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February 22, 1991
TO: BOARD OF GOVERNORS NO. 13-91
MONEY MARKET MEMBERS - ONE PER COMPLEX NO. 5-91
SEC RULES MEMBERS NO. 11-91
MONEY MARKET FUNDS AD HOC COMMITTEE NO. 6-91
PUBLIC INFORMATION COMMITTEE NO. 5-91
RE: SEC ADOPTS CHANGES TO MONEY MARKET FUND REGULATION
__________________________________________________________
As we previously informed you, the SEC proposed amendments
to Rule 2a-7 of the Investment Company Act, which currently
governs most money market funds, and to other rules applying to
money market funds (See Memorandum to Board of Governors No. 50-
90, Money Market Members - One Per Complex No. 9-90, SEC Rules
Members No. 51-90 and Public Information Committee No. 22-90,
dated July 20, 1990). On February 13th, the SEC adopted
amendments to those rules. The SEC’s release states that, "The
amendments are designed both to reduce the likelihood that a
money market fund will not be able to maintain a stable net asset
value, and to increase investor awareness that investing in a
money market fund is not without risk."
Set forth below is a summary of the newly adopted
requirements in Rule 2a-7 and other rules applying to money
market funds. A number of the Institute’s comments on the SEC’s
proposal were adopted in the final amendments. A copy of the SEC
release adopting these changes is attached.
A. Amendments to Rule 2a-7
1. Quality
a. Ratings - A money market fund may purchase a
security that has received the highest rating by any two
nationally recognized statistical rating agencies ("NRSROs"). If
only one rating agency has rated the security, that rating is
determinative. (However, the board must make certain findings in
this instance, see paragraph 5 below). These securities are
defined in the rule as "First Tier Securities".
b. Second Tier Securities - A fund may invest only up
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to 5% of its assets in Second Tier Securities (defined in the
Rule as "Eligible Securities" that are not "First Tier
Securities.") An Eligible Security is one that has received a
rating in one of the two highest categories by any two NRSROs
(or, if only one NRSRO has rated that security, by that NRSRO).
In addition to the overall 5% limit on Second Tier
Securities, a fund is limited as to the amount it may invest in
Second Tier Securities of a single issuer to the greater of 1% of
the fund’s total net assets or $1 million.
c. Unrated Securities - A fund may buy an unrated
security that is determined by the fund to be of comparable
quality to instruments that are Eligible Securities. The Rule
clarifies that a security that has not been rated will not be
considered an unrated security if its issuer has received ratings
for outstanding securities that are comparable in priority and
security with that security. With respect to long-term debt that
has a remaining maturity of less than 13 months, the long-term
debt is treated as unrated, provided the issuer does not have
other comparable short-term debt outstanding that is rated.
However, a fund may not purchase such a long-term security if it
has a long-term rating from any NRSRO that is below the second
highest category.
The Rule has been amended to require that the fund’s board
of directors approve or ratify the acquisition of each unrated
security. (See paragraph 5 below regarding the board’s duties).
d. Split-Rated Securities - Split-rated securities
that have received the highest rating by at least two NRSROs may
be purchased by a fund. A split-rated security that has received
the highest rating by only one agency may be purchased by a fund,
but must be included in the 5% basket of Second Tier Securities.
2. Maturity
a. Dollar-Weighted Average - The dollar-weighted
average portfolio maturity requirement under Rule 2a-7 was
reduced from 120 days to 90 days.
b. Single Instruments - The maturity of a single
portfolio instrument cannot exceed 13 months, except that a fund
that does not use amortized cost valuation in reliance on Rule
2a-7 may purchase government securities with remaining maturities
of up to 25 months.
3. Diversification
A fund may not invest more than 5% of its assets in the
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securities of any one issuer, except government securities (and
repurchase agreements fully collateralized by government
securities). However, the Rule contains a safe harbor from this
requirement which allows funds to exceed the 5% limitation for up
to three business days for assets invested in First Tier
Securities. This allows funds to assure liquidity in the event
of unexpected redemptions by shareholders or to invest
unanticipated cash inflows. A fund may continue to invest up to
10% of its assets in securities subject to an unconditional put
issued by any one institution.
4. Downgrades and Defaults
a. Prompt Reassessment - Under the Rule, a fund must
make a prompt reassessment as to whether a security presents
minimal credit risks where (a) a security ceases to be a First
Tier Security or, if unrated, ceases to be deemed to be of
comparable quality and (b) where the fund’s adviser becomes aware
that any NRSRO has rated a Second Tier Security or an unrated
security below its second highest rating. The release states
that in connection with the requirement, the adviser is not
expected to subscribe to every rating publication. Instead, it
is expected that an adviser would become aware of a subsequent
rating if it is recorded in the national financial press or in
publications to which the adviser subscribes. The latter
reassessment must be undertaken promptly by the board and not its
delegate, unless the security is disposed of within five business
days of the adviser becoming aware of the new rating and the
board is subsequently notified of the adviser’s actions.
b. Disposition Absent Certain Circumstances - If a
portfolio security is no longer an Eligible Security or is in
default, the fund must dispose of the security as soon as
practicable absent a specific finding by the board of directors
that this would not be in the best interests of the fund. The
Rule explicitly states that market conditions may be a factor
that the board considers in making this determination.
c. Notification - If a fund is holding a security that
is in default that accounts for 1/2 of 1% or more of the fund’s
assets, the fund must notify the SEC. The notification is only
required where the default relates to the financial condition of
the issuer.
