquidity fee and/or gate would be automatically lifted once the MMF's weekly liquid assets rise back to, or above, 30% of its total assets, although the board could lift the fee and/or gate earlier if it determines that such action is in the best interest of the MMF;
- the penny rounding method of pricing would continue to be permitted, but the amortized cost method of valuation would no longer be permitted; and
- government MMFs would be exempt from the foregoing requirements but retail MMFs would not be exempt from the foregoing requirements.
The SEC characterizes the liquidity fee as the "default" option; i.e., the ordering of redemption restrictions would be (1) the liquidity fee, and (2) if that fee is not sufficiently slowing redemptions, the suspension of redemptions. The SEC chose this ordering of redemption restrictions because it believes a liquidity fee to be less disruptive to investors than a suspension of redemptions.
The SEC views the liquidity fee as a way to reduce investors' incentives to redeem during periods of financial distress (i.e., when the liquidity concerns of MMFs are most acute). For investors who nevertheless decide to redeem during periods of distress, the SEC views the collection of a liquidity fee as preventing the related costs (i.e., the cost of using cash and selling liquid securities to fund redemptions) from being shifted to investors who are slower to redeem.20
The SEC characterizes gates as being qualitatively different than liquidity fees in that gates stop redemptions in order to (1) allow MMF managers time to assess the appropriate strategy to meet redemptions, (2) permit the MMF's internal liquidity to grow as portfolio securities mature and (3) allow time for investors to assess the level of liquidity in the MMF and for investor "panic" to subside. In addition, gates provide a "circuit breaker" protection in the event that a liquidity fee is not sufficient to deter heavy redemptions.
The SEC identifies potential tax and operational costs associated with the Liquidity Fee and Gates Alternative. For example, the SEC states its understanding that the imposition of a liquidity fee would have a tax effect for investors by decreasing the gain or increasing the loss, as applicable, associated with a redemption. The SEC identifies the need to track the tax basis of a MMF share as one of the burdens associated with this alternative.
The SEC decided to exempt government MMFs for the same reasons it decided to exempt such MMFs from the Floating NAV Alternative. In addition, the SEC indicated that it wanted to ensure that there remained an option available to those investors who are unwilling or unable to invest in MMFs that could impose liquidity fees or gates.
Unlike the Floating NAV Alternative, the SEC decided not to exempt retail MMFs from the Liquidity Fee and Gates Alternative. In the SEC's view, an exemption was warranted in the case of the Floating NAV Alternative because the Floating NAV Alternative applies at all times and the related costs and burdens associated with that alternative outweigh the benefits, as retail investors are relatively less likely to engage in mass redemptions. With respect to the Liquidity Fee and Gates Alternative, the SEC reasoned that a retail exemption was not warranted because that alternative applies only when a MMF's weekly liquid assets fall below 15% of its total assets, thus leading to lower overall costs and burdens when compared with the Liquidity Fee and Gates Alternative.
Alternative 3: Combination of Floating NAV Alternative and Liquidity Fee and Gates Alternative
As described above, the SEC noted that the Floating NAV Alternative and Liquidity Fee and Gates Alternative each have somewhat different goals and related tradeoffs. Accordingly, the SEC's third alternative proposal is a combination of those two alternatives so as to give MMFs a broader range of tools to manage heavy redemptions in times of financial stress. The SEC acknowledges that along with the benefits arising from a broader range of alternatives come the additional costs and burdens associated with those alternatives.
The SEC does not propose to extend the exemptions under the combination alternative. Accordingly, government MMFs would be exempt from the combination alternative in its entirety, but retail MMFs would be exempt only from the floating net asset value component of the combination alternative.
