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Changes to Money Market Funds Are Meant to Soften Market Shocks

The SEC issued a final rule that is expected to significantly change the way money market funds operate.The reforms include a requirement that prime institutional funds float their share prices and are intended to reduce the risk of investor runs during market sell-offs.Funds will have permission to limit investors’ ability to redeem shares during downturns.

The SEC issued Release No. 33-9616,Money Market Fund Reform; Amendments to Form PF,on July 23, 2014, shortly after voting 3-2 to approve the changes.

The rule is expected to institute the market regulator’s most significant changes to how money market mutual funds operate in response to the 2008 financial crisis.

The rule becomes effective 60 days after the rule is published in theFederal Register,which normally occurs a few days after a rule is posted to the SEC’s website.There will be a two-year transition period.

Commissioners Kara Stein and Michael Piwowar voted against the rule.Stein objected to the rule’s provisions for limiting redemptions during market downturns.Piwowar believed that the rule would put money funds at a competitive disadvantage relative to other investments.

The rule comes nearly six years after Lehman Brothers Holdings Inc. went bankrupt, triggering the failure of the $62 billion Reserve Fund, which held some Lehman debt.The fund saw its share price, or net asset value (NAV), fall below $1, a phenomenon known as “breaking the buck.”Institutional investors and corporations quickly withdrew their holdings in a massive run on the market that stabilized only after the Treasury Department guaranteed the funds.

The reforms “will reduce the risk of runs in money market funds and provide important new tools that will help further protect investors and the financial system in a crisis,” SEC Chair Mary Jo White said.

Institutional prime funds, which comprise roughly one third of the market, will be required to float their NAVs, rounded to the fourth decimal place, $1.0000.The requirement would result in the daily share prices of the funds fluctuating along with changes in the funds’ investments market values.

The SEC believes the change will reduce the incentive for investors to rush to redeem shares at the first sign of a market rout.

The SEC said government and retail money funds will be allowed to continue using the amortized cost method of pricing to maintain a stable share price.A government fund invests 99.5 percent or more of its total assets in cash, government securities, or repurchase agreements.The previous threshold was 80 percent.

Money fund boards will be able to impose liquidity fees and suspend redemptions temporarily or “gate” them for nongovernment funds if the level of weekly liquid assets falls below 30 percent of total assets.

If a fund’s level of weekly liquid assets falls below 10 percent, it will have to impose a liquidity fee of 1 percent on all redemptions.However, the fund’s board will have the discretion not to impose a fee or lower it if it’s in the fund’s interests.The board can also impose a fee as high as 2 percent.

Weekly liquid assets generally include cash, U.S. Treasury securities, other government securities that mature within 60 days, and securities that convert into cash within one week.

A fund that imposes a gate will have to lift it within 10 business days.Funds must disclose when the level of weekly liquid assets falls below the 10 percent threshold.

The market regulator largely adopted plans put forth in the June 2013 proposal in Release No. 33-9408,Money Market Fund Reform,which was widely criticized by fund managers as being too restrictive and costly.

White acknowledged that the combination of the rules could diminish the attractiveness of institutional prime funds for some investors and reduce demand for some corporate securities, but she pressed forward.

“We cannot shrink from requiring a needed change in the marketplace,” she said.

The SEC said the costs related to a floating NAV will be reduced because the Internal Revenue Service is proposing to allow money market fund investors to use a simplified tax accounting method for calculating gains and losses.Individual purchases and sales won’t have to be tracked for tax reporting.The IRS will provide relief from the “wash sale” rules for any losses on shares of a floating NAV money market fund.

Commissioner Daniel Gallagher said the tax treatment was an important threshold issue when voting on the rules.

The U.S. Chamber of Commerce said that it was disappointed with the rule.

“A floating NAV does not address run risk and would severely, if not irreparably, harm the viability of the product,’ said David Hirschmann, president of the Chamber’s Center for Capital Markets Competitiveness.

Investment Company Institute President and CEO Paul Schott Stevens said in a statement that the SEC “thoughtfully” crafted a rule that will impose structural changes across the industry.

“While we may question some aspects of the rule as adopted, we strongly believe that the SEC has the long regulatory experience and deep technical expertise required to strike the proper balance, making money market funds more resilient in times of financial stress while preserving the utility and value of these funds for investors,” he said.

In the meantime, the Financial Stability Oversight Council (FSOC) said the SEC adopted “significant” reforms.The FSOC, which is chaired by the secretary of the treasury, tried to step in in 2012 when then-SEC Chairman Mary Schapiro failed to propose a floating NAV or a capital buffer because of opposition from Republican Commissioners Gallagher and Troy Paredes and Democratic Commissioner Luis Aguilar.After the agency’s staff studied the market, they showed willingness to compromise.Schapiro left the SEC at the end of 2012; Paredes left in 2013.

The reforms also have enhanced disclosure requirements.Money market funds must disclose on their website on a daily basis their levels of daily and weekly liquid assets, the market-based NAV per share, fees and gates, and any use of affiliate sponsor support.

The rule also has stronger diversification requirements and requirements for testing funds during market sell-offs.

At the same time that it approved Release No. 33-9616, the SEC unanimously voted to issue a proposal in Release No. IC-31184,Removal of Certain References to Credit Ratings and Amendment to the Issuer Diversification Requirement in the Money Market Fund Rule.

If finalized, the proposed changes will remove references to credit ratings in Rule 2a-7 of the Investment Company Act of 1940.The proposal incorporates some of the proposed changes from Release No. 33-9408 that weren’t finalized in Release No. 33-9616.(See Proposal Seeks to Cut Credit Ratings from Money Market Fund Rule in this edition ofAccounting & Compliance Alert.)

Comments are due 60 days after publication in theFederal Register.