INVESTMENT FUNDS UPDATE. SEC Proposes Amendments to Address Runs on Money Market Funds and Increase Transparency of Money Market Fund Risks

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1 JUNE 19, 2013 INVESTMENT FUNDS UPDATE SEC Proposes Amendments to Address Runs on Money Market Funds and Increase Transparency of Money Market Fund Risks On June 5, 2013, the Securities and Exchange Commission (the SEC or the Commission ) held an open meeting (the Meeting ) to consider a recommendation from the Staff of the Division of Investment Management to propose amendments to Rule 2a-7 (the Rule ) under the Investment Company Act of 1940 (the Act ) as well as other rules and forms under the Act, the Securities Act of 1933 (the Securities Act ) and the Investment Advisers Act of 1940 (the Advisers Act ). 1 At the conclusion of the Meeting, the Commission unanimously approved the release of the proposed amendments and solicited further comment on them. 2 Designed to supplement the money market fund reforms the Commission had previously adopted in 2010, 3 the proposed amendments (the Proposed Amendments ) attempt to address the susceptibility of certain money market funds to heavy redemptions, improve their ability to manage such redemptions, and increase the transparency of the risks in money market funds, while preserving their benefits for investors and issuers alike. The Proposed Amendments include two main proposals, each of which could be adopted individually or in combination with the other proposal. Both proposals would eliminate the amortized cost method of pricing. Proposal One: Institutional prime money market funds would be required to float their net asset value ( NAV ) and sell and redeem shares based on the current market value of the securities in their underlying portfolios, similar to other open-end funds. Institutional prime money market funds would be required to price and transact their shares with greater precision than they (or other types of funds) do currently. Government and retail money market funds would be exempt from the floating NAV requirement and would continue to be permitted to use the penny rounding method of valuation to value their shares at $1.00, but would no longer be permitted to use the amortized cost method. 1 Under the Proposed Amendments, the following provisions and forms are being added to, or amended under, the securities laws referenced above: Rule 419 and Rule 482 under the Securities Act; Rule 2a-7, Rule 12d3-1, Rule 18f-3, Rule 22e-3, Rule 31a-1, Rule 30b1-7 and Rule 30b1-8 under the Act; Form N-1A under the Act and the Securities Act; Form N-MFP under the Act; Form N-CR under the Act; and Form PF under the Advisers Act. 2 See Money Market Fund Reform; Amendments to Form PF, Investment Company Act Release No (June 5, 2013) (the Proposing Release ). 3 See Money Market Fund Reform, Investment Company Act Release No (February 23, 2010) (the 2010 Adopting Release ). Sidley Austin provides this information as a service to clients and other friends for educational purposes only. It should not be construed or relied on as legal advice or to create a lawyer-client relationship. Attorney Advertising - For purposes of compliance with New York State Bar rules, our headquarters are Sidley Austin LLP, 787 Seventh Avenue, New York, NY 10019, ; One South Dearborn, Chicago, IL 60603, ; and 1501 K Street, N.W., Washington, D.C ,

2 Page 2 Proposal Two: All money market funds except for government funds would be required to impose a 2% liquidity fee on each shareholder s redemption if weekly liquid assets fall below 15% of total assets, unless the fund s board of directors determined it was in the best interests of the fund not to do so or to impose a reduced fee. The boards of such funds also would be permitted to gate redemptions, i.e., to suspend redemptions temporarily, if weekly liquid assets fall below 15% of total assets. All money market funds would be permitted continue to use the penny rounding method of valuation to value their shares at $1.00 but would no longer generally be permitted to use the amortized cost method. The Proposing Release also includes extensive discussions of the economic impact of each proposal on money market funds, investors and issuers of money market fund portfolio securities. At the Meeting and in the Proposing Release, the Commission expressed interest in receiving comments about combining Proposal One and Proposal Two into a single reform package. The Commission also notes that it considered a number of alternative options for regulatory reform, in particular recommendations from the President s Working Group on Financial Markets, which published a report on money market fund reform options in 2010, 4 and recommendations from the Financial Stability Oversight Council ( FSOC ) in The Proposed Amendments do not include many of the options from either the PWG Report or the FSOC Recommendations (e.g., capital buffers, minimum balance at risk, private emergency liquidity facility, public or private insurance and a special purpose bank) as the Commission does not believe that they would achieve our regulatory goals as well as what we propose today. 