Financial Services Alert - July 29, 2014

At a meeting held on July 23, 2014, the SEC voted 3-2 to adopt amendments (the “Amendments”) to various regulatory requirements affecting money market funds (“MMFs”).  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.  In particular, the Amendments (i) require certain 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 MMFs to impose liquidity fees and temporarily suspend redemptions, and (iii) require further diversification of MMF portfolios, amend MMF stress testing requirements, and add new reporting and disclosure requirements for MMFs.  In conjunction with adopting the Amendments, the SEC approved the issuance for public comment of proposals to further amend the MMF regulatory regime (the “Companion Proposals”).

This article provides a brief summary of the Amendments and the Companion Proposals.

Overview of the Amendments

Floating NAV

Under the Amendments, rather than using the amortized cost method to maintain a stable $1.00 NAV, a non-government institutional MMF must use a “floating” NAV calculated based on the current market-based value of the securities in its portfolio rounded to the fourth decimal place (e.g., $1.0000).  However, the SEC stated that a floating NAV MMF would be able to use amortized cost valuation to the same extent that other non-money market mutual funds are able 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).

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

• A “retail” MMF is a MMF that adopts and implements policies and procedures reasonably designed to limit beneficial owners to natural persons. 
• 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.

Liquidity Fees and Gates

The Amendments provide the board of directors of a non-government MMF with (a) the discretion to impose a “liquidity fee” of no more than 2% on redemption amounts if the MMF’s “weekly liquid assets,” as defined under Rule 2a-7, fall below the required regulatory threshold of 30% of total assets and (b) the discretion to suspend redemptions temporarily for up to 10 business days in a 90-day period (i.e., to “gate” the MMF) under the same circumstances.  In addition, the Amendments require all non‑government MMFs 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 of directors determines that imposing such a fee is not in the best interests of the MMF (or that a different fee no greater than 2% is in the MMF’s best interests).

Diversification, Disclosure and Stress Testing

Under the Amendments, MMFs will be subject to increased diversification requirements.  The Amendments add to the reporting requirements under existing Form N-MFP and impose new requirements to disclose certain information on MMF websites and report to the SEC on new Form N-CR following the occurrence of certain significant events such as portfolio security defaults or the imposition or removal of a liquidity fee or gate.  The Amendments enhance existing stress testing obligations for MMFs by requiring them 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.  Finally, 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.

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 liquidity fees and gates and floating NAV, including any related amendments to disclosure, 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 gates, including amendments to (i) diversification, (ii) stress testing, (iii) disclosure requirements not specifically related to either floating NAV or liquidity fees and 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) 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 days after publication of its formal proposing release in the Federal Register; comments on the latter proposal will be due 21 days after publication of its formal proposing release in the Federal Register.

The staff of the SEC’s Division of Corporation Finance added to its Compliance and Disclosure Interpretations posted on the SEC website new Questions 255.48‑255.49 and 260.35-260.38 which address (1) elements of the accredited investor definition for natural persons in Rule 501 of Regulation D under the Securities Act of 1933 and (2) verification of accredited investor status for purposes of the Rule 506(c) private offering exemption under Regulation D (collectively, the “Guidance”).

Accredited Investor – Natural Persons

Income Not Reported in U.S. Dollars.  The Guidance states that an issuer determining whether a purchaser whose annual income is not reported in U.S. dollars meets the income test for qualifying as an accredited investor may use either the exchange rate that is in effect on the last day of the year for which income is being determined or the average exchange rate for that year.

Assets Held Jointly with Non-Spouse.  The Guidance states that assets in an account or property held jointly with a person who is not the purchaser's spouse may be included in the calculation for the net worth test, but only to the extent of the purchaser’s percentage ownership of the account or property.

Verifying Accredited Investor Status

To rely on Rule 506(c), an issuer must take reasonable steps to verify the accredited investor status of purchasers in the offering, even if all purchasers are in fact accredited investors.  The SEC has described a principles-based approach to verification and provided factors for issuers to consider in making the necessary determinations.  Rule 506(c) also includes four non-exclusive safe harbor methods of verifying accredited investor status.  The Guidance describes situations where the strict terms of a safe harbor method have not been met and provides principle‑based variations on the safe harbor methods for meeting Rule 506(c)’s verification requirement.  (See the June 23, 2013 Financial Services Alert for a more detailed discussion of Rule 506(c) offerings.)

IRS Forms Reporting Income.  The Guidance states that an issuer may not rely on the safe harbor verification method that involves reviewing any Internal Revenue Service form that reports the purchaser's income for the “two most recent years” if the form for the most recent year is not yet available, even though the forms for the prior two years are.  The Guidance provides, however, that an issuer may satisfy Rule 506(c)’s verification requirement under the principles-based method of verification by:

• reviewing the IRS forms that report income for the two years preceding the recently completed year; and
• obtaining written representations from the purchaser that (i) an IRS form that reports the purchaser's income for the recently completed year is not available, (ii) specify the amount of income the purchaser received for the recently completed year and that such amount reached the level needed to qualify as an accredited investor, and (iii) the purchaser has a reasonable expectation of reaching the requisite income level for the current year.

