Alert October 30, 2012

OCC Publishes Final Rule Governing the Use of Amortized Cost Valuation by Short-Term Investment Funds

The OCC published a final rule (the “Final Rule”) revising the requirements imposed on banks managing short-term investment funds (“STIFs”) that value the assets of the STIFs at amortized cost, rather than mark-to-market value, for purposes of admissions and withdrawals.  This article discusses the current rule and key aspects of the revisions reflected in the Final Rule.

Under the current rule, a collective investment fund may qualify as a STIF, and therefore utilize amortized cost valuation for admissions and withdrawals (as an exception to the general requirement to use mark-to-market valuation for admissions and withdrawals) if the fund (1) maintains a dollar-weighted average portfolio maturity of 90 days  or less (taking into account interest rate resets); (2) accrues on a straight-line basis the difference between the cost of each asset and the anticipated principal receipt on maturity; and (3) holds its assets until maturity under usual circumstances.  12 CFR 9.18(b)(4)(ii)(B) (the “STIF Rule”).

Under the Final Rule, effective July 1, 2013, the weighted average portfolio maturity requirement will be reduced from 90 days to 60 days, and additional significant conditions will be imposed for a fund to qualify as a STIF.  In addition to the 60 day weighted average portfolio maturity requirement, a STIF will also be required to maintain a weighted average portfolio life maturity of 120 days or less, and will not be permitted to use interest rate resets to reduce such maturity calculation.  Also, a bank that manages a STIF will be required to calculate the difference between amortized cost and market values of the STIF’s portfolio securities at least weekly, and switch to mark-to-market valuation any time the STIF’s market value falls below a net asset value of $0.995 per participating interest (sometimes referred to as “units” herein).  These requirements imposed by the OCC are aimed at addressing the risk of principal loss by STIFs and at reducing the risks to banks that administer STIFs.

In addition to revising the STIF Rule’s portfolio maturity and valuation requirements, the Final Rule imposes additional operational requirements on bank trustees of STIFs that are subject to the Final Rule.  The written plan governing a bank’s management of a STIF will be required to include portfolio and issuer qualitative standards and concentration restrictions.  A bank managing a STIF will also be required to provide for stress tests,  to be performed at least monthly, which must include an assessment of the STIF’s ability to withstand certain destabilizing events and the magnitude of each such event that would cause the difference between the STIF’s mark-to-market valuation and amortized cost valuation to exceed $0.005 per participating interest.  The Final Rule provides that such a stress test should assess, at a minimum, the impact of a change in short-term interest rates, an increase in participant account withdrawals, a downgrade or default with respect to portfolio securities, and changes in the relative yields of applicable benchmarks.

The Final Rule will require banks managing STIFs to provide participating accounts and the OCC with significant portfolio-level and security-level information within five business days after the end of each month, including total assets under management, market value and amortized cost valuations, portfolio maturity measures, and identifying information with respect to each security.  Furthermore, a bank managing a STIF will have to adopt procedures for notifying the OCC within one business day after the occurrence of one or more of six specified significant developments with respect to a STIF, including a difference between amortized cost and mark-to-market unit values exceeding $0.0025, repricing of a STIF’s units if its mark-to-market falls below $0.995 per unit, and other events such as suspension of withdrawals from the STIF.  Finally, the Final Rule will require a bank that has suspended or limited withdrawals from a STIF and initiated liquidation of the STIF as a result of withdrawals to (1) determine that the size of the difference between amortized cost and mark-to-market unit values may cause participating accounts to experience material dilution or other unfair results; (2) formally approve the liquidation; and (3) execute the liquidation fairly and to the benefit of all participants in the STIF.

Following the proposal for revising the STIF Rule (as discussed in the April 24, 2012 Financial Services Alert), most commenters supported the revisions, but some urged the OCC to more closely track SEC Rule 2a-7, applicable to money market mutual funds (“MMMFs”).  The revisions reflected in the Final Rule were informed by revisions to SEC Rule 2a-7, although the OCC noted that differences remain due to the fact that STIFs are limited to eligible fiduciary accounts and MMMFs are retail products that may be offered to the public.  In this regard, the OCC did not adopt the daily and weekly liquidity requirements of SEC Rule 2a-7, although the Final Rule does require the adoption of liquidity standards that include provisions to address contingency funding needs by the STIF.  The preamble to the Final Rule provides additional commentary by the OCC on those liquidity standards.

The Final Rule is virtually identical to the proposed rule, and the OCC declined to accept the requests of certain commenters that a grandfathering provision for securities held by a STIF on the publication date or effective date of the Final Rule be excluded from the 60-day weighted average portfolio maturity and 120-day weighted average portfolio life maturity calculations and that the period for reporting significant developments be extended from one business day to five business days.

The Final Rule applies to the management of STIFs by national banks, federal savings associations, federal bank branches of foreign banks and any state chartered banks in states that require comparable funds to comply with the STIF Rule.  As discussed herein, the revisions reflected in the Final Rule impose significant additional obligations and costs on fiduciaries managing STIFs.  Although the revisions will likely reduce the risks associated with STIFs, the income generated by STIFs complying with the Final Rule will also be reduced, disadvantaging banks subject to the Final Rule in comparison with banks not subject to such rule.

The Final Rule’s requirement that a STIF reprice the unit values when its mark-to-market value falls below $0.995 per unit and effect admissions and withdrawals at that lower mark-to-market value (rather than a constant value of $1.00 per unit) may create operational and administrative issues for bank collective and common trust funds investing in the STIF.  In this regard, the Final Rule does not provide any exclusion to the foregoing requirement even if the trustee of the STIF has concluded based on all the facts and circumstances that a drop in the mark-to-market value below $0.9950 per unit is temporary and will quickly reverse (for example, in a situation in which a geopolitical event or natural disaster causes a sharp but short-lived drop in the mark-to-market value of the STIF).

Goodwin Procter LLP has advised a number of clients on matters related to the current STIF Rule and the Final Rule and would be pleased to address any questions you have regarding the revisions discussed herein and strategies for addressing these revisions, including those related to avoiding some of the potential adverse consequences of the Final Rule.  We also would be pleased to address potential alternative approaches to dealing with the significant impact of the Final Rule on STIFs and their participants.