6 The Proposing Release introduces other amendments, including, among other things, enhanced disclosure requirements for money market funds and other similar funds, changes to Form N-MFP, the introduction of new Form N-CR, tightening of existing diversification requirements under the Rule, new stress testing requirements and certain clarifying amendments applicable to the Rule s existing requirements. As noted in the Proposing Release, the Commission s outstanding 2011 proposal 7 to remove references to credit ratings in the Rule and Form N-MFP has not been rescinded and will be addressed at another time. These proposals are discussed in further detail below. Proposal One Floating NAV Requirement The floating NAV proposal is designed to address the current valuation and pricing methods of money market funds that, in the view of the Commission, incentivize investors to redeem money market fund shares ahead of other investors in times of fund and market stress, as seen in the financial crisis. 8 In response to that crisis, the Commission adopted amendments to the Rule (and other rules) in 2010 to reduce the risk profile of money market fund portfolios and enhance the level of disclosure made by money market funds to the Commission and the public. 4 See Report of the President s Working Group on Financial Markets, Money Market Fund Reform Options (Oct. 2010) ( PWG Report ), available at (the PWG Report ). 5 See Proposed Recommendations Regarding Money Market Fund Reform, Financial Stability Oversight Council [77 FR (Nov. 19, 2012)] (the FSOC Recommendations ). 6 See the Proposing Release at See References to Credit Ratings in Certain Investment Company Act Rules and Forms, Investment Company Act Release No (March 3, 2011). 8 See the Proposing Release at 47.

3 Page 3 In the 2010 Adopting Release, the Commission left open the possibility of additional reforms to the money market fund regulatory regime; in particular, a floating NAV requirement. The Eurozone sovereign debt crisis and the U.S. debt ceiling impasse in 2011, followed by the FSOC Recommendations, among others, heightened the Commission s concerns for the need for more fundamental changes to money market fund rules. Floating NAV and Pricing Amendments The Commission believes Proposal One, a centerpiece of the Proposing Release, would increase transparency of money market fund risks and disincentivize redemption activity resulting from investor uncertainty about the value of securities owned by money market funds. 9 Under Proposal One, money market funds (other than government funds and retail funds), would be required to float their NAV, that is, sell and redeem shares at prices that reflect the value of their portfolio assets using marketbased factors instead of the amortized cost or penny rounding conventions currently permitted by the Rule. Funds subject to this proposal would only be able to use the amortized cost convention to the extent that other mutual funds are able to do so. 10 Money market funds subject to the proposal would also be required to price their shares using a more precise method of rounding, 11 an amendment the Commission believes would increase the observed sensitivity of a fund s share price to changes in the market values of the fund s portfolio securities. 12 If adopted as proposed: Funds with a $1.00 target share price would be required to round prices to the fourth decimal place (e.g., $1.0000). 13 Funds that price shares at a different target level would be required to round to an equivalent level of precision (e.g., a fund with a $10 target share price would price its shares at $10.000). Government Fund Exemption Government money market funds have unique portfolio compositions and, in turn, different redemption pressures and risk characteristics compared to other money market funds. Indeed, the Proposing Release notes that while institutional prime money market funds experienced significant outflows during the financial crisis, institutional and retail government money market funds experienced abnormally large inflows, 14 reflecting a flight by investors to the stability and security of government money market funds. 9 See the Proposing Release at Specifically, a non-money market mutual fund is able to use amortized cost when the fund s board of directors determines, in good faith, that the fair value of debt securities with remaining maturities of 60 days or less is their amortized cost, unless the particular circumstances warrant otherwise. See Valuation of Debt Instruments by Money Market Funds and Certain Other Open-End Investment Companies, Investment Company Act Release No (May 31, 1977). 11 See proposed Rule 2a-7(c). 12 See the Proposing Release at Although the Commission notes in the Proposing Release (at 62) that a number of money market funds have recently elected to voluntarily report daily shadow NAVs at this level of precision, this is the first time that it has required money market funds to actually process share transactions using such precision. Although money market funds are required by Rule 2a-7(c)(13) to have the capacity to process transactions at prices that do not correspond to a stable price per share, the Commission has previously given guidance that such provision would require money market funds to transact with an accuracy of at least a tenth of a cent (e.g., $1.000). See 2010 Adopting Release, note 351. Therefore, money market funds that relied on such guidance and programmed their order taking software to accommodate pricing to a tenth of a cent may require further updates to accommodate hundredth of a cent pricing if the amendments are adopted as proposed. 14 See the Proposing Release at note 175.

