Alert August 07, 2014

Money Market Fund Reform – A Summary of Significant Changes

Summary

The SEC recently adopted amendments to the rules governing MMFs. Most particularly, the amendments (i) require institutional prime and institutional tax-exempt MMFs to use a floating net asset value as opposed to allowing such MMFs to maintain a stable share price through use of the amortized cost method of valuation and/or the penny rounding method of pricing, (ii) introduce mechanisms for MMF boards of directors to impose liquidity fees and/or temporarily suspend redemptions, and (iii) require further diversification of MMF portfolios, amend existing MMF stress testing requirements, and require additional reporting and disclosures from MMFs. The SEC also approved the issuance for public comment proposals to further amend the MMF and related regulatory regimes.

The July 29, 2014 Financial Services Alert included a brief overview of the SEC’s recent adoption of amendments to the rules governing money market funds (“MMFs”). The following is a further summary of the final and proposed rule amendments:

At a meeting held on July 23, 2014, the SEC voted 3-2 to adopt amendments (the “Amendments”) to various regulatory requirements affecting MMFs, with Commissioners Piwowar and Stein dissenting. The Amendments, which are set forth in SEC Release No. IC‑31166 (the “Release”), focus primarily on Rule 2a-7 under the Investment Company Act of 1940, as amended (the “1940 Act”), the principal rule that governs MMFs.

As summarized in the June 11, 2013 Financial Services Alert, the SEC initially proposed certain amendments to the regulation of MMFs on June 5, 2013 (the “Proposals”). The Amendments make a number of significant changes to the MMF regulatory framework, certain of which reflect differences from the Proposals. Most particularly, the Amendments (i) require institutional prime and institutional tax-exempt MMFs to use a floating net asset value (“NAV”) as opposed to allowing such MMFs to maintain a stable share price through use of the amortized cost method of valuation and/or the penny rounding method of pricing, (ii) introduce mechanisms for MMF boards of directors to impose liquidity fees and/or temporarily suspend redemptions, and (iii) require further diversification of MMF portfolios, amend existing MMF stress testing requirements, and require additional reporting and disclosures from MMFs. In addition, in conjunction with adopting the Amendments, the SEC approved the issuance for public comment proposals to further amend the MMF and related regulatory regimes (the “Companion Proposals”).

THE AMENDMENTS

Floating NAV

Under the Amendments, institutional prime MMFs and institutional tax-exempt MMFs (together, “FNAV MMFs”) may no longer use the amortized cost method of valuation and/or penny rounding method of pricing to maintain a stable NAV. Instead, FNAV MMFs are required to calculate their NAVs based on the current market-based value of their portfolio securities. FNAV MMFs are also required to use “basis point” rounding to calculate their share value to the nearest 1/100th of 1%, which means, in the context of a FNAV MMF seeking to transact at $1.00, that share prices would be rounded to four decimal places (i.e., $1.0000). “Basis point” rounding results in a level of precision that is 100 times more sensitive than is currently in effect for a MMF and 10 times more sensitive than for a non-money market mutual fund.

Despite the elimination of amortized cost and penny rounding for FNAV MMFs, such MMFs may value their portfolio holdings at amortized cost to the same extent that other non-money market mutual funds are permitted to do so (i.e., where 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. Please see “Valuation Guidance” below for additional information). In addition, the Release indicates that it is the SEC’s position that, under normal circumstances, a FNAV MMF would meet the definition of a “cash equivalent” for purposes of U.S. GAAP.

Government and Retail MMFs. “Retail” MMFs and “government” MMFs are exempt from the floating NAV requirement.

  • A “government” MMF is a MMF that invests at least 99.5% of its total assets in cash, government securities, and/or repurchase agreements collateralized by cash or government securities. This definition represents a significant change from the definition of government MMF that was included in the Proposals, under which a government MMF would have been permitted to invest up to 20% of its assets in non-government assets.
  • A “retail” MMF is a MMF that adopts and implements policies and procedures reasonably designed to limit beneficial owners to natural persons. The Release indicates that “beneficial ownership” typically means having voting and/or investment power. The definition of retail MMF represents a significant change from the definition that was included in the Proposals, which would have defined a retail MMF as a MMF that limits redemptions to $1 million in a single business day.

