A year ago, when opposition from the asset-management industrykilled her plan to make money-market mutual funds safer, U.S.Securities and Exchange Commission (SEC) Chairman Mary Schapirolooked to Timothy Geithner, then the Treasury Secretary, to tackle“one of the pieces of unfinished business from the financialcrisis.”

It remains unfinished.

As Schapiro and Geithner prepared to leave government toward theend of 2012, the effort started anew to make the $2.6 trillionmoney-fund industry less likely to disrupt global financialmarkets. Norm Champ, a Harvard University-trained lawyer and theSEC's top regulator of mutual funds, canvassed the remaining fourcommissioners, seeking to find common ground on which new rulescould be built after Schapiro failed to corral enough votes to pushher plan forward.

“We had hit a stalemate,” Commissioner Elisse B. Walter said inan interview. “We started with a blank sheet of paper to figure outwhere we could all agree, using the knowledge we'd acquired overthe prior two years.”

Champ and Walter succeeded in putting together a compromiseacceptable to the other commissioners, no small feat given thedivisiveness of the issue. In doing so, they scaled back Schapiro'scontroversial proposals to require all money funds to float their share prices or set aside capital to absorblosses.

Even so, companies including Fidelity Investments and FederatedInvestors Inc. oppose the more moderate proposal, saying it willdamage the appeal of money funds and add significant costs. What'smore, there's no consensus that the SEC's rules, unveiled in Junefor public comment, would prevent the kind of investor run that in2008 woke up regulators to the threat money funds pose to thefinancial system.

“Nothing has fundamentally changed to address the structuralweaknesses of money funds,” said Sheila Bair, former chairman ofthe Federal Deposit Insurance Corp. who now leads the Systemic RiskCouncil, a nonpartisan group whose members include former FederalReserve Chairman Paul Volcker and former Treasury Secretary PaulO'Neill.

Yesterday, the European Union proposed money-fund regulationthat in some ways is tougher than the SEC plan.

Vulnerability Exposed

The SEC began working with the Fed and Treasury Department onways to buttress money funds shortly after the $62.5 billionReserve Primary Fund was brought down in 2008 by a loss on LehmanBrothers Holdings Inc. debt.

The fund's decision to re-price its shares below $1, known as“breaking the buck,” set off a panic among investors, who hadassumed their principal would never be lost. They pulled $310billion from money funds in a single week, almost exclusively fromthose that were big buyers of corporate debt, according to the SEC.That almost froze the $1.76 trillion market for commercial paper, ashort-term IOU used by companies to pay everything from bills tosalaries.

To halt the run, the Treasury Department guaranteed allmoney-fund shareholders against losses from default, putting thegovernment on the hook for about $1.6 trillion in corporate andmunicipal debt, according to an estimate by research firm CraneData LLC in Westborough, Massachusetts.

The crisis showed that money funds were vulnerable to runs thatcould damage broader credit markets. Fifteen months later, the SECimposed new rules, with the industry's support. The rules improvedportfolio liquidity, required higher-rated assets, shortened theaverage maturity of fund holdings, and forced more disclosure offund holdings.

“They were way less controversial and we could get them donereasonably quickly,” Schapiro said in an interview. “We werebolstering the resiliency of money-market funds, but we were notsolving for the underlying structural problem. That was going totake more time.”

Schapiro unveiled her second set of reforms—which would havestripped funds of their fixed share price or required capitalbuffers against losses—in November 2011. Several commissioners,whose votes she needed to approve new rules, publicly expresseddoubts from the start.

Industry lobbyists met with SEC commissioners and began pressingtheir arguments—that regulators needed to study the impact of the2010 reforms, and that Schapiro's ideas would impose bank-styleregulation on an investment product.

The 10 biggest money-fund providers and the Investment CompanyInstitute, the industry's trade group, reported combined lobbyingspending of about $63 million from the beginning of 2011 throughthe first quarter of 2013 in disclosures that referencemoney-market mutual funds, according to a review of documents byBloomberg News. They found the most receptive audience withcommissioners Daniel M. Gallagher and Troy A. Paredes, two Republicans, andLuis A. Aguilar, a Democrat.

The industry considered Aguilar, a former general counsel atmoney-management firm Invesco Ltd., as a possible swing vote toblock Schapiro's proposal, according to a lobbyist who asked not tobe named because the meetings were private. Both Aguilar andGallagher complained that Schapiro's team wouldn't consider theirinput on the plan, including Aguilar's call for a study of theimpact of the 2010 rule changes. Gallagher accused Schapiro ofceding too much control to the Federal Reserve and Treasury.

Schapiro's effort collapsed in late August 2012 when Aguilar,Gallagher, and Paredes told her they would vote against it, a raremove to block a proposal from being issued. Aguilar said thestaff's proposal was too narrow and should analyze “the cashmanagement industry as a whole and the effects of the 2010amendments.”