4 Page 4 Accordingly, because government money market funds are not as susceptible to mass investor redemptions compared to other money market funds, such funds would be exempt from the floating NAV requirement. 15 The exemption would be available to money market funds that invest at least 80% of their total assets in cash, government securities or repurchase agreements that are collateralized fully. 16 Municipal (or tax exempt) money market funds would not be permitted to rely on the exemption because of the different credit and liquidity risk profile of their portfolio securities, 17 but the Commission stated its belief that the retail fund exemption (explained below) would likely cover most of these funds. Under Proposal One, funds relying on the government fund exemption would no longer be permitted to use the amortized cost convention to establish a stable NAV, but would continue to be able to use the penny rounding convention. 18 Retail Fund Exemption The Commission determined that because of the different redemption risk profile of the retail investor base and the tendency of retail investors to continue to hold money market fund shares in times of market stress, 19 retail money market funds should also be exempt from the floating NAV requirement. Under Proposal One, a retail money market fund would be defined as a money market fund that restricts a shareholder from redeeming more than $1,000,000 in any one business day, 20 a redemption limit which the Commission believes is high enough that it should continue to make money market funds a viable cash management tool for retail investors, but low enough that it should not suit the needs of institutions. 21 Under the retail fund exemption, an omnibus account holder 22 that is the shareholder of record in a money market fund may redeem more than $1,000,000 in a single day, provided that it similarly restricts each beneficial owner in the omnibus account to no more than $1,000,000 in daily redemptions. 23 A money market fund seeking to rely on the exemption would be required to have policies and procedures in place reasonably designed to monitor the omnibus account holder s ability to enforce these redemption limits. 24 The Commission expects that in some cases, funds may enter into agreements with omnibus account holders to reasonably conclude that their policies are complied with. In other cases, funds may have transparency into the activity of omnibus account providers sufficient to reach such a reasonable conclusion, or may use other verification methods (such as certifications). If a fund could not verify or reasonably conclude that an omnibus account holder is applying the redemption limit to underlying beneficial owner 15 See proposed Rule 2a-7(c)(2). The Commission notes that Proposal One may have implications for local government investment pools ( LGIPs ), which many states have established to invest in short-term securities and which are required by law or by investment policies to maintain a stable NAV per share. In order to continue to manage LGIPs, the Commission explains, state statutes and policies may need to be amended to permit the operation of LGIPs that adhere to the Rule as specified by Proposal One. See the Proposing Release at See proposed Rule 2a-7(c)(2). See also the Proposing Release at 68. Because government money market funds could invest up to 20% of their portfolio in non-government securities, the Commission cautions that such funds could still experience a credit event in that 20% portion. Despite the risks, however, it feels that requiring government money market funds to float their NAVs may be unnecessary to achieve policy goals. See Id. at See the Proposing Release at See Id. at See the Proposing Release at See proposed Rule 2a-7(c)(3). 21 See the Proposing Release at Defined in proposed Rule 2a-7(c)(3)(ii) as a broker, dealer, bank, or other person that holds securities issued by the fund in nominee name. 23 See proposed Rule 2a-7(c)(3)(ii). 24 See Id.

