One June 5, 2013, the SEC proposed amendments impacting money market funds and money market type funds. This is Part IV of a Four-Part Blog on the 671-page proposal delineated in the following compliance areas: (ia) changes the net asset value per share (“NAV”) from fixed-rate to floating-rate for certain money market funds; (ib) authorizes money [...]
One June 5, 2013, the SEC proposed amendments impacting money market funds and money market type funds. This is Part III of a Four-Part Blog on the 671-page proposal delineated in the following compliance areas: (ia) changes the net asset value per share (“NAV”) from fixed-rate to floating-rate for certain money market funds; (ib) authorizes money [...]
SEC Proposes Amendments to Money Market Fund Rules: Additional Disclosures on Websites, SAI, Form N-MFP and New Form N-CR
One June 5, 2013, the SEC proposed amendments impacting money market funds and money market type funds. This is Part II of a Four-Part Blog on the 671-page proposal delineated in the following compliance areas: (ia) changes the net asset value per share (“NAV”) from fixed-rate to floating-rate for certain money market funds; (ib) authorizes [...]
One June 5, 2013, the SEC proposed amendments impacting money market funds and money market type funds. This is Part I of a Four-Part Blog on the 671-page proposal delineated in the following compliance areas: (ia) changes the net asset value per share (“NAV”) from fixed-rate to floating-rate for certain money market funds; (ib) authorizes money [...]
One June 5, 2013, the SEC proposed amendments impacting money market funds and money market type funds. This is Part IV of a Four-Part Blog on the 671-page proposal delineated in the following compliance areas: (ia) changes the net asset value per share (“NAV”) from fixed-rate to floating-rate for certain money market funds; (ib) authorizes money market funds to suspend redemptions or impose liquidity fees during heavy redemption periods. These proposed rule changes are “designed to address money market funds’ susceptibility to heavy redemptions, improve their ability to manage and mitigate potential contagion from such redemptions, and increase the transparency of their risks, while preserving, as much as possible, the benefits of money market funds.” Under this proposal, the SEC continued that they could adopt either alternative by itself or a combination of the two alternatives.;” (ii) additional disclosures, including new Form N-CR and Form N-MFP; (iii) portfolio diversification and stress testing of money market funds holdings; (iv) additional disclosure on Form PF of money market type funds held by private equity firms.
The SEC proposed to amend the Form PF section where private equity advisers report information regarding the private funds. Specifically, “liquidity funds,” which are private funds that seek to maintain a stable NAV (or minimize fluctuations in their NAVs) and thus can resemble money market funds. For purposes of Form PF, a “liquidity fund” is any private fund that seeks to generate income by investing in a portfolio of short term obligations in order to maintain a stable net asset value per unit or minimize principal volatility for investors.
Large liquidity fund advisers, which are registered advisers with $1 billion or more in combined money market fund and liquidity fund assets, would file substantially the same information with respect to their liquidity funds’ portfolio holdings on Form PF as money market funds are required to file on Form N-MFP. In addition, provide information about any securities sold by their liquidity funds during the reporting period, including sale and purchase prices. Finally, large liquidity fund advisers would identify any money market fund advised by the adviser or its related persons that pursues substantially the same investment objective and strategy and invests side by side in substantially the same positions as a liquidity fund the adviser reports on Form PF.
Also, it was proposed to remove current Questions 56 and 57 on Form PF because these questions generally require large liquidity fund advisers to provide information about their liquidity funds’ portfolio holdings broken out by asset class (rather than security by security). And regulators would be able to derive the information currently reported in response to those questions from the new portfolio holdings information advisers would provide.
The SEC stated that the proposed Form PF changes are designed to achieve two primary goals. First, they are designed to ensure to the extent possible that any further money market fund reforms do not decrease transparency in the short-term financing markets, and to better enable FSOC to monitor and address any related systemic risks and to better enable us to develop effective regulatory policy responses to any shift in investor assets. Second, the proposed amendments to Form PF are designed to allow FSOC and us to more effectively administer our regulatory programs even if investors do not shift their assets as a result of any further money market fund reforms, as the increased transparency concerning liquidity funds, combined with information we already collect on Form N-MFP, will provide a more complete picture of the short-term financing markets in which liquidity funds and money market funds both invest.
Finally, it was reiterated what was discussed in the Form PF Adopting Release, that the SEC does not intend to make public Form PF information identifiable to any particular adviser or private fund, the Dodd-Frank Act amended the Advisers Act to preclude them from being compelled to reveal this information except in very limited circumstances.
One June 5, 2013, the SEC proposed amendments impacting money market funds and money market type funds. This is Part III of a Four-Part Blog on the 671-page proposal delineated in the following compliance areas: (ia) changes the net asset value per share (“NAV”) from fixed-rate to floating-rate for certain money market funds; (ib) authorizes money market funds to suspend redemptions or impose liquidity fees during heavy redemption periods. These proposed rule changes are “designed to address money market funds’ susceptibility to heavy redemptions, improve their ability to manage and mitigate potential contagion from such redemptions, and increase the transparency of their risks, while preserving, as much as possible, the benefits of money market funds.” Under this proposal, the SEC continued that they could adopt either alternative by itself or a combination of the two alternatives.;” (ii) additional disclosures, including new Form N-CR and Form N-MFP; (iii) portfolio diversification and stress testing of money market funds holdings; (iv) additional disclosure on Form PF of money market type funds held by private equity firms.
The current rule 2a-7 requires a money market fund’s portfolio to be diversified, both as to the issuers of the securities it acquires and providers of guarantees and demand features related to those securities. Money market funds must limit their investments in the securities of any one issuer of a first tier security (other than government securities) to no more than 5% of fund assets. They must also limit their investments in securities subject to a demand feature or a guarantee to no more than 10% of fund assets from any one provider, except that the rule provides a so-called “twenty-five percent basket,” under which as much as 25% of the value of securities held in a fund’s portfolio may be subject to guarantees or demand features from a single institution.
However, the SEC’s concern that the diversification requirements in rule 2a-7 today may not appropriately limit money market fund risk exposures has resulted in these proposed amendments to rule 2a-7.
Treatment of Certain Affiliates for Purposes of Rule 2a-7 Five Percent Issuer Diversification Requirement
The possibility for financial distress to transmit across affiliated entities was demonstrated during the 2007-2008 financial crisis when, American International Group Inc. came under financial stress, which affected a number of its affiliates. In some cases, AIG’s corporate group contagion required the sponsors of money market funds that owned AIG’s affiliates’ securities to seek no-action relief from the SEC in order for the sponsors to support their funds.
The SEC determined that although affiliates may be separate legal entities, their valuations and the creditworthiness of their securities may depend on the financial well-being of other firms in the group. And a firm may issue debt securities that would be considered to be in default if one of the firm’s affiliates is unable to meet its financial obligations.
Consequently, money market funds would aggregate their exposures to certain entities that are affiliated with each other when applying the 5% issuer diversification limit. Specific to this proposal, the definition of affiliated is if one controlled the other entity or was controlled by it or under common control with it, and control would be defined to mean ownership of more than 50% of an entity’s voting securities.
