Money Market Fund Reform

Federal RegisterMar 4, 2010

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SECURITIES AND EXCHANGE COMMISSION

17 CFR Parts 270 and 274

[Release No. IC-29132; File Nos. S7-11-09, S7-20-09]

RIN 3235-AK33

Money Market Fund Reform

AGENCY:

Securities and Exchange Commission.

ACTION:

Final rule.

SUMMARY:

The Securities and Exchange Commission (“Commission” or “SEC”) is adopting amendments to certain rules that govern money market funds under the Investment Company Act of 1940. The amendments will tighten the risk-limiting conditions of rule 2a-7 by, among other things, requiring funds to maintain a portion of their portfolios in instruments that can be readily converted to cash, reducing the maximum weighted average maturity of portfolio holdings, and improving the quality of portfolio securities; require money market funds to report their portfolio holdings monthly to the Commission; and permit a money market fund that has “broken the buck” (

i.e.

, re-priced its securities below $1.00 per share), or is at imminent risk of breaking the buck, to suspend redemptions to allow for the orderly liquidation of fund assets. The amendments are designed to make money market funds more resilient to certain short-term market risks, and to provide greater protections for investors in a money market fund that is unable to maintain a stable net asset value per share.

DATES:

The rules, rule amendments, and form are effective May 5, 2010. The expiration date for 17 CFR 270.30b1-6T is extended from September 17, 2010 to December 1, 2010. Compliance dates are discussed in Section III of the

SUPPLEMENTARY INFORMATION.

FOR FURTHER INFORMATION CONTACT:

Office of Regulatory Policy, at (202) 551-6792, Division of Investment Management, Securities and Exchange Commission, 100 F Street, NE., Washington, DC 20549-8549.

SUPPLEMENTARY INFORMATION:

The Commission is adopting amendments to rules 2a-7 [17 CFR 270.2a-7], 17a-9 [17 CFR 270.17a-9] and 30b1-6T [17 CFR 270.30b1-6T], new rules 22e-3 [17 CFR 270.22e-3] and 30b1-7 [17 CFR 270.30b1-7], and new Form N-MFP [17 CFR 274.201] under the Investment Company Act of 1940 (“Investment Company Act” or “Act”).

15 U.S.C. 80a. Unless otherwise noted, all references to statutory sections are to the Investment Company Act, and all references to rules under the Investment Company Act, including rule 2a-7, are to Title 17, Part 270 of the Code of Federal Regulations [17 CFR 270]. References to “current” rules relate to rules in their current form [17 CFR Part 270 (2009 version)], and references to “amended” rules relate to rules as they will be amended by this Release.

Table of Contents

I. Background

II. Discussion

A. Portfolio Quality

1. Second Tier Securities

2. Eligible Securities

3. Asset Backed Securities

B. Portfolio Maturity

1. Weighted Average Maturity

2. Weighted Average Life

3. Maturity Limit for Government Securities

C. Portfolio Liquidity

1. General Liquidity Requirement

2. Limitation on Acquisition of Illiquid Securities

3. Minimum Daily and Weekly Liquidity Requirements

4. Stress Testing

D. Repurchase Agreements

E. Disclosure of Portfolio Information

1. Public Web site Posting

2. Reporting to the Commission

3. Phase-Out of Weekly Reporting by Certain Funds

F. Processing of Transactions

G. Exemption for Affiliate Purchases

1. Expanded Exemptive Relief

2. New Reporting Requirement

H. Fund Liquidation

III. Compliance Dates

IV. Paperwork Reduction Act Analysis

V. Cost Benefit Analysis

VI. Competition, Efficiency, and Capital Formation

VII. Regulatory Flexibility Act Certification

VIII. Statutory Authority

Text of Rules, Rule Amendments, and Form

I. Background

On June 30, 2009, the Commission issued a release proposing new rules and rule amendments governing the operation of money market funds.

Money market funds are open-end management investment companies that are registered under the Investment Company Act. They invest in high-quality, short-term debt instruments such as commercial paper, Treasury bills and repurchase agreements. Money market funds pay dividends that reflect prevailing short-term interest rates and, unlike other investment companies, maintain a stable net asset value per share (or “NAV”), typically $1.00 per share. Money market funds have over $3.3 trillion dollars in assets under management, and comprise over 30 percent of the assets of registered investment companies.

Money Market Fund Reform, Investment Company Act Release No. 28807 (June 30, 2009) [74 FR 32688 (July 8, 2009)] (“Proposing Release”). All references to “proposed” rules relate to rules as proposed in the Proposing Release.

See

Investment Company Institute,

Trends in Mutual Fund Investing,

Nov. 2009,

available at http://www.ici.org/research/stats/trends/trends_11_09.

All money market funds are subject to rule 2a-7 under the Investment Company Act. Rule 2a-7, among other things, facilitates money market funds' ability to maintain a stable net asset value per share by permitting them to use the amortized cost method of valuation and the penny-rounding method of pricing.

But for rule 2a-7, the Investment Company Act and our rules would require a money market fund to calculate its current net asset value per share by valuing portfolio securities at their current value (“mark-to-market”).

Current rule 2a-7(a)(2) defines the amortized cost method as the method of calculating an investment company's net asset value per share (or “NAV”) whereby portfolio securities are valued at the fund's acquisition cost as adjusted for amortization of premium or accretion of discount rather than at their value based on current market factors. The penny-rounding method of pricing means the method of computing a fund's price per share for purposes of distribution, redemption, and repurchase whereby the current net asset value per share is rounded to the nearest one percent.

See

current rule 2a-7(a)(18).

See

section 2(a)(41) of the Act (defining “value” of fund assets); rule 2a-4 (defining “current net asset value” for use in computing the current price of a redeemable security); and rule 22c-1 (generally requiring open-end funds to sell and redeem their shares at a price based on the funds' current net asset value as next computed after receipt of a redemption, purchase, or sale order).

Under the amortized cost method, portfolio securities generally are valued at cost plus any amortization of premium or accumulation of discount. The basic premise underlying money market funds' use of the amortized cost method of valuation is that high-quality, short-term debt securities held until maturity will eventually return to their amortized cost value, regardless of any current disparity between the amortized cost value and market value, and would not ordinarily be expected to fluctuate significantly in value.

Therefore, the rule permits money market funds to value portfolio securities at their amortized cost so long as the deviation between the portfolio's amortized cost

and current market value

remains

minimal and results in the computation of a share price that represents fairly the current net asset value per share of the fund.

See

Valuation of Debt Instruments and Computation of Current Price Per Share by Certain Open-End Investment Companies (Money Market Funds), Investment Company Act Release No. 13380 (July 11, 1983) [48 FR 32555 (July 18, 1983)] (“1983 Adopting Release”) at nn.3-7 and accompanying text; Valuation of Debt Instruments and Computation of Current Price Per Share by Certain Open-End Investment Companies (Money Market Funds), Investment Company Act Release No. 12206 (Feb. 1, 1982) [47 FR 5428 (Feb. 5, 1982)] at nn.3-4 and accompanying text.

See

amended rule 2a-7(c)(1), (c)(8)(ii)(B)-(C) (requiring, among other things, that the fund's board of directors promptly consider what action, if any, should be taken if the deviation between the money market fund's current market value and the fund's amortized cost price per share exceeds

1/2

of 1%).

To reduce the likelihood of a material deviation occurring between the amortized cost value of a portfolio and its market-based value, the rule contains several conditions (which we refer to as “risk-limiting conditions”) that limit the fund's exposure to certain risks, such as credit, currency, and interest rate risks.

In addition, the rule includes certain procedural requirements overseen by the fund's board of directors. One of the most important is the requirement that the fund periodically “shadow price” the amortized cost net asset value of the fund's portfolio against the mark-to-market net asset value of the portfolio.

If there is a difference of more than one-half of one percent (or $0.005 per share), the fund's board of directors must consider promptly what action, if any, should be taken, including whether the fund should discontinue the use of the amortized cost method of valuation and re-price the securities of the fund below (or above) $1.00 per share, an event colloquially known as “breaking the buck.”

For example, the current rule requires, among other things, that a money market fund's portfolio securities meet certain credit quality requirements, such as being rated in the top one or two rating categories by nationally recognized statistical rating organizations (“NRSROs”). A fund, moreover, may only invest a limited portion of its portfolio in securities rated in the second highest rating category.

See

current rule 2a-7(c)(3). The current rule also places limits on the remaining maturity of securities in the fund's portfolio. A fund generally may not acquire, for example, any securities with a remaining maturity greater than 397 days, and the dollar-weighted average maturity of the securities owned by the fund may not exceed 90 days.

See

current rule 2a-7(c)(2).

See

current rule 2a-7(c)(7) (requiring that such shadow pricing be calculated at such intervals as the board of directors determines appropriate and reasonable in light of current market conditions).

See

current rule 2a-7(c)(7)(ii)(B). Regardless of the extent of the deviation, rule 2a-7 imposes on the board of a money market fund a duty to take appropriate action whenever the board believes the extent of any deviation may result in material dilution or other unfair results to investors or current shareholders. Current rule 2a-7(c)(7)(ii)(C).

See

1983 Adopting Release,

supra

note 6, at nn.51-52 and accompanying text.

As discussed in significant detail in the Proposing Release, during 2007-2008 money market funds were exposed to substantial losses, first as a result of exposure to debt securities issued by structured investment vehicles (“SIVs”), and then as a result of the default of debt securities issued by Lehman Brothers Holdings Inc. (“Lehman Brothers”). All but one of the funds that were exposed to losses from SIV and Lehman Brothers securities obtained support of some type from their advisers or other affiliated persons, which absorbed the losses or provided a guarantee covering a sufficient amount of losses to prevent the fund from breaking the buck. The Reserve Primary Fund, which held a $785 million position in Lehman Brothers debt, ultimately did not have a sponsor with sufficient resources to support it, and on September 16, 2008 the fund announced that it would re-price its securities at $0.97 per share.

It subsequently suspended redemptions as of September 17, 2008.

See

Proposing Release,

supra

note 2, at n.44 and accompanying text. The Reserve Primary Fund distributed the bulk of its assets, and investors have received more than $0.98 on the dollar.

See

Press Release, SEC, Reserve Primary Fund Distributes Assets to Investors (Jan. 29, 2010)

available at http://www.sec.gov/news/press/2010/2010-16.htm.

In response to a request by The Reserve Fund, the Commission issued an order permitting the suspension of redemptions in certain Reserve funds, to permit their orderly liquidation.

See

In the Matter of The Reserve Fund, Investment Company Act Release No. 28386 (Sept. 22, 2008) [73 FR 55572 (Sept. 25, 2008)] (order). Several other Reserve funds also obtained an order from the Commission on October 24, 2008 permitting them to suspend redemptions to allow for their orderly liquidation.

See

Reserve Municipal Money-Market Trust, et al., Investment Company Act Release No. 28466 (Oct. 24, 2008) [73 FR 64993 (Oct. 31, 2008)] (order).

The cumulative effect of these events, when combined with general turbulence in the financial markets, led to a run primarily on institutional taxable prime money market funds, which contributed to severe dislocations in short-term credit markets and strains on the businesses and institutions that obtain funding in those markets.

During the week of September 15, 2008, investors withdrew approximately $300 billion from taxable prime money market funds, or 14 percent of the assets held in those funds.

In the final two weeks of September 2008, money market funds reduced their holdings of top-rated commercial paper by $200.3 billion, or 29 percent.

See Minutes of the Federal Open Market Committee

, Federal Reserve Board, Oct. 28-29, 2008, at 5,

available at http://www.federalreserve.gov/monetarypolicy/files/fomcminutes20081029.pdf

(“

FRB Open Market Committee Oct. 28-29 Minutes”). See also

Press Release, Federal Reserve Board, Board Announces Creation of the Commercial Paper Funding Facility (CPFF) to Help Provide Liquidity

to Term Funding Markets (Oct. 7, 2008), available at http://www.federalreserve.gov/newsevents/press/monetary/20081007c.htm.