5 Page 5 transactions, the Commission would expect the fund to impose the $1,000,000 daily redemption limit on the omnibus account. 25 While the government fund exemption is based on the nature of the fund s underlying portfolio securities, the retail fund exemption is based on the identity of the fund s shareholder base, which poses a practical problem for any money market fund that currently has both retail and institutional shareholders. In order to simultaneously rely on the retail fund exemption while preserving a money manager s institutional shareholder base, such a manager that does not already have institutional money market fund options available may need to reorganize its existing funds into separate retail and institutional funds. 26 Ability to Suspend Redemptions and Liquidate Preserved Under Proposal One, all money market funds, including floating NAV funds, would continue to be able to rely on Rule 22e-3 under the Act to suspend redemptions and liquidate in times of fund and market distress with a few important changes: All money market funds would be permitted to suspend redemptions and liquidate when, among other requirements, the fund, at the end of a business day, has invested less than 15% of its total assets in weekly liquid assets. 27 Additionally, funds relying on the government or retail fund exemptions would be permitted to suspend redemptions and liquidate if the fund s penny-rounded share price were to deviate (or be determined by the board, including a majority of the independent directors, to be likely to deviate) from the stable price established by the board of directors. 28 Same-Day Settlement Many institutional money market funds permit share transactions to settle on the same day that an investor places a purchase or sell order, an accommodation facilitated by order management systems that rely upon a stable NAV. Funds that do not have systems that can support same day settlement for a floating NAV fund may need to make adjustments if Proposal One is adopted or consider pricing their shares periodically (e.g., at noon and 4 p.m. each day) to provide same-day settlement. New Required Disclosures If Proposal One is adopted, the Commission would require floating NAV money market funds to include new disclosures in advertisements and sales materials and in their summary prospectuses (or in the summary section of the statutory prospectus if no summary prospectus is used). 29 Even government and retail money funds would have to make some new disclosures, including that the fund s sponsor has no legal obligation to provide financial support to the fund. 30 A fund that relies upon the retail exemption would be expected to revise its prospectus disclosure regarding 25 See the Proposing Release at See the Proposing Release at See proposed Rule 22e-3(a)(1). 28 Id. 29 See the Proposing Release at See Id. at 140.

6 Page 6 the $1,000,000 daily redemption limit and explain how it handles redemption requests in excess of this limit on any one day. 31 Proposal Two Standby Liquidity Fees and Gates While Proposal One is designed to increase the transparency of money market fund pricing, Proposal Two relating to liquidity fees and gates is designed to give money market funds the tools to better manage heavy redemptions and limit the extent of a run. Liquidity Fees Under Proposal Two, if the weekly liquid assets of a money market fund (other than a government fund) were to fall below 15% of its total assets at the end of any business day, such fund must impose, on the next business day, a 2% liquidity fee on each shareholder s redemption. However, a fund would not be required to impose a 2% liquidity fee if its board of directors (including a majority of its independent directors) were to determine that such a fee would not be in the best interest of the fund or determine that a lower fee would be in the best interests of the fund. 32 Any fee would be lifted automatically should a fund restore its weekly liquid assets to or above 30% at the end of a business day. A fund s board of directors (including a majority of its independent directors) could also lift a liquidity fee at any time if the board determines to impose a different fee or if it determines that imposing the fee would no longer be in the best interests of the fund. 33 In the case of omnibus accounts, the Commission explains its expectation that money market funds, like existing mutual funds that have imposed redemption fees to deter market timing, would rely on contractual arrangements with financial intermediaries to require the financial intermediary to impose any redemption fees on beneficial holders holding through that intermediary. The Commission understands that money market funds will want to review their contracts with financial intermediaries to determine whether any modifications would be necessary or advisable to ensure that any liquidity fees are appropriately applied. 34 Gates Once a fund has crossed below the 15% weekly liquid asset threshold, its board of directors (including a majority of its independent directors) would be able to temporarily suspend redemptions (thus gating the fund), if it determines that doing so would be in the best interest of the fund. 35 Any gate would be automatically lifted once the fund s weekly liquid assets had risen back to or above 30% (although the gate may be lifted earlier by the board of directors). 36 A fund that imposes a gate would be required to lift it within 30 days and could not impose a gate for more than 30 days in any 90-day period. 37 This time limit is designed to protect a fund in times of stress without unduly limiting the redeemability of its shares, a hallmark of open-end investment company shares under the Act See Id. at See proposed Rule 2a-7(c)(2)(i). See also related exemption from Rule 22c-1 under the Act discussed at of the Proposing Release. 33 See proposed Rule 2a-7(c)(2)(i)(B). 34 See the Proposing Release at See proposed Rule 2a-7(c)(2)(ii). See also related exemption from Section 22(e) of the Act discussed at of the Proposing Release. 36 Id. 37 Id. 38 See the Proposing Release at 188.