Asset Backed Securities
Also, rule 2a-7 would have diversification provisions to limit the amount of exposure money market funds can have to ABS sponsors that provide express or implicit support for their ABSs. Subject to an exception, money market funds investing in ABSs, including ABCP, who rely on the ABSs sponsors’ financial strength or their ability or willingness to provide liquidity, credit, or other support to the ABSs would treat the sponsor of an SPE issuing ABS as a guarantor of the ABS subject to the diversification limitations applicable to guarantors and demand feature providers. Therefore, a fund could not invest in an ABS if, immediately after the investment, it would have invested more than 10% of its total assets in securities issued by or subject to demand features or guarantees from the ABS sponsor.
Moreover, it was proposed that, subject to an exception, all ABS sponsors would be deemed to guarantee their ABSs, unless the money market fund’s board of directors (or its delegate) determines that the fund is not relying on the ABS sponsor’s financial strength or its ability or willingness to provide liquidity, credit, or other support to determine the ABS’s quality or liquidity.
The Twenty-Five Percent Basket
The SEC noted that in 2008, as much as 30% of the municipal securities held by tax-exempt money market funds were supported by bond insurance issued by “monoline insurance companies” (a monoline insurance company generally is an insurance company that only provides guarantees to issuers of securities.). This concentration led to considerable stress in the municipal markets when some of these bond insurers were downgraded during the financial crisis. For example, a lack of confidence in the bond insurers was a primary contributor to the market “freeze” that occurred in variable-rate demand notes in 2008 when money market funds and other investors reduced their purchases of these securities or sold them to the financial institutions that had provided demand features for the securities. The freeze in turn strained the providers of the demand feature and also increased the interest the issuers of the securities were required to pay.
Therefore, they would amend rule 2a-7 to tighten the diversification requirements applicable to guarantors and providers of demand features. The amendments would eliminate the so-called “twenty-five percent basket,” under which as much as 25% of the value of securities held in a fund’s portfolio may be subject to guarantees or demand features from a single institution.
Stress Testing under the Floating NAV Alternative and Trigger Gates
If the floating NAV alternative is adopted, the SEC would amend the current stress testing requirement as it would apply to floating NAV money market funds to require that such funds test the impact of certain market conditions on fund liquidity, instead of requiring that they test the fund’s ability to maintain a stable price per share.
Currently stress testing required at such intervals as the board of directors determines appropriate and reasonable in light of current market conditions, of the money market fund’s ability to maintain a stable net asset value per share based upon specified hypothetical events that include, but are not limited to, a change in short-term interest rates, an increase in shareholder redemptions, a downgrade of or default on portfolio securities, and the widening or narrowing of spreads between yields on an appropriate benchmark the fund has selected for overnight interest rates and commercial paper and other types of securities held by the fund.
Now, each floating NAV money market fund would have to stress test its ability to avoid having its weekly liquid assets falls below 15% of all fund assets. In addition, they would stress test their ability to avoid crossing the same 15% weekly liquid asset threshold because it could trigger fees or gates.
Definitions of Daily Liquid Assets and Weekly Liquid Assets
Clarification of definitions amendments were proposed for certain characteristics of instruments that qualify as a “daily liquid asset” or “weekly liquid asset.”
First, money market funds cannot use the maturity-shortening provisions in current paragraph (d) of rule 2a-7 regarding interest rate readjustments when determining whether a security satisfies the maturity requirements of a daily liquid asset or weekly liquid asset, which include securities that will mature within one or five business days, respectively. The reason given was that using an interest rate readjustment to determine maturity as permitted under current paragraph (d) for these purposes would allow funds to include as daily or weekly liquid assets securities that the fund would not have a legal right to convert to cash in one or five business days. Therefore, this would not be consistent with the purposes of the minimum daily and weekly liquidity requirements, which are designed to increase a fund’s ability to pay redeeming shareholders in times of market stress when the fund cannot rely on the market or a dealer to provide immediate liquidity.
Second, agency discount notes with a remaining maturity of 60 days or less qualifies as a “weekly liquid asset” only if the note is issued without an obligation to pay additional interest on the principal amount. Therefore interest-bearing agency notes that are issued at a discount do not qualify.
Finally, the rule would include in the definitions of daily and weekly liquid assets amounts receivable that are due unconditionally within one or five business days, respectively, on pending sales of portfolio securities. These receivables, like certain other securities that qualify as daily or weekly liquid assets, provide liquidity for the fund because they give a fund the legal right to receive cash in one to five business days. It is expected that a fund (or its adviser) would include these receivables in daily and weekly liquid assets only if the fund (or its adviser) has no reason to believe that the buyer might not perform.
Definition of Demand Feature
It was proposed to amend the definition of demand feature in rule 2a-7 to mean a feature permitting the holder of a security to sell the security at an exercise price equal to the approximate amortized cost of the security plus accrued interest, if any, at the time of exercise, paid within 397 calendar days of exercise. This would eliminate the requirement that a demand feature be exercisable at any time on no more than 30 calendar days’ notice.
Short-Term Floating Rate Security and Second Tier Securities
Rule 2a-7(d)(4) would be amended to provide that, for purposes of determining WAL, a short-term floating rate security shall be deemed to have a maturity equal to the period remaining until the principal amount can be recovered through demand.
For second tier securities, it is currently required that money market fund shall not acquire a second tier security with a remaining maturity of greater than 45 calendar days. Immediately after the acquisition of any second tier security, a money market fund shall not have invested more than three percent of its total assets in second tier securities. However, to state more clearly the way in which this limitation operates, rule 2a-7 would state that the 45-day limit applicable to second tier securities must be determined without reference to the maturity-shortening provisions in rule 2a-7 for interest rate readjustments.
SEC Proposes Amendments to Money Market Fund Rules: Additional Disclosures on Websites, SAI, Form N-MFP and New Form N-CR
One June 5, 2013, the SEC proposed amendments impacting money market funds and money market type funds. This is Part II of a Four-Part Blog on the 671-page proposal delineated in the following compliance areas: (ia) changes the net asset value per share (“NAV”) from fixed-rate to floating-rate for certain money market funds; (ib) authorizes money market funds to suspend redemptions or impose liquidity fees during heavy redemption periods. These proposed rule changes are “designed to address money market funds’ susceptibility to heavy redemptions, improve their ability to manage and mitigate potential contagion from such redemptions, and increase the transparency of their risks, while preserving, as much as possible, the benefits of money market funds.” Under this proposal, the SEC continued that they could adopt either alternative by itself or a combination of the two alternatives.;” (ii) additional disclosures, including new Form N-CR and Form N-MFP; (iii) portfolio diversification and stress testing of money market funds holdings; (iv) additional disclosure on Form PF of money market type funds held by private equity firms.
Disclose on SAI the Investment Adviser Financial Support
The SEC proposed amendments that would require enhanced SAI and website disclosure on: (i) any type of financial support provided to a money market fund by the fund’s sponsor or an affiliated person of the fund; (ii) the fund’s daily and weekly liquidity levels; and (iii) the fund’s daily current NAV per share, rounded to the fourth decimal place in the case of funds with a $1.0000 share price or an equivalent level of accuracy for funds with a different share price (e.g., $10.000 or $100.00 per share).