The Release acknowledges certain operational challenges retail MMFs may face in complying with the natural person limitation. The Release highlights the use of social security numbers as a typical method by which a retail MMF would limit beneficial ownership to natural persons but acknowledges that MMFs will have flexibility in how they choose to comply with the natural person test (e.g., through the use of passports for non-U.S. investors). In addition, the Release recognizes that a MMF may still meet the “retail” definition notwithstanding having institutional decision-makers (e.g., plan sponsors in certain retirement arrangements, or investment advisers managing discretionary investment accounts) that could eliminate or change an investment option, such as by offering or investing in a MMF. In this context, the SEC suggests that MMFs could have policies and procedures that will help to enable the MMF to “look-through” these types of accounts and reasonably conclude that the beneficial owners are natural persons. The Release similarly notes certain issues in complying with the natural person test in an omnibus setting where MMFs will need to determine that the underlying beneficial owners of an omnibus account are natural persons. In this regard, the Release also affords flexibility to comply with the test by managing omnibus intermediary relationships in a manner that best suits a MMF’s circumstances, including through contractual arrangements or periodic certifications. The Release indicates that the SEC would expect that a MMF that intends to qualify as a retail MMF would disclose in its prospectus that it limits investments to accounts beneficially owned by natural persons.

Exemptive Relief to Reorganize MMFs as Retail or Institutional MMFs. The Release recognizes that many MMFs are owned by both retail and institutional investors, typically by way of varying eligibility criteria for different share classes of a MMF. It is also possible that an individual MMF share class (or single-class MMF) could be comprised of both retail and institutional investors. As a result of such commingling, in order for a MMF to meet the “retail” definition and continue to seek to maintain a stable NAV, the MMF may need to reorganize into separate MMFs for retail and institutional investors.

Such reorganizations may implicate certain prohibitions and protections set forth in the 1940 Act. To address these concerns, the Release sets forth exemptive relief from Sections 17(a) and 18 of the 1940 Act. This relief permits a MMF to separate retail and institutional investors via a reorganization, provided that the MMF’s board of directors, including a majority of its independent directors, determines that the reorganization results in a fair and approximately pro rata allocation of the MMF’s assets between the class being reorganized and the class remaining in the MMF. As part of implementing such a reorganization, the Release also provides MMFs with exemptive relief from Section 22(e) of the 1940 Act to permit MMFs to involuntarily redeem shareholders that will no longer be eligible investors, provided the affected shareholders receive notice at least 60 days in advance.

Proposed Amendments to Rule 10b-10 under the Securities Exchange Act of 1934. Rule 10b-10 addresses broker-dealers’ obligations to confirm their customers’ securities transactions. In the context of MMFs, the rule currently provides an exception for certain transactions in MMFs that attempt to maintain a stable NAV and where no sales load or redemption fee is charged. Under this exception, broker-dealers may provide transaction information to MMF shareholders on a monthly basis, subject to certain conditions. Absent further action by the SEC, FNAV MMFs would no longer fit within this exception. To address this issue, the SEC proposed in a Companion Proposal, exemptive relief to relieve broker-dealers from having to provide immediate confirmations to FNAV MMF shareholders. Under this proposed relief, broker-dealers may provide transaction information to FNAV MMF shareholders on a monthly basis, subject to certain conditions and provided that broker-dealers notify such shareholders of their ability to request delivery of immediate transaction confirmations.

Tax Matters. In response to the SEC’s adoption of the Amendments, the Treasury Department (“Treasury”) and the Internal Revenue Service (the “IRS”)announced proposed regulations providing a simplified, aggregate annual method of tax accounting for shareholders in FNAV MMFs. Under these proposed regulations, such shareholders may determine gains and losses with respect to the aggregate value of their shares in the FNAV MMF over a specified period of time. Treasury and the IRS also issued a revenue procedure that provides relief from the “wash sale” rules completely.

Liquidity Fees and Redemption Gates

The Amendments provide a non-government MMF with the discretion to impose a “liquidity fee” of no more than 2% on redemption amounts and/or temporarily suspend redemptions (or “gate” the MMF) when the MMF’s “weekly liquid assets,” as defined in Rule 2a-7, fall below the regulatory threshold of 30% of total assets, if the MMF’s board of directors, including a majority of its independent directors, determines that doing so is in the best interests of the MMF. In addition, the Amendments require a non government MMF to impose a liquidity fee of 1% if the MMF’s weekly liquid assets fall below 10% of total assets, unless the MMF’s board, including a majority of its independent directors, determines that imposing such a fee is not in the best interests of the MMF (or that a lower or higher (not to exceed 2%) fee is in the MMF’s best interests). This approach represents a change from the Proposals, which would have required non-government MMFs to impose a 2% liquidity fee (absent a board determination that such fees were not in the best interests of the MMF) and would have permitted such MMFs to impose redemption gates after its weekly liquid assets fell below 15%. Similar to FNAV MMFs, the Release indicates that it is the SEC’s position that, under normal circumstances, a MMF that has the ability to impose a liquidity fee or redemption gate would meet the definition of a “cash equivalent” for purposes of U.S. GAAP. The Release notes, however, that, if a MMF imposes a fee or gate, shareholders would need to reassess if their investments in such MMF continue to meet the definition of a cash equivalent.

