Vol. 18, No. 6 • June 2011 Funds — What’s Next?

by Jack W. Murphy, Stephen T. Cohen and Sumeera Younis

ven after significant regulatory reform, money market funds remain a potential target for additional oversight and regulation. This article briefly reviews the key steps taken by lawmakers and regulators since E the events of September 2008. It then discusses further changes that may be proposed and offers alternative approaches in an effort to resolve the question of “What’s next?”

Introduction funds struggling to meet heavy redemptions. On September 15, 2008, In the wake of those events, the Securities Holdings Inc. filed for Chapter 11 bankrupt- and Exchange Commission (SEC) proposed cy protection, causing the Reserve Primary and adopted extensive amendments to Rule Fund to become the second money market 2a-7 under the Investment Company Act of fund in history to break the dollar share price 1940, as amended (the 1940 Act), which were and triggering a widespread “flight to qual- designed to address many of the issues with ity” which left many prime money market which money market funds grappled during the weeks following the Lehman . Mr. Murphy is a partner, and Mr. Cohen and Ms. Notwithstanding those amendments, how- Younis are associates, in the Financial Services ever, lawmakers, regulators and industry Group of Dechert LLP. From 1994 to 1997, Mr. leaders have continued to engage in a discus- Murphy served as Associate Director and Chief sion about whether additional regulatory Counsel of the SEC’s Division of Investment changes are necessary to address perceived Management. issues relating to the money market fund industry and, if so, what form those changes The 2010 Rule 2a-7 Amendments should take. In February 2010, the SEC adopted amend- The public debate about the future of the ments to Rule 2a-7 and other rules governing money market fund industry has taken place money market funds (the Amendments).1 K e y against the backdrop of the Dodd-Frank Wall provisions of the Amendments require money Street Reform and Consumer Protection Act market funds to: of 2010 (Dodd-Frank). While not directed specifically at money market funds, Dodd- • Comply with enhanced portfolio quality Frank created the Financial Stability Oversight and maturity requirements; Council (FSOC), which is tasked with the responsibility for identifying and designating • Comply with stringent portfolio liquid- as systemically significant nonbank financial ity requirements; companies (Significant Nonbanks) and sub- jecting those entities to prudential regulation • Periodically “stress test” the fund’s abil- by the Board of Governors of the Federal ity to maintain a stable $1.00 net asset Reserve System (FRB). Money market funds value (NAV) per share upon the occur- and their sponsors are among the non-bank rence of certain hypothetical events; financial companies that have been suggested as possible targets of FSOC consideration. • Disclose fund portfolio and other infor- Adding fuel to the fire of the debate is the mation in public Web site postings on a report of the President’s Working Group on monthly basis; Financial Markets (PWG) on “Money Market Fund Reform Options” (the PWG Report). • Electronically report portfolio and The PWG Report, which was subsequently other information to the SEC on Form published by the SEC for public comment, N-MFP; and identified several perceived issues raised (or at least not addressed) by the manner in which • Be able to process transactions at prices money market funds currently are operated other than a stable $1.00 NAV no later and regulated. Most recently, on May 10, 2011, than October 31, 2011. the SEC hosted a roundtable discussion on money market funds and where The Amendments also adopted Rule 22e-3, industry participants and regulators, including which permits a money market fund to sus- members of the FSOC, came together to dis- pend redemptions of its shares in anticipation cuss the future of money market funds. of the liquidation of the fund. The SEC also Clearly, therefore, money market funds broadened the relief provided by Rule 17a-9, remain in the spotlight and additional regula- which now permits fund affiliates to purchase tory measures (whether from the FSOC, the portfolio securities from money market funds, FRB and/or the SEC) may be forthcoming. subject to a “claw-back” requirement that This article will briefly review the key steps that any profit realized from a subsequent sale of have been taken since the events of September a purchased (other than a security 2008. It will then discuss some of the regulatory that is in or is no longer an Eligible and structural changes that have been proposed Security under Rule 2a-7) must be returned by industry participants and others to further to the fund. strengthen the ability of money market funds Although the Amendments were compre- to operate in the face of future crises. The pur- hensive in scope, at the time they were adopted pose of the article is not to suggest that there is SEC Chairman Mary Schapiro characterized a “silver bullet” that can cure all of the real and them as “an important first step in our efforts imagined ills surrounding the money market to strengthen the money market regime.” 2 fund industry. Rather, the purpose is to encour- This statement and other statements made by age those engaged in the debate to give serious the SEC and its Staff indicate that addition- consideration to the proposals described as al modifications to the SEC’s regulation of they determine the next steps to be taken. money market funds may yet be forthcoming.

