Money Market Funds: Emerging Issues in 2013

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2 Caveat This outline is for informational purposes only and does not constitute legal advice or create an attorney-client relationship Consult your own attorney for legal advice on the issues discussed in this outline IRS Circular 230 Disclosure To ensure compliance with the requirements imposed by the IRS, we inform you that any tax advice contained in this communication was not intended or written to be used, and cannot be used, for the purpose of (i) avoiding tax-related penalties under the Internal Revenue Code or (ii) promoting, marketing, or recommending to another party any matters addressed herein This outline may constitute attorney advertising This is MoFo. 2

3 Introduction Stresses in the home mortgage market in 2007 presented challenges to money market funds holding commercial paper issued by SIVs No money market fund broke the buck as a result September 15, 2008: Lehman bankruptcy filed Reserve Primary Fund holds $785M in Lehman paper, over 1% of the Fund s assets Immediate valuation questions and investor redemptions Concern about a run on the Fund and breaking the buck Lehman debt valued at 80% Assurances of support for $1.00 NAV Early redeemers paid $1.00, before redemptions halted Fund breaks the buck on September 16, 2008 This is MoFo. 3

4 Introduction Investors file multiple suits immediately Demand halt on redemptions, damages against adviser and Bents Claw-back of $1.00 payments to early redeemers Some claims against Trustees SEC orders halt to Fund redemptions and payments SEC investigates, ultimately files suit against adviser and Bents All litigation transferred to SDNY, stayed in favor of SEC suit Court approves SEC-proposed distribution plan for Fund All investors have now received over 99%, no claw-back Fights over advisor fees, legal fees, insurance proceeds This is MoFo. 4

5 Emergency Measures Federal regulators stepped in to stabilize money market funds and calm jittery investor nerves with unprecedented emergency measures Treasury Temporary Guarantee Program for Money Market Funds Federal Reserve Board Asset-Backed Commercial Paper Money Market Mutual Fund Liquidity Program Federal Reserve Board Commercial Paper Funding Facility Federal Reserve Board Money Market Fund Investor Funding Facility SEC No-action relief permitting money market fund sponsors to provide financial support to more than 100 money market funds in over 18 fund complexes Facilitating money market fund participation in various emergency programs Contributing to the design and administration of Treasury programs Permitting expanded use of amortized cost for a limited time This is MoFo. 5

6 ICI Money Market Working Group Investment Company Institute s Money Market Working Group in March 2009 issues report containing recommendations for money market fund reform Liquidity standards: 5% daily and 20% weekly Maturity: reduce weighted average maturity from 90 days to 75 days Credit quality: improvements to credit analysis and new products KYC: know your customer requirements Redemptions: authorize fund boards to temporarily suspend redemptions Disclosure: Monthly website disclosure of portfolio holdings and IAA rules regarding funds not registered under the 1940 Act Oversight: Enhanced government oversight of money market funds through enhanced reporting requirements Sponsor support: amend rule to facilitate greater sponsor financial support without need for SEC approval Treasury programs: extend Treasury Temporary Guarantee program until 9/18/09 Tier 2 securities: eliminate investments in Tier 2 securities Boards: Refine board oversight of money market funds This is MoFo. 6

7 Rule 2a-7 Amendments In response to market turmoil, SEC revised Rule 2a-7 on January 27, 2010 Liquidity requirement 10% daily and 30% weekly illiquid securities limited to 5% Credit quality Maturity Tier 2 limit reduced to 3% from 5% Tier 2 limit of 0.5% per issuer and 45 day maximum maturity WAM reduced to 60 days from 90 days maximum WAL established at 120 days maximum Know your customer requirement Stress testing Required for changes in interest rates, redemptions and credit quality This is MoFo. 7

8 Rule 2a-7 Amendments NRSROs Board must designate at least four NRSROs that they determine are reliable SEC proposed to remove references to NRSROs on March 3, 2011 in response to Dodd Frank Act mandate Removed requirement that asset backed securities must be rated Repos Cash collateral must be cash items or government securities for look-through treatment Must evaluate counterparty creditworthiness Disclosure Monthly website disclosure of portfolio and shadow NAV - 60 day lag Processing Funds must have capacity to process trades at a price other than $1.00 Redemptions Board can suspend redemptions if fund is about to break a buck and board decides to liquidate fund Fund affiliates Rules eased allow purchase of portfolio securities by affiliates Prior SEC notification required This is MoFo. 8

9 President s Working Group Report of the President s Working Group on Financial Markets Money Market Reform Options was issued on October 20, 2010 Potential options include Floating NAV Private emergency liquidity facility Mandatory redemptions in kind Money market fund insurance Two-tier system of money market funds Enhanced protections for stable NAV Stable NAV for retail investors only Regulate Stable NAV Money Market Funds as Special Purpose Banks Enhanced restraints on unregulated money market fund substitutes This is MoFo. 9

10 SEC Follow-up to PWG Report SEC requested comments on PWG Report and held a Roundtable on Money Market Funds and Systemic Risk to address Potential for money market funds to pose systemic risk to broader financial markets What makes money market funds vulnerable to runs How to view money market funds in context of systemic risk analysis Possible options for further regulatory reform and implications Floating NAV Regulation as Special Purpose Banks Mandatory reserve or capital requirements Liquidity fees This is MoFo. 10

11 Follow-up to PWG Report Investment Company Institute holds 2011 Money Market Funds Summit addressing Money markets today: moving past the financial crisis Understanding global money market fund industry Money market fund regulatory changes post-financial crisis What s next for money market funds Industry Comments: Mixed support for private liquidity facility General opposition to: Redemptions in kind Floating NAV Two-tier system Other Comments: Some support for Floating NAV Some support for Special Purpose Bank for stable NAV money market funds. This is MoFo. 11