See

Investment Company Institute, Report of the Money Market Working Group, at 62 (Mar. 17, 2009),

available at http://www.ici.org/pdf/ppr_09_mmwg.pdf

(“ICI Report”) (analyzing data from iMoneyNet);

See also

Thomas K. Hahn,

Commercial Paper

(Federal Reserve Bank of Richmond, Economic Quarterly Vol. 79/2, Spring 1993), at Fig. 4 (showing historical spreads between A-1/P-1 commercial paper and A-2/P-2 commercial paper between 1974 and 1992, including the tendency of such spreads to spike shortly before and during recessions); Comment Letter of the Investment Company Institute (Sept. 8, 2009) (“ICI Comment Letter”) (noting that the market for Tier 2 commercial paper is less deep with fewer issuers than the Tier 1 market).

See, e.g.,

Comment Letter of Invesco AIM Advisors, Inc. (Sept. 4, 2009) (“Invesco Aim Comment Letter”) (noting that it has historically avoided the second tier market due to, among other factors, the less overall market liquidity of second tier securities); ICI Comment Letter.

See also

Proposing Release,

supra

note 2, at Section II.A.1 for a discussion of the wider credit spreads of second tier securities during the fall of 2008, indicating the extent to which such securities traded at a discounted price.

Commenters were evenly divided between those supporting our proposed elimination of money market funds' ability to acquire second tier securities and those against our proposal. In general, most money market fund sponsors who commented supported elimination,

while most issuers of second tier securities who commented opposed elimination.

Those supporting elimination argued that it would be an effective way to increase the safety of money market funds and would reduce the likelihood that a fund would break the buck. Some commenters noted that the money market funds they manage have not acquired second tier securities historically

because of second tier issuers' weaker credit profiles, smaller issuer program sizes, and lower market liquidity.

A few commenters noted that eliminating money market funds' ability to acquire second tier securities should result in minimal market disruption because money market funds currently hold small amounts of such securities.

See, e.g.,

Comment Letter of Bankers Trust Company, N.A. (Aug. 28, 2009) (“Bankers Trust Comment Letter”); BlackRock Comment Letter; Comment Letter of Charles Schwab Investment Management, Inc. (Sept. 4, 2009) (“Charles Schwab Comment Letter”); Dreyfus Comment Letter; Vanguard Comment Letter.

But see

Comment Letter of Federated Investors, Inc. (Sept. 8, 2009) (“Federated Comment Letter”); Fidelity Comment Letter (opposing elimination).

See, e.g.,

Comment Letter of the American Securitization Forum (Sept. 8, 2009) (“Am. Securit. Forum Comment Letter”); Comment Letter of the U.S. Chamber of Commerce, Center for Capital Markets Competitiveness (Sept. 8, 2009) (“Chamber Comment Letter”); Dominion Res. Comment Letter; Comment Letter of XTO Energy Inc. (Sept. 3, 2009) (“XTO Energy Comment Letter”).

See, e.g.,

Dreyfus Comment Letter; Invesco Aim Comment Letter.

See, e.g.,

Invesco Aim Comment Letter.

See, e.g.,

ICI Comment Letter; Comment Letter of TD Asset Management (Sept. 8, 2009) (“TDAM Comment Letter”).

Commenters that opposed the proposal disagreed that second tier securities significantly increase risk at money market funds,

argued that a complete ban would not be justified on a cost-benefit basis,

and stated that a ban would have a material adverse impact on second tier security issuers.

Some commenters noted that in a report of default rates through 2006, second tier securities have default rates substantially similar to those of first tier securities.

These commenters also noted that rating agencies require that second tier security issuers establish backup liquidity lines of credit providing 100 percent coverage for any issuance.

Several commenters agreed

with our statement in the Proposing Release that second tier securities were not the direct cause of strains on money market funds during the 2007-2008 period.

A few stated that banning the acquisition of second tier securities would reduce diversification of money market fund portfolio holdings and thus increase risk, noting in particular that a greater percentage of second tier security issuers are not financial institutions, compared to first tier security issuers.

See, e.g.,

Comment Letter of the Association for Financial Professionals (Sept. 8, 2009) (“Assoc. Fin. Professionals Comment Letter”); Chamber/Tier 2 Issuers Comment Letter; Dominion Res. Comment Letter.

See, e.g.,

Comment Letter of Fund Democracy and the Consumer Federation of America (Sept. 8, 2009) (“CFA/Fund Democracy Comment Letter”); Chamber Comment Letter; Dominion Res. Comment Letter.

But see

TDAM Comment Letter (stating that the benefits of eliminating second tier securities will far outweigh any disadvantages).

See, e.g.,

Chamber Comment Letter; Dominion Res. Comment Letter; Comment Letter of Treasury Strategies, Inc. (Sept. 8, 2009) (“Treasury Strategies Comment Letter”).

Chamber Comment Letter; Chamber/Tier 2 Issuers Comment Letter. These commenters were citing the following study:

Moody's Investors Service,

Short-Term Corporate and Structured Finance Rating Transition Rates, 1972-2006

(June 2007),

available at http://www.moodys.com/cust/content/content.ashx?source=staticcontent/free%20pages/regulatory%20affairs/documents/st_corp_and_struc_transition_rates_06_07.pdf

(showing, for example, a default rate for P-1 rated commercial paper over a 365 day time horizon of 0.02% versus a default rate for P-2 rated commercial paper of 0.10% over the same time horizon).

We note, however, that commenters did not discuss conditions under which those issuers would not be permitted to draw on those backup liquidity facilities. It is our understanding that such backup liquidity facilities typically do not provide a full backstop of liquidity support because they contain conditions limiting an issuer's ability to draw on the facility if the issuer has experienced a “material adverse change,” which would often occur if the financial situation of the issuer had declined due to financial market or other economic turmoil.

See also

Hahn,

supra

note 34 (stating that backup lines of credit generally will not be useful for a firm whose operating and financial condition has deteriorated to the point where it is about to default on its short-term liabilities because credit agreements often contain “material adverse change” clauses that allow banks to cancel credit lines if the financial condition of the firm changes significantly); Pu Shen,

Why Has the Nonfinancial Commercial Paper Market Shrunk Recently?

, Federal Reserve Bank of Kansas City Economic Review, at 69 (First Quarter 2003) (stating that

commercial paper backup facilities are only meant to provide emergency assistance for short-term liquidity difficulties and not to enhance the credit quality of issues); Standard & Poor's,

2008 Corporate Criteria: Commercial Paper,

at 3 (Apr. 15, 2008) (“Given the size of the CP market, backup facilities could not be relied on with a high degree of confidence in the event of widespread disruption.”).

See, e.g.,

Chamber/Tier 2 Issuers Comment Letter; Federated Comment Letter; Fidelity Comment Letter.

See, e.g.,

Treasury Strategies Comment Letter; USAA Comment Letter; XTO Energy Comment Letter. We note that while a greater

percentage

of second tier security issuers do appear to be non-financial companies, there are a much greater

number

of non-financial first tier issuers and thus it is not clear that money market funds would not be able to achieve sufficient diversification in their portfolio holdings even if limited to acquiring first tier securities. The Chamber/Tier 2 Issuers Comment Letter also states that prohibiting money market funds from acquiring second tier securities would “cut the pool of

potential issuers

by 43%” (emphasis added). Any diversification is not driven only by the

number

potential

issuers, however. It is also determined by the amount of money market fund

assets

that can be

actually

allocated to different issuers. For example, while there are over 200 P-2 rated commercial paper programs, only approximately half of these programs are active in issuing

any

commercial paper and only 16 programs have an average quarterly outstanding issuance in excess of $500 million.

See

American Securit. Forum Comment Letter. In addition, during the market turmoil of 2007 and 2008, second tier securities did not exhibit less risky or countervailing economic metrics relevant to money market funds maintaining a stable net asset value compared to first tier securities.

See

Proposing Release,

supra

note 2, at Section II.A.1, at n.98 and accompanying text and chart. In fact, AA-rated non-financial commercial paper did exhibit significantly greater price stability than A2/P2-rated non-financial commercial paper during the fall of 2008.

See

Federal Reserve Board, Commercial Paper Data,

available at http://www.federalreserve.gov/DataDownload/Choose.aspx?rel=CP

(“Federal Reserve Commercial Paper Data”).

See also

V.V. Chari, L. Christiano & P. Kehoe,

Facts and Myths about the Financial Crisis of 2008,

Federal Reserve Bank of Minneapolis Working Paper 666, at Fig. 7B (Oct. 2008).

Commenters also asserted that prohibiting the acquisition of second tier securities would have unintended consequences for the capital markets. They stated that it might discourage investors other than money market funds from investing in second tier securities, causing a more substantial reduction in the issuance of second tier securities.

Some argued that if second tier issuers are not able to issue sufficient commercial paper, they will be forced to borrow more from banks, which is a less flexible and more costly alternative that will increase borrowing costs.

Finally, two commenters stated that a complete ban on the acquisition of second tier securities by money market funds might have a negative effect on those issuers of first tier securities that are viewed as presenting a higher risk of being downgraded, because money market funds may elect not to invest in those securities out of concern that the securities might soon become second tier securities.

See, e.g.,

Chamber Comment Letter; Dominion Res. Comment Letter; Treasury Strategies Comment Letter. Commenters asserted that eliminating money market funds' ability to acquire second tier securities might have a substantially greater adverse impact on second tier issuers, and thus potentially on capital formation because other investors in second tier securities or lesser quality first tier securities might avoid investment in those securities as a result of our rule amendments. Investor behavior in this regard is difficult to predict. It is equally likely that investors in second tier paper would demand higher yields, increasing issuers' financing costs. As discussed below, however, we are not precluding money market funds from investing in second tier securities. Accordingly, we do not need to reach a conclusion on this matter.

See, e.g.,

Am. Elec. P. Comment Letter; Chamber/Tier 2 Issuers Comment Letter; Dominion Res. Comment Letter; XTO Energy Comment Letter. We note that money market funds hold a relatively low percentage of outstanding second tier commercial paper.

See

Bank of America Merrill Lynch, Tier-2 US Commercial Paper Market Update (Oct. 15, 2009) (attached to the Am. Securit. Forum Comment Letter) (indicating that over 75% of Tier-2 commercial paper is held by insurance firms, corporations and banks, and that only 11% is held by the asset management industry, which would include money market funds as well as other mutual funds and asset managers).

Fidelity Comment Letter; USAA Comment Letter. Two other commenters suggested that the Commission should consider the effect of banning the acquisition of second tier securities on tax-exempt money market funds, and in particular single-State funds.

See

Dreyfus Comment Letter; Federated Comment Letter. As discussed further in the cost benefit analysis section of this Release, based on our review of money market fund portfolios in September 2008, very few money market funds, including tax-exempt funds, will be impacted by our amendments relating to second tier securities. The greatest potential impact on tax-exempt funds will be the 45-day maturity limitation for acquisition of second tier securities. Given the prevalence of variable rate demand notes among municipal securities, however, we believe that tax-exempt funds should be able to effectively manage the 45-day maturity limit without a substantial impact. Accordingly, we do not believe that a special accommodation for tax-exempt money market funds is required with respect to second tier securities.

The focus of our concerns is and must be on the risk to money market funds and their shareholders from their investments in second tier securities. While, as commenters noted,

second tier securities do not appear to be subject to substantially greater default risk than first tier securities they present greater credit spread risk and trade in thinner markets,

all of which can lead to greater price volatility and illiquidity in times of market stress.

While these characteristics may not pose the same degree of risk to money market funds as the likelihood that a security could default and become worthless, they can adversely affect money market funds' ability to maintain a stable net asset value. This is particularly the case given money market funds' narrow margin for deviation between the mark-to-market value of their assets and the amortized cost value of those assets, and the significant negative impact on money market funds and their investors if a fund breaks the buck.

See supra

note 44 and accompanying text.