Implications for Securitization
The implementation of any of the alternatives described above could render MMFs less attractive relative to other investments. If investors do reallocate funds from MMFs to other investment options, MMFs could become less active investors and may reduce their investments in ABCP and other short-term ABS. In addition, these alternatives could render MMFs less desirable as cash management tools for highly-rated transactions because (1) the traditional stable $1.00 share price helps to create certainty as to the level of securitization account balances over time and (b) the prospect of liquidity fees and gates threatens the unfettered access to funds typically enjoyed by MMF investors, including securitization servicers and trustees. Finally, the tax and other administrative and operational burdens associated with these alternatives will likely lead to lower yields on MMFs due to increased costs, thus further diminishing the attractiveness of MMFs as a cash management tool.
Amendments to Diversification Requirements
In an effort to further promote diversification in order to limit the exposure of a MMF to any one issuer, guarantor or demand feature, the Proposed Rules:
- require MMFs to treat certain entities that are affiliated with each other as single issuers when applying Rule 2a-7’s 5% issuer diversification requirement;
- require MMFs to treat the sponsors of ABS as guarantors subject to Rule 2a-7’s diversification requirements unless the fund’s board makes certain findings; and
- eliminate the "twenty-five percent bucket."
Current Diversification Requirements Under Rule 2a-7
Rule 2a-7 requires a MMF's portfolio to be diversified, both as to the issuers of the securities it acquires and the providers of guarantees and demand features related to those securities. Generally, MMFs must limit their investments in the securities of any one issuer of a first tier security21 (other than government securities) to no more than 5% of fund assets. However, Rule 2a-7 does not require a MMF to aggregate its exposures to entities that are affiliated with each other when measuring its exposure.
A MMF also may invest no more than 0.5% of fund assets in any one issuer of a second tier security.22 MMFs must also generally limit their investments in securities subject to a demand feature or a guarantee from any single institution to no more than 10% of fund assets; provided, that under the “twenty-five percent basket,” up to 25% of the value of securities held in a MMF's portfolio may be subject to guarantees or demand features from a single institution.
Treatment of ABS Under the Proposed Rules
Rule 2a-7's current diversification provisions require no diversification of exposure to ABS sponsors because SPEs, rather than the sponsors themselves, issue the ABS, and the support that ABS sponsors provide, implicitly or explicitly, typically does not meet Rule 2a-7's definition of a “guarantee” or “demand feature." The SEC is concerned that the experience with structured investment vehicles ("SIVs")23 suggests a potential weakness in Rule 2a-7’s diversification requirements; namely, that MMFs investing in ABS, including ABCP, rely on the ABS sponsors’ financial strength or their ability or willingness to provide liquidity, credit, or other support to the ABS.
Subject to the exception described below, the Proposed Rules would require MMFs to treat the sponsor of an SPE issuing ABS as a guarantor of the ABS subject to Rule 2a-7’s diversification limitations applicable to guarantors and demand feature providers. As a result, a MMF could not invest in an ABS if, immediately after the investment, the MMF would have invested more than 10% of its total assets in securities issued by or subject to demand features or guarantees from the sponsor of that ABS.
As a general rule, all ABS sponsors will be deemed to guarantee their ABS. This general rule is based on the SEC's belief that MMFs rely on sponsors’ financial strength or their ability or willingness to provide liquidity, credit or other support to evaluate both the creditworthiness and liquidity of ABS.24 However, an ABS sponsor would not be deemed to guarantee the ABS if the MMF's board determines that the MMF is not relying on the ABS sponsor’s financial strength or its ability or willingness to provide liquidity, credit, or other support to determine the ABS’s quality or liquidity.
Treatment of Affiliates Under the Proposed Rules
Due to the SEC's concern about the concentration of risk to a single economic enterprise and because financial distress at one issuer within an economic enterprise can quickly spread to affiliates within the same economic enterprise who may also be issuers, the Proposed Rules seek to amend Rule 2a-7’s diversification requirements to require that MMFs limit their exposure to affiliated groups, rather than to discrete issuers in isolation. Entities would be affiliated for this purpose if one controlled the other entity or was controlled by it or under common control with it. For this purpose only, control would be defined to mean ownership of more than 50% of an entity’s voting securities25
Elimination of the Twenty-Five Percent Bucket Under the Proposed Rules
The Proposed Rules seek to eliminate the so-called “twenty-five percent basket,” under which as much as 25% of the value of securities held in a MMF's portfolio may be subject to guarantees or demand features from a single institution. The SEC states that most MMFs do not use the twenty-five percent basket. Those MMFs that do use the twenty-five percent basket do not make significant use of it. For those MMFs that do use the basket, the elimination of the twenty-five percent basket is designed to reduce concentration risk by limiting the extent to which a MMF becomes exposed to a single guarantor or demand feature provider.