Non-U.S. Tax Forms Reporting Income.  The Guidance states that an issuer may not rely on the safe harbor method that involves reviewing IRS forms that report the purchaser’s income for the two most recent years if the purchaser is not a U.S. taxpayer and therefore cannot provide an Internal Revenue Service form that reports income, even the non-U.S. purchaser can provide comparable tax forms from a foreign jurisdiction.  The Guidance provides, however, that an issuer may satisfy Rule 506(c)’s verification requirement under the principles-based method of verification by reviewing filed tax forms from a non-U.S. jurisdiction that report income if that jurisdiction imposes penalties for falsely reported information that are comparable to those that apply to false reporting on IRS forms.

Tax Assessments.  The Guidance notes that because tax assessments are often prepared annually it may not always be possible for an issuer to use them to rely on the safe harbor method that involves reviewing documentation of the purchaser's assets and liabilities dated within the prior three months.  The Guidance provides, however, that an issuer may satisfy Rule 506(c)’s verification requirement under the principles-based method of verification if it uses the most recently available tax assessment when determining whether the purchaser has the requisite net worth. The Guidance notes that, for example, if the most recent tax assessment shows a value that, after deducting the purchaser's liabilities results in a net worth substantially in excess of $1 million, it may be sufficient verification that the purchaser has met the net worth test.

Report from a Non-U.S. Consumer Reporting Agency.  The Guidance states that if, in order to determine the purchaser's liabilities, an issuer reviews a consumer report from a non-U.S. consumer reporting agency that performs functions similar to those of a U.S. nationwide consumer reporting agency, the issuer has not met the requirement for the safe harbor in Rule 506(c)(2)(ii)(B) that it review a consumer report from one of the “nationwide consumer reporting agencies” to make that determination.  The Guidance provides, however, that an issuer may satisfy Rule 506(c)’s verification requirement under the principles-based method of verification by reviewing a consumer report from such a non-U.S. consumer reporting agency and taking any other steps necessary to determine the purchaser's liabilities (such as a written representation from the purchaser that all liabilities have been disclosed).

Reason to Question the Information Reviewed.  In addressing each of the foregoing situations, the Guidance notes that if, after undertaking the principles‑based inquiry described for that situation, the issuer has reason to question the conclusion that inquiry is designed to support, e.g., because the information reviewed appears unreliable, then the issuer must undertake additional measures to establish that it has taken reasonable steps to verify the purchaser’s accredited investor status.  The Guidance provides an example of how such a question might arise in the situation where the issuer undertakes the principle-based review of IRS forms described above to determine the purchaser’s income.  The Guidance observes that “if, based on that review, the purchaser's income for the most recently completed year barely exceeded the threshold required, the review described in the Guidance might not constitute sufficient verification and more diligence might be necessary.”

The Securities Industry and Financial Markets Association (SIFMA) issued a memorandum (the “Memorandum”) with guidance for registered broker-dealers and investment advisers on various non-exclusive means of verifying an investor’s accredited investor status so as to have a basis for submitting a written confirmation of that determination to an issuer seeking to rely on the private offering exemption in Rule 506(c) of Regulation D under the Securities Act of 1933 (the “Securities Act”).  Rule 506(c) provides four non-exclusive safe harbor methods for an issuer to meet the requirement that it take “reasonable steps” to verify that all purchasers in a Rule 506(c) offering are accredited investors.  (See the June 23, 2013 Financial Services Alert for a more detailed discussion of Rule 506(c).)  The Memorandum recognizes that two of the safe harbors may be not be attractive to purchasers who may not wish to provide personal financial information about their annual income or the amount of their assets and liabilities.  In order to facilitate reliance on the safe harbor method that permits an issuer to rely on a written confirmation of a purchaser’s accredited investor status provided by a registered broker-dealer, registered investment adviser, licensed attorney, or certified public accountant, when that party has taken reasonable steps to verify the purchaser’s accredited investor status before providing the confirmation, the Memorandum outlines reasonable steps that registered broker-dealers and investment advisers may take to verify the purchaser’s accredited investor status, while noting that the guidance in the Memorandum may also be useful to issuers and other market participants.  This article provides a brief summary of the methods discussed in the Memorandum, which provides important additional detail on the various elements of each method.

Verification - Natural Persons

Account Balance Method.  SIFMA believes that a broker-dealer or investment adviser will have taken reasonable steps to verify that its client meets the net worth test for accredited investor status (generally, individual net worth (or joint net worth with spouse) in excess of $1 million, not including primary residence) if (i) the client (a) has had an account with the firm for at least six months, (b) has (individually or jointly with the client’s spouse) at least $2 million in cash and marketable securities in the account prior to making the investment in the Rule 506(c) offering (net of any amounts borrowed to purchase securities on margin) and (c) has provided the representations in the form of accredited investor questionnaire attached to the Memorandum (the “Purchaser Representations”), including the representation that the client has not borrowed or guaranteed any business loans other than those disclosed to the firm; and (ii) the firm is unaware of facts indicating that the client is not an accredited investor.  The $2 million threshold reflects an assumption that the client has $1 million of liabilities.  (The basis for this assumption is discussed in more detail in the Memorandum.)  The Memorandum instructs that if the client has made any business loans or guarantees of business loans or drawn on a personal line of credit, and the amount of these obligations exceeds the fair value of the client’s assets posted as collateral, then the $2 million threshold should be increased by that excess amount.