7 Page 7 Government Fund Exemption As described above, because government money market funds historically experience inflows, rather than outflows, in times of stress, government funds would be exempt from Proposal Two. However, a government money market fund would be permitted to voluntarily impose a fee or gate under the same regime provided that its prospectus affirmatively permitted it to do so. 39 Penny Rounding Under Proposal Two, money market funds would no longer be permitted to use the amortized cost convention to establish a stable NAV, but would continue to be able to use the penny rounding convention. Ability to Suspend Redemptions and Liquidate Preserved Under Proposal Two, all money market funds would continue to be able to rely on Rule 22e-3 under the Act to suspend redemptions and liquidate in times of fund and market distress. Under this rule as proposed to be revised, a money market fund would be permitted to suspend redemptions and liquidate if, among other requirements, the fund, at the end of a business day, has invested less than 15% of its total assets in weekly liquid assets or if the fund s pennyrounded share price were to deviate (or is determined by the board, including a majority of the independent directors, to be likely to deviate) from the stable price established by the board of directors. 40 New Required Disclosures If Proposal Two is adopted, the Commission would require money market funds (except funds relying on the government fund exemption) to include new disclosures in advertisements and sales materials and in their summary prospectuses (or in the summary section of the statutory prospectus if no summary prospectus is used). 41 This would be in addition to new prospectus disclosure about the operation of the liquidity fees and gates and new disclosure in the statement of additional information (SAI) about the historical occasions on which the fund s weekly liquid assets have fallen below 15% of its total assets, or on which the fund has imposed liquidity fees or gates. 42 Government funds relying on the exemption would also have to make some new disclosures, including that the fund s sponsor has no legal obligation to provide financial support to the fund. 43 Affiliated Purchases Preserved All money market funds, under either Proposal One or Proposal Two, including floating NAV funds, would continue to be permitted to rely on Rule 17a-9 to allow affiliated persons of the money market fund to purchase portfolio securities from the fund under certain circumstances. 39 See the Proposing Release at See proposed Rule 22e-3(a)(1). 41 See the Proposing Release at See Id. at See Id. at

8 Page 8 Combining the Floating NAV and Standby Liquidity Fee/Gate Proposals The Commission is also considering combining the floating NAV and liquidity fee/gate proposals into a single reform package. This combination, the Commission notes, would give a floating NAV money market fund a broader range of tools to manage redemptions in a time of crisis. 44 Under a combined approach, an institutional prime money market fund would be required to float its NAV, providing greater pricing transparency to the public, and would be permitted to impose liquidity fees and gates in the circumstances described above. Retail funds would continue to be exempt from the floating NAV requirement, and government funds would be exempt from both proposals. Other Proposed Amendments Enhanced Disclosure To enhance further the transparency of money market fund risks, the Proposed Amendments include new disclosure requirements that would give investors an opportunity to better evaluate the risks of investing in a particular fund and give the Commission and other regulators more information to better regulate the industry. Sponsor Support. The Proposed Amendments would require a money market fund to disclose historical instances of sponsor support in its SAI. 45 A money market fund also would be required to disclose on new Form N-CR (see discussion below) 46 present instances of sponsor support and, on the same day as the Form N-CR filing, to disclose the same information on its website. Such disclosure, the Commission believes, would help money market fund investors understand the nature and extent that a sponsor has supported the fund, and in turn the risks of investing in such fund. 47 Financial support would include: 48 i. any capital contribution; ii. iii. iv. purchase of a security from the fund in reliance on Rule 17a-9; purchase of any defaulted or devalued security at par; purchase of fund shares; v. execution of a letter of credit or letter of indemnity; vi. vii. viii. capital support agreement (whether or not the Fund ultimately received support); performance guarantee; or any other similar action to increase the value of the fund s portfolio or other support to the fund during times of stress See the Proposing Release at See Instruction 1 to proposed Item 16(g) of Form N-1A. 46 See proposed Rule 2a-7(h)(10)(v). 47 See the Proposing Release at See Instruction 1 to proposed Item 16(g) of Form N-1A. 49 It is unclear whether the Commission would interpret this broad definition of financial support to include the waiver or reimbursement of a money market fund s expenses by a fund sponsor, advisor, distributor or administrator in order for the fund to maintain a zero or positive investment yield during a persistent low-interest rate environment.