THE INVESTMENT LAWYER 2 Implications of the Implementation non-delegable and must be made by a vote of of Dodd-Frank for Money no less than two-thirds of the FSOC’s voting Market Funds members then serving, including an affirma- tive vote by the Chairperson. Designation as a On July 21, 2010, President Obama signed Significant Nonbank would cause a financial into law Dodd-Frank, 3 which made sweeping company to become subject to a set of pru- changes to the supervisory and regulatory dential standards and requirements, including regime governing the US financial markets. heightened capital and liquidity requirements, Among the most significant aspects of the new to be developed and implemented by the FRB, law for money market funds are: (i) the estab- either on its own initiative or pursuant to rec- lishment of the FSOC; and (ii) a requirement ommendations of the FSOC under Sections to remove references to Nationally Recognized 165 and 166 of Dodd-Frank. Statistical Rating Organizations (NRSROs) Section 113(a)(2) of Dodd-Frank sets forth from SEC rules, including Rule 2a-7. ten specific factors for the FSOC to con- sider when determining whether to make a Establishment of the FSOC Significant Nonbank designation:

Title I of Dodd-Frank established the (1) Leverage . The extent to which the com- FSOC, a new body charged with monitor- pany’s assets are or may be leveraged; ing systemic risks to the US financial sys- (2) Off-balance-sheet exposures . The extent tem. Chaired by the Secretary of the US and nature of any off-balance-sheet expo- Department of the Treasury (Treasury), the sures of the company; FSOC is comprised of representatives from (3) Significant Transactions and Relationships . each of the major financial regulatory agen- The extent and nature of the transac- cies and has ten voting members and five tions and relationships of the company nonvoting members.4 Under Section 113 of with other significant nonbank financial Dodd-Frank, the FSOC is given broad author- companies and significant bank holding ity to designate Significant Nonbanks and to companies; subject those companies to prudential regula- (4) Credit for Businesses and Governments . tion by the FRB. In addition, Section 120 of The importance of the company as a Dodd-Frank gives the FSOC the authority to source of credit for households, business- recommend that a primary financial agency, es, and state and local governments and as such as the SEC, apply new or heightened a source of liquidity for the US financial standards and safeguards to significant finan- system; cial activities (Significant Financial Activities) (5) Credit for Underserved Populations. The conducted by entities under its jurisdiction. importance of the company as a source of credit for low-income, minority, or under- Authority to Designate served communities, and the impact that Signifi cant Non-Banks the failure of such company would have on the availability of credit in such com- Section 113 of Dodd-Frank empowers the munities; FSOC to determine that a “nonbank financial (6) . The extent company” shall be supervised by the FRB and to which assets are managed rather than be subject to prudential standards. To make owned by the company and the extent to this determination, the FSOC must conclude which ownership of assets under manage- that material financial distress at the US non- ment is diffuse; bank financial company, or the nature, scope, (7) Size, Complexity, and Interconnected ness, size, scale, concentration, interconnectedness, etc. The nature, scope, size, scale, concen- or mix of its activities, could pose a threat to tration, interconnectedness and mix of the the financial stability of the United States. The activities of the company; FSOC’s determination to designate a nonbank (8) Existing Regulation. The degree to which financial company as a Significant Nonbank is the company is already regulated by one

3 Vol. 18, No. 6 • June 2011 or more primary financial regulatory prudential standards specified for Significant agencies; Nonbanks are either already addressed more (9) Financial Assets. The amount and nature comprehensively in current money market of the financial assets of the company; fund regulations or would be an inappropriate and fit for money market funds.9 (10) Liabilities . The amount and types of the liabilities of the company, including the Authority to Designate degree to which the company relies on Signifi cant Financial Activities short-term funding. In addition to its authority to designate In addition, the FSOC may consider any Significant Nonbanks, the FSOC has the other risk-related factors that it deems appro- authority to provide for more stringent reg- priate. Dodd-Frank does not indicate how ulation of Significant Financial Activities much weight the FSOC should give to each conducted by a bank, bank holding company factor in determining whether to designate a (BHC) or any nonbank financial company, particular nonbank financial company as a if the FSOC determines that the conduct, Significant Nonbank. scope, nature, size, scale, concentration, or Several recent events indicate that the interconnectedness of the financial activities FSOC may be considering money market or practices could create or increase the risk funds as possible candidates for designation as of significant liquidity, credit, or other prob- Significant Nonbanks. For example, in early lems spreading among BHCs and nonbank October 2010, the FSOC issued an advance financial companies, financial markets of notice of proposed rulemaking (the ANPR) the United States, or low-income, minority, seeking public comment on the criteria that or underserved communities. If an activity should inform its designation of Significant is deemed by the FSOC to be a Significant Nonbanks under Dodd-Frank. 5 Certain ques- Financial Activity, the FSOC is empowered tions in the ANPR may have been directed to recommend that the primary financial at money market funds. More recently, FRB regulatory agency or agencies apply new Governor Tarullo suggested that a few hedge or heightened standards and safeguards to funds and mutual funds, potentially including the activity. The FSOC’s recommendations money market funds, could be on the short list may include proscribing the conduct of the for designation.6 Significant Financial Activity in specific ways The money market fund industry has (such as by limiting its scope, or apply- strongly opposed the notion that a money mar- ing particular capital or risk management ket fund should be designated as a Significant requirements to the conduct of the activity) Nonbank. In its comments on the ANPR, or prohibiting the activity in its entirety. In the Investment Company Institute (ICI), the making its recommendations, the FSOC is national association that represents the mutu- required to take into account the costs to al fund industry, argued that designating a -term economic growth, consult with the money market fund as a Significant Nonbank primary financial regulatory agencies and “would not be an appropriate tool for further provide notice to the public and opportunity strengthening the resilience of money market for public comment on any recommendations. funds to severe market distress.” 7 In particu- The FSOC must also report to Congress on lar, the ICI pointed out that money market any such recommendation and its implemen- funds are highly regulated by the SEC and are tation. subject to stringent quality, liquidity, maturity If the FSOC recommends that a primary and diversification standards. Commenters financial regulatory agency imposes stricter also argued that: (i) the 2a-7 Amendments regulations on the conduct of a Significant have addressed the risks presented during Financial Activity, the agency is required either the 2008 financial crisis; 8 (ii) money market to: (i) impose the standards recommended by funds are a regulatory success and are already the FSOC, or similar standards that the FSOC subject to robust regulation; and (iii) the deems acceptable; or (ii) explain in writing to