Duration of Liquidity Fees and Redemption Gates. The Amendments allow a MMF to impose a liquidity fee or redemption gate at any point during the day after a MMF’s weekly liquid assets fall below 30%. The Amendments require that (i) any liquidity fee or redemption gate be lifted automatically once the MMF’s weekly liquid assets have risen to at least 30% of the MMF’s total assets and (ii) a MMF lift any redemption gate it imposes within 10 business days and limit any redemption gates to no more than 10 business days in any 90-day period. The SEC stated that a MMF’s board can always determine that it is in the best interests of the MMF to lift a liquidity fee or redemption gate before the MMF’s level of weekly liquid assets reaches 30% of its total assets.

Board Considerations. The Release provides a non-exhaustive list of guideposts for MMF boards of directors to consider when determining whether a MMF should impose discretionary liquidity fees and/or redemption gates, such as the relevant indicators of liquidity stress in the markets and a MMF’s current and expected liquidity profile. The SEC stated that a MMF’s board of directors would likely need to monitor the imposition of a liquidity fee, including the size of the liquidity fee, or redemption gate and whether such measures continue to be in the best interests of the MMF. The Amendments do not require that best interest determinations relating to liquidity fees and redemption gates be made at an in-person meeting but do require any such determinations to be made by the board of directors, including a majority of the independent directors. In this connection, the Release makes clear that the ultimate decision of when and how a MMF will impose liquidity fees and redemption gates rests with the board and, while the MMF’s adviser may provide input on the circumstances suggesting the imposition of a fee or gate, the board may not delegate this decision to the adviser.

Government MMFs. A government MMF will not be subject to the liquidity fee and redemption gate provisions summarized above unless it voluntarily reserves the discretion to impose a liquidity fee or redemption gate in accordance with the provisions applicable to non-government MMFs and its ability to do so is disclosed in such MMF’s prospectus.

Diversification

Under the Amendments, MMFs will be subject to stricter diversification requirements, as follows:

Treatment of Affiliates for 5% Diversification Requirement. MMFs must limit their exposure to affiliated groups, rather than to discrete issuers, by treating certain entities that are affiliated with each other as single issuers when applying the 5% issuer diversification limit.

25% “Basket”. Currently, 25% of a MMF’s portfolio may be subject to guarantees or demand features from a single institution. The Amendments remove this 25% basket for MMFs other than tax-exempt MMFs. For tax-exempt MMFs, including single-state MMFs, the Amendments reduce to 15%, rather than eliminate (as was proposed), the 25% basket.

Asset-Backed Securities. MMFs must treat the sponsors of asset-backed securities (“ABS”) as guarantors subject to Rule 2a-7’s 10% diversification limit applicable to guarantees and demand features, unless the MMF’s board (or its delegate) determines that the MMF is not relying on the sponsor’s financial strength or its ability or willingness to provide liquidity, credit or other support to determine the ABS’s quality or liquidity.

Disclosure and Reporting

Disclosure Documents. The Amendments also modify a number of disclosure requirements related to the floating NAV requirement and liquidity fees and redemption gates. For example, the Amendments require that MMFs that seek to maintain a stable NAV and FNAV MMFs include specific disclosure statements in their advertisements or other sales materials and in the summary section of the statutory prospectus, depending on the nature of the MMF. Form N-1A currently requires MMFs to disclose any restrictions on redemptions in their registration statements. In this regard, the SEC noted its expectation that, to comply with existing disclosure requirements, MMFs (other than government MMFs that have not chosen to rely on the ability to impose liquidity fees and suspend redemptions) will disclose the potential imposition of liquidity fees and/or redemption gates, including a board’s discretionary powers regarding the imposition of liquidity fees and redemption gates. The Amendments also require that a MMF disclose in its statement of additional information historical instances in which the MMF has received financial support from a sponsor or affiliate during the last 10 years (but not for occasions that occurred before the compliance date of the Amendments).

Website Disclosure. The Amendments require a MMF to disclose prominently on its website, on a daily basis (and to provide six months of historical information), the percentage of the MMF’s total assets that are invested in daily and weekly liquid assets and net shareholder inflows or outflows. The Amendments also require website disclosure of a MMF’s current NAV per share (calculated based on current market factors), rounded to the fourth decimal place in the case of a FNAV MMF, and certain information that the MMF is required to report to the SEC on Form N-CR, including the imposition and removal of liquidity fees and redemption gates and the provision of financial support to the MMF.