Investment Amount Method.  SIFMA believes that a broker-dealer or investment adviser will have taken reasonable steps to verify its client’s accredited investor status under the net worth test if (1) the client (a) has been with the firm for at least six months, (b) (i) invests at least $250,000 in the Rule 506(c) offering or (ii) makes an unconditional commitment, callable in whole at any time, to invest at least $250,000 in the Rule 506(c) offering, and (c) has provided the Purchaser Representations, including the representation that the proposed investment is less than 25% of the client’s net worth (individually or jointly with the client’s spouse), (2) the firm is unaware of facts indicating that the client is not an accredited investor and (3) in the case where the client is making a capital commitment, the firm has knowledge that the client has fulfilled a call under a prior commitment.

Verification - Legal Entities

Accredited Investor Based on Entity Type.  If a legal entity claims to qualify as an accredited investor because it is one of various types of entities specifically identified as such in Regulation D (e.g., because it is a bank, an insurance company, or a registered broker-dealer), SIFMA believes that verification of that qualification at least annually will constitute reasonable steps to verify accredited investor status absent any facts indicating a change in status.  The Memorandum does not specify how to verify accredited investor status for these types of entities except to note that a broker-dealer or investment adviser’s registration with the SEC can be verified on the FINRA’s BrokerCheck website.

Accredited Investor Based on Entity Type and Assets.  If a legal entity claims to qualify as an accredited investor on the basis of a combination of entity type and assets (e.g., because it is a 501(c)(3) organization, corporation, Massachusetts or similar business trust, or partnership, not formed for the specific purpose of acquiring the securities offered, with total assets in excess of $5,000,000), SIFMA believes that a person will have taken reasonable steps to verify the entity’s accredited investor status if (a) it confirms that the entity is named on a broker-dealer’s or investment adviser’s current list of clients that qualify as “institutional accounts” as defined in FINRA Rule 4512(c)(3)22 or as Qualified Institutional Buyers as defined in Rule 144A under the Securities Act (which are required to have investible assets of at least $100 million), or (b) the entity makes an investment in the Rule 506(c) offering in excess of $5 million and the entity provides a written representation that it was not formed for the purpose of making that investment and has made at least one prior investment in securities (whether in a primary offering or in the secondary market).

Law Firm Support 

Exhibit C to the Guidance lists law firms, including Goodwin Procter, that believe that the procedures in the Memorandum provide reasonable guidance for registered broker-dealers and investment advisers to apply in their particular circumstances.

The FDIC issued guidance (the “Guidance”; FIL-40-2014) to banks and savings associations that have elected S-corporation tax treatment (collectively, “S-corporation Banks” and each an “S-corporation Bank”) concerning the factors that the FDIC will consider when it receives a request from an S-corporation Bank to pay dividends to its shareholders “to cover taxes on their pass-through share of the [S-corporation Bank’s] earnings, where these dividends would otherwise not be permitted under the capital conservation buffer contained in the new Basel III capital rules.”  The capital conservation buffer, when it takes effect, will limit the amount of dividends a bank can pay when its capital ratios fall below the threshold levels of the buffer.  The capital conservation buffer will be phased-in over the years 2016 through 2018 and will become fully effective in 2019.  There are currently approximately 2,000 U.S. community banks, which are structured for tax purposes as Subchapter S corporations.

In the Guidance, the FDIC states that in evaluating requests from S-corporation Banks for exceptions to the limits of the capital conservation buffer it would consider each of the following four factors:

• whether the S-corporation Bank was requesting a dividend of no more than 40% of its net income;
• whether the S-corporation Bank believes that the dividend payment is necessary to allow its shareholders to pay income taxes associated with their pass-through share of the S-corporation Bank’s earnings;
• whether the S-corporation Bank has a composite rating of at least 1 or 2 under the CAMELS rating system and is not subject to a written supervisory directive; and
• whether the S-corporation Bank is at least “adequately capitalized” and would remain adequately capitalized after the payment of the requested dividend.

The FDIC states in the Guidance that it will consider requests on a case-by-case basis, but, absent significant safety-and-soundness concerns, it would generally expect to approve requests for such exceptions from a well-rated S-corporation Bank that satisfies the four factors if the request is limited to “the payment of dividends to cover shareholders’ taxes on their portion of an [S-corporation Bank’s] earnings.”  Without such relief, the FDIC notes, an S-corporation Bank’s ability to attract capital could be adversely affected.

After a one-year transitional period, the Alternative Investment Fund Managers Directive (AIFMD) officially went into effect on July 22, 2014.  This means that both EU managers managing funds and non-EU managers marketing funds to EU investors must comply with the terms of this far-reaching directive.  Glynn Barwick in the firm’s London Office provides additional insight in the July 7th publication issue of InvestHedge, and more recently is quoted by Investment & Pensions Europe.