THE INVESTMENT LAWYER 4 the FSOC, no later than 90 days after the date (iii) Credit quality standards for port- on which the FSOC issues the recommenda- folio securities with conditional de- tion, why it has determined not to follow the mand features;11 recommendation. (iv) Requirements to monitor portfolio Removal of NRSRO Ratings securities for ratings downgrades and from Rule 2a-7 other credit events; and

Section 939A of Dodd-Frank directed the (v) Requirement to periodically stress SEC to: test a money market fund’s ability to maintain a stable $1.00 NAV per share. (i) Review its rules for any references to or requirements regarding credit By eliminating NRSRO ratings from Rule ratings that require the use of an as- 2a-7, the NRSRO Proposal would remove an sessment of the creditworthiness of a objective test and replace it with a more flex- security or money market instrument; ible standard that arguably could allow a money market fund to invest in portfolio securities that (ii) Remove those references or re- would not qualify as fund investments under the quirements; and current rule. However, in the proposing release, the SEC indicated that a money market fund (iii) Substitute in place of the credit could continue to look to NRSRO ratings if the ratings in those rules other standards fund’s board concludes that the ratings establish of creditworthiness that the SEC standards that are similar to those proposed and deems appropriate. are credible and reliable, and those determinations are reflected in the fund’s procedures. Many in the On March 3, 2011, the SEC proposed a industry anticipate that, if the NRSRO Proposal set of amendments to certain rules, includ- is adopted, money market fund boards may write ing Rule 2a-7 under the 1940 Act that would the current rating requirements of Rule 2a-7 into remove references to credit ratings issued by their fund procedures, rather than foregoing the NRSROs (the NRSRO Proposal) and replace protection provided by the current ratings floor. them with new, more subjective, standards of 10 creditworthiness. PWG Report on Money Rule 2a-7 has long imposed portfolio qual- ity requirements that limit a money mar- Market Fund Reform Options ket fund’s portfolio holdings by reference to On October 21, 2010, the PWG released the NRSRO ratings. While Rule 2a-7 has also PWG Report,12 which was subsequently pub- required money market funds to conduct their lished by the SEC for public comment.13 T h e own credit analysis of all portfolio invest- PWG Report acknowledged that the SEC’s ments, the use of NRSRO ratings has pro- adoption of the Amendments to Rule 2a-7 was vided a useful “floor,” limiting the universe of an important “first-step” in making money potential fund investments to those rated no market funds more resilient and less risky. lower than the top two rating categories. The However, the PWG Report recommended that NRSRO Proposal would remove all references more be done to address systemic risks and to credit ratings from Rule 2a-7, impacting the structural vulnerabilities of money mar- five elements of the rule: ket funds to “runs.” To that end, the PWG Report presented the following possible reform (i) Determination of whether a port- options for consideration by the FSOC: folio security is an “Eligible Security;” • Floating net asset values; (ii) Determination of whether a port- folio security is either a “First Tier Se- • Privately sponsored emergency liquidity curity” or “Second Tier Security;” vehicles;

