Alert June SEC Money Market Fund Reforms Could Significantly Affect Corporate Cash Management. Introduction. Background Stable Share Pricing

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1 Alert June 2013 In This Alert: SEC Money Market Fund Reforms Could Significantly Affect Corporate Cash Management Introduction Background Stable Share Pricing The Lehman Collapse The SEC Proposals Floating Net Asset Value Alternative Standby Liquidity Fees and Gates Other Reforms Impact on Investors and Issuers Conclusion SEC Money Market Fund Reforms Could Significantly Affect Corporate Cash Management Introduction Since their birth in the 1970s, money market funds have become a $3 trillion industry and a primary vehicle for the holding of individual, corporate, and institutional cash positions. On June 5, 2013, the Securities and Exchange Commission announced proposals that would fundamentally alter the rules governing money market funds. The SEC stated that it is seeking to improve the ability of these funds to mitigate the effects of heavy redemptions, or runs, and to increase risk transparency, while preserving, as much as possible, the benefits of money market funds. Two alternatives floating per share net asset value and standby liquidity fees and gates are at the core of the SEC s proposed reforms. Under either alternative, institutional and commercial investors would see changes in their ability to treat money market funds as available-ondemand cash equivalents. Because money funds are major holders of commercial paper and other short term debt, businesses that rely on these types of instruments for financing could also be affected. This Alert briefly describes the background of the SEC s proposals, the alternative approaches, and how adoption could affect money market fund investors and short term debt issuers. The proposals are complex, and the SEC s 697-page release invites commenters to address over 1,000 questions. The comment period ends on September 17, Because of the potential impact on investors and markets, companies and institutions that use these funds for cash management, or that issue securities which money funds hold, should consider submitting comments. Background Stable Share Pricing Investment Company Act Rule 2a-7 is the basis for the money market fund industry. Rule 2a-7 permits money market funds to maintain a fixed share price (usually $1) and exempts these funds from the requirement -- applicable to other mutual funds -- to compute their daily share price based on the fair market value of the fund s portfolio securities. Money market funds use two devices penny-rounding and amortized cost -- to stabilize share prices. Under penny rounding, the fund s per share net asset value can be rounded to the nearest cent (e.g., a net asset value of $.995 can be rounded to $1). Under the amortized cost valuation method, securities in a money market fund s portfolio with maturities of

2 less than 60 days may be valued at cost, adjusted for the amortization of any discount or premium from maturity value. Because of stable $1 pricing and periodic distribution of all interest income, investors have come to view money market funds as the functional equivalent of bank deposits. Money market fund accounts do not, however, enjoy the protection of federal deposit insurance, and the fund s ability to maintain a stable price is not guaranteed. If the net asset value of a money market fund falls below $1, notwithstanding penny rounding and amortized cost valuation, it is said to have broken the buck. The Lehman Collapse On September 15, 2008, Lehman Brothers Holdings filed for bankruptcy. The following day, a prominent fund group, The Reserve Fund, announced that one of its money market funds, which held a substantial position in Lehman Brothers commercial paper, would break the buck and price its securities at $0.97. During the following week, investors, fearing that other money market funds would follow suit, withdrew approximately 14 percent of the assets of all money market funds that held commercial paper (known as prime funds). To conserve cash and meet withdrawal requests, money market fund managers stopped investing, and the market for commercial paper and other short-term debt instruments essentially froze. In order to restore the ability of short term borrowers to obtain financing, the Department of the Treasury was compelled to temporarily guarantee shares of money market funds. Since 2008, the SEC has been exploring ways of addressing the susceptibility of money market funds to runs, as illustrated in the Reserve Fund situation, and of reducing the risk that a failure of one fund will lead to a sudden exodus from others, with attendant disruption in the credit markets. A variety of possible measures has been considered, but, until recently, there was no Commission majority supporting any specific proposal. During the past year, the SEC has come under increasing pressure from the Financial Stability Oversight Council an interagency body created by the Dodd-Frank Act -- to agree on an approach to money market fund reform. The SEC Proposals As noted above, the SEC has proposed two alternatives floating net asset value and liquidity fees and gates. However, the alternatives are not mutually exclusive, and the SEC stated in its release announcing the proposed reforms that a third alternative a combination of the first two alternatives might also be adopted. Floating Net Asset Value Alternative Under the floating net asset value alternative, money market funds would be required to sell and redeem shares at the actual per share net asset value of the securities in the fund s portfolio, determined by marking the portfolio to market. Penny rounding pricing and amortized cost valuation would no longer be available as price stabilizers. Money market funds would be required to compute their net asset value to the nearest basis 2 Alert June 2013

3 point, i.e., 1/100 th of one percent and share prices would vary with the market value of the fund s securities portfolio. Two types of money market funds would be exempt from the floating net asset value requirement government funds and retail funds. Money market funds in those categories could continue to use penny rounding (but not amortized cost valuation) to maintain a stable net asset value. A government fund would be defined as a money market fund that maintains at least 80 percent of its total assets in cash, government securities, or repurchase agreements fully collateralized by government securities. A retail fund would be defined as a money market fund that does not permit a shareholder to redeem more than $1 million in a single business day. Standby Liquidity Fees and Gates Under the second alternative, money market funds could continue to use penny rounding (but not amortized cost) to maintain a stable $1 share price. However, to discourage runs, funds would be required to institute an exit or liquidity fee in certain circumstances, and fund directors would be permitted to suspend redemptions (referred to as imposing a gate ). Specifically, if a money market fund s weekly liquid assets fell below 15 percent of its total assets, the fund would be required to charge a 2 percent liquidity fee on redemptions, unless the board (including a majority of the independent directors) determined that the fee was not in the fund s best interest. In addition, the fund board would be permitted to suspend redemptions for up to 30 days, or until weekly liquid assets rose to 30 percent of the fund s total assets. Weekly liquid assets would include cash, U.S. Treasury securities, other government securities with a remaining maturity less than 60 days, and securities that convert to cash within a week. As under the first alternative, government money market funds would be exempt from these requirements; government funds could, however, impose fees or gates voluntarily. Unlike the first alternative, there would be no exemption for retail funds. Other Reforms In addition to the two alternatives, the SEC has proposed to increase money market fund portfolio diversification requirements, to enhance stress testing, and to require additional disclosure. In particular, all money market funds would be required to make daily website disclosure of the fund s weekly liquid net assets and of its shadow net asset value that is, its net asset value based on the market value of its portfolio. Impact on Investors and Issuers The SEC s June 5 release contains extensive discussion of the possible consequences of its proposals. Some of the potential effects on money market fund investors and short term borrowers are summarized below. Money market fund accounts may become less attractive, relative to other cash management alternatives. 3 Alert June 2013