A few commenters argued that the increase in spreads of Tier 2 commercial paper over Tier 1 commercial paper during the fall of 2008 was due to the Federal Reserve Board's announcement of its creation of the Commercial Paper Funding Facility (CPFF) on October 7, 2008, which only supported issuance of 90-day Tier 1 commercial paper.

See

Chamber Comment Letter; Chamber/Tier 2 Issuers Comment Letter; Dominion Res. Comment Letter. We note, however, that spreads between Tier 1 and Tier 2 commercial paper widened significantly (by well over 300 basis points) immediately after the bankruptcy of Lehman Brothers was announced on September 14, 2008—well before the CPFF was announced on October 7.

See

Federal Reserve Commercial Paper Data,

supra

note 47 (comparing AA and A2/P2 rated 30-day and 60-day nonfinancial commercial paper rates).

We note that second tier securities are also more likely to be downgraded than first tier securities.

See

Moody's Investors Service,

Short-Term Corporate and Structured Finance Rating Transition Rates, supra

note 44, cited in Chamber/Tier 2 Issuers Comment Letter (showing that for each time period, commercial paper with a P-2 rating had a greater percentage chance of being downgraded than commercial paper with a P-1 rating, and that this gap widened over time—for example, P-2 rated commercial paper had a 1.09% chance of being downgraded over a 60-day period compared to a 0.72% chance of P-1 commercial paper being downgraded (a 0.37% difference); P-2 rated commercial paper had a 2.07% chance of being downgraded over a 120-day period compared to a 1.46% chance of P-1 commercial paper being downgraded (a 0.61% difference); and P-2 rated commercial paper had a 4% chance of being downgraded over a 270-day period compared to a 3.18% chance of P-1 commercial paper being downgraded (a 0.82% difference)).

Several commenters asserted that there are high-quality second tier securities available and that money market funds conducting a thorough credit risk analysis may conclude that certain second tier securities provide a higher yield than first tier securities while still maintaining a risk profile consistent with investment objectives for money market fund investment.

In these circumstances, investment in higher yielding second tier securities may benefit fund investors. These commenters suggested that, given these benefits, it may be more appropriate for

us to preserve money market funds' ability to invest in second tier securities, but to a reduced degree.

See, e.g.,

Fidelity Comment Letter; Comment Letter of Thrivent Mutual Funds (Sept. 8, 2009) (“Thrivent Comment Letter”).

See, e.g.,

Federated Comment Letter (suggesting, as an alternative to eliminating money market funds' ability to acquire second tier securities, further limitations including reducing the percentage of fund assets permitted to be invested in second tier securities and limiting the final maturity of permissible second tier securities).

See also

Comment Letter of the American Bar Association (Committee on Federal Regulation of Securities and Committee on Securitization and Structured Finance) (Sept. 12, 2008) (available in File No. S7-19-08); Comment Letter of the Institutional Money Market Funds Association (Sept. 5, 2008) (available in File No. S7-19-08); Comment Letter of the Securities Industry and Financial Markets Association (Dec. 8, 2009) (available in File No. S7-19-08). Comment letters submitted in File No. S7-19-08 are available on the Commission's Web site at:

http://www.sec.gov/comments/s7-19-08/s71908.shtml.

See, e.g.,

Dreyfus Comment Letter; ICI Comment Letter; Comment Letter of J.P. Morgan Asset Management (Sept. 8, 2009) (“J.P. Morgan Asset Mgt. Comment Letter”).

See also

Proposing Release,

supra

note 2, at nn.108-110 and accompanying text.

See, e.g.,

Comment Letter of the Northern Funds and Northern Institutional Funds—Independent Trustees (Sept. 8, 2009) (“Northern Funds Indep. Trustees Comment Letter”); Comment Letter of the Tamarack Funds Trust (Sept. 8, 2009) (“Tamarack Funds Comment Letter”).

See also

Comment Letter of Charles Schwab & Co., Inc. (Sept. 5, 2008) (available in File No. S7-19-08); Comment Letter of Dechert LLP (Sept. 5, 2008) (available in File No. S7-19-08); Comment Letter of Realpoint (Aug. 14, 2008) (available in File No. S7-19-08). We have recently adopted rule amendments designed to improve our regulation and oversight of NRSROs, which help address the integrity of their rating procedures and methodologies.

See

Amendments to Rules for Nationally Recognized Statistical Rating Organizations, Exchange Act Release No. 61050 (Nov. 23, 2009) [74 FR 63832 (Dec. 4, 2009)]; Amendments to Rules for Nationally Recognized Statistical Rating Organizations, Exchange Act Release No. 59342 (Feb. 2, 2009) [74 FR 6456 (Feb. 9, 2009)]; Oversight of Credit Rating Agencies Registered as Nationally Recognized Statistical Rating Organizations, Exchange Act Release No. 55857 (June 5, 2007) [72 FR 33564 (June 18, 2007)].

See

ICI Comment Letter; TDAM Comment Letter.

See

ICI Comment Letter.

See, e.g.,

Comment Letter of State Street Global Advisors (Sept. 8, 2009) (“State Street Comment Letter”); Vanguard Comment Letter.

See

ICI Comment Letter.

See also

J.P. Morgan Asset Mgt. Comment Letter; Comment Letter of Stradley Ronon Stevens & Young, LLP (Sept. 8, 2009) (“Stradley Ronon Comment Letter”).

Only a few commenters have supported removing references to NRSRO ratings.

These commenters principally asserted that removing credit ratings references would prevent fund boards and advisers from overreliance on NRSRO ratings and encourage advisers to make independent decisions about whether a security presents a credit risk.

Other commenters, however, countered that eliminating NRSRO ratings from the rule would do nothing to prevent a fund manager from being highly dependent upon NRSRO ratings in making its minimal credit risk determination.

See

Comment Letter of James B. Burnham, Business School Professor, Duquesne University (Aug. 27, 2009) (“J. Burnham Comment Letter”); Comment Letter of Moody's Investors Service (Sept. 8, 2009) (“Moody's Comment Letter”); Comment Letter of James L. Nesfield (Jul. 4, 2009) (“J. Nesfield Comment Letter”); Comment Letter of the Shadow Financial Regulatory Committee (Sept. 14, 2009) (“Shadow FRC Comment Letter”); Comment Letter of John M. Winters, CFA (Jul. 23, 2009).

See also

Comment Letter of Professor Lawrence J. White (Sept. 5, 2008) (available in File No. S7-19-08); Comment Letter of Professor Frank Partnoy (Sept. 5, 2008) (available in File No. S7-19-08); Comment Letter of the Government Finance Officers Association (Sept. 5, 2008) (available in File No. S7-19-08); Comment Letter of the Financial Economists Roundtable (Dec. 1, 2008) (available in File No. S7-19-08).

See

J. Burnham Comment Letter; Moody's Comment Letter; J. Nesfield Comment Letter; Shadow FRC Comment Letter. One commenter asserted that transparency of portfolio holdings was a better approach than using references to NRSRO ratings. J. Nesfield Comment Letter. We note that we are amending rule 2a-7 to require money market funds to disclose information about their portfolio holdings each month on their Web sites.

See infra

Section II.E.1.

Stradley Ronon Comment Letter (removing the references would not prevent advisers from relying too heavily on NRSRO ratings under their own internal credit risk analysis).

Commenters did, however, largely support the approach of allowing funds to designate a minimum number of NRSROs that the fund would look to under rule 2a-7 in determining whether a security is an eligible security. They asserted that NRSRO designation would encourage competition among NRSROs to achieve designation and reduce the cost of subscribing to all NRSROs' ratings.

They also noted that this approach would permit funds to focus better on standards, methods, and current ratings levels developed by designated NRSROs.

Several commenters expressed concern, however, that requiring designation of only three NRSROs would result in funds designating the three largest NRSROs, which could further entrench their market dominance.

Other commenters stated that designating NRSROs could disadvantage small NRSROs with well-developed capabilities regarding certain investments and suggested that the fund should have flexibility to rely on the particular NRSROs it determines have the best expertise to evaluate a particular security.

Some commenters, while supporting designation of NRSROs, asserted that fund boards are unprepared to make such determinations and urged that fund advisers be given the responsibility.

See, e.g.,

Federated Comment Letter; Fidelity Comment Letter; ICI Comment Letter.

See

Am. Securit. Forum Comment Letter.

See, e.g.,

Comment Letter of DBRS Limited (Sept. 8, 2009) (“DBRS Comment Letter”); Comment Letter of Wells Fargo Funds Management, LLC (Sept. 8, 2009) (“Wells Fargo Comment Letter”). Three of the 10 NRSROs registered with the Commission issued approximately 97% of all outstanding ratings across all categories reported to the Commission for 2008.

See

SEC, Annual Report on Nationally Recognized Statistical Rating Organizations

(Sept. 2008) at 10.

See

Tamarack Funds Comment Letter; TDAM Comment Letter.

See

Comment Letter of the American Bar Association (Committee on Federal Regulation of Securities) (Sept. 9, 2009) (“ABA Comment Letter”); Comment Letter of the Mutual Fund Directors Forum (Sept. 8, 2009) (“MFDF Comment Letter”); Comment Letter of Northern Funds and Northern Institutional Funds (Sept. 8, 2009) (“Northern Funds Comment Letter”).

The Commission is committed to reevaluating the use of NRSRO ratings in our rules. Recently we eliminated references to NRSRO ratings in several rules where we concluded that they were no longer warranted as serving their intended purposes and where the elimination was consistent with the protection of investors.

Today, as discussed in more detail below, we are eliminating the only provision in rule 2a-7 that limits money market funds to investing in a type of security

only

if it is rated.

We continue to work to further the goals of the Credit Rating Agency Reform Act in order to improve the quality and reliability of securities ratings.

See

NRSRO References Adopting Release,

supra

note 73.

Compare

amended rule 2a-7(a)(12)

with

current rule 2a-7(a)(10)(i)(B).

See, e.g.,

Proposed Rules for Nationally Recognized Statistical Rating Organizations, Exchange Act Release No. 61051 (Nov. 23, 2009) [74 FR 63866 (Dec. 4, 2009)] (proposing rule amendments and a new rule requiring each NRSRO to: (1) Furnish an annual report describing the steps taken by the firm's designated compliance officer during the fiscal year with respect to certain compliance matters; (2) disclose additional information about sources of revenues on Form NRSRO; and (3) make publicly available information about revenues of the NRSRO attributable to persons paying the NRSRO for the issuance or maintenance of a credit rating).

We have found no evidence that suggests that over-reliance on NRSRO ratings contributed to the problems that money market funds faced during the debt crisis. Our staff closely examined, for example, why some money market funds held securities issued by certain SIVs that became distressed in 2007. The staff exams appear to indicate that the minimal creditworthiness evaluations of SIVs made by advisers to funds that held those SIVs differed from the evaluations made by advisers to funds that did not invest in those SIVs in the emphasis the advisers gave to particular elements of the analysis.

Had fund managers relied too heavily on credit rating agencies, we would have expected to see far more funds

holding Lehman Brothers commercial paper when it defaulted than we did.

See

Proposing Release,

supra

note 2, at note 135.

See Fitch: Market Challenges Offer `Lessons' for Rated Money Market Funds,

Business Wire (Oct. 1, 2008) (“Most funds were able to eliminate or minimize their exposure to securities issued by SIVs and Lehman Brothers by limiting their absolute exposures and/or taking measures to scale back their risk as the credit picture deteriorated.”).

See

Bloomberg Terminal Database, LEH (Equity) CRPR (historical short-term credit ratings for credit rating agencies, including Moody's and Fitch, indicate that these agencies did not downgrade their ratings of Lehman Brothers debt before the company filed for bankruptcy); Bob Ivry, Mark Pittman & Christine Harper,

Sleep-At-Night-Money Lost in Lehman Lesson Missing $63 Billion,

Bloomberg

(Sept. 8, 2009),

available at http://www.bloomberg.com/apps/news?pid=email_en&sid=aLhi.S5xkemY

(historical short-term credit ratings for Moody's and Fitch indicate that these credit rating agencies did not downgrade their ratings of Lehman Brothers debt before the company filed for bankruptcy); David Segal,

The Silence of the Oracle,

New York Times

(Mar. 18, 2009) (noting Moody's rated Lehman Brothers' debt A2 before the firm's bankruptcy)

The current provisions of rule 2a-7 were designed to prevent excess reliance on credit rating agencies.

