On June 5, 2013, the SEC voted unanimously to propose changes to the manner in which money market funds (“MMFs”) are regulated. The proposed changes contemplate two substantive reform regimes (the “First and Second Alternatives,” as described below), which could be adopted singly or in some combined form. The proposed changes also contemplate heightened disclosure, asset diversification, stress-testing and other requirements for MMFs.
The proposed compliance dates are as follows: generally, the First Alternative would become effective two years after approval of final rules; the Second Alternative would become effective one year after final approval; and the other proposals would become effective nine months after final approval. The comment period ends on September 17, 2013. With respect to any proposed amendments requiring certain historical disclosures, the SEC has proposed that MMFs would be required only to disclose events that occur following the respective compliance date.
The SEC’s proposed changes, certain of which are summarized below, represent the latest step in the lengthy and ongoing public debate regarding the regulation of MMFs in the post-financial crisis era. An in-depth analysis of the proposed changes will be provided in an upcoming Legal Update.
Summary of the Two Proposed Alternatives for Regulatory Reform
Currently, Rule 2a-7 allows MMFs to use the “amortized cost” method of valuing their portfolio securities (acquisition cost, with any premium or discount amortized to remaining maturity) and the “penny-rounding” method of determining their share price (rounding to the nearest penny). Combined, the amortized cost and penny-rounding methods enable MMFs to maintain a stable share price, typically $1.00.
Under both the First and Second Alternatives, MMFs would no longer be able to use the amortized cost method of valuing their portfolio securities (other than to the same limited extent that other mutual funds are permitted to do so), and instead would be required to use daily market prices in determining net asset value (“NAV”). Further, under the First Alternative, certain MMFs would no longer be permitted to use the penny-rounding method of determining share price, resulting in a “floating” NAV. The Second Alternative contemplates imposing certain restrictions on redemptions if liquidity levels fall, but maintains penny-rounding. Each alternative is briefly summarized below.
First Alternative: Floating NAV – Under the First Alternative, non-governmental institutional MMFs would no longer be permitted to use the penny-rounding method. Instead, these MMFs would be required to round their share prices more precisely. For example, an MMF with a target share price of $1.00 would be required to round prices (and process share purchases and redemptions) to the 4th decimal place (i.e., $1.0000).
Fixed NAV allows businesses to use MMFs as cash-management vehicles without incurring taxable gains or losses. Floating NAV would create daily gains and losses for such uses. Under the present “wash sale rules,” losses on securities repurchased within 30 days are disallowed. To avoid burdening the cash management use of MMFs, the IRS has posted a notice proposing to exempt small losses on the sale of MMF shares from the wash sale rules.
“Government” and “retail” MMFs would still be able to round their share prices to the nearest penny (i.e., use the penny-rounding method), which would generally enable these MMFs to continue to maintain a stable share price, e.g., $1.00. Government MMFs would be defined as funds that invest at least 80% of their assets in cash, government securities or fully collateralized repurchase agreements. Retail MMFs would be defined as funds that, under most circumstances, limit a given investor’s withdrawals to $1 million per day.
As mentioned above, for all MMFs, amortized cost valuation would no longer be permitted; daily market valuations would be required.
Second Alternative: Liquidity Fees and Redemption Gates – Under the Second Alternative, if a non-governmental MMF’s “weekly liquid assets” (as defined in Rule 2a-7) falls below 15% of its total assets, the MMF must impose a liquidity fee of 2% on all redemptions, unless the MMF’s board of directors (including a majority of its independent directors) determines that imposing such a fee would not be in the MMF’s best interest (or determines that a lower fee would be in the MMF’s best interest). The board also would have the power to suspend redemptions (impose a “gate”) for a limited period of time if the board determines that doing so would be in the MMF’s best interest.
Government MMFs would be excluded from these fee and gate requirements, but would be allowed to impose a fee or gate if the MMF’s ability to do so is disclosed in its prospectus.
Under the Second Alternative, MMFs would be able to continue using the penny-rounding method, enabling MMFs to generally maintain a stable share price (although, as mentioned above, amortized cost valuation would no longer be permitted).
Summary of Certain Additional Proposals
New Form N-CR – MMFs would be required to promptly disclose certain events on this new form, such as: the imposition or removal of fees or gates (assuming the Second Alternative is adopted), material defaults on portfolio securities, weekly liquidity levels falling below 15%, receipt of financial support from the MMF’s sponsor or other fund affiliate and, for MMFs permitted to maintain a stable share price via penny-rounding, the market NAV per share declining significantly below the intended stable price.
Website Disclosures – On a daily basis, MMFs would be required to disclose receipt of financial support from the sponsor or other fund affiliate, the levels of daily and weekly liquid assets, portfolio holdings, daily net inflows and outflows, and the daily market NAV per share.
Revised Form N-MFP – Form N-MFP would require additional disclosures regarding an MMF’s portfolio holdings, as well as disclosures regarding the MMF’s daily and weekly liquid assets and cash holdings, and weekly gross subscriptions and redemptions. This information would be made available immediately, as opposed to the current 60-day delay.
Revised Form PF – Advisers managing at least $1 billion in aggregate money market and liquidity fund assets would be required to disclose on Form PF information similar to that which would be required on Form N-MFP.
SAI Disclosure of Financial Support – Under the proposal, an MMF would be required to disclose in the statement of additional information past instances of financial support received from the sponsor or other fund affiliates.
Treatment of Affiliates for Purposes of Rule 2a-7 Diversification – Under current Rule 2a-7, an MMF generally may not invest more than 5% of its assets in a single issuer. Under the proposal, MMFs would be required to aggregate their investments in affiliated entities for purposes of this 5% limit. For this purpose, an entity would be affiliated with another if it controlled the other entity, was controlled by it, or was under common control with it, and control would be defined to mean ownership of more than 50% of an entity’s voting securities.
Removal of “25% Basket” for Guarantee and Demand Feature Diversification – Rule 2a-7 currently applies a 10% diversification limit on guarantees and demand features, but that 10% limit applies only to 75% of an MMF’s total assets. This permits an MMF to have as much as 25% of its portfolio be subject to guarantees or demand features from a single institution (commonly called the “25% bucket”). Under the proposal, the 25% bucket would be removed.
Diversification for Sponsors of Special-Purpose Entities – Under current Rule 2a-7, each special-purpose entity that issues asset-backed securities (“ABS”) is considered a separate issuer. As a result, an MMF’s portfolio could consist entirely of securities issued by multiple special-purpose entities, all with a single sponsor on which the MMF could seek to rely for liquidity and capital support.
Under the proposal, MMFs would be required to treat the sponsor of a special-purpose entity that issues ABS as a guarantor of the ABS subject to Rule 2a-7’s diversification limitations applicable to guarantors and demand feature providers (i.e., the 10% diversification limit described above). In other words, the 10% requirement would be extended to apply to special-purpose entities with the same sponsor. The board of the MMF would be allowed to waive this requirement by determining that the MMF is not relying on the sponsor of the special-purpose entities to establish or guarantee the quality of the ABS issued by the special-purpose entities.
Additional Stress Testing – Under the proposal, an MMF would be require to stress-test against, among other things, the MMF’s weekly liquid assets falling below 15% of its total assets.