Alert July 07, 2009

Proposed SEC Amendments to Rules Affecting Money Market Funds

As discussed in the June 30, 2009 Alert, the SEC has proposed significant amendments to Rule 2a-7 under the Investment Company Act of 1940, as amended (the “1940 Act”).  Rule 2a-7 sets forth the principal requirements applicable to registered investment companies operating as money market funds.  The SEC also has proposed amendments to certain other rules, as well as two new rules, that if adopted, also will affect money market funds.  This article summarizes the principal elements of the proposal reflected in the formal release, which is available at http://sec.gov/rules/proposed/2009/ic-28807.pdf.

Principal Changes to Rule 2a-7.  Rule 2a-7 currently applies risk-limiting provisions to all money market funds in three areas: (a) the credit quality of the securities acquired, (b) the maturity of the securities acquired and the weighted average maturity of the portfolio as a whole, and (c) the diversification of the fund’s holdings among non-governmental issuers, guarantors and providers of certain liquidity rights commonly referred to as “demand features.”  In addition, the SEC historically has interpreted Section 22(e) of the 1940 Act to restrict a money market fund from investing more than 10 percent of its assets in illiquid securities.  (Section 22(e) generally requires that a registered investment company may not suspend redemptions, and it must pay shareholders their redemption proceeds within 7 days.)  The proposed amendments to Rule 2a-7 would make the following principal changes in each of these areas:

Quality Limitations

  • Acquisitions of Second Tier Securities Prohibited.  Under the proposed amendments, a money market fund would no longer be permitted to acquire “second tier securities,” that is, securities that at the time of acquisition have short‑term ratings from the requisite nationally recognized statistical ratings organizations (“NRSROs”) in the second highest short-term ratings category, or unrated securities of comparable quality.  In other words, a money market fund would only be able to purchase the highest quality securities, which currently are referred to as “first tier securities” under Rule 2a-7.
  • Unrated Securities as Eligible Securities.  Under the proposed amendments, if an unrated security had at the time of issuance a remaining maturity of more than 397 days, but a remaining maturity of 397 days or less and has received a long-term rating that is not within one of the two highest long-term rating categories, it may be an “eligible security” (that is, eligible for purchase by a money market fund) only if it has received a long-term rating from the requisite NRSROs in one of the two highest long-term rating categories.  The current definition of an eligible security permits an unrated securities that has received a long-term rating that is not in one of the three highest long-term rating categories to be an eligible security only if it has received a long-term rating from the requisite NRSROs in one of the three highest long-term rating categories.
  • Required Board Reassessments of Credit Quality.  Under the proposed amendments, a money market fund’s board only would be required to reassess the credit quality of a security (that is, whether the security continues to present minimal credit risks) if, subsequent to the money market fund’s acquisition of an unrated security, the board becomes aware that the unrated security has received a rating from any NRSRO below its highest short-term rating category.  Rule 2a-7 currently requires the board to reassess the credit quality of a security if, subsequent to acquisition, the security ceases to be a first tier security or the fund’s adviser becomes aware that an unrated security or a second tier security has received a rating from an NRSRO below the NRSRO’s second highest short-term rating category.

Maturity Limitations

  • Reduced Weighted Average Maturity Limit.  The proposed amendments would reduce the upper limit for the weighted average maturity of a money market’s portfolio from 90 days to 60 days.
  • New Weighted Average Life Maturity Limit.  The proposed amendments would introduce a “weighted average life maturity” limit of 120 days.  Weighted average life maturity would be calculated without taking into account provisions of Rule 2a‑7 that allow a fund holding’s maturity to be shortened when determining whether the weighted average maturity limit has been met.  The practical effect of this limit would be to restrict a money market fund’s investments in long-term adjustable rate securities.

