United States: FSOC Recommends And Seeks Comment On Money Market Mutual Fund Reform

On November 13, the Financial Stability Oversight Council (FSOC) voted unanimously to advance its report entitled "Proposed Recommendations Regarding Money Market Mutual Fund Reform." FSOC was established by the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank Act) to identify risks to the financial stability of the United States, to promote market discipline, and to respond to emerging risks to the stability of the United States' financial system.

The proposal follows U.S. Securities and Exchange Commission (SEC) Chairman Mary L. Schapiro's announcement in August 2012 that a majority of SEC commissioners would not support money market reforms proposed by the SEC staff.¹ Even after the SEC's failure to adopt money market reform Chairman Shapiro (a voting FSOC member) continued to lobby for money market reform stating in a Wall Street Journal opinion piece "[t]he Financial Stability Oversight Council and all who care about financial stability must act to prevent it from happening again." In addition to Chairman Shapiro, Secretary Geithner has been beating the money market reform drum and in a September 27 letter to FSOC members recommended that FSOC pursue money market fund reform alternatives including those put forth by Chairman Shapiro as well as additional measures, such as the imposition of "capital and enhanced liquidity standards, potentially coupled with liquidity fees or temporary 'gates' on redemptions ..."²

True to Chairman Shapiro's and Secretary Geithner's statements, FSOC proposed three alternative approaches to money market fund reform and requested public comment on such proposals. FSOC issued the money market reform proposals under Section 120 of the Dodd-Frank Act, which authorizes FSOC to "issue recommendations to primary financial regulatory agencies to apply 'new or heightened standards and safeguards' for a financial activity or practice conducted by bank holding companies or nonbank financial companies under the regulatory agency's jurisdiction." FSOC makes it clear that the three alternative proposals are not mutually exclusive and any reform could include components of each. The three alternatives FSOC proposed are:

(1) Floating Net Asset Value. Under the first alternative, money market funds (MMFs) would be required to use a floating net asset value (NAV) instead of seeking to maintain a constant share price of $1 per share. FSOC believes that this approach "could make investors less likely to redeem en masse when faced with the prospect of even modest losses by eliminating the 'cliff effect' associated with breaking the buck." FSOC also believes this approach would demonstrate to investors that their money is at risk and that it is possible to lose money in the MMF. However, switching to a floating NAV would change the tax treatment of MMFs, potentially subjecting shareholders to capital gains taxes on redemptions rather than just dividend income. FSOC acknowledged that a floating NAV would likely increase the administrative burdens and costs on MMFs in order to conform with basis reporting rules.

Pepper Points: Among other items, FSOC is seeking comment on whether this alternative would cause investors to shift their investments to alternative investments. It also requested comments with respect to the tax implications of a floating NAV including the basis reporting rules in light of the large volume of MMF share transactions compared to other mutual funds and whether administrative relief from the IRS was appropriate with respect to tax treatment. It is also interesting that FSOC continues to claim that investors are unaware of MMF risks despite prominent prospectus disclosure and the well-publicized demise of the Reserve Fund.

(2) Stable NAV with NAV Buffer and "Minimum Balance at Risk." Under the second alternative, MMFs would continue to seek to maintain a constant share price of $1 per share; however, MMFs would be required to have an NAV buffer with a tailored amount of assets of up to 1 percent to absorb day-to-day fluctuations in the value of the MMF's securities. The FSOC report indicates that various sources could be used to fund the NAV buffer, such as an escrow account, subordinated buffer shares and retained earnings. In addition to the NAV buffer, MMFs would require that 3 percent of any shareholder's highest account value in excess of $100,000 during the prior 30 days (the "MBR") be available for redemption with a 30-day delay. The FSOC report further indicates that "[f]or those investors subject to an MBR requirement, a portion of the investor's MBR could be subject to first loss (subordinated) if the investor had made net redemptions in excess of $100,000 during the prior 30 days, with the extent of subordination approximately proportionate to the shareholder's cumulative net redemptions during the prior 30 days. In the event that an MMF suffered losses in excess of its NAV buffer, and only in such an event, the subordinated portions of shareholders' MBRs would absorb losses before other shares do." The NAV buffer requirement and the MBR would not apply to Treasury MMFs and the MBR requirement would not apply to shareholders with account balances of less than $100,000.

Pepper Points: Among other items, FSOC is seeking comment on whether investors would discontinue investing in MMFs subject to these requirements, and, if a reduction in demand is anticipated, to which other investment vehicles investors would most likely shift money. Alternative two mostly impacts large institutional investors because the MBR would not apply to account balances of less than $100,000. In light of these requirements, institutional investors may shift their money to unregistered products or money market alternatives, including more risky ultra-short duration bond funds or private liquidity pools. However, retail investors would not escape the effect of this alternative as the associated costs of compliance would be borne by all investors and likely reduce yields of MMFs.

(3) Stable NAV with NAV Buffer and Other Measures. Similar to the second alternative, under the third alternative MMFs would be required to have an NAV buffer. However, "the NAV buffer would serve as the primary tool to increase the resiliency of MMFs and reduce their vulnerability to runs." The NAV buffer would be tailored to the riskiness of the assets and would range from 0 percent to 3 percent. Similar to the second alternative, the NAV buffer requirement would not apply to Treasury MMFs. FSOC indicated that the "other measures" under this alternative could include the following: more stringent investment diversification requirements, increased minimum liquidity levels, and more robust disclosure requirements.

Pepper Points: Similar to alternatives one and two, FSOC is seeking comment on whether investors would discontinue investing in MMFs subject to these requirements. Similar to alternative two, investors may shift their money to other alternatives. There will also be costs associated with complying with these regulations. In light of these costs, yields may decrease on these investments and as a result, investors may opt for other alternatives. The impact of suggested "other measures" such as more stringent diversification and minimum liquidity requirements could make MMFs unable to compete against other alternatives because eligible investments may preclude yields that are competitive with other products.

Comments are due 60 days after publication in the Federal Register, which likely means a mid- to late-January deadline. Comments can be submitted through the Federal eRulemaking Portal at http://www.regulations.gov. After the comment period, FSOC may issue its final recommendation. Under the Dodd-Frank Act, the SEC would be required to "impose the recommended standards, or similar standards that [FSOC] deems acceptable, or explain in writing to [FSOC] within 90 days why it has determined not to follow the recommendation." In the alternative, the FSOC report stated that "[i]f the SEC moves forward with meaningful structural reforms of MMFs before [FSOC] completes its Section 120 process, [FSOC] expects that it would not issue a final Section 120 recommendation to the SEC."

Footnotes

1. Statement of SEC Chairman Mary L. Schapiro on Money Market Fund Reform, available at http://www.sec.gov/news/press/2012/2012-166.htm (last visited Nov. 14, 2012).

2. Letter from Timothy Geithner to Members of the Financial Services Oversight Committee, available at http://www.treasury.gov/connect/blog/Documents/Sec.Geithner.Letter.To.FSOC.pdf (last visited Nov. 14, 2012).

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