12 Dissention at the SEC August SEC Chair Mary Schapiro tables a proposed rulemaking because of lack of support from three Commissioners Followed statement that a majority of Commissioners would not support MMF reforms without further study SEC proposals reportedly would have Required MMFs to choose between two alternative structures Floating NAV Adopt capital buffer of less than 1% of assets combined with 3% redemption holdback This is MoFo. 12

13 IOSCO Report October 9, 2012 International Organization of Securities Commissions calls for additional regulation of MMFs Financial Stability Board, established by Group of 20, considers MMFs to be part of shadow banking system FSB urged IOSCO to review potential reforms that would mitigate MMF susceptibility to runs and other systemic risks Report made 15 broad recommendations, including options for floating NAVs, NAV buffers, liquidity, stress testing and know your customer requirements IOSCO recommended that use of amortized cost accounting be subject to strict conditions and monitoring IOSCO recommended that regulators require stable NAV MMFs convert to floating rate NAV funds when workable The SEC did not endorse the IOSCO report This is MoFo. 13

14 FSOC Recommendations November Financial Stability Oversight Council proposed MMF reforms DFA Section 120 authorized FSOC to recommend actions to SEC and seek public comment Recommendations are not binding or legally enforceable, but SEC must act or tell FSOC why not Urged SEC to consider three options Option One Floating NAV Option Two Stable NAV with NAV buffer and minimum balance at risk Buffer would absorb daily variations Minimum balance at risk would be 3% of an investor s highest account value in excess of $100,000 during previous 30 days, to be held back for 30 days Option Three Stable NAV with NAV buffer and other measures Risk-based NAV capital requirement of 3% More stringent diversification, liquidity and disclosure requirements This is MoFo. 14

15 FSB Consultative Document November 18, 2012 Financial Stability Board issues report - Strengthening Oversight and Regulation of Shadow Banking Defines shadow banking system as credit intermediation involving entities and activities (fully or partially) outside the regular banking system (including MMFs) FSB believes that MMFs are part of the shadow banking system Five specific recommendations Mitigate spill-over effect between regular baking system and shadow banking system Reduce susceptibility of MMFs to runs Endorses IOSCO recommendations for MMFs, especially floating NAV Assess and mitigate systemic risks posed by other shadow banking entities Assess and align incentives associated with securitization Dampen risks and pro-cyclical incentives associated with secured financing contracts such as repos, and secured lending that may exacerbate funding strains in times of runs This is MoFo. 15

16 SEC Staff Risk Study Division of Risk, Strategy and Financial Innovation, at request of three Commissioners published its report on November 30, 2012 Addresses questions relating to: Causes of investor redemptions during financial crisis Whether MMFs that break the buck outside of a period of financial distress would cause systemic problems Efficacy of the 2010 MMF reforms Risks of proposed MMF reforms Risks of migration to alternative, unregulated funds now under study Effects on commercial paper market, market for municipal debt, and on corporate borrowers and municipalities that sell debt to MMFs Found greater effect on financial companies issuing commercial paper and shortterm municipalities to fund debt This is MoFo. 16

17 Reserve Prime Fund Case After more than 3 years of litigation, SEC case against MMF s adviser and executives went to trial in 2012 Key focus of SEC claims against adviser was alleged misrepresentations to the Trustees In response, adviser s counsel alleged collusion between the Trustees and SEC Revisions to board minutes after the fact Trustees were anticipated to be the SEC s star witnesses at trial Removed from witness list days before the trial Close focus on Trustees actions in crisis Questions posed to adviser Rejection of adviser recommendations Jury exonerates Adviser and executives of fraud; finds negligence Adviser and executives sue independent directors for fraud This is MoFo. 17

18 Lessons from the Crisis MMF directors are not off the hook Just because the SEC did not sue the independent directors this time, it can still come after directors in the future under various theories, including breach of fiduciary duty Directors have liability under state law When dramatic events unfold quickly, take immediate action Stay fully informed Require regular reports from and communication with management Meet frequently Don t make assumptions get the facts Keep counsel in the loop Continuously monitor redemptions and liquidity This is MoFo. 18

19 Lessons from the Crisis Funds should maintain an adequate record of director deliberations Document questions, requests for information Document discussions with management Document meetings in executive session Topical versus detailed minutes Be careful to maintain attorney-client privilege Review adequacy of Rule 2a-7 and valuation policies and procedures Hourly pricing versus daily pricing Hourly pricing underscores the need for workable pricing procedures Adequacy of credit monitoring procedures Disaster planning Anticipate emergency procedures in the event of a nuclear event (e.g., bankruptcy of issuer of large fund holding) Discuss emergency procedures with management Periodically test emergency procedures This is MoFo. 19

20 Lessons from the Crisis D&O/E&O Insurance Review scope of exclusions Adequate coverage for formal and informal investigations Insured-versus-insured exclusions Consider Side A insurance Be aware of what it provides, and what it does not provide Review and communications policies Avoid stream of consciousness s take on different meanings when viewed after the fact I shot the clerk problem (inadvertent confession) Preserve privilege in communications Think twice before hitting reply to all Schedule regular and frequent telephone calls among directors and management, and among directors themselves Schedule frequent placeholder meetings This is MoFo. 20

21 Looking Ahead New top regulators at SEC and Treasury may alter the mix of competing interests Indications that some SEC Commissioners may compromise on MMF reforms MMF industry continues strong opposition but shows readiness to compromise Different reforms may apply to different types of MMFs Retail v. institutional Type of asset class Taxable v. tax free Will solution be driven by politics or real risks? This is MoFo. 21