5 Vol. 18, No. 6 • June 2011 • Mandatory redemptions in-kind; Under this proposal, any prime money market fund that intends to maintain a stable $1.00 • Insurance for money market funds; NAV would be required to participate in the Liquidity Facility, although Treasury and • A two-tier system providing enhanced other government money market funds would protections for stable NAV money mar- be exempt from participating. Prime money ket funds; market funds that do not participate in the Liquidity Facility would be required to switch • A two-tier system reserving stable NAV to a floating NAV or convert into a Treasury money market funds solely for retail in- or government money market fund. vestors; The proposal envisions that, during times of unusual market stress, the Liquidity Facility • Regulating stable NAV money market would purchase high-quality, short-term secu- funds as special purpose banks; and rities from prime money market funds at amor- tized cost, thereby: (i) enabling funds to meet • Enhancing constraints on unregulated redemptions while maintaining a stable $1.00 money market fund substitutes. NAV; and (ii) helping to protect the broader money markets by allowing funds to avoid sell- Before the PWG Report was released some ing into a challenging market. The Liquidity observers had expected the PWG Report to Facility would not be intended to provide propose that money market funds be required credit support, but rather would assist a money to move away from maintaining a stable share market fund that requires cash by purchasing price and adopt floating NAVs. Suggestions high-quality instruments from the fund. The that money market funds should be forced to Liquidity Facility would be designed to provide move to a floating NAV have been strongly a liquidity backstop only after a money market resisted by both the money market fund indus- fund has utilized a substantial portion of its try and issuers of short-term , among oth- minimum mandated liquidity positions. ers. 14 Although the PWG Report discussed The Liquidity Facility would be a state- various reform options for the FSOC to con- chartered bank or trust company, and would sider, the Report refrained from recommend- comply with applicable banking laws. As such, ing any particular reform. the Liquidity Facility would be a member of the FRB, eligible to access the discount Other Suggestions for Reform window in the ordinary course, and would issue time deposits that are eligible for FDIC Offered by Industry Participants insurance, although it is not anticipated that Largely in response to the SEC’s publica- the facility would seek to insure those deposits. tion of the PWG Report for public com- The Liquidity Facility would have two direct ment, several industry participants suggested sources of capital. The initial capital would be or elaborated upon various reform options. provided by sponsors of prime money market These included: (i) creating a private emer- funds, based on their assets under manage- gency liquidity facility; (ii) permitting a capital ment, with an aggregated target initial equity reserve to be maintained within a money mar- of $350 million. The minimum contribution ket fund; and (iii) permitting money market for the smallest money market funds or new funds to impose a special “redemption fee” money market funds would be $250,000 and during periods of market turbulence. the maximum contribution would be capped at 4.9 percent of the total initial equity. After Private Emergency Liquidity Facility the initial capitalization, the Liquidity Facility would require ongoing commitment fees of In its comments on the PWG Report, the its member funds, which would accrue for the ICI strongly supported the creation of a pri- benefit of current and future money market vate emergency liquidity facility for prime fund shareholders, not the Liquidity Facility’s money market funds (the Liquidity Facility).15 equity holders.

THE INVESTMENT LAWYER 6 A money market fund seeking to sell securi- funds to serve as a buffer to shield the fund’s ties to the Liquidity Facility would be required ability to maintain a stable price per share to present its entire portfolio to the Liquidity (the Capital Reserve).16 In its comment letter Facility’s credit analysts for review. A money on the PWG Report, Fidelity Management market fund could only access the Liquidity & Research Company (Fidelity) supported Facility if the credit analysts determine that the creation of a Capital Reserve that would its securities are suitable for purchase by the be funded by holding back a portion of a Liquidity Facility. The Liquidity Facility would money market fund’s income similar in size be subject to stringent asset policies to avoid to the amount funds paid for the Treasury’s absorbing and to minimize through Temporary Guarantee Program for Money diversification, concentration and duration Market Mutual Funds. Fidelity maintained risk controls the impact of any default. that this proposal would address the features In its comment letter, the ICI sought to of money market funds that the PWG Report address many of the concerns raised in the argued create an “incentive to redeem shares PWG Report regarding a private liquidity facil- before other shareholders,” stating that the ity. For example, the ICI stated that requiring proposal would create a reserve that could all stable NAV prime money market funds to absorb losses if the fund was forced to sell participate in the liquidity facility would help assets at a loss. In particular, with a Capital eliminate both investor confusion over prime Reserve in place: money market funds, as well as the potential for non-participating funds to benefit from (i) Investors would be less likely to the market stability that a voluntary liquidity redeem their shares in fear that the facility would provide. In addition, the ICI money market fund’s liquidity would stated that the proposed Liquidity Facility is be depleted; being designed to address capacity concerns raised by the PWG Report and, together with (ii) The focus on the $1.00 stable NAV the new liquidity requirements imposed by the would become less of a concern for Rule 2a-7 Amendments, would offer, during shareholders because a money mar- future periods of unusual market stress, the ket fund’s market-based NAV would liquidity required to allow funds to withstand be above $1.00 per share on a regular events similar in magnitude to those experi- basis; and enced during the 2008 financial crisis. The ICI also addressed the potential conflicts of inter- (iii) Money market funds would be est that may arise when liquidity is in short better equipped to handle credit and supply, noting that the proposed independent interest rate risks that may result in credit function would be intended to effective- unrealized losses. ly minimize losses while providing liquidity. The proposed Liquidity Facility governance Moreover, as envisioned by Fidelity, the structure would include a board comprised Capital Reserve would be mandatory, regu- of representatives from a range of fund sizes, lated, transparent, and subject to board over- as well as independent directors to provide sight. balanced oversight. Finally, the ICI sought Although some shareholders may object to to quell the concern of potential “moral haz- potentially lower returns due to the holding ards” by requiring that prime money market back of income necessary to create the Capital funds not only maintain the Rule 2a-7 man- Reserve, the Fidelity proposal offers a solution dated levels of liquidity, but also pay an access that could be easily adopted and implemented fee for using the Liquidity Facility. by money market funds. The proposal would also be consistent with the PWG Report’s rec- Creation of a Capital Reserve ommendation that money market funds inter- nalize the cost of risks associated with their Other parties have suggested the creation operation. The proposal to create a Capital of a capital reserve within money market Reserve has received support from several