Investor Stampede

Money-market mutual funds first appeared in 1971 as ahigher-earning substitute for bank deposits, whose interest rateswere capped by the Federal Reserve. Thousands of households andbusinesses use them as a safe place to park cash, though unlikebank accounts they're not federally insured.

For investors, the appeal of money funds stems from their stablepricing of $1 a share, implying that the value of the principalwon't decline.

Only two money funds have ever dropped below $1. The $35 millionCommunity Bankers U.S. Government Mutual Fund was too small tocause wider fallout when it blew up in 1994. The Reserve PrimaryFund proved to be a bigger deal in September 2008.

Unsure of the safety of other funds and the stability of otherlarge banks, companies and large institutions across the worldresponded to Reserve Primary's troubles by stampeding out of scoresof money funds, known as prime funds, that held commercial paper.One large sovereign wealth fund pulled more than $10 billion fromBlackRock Inc. in a single withdrawal, according to an employee ofthe money manager who asked not to be named because the informationwasn't public.

Money-market funds are the largest collective buyer of U.S.commercial paper, and their sudden withdrawal caused the market toseize up. Companies with outstanding paper faced possibleinsolvency because they couldn't roll maturing debt into newissues.

After the crisis, Schapiro aimed to prevent another seizure inthe commercial paper market more than she sought to protectinvestors in any one money fund. That mission gained urgency afterCongress stripped the Treasury and Fed of their abilities to bailout money funds.

“This core part of our financial system is now operating withouta net,” Schapiro told the Senate Banking Committee on June 21,2012.

When Schapiro left the SEC in mid-December, after four years ofsteering the agency's response to the financial crisis, the seedsof a new effort were already planted.

Aguilar, Gallagher, and Paredes had taken heat from formerregulators such as Arthur Levitt, who led the SEC during the 1990sand labeled the failure to propose new rules for money funds a“national disgrace.”

Geithner had called on the Financial Stability Oversight Council(FSOC), a creature of the 2010 Dodd-Frank law, to recommend newmoney-fund rules. The FSOC was created by Congress to fillregulatory gaps and monitor the kinds of threats that contributedto the financial crisis. In late November, the FSOC issued aproposal consistent with the ideas favored by Schapiro and herstaff.

Preemptive Action

With the FSOC looking over their shoulder, SEC commissionerswere united in wanting to show the agency could get the job done,Walter said.

“The interest of FSOC changes the dynamic, brings in anotherforce,” Walter said. “Everyone at the SEC agreed, no matter whattheir view was on the merits, that it was preferable that action onthis issue should be taken by us.”

Aguilar, Gallagher, and Paredes also had gotten something theywanted: in late November, the SEC issued a study on the 2008 runand the role of current rules. The report made it clear thatinvestors ran from prime funds and parked cash in funds that boughtU.S. government debt, whose assets grew by $409 billion betweenearly September and early October 2008, according to SEC data. Italso showed that retail investors hadn't contributed much to therun.

After the study was issued on Nov. 30, Aguilar said he wouldconsider additional regulation.

Some fund companies were already pushing the commission toexempt retail funds from new rules, laying the groundwork for acompromise. On Nov. 22, Charles Schwab Corp. Chief ExecutiveOfficer Walter Bettinger wrote in the Wall Street Journal thatimposing a floating share price on prime funds used by institutions“is the right thing to do to bring the debate to closure.” Retailfunds should be allowed to keep the fixed $1 share price, hewrote.

Bettinger's article, along with the SEC staff study, became animportant factor because it signaled a compromise acceptable to keypeople in the industry, according to a person familiar with theSEC's deliberations, who asked who asked not to be named becausenegotiations over the rule were private. A retail exemption wasalso favored by some commissioners, including Walter.

When Walter stepped into the chairman's job in December, shebegan by holding individual meetings with each commissioner, a typeof walk-the-halls diplomacy that Schapiro rarely practiced.Gallagher and Paredes gave her a list of must-do issues, whichincluded a new proposal for money funds, according to two peoplefamiliar with the matter.

From the start, Walter expected she would have to find a way tobridge diverging views on the commission. Gallagher and Paredeswere united against the idea for a capital buffer, though they wereopen to changing the fixed-share price.

The Republican commissioners also liked an idea favored by theInvestment Company Institute. ICI wanted to give money funds theability to put down “gates,” or suspend withdrawals, when a fundwas under stress, and to impose fees on redemptions, which wouldhelp rebuild a fund's liquidity.

Walter also worked with a new director of investment management,the SEC division developing the rule. Champ, who joined the SEC inJanuary 2010 from hedge-fund manager Chilton Investment Co., wasless enamored of capital buffer, according to two people familiarwith the matter who asked not to be named.