Form N-CR. The Amendments require that MMFs file a report with the SEC when certain significant events occur. Generally, a MMF will be required to file Form N-CR if the following events occur: a portfolio security defaults; an affiliate provides financial support; the MMF experiences a significant decline in its shadow price; or liquidity fees and redemption gates are imposed or removed. In most cases, a MMF will be required to submit a brief summary filing on Form N-CR within one business day of the occurrence of such an event, and a more detailed filing within four business days. Form N-CR requires a brief discussion of the primary considerations or factors taken into account by a MMF’s board of directors in its decision to impose or not impose a liquidity fee and/or redemption gate. Significantly, the Amendments clarify that certain routine actions (e.g., routine fee waivers or expense reimbursements, routine interfund lending, and routine interfund purchases of fund shares) and actions not reasonably intended to increase or stabilize the value or liquidity of a MMF’s portfolio, do not need to be reported as financial support on Form N-CR.

Form N-MFP. The Amendments require certain new information to be included on a MMF’s Form N-MFP filings. This new information includes a MMF’s NAV per share (and shadow price), daily and weekly liquid assets, and shareholder flows on a weekly basis within the monthly filing of the form. The Amendments also require information about fee waivers during a reporting period and eliminate the 60-day delay on public availability of Form N-MFP data.

Private Liquidity Fund Reporting. The Amendments revise Form PF reporting for “large liquidity fund advisers” (i.e., registered advisers with at least $1 billion in combined MMF and liquidity fund assets) to require that they report virtually the same information with respect to their liquidity funds’ portfolio holdings on Form PF as MMFs are required to file on Form N-MFP.

Stress Testing

MMFs are currently subject to certain stress testing requirements, originally adopted in 2010, that require MMFs to adopt procedures for periodic testing of their ability to maintain a stable NAV based on (but not limited to) certain hypothetical events. The Amendments enhance these stress testing requirements by requiring MMFs to periodically test their ability to maintain weekly liquid assets of at least 10% and to minimize principal volatility in response to specified hypothetical events. The hypothetical events include (i) increases in the level of short-term interest rates, (ii) downgrades or defaults of particular portfolio positions, each representing various portions of a MMF’s portfolio, and (iii) the widening of spreads in various sectors to which the MMF’s portfolio is exposed. Each of the hypothetical events is to be tested in combination with varying levels of shareholder redemptions. The Amendments also modify existing board reporting requirements with respect to the results of stress testing, requiring, among other things, that a MMF’s investment adviser’s report to the board include, in the case of a stable NAV MMF, information regarding its ability to maintain a stable price per share, any significant assumptions made when performing the stress tests, and any information as may reasonably be necessary for the board to evaluate the stress testing.

VALUATION GUIDANCE

As indicated above, the Amendments permit retail and government MMFs to continue to use the amortized cost method of valuation and/or penny rounding method of pricing to maintain a stable NAV. The Release clarifies that FNAV MMFs, consistent with non-money market mutual funds, may use the amortized cost method to value fixed income securities with remaining maturities of 60 days or less if the fund’s board of directors determines, in good faith, that the fair value of such securities is their amortized cost, unless the particular circumstances warrant otherwise. The Release makes clear that the fair value of such securities must be determined each time that a fund’s shares are priced, which would be intra-day for funds that strike a NAV more than once per day. The Release also includes expanded valuation guidance that is generally applicable to all registered funds regarding (i) the treatment of evaluated prices from independent pricing services as fair values and the role of the board of directors in authorizing the use of these evaluated prices and (ii) the valuation of thinly-traded securities.

COMPLIANCE DATES

The Amendments are effective 60 days after the publication of the Release in the Federal Register (the “Effective Date”). The compliance date for the Amendments related to floating NAV and liquidity fees and redemption gates, including any related amendments to disclosure requirements, is 2 years after the Effective Date. The compliance date for amendments that are not specifically related to either floating NAV or liquidity fees and redemption gates, including amendments to (i) diversification, (ii) stress testing, (iii) disclosure requirements not specifically related to either floating NAV or liquidity fees and redemption gates, (iv) Form PF, and (v) Form N-MFP, is 18 months after the Effective Date. The compliance date for Form N-CR and related requirements is 9 months after the Effective Date.

COMPANION PROPOSALS

In the Companion Proposals, the SEC (i) re-proposed the removal of NRSRO rating references from Rule 2a-7 and Form N-MFP and (ii), as briefly discussed above, proposed exemptive relief from the immediate confirmation delivery requirements of Rule 10b-10 under the Securities Exchange Act of 1934 for transactions in shares of any MMF required to use a floating NAV. Comments on the former proposal will be due 60 after publication of its formal proposing release in the Federal Register; comments on the latter proposal must be received on or before August 19, 2014.