7 Vol. 18, No. 6 • June 2011 industry participants. On May 5, 2011, The sider their liquidity needs before taking action Charles Schwab Corporation and Wells Fargo to redeem; (ii) shareholders that redeem dur- Funds Management, LLC signed a joint letter ing a time of market stress are redeemed at with Fidelity expressing their support of the an appropriate price of the money market proposals.17 fund’s shares; and (iii) shareholders that do Regulatory and tax issues that would need not redeem their shares will not be unfairly to be worked out before the Capital Reserve impacted by redeeming shareholders. HSBC proposal could be implemented could include: suggested that some of the challenges pre- (i) allowing a fund to hold back a portion of sented by the proposal would include: (i) deter- its income notwithstanding a stated policy mining when to apply the redemption charge; that all or substantially all of its income will be (ii) avoiding the redemption charge being paid to shareholders; and (ii) ensuring that the incorrectly perceived as a tax; and (iii) ensur- hold back of income would not jeopardize ing the proper accounting methodology is used the fund’s tax status under Subchapter M of to determine the amount of the charge. the Internal Revenue Code of 1986.

Redemption Fees During Other Suggestions and Market Turbulence Reform Options In addition to the suggestions discussed, Another approach suggested by com- there are other possible changes that could menters on the PWG Report to address money assist money market funds during times of market funds’ susceptibility to runs by inves- market stress. Two possible reform options tors was detailed in a comment letter filed that could be considered include: by HSBC, 18 which maintained that the most effective means of mitigating systemic risk (i) Permitting the board of a money would be to apply a charge on redemptions market fund to temporarily suspend that accurately reflects the cost of raising redemptions during market turbulence liquidity to meet redemptions and hence the without requiring subsequent liquida- realizable value of the shares being redeemed. tion of the fund; and HSBC proposed that, during a period of mar- ket stress or idiosyncratic stress experienced (ii) Permitting money market funds by an individual money market fund, the price to issue a “capital” or “support” share of a fund’s shares would be estimated to inves- class to the investment adviser or its af- tors not at the stable $1.00 NAV, but rather at fi liates. the variable NAV price, which would include an estimate of the sale price of any distressed Temporary Suspension of Redemptions asset. If an investor redeems during the period, the proceeds would be met by selling a repre- Under Section 22(e) of the 1940 Act, the sentative portion of the money market fund’s board of a money market fund generally is not assets, including any distressed securities. The permitted to suspend redemptions. However, difference between the money market fund’s as adopted in 2010, Rule 22e-3 permits a stable $1.00 NAV and the actual value of the money market fund board to suspend redemp- redeemed shares could be called a “redemp- tions of the fund’s shares if: (i) the board tion charge” or some other acceptable term, determines that the deviation between the such as a “liquidity protection payment.” This fund’s shadow NAV and stable $1.00 NAV amount would be retained by the money may result in dilution and other unfair results market fund to prevent a drop in the fund’s to investors or existing shareholders; (ii) the market based NAV per share as a result of the board has approved irrevocably the liquida- redemption. tion of the fund; and (iii) the fund notifies the HSBC noted that this proposal would pro- SEC prior to the suspension. This relief would vide a number of benefits, which include be useful to a money market fund, such as the ensuring that: (i) shareholders carefully con- Reserve Primary Fund, that has broken the