Diversification Limitations

  • Repurchase Agreement Deemed to be “Collateralized Fully.”  A money market fund may treat the acquisition of a repurchase agreement as the acquisition of the collateral underlying the repurchase agreement for purposes of Rule 2a-7’s diversification requirements, provided that the repurchase agreement is “collateralized fully,” as that term is defined in Rule 5b-3 under the 1940 Act.  Under the proposed amendments, a repurchase agreement would be collateralized fully only if the collateral consists of cash items and/or government securities and the fund’s board has evaluated the creditworthiness of the seller of the repurchase agreement.  Under Rule 2a-7 currently, a repurchase agreement may be collateralized fully if the collateral consists of securities that at the time the repurchase agreement is entered into are rated in the highest short-term ratings category by the requisite NRSROs or are unrated securities of comparable quality.  Rule 2a-7 currently contains no express obligation to evaluate the creditworthiness of the repurchase agreement seller if the repurchase agreement is otherwise collateralized fully.

New Liquidity Limitation

  • Under the proposed amendments, a new liquidity limitation based on a money market fund’s right to receive cash would replace the current 10 percent illiquid securities limitation, which is based on a fund’s ability to find a buyer for its holdings.  Specifically, all money market funds would have to maintain daily and weekly liquid assets “sufficient to meet reasonably foreseeable shareholder redemptions” in light of the fund’s obligations under Section 22(e) of the 1940 Act and any commitment that the fund has made to its shareholders.  In addition, under the proposed amendments:
    • Board Determination-Retail/Institutional Fund.  A money market fund’s board would have to determine at least annually whether a fund should be designated as a “retail fund” or an “institutional fund,” that is, whether the money market fund is intended primarily for retail investors or institutional investors.
    • Retail Fund Obligations.  A money market fund designated by its board as a “retail fund” would have to maintain: (a) a minimum of 5% of its total assets in cash, direct obligations of the U.S. government and securities that will mature or are subject to a demand feature that is exercisable and payable within one business day (but this requirement would not apply to tax exempt money market funds), and (b) a minimum of 15% of its total assets in cash, direct obligations of the U.S. government and securities that will mature or are subject to a demand feature that is exercisable and payable within five business days.  These tests would have to be met each time the fund acquired a security.
    • Institutional Fund Obligations.  A money market funds designated by its board as a “institutional fund” would have to maintain: (a) a minimum of 10% of its total assets in cash, direct obligations of the U.S. government and securities that will mature or are subject to a demand feature that is exercisable and payable within one business day (but this requirement would not apply to tax exempt money market funds), and (b) a minimum of 30% of its total assets in cash, direct obligations of the U.S. government and securities that will mature or are subject to a demand feature that is exercisable and payable within five business days.  These tests would have to be met each time the fund acquired a security.
    • Identifying Investor Risk Characteristics.  A money market fund would have to adopt policies and procedures pursuant to Rule 38a-1 under the 1940 Act (the rule that requires registered funds to adopt compliance programs) to insure that the fund is complying with its general obligations under Section 22(e) to assure that it has sufficient liquidity to meet the needs of its shareholders.  Specifically, the policies and procedures would need to assure that the fund was taking appropriate efforts to determine the risk characteristics of the fund’s shareholders, including those shareholders who hold fund shares through omnibus accounts, “portals” or other arrangements that provide the fund with little or no transparency with respect to the ultimate shareholder.

Other Proposed Changes to Rule 2a-7

The proposed amendments also include the following:

  • Board Determination on the Fund’s Capacity to Redeem Shares.  A money market fund’s board would have to determine at least annually that the fund or its transfer agent has the capacity to redeem and sell fund shares at a price per share calculated using market prices of fund assets, even if, for example, the use of market prices would result in a net asset value that differs from the stable net asset value the fund seeks to maintain;
  • Notification to the SEC.  A money market fund would have to notify the SEC if an affiliated person acquires any security from the fund in reliance on Rule 17a-9 under the 1940 Act (proposed amendments to Rule 17a-9 are discussed below).  Currently, a money market fund must notify the SEC only if an event of default or event of insolvency occurs with respect to the issuer of a security, guarantee or demand feature that accounts for at least 0.5% of the fund’s total assets.
  • Stress Testing.  A money market fund using the amortized cost method of valuation would have to adopt procedures for periodic testing of its ability to maintain a stable net asset value per share upon the occurrence of certain specified hypothetical events, including changes in interest rates, increases in shareholder redemptions, downgrades and defaults of portfolio securities, and the widening or narrowing of spreads between yields on appropriate benchmarks that the fund has selected for overnight interest rates and commercial paper and other types of instruments held by the fund.  In addition, a money  market fund would have to report the results of its testing to the board, and the fund’s investment adviser would have to provide an assessment of the fund’s ability to withstand the events that are reasonably likely to occur within the following year.  The fund also would have to retain copies of its periodic test results and its adviser’s assessments for at least 6 years, 2 years in an easily accessible place.
  • Public Disclosure.  A money market fund would have to report its portfolio holdings monthly to the SEC and post them on the fund’s public website within 2 business days following month end.