All money market funds would have to disclose current and historical events of sponsor support. The SEC stated that they “believe that these disclosure requirements would clarify, to current and prospective money market fund investors as well as to the Commission, the frequency, nature, and amount of financial support provided by money market fund sponsors.” They continued that “[c]urrently, when sponsor support is provided during circumstances in which a money market fund experiences stress but does not “break the buck,” and sponsor support is not immediately disclosed, investors may be unaware that their money market fund has come under stress.”
Specifically, Form N-1A would require money market funds to provide SAI disclosure regarding historical instances in which the fund has received financial support from a sponsor or fund affiliate. The proposed amendments would require each money market fund to disclose any occasion during the last ten years on which an affiliated person, promoter, or principal underwriter of the fund, or an affiliated person of such person, provided any form of financial support to the fund. With respect to each such occasion, funds would describe the nature of support, the amount of support, the date the support was provided, the security supported and its value on the date the support was initiated (if applicable), the reason for the support, the term of support (if applicable), and any contractual restrictions relating to the support. “Financial support” is defined as, but not be limited to (i) any capital contribution, (ii) purchase of a security from the fund in reliance on rule 17a-9, (iii) purchase of any defaulted or devalued security at par, (iv) purchase of fund shares, (v) execution of a letter of credit or letter of indemnity, (vi) capital support agreement (whether or not the fund ultimately received support), (vii) performance guarantee, or (viii) any other similar action to increase the value of the fund’s portfolio or otherwise support the fund during times of stress. In addition, if the fund has participated in a merger with another investment company during the last ten years, the fund must additionally provide the required disclosure with respect to the other investment company.
New Disclosures on Websites and Form N-MFP
Proposed amendments to rule 2a-7 would require money market funds to disclose prominently on their websites the percentage of the fund’s total assets that are invested in daily and weekly liquid assets, as well as the fund’s net inflows or outflows, as of the end of the previous business day. The proposed amendments would require a fund to maintain a schedule, chart, graph, or other depiction on its website showing historical information about its investments in daily liquid assets and weekly liquid assets, as well as the fund’s net inflows or outflows, for the previous 6 months, and would require the fund to update this historical information each business day, as of the end of the preceding business day. These amendments would complement the proposed requirement, as discussed elsewhere in the proposal, for money market funds to provide on their monthly reports on Form N-MFP the percentage of total assets invested in daily liquid assets and weekly liquid assets broken out on a weekly basis. The daily website disclosure of liquid asset levels would help investors estimate, in near-real time, the likelihood that a fund may be able to satisfy redemptions by using internal cash sources (rather than by selling portfolio securities) in times of market turbulence, or, if our liquidity fees and gates proposal is adopted, whether a fund may approach or exceed a trigger for the potential imposition of a liquidity fee or gate. In addition, each money market fund would disclose daily, prominently on its website, the fund’s current NAV per share, rounded to the fourth decimal place in the case of a fund with a $1.0000 share price of an equivalent level of accuracy for funds with a different share price (the fund’s “current NAV”) as of the end of the previous business day. The fund would maintain a schedule, chart, graph, or other depiction on its website showing historical information about its daily current NAV per share for the previous 6 months, and would require the fund to update this historical information each business day as of the end of the preceding business day.
New Form N-CR
A new rule was proposed that would require money market funds to file new Form N-CR with the SEC when certain events occur. Funds would file Form N-CR in instances of portfolio security default, sponsor support of funds, and other similar significant events. The SEC stated that “this information would enable the Commission to enhance its oversight of money market funds and its ability to respond to market events. It would also provide investors with better and more timely disclosure of potentially important events.”
No matter what alternative is adopted, it was proposed that a money market fund file a report on Form N-CR if the issuer of one or more of the fund’s portfolio securities, or the issuer of a demand feature or guarantee, experiences a default or event of insolvency (other than an immaterial default unrelated to the financial condition of the issuer), and immediately before the default or event of insolvency the portfolio security or securities (or the securities subject to the demand feature or guarantee) accounted for at least 1/2 of 1% of the fund’s total assets. Although rule 2a-7 currently requires money market funds to report defaults or events of insolvency to the SEC by email, the SEC indicated that reporting these events on Form N-CR would provide important transparency to fund shareholders, and also would provide information more uniformly and efficiently to the SEC. Funds would disclose certain information about these reportable events, including the nature and financial effect of the default or event of insolvency, as well as the security or securities affected. The form would be filed within one business day after the default or event of insolvency occurs.
Additionally, under each proposed reform alternative, all money market funds would be required to report all instances of sponsor support on proposed Form N-CR. In addition to the new requirements on the SAI, Form N-CR would require funds receiving such financial support to disclose certain information about the support, including the nature, amount, and terms of the support, as well as the relationship between the person providing the support and the fund. The form would be filed within one business day after a fund receives such financial support.
In addition, funds that are permitted to transact at a stable price would file a report on proposed Form N-CR on the first business day after any day on which the fund’s current NAV per share (rounded to the fourth decimal place in the case of a fund with a $1.0000 share price, or an equivalent level of accuracy for funds with a different share price) deviates downward significantly from its intended stable price (generally, $1.00). Specifically, if the floating NAV alternative is adopted, only government or retail money market funds would file a report on Form N-CR if the fund’s current NAV per share deviates downward from its intended stable price by more than 1/4 of 1 percent.
If the liquidity fees and gates alternative is adopted, all money market funds would file a report on Form N-CR if the fund’s current NAV per share deviates downward from its intended stable price by more than 1/4 of 1 percent. The form would be filed within one business day following the reportable movement of the fund’s current NAV. Also, report on Form N-CR if fund reaches the threshold triggering board consideration of a liquidity fee or redemption gate, if the proposed liquidity fees and gates alternative are adopted. Include a description of the fund’s response (such as whether and why a fee was not imposed, as rule 2a-7 requires by default, or whether any why a gate was imposed). The SEC stated that “the factors specified in the required disclosure are necessary for investors and the Commission to understand the circumstances surrounding the fund’s weekly liquid assets falling below 15% of total fund assets, or the imposition or removal of a liquidity fee or gate. This in turn could affect the Commission’s oversight of the fund and regulation of money market funds generally, and could influence investors’ decisions to purchase shares of the fund or remain invested in the fund. Disclosure of the board’s analysis regarding whether to impose a liquidity fee or gate could provide investors and the Commission with a greater understanding of the events affecting and potentially causing stress to the fund, and could provide insight into the manner in which the board handles periods of fund stress.”
Funds would file Form N-CR when the board lifts the fee or resumes redemptions of fund shares. Funds would file the initial report on Form N-CR on the first business day following any occasion on which the fund’s weekly liquid assets fall below 15% of its total assets, the fund’s board imposes (or removes) a liquidity fee, or the fund’s board temporarily suspends (or resumes) the fund’s redemptions, which report would provide the date of the triggering event(s). Funds would need to file an amendment to the initial report on Form N-CR by the fourth business day following any of these triggering events, which amendment would provide additional detailed information about the event(s) (namely, a description of the facts and circumstances leading to the triggering event, as well as a discussion of the fund board’s analysis supporting the decision with respect to the imposition of fees or gates).
