Alert July 30, 2013

SEC Staff Issues Guidance on Counterparty Risk Management Practices for Tri-Party Repurchase Agreements

The Staff of the SEC’s Division of Investment Management recently issued guidance (the “IM Guidance Update”) for mutual funds and their investment advisers relating to the use of tri-party repurchase agreements (“Tri-Party Repos”).  While the IM Guidance Update may be useful to any mutual fund that engages in Tri-Party Repos, the Staff recognizes that money market funds (“MMFs”) may find it to be particularly relevant in light of their significant holdings of Tri-Party Repos when compared to non-money market mutual funds.

Tri-Party Repos are typically structured as repurchase agreements where the fund purchases securities from a dealer counterparty subject to the dealer counterparty’s agreement to repurchase the securities at an agreed-upon date and price.  In a Tri-Party Repo, as contrasted with a bi-lateral arrangement, a third-party clearing bank facilitates settlement of the repurchase agreement by, for example, transferring securities and/or cash between the dealer counterparty’s and the MMF’s accounts at various stages of the Tri-Party Repo.

The IM Guidance Update provides the Staff’s views on the types of legal and operational considerations that a MMF and its investment adviser should consider if a counterparty fails and defaults on its obligations under a Tri-Party Repo.  The IM Guidance Update focuses on the importance of advance planning for the handling of a default of a Tri-Party Repo and cites the following examples of prudent risk management practices in this context:

  • Review the master repurchase agreements and related documentation to consider any specified repo default procedures.  The IM Guidance Update states that the MMF may want to consider preparing templates of any notifications or other documents that may be necessary in the event of a default.
  • Consider operational aspects of managing a default.  The IM Guidance Update states that a MMF may want to review the MMF’s systems and those of its custodian to ensure that they are “capable of appropriately holding, valuing, trading and accounting for the collateral underlying” the MMF’s repurchase agreements.
  • Consider, to the extent possible, whether there are potential legal considerations under the Investment Company Act of 1940 (the “1940 Act”) or otherwise that the fund could consider in advance or will need to evaluate at the time of any repo default.  The IM Guidance Update discusses a number of considerations under Rule 2a-7 under the 1940 Act, which is the rule that provides the regulatory framework applicable to MMFs.  In this regard, the IM Guidance Update recognizes that Rule 2a-7’s limitations on a MMF’s portfolio (for example, with respect to maturity and the types of securities eligible for MMF investments, so called “eligible securities”) may present issues if a fund is forced to accept a Tri-Party Repo’s underlying collateral.  The IM Guidance Update also notes that the MMF should identify any required notifications to the SEC and/or the MMF’s board of directors as a result of a default.  In addition, the IM Guidance Update highlights the possibility that a defaulted repo might trigger an automatic stay under the U.S. Bankruptcy Code or federal banking laws and regulations.