9 Page 9 Website Disclosure. Under the Proposed Amendments, a money market fund would be required to disclose prominently on its website, on a daily basis, the following information, in each case as of the end of the previous business day: 50 the percentage of daily and weekly liquid assets; the net inflows and outflows; and the current mark-to-market NAV per share (rounded to the fourth decimal place for funds with a $ share price or an equivalent level of accuracy). The Proposed Amendments would require that the fund maintain on its website six months of historical records of such information. 51 Amendments to Form N-MFP. Money market funds are currently required to file information about their portfolio holdings on Form N-MFP within five days after the end of each month. The Commission makes this information available with a 60-day delay. Money market funds are also required to disclose much of the portfolio holdings information that Form N-MFP requires on the fund s website each month no later than the fifth business day of each month. 52 Under the Proposed Amendments, Form N-MFP would be amended to make conforming changes related to Proposal One and Proposal Two discussed above and would require funds to report the following new items: 53 Identification of portfolio securities (CUSIP, Legal Entity Identifier ( LEI ) and at least one other security identifier relating to each portfolio security). Fair value categorization of portfolio securities (whether a security is categorized as a level 1, level 2 or level 3 measurement in the fair value hierarchy of U.S. Generally Accepted Accounting Principles). Additional portfolio security information (the total principal amount, the purchase date, the yield at purchase, the yield as of the Form N-MFP reporting date and the purchase price of each portfolio security). 54 Amount of cash holdings. Daily Liquid Assets (to be reported on a weekly basis). Weekly Liquid Assets (to be reported on a weekly basis). Weekly gross redemptions and subscriptions. Waivers and/or reimbursements of operating expenses or management fees. For the 20 largest shareholders of record of the fund, the total percentage of shares outstanding held. Maturity date of each portfolio security (using the maturity date used to calculate the dollar-weighted average life maturity ( WAL )). In addition, the Proposed Amendments would eliminate the 60-day delay on public availability of the information filed on Form N-MFP and would make such information immediately available to the public upon filing. 55 The 60-day delay was originally adopted in 2010 to address concerns regarding potential reactions of investors to the disclosure of 50 See proposed Rule 2a-7(h)(10). 51 Id. 52 See Rule 2a-7(c)(12)(ii). 53 See proposed Form N-MFP. 54 In addition, money market funds would be required to report this information separately for each lot purchased and for any security sold during the reporting period. 55 See proposed Rule 30b1-7 (eliminating subsection (b), public availability).

10 Page 10 funds portfolio information and shadow NAVs. 56 Although the Commission then believed that the shadow price data should not be made public immediately, the Commission now believes that the immediate release of the shadow price data would not be harmful. 57 The Proposed Amendments would also harmonize the specific portfolio holdings information that Rule 2a-7 currently requires funds to disclose on their websites with the corresponding portfolio holdings information proposed to be reported on Form N-MFP 58 as well as make further clarifying amendments to the form. New Form N-CR. The Proposed Amendments include new Form N-CR, which the Commission believes would enhance its oversight of money market funds and its ability to respond to market events. 59 Similar to Form 8-K under the Securities Exchange Act of 1934 (the Exchange Act ), a filing on Form N-CR would be required upon the occurrence of certain events, such as instances of portfolio security default, sponsor support of funds (see Sponsor Support above), a deviation of ¼ of 1 percent in the mark-to-market NAV of a fund permitted to transact at a stable price (e.g., to $ from $1.0000), reaching the threshold for board consideration of a liquidity fee or redemption gate, board lifting of a liquidity fee or redemption gate and other similar significant events. 60 Unless otherwise specified in the form, money market funds would be required to file a report on Form N-CR within one business day of the event that triggered the filing. 61 Confirmation Rule. Rule 10b-10 under the Exchange Act requires broker-dealers to immediately confirm customers securities transactions. 62 The Rule contains an exemption for transactions of money market funds that attempt to maintain a stable net asset value and where no sales load or redemption fee is charged. Under this exemption, brokerdealers are permitted to provide money market fund transaction information to shareholders on a monthly basis in lieu of individual, immediate confirmations. The Commission is seeking comment on whether Rule 10b-10 should be left unchanged if Proposal One is adopted, which would have the practical effect of requiring broker-dealers to provide investors in floating NAV money market funds with immediate confirmations of their transactions and may significantly impact broker-dealers confirmation systems and operations. Amendments to Form PF. To address the systemic risk that may result from investors seeking alternatives, such as private funds, to money market funds as a result of the Proposed Amendments, 63 large liquidity fund advisers 64 would be required to file on Form PF the same information with respect to their liquidity funds portfolio holdings as money market funds are required to file on Form N-MFP. 65 Tightening of Diversification Requirements In an effort to limit further money market fund risk exposure, the Proposed Amendments include measures to tighten the Rule s existing diversification requirements. 56 See the 2010 Adopting Release at note See the Proposing Release at See proposed Rule 2a-7(h)(10)(i)(B). 59 See the Proposing Release at See proposed Rule 30b1-8 and proposed Form N-CR. 61 See General Instruction A to proposed Form N-CR. 62 See Exchange Act Rule 10(b)-10b. 63 See the Proposing Release at Defined as registered advisers with $1 billion or more in combined money market fund and liquidity fund assets. 65 See proposed Question 63 in Section 3 of Form PF.