Amendments to Form N-MFP
There were several additional proposed amendments to Form N-MFP. Currently, each money market fund must file information on Form N-MFP electronically within five business days after the end of each month and that information is made publicly available 60 days after the end of the month for which it is filed. It was proposed, that regardless of the alternative proposal adopted to make Form N-MFP publicly available immediately upon filing. Also, to provide flexibility, unless otherwise specified, a fund may report information on Form N-MFP as of the last business day or any later calendar day of the month.
First, report on Form N-MFP the IOSCO established security Legal Entity Identifier along with the security CUSIP.
Second, for SEC industry evaluation purposes, money market funds would report whether a security is categorized as a level 1, level 2, or level 3 measurements in the fair value hierarchy under U.S. Generally Accepted Accounting Principles. Level 1 measurements include quoted prices for identical securities in an active market (e.g., active exchange-traded equity securities; U.S. government and agency securities). Level 2 measurements include: (i) quoted prices for similar securities in active markets; (ii) quoted prices for identical or similar securities in non-active markets; and (iii) pricing models whose inputs are observable or derived principally from or corroborated by observable market data through correlation or other means for substantially the full term of the security. Securities categorized as level 3 are those whose value cannot be determined by using observable measures (such as market quotes and prices of comparable instruments) and often involve estimates based on certain assumptions.
Finally, money market funds would report, on a weekly basis, the amount of cash they hold, the fund’s Daily Liquid Assets and Weekly Liquid Assets, and whether each security is considered a Daily Liquid Asset or Weekly Liquid Asset, and the weekly gross subscriptions (including dividend reinvestments) and weekly gross redemptions for each share class, once each week during the month reported. Money market funds would continue to file reports on Form N-MFP once each month, but certain information (including disclosure of Daily Weekly Liquid Assets and shareholder flow) would be reported weekly within the Form.
One June 5, 2013, the SEC proposed amendments impacting money market funds and money market type funds. This is Part I of a Four-Part Blog on the 671-page proposal delineated in the following compliance areas: (ia) changes the net asset value per share (“NAV”) from fixed-rate to floating-rate for certain money market funds; (ib) authorizes money market funds to suspend redemptions or impose liquidity fees during heavy redemption periods. These proposed rule changes are “designed to address money market funds’ susceptibility to heavy redemptions, improve their ability to manage and mitigate potential contagion from such redemptions, and increase the transparency of their risks, while preserving, as much as possible, the benefits of money market funds.” Under this proposal, the SEC continued that they could adopt either alternative by itself or a combination of the two alternatives.;” (ii) additional disclosures on Form N-CR and Form N-MFP; (iii) portfolio diversification and stress testing of money market funds holdings; (iv) additional disclosure on Form PF of money market type funds held by private equity firms.
The proposed floating NAV would apply to all money market funds, except government and retail money market funds. It was noted that when a fund’s shadow price is less than the fund’s $1.00 share price, money market fund shareholders have an incentive to redeem shares ahead of other investors in times of fund and market stress. Government money market funds are exempt because they face different redemption pressures and have different risk characteristics than other money market funds because of their unique portfolio composition. These funds are defined as funds that maintain at least 80% of their total assets in cash, government securities, or repurchase agreements that are collateralized fully.
Retail money market funds are exempt because retail investors historically have behaved differently from institutional investors in a crisis, being much less likely to make large redemptions quickly in response to the first sign of market stress. Thus, prime money market funds that are limited to retail investors in general have not been subject to the same pressures as institutional or mixed funds. Retail money market funds are defined as a money market fund that restricts a shareholder of record from redeeming more than $1,000,000 in any one business day. The SEC requested comments to add other components to the definition of retail money market fund to include maximum account size, shareholder concentration and shareholder characteristics.
It was noted that under the proposed retail money market fund exemption, a fund would not be required to impose its redemption limits on an omnibus account holder, provided that the fund has policies and procedures reasonably designed to allow the conclusion that the omnibus account holder does not permit any beneficial owner from “directly or indirectly” redeeming more than $1,000,000 in a single day. The proposed rule would not require retail money market funds to enter into explicit agreements or contracts with omnibus account holders at any stage in the chain, but would instead allow funds to manage these relations in whatever way that best suits their circumstances.
However, it was proposed that all money market funds would be required to disclose on a daily basis their share price with portfolios valued using market factors and applying basis point rounding. The SEC stated that in line with this increased transparency on the valuation of money market funds’ portfolios, and in light of the fact that this increased transparency renders penny rounding alone an equal method of achieving price stability in money market funds. Therefore, exempt floating NAV funds, i.e. government and retail money market funds, are required to use penny rounding pricing alone of portfolio securities.
Money market funds would only be able to use amortized cost valuation to the extent other mutual funds are able to do so, where the fund’s board of directors determines, in good faith, that the fair value of debt securities with remaining maturities of 60 days or less is their amortized cost,
The SEC also proposed to require that all money market funds, other than government and retail money market funds, price their shares using a more precise method of rounding. The proposal would require that each money market fund round prices and transact in its shares at the fourth decimal place in the case of a fund with a $1.00 target share price (i.e., $1.0000) or an equivalent level of precision if a fund prices its shares at a different target level
If approved the, the compliance date would be two years. This would allow time for money market funds converting to a floating NAV on a permanent basis to make system modifications and time for funds to respond to redemption requests.
Additional Redemption Restrictions
As an alternative to the floating NAV proposal discussed above, the SEC proposed to continue to allow money market funds to transact at a stable share price under normal conditions but require them to: (1) to institute a liquidity fee in certain circumstances and (2) permit money market funds to impose a gate in certain circumstances. The fees and gates alternative proposal would require that if a money market fund’s weekly liquid assets fell below 15% of its total assets, the fund must impose a liquidity fee of 2% on all redemptions unless the board of directors of the fund (including a majority of its independent directors) determines that imposing such a fee would not be in the best interest of the fund. The board may also determine that a lower fee would be in the best interest of the fund. They stated that when a fund’s weekly liquid assets are at least 50% below the minimum required weekly liquidity (i.e., weekly liquid assets have fallen from 30% to 15%), the fund is under sufficient stress to warrant that the fund’s board be permitted to suspend redemptions in light of a decision to liquidate the fund (and therefore facilitate an orderly liquidation).
It was also proposed that when a money market fund’s weekly liquid assets fall below 15% of total assets, the money market fund board would also have the ability to impose a temporary suspension of redemptions (also referred to as a “gate”) for a limited period of time if the board determines that doing so is in the fund’s best interest. Such a gate could be imposed, for example, if the liquidity fees were not proving sufficient in slowing redemptions to a manageable level.
Also, any fee imposed would be lifted automatically once the money market fund’s level of weekly liquid assets had risen to or above 30%, and it could be lifted at any time by the board of directors (including a majority of its independent directors) if the board determines to impose a different fee or if it determines that imposing the fee is no longer in the best interest of the fund.
