Alert April 28, 2009

ICI Recommends New Regulatory and Oversight Standards for Money Market Funds

In response to the recent turmoil involving the money market generally and money market funds in particular, the Investment Company Institute (the “ICI”) in November 2008 formed a working group of leading industry executives (the “Working Group”) to develop recommendations to improve the functioning of the money market and the operation and regulation of funds investing in that market.  The ICI’s Board of Governors recently adopted without modification all 24 of the Working Group’s recommendations.  The Independent Directors Council, among others, has endorsed the Working Group’s recommendations.

The Working Group’s primary focus was on money market funds, i.e., registered investment companies that comply with Rule 2a-7 under the Investment Company Act of 1940 (the “1940 Act”).  Rule 2a-7 allows a registered investment company to maintain a stable net asset value per share by exempting it from the 1940 Act’s requirement that for pricing fund shares for purchases and redemptions, the fund’s portfolio securities should be valued at market quotations if readily available, and otherwise at fair value.  To comply with the rule, however, a fund must meet strict requirements relating to the quality and length of maturity for its portfolio securities, as well as overall portfolio diversification.  In addition, a registered investment company may not call itself a money market fund or have a similar name unless it complies with Rule 2a-7.  Among the Working Group’s recommendations were recommendations to help differentiate money market funds from U.S. and offshore collective investment schemes that compete with money market funds but which do not follow some or all of Rule 2a-7’s risk-limiting requirements.

The Working Group’s recommendations expressly address two themes.  First, money market funds should be better positioned to sustain prolonged and extreme redemptions pressures.  Second, if a run on a money market fund should occur, the run should be stopped immediately and all investors in the fund treated fairly.  The Working Group’s recommendations are as follows:

Liquidity Requirements and Stress Testing:

  • The SEC should amend Rule 2a-7 to require taxable money market funds to meet a minimum daily liquidity under which a standard 5% of a fund’s assets would be held in securities accessible within one day.
  • The SEC should amend Rule 2a-7 to require all money market funds to meet a minimum weekly liquidity under which a standard 20% of a fund’s assets would be held in securities accessible within 7 days.
  • The SEC should amend Rule 2a-7 to require all money market funds to “stress test” their portfolios regularly to assess a portfolio’s ability to meet hypothesized levels of credit risk, shareholder redemptions, and interest rate changes.

Portfolio Maturity:

  • The SEC should amend Rule 2a-7 to reduce the weighted average maturity limitation for money market funds from 90 days to 75 days.
  • The SEC should amend Rule 2a-7 to require that money market funds also meet a new weighted average maturity requirement, which the Working Group refers to as “spread WAM.”  For spread WAM purposes, a security’s maturity is its stated final maturity date or the date on which the fund may demand payment of principal and interest (i.e., without consideration of any interest rate reset dates of variable- and floating-rate securities).  Under the Working Group’s recommendation, a money market fund’s spread WAM could not exceed 120 days.

Credit Analysis:

  • The SEC should amend Rule 2a-7 to require money market fund advisers to establish a “new products” or similar committee that would review and approve new structures prior to investment by their funds.
  • A money market fund’s adviser should consider and, when appropriate, follow best practices in connection with its minimal credit risk determinations.
  • The SEC should retain Rule 2a-7’s references to nationally recognized statistical rating organizations, or NRSROs, as an important “floor” on permissible investments. 
  • The SEC should amend Rule 2a-7 to require money market fund advisers to designate and publicly disclose, pursuant to procedures approved by the fund’s board of directors, a minimum of three NRSROs that the fund’s adviser will monitor for purposes of determining eligibility of portfolio securities.

Assessments of Client Risk:

  • The SEC should require money market funds to develop procedures for admitting shareholders to their funds to ensure, to the extent possible, that funds (a) understand the expected redemption practices and liquidity needs of those investors, or (b) when such information is not available, mitigate possible adverse effects that may result from such unpredictability.
  • The SEC should require money market funds to post monthly website disclosures of client concentration levels by type of client and the risks that such concentration, if any, may pose to the fund.