Under rule 2a-7, adequate ratings alone do not provide a basis for eligibility. As we have noted before, a determination that a security is an eligible security is a necessary but not sufficient finding in order for a fund to acquire the security.

The rule also requires fund boards (which typically rely on the fund's adviser) to determine that the security presents minimal credit risks, and specifically requires that determination “be based on factors pertaining to credit quality in addition to any ratings assigned to such securities by an NRSRO.”

Thus, credit ratings provide an important

but not exclusive

input into the investment decision-making process,

and the unreliability or low quality of ratings issued by one or more NRSROs can (and should) be addressed by an investment adviser providing a thorough analysis of the security to determine if it involves minimal credit risks. The use of these ratings provides an independent perspective on the creditworthiness of short-term securities that we have considered, in part, when determining whether to exercise our exemptive authority to permit money market funds to use the amortized cost method of valuation.

100

See

Revisions to Rules Regulating Money Market Funds, Investment Company Act Release No. 18005 (Feb. 20, 1991) [56 FR 8113 (Feb. 27, 1991)] (“1991 Adopting Release”) at Section II.A.

See, e.g.,

id.

at text accompanying n.18.

Current rule 2a-7(c)(3)(i).

See

1991 Adopting Release,

supra

note 96, at Section II.A.

100

See

1983 Adopting Release,

supra

note 6, at paragraphs following n.31.

This is not to say, however, that we are content with the current approach of rule 2a-7. Any one of the growing number of NRSROs, regardless of its expertise in rating short-term securities of the type held by money market funds, could have deemed a security unfit for a money market fund to acquire or, conversely, deemed a security to be eligible for investment by a money market fund. To address this concern, we are adopting amendments to rule 2a-7 that shift responsibility to money market fund boards for deciding which NRSROs they will use in determining whether a security is an eligible security for purposes of the rule.

The amendments are designed, among other things, to foster greater competition among NRSROs to produce the most reliable ratings in order to obtain designation by money market fund boards. Accordingly, we believe this approach will improve the utility of the rule's use of NRSRO ratings as threshold investment criteria, and is consistent with the goals of Congress in passing the Credit Rating Agency Reform Act.

101

See

Senate Committee on Banking, Housing, and Urban Affairs, Credit Rating Agency Reform Act of 2006, S. Rep. 109-326, at 1 (2006) (“Senate Report No. 109-326”) (“The purpose of the `Credit Rating Agency Reform Act' * * * is to improve ratings quality for the protection of investors and in the public interest by fostering accountability, transparency, and competition in the credit rating industry.”). In 2007, pursuant to the Credit Rating Agency Reform Act, we adopted rules to implement a program for registration and Commission oversight of NRSROs (“NRSRO Rules”). Oversight of Credit Rating Agencies Registered as Nationally Recognized Statistical Rating Organizations, Exchange Act Release No. 55857 (June 5, 2007) [72 FR 33564 (June 18, 2007)] (“NRSRO Rules Adopting Release”). Our rule amendments regarding NRSROs have been designed, among other things, to foster greater competition among NRSROs and to encourage more of them to enter the market.

See, e.g.,

Amendments to Rules for Nationally Recognized Statistical Rating Organizations, Exchange Act Release No. 61050 (Nov. 23, 2009) [74 FR 63832 (Dec. 4, 2009)], at nn.1-3 and accompanying text (

citing

Senate Report No. 109-326, at 1).

a. Number of Designated NRSROs

Under amended rule 2a-7, each money market fund must designate in its registration statement

102

at least four NRSROs that the fund will use to determine, among other things, whether a security is an eligible security.

103

Several commenters expressed concern that permitting funds to designate only three NRSROs (which was recommended by the ICI Report) would simply embrace the current market for ratings, which is dominated by three rating agencies.

104

We share these commenters' concerns and thus are requiring funds to designate at least four NRSROs, an approach recommended by commenters as a way to foster competition among NRSROs to develop a specialized service of providing short-term ratings to money market funds and improve independent credit ratings for purposes of the rule.

105

We also believe that the designation of at least four NRSROs will allow funds to designate smaller NRSROs that specialize in rating particular investments.

102

The fund must disclose the designated NRSROs, including any limitations with respect to the fund's use of such designation, in the fund's SAI. Amended rule 2a-7(a)(11)(iii). In response to our request for comment on whether to require disclosure of designated NRSROs in money market funds' SAI,

see

Proposing Release,

supra

note 2, at text accompanying n.115, several commenters suggested we require disclosure of designated NRSROs in the fund's registration statement.

See, e.g.,

Fidelity Comment Letter (recommending disclosure in the fund's SAI); Invesco Aim Comment Letter (same); ICI Comment Letter (recommending disclosure in the fund's prospectus or Web site). In contrast, one commenter objected to disclosure of designated NRSROs in the fund's registration statement on the grounds that investors do not consider this information to be material and stickering the fund's prospectus for each change in designation would be too costly.

See

Federated Comment Letter.

We believe that the identity of each designated NRSRO is not essential information for investors, but that some investors may find it useful, and therefore are requiring it in the SAI.

See generally

Form N-1A at General Instruction C.2(b) (noting that the purpose of the SAI is to provide additional information about a fund that is not necessary to be in the prospectus but that some investors may find useful).

103

Amended rule 2a-7(a)(11). A fund may designate only credit rating agencies that are registered as NRSROs with the Commission under the Exchange Act and the rules adopted under those provisions.

See

section 15E of the Exchange Act [15 U.S.C. 78o-7]; 17 CFR 240.17g-1. In response to our request for comment, one commenter recommended permitting designation of unregistered credit rating agencies on the grounds that this could promote competition.

See

Moody's Comment Letter. Two commenters opposed designation of an unregistered credit rating agency, and one of these commenters argued that the potential for introducing under-researched data into the marketplace could disrupt the orderly functioning of markets.

See

DBRS Comment Letter; Invesco Aim Comment Letter. In light of the enhanced disclosure obligations and ongoing rulemaking initiatives designed to improve the quality and reliability of ratings issued by registered NRSROs, we are maintaining the requirement that only credit rating agencies registered as NRSROs with the Commission may be designated under the rule.

See, e.g.,

supra

note 93.

104

See, e.g.,

DBRS Comment Letter; Wells Fargo Comment Letter; C. Wesselkamper Comment Letter.

105

See

DBRS Comment Letter; Fidelity Comment Letter. In response to our request for comment on the appropriate number of NRSROs a board should designate, another commenter requested we require funds to designate at least five NRSROs as a way to encourage new entrants to the market.

See

Federated Comment Letter.

See also

Proposing Release,

supra

note 2, at text following n.113 and at n.117 and accompanying text (requesting comment).

Under the amendments, a fund could designate an NRSRO with respect to short-term credit ratings for only certain types of issuers or securities.

106

This

would allow a fund, for example, to designate an NRSRO that specializes in securities issued by insurance companies or banks.

107

This approach, which was supported by several of the commenters,

108

may further encourage new entrants among NRSROs that fund managers might not otherwise consider designating due to lack of confidence in ratings outside the NRSROs' areas of expertise.

106

Amended rule 2a-7(a)(11)(i)(A) (providing that a money market fund's board of directors may designate an NRSRO whose short-term credit ratings with respect to any obligor or security or

particular obligors or securities will be used by the fund to determine whether a security is an eligible security).

107

A fund that has designated an NRSRO to use in determining the eligibility of insurance company-issued securities need not review or monitor any class of ratings that the NRSRO issued with respect to other securities or their issuers in which the fund may invest. A fund adviser (under delegated authority) would be free (but not required) to consider these ratings in determining whether the non-insurance company-issued security (or its issuer) presents minimal credit risks. Amended rule 2a-7(c)(3)(i).

108

See

DBRS Comment Letter; Moody's Comment Letter; Wells Fargo Comment Letter.

b. Board Designation and Annual Determination

The amendments require each money market fund's board of directors to designate the NRSROs on which the fund will rely for purposes of the rule. In addition, the board must determine at least once each calendar year that each designated NRSRO issues credit ratings that are sufficiently reliable for such use.

109

Before designating an NRSRO and before making its annual determination, a board should have the benefit of the adviser's evaluation regarding the quality of the NRSRO's short-term ratings.

110

We would anticipate that the board's designations and annual determinations would be based on recommendations of the fund adviser and its credit analysts, who would have evaluated each NRSRO based on their experiences in addition to any information provided by the NRSRO. We would expect the adviser's annual evaluation to be based, among other things, on an examination of the methodology an NRSRO uses to rate securities, including the risks they measure, and the NRSRO's record with respect to the types of securities in which the fund invests, including asset backed securities.

111

The reliability of a newly registered NRSRO could be evaluated based upon the quality and relevant experience of the personnel conducting the rating. Even with the recommendations of the fund adviser, we recognize that ultimately, a board's determination whether an NRSRO's ratings are “sufficiently reliable” for use in determining whether a security is an eligible security will be a matter of judgment.

109

Amended rule 2a-7(a)(11)(i). We are requiring funds to perform the annual determination once each calendar year to simplify compliance so that a fund is not in violation of the rule if the board's determination occurs soon after the year anniversary of the previous determination.

110

Fund boards may, however, also find an NRSRO's record with respect to long-term securities to be helpful in evaluating the overall quality of the organization.

111

See

Moody's Comment Letter (advocating that any board designation be “based on the board's assessment of ratings' attributes, such as quality, comparability and historical performance.”). We have recently adopted rule amendments relating to NRSROs that should help fund advisers and their credit analysts in performing their evaluations. Our amendments require NRSROs, among other things, to disclose information about their ratings methodology, experience and performance. For example, NRSROs must disclose in their applications their ratings experience, performance in assessing the creditworthiness of securities and obligors, procedures and methodologies used in determining credit ratings, the types of conflicts NRSROs face and how they manage those conflicts, and the qualifications of the NRSRO's credit analysts.

See

Items 6, 7 and Exhibits 1, 2, 6, 7, 8 of Form NRSRO. In addition, NRSROs currently are required to disclose on a public Web site a random sample of 10% of the ratings histories of issuer paid ratings in each class of credit ratings for which the NRSRO is registered and has issued 500 or more issuer paid credit ratings. Rule 17g-2(a)(8) and (d) [17 CFR 240.17g-2(a)(8) and (d)]. In June of this year, these public disclosures will have to include ratings action histories for

all

credit ratings initially determined on or after June 26, 2007.

See

Amendments to Rules for Nationally Recognized Statistical Ratings Organizations, Exchange Act Release No. 61050 (Nov. 23, 2009) [74 FR 63832 (Dec. 4, 2009)] at text following n.19 and compliance date.

Many commenters expressed concern that a money market fund's board of directors does not have the necessary expertise to designate NRSROs, and urged that we delegate the authority to fund advisers to make the designation.

112

A number of these commenters seem to assume that we would require fund boards to engage in the type of analysis that we expect the adviser will provide the board for its consideration. We believe that it will be useful for boards to consider the designation of NRSROs, a role not unlike the role that many boards play in approving other matters of substantial significance to the operation of the fund.

113

Board designation and determination (at least once a calendar year) will serve as a check on fund managers that may have conflicts of interest in selecting an NRSRO from which the manager seeks a rating for the fund (in order to facilitate marketing the fund),

114

or an NRSRO that may accommodate the fund's investment in higher yielding, riskier securities.

115

112

See, e.g.,

ABA Comment Letter; MFDF Comment Letter; Northern Funds Comment Letter. These commenters responded to our discussion of this approach in the Proposing Release.

See

Proposing Release,

supra

note 2, at text following n. 118.