In addition, any money market fund that imposes a gate would need to lift that gate within 30 days and a money market fund could not impose a gate for more than 30 days in any 90-day period. Under this proposal, rule 22e-3 would be amended to permit the suspension of redemptions and liquidation of a money market fund if the fund’s level of weekly liquid assets falls below 15% of its total assets.
The SEC stated that under this option, rule 2a-7 would continue to permit money market funds to use the penny rounding method of pricing so long as the funds complied with the conditions of the rule, but would not permit use of the amortized cost method of valuation. They would eliminate the use of the amortized cost method of valuation for money market funds under the fees and gates alternative for the same reasons given under the retail and government exemptions to the floating NAV alternative. Because the continued use of amortized cost valuation for all securities in money market funds’ portfolios is inappropriate given that these funds will already be valuing their securities using market factors on a daily basis due to new website disclosure requirements and given that penny rounding otherwise achieves the same level of price stability.
If a proposed combination of Floating NAV money market funds and the gate restrictions is approved, Floating NAV money market funds would be permitted to suspend redemptions, when, among other requirements, the fund, at the end of a business day, has less than 15% of its total assets in weekly liquid assets. And the exempt government money market funds and retail money market funds, would be able to suspend redemptions and liquidate if either (1) the fund, at the end of a business day, has less than 15% of its total assets in weekly liquid assets or (2) the fund’s price per share as computed for purposes of distribution, redemption, and repurchase is no longer equal to its stable share price or the fund’s board (including a majority of disinterested directors) determines that such a change is likely to occur.
It was noted that many states have established local government investment pools (“LGIPs”), money market fund-like investment pools that invest in short-term securities, that are required by law or investment policies to maintain a stable NAV per share. The Government Accounting Standards Board (“GASB”) states that LGIPs that are operated in a manner consistent with rule 2a-7 (i.e., a “2a7-like pool”) may use amortized cost to value securities (and presumably, facilitate maintaining a stable NAV per share). The floating NAV proposal, if adopted, may have implications for LGIPs.
The SEC proposed to add disclosures designed to inform investors about the primary general risks of investing in money market funds in this bulleted disclosure statement. Similar to the current requirements for a similar disclosure statement on their advertisements and sales materials, the proposed amendments would require a disclosure statement to emphasize that money market fund sponsors are not obligated to provide financial support, and that money market funds may not be an appropriate investment option for investors who cannot tolerate losses.
Specifically, they would require each money market fund (other than government money market funds that have chosen to rely on the proposed rule 2a-7 exemption for government money market funds from any fee or gate requirements) to include the following bulleted disclosure statement on their advertisements and sales materials:
(i) You could lose money by investing in the Fund.
(ii) The Fund seeks to preserve the value of your investment at $1.00 per share, but cannot guarantee such stability.
(iii) The Fund may impose a fee upon sale of your shares when the Fund is under considerable stress.
(iv) The Fund may temporarily suspend your ability to sell shares of the Fund when the Fund is under considerable stress.
(v) An investment in the Fund is not insured or guaranteed by the Federal Deposit Insurance Corporation or any other government agency.
(vi) The Fund’s sponsor has no legal obligation to provide financial support to the Fund, and you should not expect that the sponsor will provide financial support to the Fund at any time.
In addition, an amendment was proposed to Form N-1A to require money market funds (other than government money market funds that have chosen to rely on the proposed rule 2a-7 exemption from the fees and gates requirements) to provide disclosure in their SAIs regarding any occasion during the last 10 years (but not before the compliance period) on which the fund’s weekly liquid assets have fallen below 15%, and with respect to each such occasion, whether the fund’s board of directors determined to impose a liquidity fee and/or suspend the fund’s redemptions. With respect to each occasion, it was proposed requiring funds to disclose: (i) the length of time for which the fund’s weekly liquid assets remained below 15%; (ii) the dates and length of time for which the fund’s board of directors determined to impose a liquidity fee and/or temporarily suspend the fund’s redemptions; and (iii) a short discussion of the board’s analysis supporting its decision to impose a liquidity fee (or not to impose a liquidity fee) and/or temporarily suspend the fund’s redemptions. It is expected that this disclosure could include (as applicable, and taking into account considerations regarding the confidentiality of board deliberations) a discussion of the following factors relating to the board’s decision to impose a liquidity fee and/or suspend redemptions: the fund’s shadow price; relevant market indicators of liquidity stress in the markets; changes in spreads for portfolio securities; the fund’s future liquidity profile (taking into account predicted redemptions and other expectations); the fund’s ability to apply any collected fees quickly to rebuild fund liquidity; and the predicted time for portfolio securities to mature and provide internal liquidity to the fund, and for potentially distressed portfolio securities to mature or recover.
On April 10, 2013, CFTC and the SEC issued final rules and guidelines to require certain regulated entities to establish programs to address risks of identity theft. These rules and guidelines implement provisions of the Dodd-Frank Wall Street Reform and Consumer Protection Act, which amended section 615(e) of the Fair Credit Reporting Act (FCRA) and directed the Commissions to adopt rules requiring entities that are subject to the Commissions’ respective enforcement authorities to address identity theft. The rules require financial institutions to develop and implement a written identity theft prevention program designed to detect, prevent, and mitigate identity theft in connection with certain existing accounts or the opening of new accounts. The rules included guidelines to assist entities in the formulation and maintenance of programs that would satisfy the requirements of the rules.
The Rules Effective Date is May 19, 2013, and the Compliance Date is November 19, 2013.
The CFTC added new subpart C to part 162 of the CFTC’s regulations, and the SEC added new subpart C; Regulation S-ID: Identity Theft Red Flags to part 248 of the Securities Exchange Act of 1934, the Investment Company Act of 1940, and the Investment Advisers Act of 1940.
In February 2012, the Commissions jointly proposed for public notice and comment identity theft red flags rules and guidelines and card issuer rules.
The final rules are substantially similar to the proposed rules, and they do not exclude any entities registered with the Commissions from their scope. The SEC’s scope provides that the final rules apply to:
- A broker, dealer or any other person that is registered or required to be registered under the Exchange Act.
- An investment company that is registered or required to be registered under the Investment Company Act, that has elected to be regulated as a business development company, or that operates as an employees’ securities company under that Act.
- An investment adviser that is registered or required to be registered under the Investment Advisers Act.
As in the proposed rules, the Commissions defined the term “covered account” in the final rules as: (i) an account that a financial institution or creditor offers or maintains, primarily for personal, family, or household purposes, that involves or is designed to permit multiple payments or transactions; and (ii) any other account that the financial institution or creditor offers or maintains for which there is a reasonably foreseeable risk to customers or to the safety and soundness of the financial institution or creditor from identity theft, including financial, operational, compliance, reputation, or litigation risks. The CFTC’s definition includes a margin account as an example of a covered account. The SEC’s definition includes, as examples of a covered account, a brokerage account with a broker-dealer an account maintained by a mutual fund (or its agent) that permits wire transfers or other payments to third parties.
The Commissions defined an “account” as a “continuing relationship established by a person with a financial institution or creditor to obtain a product or service for personal, family, household or business purposes.” The CFTC’s definition specifically includes an extension of credit, such as the purchase of property or services involving a deferred payment. The SEC’s definition includes, as examples of accounts, “a brokerage account, a mutual fund account (i.e., an account with an open-end investment company), and an investment advisory account.”