THE INVESTMENT LAWYER 8 dollar share price and needs to liquidate in an redemptions or move to liquidate within a orderly manner. However, the rule provides lit- certain period of time. tle comfort to a fund that, unlike the Reserve Obviously, a suspension of redemptions Primary Fund, does not hold defaulted securi- would be a drastic step that would be under- ties but rather finds itself (i) holding securities taken by a money market fund only as a last of creditworthy issuers that have experienced resort. In fact, the marketplace could be expect- a decline in market value due to a liquidity ed to prevent abuses of this rule, as investors crisis such as that which occurred after the (particularly larger investors) could be expect- Lehman bankruptcy and (ii) facing heavy and ed to move away from funds that suspend sustained redemptions as a result of a “flight redemptions without good cause. However, to quality” by investors. allowing the temporary suspension of redemp- One possible measure that could help pre- tions could provide a money market fund with vent a run on money market funds would enough “breathing room” during a market be to permit the board of a money market liquidity crisis to allow the fund’s manager fund to authorize the temporary suspension and board to seek solutions to the problems of redemptions of fund shares during mar- confronting the fund, whether through sales of ket emergencies without requiring the board securities to affiliates or otherwise, cash infu- to liquidate the fund. This alternative would sions or a merger with a more stable fund.19 empower boards of money market funds to One area of concern is that a temporary act for the protection of fund shareholders suspension of redemptions may impose hard- during a market crisis and allow time for the ships on investors who rely on their ability to markets to return to normalcy. It could also redeem shares. Indeed, this was one of the allow time for more of the money market SEC’s concerns when it adopted Rule 22e-3 fund’s portfolio holdings to mature, as well under the 1940 Act, and is a reason why, under as time to liquidate fund assets in an orderly Rule 22e-3, a board must irrevocably liquidate manner, each of which could provide the fund the fund in order to suspend redemptions with additional liquidity to meet redemptions. in reliance on the Rule. 20 However, where a Section 22(e)(2) of the 1940 Act provides money market fund does not hold defaulted that a fund may suspend redemptions for any securities and a drop in the market-based NAV period during which an emergency exists as a of its shares is the result of market illiquid- result of which (i) disposal of the securities ity, a temporary suspension may make sense. owned by it is not reasonably practicable, or Moreover, the breathing space that would (ii) it is not reasonably practicable for the com- be provided by a temporary suspension of pany to fairly determine NAV. Section 22(e) redemptions could help prevent a fund from provides that the SEC by rules or regulations being forced to sell securities into an illiquid shall determine the conditions under which market, and thus go a long way toward eas- an emergency shall be deemed to exist. In ing any concerns that the FSOC may have reliance on this statutory authority, the SEC regarding the systemic impact that money could adopt a rule permitting a money market market funds may have on the rest of the US fund board to temporarily restrict or suspend economy, including the short-term commer- redemptions of the fund’s shares if the board cial paper market. determines that: (i) the secondary market for the securities in which a substantial portion Issuance of a “Capital” or of the fund’s portfolio is invested has become “Support” Share Class illiquid, with the result that it is unlikely that the fund could sell sufficient securities to meet During the financial crisis and under other redemptions without realizing losses; and (ii) circumstances, certain fund advisers (or their the fund is faced with redemption requests affiliates) have provided money market funds that substantially exceed cash and liquid assets with a capital infusion in order to increase the available to meet such redemptions. If deemed funds’ shadow NAV. These capital infusions necessary, the SEC could require that the were simply a contribution of a sum of money money market fund either begin processing to the fund, made by the adviser or its affiliate