113

See, e.g.,

amended rule 2a-7(c)(8) (requiring the fund's board of directors to establish procedures to stabilize the fund's NAV, including procedures providing for, among other things, the board's periodic review of the fund's shadow price, the methods used for calculating shadow price, and what action, if any, the board should initiate if the fund's shadow price exceeds amortized cost by more than

1/2

of 1%).

114

See

Wells Fargo Comment Letter.

115

See

Moody's Comment Letter (noting that the more narrowly defined the categories of ratings for which a designation can be obtained, the “easier it could be for mutual funds to game the system,

e.g.,

by dropping an NRSRO from its list of designated NRSROs for a particular class of ratings because the NRSRO has introduced a more conservative ratings methodology.”).

c. Operation of the Rule

Once a board has designated the NRSROs, the fund could look to the designated NRSROs whenever it has to consider credit ratings under rule 2a-7 unless and until the board changes the designation.

116

A fund must look to only the designated NRSROs to determine whether the security is an eligible security, a rated security,

117

and whether it is a first tier or a second tier

security.

118

Under the amendments, a security is an unrated security if neither the security nor its issuer has received a short-term rating from any of the designated NRSROs.

119

Accordingly, before investing in the security, the fund adviser must make a determination that the security is of comparable quality to a rated security.

120

After a money market fund acquires a security, the fund manager must monitor only the ratings of designated NRSROs to determine whether a change in those ratings requires the board to reassess promptly whether the security continues to present minimal credit risks or to dispose of a portfolio security that is no longer an eligible security.

121

116

We have changed the term from “NRSRO” to “designated NRSRO” throughout the rule each time it is used. As a consequence, changes in the fund's designated NRSROs may affect the ability of the fund to purchase a new security or roll over a current holding, and may require the fund to reassess promptly whether the security continues to present minimal creditworthiness and dispose of a current holding. This is because a new designation of an NRSRO (or a removal of a designated NRSRO) is now treated under the rule as the equivalent of a credit event requiring the fund board or adviser to consider the rating of the newly designated NRSRO (or preclude the consideration of a formerly designated NRSRO). For example, if a fund acquires an unrated security (

i.e.,

a security (or its issuer) that does not have a short-term rating from a designated NRSRO) that the fund considered to be equivalent to a first tier security and the fund thereafter designates a new NRSRO that has rated the security as a second tier security, the fund must then treat the security as a second tier security. The fund would not be required to dispose of the security (although it would be required to perform a credit assessment, which might prompt it to dispose of the security) even if the position in the security exceeds the fund's limits on second tier securities, because compliance with the limits on second tier securities is determined immediately after the fund acquires the security.

See

amended rule 2a-7(c)(3)(ii); 2a-7(c)(4)(i)(C). The fund could only roll over the position to the extent that immediately after the rollover the fund would meet the rule's limits on second tier securities.

See

amended rule 2a-7(a)(1) (defining “acquisition” to include a rollover of a position in security).

117

Amended rule 2a-7(a)(23) (defining the term “requisite NRSROs”). For purposes of determining whether a rated security is an eligible security and a first tier security, rule 2a-7 requires the fund to determine whether the security (or its issuer) has received a short-term rating from the requisite NRSROs. Amended rule 2a-7(a)(12)(i). Under the amended rule, the requisite NRSROs must be drawn from the designated NRSROs. Amended rule 2a-7(a)(23). Thus, for example, a security that is rated as a first tier security by two NRSROs, only one of which is a designated NRSRO, and as a second tier security by another designated NRSRO, is a split-rated security and thus a second tier security.

Id.

118

Amended rule 2a-7(a)(12) (defining “eligible security”); amended rule 2a-7(a)(14) (defining “first tier security”); and amended rule 2a-7(a)(24) (defining “second tier security”).

119

Amended rule 2a-7(a)(30) (defining “unrated security” by reference to amended rule 2a-7(a)(21), which defines a “rated security” as, among other things, a security that has received or been issued by an issuer that has received a short-term rating by a designated NRSRO).

120

Amended rule 2a-7(a)(12) (defining “eligible security”).

121

Amended rule 2a-7(c)(7)(i)(A) (requiring a fund's board of directors to reassess promptly whether the security continues to present minimal credit risks and cause the fund to take action if: (i) The security ceases to be a first tier security because it no longer has the highest rating from the requisite NRSROs or, in the case of an unrated security, the board determines it is no longer of comparable quality to a first tier security, or (ii) the security is an unrated security or second tier security and the fund's investment adviser (or portfolio manager) becomes aware since acquisition of the security that any designated

NRSRO has given it a rating below the designated NRSRO's second highest short-term rating); amended rule 2a-7(c)(7)(ii)(B) (requiring a fund to dispose of a security that ceases to be an eligible security as soon as practicable consistent with achieving an orderly disposition of the security, absent a finding by the board of directors that disposal of the portfolio security would not be in the best interests of the money market fund).

3. Asset Backed Securities

We are amending rule 2a-7 to eliminate a requirement that an asset backed security (“ABS”) be rated by at least one NRSRO in order to be an eligible security that a money market fund may acquire.

122

As a consequence, funds may acquire an unrated asset backed security that otherwise meets the requirements of rule 2a-7, including those requirements that apply to unrated securities.

123

122

We are thus amending current rule 2a-7(a)(10)(ii) to eliminate paragraph (B) and renumber paragraph 2a-7(a)(10)(ii)(A) as 2a-7(a)(12)(ii).

123

See, e.g.,

amended rule 2a-7(a)(12)(ii); (c)(3)(iv)(C); (c)(7)(i)(A)(

). As under the current rule, if an asset backed security is a rated security, it will be required to satisfy the rule's ratings criteria. Amended rule 2a-7(a)(12)(i).

In 1996, we limited funds to investing in rated ABSs because we thought that NRSROs played a beneficial role in assuring that assets underlying an ABS were properly valued and would support the cash flows required to fund the ABS, and we were concerned that fund advisers may not be in as good a position to perform the legal, structural, and credit analysis that the rating agencies performed.

124

As discussed in the Proposing Release, NRSROs rapidly downgraded ABSs from their status as first tier securities over a short time period during 2007-2008.

125

The NRSROs thus did not seem to play a role in buttressing the minimal credit risk analysis of fund management sufficient to warrant a requirement that

all

ABSs be rated to be eligible for money market fund investment. We would otherwise have expected a slower, more orderly downgrading process for these ABSs, which would have permitted money market funds to gradually roll off the paper.

124

Revisions to Rules Regulating Money Market Funds, Investment Company Act Release No. 21837 (Mar. 21, 1996) [61 FR 13956 (Mar. 28, 1996)] at Section II.E.4; Revisions to Rules Regulating Money Market Funds, Investment Company Act Release No. 19959 (Dec. 17, 1993) [58 FR 68585 (Dec. 28, 1993)] (“1993 Proposing Release”) at nn.110-112 and accompanying text.

125

See

Proposing Release,

supra

note 2, at Section II.A.4.

See also

Standard & Poor's,

Global Structured Finance Default and Transition Study—1978-2008: Credit Quality of Global Structured Securities Fell Sharply in 2008 Amid Capital Market Turmoil

(Feb. 25, 2009),

available at http://www2.standardandpoors.com/portal/site/sp/en/ca/page.article/3,3,3,0,1204847668460.html

(showing greater default rate and significantly greater downgrades in structured finance securities).

We received only a few comments on this approach.

126

One NRSRO commenter supported removing this requirement.

127

Two urged us to keep the ratings requirement for ABSs,

128

and one of those asserted that ratings “under appropriate criteria” enhance the liquidity of ABSs and provide credit and structural expertise and research that benefit investors.

129

As noted above, we do not believe that NRSRO ratings of ABSs served this function during the 2007-2008 turmoil in the ABS marketplace, and we no longer believe that the provision of rule 2a-7 that has required such ratings for

all

ABSs is warranted as serving its intended purpose, and thus we are eliminating this requirement.

130

126

We also solicited comment generally on whether, and if so how, we should amend rule 2a-7 to generally address the risks presented by ABSs. We received a number of comments in response to this request, and will consider them in developing further amendments to rule 2a-7.

127

See

Moody's Comment Letter.

128

See

Am. Securit. Forum Comment Letter; Shriver Poverty Law Ctr. Comment Letter.

129

See

Am. Securit. Forum Comment Letter.

130

See

Statement of Lawrence J. White, SEC Roundtable to Examine Oversight of Credit Rating Agencies at 2 (Apr. 15, 2009) (initial ratings on bonds securitized from subprime residential mortgages “proved to be excessively optimistic”—especially for the bonds based on mortgages originated in 2005 and 2006).

We do note, however, that as part of the minimal credit risk analysis that any money market fund must conduct before investing in an ABS, the board of directors (or its delegate) should: (i) Analyze the underlying ABS assets to ensure that they are properly valued and provide adequate asset coverage for the cash flows required to fund the ABS under various market conditions; (ii) analyze the terms of any liquidity or other support provided by the sponsor of the ABS; and (iii) otherwise perform the legal, structural, and credit analyses required to determine that the particular ABS involves appropriate risks for the money market fund.

131

See

1993 Proposing Release,

supra

note 124, at nn.108-111 and preceding and accompanying text.

B. Portfolio Maturity

We are adopting amendments to rule 2a-7 to further restrict the maturity limitations on a money market fund's portfolio in order to reduce the exposure of money market fund investors to certain risks, including interest rate risk, spread risk, and liquidity risk. First, we are reducing the maximum weighted average portfolio maturity permitted by the rule from 90 days to 60 days. Second, we are adopting a 120-day limit on the weighted average life of a money market fund's portfolio, which will limit the portion of a fund's portfolio that could be held in longer term adjustable-rate securities. Finally, we are deleting a provision in the rule that permitted certain money market funds to acquire Government securities with extended maturities of up to 762 calendar days.

1. Weighted Average Maturity

We are amending rule 2a-7 to require that each money market fund maintain a dollar-weighted average portfolio maturity (WAM) appropriate to its objective of maintaining a stable net asset value or price per share, but in no case greater than 60 days.

132

We believe that such a limit on the maximum WAM will result in money market funds that are more resilient to changes in interest rates that may be accompanied by other market shocks, and thus reduce the likelihood of a run and better protect money market fund investors. As we explained in the Proposing Release, a portfolio weighted towards securities with longer maturities increases the fund's exposure to interest rate risk, amplifies spread risk, and decreases the

ability of a fund to pay redeeming shareholders.

133

132

See

amended rule 2a-7(c)(2).

133

See

Proposing Release,

supra

note 2, at Section II.B.1.

Most commenters that addressed this proposal supported further reducing the maximum WAM of fund portfolios in order to reduce the funds' exposure to related risk. Those commenters were divided between those supporting the 60-day maximum WAM that we proposed

134

and those supporting a reduction to 75 days.

135

Other commenters argued for no reduction at all (

i.e.,

leaving the limit at 90 days).

136

Commenters supporting a maximum WAM limitation of 60 days believed that such a reduction would be appropriate to increase the stability and liquidity of money market funds

137

and would reduce funds' exposure to interest rate risk.

138

One asserted that a 60-day limitation is appropriate as it prioritizes a money market fund's safety and liquidity over yield.

139

134

See, e.g.,

Goldman Sachs Comment Letter; Comment Letter of the Institutional Money Market Funds Association (Sept. 8, 2009) (“IMMFA Comment Letter”); Northern Funds Indep. Trustees Comment Letter.

135

See, e.g.,

Charles Schwab Comment Letter; Comment Letter of GE Asset Management Incorporated (Sept. 8, 2009) (“GE Asset Mgt. Comment Letter”); T. Rowe Price Comment Letter.

136

See, e.g.,

State Street Comment Letter; Comment Letter of Victory Capital Management (Sept. 8, 2009) (“Victory Cap. Mgt. Comment Letter”); Wells Fargo Comment Letter.

137

See

Tamarack Funds Comment Letter.

138

See

TDAM Comment Letter.

139

See

Invesco Aim Comment Letter.

Commenters supporting a maximum WAM of 75 days argued that such a limitation would achieve the Commission's goal of reducing funds' exposure to interest rate risk while providing funds with sufficient flexibility to invest in high quality securities when shorter term investments are scarce.

