Former Securities & Exchange Commission Deputy Director of the Division of Investment Management Robert Plaze posted a recent "Special Bulletin," entitled, "Potential Overhaul of Money Market Funds Regulation: A Summary of the SEC Proposal and Discussion of Its Potential Implications." Plaze, now a Partner at Stroock & Stroock & Lavan LLP, wrote the piece along with Nicole Runyan and Lauren Connolly. It says, "On June 5, 2013, the Securities and Exchange Commission proposed long-anticipated amendments to rules under the Investment Company Act of 1940 and related requirements that govern money market funds. The SEC's proposal is the latest action by U.S. regulators as part of the ongoing debate about the systemic risks posed by money market funds and the need for additional reform in light of the SEC's reforms in 2010. This Stroock Special Bulletin provides an overview of the SEC's proposal, including a discussion of the two alternative regulatory regimes proposed by the SEC."

Plaze explains, "The first alternative would require institutional prime money funds to "float" their net asset value per share instead of using a stable value (generally, $1.00). The second alternative would permit all money market funds to continue to transact at a stable share price, although certain funds would be required to impose a liquidity fee in times of market and/or fund stress and permitted to temporarily suspend redemptions (i.e., impose a "gate") in similar circumstances. This Bulletin discusses each alternative in detail and also highlights potential implications and issues arising under each alternative, including with respect to omnibus and multiple accounts, tax and accounting matters, board considerations and obligations, and disclosure matters that sponsors and boards of money market funds may wish to consider."

His intro adds, "The Bulletin also focuses on the various rules and rule amendments proposed by the SEC that would significantly expand disclosure and reporting by money market funds, including the adoption of new Form N-CR and amendments to Form N-MFP and Form PF along with increased website disclosure (including real-time disclosure of net asset value, fund liquidity levels and sponsor support), which are intended to increase transparency for both investors (to more fully understand the risks of investing in a particular fund) and the SEC (to obtain additional information needed to engage in oversight of these funds). Finally, the Bulletin addresses the SEC’s proposed amendments to Rule 2a-7 that would, among other things, further tighten its diversification requirements and revise its stress testing requirements."

After discussing some Background, Plaze says on the proposed alternatives, "Under the Floating NAV Alternative, institutional Prime Funds would be required to price their shares in a way that reflects the value of their portfolio securities, using market-based factors, so that gains and losses would be reflected each day, similar to other types of mutual funds. To increase the "observed sensitivity" of a money fund's share price, prices would have to be calculated to the fourth decimal place for institutional Prime Funds with a target NAV of $1.00 per share (i.e., $1.0000). The rounding convention for institutional Prime Funds would thus change from penny rounding (i.e., to the nearest 1%) to "basis point" rounding (i.e., to the nearest 1/100th of 1%), a more precise standard than the 1/10th of 1% currently required for most mutual funds. Amortized cost valuation could not be used by any money funds (except for 60-day paper)."

He tells us, "Government money funds and retail money funds (including retail Prime Funds) could continue to maintain a stable NAV. These funds could no longer use the amortized cost method of valuing securities, but would be permitted to continue to use the penny rounding method of pricing their shares to maintain a stable price per share. As proposed by the SEC, government money market funds would be money funds that maintain at least 80% of their total assets in cash, "government securities" (as defined in Section 2(a)(16) of the 1940 Act), or repurchase agreements that are collateralized fully with government securities. Allowable securities would include securities issued by government-sponsored entities such as the Federal Home Loan Banks, government repurchase agreements, and those issued by other instrumentalities of the U.S. government."

Plaze adds, "The SEC did not propose a separate exemption for tax-exempt money funds that invest in municipal securities. Securities issued by state and municipal governments generally would not qualify as "government securities" for purposes of the Government Fund exemption, as the SEC does not believe that such securities generally share the same credit and liquidity traits as U.S. government securities. The SEC stated that it believed that because the investor base of Municipal Funds tends to be retail shareholders (as the tax benefit of investing in Municipal Funds is limited to individual investors), most Municipal Funds should be able to qualify as Retail Funds."

He comments on "Omnibus and Multiple Accounts," "A growing number of money fund retail shareholder accounts today are held in omnibus accounts that may not provide the fund and its transfer agent sufficient transparency to identify redemptions that exceed the $1 million limit of the proposed Retail Fund exemption. Many omnibus accounts, themselves, could be expected to make redemptions in excess of $1 million on a regular basis, which would further narrow the utility of the Retail Fund exemption. In order to address this issue, the SEC proposed to permit a money fund relying on the Retail Fund exemption to, with respect to an "omnibus account holder," disregard the $1 million per day redemption limit if the fund has policies and procedures in place reasonably designed to permit it to conclude that the omnibus account holder (and each omnibus account holder up the ownership chain) does not permit redemptions by any beneficial owner of more than $1 million per day."

The Stroock piece also discusses some of the tax and accounting implications. It says, "Money funds' current ability to maintain a stable NAV per share simplifies tax compliance for their investors. Under the current regulatory regime, purchases and sales of money fund shares at a stable share price generate no gains or losses. One of the consequences of the adoption of the Floating NAV Alternative may be that each sale of institutional Prime Fund shares would require a shareholder to recognize gains and losses, which would likely involve payment of very little additional taxes but could result in significant reporting burdens on shareholders because each transaction would have to be tracked and reported on the shareholder's tax returns. In addition, as a result of the "wash sale" rules, a shareholder may be unable to offset some of the gains with some of the losses."

It adds, "The SEC reported, however, that the Treasury Department and the Internal Revenue Service were contemplating administrative relief that could reduce or eliminate tax burdens associated with money funds moving to a floating NAV. On July 3, 2013, the Treasury Department and the IRS proposed a revenue procedure that would permit investors in a floating NAV money fund (i.e., an institutional Prime Fund) to avoid wash sale rules in certain circumstances. The willingness of the tax authorities to provide administrative relief in order to make an SEC rule proposal more workable is perhaps unique, and represents one of the tangible advantages to the money fund industry of SEC collaboration with other financial regulators under the auspices of FSOC. The SEC also addressed the accounting implications for the financial statements of a business investing in a floating NAV money fund. The question had been raised as to whether, if the SEC were to adopt the Floating NAV Alternative, businesses would be able to treat their fund shares as a “cash equivalent” on their balance sheets under U.S. generally accepted accounting principles ("GAAP"). As a result, there was a concern that businesses may need to use some other vehicle to invest their cash, potentially reducing by a substantial amount the assets of institutional money funds."

Finally, they add, "The SEC took the unusual step in the Proposing Release of interpreting GAAP as permitting shares of a floating NAV money fund (i.e., an institutional Prime Fund) to be treated as a "cash equivalent" because the fluctuations in value of shares likely would be "insignificant." The SEC's interpretation is important because it may head off an exodus of institutional investors from money funds should the SEC adopt the Floating NAV Alternative. It would, however, appear to undercut one of the SEC's purposes in proposing to require money funds to adopt a floating NAV, which would be to persuade investors to treat their fund holdings as investments subject to the risk of loss, rather than as riskless cash."

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