June 24 (Bloomberg) -- The U.S. Securities and Exchange Commission proposed rules aimed at preventing losses for money- market fund investors after last year’s collapse of the Reserve Primary Fund triggered a run on the $3.8 trillion industry.

The agency’s commissioners voted 5-0 today to seek public comment on a plan to require that funds hold more liquid assets and cut the average maturity of securities in their portfolios. The proposals resemble recommendations made in March by the Investment Company Institute, a Washington-based industry group.

“The commission is considering proposals that would strengthen money-market fund regulation,” SEC Chairman Mary Schapiro said at a meeting in Washington. “Because these funds are securities products, they are not immune from” losses.

The SEC has been considering rules for money-market funds since the $62.5 billion Reserve Primary was forced to liquidate amid losses on debt issued by Lehman Brothers Holdings Inc., the investment bank that failed in September. The agency is trying to reduce the chances of funds’ values falling below $1 a share and make them a more stable source of financing for U.S. firms.

Money-market funds, used by individuals and institutions as an alternative to bank accounts, let investors deposit and withdraw cash on short notice. They are among the biggest buyers of commercial paper issued by banks and other companies and can typically hold only fixed-income securities within 397 days of maturity.

Asset Sales

The SEC proposal would require funds whose institutional investors include companies and public pension funds to make sure at least 10 percent of their assets could be sold in one day and a minimum of 30 percent could be divested within a week.

Cash would have to make up 5 percent of assets for funds with individual investors and 15 percent of the portfolio would have to be in holdings that could be sold within a week.

The SEC proposed that the maximum weighted-average maturity of all holdings for money-market funds drop to 60 days from 90. Money funds would also be prohibited from investing in securities that don’t receive top rankings from ratings companies. Currently, the SEC permits 5 percent of a fund’s assets to be lower-rated securities.

To prevent losses during runs, the SEC proposal would authorize a fund’s board of directors to bar investors from selling their shares when the net-asset value falls below $1.

SEC staff will seek public comments on the proposals for 60 days before determining whether to make any changes. Any rules must be approved in a second vote by commissioners to become binding.

Net-Asset Value

Money funds aren’t required to value their holdings at current market prices, except to reflect a permanent markdown. That lets them maintain a constant net-asset value, or NAV, and sell and redeem shares at $1 apiece. Funds drop below $1 a share when permanent losses exceed 0.5 percent of net assets, forcing the NAV to be rounded down to 99 cents.

President Barack Obama’s administration, in a plan for overhauling financial regulation released June 17, called on government agencies including the SEC, the Treasury Department and the Federal Reserve to review whether money funds should adopt a floating NAV. The Obama proposal also requested study of ways money funds could obtain access to “emergency” funding from “private sources.”

Sign of Trouble

Andrew Donohue, director of the SEC unit that oversees money managers, said in an April speech that the stable $1 share prices encourages investors to flee money funds at the first sign of trouble.

If a fund suffers even a small loss, withdrawals by large institutional investors can force a fund to fall below $1 a share. The fastest-moving shareholders can escape with all their money while slower ones get stuck with losses, Donohue said.

The SEC plans to ask investors and fund companies about a floating net-asset value, which was not among the rule proposals commissioners voted on today. Some asset managers, including Legg Mason Inc. Chief Executive Officer Mark Fetting, fear such a change would reduce the attractiveness of money funds.

Fetting, in a May 8 interview, pledged to “fight it very hard.”

Robert Plaze, an associate director in the SEC’s investment management division, said the agency is proceeding cautiously in considering a floating share price because of the potential consequences for an industry that manages “about $4 trillion.”

“A lot of companies rely on money-market funds to fund their short-term financing needs,” Plaze said. “We don’t want to make a precipitous move without fully understanding what the implications are.”

‘Discredited’

SEC Commissioner Kathleen Casey criticized an aspect of the agency’s plan that she said would increase funds’ reliance on “discredited” credit-ratings companies.

Moody’s Investors Service, Standard & Poor’s and Fitch Ratings have drawn fire from investors and lawmakers who claim they contributed to the financial crisis by assigning mortgage bonds their highest AAA rankings and maintaining those assessments months after loans began defaulting in 2007.

Under the SEC proposal issued today, the agency will seek public comment on whether money-market fund boards of directors should have to designate companies whose ratings they rely on in determining whether funds can hold certain securities.

“If the commission were to adopt this approach, we would be going absolutely in the wrong direction,” said Casey, a Republican. She noted that Obama’s regulatory plan urges agencies to reduce use of ratings “wherever possible.”

The SEC will solicit comments on whether it should strip references to ratings in its money-market rules. The agency never acted on a similar proposal made last year.

Debt Securities

The SEC said it will also ask whether it should revise rules that allow money-market funds to purchase debt securities backed by mortgages and other loans.

Such investments have drawn scrutiny after Baltimore-based Legg Mason and other companies spent billions of dollars propping up money-market funds that purchased debt issued by so- called structured investment vehicles.

“Certain types of asset-backed paper haven’t performed well, but that’s a tiny fraction of that sector,” said Deborah Cunningham, head of taxable money-market funds at Federated Investors Inc. “They will get a ton of comment that says, ‘No, why even consider that?’”

To contact the reporter on this story: Jesse Westbrook in Washington at jwestbrook1@bloomberg.net.

Last Updated: June 24, 2009 16:28 EDT