140

Some expressed concern about whether a 60-day WAM would reduce a money market fund's ability to generate sufficient yield.

141

Still others argued that a shorter WAM could make some money market funds more risky because of the alternative investment strategies they might employ as a result.

142

Finally, two commenters opposing any change in the maximum WAM permitted by rule 2a-7 argued that liquidity risk to funds is more appropriately limited by other aspects of our amendments to rule 2a-7, and that the resulting reduction in yield would “homogenize” money market funds to such an extent that investors may be driven to invest in unregulated funds, thus increasing systemic risk.

143

140

See, e.g.,

Charles Schwab Comment Letter; GE Asset Mgt. Comment Letter; ICI Comment Letter.

141

See, e.g.,

Charles Schwab Comment Letter; Comment Letter of Crane Data LLC and Money Fund Intelligence (Aug. 31, 2009) (“Crane Data Comment Letter”); T. Rowe Price Comment Letter.

142

One commenter noted that a WAM limitation longer than 60 days would allow a fund to improve the credit profile of its portfolio by substituting longer term Government securities for shorter term corporate securities.

See

BlackRock Comment Letter. Another commenter argued that a reduction would lead to fund portfolios with a “barbelled” maturity structure in which the fund balanced the low yield offered by the large amount of very short-term securities it would be required to hold with an offsetting amount of riskier longer term securities, which could increase the riskiness of fund portfolios.

See

Comment Letter of Waddell & Reed/Ivy Fund Portfolio Managers (Sept. 8, 2009) (“Waddell & Reed Comment Letter”). Another stated that higher risk issuers tend to be limited to issuing shorter maturity securities, so a shorter WAM limitation could increase a fund's credit risk profile.

See

Wells Fargo Comment Letter.

143

See

Fidelity Comment Letter; State Street Comment Letter. Several commenters also asserted that any reduction in WAM would increase issuers' reliance on short-term funding, also increasing systemic risk.

See, e.g.,

Am. Securit. Forum Comment Letter; State Street Comment Letter; Wells Fargo Comment Letter.

We believe that the maximum WAM permissible for money market funds should be reduced to 60 days in order to reduce the likelihood of funds breaking the buck. The increased resilience to simultaneous stresses from interest rate and other risks that a money market fund would achieve through a maximum WAM of 60 days is significant. A fund with a 90-day WAM could withstand an instantaneous change in interest rates of 200 basis points before breaking the buck.

144

In contrast, a fund with a WAM of 60 days could withstand an interest rate change of 300 basis points without breaking the buck.

145

Although an interest rate change of such a magnitude may be unlikely to occur,

146

funds must also be able to withstand multiple shocks occurring simultaneously, such as those that occurred in September 2008 when there was a simultaneous increase in LIBOR rates and widening spreads due to credit deterioration and liquidity pressures, together with extraordinary redemptions.

147

144

See

Fidelity Comment Letter.

145

Our staff supplemented stress test analysis conducted by commenters with more data points and stress scenarios to illustrate the impact on a money market fund's net asset value per share from multiple stresses on that fund's portfolio. A fund with a 75-day WAM could withstand an interest rate change of less than 250 basis points without breaking the buck. We note that these scenarios also represent the most conservative scenarios because they assume that the money market fund started with a market-based net asset value of $1.00. It is our understanding that at any point in time, a large number of money market funds will not start from a market-based net asset value of $1.00—many will start with a market-based net asset value of less than a dollar and thus a smaller interest rate change will cause the funds to break the buck.

146

Interest rate shocks of a 300 basis point magnitude over a relatively short period of time have occurred, although not since the late 1970s.

See

Federal Reserve Bank of New York, Historical Changes of the Target Federal Funds and Discount Rates, 1971 to present,

available at http://www.newyorkfed.org/markets/statistics/dlyrates/fedrate.html.

In low interest rate environments (such as today), a shock in interest rates could occur if the Federal Reserve determines to raise interest rates quickly, for example, to stave off inflation as the economy recovers or to strengthen the U.S. dollar.

147

See

Proposing Release,

supra

note 2, at nn.47-48, 53, 63, 66-67 and accompanying text.

See also

JPMorgan Prime Money Market Fund Quarterly Fact Sheet (Dec. 31, 2009),

available at https://www.jpmorganfunds.com/cm/BlobServer/FS-PMM-P.PDF?blobcol=urldata&blobtable=MungoBlobs&blobkey=id&blobwhere=1158572105887&blobheader=application%2FPDF&blobheadername1=Content-Disposition&ssbinary=true&blobheadervalue1=inline;filename=FS-PMM-P.PDF

(showing the fund's WAL over the previous year).

Twenty-one commenters supported adding a WAL limit to the rule.

159

One large money market fund manager, for example, described the WAL as “a very prudent addition to the rule that, combined with the minimum liquidity requirements * * * represents an important and substantive risk reduction in the permissible construction of a money fund portfolio.”

160

Another acknowledged that “the risk that such a security will begin to deviate significantly from its Amortized Cost increases with its maturity,” and agreed that “the new 120-day WAL limit should control this risk.”

161

159

See, e.g.,

Bankers Trust Comment Letter; Goldman Sachs Comment Letter; Northern Funds Trustees Comment Letter.

160

See

BlackRock Comment Letter.

161

See

Federated Comment Letter.

Two commenters generally opposed a WAL limitation.

162

One urged us to consider, instead, revising the maturity-shortening provisions of rule 2a-7 to require money market funds to measure the maturity of adjustable-rate securities by reference to their final legal maturity date rather than the date at which the interest rate resets.

163

Such a change

would dramatically reduce the ability of money market funds to invest in floating rate securities, and as we discuss below, such a reduction may be unnecessary.

164

Another commenter asserted that the WAL limitation was unnecessarily restrictive of prime retail funds and disagreed with our assessment of the spread risk posed by floating-rate Government securities.

165

The commenter, however, offered no explanation of why the exposure to spread risk would have less harmful consequences for a prime retail fund than for other types of funds and thus be of less concern.

162

See

Thrivent Comment Letter; USAA Comment Letter.

163

See

USAA Comment Letter. Amended rule 2a-7(d) allows money market funds to shorten the

maturity of an adjustable-rate portfolio security for purposes of the WAM limitation by referring to the security's interest rate reset date, rather than the final legal maturity of the security, if the security has a final maturity of 397 days or less (for corporate securities) or an interest rate that adjusts no less frequently than every 397 days for Government securities.

164

This comment also implies that rule 2a-7 should only have a WAL limitation (and not a separate WAM limitation). We believe that the WAM and WAL limitations address different risks (with the WAM primarily aimed at limiting interest rate risk and the WAL primarily aimed at limiting spread risk) and thus believe having both limitations in rule 2a-7 protects money market funds and their investors.

165

See

Thrivent Comment Letter.

Most commenters supported the proposed WAL limit of 120 days,

166

which the ICI comment letter described as “flexible enough even during `normal' market conditions to not unduly restrict a fund's ability to offer a diversified portfolio of short-term, high quality debt securities.”

167

Four commenters supported a WAL with a longer term, with two of these commenters suggesting a longer WAL for government money market funds than for other money market funds.

168

One of these commenters argued that the spread risk associated with Government floating-rate securities is different from the spread risk associated with non-Government securities.

169

Another commenter only supported a WAL limitation applicable to Government securities with maturities of more than two years, arguing that applying a 120-day WAL to all adjustable-rate Government securities would disrupt the short-term debt markets and hinder the ability of Government security issuers to meet internal funding needs.

170

166

See, e.g.,

BlackRock Comment Letter; Invesco Aim Comment Letter; Comment Letter of Ridge Worth Capital Management, Inc. (“RidgeWorth Comment Letter”).

167

ICI Comment Letter.

168

See

Fidelity Comment Letter (supporting a 150-day WAL for government money market funds and a 120-day WAL for all other money market funds); Victory Cap. Mgt. Comment Letter (supporting a 150-day WAL); C. Wesselkamper Comment Letter (supporting a 180-day WAL for government money market funds and a 150-day WAL for all other money market funds); Wells Fargo Comment Letter (supporting a 180-day WAL).

169

See

Fidelity Comment Letter.

170

See

Comment Letter of Fannie Mae (Sept. 3, 2009) (“Fannie Mae Comment Letter”). One commenter also argued that a 120-day WAL would limit Government security issuers' ability to meet their funding needs.

See

Fidelity Comment Letter.

On balance, we conclude that 120 days is an appropriate length of time for the WAL limitation. A WAL limitation of, for example, 90 days appears to be unnecessarily restrictive to money market funds because it could significantly constrain the range of high-quality, short-term debt securities in which money market funds may invest, particularly when combined with our new minimum liquidity requirements.

171

Such a short WAL limitation also may provide spread risk protection beyond what is reasonably necessary to enhance the stability of money market funds. For a money market fund to break the buck while maintaining a WAL of 90 days, average spreads on

all

securities in the fund's portfolio would have to widen beyond 200 basis points.

172

Other securities held by money market funds may not simultaneously face such spread widening even if the commercial paper market is under stress.

173

Accordingly, protection across an

entire

money market fund portfolio against spread widening of the magnitude experienced in the commercial paper market during the fall of 2008 may be unnecessary.

171

One commenter stated that the Commission should not impose a WAL shorter than 120 days, asserting that a shorter limitation would be unnecessarily restrictive and limit a fund's ability to maintain a diversified portfolio of high quality short-term debt securities.

See

Charles Schwab Comment Letter. No commenters supported a shorter WAL than 120 days.

172

This assumes that there are no other simultaneous shocks to the fund's portfolio from redemption pressures or otherwise. In order to evaluate commenters' discussion about the appropriate length of time for a WAL limitation in the context of the shocks a money market fund might face, we again referred to stress test scenarios.

173

Such spread widening even in commercial paper has been rare and commercial paper typically only comprises a portion of money market funds' portfolios. Spreads between 3-month commercial paper and the 3-month Treasury bill widened to approximately 300 basis points at the height of the financial crisis in the fall of 2008 and widened similarly in the mid-1970s, but otherwise have rarely widened by 200 basis points in the last 50 years. This analysis is based on commercial paper spread data contained in Bradley T. Ewing, Gerald J. Lynch & James E. Payne,

Monetary Volatility and the Paper-Bill Spread

, in Progress in Economics Research (2006), at p. 58, supplemented with data from Bloomberg on spreads between yields of 3-month commercial paper and the 3-month Treasury bill.

On the other hand, we are not convinced that a WAL significantly longer than 120 days would be appropriate for a money market fund that is seeking to maintain a stable net asset value. For example, with a 150-day WAL, a money market fund would break the buck with a spread widening of just over 120 basis points (assuming no other simultaneous stresses on the fund's portfolio).

174

Historically, commercial paper spreads, for example, have widened to that extent fairly frequently.

175

Given this limited resilience to spread widening, and given that a money market fund would break the buck even earlier if any other shocks to the fund's portfolio occurred simultaneously, we have determined not to adopt a longer WAL, such as a 150- or 180-day WAL. We note that the European Union's Committee of European Securities Regulators has also recently proposed requiring that short-term money market funds adhere to a maximum 120-day WAL.

176

174

This is based on our staff's analysis of stress test scenarios.

175

See

Ewing

et al., supra

note 173, at 58.

176

See

Committee of European Securities Regulators Consultation Paper,

A Common Definition of European Money Market Funds,

CESR/09-850 (Oct. 20, 2009),

available at http://www.cesr.eu/index.php?page=consultation_details&id=151.

In addition, Europe's Institutional Money Market Fund Association (IMMFA) recently has adopted changes to its code of conduct that will require IMMFA money market funds to adhere to a maximum 120-day WAL.

See

IMMFA Code of Practice, at Section 40,

available at http://www.immfa.org/About/Codefinal.pdf.

We also note that the rating agencies have taken varied approaches to limiting the WAL of rated money market funds. Fitch has adopted revised ratings requirements limiting top-rated money market funds to a WAL of 120 days, but allowing longer WALs for lesser rated money market funds.

