On November 13, 2012, the Financial Stability Oversight Council (the “FSOC”) published proposed recommendations for money market mutual fund (“MMF”) reform for public comment. As further discussed below, the FSOC’s proposal sets forth three alternative recommendations for MMF reform: (i) a floating net asset value (“NAV”), (ii) a stable NAV with an NAV buffer and minimum balance at risk and (iii) a stable NAV with an NAV buffer and other measures. According to the FSOC, the proposal seeks to address “structural vulnerabilities of MMFs that leave them susceptible to destabilizing runs.”
The FSOC issued the proposal pursuant to Section 120 of the Dodd-Frank Act, which gives the FSOC the authority to issue recommendations to primary financial regulatory agencies to apply new or heightened standards if current activities exist that could create or increase the risk of significant liquidity, credit or other related problems in the U.S. financial markets. The proposal follows the August 2012 announcement of then-SEC Chairman Mary Schapiro that the majority of the SEC commissioners would not support a staff proposal to reform the structure of MMFs. For further discussion of the SEC Chairman’s statement, please see the September 26, 2012 Davis Polk Investment Management Regulatory Update.
The FSOC’s three alternative recommendations for MMF reform are as follows:
Floating NAV. The first recommendation would require MMFs to have a floating NAV that would fluctuate based on the value of the underlying portfolio holdings, rather than a stable NAV of $1.00 per share. This recommendation would require, among other things, removing the provisions of Rule 2a-7 of the Investment Company Act that allow MMFs to use the amortized cost method of valuation and the penny-rounding method of pricing to maintain a stable NAV. The FSOC recommended allowing existing MMFs to maintain a stable NAV for a phase-out period, potentially lasting as long as five years, and prohibiting new share purchases in the grandfathered stable-NAV MMFs after a predetermined date.
According to the FSOC, one advantage of a floating NAV is that investors would be more accustomed to fluctuations in NAV and, therefore, less likely to redeem en masse in the event that the MMF suffers losses. However, the FSOC acknowledged that this recommendation has certain disadvantages, including that significant tax, accounting and operational issues would need to be addressed in order to transition MMFs from a stable NAV to a floating NAV.
Stable NAV with NAV Buffer and Minimum Balance at Risk. The second recommendation would require MMFs to have an NAV buffer in order to absorb daily variations in the value of the underlying portfolio holdings and to allow the MMF to maintain a stable NAV. The size of the NAV buffer would be a tailored amount of assets of up to 1% in excess of those needed for a MMF to maintain a $1.00 share price. The size of the NAV buffer would depend on the riskiness of the MMF’s assets. The FSOC recommended a one-year transition period to establish one-half of the buffer and a two-year transition period to establish the full buffer.
The NAV buffer requirement would be paired with a minimum balance at risk (“MBR”) requirement, whereby MMFs would be required to hold back a redeeming investor’s MBR, calculated as 3% of the investor’s highest account value in excess of $100,000 during the previous 30 days, for a 30-day period. Redemptions that leave the investor’s remaining balance with at least the MBR amount would not be subject to the 30-day delay. Any losses suffered by a MMF in excess of its NAV buffer would be first absorbed by the MBRs of investors that redeemed during the prior 30-day period.
The NAV buffer and MBR requirements would not apply to Treasury MMFs (i.e., MMFs that invest at least 80% of their assets in cash, treasury securities and treasury repos), and the MBR requirement would not apply to investors with account balances of less than $100,000.
According to the FSOC, an advantage of this alternative is that the MBR requirement would create a disincentive for investors to redeem when an MMF is under stress (since their MBRs would be the first to bear any losses in excess of the MMF’s NAV buffer) and would provide some protection for nonredeeming investors since they would not be forced to bear all of the MMF’s losses that exceed its NAV buffer. However, the FSOC also acknowledged that this recommendation has several disadvantages, including that the NAV buffer and MBR would likely involve operational and technology costs.
Stable NAV with NAV Buffer and Other Measures. The third recommendation would require an NAV buffer similar to the one required under the second recommendation, but this buffer would be sized at 3% instead of 1% in order to provide more fulsome loss-absorption capacity. The NAV buffer could be combined with other measures to enhance the MMF’s loss-absorption capacity and mitigate run vulnerabilities such as “more stringent investment diversification requirements, increased minimum liquidity levels, and more robust disclosure requirements.” Due to the size of this buffer, the FSOC recommended a multiyear transition period, with a one-year transition period to establish one-sixth of the buffer and a two-year transition period to establish one-third of the buffer.
According to the FSOC, the three proposed recommendations are not necessarily mutually exclusive but may be implemented in combination to address MMFs’ structural vulnerabilities. As an example, the proposal indicated that an MMF could be permitted to use a floating NAV or, if it prefers to maintain a stable NAV, implement the measures in the second or third recommendation.
Comment Period. The comment period ends on January 18, 2013. The FSOC will consider the comments and determine whether to issue a final recommendation to the SEC. If the FSOC issues a final recommendation, then, pursuant to the Dodd-Frank Act, the SEC will be required to either implement the FSOC’s recommendations (or similar recommendations that the FSOC deems acceptable) or provide a written explanation to the FSOC as to why it has not followed the FSOC’s recommendations.