New Dynamic

Champ worked side-by-side with Craig Lewis, the SEC's chiefeconomist, whose division had produced the study showing howinvestors fled prime funds and rushed into those that held U.S.Treasury debt.

By late December, Champ had produced a two-page summary thatdidn't include a capital buffer or other costlier reformschampioned by the Federal Reserve and systemic-risk regulators.

“Norm Champ brought an openness and willingness to engage indialogue that was missing,” Aguilar said in an interview. “He wasinstrumental in turning the tide toward a constructiveprocess.”

Champ and his staff were looking for a way to carve out retailmoney funds, but there wasn't an existing rule that distinguishedthem from institutional products. Investment companies themselveshad different categorization methods.

The breakthrough came when the United Services AutomobileAssociation, an investment adviser that caters to military membersand veterans, proposed identifying retail funds as ones that limita shareholder's redemptions to $250,000 a day. Funds that set thelimit would be able to keep the stable $1 share price. The SECembraced the concept and adjusted the threshold to $1 million aday.

“That was sort of a eureka moment, like 'here is a really goodidea,'” Walter said.

Walter was replaced in April by Mary Jo White, who was favoredby the White House to reestablish the regulator's reputation as atough sheriff of Wall Street. By then, the proposal's mainingredients were already decided.

White didn't ask for substantive changes, according to twopeople familiar with the matter.

In an interview, Schapiro questioned the decision to exemptfunds that invest in government debt. Schapiro now works forPromontory Financial Group LLC, which has done work for BloombergLP, the parent company of Bloomberg News.

“There is no investment product that is risk-free,” Schapirosaid. “While the run was on a prime fund, my preferred approachwould be to fix the structural weaknesses of a stable share pricefor all money-market funds.”

Other critics say the proposal is weak because it didn't includethe capital buffer, which had been advocated by Robert E. Plaze,the SEC's longtime expert on money funds, and some at the FederalReserve. Plaze retired from the agency in August.

Forcing money funds to hold capital against losses wasn'tpopular with some securities regulators, who thought it wouldimpose costly, bank-like rules on an investment product.

Walter shared that concern, although she didn't say so publicly,as the commission struggled with the rule in early 2012. Her doubtswere supported by SEC economists, whose work showed that many primefunds couldn't raise capital without reducing the returns theypromise to investors or reducing their holdings of commercialdebt.

“The capital buffer was very different because it was adding afeature that doesn't exist in this space,” she said. “Frankly, Ihad always worried, and then when I heard from the economists, Iwas more worried that capital buffers would really be too expensiveto work.”

EU Plan

In Europe, Michael Barnier, the EU's financial services chief,proposed yesterday that money-market funds there that maintain afixed share price be required to build a cash buffer equivalent to3 percent of assets. Existing funds would have three years to meetthe requirement. German Finance Minister Wolfgang Schaeuble and hisFrench counterpart, Pierre Moscovici, had called for stable-NAVfunds to be banned in the EU.

Federal Reserve Chairman Ben S. Bernanke said in June that, byincluding a floating share price in its proposal, the SEC was“moving in the right direction, and I'm hopeful that what comes outwill be something that's sufficient to meet the very important needof stabilizing the money-market funds.”

The Treasury Department, whose secretary chairs FSOC, sharesthat view, according to a person familiar with the matter who askednot to be named. Treasury officials believe the SEC's plan islargely consistent with FSOC's recommendations issued in November,the person said.

Industry Resistance

“The Fed and Treasury will declare victory if there is either afloating NAV or a redemption limit,” Jaret Seiberg, senior policyanalyst at Guggenheim Securities LLC's Washington Research Group,said in a phone interview. “If the SEC can't get this across thefinish line, FSOC will wade back in.”

The Investment Company Institute and many fund companies stilloppose a floating-share price for institutional prime funds.Boston-based Fidelity Investments wants the SEC, at a minimum, toexempt funds that buy municipal debt from the proposal, said NancyPrior, head of money funds at Fidelity.

Plaze, who became a law partner at Stroock & Stroock &Lavan LLP, has criticized the agency's decision to include ICI'sproposal for redemption gates. In an interview, Plaze saidinvestors might flee a struggling fund if they thought it waspreparing to suspend withdrawals.

“The way the SEC structured the gates would be destabilizing,”Plaze said in an interview. Plaze also said the floating-shareprice should be imposed on retail funds as well.

Looking back, Plaze said, the agency might have achieved astronger rule had it moved forward with fuller reforms in 2010. Thecrisis was fresher in the minds of investors, regulators andtaxpayers at that time.

“Every time there is a crisis, there is an immediate effort withmissionary zeal to fix it,” Plaze said. “The problem, of course, iswe didn't know what to do. We just didn't.”

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