9 Vol. 18, No. 6 • June 2011 with no right to, or expectation of, future would have to provide relief from Section 18(f) repayment. Another possible reform option (1).21 The SEC may also need to grant relief would be to provide advisers or their affiliates under Sections 2(a)(32), Sections 22(e), Section with the ability to infuse capital into a money 22(c) and Rule 22c-1 in order to deem the market fund to support the $1.00 share price Support Shares to qualify as redeemable securi- through the purchase of subordinated “capital” ties and to permit the payment of redemption or “support” shares (Support Shares). Support proceeds only under certain circumstances. Shares would be a separate, junior class of Relief may also be necessary under Rules 2a-7 equity security privately issued by the fund. and 30b1-7 to permit a fund that has issued The capital represented by Support Shares Support Shares to meet certain requirements of would be available to support the market-based those rules. Accounting and tax considerations NAV per share of the public shares of the fund would also need to be considered. that are held by individuals and institutional A rule permitting (but not requiring) money investors. Support Shares could be sold only to market funds to issue Support Shares would the Fund’s adviser or its affiliates. encourage advisers and their affiliates to infuse Support Shares would be subordinated to capital into a fund to support the fund’s ability the publicly offered share classes of the money to maintain a $1.00 share price. The amount market fund and, in the event of a liquidation of the capital attributable to Support Shares of the fund, the Support Shares would be enti- would be retained by the fund as necessary tled to receive liquidation proceeds only after to support the $1.00 share price. However, in the holders of the public shares have received the event the market recovers and the market- proceeds equal to $1.00 per share. Support based NAV of the fund exceeds $1.00 per share Shares could be redeemable, but the ability to without taking into account the capital of the redeem would be restricted to only those times Support Shares, the adviser would be allowed when the shadow NAV of the public share to redeem the Support Shares and recover classes of the money market fund exceeds some or all of its capital contribution. $1.00 per share for a specified number of days and would remain at or above $1.00 immedi- Conclusion ately following the redemption of the Support Shares. Support Shares would also not be There is, of course, no definitive answer entitled to receive any dividends unless the to the question of “What’s next?” for money payment of dividends is deemed necessary to market funds. Over the next few weeks and avoid negative tax consequences to the fund. months, industry participants, regulators and Other possible characteristics of Support others will debate what steps, if any, should Shares could be that: (i) they would not pay be taken, as well as the merits of each of the any management fees on assets attributable to proposals currently on the table. In addition, the Support Shares; (ii) they could be voting other proposals may be developed and debat- securities, but the adviser would “mirror vote” ed. Nonetheless, one point is clear – there is no the shares (that is, vote in the same proportion “silver bullet” that can, by itself, remedy the as the other shares); and (iii) they would not situation, prevent future problems and satisfy be transferable to any other party except the all parties. There are, however, a number of adviser or its affiliates. Finally, the existence useful proposals that have been put forward and general terms of the Support Shares by the industry and regulators. A combination would be disclosed in the money market fund’s of several of these proposals would increase registration statement. available liquidity in times of market stress, The framework for creating Support Shares provide a buffer to help preserve the dollar would have to be carefully crafted in order share price, encourage fund advisers and their to be permitted under the 1940 Act. Because affiliates to support the fund’s share price the Support Shares would be subordinated to and allow money market funds to continue a money market fund’s publicly offered share to serve as an effective financial intermediary class(es) with respect to the distribution of between short-term investors and issuers that assets and payment of dividends, the SEC likely need short-term financing.

THE INVESTMENT LAWYER 10 Post-Script – Discussions Continue Protect Investors,” (Jan. 27, 2010) available at http://www. As this article was going to print, the sec.gov/news/press/2010/2010-14.htm . SEC hosted a roundtable discussion, which 3. Pub. L. No. 111-203, 124 (July 21, 2010). was moderated by Director Eileen Rominger 4. Voting members include: (i) the Secretary of the and Associate Director Robert Plaze of the Treasury, who shall serve as Chairperson of the FSOC; SEC’s Division of Investment Management. (ii) the Chairman of the FRB; (iii) the Comptroller of the Participants at the roundtable included the Currency; (iv) the Director of the Bureau of Consumer SEC Chairman and Commissioners, repre- Financial Protection; (v) the Chairman of the SEC; sentatives of the FSOC, academics, and pro- (vi) the Chairperson of the Federal Deposit Insurance Corporation; (vii) the Chairperson of the Commodity fessionals from the investment management Futures Trading Commission; (viii) the Director of the industry. During the three-hour roundtable, Federal Housing Finance Agency; (ix) the Chairman of the moderators and participants engaged in a the National Credit Union Administration Board; and discussion of the systemic risk inherent in the (x) an independent member appointed by the President, money market fund industry. The informal by and with the advice and consent of the Senate, having nature of the roundtable permitted the partici- insurance expertise. pants to offer their thoughts and opinions on Nonvoting members include: (i) the Director of the various issues, including: Office of Financial Research; (ii) the Director of the Federal Insurance Office; (iii) a state insurance com- missioner, to be designated by a selection process • The factors that make money market determined by the state insurance commissioners; (iv) a funds vulnerable to runs; state banking supervisor, to be designated by a selection process determined by the state banking supervisors; • The role of money market funds in the and (v) a state securities commissioner (or an officer performing like functions), to be designated by a selec- short-term fi nancial markets in relation tion process determined by such state securities com- to systemic risk analysis; and missioners. 5. Advance Notice of Proposed Rulemaking Regarding • Various regulatory options including: Authority to Require Supervision and Regulation of Certain Nonbank Financial Companies (Oct. 1, 2010) available ° Requiring a fl oating NAV; a t http://www.treas.gov/FSOC/docs/2010-25321_PI.pdf ; 75 Fed. Reg. 61653 (Oct. 6, 2010). ° Possible regulation of money market 6. James Hamilton, “Fed Governor Says List of Hedge funds as banks; Funds and Mutual Funds Deemed Systematically Important under Dodd-Frank Should Be a Short One,” The creation of a Liquidity Facility; http://jimhamiltonblog.blogspot.com/2011/04/fed-governor- ° says-list-of-hedge-funds.html (April 13, 2011) (last visited May 11, 2011). ° The creation of a Capital Reserve, and 7. Comment letter from Paul Stevens, President and Chief Executive Officer, Investment Company Institute (Feb. 15, ° Liquidity fees. 2011) available at http://www.regulations.gov/contentStream er?objectId=0900006480bf8c4b&disposition=attachment& After this article goes to print, the ICI will contentType=pdf . be hosting its Money Market Funds Summit 8. Comment letter from John Hollyer, Principal and on May 16, 2011 at which industry leaders and Head of Risk Management and Strategy Analysis, analysts will discuss the global money market Vanguard & Gus Sauter, Managing Director and Chief fund industry, the progress that has been made Investment Officer, Vanguard (Feb. 25, 2011) avail- able at http://www.regulations.gov/contentStreamer?object in strengthening money market funds and the Id=0900006480bf887d&disposition=attachment&content current policy debates over next steps. Type=pdf . 9. Comment letter from John D. Hawke, Jr., Arnold & Notes Porter (Feb. 24, 2011) available at http://www.regulations. gov/contentStreamer?objectId=0900006480bf767d&disposit 1. See Money Market Fund Reform , SEC Release No. ion=attachment&contentType=pdf . IC-29132 (Feb. 23, 2010) (the Adopting Release). 10. See References to Credit Ratings in Certain Investment 2. Press Release, Securities and Exchange Commission, Company Act Rules and Forms , SEC Release No. IC-29592 “SEC Approves Money Market Fund Reforms to Better (Mar. 3, 2011).