As proposed, the final rules require each financial institution to periodically determine whether it offers or maintains covered accounts. As a part of this periodic determination, a financial institution or creditor must conduct a risk assessment that takes into consideration: (1) the methods it provides to open its accounts; (2) the methods it provides to access its accounts; and (3) its previous experiences with identity theft. A financial institution should consider whether, for example, a reasonably foreseeable risk of identity theft could exist in connection with accounts it offers or maintains that may be opened or accessed remotely or through methods that do not require face-to-face contact, such as through email or the Internet, or by telephone. In addition, if financial institutions offer or maintain accounts that have been the target of identity theft, they should factor those experiences into their determination. The Commissions anticipate that entities will be able to demonstrate that they have complied with applicable requirements, including their recurring determinations regarding covered accounts. If a financial institution initially determines that it does not need to have a Program, it is required to periodically reassess whether it must develop and implement a Program in light of changes in the accounts that it offers or maintains and the various other factors set forth in the regulations.
The rules provide that each financial institution that offers or maintains one or more covered accounts must develop and implement a written Program designed to detect, prevent, and mitigate identity theft in connection with the opening of a covered account or any existing covered account. These provisions also require that each Program be appropriate to the size and complexity of the financial institution or creditor and the nature and scope of its activities. Thus, the final rules are designed to be scalable, by permitting Programs that take into account the operations of smaller institutions.
The final rules set out the four elements that financial institutions and creditors must include in their Programs. These elements are being adopted as proposed and are identical to the elements required under the FCRA Agencies’ final identity theft red flags rules.
The elements of the Program should be as follows:
(1) Develop a Program that includes reasonable policies and procedures to identify relevant red flags for the covered accounts that the financial institution or creditor offers or maintains, and incorporate those red flags into the Program. Rather than singling out specific red flags as mandatory or requiring specific policies and procedures to identify possible red flags, this first element provides financial institutions and creditors with flexibility in determining which red flags are relevant to their businesses and the covered accounts they manage over time. The list of factors that a financial institution or creditor should consider are included in Section II of the guidelines, which appear at the end of the final rules. Given the changing nature of identity theft, the Commissions believe that this element allows financial institutions or creditors to respond and adapt to new forms of identity theft and the attendant risks as they arise.
(2) Implement reasonable policies and procedures to detect the red flags that the Program incorporates. This element does not provide a specific method of detection. Instead, Section III of the guidelines provides examples of various means to detect red flags.
(3) Implement reasonable policies and procedures to respond appropriately to any red flags that they detect. This element incorporates the requirement that a financial institution or creditor assess whether the red flags that are detected evidence a risk of identity theft and, if so, determine how to respond appropriately based on the degree of risk. Section IV of the guidelines sets out a list of aggravating factors and examples that a financial institution or creditor should consider in determining the appropriate response.
(4) Implement reasonable policies and procedures to periodically update the Program (including the red flags determined to be relevant), to reflect changes in risks to customers and to the safety and soundness of the financial institution or creditor from identity theft. As discussed above, financial institutions and creditors are required to determine which red flags are relevant to their businesses and the covered accounts they offer or maintain. The Commissions are requiring a periodic update, rather than immediate or continuous updates, to be parallel with the identity theft red flags rules of the Agencies and to avoid unnecessary regulatory burdens. Section V of the guidelines provides a set of factors that should cause a financial institution or creditor to update its Program.
The Program must be written and approved by either its board of directors, an appropriate committee of the board of directors, or if the entity does not have a board, from a designated senior management employee. However, if a financial institution has a Program in place, the board is not required to reapprove the existing Program in response to this requirement, provided the Program otherwise meets the requirements of the final rules.
In addition, financial institutions must involve the board of directors, an appropriate committee thereof, or a designated senior management employee in the oversight, development, implementation, and administration of the Program. The designated senior management employee who is responsible for the oversight of a broker-dealer’s, investment company’s or investment adviser’s Program may be the entity’s chief compliance officer. Also, they must train staff, as necessary, to effectively implement their Programs.
Finally, financial institutions must exercise appropriate and effective oversight of service provider arrangements. The Commissions believe that it is important that the rules address service provider arrangements so that financial institutions and creditors remain legally responsible for compliance with the rules, irrespective of whether such financial institutions and creditors outsource their identity theft red flags detection, prevention, and mitigation operations to a service provider. The final rules do not prescribe a specific manner in which appropriate and effective oversight of service provider arrangements must occur. Instead, the requirement provides flexibility to financial institutions and creditors in maintaining their service provider creditors are still required to fulfill their legal compliance obligations.
Municipal Industry Group Issues Paper in Response to MSRB Notice on Enhanced Disclosure of Bank Loans
As a result of the growing concerned about the lack of disclosure on bank loans, the Municipal Securities Rulemaking Board (“MSRB”) issued a notice last year encouraging issuers to voluntarily post information about them on EMMA. The board said “the availability of timely information about bank loan financings is important for market transparency and promoting a fair and efficient market” and that bondholders and potential investors need such information to assess their muni holdings or make muni investment decisions. The public is often in the dark about the details of the borrowing, with investors and regulators sometimes having to wait for annual statements to learn loans even exist. “I think it’s great that there’s again another opportunity, another tool for state and local governments to tap, but I do think we do need to be vigilant about some of the pitfalls in that private funding market,” said MSRB Executive Director Lynnette Kelly.
Many loans are being used as substitutes for the liquidity facilities and letters of credit that banks provide to back variable-rate demand bonds, according to Thomas Jacobs, who tracks products related to municipal bonds as a vice president for Moody’s Investor Service.
In response, a municipal bond market task force issued a paper recently urging state and local issuers and conduit borrowers to consider voluntarily disclosing certain information about bank loans. The groups, which included the National Federation of Municipal Analysts and National Association of Bond Lawyers, as well as dealer, banker, issuer, financial advisor and other organizations, joined together to help issuers and other market participants decide whether to disclose information about bank loans.
“This is a significant achievement, which demonstrates the industry’s commitment to reach consensus on a framework to analyze important disclosure issues,” said Allen Robertson, a shareholder at Robinson, Bradshaw & Hinton, PA who is to become NABL’s president in October. “This paper encourages careful consideration of making voluntary disclosure about bank loans, while acknowledging that issuers and borrowers may conclude not to provide voluntary disclosure about a particular bank loan depending on the facts and circumstances.”
“Contrary to the expectations of many participants in the municipal market, however, banks have continued to make a substantial amount of bank loans on a non-bank-qualified basis since January 1, 2011,” according to the white paper. “Because the incurrence of additional debt, including Bank loans, is not one of the material events for which disclosure is required under SEC Rule 15c2-12, holders of an issuer’s outstanding bonds may not become aware of a bank loan or its impact on the issuer’s creditworthiness until the issuer’s next financial audit is released or new bonds are sold.”