11 Page 11 Treatment of Affiliates. Under the Proposed Amendments, money market funds would be required to aggregate affiliates when applying the Rule s 5% issuer diversification limit. 66 An entity would be affiliated with another entity for this purpose if it controlled, is controlled by or is under common control with the other entity. Control for this purpose only would be defined as ownership of more than 50% of an entity s voting securities. 67 Elimination of 25% Basket For Demand Features and Guarantees. Under the current Rule, as much as 25% of a money market fund s portfolio may be subject to guarantees or demand features from a single institution. 68 To address the risks that money market funds faced during the financial crisis as a result of their exposure to providers of demand features and guarantees, 69 the Proposed Amendments eliminate this 25% basket from the Rule. The Commission does not anticipate that this amendment will have a significant impact on the industry as Form N-MFP data suggest that the majority of money market funds do not rely on the 25% basket in their day-to-day operations. 70 Asset-Backed Securities. To help address the substantial losses that money market funds suffered during the financial crisis due to investments in certain types of asset-backed securities ( ABS ), the Proposed Amendments would require that money market funds treat the sponsor of the special purpose entity ( SPE ) that issues the ABS as a guarantor of the ABS for the purposes of the Rule s diversification limitations relating to guarantors and demand feature providers. 71 Practically, this means that a fund could not invest in an ABS if, immediately after the investment, such fund would have invested more than 10% of its total assets in securities issued by, or subject to demand features or guarantees from (which would include all ABS securitizations sponsored by), the ABS sponsor. 72 The only exception would be where a fund s board of directors (or its delegate) determines that the fund is not relying on the ABS sponsor s financial strength or its ability or willingness to provide liquidity, credit or other support to determine the quality or liquidity of the ABS. 73 Stress Testing The Proposed Amendments include amendments to the Rule s stress testing requirements, with variations depending on whether Proposal One or Proposal Two (or both) is adopted. For example, if Proposal One is adopted, money market funds would be required to test the impact of certain market conditions on fund liquidity, instead of the fund s ability to maintain a stable price per share. 74 Specifically, each floating NAV money market fund would be required to test its ability to avoid having its weekly liquid assets fall below 15% of total fund assets. Money market funds exempt from the floating NAV requirement would be required to test both their ability to avoid having their weekly liquid assets fall below 15% of all fund assets and their ability to maintain a stable share price. 75 If Proposal Two is adopted, all money market funds would be required to test their ability to avoid having their weekly liquid assets fall below 15% of all fund assets, as well their ability to maintain a stable share price See proposed Rule 2a-7(d)(3)(ii)(F). 67 Id. 68 See Rule 2a-7(c)(4)(iii). 69See the Proposing Release at See the Proposing Release at See proposed Rule 2a-7(a)(16)(ii). 72 See the Proposing Release at See proposed Rule 2a-7(a)(16)(ii). 74 See proposed Rule 2a-7(g)(7)(i). 75 Id. 76 See proposed Rule 2a-7(g)(9)(i).