Suspension of Redemptions:

  • A money market fund’s board, including its independent directors, should be authorized to suspend under exigent circumstances fund redemptions and purchases for 5 business days if a fund has broken, or the board reasonably believes the fund may be about to break, a dollar so that the fund may (a) seek credit support or otherwise address the net asset value, or (b) determine to suspend redemptions permanently and liquidate the fund.
  • The SEC should adopt a rule, or make temporary Rule 22e-3T under the 1940 Act permanent, to permit a money market fund permanently to suspend redemptions upon the fund board’s decision to liquidate the fund.  Temporary Rule 22e-3T was discussed in the November 25, 2008 Alert.

Disclosure Regarding Money Market Funds and Similar Unregistered Products:

  • Money market funds should be required to reassess and, if appropriate, revise the risk disclosures they provide to investors and the markets.
  • The SEC should require money market funds to provide monthly website disclosure of portfolio holdings.
  • The SEC should adopt a rule under the Investment Advisers Act of 1940 designed to reduce investor and market confusion about funds that appear to be similar to money market funds, but do not comply with the risk-limiting provisions in Rule 2a-7 applicable to money market funds.  The new rule would apply to investment advisers to collective investment schemes that are not registered investment companies.

Government Oversight:

  • The money market industry should work with the appropriate government entity to develop a nonpublic reporting regime for all institutional investors in the money market to report data that would assist the government entity to fulfill its mission of overseeing the markets as a whole.
  • The SEC should formalize a program under which SEC staff would monitor each money market fund category for funds whose performance (excluding the effect of fees) clearly exceeds their peers’ during any month and determine the reasons for such outperformance.  The program would also monitor an additional 10 randomly selected funds each month.

Modifications to Rule 17a-9:

  • The SEC should amend Rule 17a-9 under the 1940 Act to allow an affiliated person of a money market fund to purchase an “Eligible Security” from a fund.  Section 17(a) of the 1940 Act prohibits an affiliated person of a registered investment company from acting as a principal in certain transactions with the registered investment company.  Rule 17a-9 is an exemption from Section 17(a), and it currently permits an affiliated person of a money market fund to purchase from the fund a security that no longer is an Eligible Security.
  • The SEC should amend Rule 2a-7 to require nonpublic notice to the SEC of any affiliated purchase in reliance on Rule 17a-9.

Government Programs:

  • The U.S. Treasury should extend the Treasury Guarantee Program until the program expires by its terms on September 18, 2009.  The U.S. Treasury already has taken this step as reported in the March 31, 2009 Alert.
  • The SEC staff should be given the authority to reinstate no-action relief permitting money market funds to use amortized cost for shadow pricing certain securities, under specified market conditions (as described in the October 14, 2008 Alert), either at the staff ‘s own motion or upon request by the industry. 

Forward-Looking Enhancements:

  • The SEC should amend Rule 2a-7 to eliminate “Second Tier Securities” from the rule’s definition of an Eligible Security. 
  • The SEC should modernize Rule 2a-7 to reflect the appropriate oversight role for money market fund boards of directors.  The Working Group noted that currently Rule 2a-7 only imposes on fund boards a number of responsibilities, many of which it expects the boards to delegate. 

Recommendations from Other Sources:  The Working Group also examined a number of recommendations from other sources, including (a) requiring money market funds to “float” their net asset values per share, instead of permitting them to maintain a stable net asset value per share, (b) subjecting money market funds to minimum capital requirements, (c) separating money market funds into those that are intended for retail clients and those that are intended for institutional clients and (d) giving more authority to money market funds to permit in-kind redemptions under certain circumstances.  The Working Group stated that it elected not to endorse any of those other recommendations.

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Some of the Working Group’s recommendations probably will be adopted without much criticism.  The SEC already issues, for example, no-action letters relating to purchases of Eligible Securities by affiliated persons, which is similar to the Working Group’s Rule 17a-9 recommendation.  We expect, however, that other recommendations of the Working Group are likely to encounter objections from certain quarters.  In particular, we expect that money market funds distributed primarily through third-party distribution channels will object to any proposal that would require them to develop procedures for admitting shareholders.  Investment advisers to unregistered funds that compete with money market funds also would probably object to any proposal that limits or otherwise restricts their management of those funds, especially as those unregistered funds are not intended for sale to retail investors, but only to institutional investors, who are assumed to have the sophistication to protect their own interests.