Bondholders and investors may want such information as whether the bank loan increases the issuer’s outstanding debt or whether certain assets previously available to secure bonds are pledged to the bank as security for the bank loan, the groups said. And issuers could voluntarily disclose on the MSRB’s EMMA system, documents relating to a bank loan, such as the loan or financing agreement.
Also, private bank loans are riding a wave of popularity among cities, counties and other local governments, leaving the $3.7 trillion municipal bond market racing to assess and contain any risks they may pose. The climb in borrowing, either by selling bonds to banks or through direct loans, has been swift and steep. U.S. banks held a record high level of municipal bonds and loans in the final quarter of 2012, $363.1 billion, according to the Federal Reserve, one of the few sources of data on the loans. Banks have long made tax-exempt and taxable bank loans to issuers, but since 2009, they have been more willing “to make an increasing amount of tax-exempt bank loans to issuers as an alternative to publicly offered tax-exempt bond issues,” according to the white paper.
The 2009 federal stimulus plan raised the amounts of “bank-qualified obligations” that banks could hold, as part of a grander scheme to thaw a municipal credit freeze. In 2009 and 2010, issuance of the obligations doubled. Essentially, the obligations are exceptions to part of the tax code that prevents banks from deducting the carrying cost of municipal bonds from their taxes. By doing so, the tax code eliminates the appeal of most tax-exempt debt for banks. When the stimulus plan expired issuance of the qualified obligations slowed, but the public sector continued relying on banks in general, the task force found.
The NFMA and Government Finance Officers Association may follow up with drafting best practice documents that provide further guidance for issuers and other market participants, said Robertson and Lisa Washburn, a managing director at Municipal Market Advisors who is NFMA’s secretary.
In the next few years, the Treasury plans to completely “wind down” FNMA and FHLMC, and the impact on the pre-refunded and escrowed-to-maturity municipal securities could be devastating. According to the Municipal Market Advisors Research, in 2009 bond refunding was 35% of the $400 billion municipal bond refunding activity, new money was the remaining source activity.
Because of the government divestment, the escrowed values of FNMA and FHLMC bonds will drop significantly, and the municipal issuers of pre-refunded bonds will have the daunting task of meeting their contracts stipulating that the cash value of pre-refunded securities escrowed by FNMA and FHLMC bonds must be sufficient enough to pay the principal and interest of the issue being refunded, on the original interest and maturity dates or on an early call date. It is likely that many of these municipal bonds will default, which would cause the municipal issuers’ bond ratings to decline, and consequently negatively impact bonds prices across the entire municipal securities bond market.
Even now, there is a wide spread between the yields (interest payments divided by market value) of FNMA and FHLMC mortgage-backed bonds and Treasury bonds. In a recent article, Walt Schmidt, a mortgage strategist at FTN Financial stated that [m]ost of the reason for the wider spreads is “based on uncertainties regarding prepayments and supply, not credit-based downgrade fears.”
Why is there not more publicity and action being taken on this inevitable market price bubble bursting? Because prior to the Treasury’s plan to wind down the “reverse privatized ” FNMA and FHLMC corporations, it was, and still is, generally accepted by auditors and compliance professionals that these two corporations are in substance, implicitly government-backed. Therefore, the Generally Accepted Auditing Principal of ‘substance over form’ is why securities issued by FNMA and FHLMC have been accepted as government-backed by the industry and investors.
This fallacy has evolved into a threat to the municipal securities industry because there has been a concerted effort by the Obama Administration and the U.S. Treasury to wind down FNMA and FHLMC, which essentially means to “privatize” them and withdraw U.S. Government support. President Obama has stated several times that the U.S. Taxpayer will no longer support Wall Street corporations, and he has been recently joined by the junior senator from Massachusetts, Senate Banking Committee member, Elizabeth Warren.
The privatization of these agencies will likely follow with the new private owners securitizing their assets thru Special Purpose Entities (“SPEs”), and traunching these new securities based on the similar risks of collateralized mortgage obligations. These new owners of FNMA and FHLMC will likely pool the ex-agencies’ receivables due from FNMA and FHLMC owned or guaranteed mortgages to create new securities and issue them through their SPE’s. With the current market trend, this will eventually cause downward pricing pressure on FNMA and FHLMC issued bonds used as escrow for refunded securities.
The U.S. Government’s efforts to wind down FNMA and FHLMC began over four years ago.
On November 4, 2008, the U.S. Department of the Treasury in a press release stating that “[o]ne member recommended that Treasury should consider entering into a swap agreement with FNMA and FHLMC to enable them to grow their mortgage portfolio without the need to issue new debt under their name. If the mandate for these GSE’s (Government Sponsored Enterprises) is to “grow for a short period” and then to “shrink” then it doesn’t make sense for them to issue additional paper given the ambiguity of their future mission and the wide spreads to Treasuries that their bonds trade in the marketplace.”
In 2011 the Obama Administration reported that the government “will work with FHFA to determine the best way to responsibly reduce Fannie Mae (FNMA) and Freddie Mac’s (FHLMC) role in the market and ultimately wind down both institutions, creating the conditions for private capital to play the predominant role in housing finance. These efforts must be undertaken at a deliberate pace, which takes into account the impact that these changes will have on borrowers and the housing market.” Further “[i]mplementing a wind down of Fannie Mae and Freddie Mac’s future participation in the housing market requires recognition of both the fragile state of that market today and the private sector’s need for clarity about the speed with which that transition will take place. As the market begins to heal and private investors return, we will seek opportunities, wherever possible, to accelerate Fannie Mae and Freddie Mac’s withdrawal.”
On August 17, 2012 in a press release the U.S. Department of the Treasury announced a set of modifications to the Preferred Stock Purchase Agreements (PSPAs) between the Treasury Department and the Federal Housing Finance Agency (FHFA) as conservator of Fannie Mae and Freddie Mac (the Government Sponsored Enterprises or GSEs) that will help expedite the wind down of Fannie Mae and Freddie Mac, make sure that every dollar of earnings each firm generates is used to benefit taxpayers, and support the continued flow of mortgage credit during a responsible transition to a reformed housing finance market.
They continued that “[w]ith today’s announcement, we are taking the next step toward responsibly winding down Fannie Mae and Freddie Mac, while continuing to support the necessary process of repair and recovery in the housing market,” said Michael Stegman, Counselor to the Secretary of the Treasury for Housing Finance Policy. “As we continue to work toward bi-partisan housing finance reform, we are committed to putting in place measures right now that support continued access to mortgage credit for American families, promote a responsible transition, and protect taxpayer interests.”
They indicated that the modifications to the PSPAs are consistent with FHFA’s strategic plan for the conservatorship of Fannie Mae and Freddie Mac that it released in February 2012. One of the key components of the modifications the agreements (with GSE’s) requires an accelerated reduction of Fannie Mae and Freddie Mac’s investment portfolios. Those portfolios will now be wound down at an annual rate of 15 percent — an increase from the 10 percent annual reduction required in the previous agreements. As a result of this change, the GSEs’ investment portfolios must be reduced to the $250 billion target set in the previous agreements four years earlier than previously scheduled.