4 Today, money market fund investors typically assume that they will be able to withdraw their original investment without any loss of principal. Under the floating net asset value approach, this ability to redeem at a fixed share amount would disappear. While stable $1 pricing would continue under the fees-and-gates alternative, investors would run that risk that, in the event of financial stress, they would face either a liquidity fee haircut or a 30 day withdrawal delay. Stable value government money market funds would continue to exist, but the return on such funds is likely to be considerably lower than on prime funds. Some institutional investors may be precluded from using money funds. While the proposed reforms might make many non-retail investors more reluctant to use money market funds (other than government funds), some might be unable to do so. The SEC s release notes that some institutional investors, including certain state and local governmental authorities, are prohibited by law or by internal policies and guidelines from investing assets in a money market fund unless the fund has a stable value per share or does not restrict redemptions. Money market fund investments will require more active oversight. While one of the objectives of the SEC s reforms is to reduce the risk of runs, it could have the opposite affect. At minimum, investors would need to be more vigilant. For example, weekly liquid assets and shadow net asset values would become available on a daily basis under the enhanced disclosure proposals. To avoid the risk of a redemption fee or a gate, investors would likely monitor these disclosures closely and withdraw from a fund as its weekly liquidity approached the 15 percent trigger level or if its net asset value diverged from its share price. Investors who failed to engage in active monitoring could face losses or the inability to access their accounts. The commercial paper market could become more volatile and uncertain. The changes in money market funds may cause some investors to shift cash to other alternatives, such as bank deposits, direct investment in money market securities, or private liquidity funds. Such shifts might occur on a long term basis or temporarily, in response to a perceived increased risk of liquidity fees or gates. The SEC release notes that, if capital flowed from money market funds to bank deposits, the availability of short-term financing may be affected because banks tend to fund longer-term lending and capital investments. Similarly, a shift from prime money market funds to government money market funds could decrease demand for commercial paper and result in rate increases. Money market funds would have tax consequences that do not exist today. Today, transactions in money market fund shares do not have tax consequences. Under the floating net asset value alternative, share prices could fluctuate, and taxable investors would have to recognize gain or loss on sales (and would have to maintain records to support tax reporting). In addition, the wash sale rules would apply. Those rules 4 Alert June 2013

5 preclude recognition of a tax loss, if, within 30 days of the sale, the investor buys the same securities. Most money fund sales occur within 30 days of a purchase, since investors reinvest dividends, and dividends are typically paid monthly. Under the liquidity fee alternative, there could also be tax and recordkeeping implications for investors. The SEC release states that, for tax purposes, a liquidity fee would be treated as a reduction in proceeds and would not in itself have tax consequences. However, in some circumstances, subsequent dividends from a fund that had imposed a liquidity fee might have to be treated partially as reductions in basis, rather than as income. The accounting ramifications of floating net asset value are open to debate. The release points out that a floating net asset value may raise a question as to whether money market fund shares could classified as a cash equivalent on corporate balance sheets. If floating net asset value money fund shares are not cash equivalents for financial reporting purposes, their status under debt covenants that require borrowers to maintain certain levels of cash and cash equivalents would change. GAAP defines cash equivalents as short-term, highly liquid investments that are readily convertible to known amounts of cash and that are so near their maturity that they present insignificant risk of changes in value. The release states that the Commission believes that an investment in a money market fund with a floating NAV would meet the definition of a cash equivalent * * * [unless] events may occur that give rise to credit and liquidity issues. Nonetheless, the release asks commenters to address the issue of how floating net asset value money market fund shares would be treated under GAAP. The release is silent on the accounting impact of liquidity fees and gates. For further information please contact Daniel L. Goelzer Daniel.Goelzer@bakermckenzie.com 815 Connecticut Avenue Washington, DC United States Conclusion The SEC s reforms, if implemented, would have a substantial impact on money market funds, investors, and companies that rely on money market financing. The proposals are, however, controversial, and it is by no means certain that any of the approaches in the June 5 release will be adopted in their current form. Companies and institutions that would be affected by money market fund reform should consider submitting comments so that the SEC will have a complete picture of the costs and benefits of its proposals. Baker & McKenzie has also prepared a more detailed summary of the SEC s money market fund reform proposals. That summary, which also focuses on the impact on securitization transactions, is available at SEC's Proposed Money Market Reforms - Detailed Summary; Implications for Securitization Baker & McKenzie. All rights reserved. Baker & McKenzie International is a Swiss Verein with member law firms around the world. In accordance with the common terminology used in professional service organizations, reference to a partner means a person who is a partner, or equivalent, in such a law firm. Similarly, reference to an office means an office of any such law firm. This may qualify as Attorney Advertising requiring notice in some jurisdictions. Prior results do not guarantee a similar outcome. 5 Alert June 2013