In addition, funds will have to report on Form N-SAR
actions taken with respect to defaulted securities held during
the period covered by the report and identify securities held on
the last day of the period covered by the report that are no
longer Eligible Securities.
5. Board Responsibilities Under the Rule
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A new paragraph has been added to Rule 2a-7 to clarify the
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responsibilities of the fund’s board of directors. The paragraph
provides that the board may delegate all of its responsibilities
to the adviser or an officer of the fund it has under the Rule
other than the following:
a. the determination that the fund should maintain
a stable net asset value;
b. the establishment of amortized cost method
procedures to achieve a stable net asset value;
c. the prompt reassessment of a Second Tier
Security or unrated security if the adviser becomes aware that
such has received a rating by any NRSRO below the NRSRO’s second
highest rating;
d. the determination in the event of a default or
a security ceasing to be an Eligible Security that disposal of
the security would not be in the best interests of the fund;
e. its obligation to approve or ratify the
purchase of an unrated security (other than a government
security) or a security that is an Eligible Security based on the
rating of one NRSRO; and
f. in connection with the penny-rounding pricing
method, the duty to supervise the delegate.
With respect to the board’s duties to approve or ratify the
purchase of unrated securities or securities that have been rated
by only one NRSRO, the Release states that it would not be
necessary to convene the board for each purchase of such a
security. Instead, the board could establish an approved list of
securities, provided that it periodically makes the requisite
credit risk determinations with respect to the securities on the
list. In addition, the adviser could acquire a security in
accordance with the guidelines established by the board, but the
board would have to ratify the acquisition at the next meeting.
(See f.n. 78 in the attached release).
6. Independent Credit Analysis
The release reiterates the duty of the board of directors
(or its delegate) to evaluate the creditworthiness of the issuer
of any portfolio security and any entity providing a credit
enhancement for a portfolio security. The release states that
possession of a certain rating by a NRSRO is not a "safe harbor".
The SEC clarifies in the release that the factors listed in the
Division of Investment Management’s May 8th letter concerning
credit analysis are only examples of factors that should be
considered in this analysis.
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B. Disclosure in the Prospectus and in Advertisements and Sales
Literature
Money market funds are required to disclose prominently on
the cover page of prospectuses (1) that investments in the money
market fund are neither insured nor guaranteed by the U.S.
Government and (2) that there is no assurance that the fund will
be able to maintain a stable net asset value of $1.00 per share.
Funds are also required to include this legend in advertisements
and sales literature.
C. Funds Eligible to Quote Seven Day Yields
Rule 482 under the Securities Act has been amended to
prohibit funds that do not meet the risk-limiting conditions
stated in Rule 2a-7 (i.e., the limitations concerning maturity,
diversification and quality) from quoting a seven-day yield
figure.
D. Holding Out Requirement
A fund may not hold itself out as a money market fund or
use a similar term in its name unless it complies with the
maturity, diversification and quality requirements under Rule
2a-7.
E. Transition Period
Most of the amendments to the rules applying to money
market funds will be effective June 1, 1991. However, investment
companies whose registration statements become effective on or
after May 1, 1991, and investment companies with fiscal years
ending on December 31, must include the required disclosure on
prospectuses used on or after May 1, 1991. For other investment
companies, the disclosure must be included on prospectuses
contained in any post-effective amendment filed on or after May
1, 1991. The release states that the SEC would not object if the
post-effective amendment filed to add the cover page disclosure
is filed pursuant to Rule 485(b), provided the conditions for
filing thereunder are satisfied.
The release also states that if the registration statement
of a fund discloses investment policies that are less restrictive
than those required by the new amendments, the SEC will not
object if the fund does not revise its disclosure upon the
effective date of the amendments, provided the current disclosure
is not misleading.
In addition, the release states that funds are not required
to dispose of securities owned at the time of the adoption of the
amendments to Rule 2a-7 to comply with the new diversification,
maturity and quality requirements.
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F. Tax-Exempt Funds
The new diversification (5%) and quality requirements
(5%/1% test for Second Tier Securities) do not apply to tax-
exempt money market funds. However, it appears that the revised
treatment of split-rated securities is applicable to tax-exempt
funds. Thus, a security that has been rated in the second
highest category by only one NRSRO and is also rated below the
second highest category by another NRSRO is no longer eligible
for purchase. Moreover, tax-exempt funds may only purchase
unrated securities or securities rated by only one NRSRO that the
board has approved or ratified, and the reassessment and
disposition provisions of the rule are also applicable to tax-
exempt funds.
Amy B.R. Lancellotta
Assistant General Counsel
Attachment