A former top Securities and Exchange Commission official predicted yesterday that the agency will soon call on tax-exempt money market funds to better diversify their portfolios and to improve disclosure to shareholders and investors.

"I don't have a crystal ball or a final say in this anymore," said Kathryn McGrath, former chief of investment management at the SEC. "But I think we all have to be prepared to see some major changes coming in terms of the regulatory front that may make it tougher for money funds to operate," said Ms. McGrath, speaking at an industry conference on municipal money funds in New York.

Ms. McGrath, who joined the Washington law firm of Morgan, Lewis & Bockius in the summer of 1990, was offering her views on the agency's upcoming revisions to Rule 2a-7, which governs the quality and diversity of securities held by money market funds.

The SEC earlier this year issued new standards for both taxable and tax-exempt funds, but most of the rigorous new requirements governing the type and variety of securities that funds can hold do not apply to tax-exempts.

"They punted," because at the time they did not know enough about issues on the tax-exempt side, Ms. McGrath said. But the SEC's investment management staff is learning rapidly and will probably propose a rule this winter or spring, she said. The agency asked industry groups like the Investment Company Institute for feedback on what requirements, if any, would be appropriate for tax exempts.

In March, the ICI recommended that most of the SEC's new quality and diversification standards be adopted for tax-exempt funds as long as the limit on a fund's holdings in "split securities" be relaxed for the sector. Split securities are short-term debt rated differently by various rating agencies. The ICI also urged less rigid diversification requirements for funds that invest in the securities of single states.

"The most likely changes are in the diversification area," Ms. McGrath said. She pointed to a possible tightening of standards that now permit funds to concentrate up to 25% of their investments in the securities of a single issuer. That probably will be reduced, except in the case of single-state funds, she said.

"The SEC may require portfolio managers of tax-free money funds to invest a certain percentage of fund assets only in first-tier securities," she says in a written outline submitted at the conference, referring to short-term paper given the highest ratings. "At present, a tax-free money fund can invest in any combination of issues with the two highest ratings or in unrated paper considered to be of comparable quality as determined by a fund's board."

While the ICI did not focus on insured deals, she said the SEC is going to be looking "very closely" at credit enhancement issue.

"The pattern in the past more often than not is that the SEC will react favorably -- or at least address -- the concerns of this type that have been raised by the investment company industry, and I think that's likely to be done here too."

She noted that some of the major mutual fund groups advised the SEC to apply the strict 2a-7 standards across the board. Of course, those "big operators" probably have the capital to meet the toughest standards and, she noted candidly, would have a "competitive advantage" as a result of smaller firms exiting the market.

"The SEC may also try to [require] more disclosure" by funds, she said, such as warning labels to alert investors to the fact that tax-exempt money funds are not subject to quite the same rules as taxables.

"They also may do more in terms of current reporting to shareholders of unusual events," such as problems experienced by Mutual Benefit Life Insurance Co., which backed a number of bonds that were popular with funds.

Mutual Benefit was seized by New Jersey insurance regulators earlier this year, following a run on the insurer's assets. Variable-rate bonds that were insured by the company became immediately illiquid.

Ms. McGrath said an SEC decision to further regulate tax-exempt funds is a tough one because smaller funds may not have the money to hire the staff needed to better analyze the credit quality of the securities they buy.

"What the rule technically requires managers to do can be very expensive and difficult, particularly in the case of smaller funds with smaller staffs," she said. "They may not have the buying power to get the best quality issues or the man or woman power to be able to carefully analyze the credit quality of what they are buying."

But Ms. McGrath said it is a decision funds will have to make soon, particularly since the SEC is beefing up inspections and enforcement in the money market arena.

"My perspective is that there is a lack of compliance out there that is going to be detected, and fund managers, particularly smaller ones, unfortunately have to make a business decision whether they want to pay to staff up and stay in this market or they are going to have to leave it."

She said it is her understanding that there are some enforcement cases concerning 2a-7 "in the pipeline" at the SEC.

The big question, she said, is whether funds should be allowed to call themselves tax-exempt money market funds if they cannot operate according to rules the SEC decides are minimally necessary to protect investors. There is no prohibition against brining out a fund that calls itself a short-term municipal bond fund, she said.

"It can call itself the next best thing to a money market," she said. "The [question] is whether everyone has a constitutional right to operate and sell to the public a tax-exempt money market fund if they can't meet these rules."

"If the issuers and underwriters of securities pull up their socks and respond by creating the types of issues and providing the kinds of instruments that funds need, things will work out pretty well."

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