12 Page 12 The Commission is also proposing numerous other amendments and clarifications to the stress testing provisions of the Rule that would apply equally if Proposal One or Proposal Two is adopted. Clarifying Amendments The Proposed Amendments include the following clarifications to certain 2010 Amendments to the Rule. These clarifying amendments would apply if either Proposal One or Proposal Two, or both, is adopted: Definition of Daily Liquid Assets and Weekly Liquid Assets. Money market funds would not be able to use the maturity-shortening provisions in current paragraph (d) of the Rule regarding interest rate adjustments when determining whether a security satisfies the maturity requirements of a daily liquid asset or weekly liquid asset. 77 An agency discount note with a remaining maturity of 60 days or less would qualify as a weekly liquid asset only if the note is issued without an obligation to pay additional interest on the principal amount. 78 The definitions of daily and weekly liquid assets would be amended to include amounts receivable that are due unconditionally within one or five business days, respectively, on pending sales of portfolio securities. 79 Definition of Demand Feature. The definition of demand feature under the Rule would be amended to mean a feature permitting the holder of a security to sell the security at an exercise price equal to the approximate amortized cost of the security plus accrued interest, if any, at the time of exercise paid within 397 calendar days of exercise. 80 This amendment would effectively eliminate the requirement that a demand feature be exercisable at any time on no more than 30 calendar days notice. Short-Term Floating Rate Securities. Under the Proposed Amendments, for the purposes of determining WAL, a shortterm floating rate security would be deemed to have a maturity equal to the period remaining until the principal amount can be recovered through demand. 81 Second Tier Securities. The 45-day remaining maturity limit applicable to second tier securities would be determined without reference to the maturity-shortening provisions in the Rule for interest rate adjustments. 82 Comment Period Public comments on the proposed rule amendments must be received by the SEC on or before 90 days after publication in the Federal Register. 77 See proposed Rule 2a-7(a)(8) and proposed Rule 2a-7(a)(31). 78 See proposed Rule 2a-7(a)(31)(iii). 79 See proposed Rule 2a-7(a)(8)(iv) and proposed Rule 2a-7(a)(31)(v). 80 See proposed Rule 2a-7(a)(9). 81 See proposed Rule 2a-7(i)(4). 82 See proposed Rule 2a-7(d)(2)(ii).

13 Page 13 Proposed Compliance Periods Proposal One would have a compliance period of two years to allow money market funds, intermediaries and other service providers to make system modifications necessary to implement a floating NAV. Proposal Two would have a compliance period of one year to allow money market funds and their sponsors to make the necessary operational changes to implement the liquidity fees and gates. All other Proposed Amendments not specifically related to either Proposal One or Proposal Two would have a compliance period of nine months. * * * If you have any questions regarding this update, please contact the Sidley lawyer with whom you usually work. The Investment Funds Practice of Sidley Austin LLP Sidley has a premier, global practice in structuring and advising investment funds and advisers. We advise clients in the formation and operation of all types of alternative investment vehicles, including hedge funds, fund-of-funds, commodity pools, venture capital and private equity funds, private real estate funds and other public and private pooled investment vehicles. We also represent clients with respect to more traditional investment funds, such as closed-end and open-end registered investment companies (i.e., mutual funds) and exchange-traded funds (ETFs). Our advice covers the broad scope of legal and compliance issues that are faced by funds and their boards, as well as investment advisers to funds and other investment products and accounts, under the laws and regulations of the various jurisdictions in which they may operate. In particular, we advise our clients regarding complex federal and state laws and regulations governing securities, commodities, funds and advisers, including the Dodd-Frank Act, the Investment Company Act of 1940, the Investment Advisers Act of 1940, the Securities Act of 1933, the Securities Exchange Act of 1934, the Commodity Exchange Act, the USA PATRIOT Act and comparable laws in non-u.s. jurisdictions. Our practice group consists of approximately 120 lawyers in New York, Chicago, London, Hong Kong, Singapore, Shanghai, Tokyo, Los Angeles and San Francisco. To receive future copies of this and other Sidley updates via , please sign up at BEIJING BOSTON BRUSSELS CHICAGO DALLAS FRANKFURT GENEVA HONG KONG HOUSTON LONDON LOS ANGELES NEW YORK PALO ALTO SAN FRANCISCO SHANGHAI SINGAPORE SYDNEY TOKYO WASHINGTON, D.C. Sidley Austin refers to Sidley Austin LLP and affiliated partnerships as explained at