Money-market mutual funds would be forced to create capitalbuffers equaling 1 percent to 3 percent of assets to protectagainst losses under a plan now favored by the U.S. Securities andExchange Commission, according to three people briefed on theregulator's deliberations.

Top SEC officials, seeking to make money funds safer, prefer theplan over another capital buffer idea crafted by FidelityInvestments and calls to eliminate the funds' stable share price,said the people, who asked not to be identified because theyweren't authorized to speak publicly. The concept is based onrecommendations submitted to the agency in January by universityeconomists known as the Squam Lake Group.

“Some variant of the Squam Lake proposal would be a significantimprovement that would reduce the risk that money market funds posesystemic problems in the future,” Eric Rosengren, president of theFederal Reserve Bank of Boston and a frequent critic of the riskposed by money funds, said yesterday in an e-mailed statement.

Regulators and fund executives have wrestled for almost threeyears over how to prevent a recurrence of the run on money marketfunds that followed the September 2008 collapse of the $62.5billion Reserve Primary Fund. The industry has fought a proposal tostrip funds of their stable share price, saying it would kill theproduct that manages $2.64 trillion for companies and households,and represents the largest collective purchaser of short-termcorporate debt in the U.S.

Squam Lake Proposal
The SEC's staffremains undecided on several details of the plan, including exactlyhow big the buffer should be, two of the people said. If the planis endorsed by agency staff, SEC commissioners will have to approveit and may still consider rival proposals, the people said.

Florence Harmon, a spokeswoman for the SEC, declined tocomment.

The so-called Squam Lake proposal would require funds toestablish a segregated account holding cash or liquid assets suchas U.S. Treasuries. The money would be used to bail out a fund ifit suffered investment losses.

Any fund failing to maintain the required buffer would be forcedto announce that failure and convert to a floating share pricewithin 60 days, according to the proposal.

Under the plan, funds would sell bonds, or subordinated shares,to raise money for the buffer from a separate group of investors.Those investors would lose money if the buffer were tapped to coverinvestment losses.

'Significant' Premium
The fund would paybond investors interest, reducing the return to fund shareholders.Shareholders would benefit from the insurance provided by thebuffer.

A key question is how much bond investors would demand in returnfor taking on the fund's investment risk.

“We don't think it would be difficult to attract investors orthat the premium would be very significant,” René M. Stulz, aneconomist at Ohio State University's Fisher College of Business anda Squam Lake Group member, said yesterday in a telephone interview.“We're really talking about an extremely low probability risk.”

The SEC could release a proposed rule and ask for public commentas early as October, two of the people familiar with the processsaid.

Gus Sauter, chief investment officer at Valley Forge,Pennsylvania-based Vanguard Group Inc., said he would need to studythe Squam Lake plan in greater detail before saying whether hisfirm would support it.

Fidelity Plan
“We certainly haven't gottento the point where we're satisfied enough to say any particularplan is the right way to go,” Sauter said in a telephone interviewyesterday.

Under the idea floated by Boston-based Fidelity in May andbacked by Wells Fargo & Co. and Charles Schwab Corp., fundswould build buffers gradually over a number of years by withholdingreturns. The money, which wouldn't be segregated from the fund,would be capped at 0.5 percent of assets to prevent the fund pricefrom rising above a stable $1 share price.

“We are reviewing the details of the Squam Lake proposal and areexploring several questions related to it, as well as severalvariants of the concept,” Adam Banker, a Fidelity spokesman, saidyesterday in an e-mailed statement.

Banker said the firm looked forward to “continued dialogue” withregulators and others in the industry.

Sauter said the Squam Lake plan had advantages and disadvantagescompared with the Fidelity proposal. “Certainly it's moreexpensive, and so would create some drag on performance,” hesaid.

Floating Share Price
A government panel,charged with gauging systemic risks under last year's Dodd-Frankfinancial overhaul law, directed the SEC on July 26 to focus onthree potential regulatory reforms for money funds. In its annualreport, the Financial Stability Oversight Council, known as FSOCand headed by Federal Reserve Chairman Ben S. Bernanke, singled outproposals for a floating share price, capital buffers and stepsthat would deter fund investors from redeeming shares.

FSOC's members also include SEC Chairman Mary Schapiro andTreasury Secretary Timothy Geithner.

The Investment Company Institute's money-fund working group hasscheduled a meeting with regulators for the second week in August,two of the people said.

“The ICI remains open to ideas to strengthen money market fundsfurther, including ways to enhance liquidity and minimize the risksof a fund breaking a dollar,” Ianthe Zabel, a spokeswoman for theWashington-based trade group, said yesterday in an e-mailedstatement.

'Enhance Liquidity'
ICI members haverepeatedly warned that customers, especially institutionalinvestors, would abandon money funds if they lost their stableshare price.

Funds maintain a steady $1 share price by recording holdings attheir expected value at maturity and by rounding to the nearest 1cent. That means the fund can ignore small fluctuations in themarket price of holdings and suffer a loss of less than half a centwithout breaking the buck.

Groups including the FSOC and the Squam Lake economists havesaid the stable share price also can induce investor runs. Smalllosses grow as a proportion of a fund's assets as investorswithdraw, giving shareholders an incentive to redeem shares beforeothers, they say. Advocates for a floating share price includeformer Fed Chairman Paul Volcker and Sheila Bair, former chairmanof the Federal Deposit Insurance Corp.

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