See

Fitch Ratings,

Global Money Market Fund Rating Criteria

(Oct. 5, 2009),

available at http://www.fitchratings.com/creditdesk/reports/report_frame.cfm?rpt_id=470368.

Standard & Poor's has proposed more restrictive requirements that would limit top-rated money market funds to a WAL of 90 days, subject to upward adjustment to no more than 120 days depending on the extent of Government securities in the money market fund's portfolio.

See

Standard & Poor's,

Principal Stability Fund Rating Criteria

(Jan. 5, 2010),

available at http://www2.standardandpoors.com/spf/pdf/events/FITcon11410RFC.pdf.

Finally, we are not providing for a longer WAL for money market funds that primarily invest in Government securities. While some commenters asserted that adjustable-rate Government securities have a more benign credit risk profile,

177

they are still exposed to widening interest rate spreads to the same extent as non-Government securities and, as we noted in the Proposing Release, spreads on certain adjustable-rate Government securities did widen during the fall of

2008.

178

In addition, many prime money market funds also hold a sizeable portion of Government securities (and may hold even more Government securities after the adoption of rule 2a-7's new liquidity requirements). Given this fact, allowing government money market funds to have a longer WAL solely because they hold more Government securities than prime funds do, does not appear to us to be an approach that treats the risks attendant to longer term, adjustable-rate Government securities equally, and thus appears inappropriate.

177

See, e.g.,

Fidelity Comment Letter.

But see

BlackRock Comment Letter (recent events have shown that spread relationships can be variable for agency securities); Wells Fargo Comment Letter (credit spreads on Government securities widened to a significant degree in 2008).

178

See

Proposing Release,

supra

note 2, at Section II.B.2. We understand that many floating-rate securities issued by Federal agencies and outstanding during the financial crisis had rates tied to LIBOR. As noted in the Proposing Release, the “TED” spread (the difference between the U.S. Treasury Bill rate and LIBOR) reached a high of 463 basis points on October 10, 2008.

See id.,

at n.67. We understand that most adjustable-rate Government securities held by money market funds had a final maturity of two years or less and thus limiting the WAL limitation to adjustable-rate Government securities with final maturities greater than two years would not address these securities' spread risk.

3. Maturity Limit for Government Securities

The Commission is deleting a provision of rule 2a-7 that has permitted a fund that relied exclusively on the penny-rounding method of pricing to acquire Government securities with remaining maturities of up to 762 days, rather than the 397-day limit otherwise provided by the rule.

179

As we noted in the Proposing Release,

180

we are unaware of any money market fund that currently relies solely on the penny-rounding method of pricing, and none that holds

fixed-rate

Government securities with remaining maturities of two years, which would involve the assumption of a substantial amount of interest rate risk. We received one comment on this topic, which supported the change.

181

Accordingly, we are adopting this change as proposed.

182

179

See

current rule 2a-7(c)(2)(ii). In a conforming change, we also are amending as proposed the maturity-shortening provision of the rule for variable-rate Government securities to require that the variable rate of interest is readjusted no less frequently than every 397 days, instead of 762 days as the rule has permitted.

See

amended rule 2a-7(d)(1).

180

See

Proposing Release,

supra

note 2, at Section II.B.3.

181

See

BlackRock Comment Letter.

182

We also requested comment in the Proposing Release on whether we should impose a limitation on the maximum final legal maturity of adjustable-rate Government securities that money market funds are permitted to acquire. We received only two comments on this proposal. One commenter encouraged us to constrain any limitation on adjustable-rate Government securities with a final legal maturity in excess of two years.

See

Fannie Mae Comment Letter. Another asserted that the WAL limitation provided a sufficient limitation on the risks posed by long-term adjustable-rate Government securities.

See

Federated Comment Letter. We are aware that WAL creates some limitation of this risk, but that even with a 120-day WAL limitation, a fund would still have some ability to acquire longer term adjustable-rate Government securities. No commenters provided us with any data on the extent of adjustable-rate Government securities outstanding from time to time. Two commenters indicated that these securities experienced variable spreads during the financial crisis.

See

BlackRock Comment Letter; Wells Fargo Comment Letter. In the future, we may reconsider whether to limit the maximum maturity of adjustable-rate Government securities that can be held by money market funds after obtaining additional data.

C. Portfolio Liquidity

We are amending rule 2a-7 to require that money market funds maintain a sufficient degree of liquidity necessary to meet reasonably foreseeable redemption requests and reduce the likelihood that a fund will have to meet redemptions by selling portfolio securities into a declining market. As discussed in the Proposing Release, money market funds generally have a higher and less predictable volume of redemptions than other open-end investment companies.

183

Their ability to maintain a stable net asset value will depend, in part, on their ability to convert portfolio holdings to cash to pay redeeming shareholders without having to sell them at a loss. The liquidity of fund portfolios became a critical factor in permitting them to absorb very heavy redemption demands in the fall of 2008 when the secondary markets for many short-term securities seized up.

183

See

Proposing Release,

supra

note 2, at n.172 and accompanying text.

Commenters generally agreed with our analysis of the liquidity needs of money market funds.

They emphasized the importance of liquidity for money market funds and their ability to meet shareholder redemptions.

184

Several also acknowledged the need to place outside limits on the risks money market funds may take.

185

Most commenters supported amending the rule to impose more robust liquidity requirements, but many disagreed with our specific proposals.

186

Some asserted that the proposed requirements might negatively affect funds' ability to manage their portfolios, place excessive burdens on the board of directors, and affect the markets of some portfolio securities.

187

Others argued that the proposals are not sufficient to meet money market funds' liquidity concerns.

188

184

See, e.g.,

Comment Letter of the Securities Industry and Financial Markets Association (Sept. 8, 2009) (“SIFMA Comment Letter”); State Street Comment Letter.

185

See, e.g.,

Federated Comment Letter; Comment Letter of the Independent Directors Council (Sept. 8, 2009) (“IDC Comment Letter”).

186

See, e.g.,

State Street Comment Letter (opposing a general liquidity standard and different minimum liquidity thresholds for retail and institutional funds); Invesco Aim Comment Letter (same).

187

See, e.g.,

Fidelity Comment Letter; ICI Comment Letter; Shadow FRC Comment Letter.

188

See, e.g.,

Fund Democracy/CFA Comment Letter (requesting that the Commission mandate private liquidity insurance for money market funds); HighMark Capital Comment Letter (suggesting a private liquidity bank or that Treasury continue to provide emergency liquidity as possible solutions to address liquidity concerns); Vanguard Comment Letter (asserting that the proposed rule does not address liquidity risk arising from factors other than size of accounts, such as geographical concentration of the shareholders); Waddell & Reed Comment Letter (recommending some type of permanent backstop be available to money market funds); Wells Fargo Comment Letter (suggesting the Federal Reserve set up a secured lending facility to serve as a lender of last resort).

After reviewing the comments, and based on our analysis of redemption activity during the 2008 run on money market funds, we are amending rule 2a-7 to add three new provisions, substantially as proposed, which address different aspects of portfolio liquidity.

189

Together, we believe they will result in money market funds that are better able to absorb large amounts of redemptions.

189

See

Proposing Release,

supra

note 2, at Section II.C.1-2.

1. General Liquidity Requirement

We are amending rule 2a-7, as proposed, to require that each money market fund hold securities that are sufficiently liquid to meet reasonably foreseeable shareholder redemptions in light of its obligations under section 22(e) of the Act and any commitments the fund has made to shareholders (the “general liquidity requirement”).

190

Depending upon the volatility of its cash flows (particularly shareholder redemptions), this new provision may require a fund to maintain greater liquidity than would be required by the daily and weekly minimum liquidity requirements set forth in the rule and discussed below.

190

Amended rule 2a-7(c)(5).

Most commenters who addressed this proposal supported the addition of a general liquidity requirement.

191

They agreed that funds should be required to assess appropriate levels of liquidity above the minimums set forth in the rule.

192

Some commenters, however, expressed concerns that the proposed requirement was too vague,

193

or was

unnecessary in light of the minimum daily and weekly liquidity requirements.

194

We disagree. Funds will have different liquidity needs that we cannot sufficiently anticipate and codify in a rule beyond the minimums we are adopting today.

195

Therefore, we believe it is incumbent upon the management of each fund and its board of directors to evaluate the fund's liquidity needs and to protect the fund and its shareholders from the harm that can occur from failure to properly anticipate and provide for those needs.

191

See, e.g.,

ICI Comment Letter; Northern Funds Indep. Trustees Comment Letter; Tamarack Funds Comment Letter.

192

See, e.g.,

Federated Comment Letter; ICI Comment Letter.

193

See, e.g.,

Charles Schwab Comment Letter; Dreyfus Comment Letter. We note, however, that

similar general requirements in rule 2a-7 have not hampered fund managers.

See, e.g.,

current rule 2a-7(c)(2) (requiring a money market fund to maintain a dollar-weighted average portfolio maturity appropriate to its objective of maintaining a stable net asset value per share or price per share). Thus, we do not share commenters' concerns that the general liquidity standard could expose a money market fund to liability based on hindsight review of the fund's subjective determinations and market events.

194

See, e.g.,

TDAM Comment Letter. Another commenter asserted that money market funds are already subject to this requirement under section 22(e) of the Act.

See

State Street Comment Letter. The general liquidity requirement, together with rule 2a-7's specific obligations related to illiquid securities and daily and weekly liquid assets, identifies the liquidity obligations that are specific to money market funds.

195

For example, suggestions that we require each fund to maintain sufficient liquidity to meet redemptions by the largest shareholders seem inadequate because they assume that only those shareholders will redeem.

See

Stradley Ronon Comment Letter; SIFMA Comment Letter.

To comply with this general liquidity requirement, we would expect money market fund managers to consider factors that could affect the fund's liquidity needs, including characteristics of a money market fund's investors and their likely redemptions.

196

For example, some shareholders may have regularly recurring liquidity needs, such as to meet monthly or more frequent payroll requirements. Others may have liquidity needs that are associated with particular annual events, such as holidays or tax payment deadlines. A fund also would need to consider the extent to which it may require greater liquidity at certain times when investors' liquidity needs may coincide. In addition, a volatile or more concentrated shareholder base would require a fund to maintain greater liquidity than a stable shareholder base consisting of thousands of retail investors.

197

196

See

Proposing Release,

supra

note 2, at text following n.205.

197

See

Thrivent Comment Letter (suggesting that we approach portfolio liquidity on the basis of concentration among a fund's shareholders). In determining the amount of liquidity available to meet the requirements of rule 2a-7, funds should not consider the fund's ability to access overdraft protection, lines of credit, and inter-fund borrowing arrangements.

See

Federated Comment Letter (suggesting that we adopt the opposite approach). A fund that borrowed to satisfy redemptions would leverage its holdings, thus amplifying the risk of shareholder losses if the fund eventually broke the buck.

Thus, to comply with rule 2a-7, as amended, money market funds should adopt policies and procedures designed to assure that appropriate efforts are undertaken to identify risk characteristics of shareholders.

198

In other words, fund boards should make sure that the adviser is monitoring and planning for “hot money.” In their consideration of these procedures and in the oversight of their implementation, fund boards should appreciate that, in some cases, fund managers' interests in attracting additional fund assets may be in conflict with their overall duty to manage the fund in a manner consistent with maintaining a stable net asset value.

199

We urge directors to consider the need for establishing guidelines that address this conflict.

198

Upon adoption of these amendments, such policies and procedures are, we believe, required under rule 38a-1 under the Investment Company Act (the “compliance rule”). Although two commenters suggested that the requirement to adopt the policies and procedures should be incorporated in rule 2a-7, we do not see a reason to duplicate the requirements for policies and procedures encompassed in the compliance rule.

See

Dreyfus Comment Letter; Comment Letter of Fifth Third Asset Management, Inc. (Sept. 8, 2009) (“Fifth Third Comment Letter”). One commenter recommended that “know your customer” policies apply only to shareholders whose redemptions (in their entirety) would have a material impact on the fund's ability to satisfy redemptions. Stradley Ronon Comment Letter.