On August 17, 2012, Rueter’s responded to this new action by publishing that “[t]he U.S. Treasury on Friday revamped the bailout of Fannie Mae and Freddie Mac to curb chances the giant mortgage finance firms could emerge from government control as the powerful, profit-driven corporations they once were. The Treasury said it would require the companies, whose massive losses threatened the financial system after the housing bubble burst in 2007, to shrink their investment portfolios more quickly and turn over any profits to taxpayers.”
It is because the Treasury is focusing on housing market and its recovery, that the nexus of FNMA and FHLMC issued bonds to the municipal securities market has not been revealed.
[This blog was published in the April 11, 2013 issue of "Bond Buyer"]
SEC Requires Mutual Funds to Validate Information Submitted to the National Securities Clearing Corporation Through the Mutual Fund Profile Service Database
On March 25, 2013, the National Securities Clearing Corporation (“NSCC)” updated its previous announcement that it will be enhancing the Mutual Fund Profile Service II Profile Security Issue database with a web-based data extraction and comparison tool allowing fund members to update and compare data against their prospectuses and other source documents filed with the SEC. A new mainframe batch record called “Specific Data,” will be added to include the new fields that will become available on the web application specific to 408(b)(2) reporting needs. The scheduled Production date for implementation of the new Profile Security Comparison Tool web application and mainframe batch files is May 20, 2013. Testing will be available for fund members to begin testing effective April 15, 2013. Funds are urged to familiarize themselves with the new functionality and begin reviewing their data in the comparison tool.
In early 2009, the SEC amended SR-NSCC-2008-08 added a new agreement for fund members regarding mutual fund profile information. The rule amendment required a written agreement between the fund member and the NSCC that fund members have taken reasonable steps to validate the accuracy of their submitted data. NSCC indicated that the intent of the amendments is to expand the Fund Profile’s capacity to be a comprehensive and accurate source for distributors. The new agreement is not intended to be a basis for any independent legal rights against the fund member and third parties aren’t permitted to rely on the agreement as a representation of the accuracy of information provided in the Fund Profile. The exact language in the amendment to Rule 52 is “Each Fund Member agrees with the Corporation that the Fund Member will take reasonable steps to validate the accuracy of the MFPS data that it submits to the Corporation.” According to the NSCC, the tenet of the amendments is that the requirements are consistent with section 17A of the Securities Exchange Act of 1934 to facilitate prompt and accurate clearance and settlement of securities transactions.
The NSCC initially developed the Fund Profile as a repository of mutual fund prospectuses and operational information that is organized into three databases. The databases are organized as follows: (i) the Security Issue Database, containing information such as security identification number, security name, fee structure, investment objectives, breakpoint schedule data and blue sky eligibility; (ii) the Participant Database, containing contact information, NSCC processing capabilities and restrictions on requirements; and (iii) the Distribution Database, containing projected or actual distributions, capital gains and dividend amounts and details, and commission information. NSCC fund members input data regarding their mutual funds into the Security Issue and Participant Profile databases. The designated end users for the system are mutual fund third-party selling members.
At that time, the NSCC developed assistance to funds members in validating their data once it is input into the Fund Profile. These included database reports that note probable inconsistencies among related data fields and arranging for free access by fund members to a vendor tool that verifies Fund Profile data. Also, NSCC supported the system by providing help contacts at the NSCC and an on-line web demonstration.
Mutual funds should have developed and implemented under rule 38a-1 requirements to document the Fund Profile validating process for future CCO and regulatory review. Further, fund legal personnel should review and execute the written NSCC agreement to take reasonable steps to validate the fund profile information, and consult with the fund Board to determine if a resolution is required for the agreement.
In December 2012, the SEC arraigned cease and desist orders to several former mutual fund directors until a hearing addressing their allegations are held in an administrative law court.
The fund directors allegedly violated Accounting Series Release No. 118, which the SEC provided specific guidance on with letters distributed in 1999 and 2001. In these letters they explained that “[i]n reviewing and approving pricing procedures, boards should determine whether those methodologies and procedures are reasonably likely to result in the valuation of securities at prices which the funds could expect to receive upon their current sale.”
The December order stated that between at least January 2007 and August 2007, significant portions of the Funds’ portfolios contained below-investment grade debt securities, some of which were backed by subprime mortgages, for which market quotations were not readily available. Under the Investment Company Act, those securities were required to be valued at fair value as determined in good faith by the Directors.
The funds’ securities valuations procedures provided that securities were initially recorded at cost. For daily pricing, the securities were recorded at cost unless there was a partial sale. At that time, the system issued exception reports for any security sold whose selling price was greater than 5% of its holding value. Otherwise the securities were continually recorded at costs or previous holding values. At month end, fund accounting randomly sampled 10% of the securities listed on the monthly exception report, except for two months out of the year for annual audits when the sample was 100%. These sampled securities were sent for broker quotes, and if the confirmation prices were greater than 5% of the holding value, the securities were sent to the fund adviser for valuation, or they were randomly selected to be valued using the internal pricing matrix. In many in instances Fund Accounting choose to ignore the price confirmations. It was noted that contrary to the statements in the Fair Valuation form provided to the Fund Board, the internal matrix was only used to price 125 of the securities held by funds at March 31, 2007. The fund adviser could also override prices provided by broker confirmations when it had “ a reasonable basis to believe that the price . . . does not accurately reflect the fair value of the portfolio security.
The SEC stated that the Respondents knew or should have known that Fund Accounting relied heavily on price confirmations when making fair valuation decisions, but that there was nothing requiring Fund Accounting to identify or explain those instances where the price confirmations differed materially from the Funds’ price. Further, while the Valuation Committee did receive the price confirmations that Fund Accounting solicited from independent broker-dealers, the Valuation Committee did not perform any additional tests to validate the fair values of portfolio securities that had not been sold or confirmed from a broker- dealer [emphasis added]. Less than 25% of the approximately 350 securities held by the Funds that were required to be fair valued were actually sold in the first six months of 2007 and price confirmations were sought for as few as 10% of the fair valued securities through broker-dealers on a monthly basis.
In its guidance, the SEC indicated that when the board has vested a comparatively greater amount of discretion in fund management, or when pricing procedures are relatively vague, we believe that the board’s involvement must be greater and more immediate. Also, a board acts in good faith when its fair value determination is the result of a sincere and honest assessment of the amount that the fund might reasonably expect to receive for a security upon its current sale, based upon all of the appropriate factors that are available to the fund. Furthermore, we believe that a board acts in good faith when it “continuously review[s] the appropriateness of the method used” in determining the fair value of the fund’s portfolio securities. Compliance with the good faith standard generally reflects the directors’ faithfulness to the duties of care and loyalty that they owe to the fund.
There are three takeaways for fund boards from this enforcement action. First, funds should utilize a pricing service to daily price all held securities. Second, it is known that fund advisers have extraordinary influence over fund pricing processes, especially with fund administrators, however any overrides they provide should be completely explained and vetted by the board of directors/trustees. Lastly, the Valuation Committee or Fund Accounting should utilize a pricing model that would effectively analyze future cash flows that a particular bond in a portfolio would generate. Also, there are pricing programs available that price derivatives. At Integral Financial, PC we are a strategic partner, and our consultants are proficient program operators, with a renowned derivatives pricing company.