Proposed Changes to Other Rules under the 1940 Act 

The SEC’s proposal includes two new rules under the 1940 Act and amends two existing 1940 Act rules (other than Rule 2a-7) as follows:

  • Transactions with Affiliates.  Proposed amendments to Rule 17a-9 under the 1940 Act would permit an affiliated person of a money market fund to purchase from the fund a security that remains an eligible security if the purchase price were paid in cash and were equal to the greater of the amortized cost or market price.  In addition, if the affiliated person sold the security for a higher price, the affiliated person would have to pay the fund the difference between the sale price and the amount paid to the fund.  Currently, Rule 17a-9 only permits affiliated persons from purchasing from a money market fund a security that no longer is an eligible security.
  • Redemptions.  Proposed Rule 22e-3 under the 1940 Act would exempt a money market fund from the requirements of Section 22(e) of the 1940 Act (as discussed above) if (a) the money market fund’s market-based net asset value per share is less than its stable net asset value per share, (b) the fund’s board, including a majority of its disinterested directors, has approved the liquidation of the fund, and (c) the fund, prior to suspending redemptions, notifies the SEC of its decision to suspend redemptions and liquidate its portfolio.  The proposed rule also would, if adopted, exempt from the requirements of Section 22(e) a fund that has acquired shares of a money market fund pursuant to Section 12(d)(1)(E) of the 1940 Act (that is, the acquiring fund is a feeder fund in a master-feeder complex), provided that the acquiring/feeder fund also notifies the SEC that it has suspended redemptions.  Proposed Rule 22e-3 is based in part on Temporary Rule 22e-3T under the 1940 Act (discussed in the October 28, 2008 Alert), which generally exempts a fund from the requirements of Section 22(e) if the fund is participating in the U.S. Treasury’s Temporary Guarantee Program for Money Market Funds and is liquidating in accordance with the terms of that program.
  • Monthly Portfolio Reporting.  Proposed Rule 30b1-6 under the 1940 Act would require a money market fund to file within two business days after the end of each month a schedule of its investments on new Form N-MFP.  To avoid duplicative reporting, the SEC has proposed related amendments to Rule 30b1-5 under the 1940 Act.  Under amended Rule 30b1-5, a money market fund would be exempt from the requirement to provide a schedule of its investments in response in its reports on Form N‑Q for its first and third quarters, but would still be subject to Form N-Q’s controls/procedures and certification requirements.

Request for Comment on Measures Not Proposed.  The SEC has not proposed, but is asking for comment on other possible charges to money market fund regulation, including, among others, the following:

  • Investments in SIVs and Other Asset Backed Securities.  Whether, and if so, how the SEC should amend Rule 2a-7 to address risks presented by structured investment vehicles (commonly known as SIVs) and asset backed securities;
  • Reducing the Maximum Permitted Maturity Applicable to Non-Governmental Securities.  Whether Rule 2a-7 should reduce the maximum permitted maturity for non-governmental securities from 397 days to 270 days;
  • Public Disclosure of Shadow Prices.  How investors in money market funds might react to the disclosure of market-based values for fund holdings (that is, the values assigned as part of the process of “shadow pricing” currently required under Rule 2a-7 as a means of testing the deviation of a money market fund’s net asset value based amortized cost from its net asset value based on market values) and related consequences for money market funds themselves;
  • Elimination Amortized Cost Method of Valuation.  Whether the ability to use the amortized cost method of valuation should be eliminated;
  • Required In-Kind Redemptions.  Whether money market funds should be required to satisfy redemption requests in excess of a certain size through in-kind redemptions.
Public Comment.  Comments on the proposed amendments and proposed new rules are due by September 8, 2009.