Implications for Securitization
The amendments to the diversification requirements could limit the ability of a MMF to invest in ABCP or other short-term ABS of larger securitization sponsors, as the MMF would no longer be permitted to consider only the issuing SPE in determining whether the MMF has satisfied Rule 2a-7's diversification requirements. The SEC has requested a wide range of comments on its proposed amendments to the diversification requirements, including whether the presumption that ABS investors rely on sponsor support is accurate.
Amendments to Stress Testing Requirements
Rule 2a-7 contains a requirement that MMFs adopt procedures providing for the periodic stress testing of their portfolios. These tests are designed to assess a MMF's ability to maintain a stable $1.00 share price based on hypothetical events, such as changes in short-term interest rates and downgrades and defaults of securities in its portfolio.
In the event that the Floating NAV Alternative is adopted, the SEC proposes to modify the stress test requirement such that it assesses whether hypothetical events could cause a MMF's weekly liquidity to fall below 15% of its total assets. In the event that the Liquidity Fee and Gates Alternative is adopted, the SEC proposes to require stress testing of both (a) a MMF's ability to maintain a stable $1.00 share price and (b) its ability to maintain weekly liquidity in excess of 15% of its total assets. If a combination of the Floating NAV Alternative and the Liquidity Fee and Gates Alternative is adopted, the SEC indicates that it would require stress testing only as to a MMF's ability to maintain weekly liquidity and not ability to maintain a stable $1.00 share price.
It is unlikely that the stress testing requirements will have significant implications for securitizations. However, to the extent that these new requirements increase costs and reduce yields to MMF investors, the requirements could be a contributing factor in making MMFs relatively less attractive as a cash management tool.
Amendments to Disclosure Requirements and Forms
The Proposed Rule contains various amendments to the disclosure and reporting requirements of Rule 2a-7. Those amendments require:
- disclosure of financial support received by a MMF from affiliated persons and other specified parties;
- disclosure of portfolio security defaults and other significant events;
- daily disclosure of daily liquid assets and weekly liquid assets;
- daily disclosure of current net asset value per share;
- enhanced disclosure of portfolio holdings; and
- quarterly disclosure by liquidity fund advisors.26
The Proposed Rules, if adopted, would have a substantial impact on nearly all participants in the MMF industry. While the Proposed Rules contain safeguards designed to prevent or mitigate the effects of heavy redemptions, those safeguards come at the price of altering one, or both, of the characteristics of MMFs most prized by investors; namely, the stable $1.00 share price and the investors' unfettered ability to redeem MMF shares. The Proposed Rules will likely also lead to compliance costs that will be significant, particularly in relation to the already narrow interest rate margins against which such costs are applied.
With respect to securitization, one possible consequence of the Proposed Rules is that MMFs may be rendered less attractive to investors than other types of investments, thus potentially reducing the level of investment made by MMFs in ABS and other securities. Another consequence may be that MMFs become less desirable as cash management tools for highly rated securitizations. Finally, the proposed amendments to the portfolio diversification requirements of Rule 2a-7 could limit the ability of MMFs to invest in ABCP and other short-term ABS of larger securitization sponsors.
We expect the SEC to receive many comments on the Proposed Rules from all of the major constituents of the MMF industry. It is likely to take many months for the SEC to issue final rules after the close of the comment period. Although it is not certain whether the Proposed Rules will be adopted in substantially their present form, it is clear that the SEC envisages major reforms for the MMF industry. Accordingly, it is important for all market participants to consider the implications of the Proposed Rules in light of their individual circumstances.