11 Vol. 18, No. 6 • June 2011 11. A conditional demand feature is a demand feature that 15. Comment letter from Paul Stevens, President and does not provide, by its terms, that it would be readily exer- Chief Executive Officer, Investment Company Institute cisable in the event of a default in payment of principal or (Jan. 10, 2011) available at http://www.sec.gov/com- interest on the underlying security. See Rule 2a-7(a)(6) and ments/4-619/4619-49.pdf . 2a-7(a)(28). 16. Comment letter from Scott Goebel, Senior Vice 12. See “Report of the President’s Working Group on President and General Counsel, Fidelity Management & Financial Markets: Money Market Fund Reform Options,” Research Company (Jan. 10, 2011) available at http://www. available at http://treas.gov/press/releases/docs/10.21%20 sec.gov/comments/4-619/4619-36.pdf . PWG%20Report%20Final.pdf . In 2009, Treasury had pro- posed that the PWG prepare a report on fundamental 17. Comment Letter from Scott Goebel of Fidelity changes needed to address systemic risk and to reduce Management & Research Company, Carrie Dwyer of the susceptibility of money market mutual funds to runs. The Charles Schwab Corporation and C. David Messman See “Financial Regulatory Reform: A New Foundation,” of Wells Fargo Funds Management, LLC (May 3, 2011) available at http://www.financialstability.gov/docs/regs/ available at http://www.sec.gov/comments/4619/4619-97.pdf . FinalReport_web.pdf . 18. Comment letter from John Flint, Chief Executive, 13. Press Release, Securities and Exchange Commission, HSBC Global Asset Management (Feb. 28, 2011) available “SEC Publishes Request for Comment on President’s at http://www.sec.gov/comments/4-619/4619-84.pdf . Working Group Report on Money Market Fund Reform 19. The SEC could also add conditions restricting the Options,” (Nov. 3, 2010) available at http://sec.gov/news/ ability of a fund to rely on the temporary suspension rule press/2010/2010-211.htm . if the fund holds defaulted securities which accounted for 14. However, we note that a Wall Street Journal editorial more than one-half of one per centum of the fund’s port- suggested that, if money market funds adopt a floating folio immediately prior to the default. NAV, investors would better understand the risks that 20. See Adopting Release, supra n.1, at Section II.H. funds can lose value. ( Taxpayers and Money Market Funds , Review and Outlook, Wall St. J. (May 9, 2011)). 21. It should be noted that Section 18(f) contains, as a In response to this editorial, Paul Stevens, President and condition to the exception from the definition of senior Chief Executive Officer of the ICI, argued that the Wall security that permits series funds, a requirement that “the Street Journal editorial ignored the progress that has been only other outstanding class of the issuer’s stock consists made to make money market funds more resilient to a of a common stock upon which no dividend (other than financial crisis and failed to acknowledge the economic a liquidating dividend) is permitted to be paid and which disruption and risks of a floating NAV. (Paul S. Stevens, in the aggregate represents not more than one-half of Letter to the Editor, Wall St. J. (May 11, 2011) available at one per centum of the issuer’s outstanding voting securi- http://www.ici.org/mmfs/snav/11_resp_wsj_mmfs (last vis- ties.” While unclear, this statutory language arguably ited May 11, 2011)). could be read to permit the issuance of Support Shares.

Copyright © 2011 CCH Incorporated. All Rights Reserved Reprinted from The Investment Lawyer June 2011, Volume 18, Number 6, pages 1,11-21, with permission from Aspen Publishers, Wolters Kluwer Law & Business, New York, NY, 1-800-638-8437, www.aspenpublishers.com

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THE INVESTMENT LAWYER 12