See also

SIFMA Comment Letter. Another commenter argued that the relevant shareholder characteristics should be limited to clearly defined parameters such as historical net flows.

See

RidgeWorth Comment Letter. We are not identifying specific characteristics that should be addressed in a fund's policies and procedures because we believe that money market funds are in a better position to do so. For example, concurrent redemptions of several shareholders may have a material effect on a fund's ability to satisfy redemptions even if the shareholders' individual redemptions alone would not have such an effect. Nor are we setting limits as to the scope of the policies and procedures because different money market funds may have different needs in this regard.

199

See

Proposing Release,

supra

note 2, at n.180 and accompanying text.

As some commenters noted, identification of these risks may be more challenging when share ownership is less transparent because the shares are held in omnibus accounts.

200

Funds may seek access to information about the investors who hold their interests through omnibus accounts in addition to considering information about the omnibus accounts, including their aggregate historical redemption patterns and the account recordholder's ability to redeem the entire account.

201

200

See, e.g.,

Comment Letter of the Coalition of Mutual Fund Investors (Sept. 10, 2009) (“CMFI Comment Letter”); HighMark Capital Comment Letter.

201

Some commenters argued that we should require greater transparency of investments held through financial intermediaries to allow funds to better monitor client profiles.

See, e.g.,

BlackRock Comment Letter; CMFI Comment Letter. Funds may seek to access this information in contractual arrangements with their financial intermediaries.

2. Limitation on Acquisition of Illiquid Securities

We are amending rule 2a-7 to further limit a money market fund's investments in illiquid securities (

i.e.,

securities that cannot be sold or disposed of in the ordinary course of business within seven days at approximately the value ascribed to them by the money market fund).

202

Under the amended rule, a money market fund cannot acquire illiquid securities if, immediately after the acquisition, the fund would have invested more than five percent of its total assets in illiquid securities.

203

202

We have construed section 22(e) of the Investment Company Act, which requires registered investment companies to satisfy redemption requests within seven days, to restrict a money market fund from investing more than 10% of its assets in illiquid securities.

See

1983 Adopting Release,

supra

note 6, at nn.37-38 and accompanying text; Acquisition and Valuation of Certain Portfolio Instruments by Registered Investment Companies (Mar. 12, 1986) [51 FR 9773 (Mar. 21, 1986)], at n.21 and accompanying text; Proposing Release,

supra

note 2, at n.171 and accompanying text.

203

Amended rule 2a-7(c)(5)(i).

In light of the risk that liquid assets would become illiquid thereby impairing the ability of a money market fund to meet redemption demands, we proposed to prohibit funds from acquiring securities that were, at the time of their acquisition, already illiquid. Many fund commenters objected, arguing such a limitation could preclude them from investing in certain high quality illiquid securities in which money market funds have historically invested,

204

make it more difficult for tax-exempt funds to construct a well-diversified, high quality portfolio,

205

and prevent funds from investing in new types of securities that are illiquid until a market for them has been established.

206

Others asserted that a ban may be unnecessary in light

of the new daily and weekly liquidity standards.

207

204

These include, among other securities, term repurchase agreements, some time deposits, and insurance company funding agreements.

See, e.g.,

Am. Bankers Assoc. Comment Letter; Comment Letter of New York Life Investments (Sept. 14, 2009); Comment Letter of Promontory Interfinancial Network, LLC (Sept. 8, 2009); Wells Fargo Comment Letter.

205

See

Stradley Ronon Comment Letter; Wells Fargo Comment Letter.

206

See, e.g.,

Deutsche Comment Letter; Stradley Ronon Comment Letter; USAA Comment Letter.

207

See, e.g.,

Charles Schwab Comment Letter; TDAM Comment Letter.

These comments persuaded us that prohibiting funds from acquiring

any

illiquid securities may have undesirable consequences for money market funds. Instead, we are further limiting the circumstances under which a money market fund may acquire illiquid securities. Under the amended rule, a fund cannot acquire an illiquid security if, after the purchase, more than five percent of the fund's total assets would consist of illiquid securities.

208

Several commenters suggested that we lower the existing 10 percent limit as an alternative to our proposal.

209

We are reducing by half the existing limit in order to strike a balance between our concern regarding liquidity risk,

i.e.,

a fund's ability to satisfy redemption demands if it is holding illiquid securities, and funds' concerns that they retain some ability to make investments in high quality illiquid securities.

208

Amended rule 2a-7(c)(5)(i).

209

See

Federated Comment Letter; J.P. Morgan Asset Mgt. Comment Letter; Vanguard Comment Letter; Wells Fargo Comment Letter (all recommending a 5% percent limit).

See also

TDAM Comment Letter (recommending that we reduce the existing limit). Other commenters argued that we should maintain the 10% limit.

See, e.g.,

Charles Schwab Comment Letter; Deutsche Comment Letter.

We are also amending the rule to define the term “illiquid security” as a security that cannot be sold or disposed of in the ordinary course of business within seven days at approximately the value ascribed to it by the money market fund. At the suggestion of commenters, we would not treat as illiquid a security that could not be sold at amortized cost.

210

See

amended rule 2a-7(a)(19).

See, e.g.,

Charles Schwab Comment Letter; Wells Fargo Comment Letter. The proposed rule defined “liquid security” with reference to the security's “amortized cost value.”

See

proposed

rule

2a-7(a)(18). Under the amended rule, a money market fund using the amortized cost method will be able to treat as liquid a security that the fund can sell at a price that deviates from the security's amortized cost value, as long as the price approximates the market-based value that the fund has ascribed to the security for purposes of determining its shadow price. Because the market-based value assigned by a money market fund to its securities is the measure that ultimately justifies the fund's use of a stable net asset value, a money market fund should treat as illiquid any security that cannot be sold at a price approximating such market-based value.

See

1983 Adopting Release,

supra

note 6, at n.37 and paragraphs following n.39.

3. Minimum Daily and Weekly Liquidity Requirements

The Commission is adopting new liquidity requirements that mandate each money market fund maintain a portion of its portfolio in cash and securities that can readily be converted into cash. More specifically, we are amending rule 2a-7 to require all

taxable

money market funds to hold at least 10 percent of their total assets in “daily liquid assets” and

all

money market funds to hold at least 30 percent of their total assets in “weekly liquid assets.”

211

A money market fund must comply with the daily and weekly liquidity standards at the time each security is acquired.

212

211

See

amended rule 2a-7(c)(5)(ii)-(iii).

See also

amended rule 2a-7(a)(8) (defining “daily liquid assets”); 2a-7(a)(32) (defining “weekly liquid assets”);

infra

notes 229-243 and accompanying text. “Total assets” means with respect to a money market fund using the amortized cost method, the total amortized cost of its assets and, with respect to any other money market fund, the total market-based value of its assets.

See

amended rule 2a-7(a)(27).

212

See

amended rule 2a-7(a)(8); 2a-7(a)(32)

One commenter recommended that the minimum liquidity standards apply on an ongoing basis, which could require money market funds with holdings that fall below the requirements to sell securities in order to meet the requisite daily and weekly liquid asset thresholds.

See

Fund Democracy/CFA Comment Letter. We do not agree with such an approach. A money market fund whose portfolio does not meet the minimum daily or weekly liquidity standards is not in violation of the rule, but may not acquire any assets other than daily or weekly liquid assets.

See

Dreyfus Comment Letter (requesting that the standards incorporate some flexibility to allow funds not to comply with them under unforeseeable circumstances).

As we explained in the Proposing Release, current liquidity standards applicable to money market funds presume that a fund is able to find a buyer of its securities.

213

Our new approach would include as a “daily liquid asset” or “weekly liquid asset” only cash or securities that can readily be converted to cash (as discussed below). Thus, a fund should be able to use those assets to pay redeeming shareholders even in market conditions (such as those that occurred in September and October 2008) in which money market funds cannot rely on a secondary or dealer market to provide immediate liquidity.

213

See

Proposing Release,

supra

note 2, at Section II.C.2.

Commenters who addressed the issue largely supported the introduction of daily and weekly liquidity standards.

214

One large sponsor of money market funds asserted that it “recognize[d] that a meaningful and sustained level of liquidity has the potential to ease concerns of investors and may be useful for unforeseen events.”

215

Another agreed that “mandating liquidity requirements will bolster investor confidence in the ability of money market funds to sustain prolonged redemption pressures with increased levels of immediate cash on hand, both on a daily and weekly basis.”

216

One commenter, however, urged us to rely solely on the general liquidity requirement, arguing that requiring a minimum requirement would require unnecessary levels of liquidity at times that will not be sufficient during a severe market crisis.

217

214

See, e.g.,

Calvert Comment Letter; Vanguard Comment Letter.

215

J.P. Morgan Asset Mgmt. Comment Letter.

216

Invesco Aim Comment Letter.

217

See

Wells Fargo Comment Letter.

See also

T. Rowe Price Comment Letter (the weekly liquidity standard is overly restrictive in light of the daily liquidity standard and other proposed changes to rule 2a-7).

Markets can become illiquid very rapidly in response to events that money market fund managers may not anticipate. The failure of a single fund to anticipate such conditions may lead to a run of the sort we saw in September 2008 affecting all or many funds. We think it would be ill-advised to rely solely on the ability of managers to anticipate liquidity needs, which may arise from events the money market fund manager cannot anticipate or control. We acknowledge our minimum standards alone may not establish sufficient liquidity to allow funds to meet every liquidity crisis, which is why we also are adopting a general liquidity requirement (discussed above) to supplement the minimum requirements.

Distinguishing between Retail and Institutional Funds.

In the Proposing Release, we observed that institutional money market funds need (and typically maintain) greater portfolio liquidity. These funds had substantially greater redemption pressure on them in the fall of 2008. During the four-week period ending October 8, 2008, prime institutional funds (or share classes) experienced 30 percent net outflows compared to only 4.6 percent outflows of prime retail funds, according to data compiled by the ICI.

218

Consequently, we proposed to impose substantially lower liquidity requirements on retail funds because the higher thresholds appeared unnecessary and would have resulted in higher costs on them in terms of lower yields. For example, instead of 30 percent “weekly liquid assets,” we proposed to require that

retail prime money market funds maintain 15 percent “weekly liquid assets.” We proposed to require that each money market fund's board make an annual determination whether a fund was an institutional fund (and thus subject to the higher liquidity requirements) based on the nature of record owners of shares, minimum initial investment requirements, and cash flows from purchases and redemptions.

219

218

See

ICI,

Money Market Mutual Fund Assets Historical Data, available at http://www.ici.org/pdf/mm_data_2010.pdf.

See also

Proposing Release,

supra

note 2, at n.63 and accompanying text. The Proposing Release also noted that on September 17, 2008, approximately 4% of prime retail money market funds (or share classes) and 25% of prime institutional money market funds had outflows greater than 5%; on September 18, 2008, approximately 5% of prime retail funds and 30% of prime institutional funds had outflows greater than 5%; and on September 19, 2008, approximately 5% of prime retail funds and 22% of prime institutional funds had outflows greater than 5%. Proposing Release,

supra

note 2, at n.185.

219

See proposed rule 2a-7(a)(17) (defining “institutional fund”); Proposing Release,

supra

note 2, at Section II.C.2.a-b.

Most commenters representing money market funds argued against drawing such a regulatory distinction, asserting that there are inherent difficulties in determining the difference between the two types of funds within a generally applicable definition.

220

Commenters asserted that many money market funds include both types of shareholders, and even if one could distinguish a fund with an institutional rather than a retail shareholder base, not all shareholders behave in the same manner and present the same liquidity challenges as their peers.

221

Others expressed concern that the fund's board is not in the best position to make these determinations.

222

The difficulty in drawing bright lines led some commenters to express concern with the competitive consequences that might result when fund boards of directors come to different conclusions.

223

220

See, e.g.,

BlackRock Comm

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