On December 15, 2021, the U.S. Securities and Exchange Commission (the “SEC”) voted, by a 3-2 vote, to propose money market fund reforms that would significantly impact the regulatory framework governing money market funds (“MMFs”). According to the SEC, the proposed reforms are designed to improve the resiliency of MMFs by reducing the risk of shareholder “runs” on MMFs, especially during times of liquidity stress. The SEC indicated that the proposed rulemaking is informed by the experiences of MMFs during March 2020 in connection with the market volatility from the onset of the COVID-19 pandemic, which included heavy outflows from institutional prime MMFs. The public comment period for the proposed reforms will remain open until 60 days after the date of publication in the Federal Register.
The proposed reforms consist of amendments to Rule 2a-7 under the Investment Company Act of 1940 (the “1940 Act”), the primary rule governing the operation of MMFs, and related reporting and disclosure form amendments. The key aspects of the proposed changes are summarized below.
Removal of Liquidity Fees and Redemption Gates Provisions
The reforms would remove the ability of a MMF to impose liquidity fees or redemption gates (“fees and gates”) once the fund falls below certain liquidity thresholds. Currently, Rule 2a-7 gives the board of directors of a MMF discretion to impose liquidity fees (of up to 2%) and/or redemption gates (for up to 10 business days during any 90-day period) if the fund’s “weekly liquid assets” fall below 30% of its total assets. Although government MMFs are not subject to the fees and gates provisions, a government MMF is permitted to impose fees and/or gates by reserving the authority to do so and disclosing that authority in its prospectus. Government MMFs have rarely, if ever, opted into the ability to impose fees and gates.
The fees and gates provisions were added to Rule 2a-7 in 2014 to provide MMFs with new tools to help curb runs during extraordinary circumstances. The SEC intended fees and gates to serve as redemption restrictions that would provide a “cooling off” period to temper short-term investor panic and preserve liquidity in times of market stress. According to the SEC, the fees and gates provisions did not have their intended effect during the period of market stress in March 2020. Instead, even though no MMF imposed a fee or gate (and only one institutional prime MMF reported weekly liquid assets below the 30% threshold), the mere possibility of the imposition of a fee or gate appears to have increased redemptions – investors may have been more inclined to redeem as a MMF approached the 30% threshold out of uncertainty about whether the MMF’s board would use its discretion to impose a fee or gate if the MMF reached this threshold. At the same time, to avoid the uncertainty associated with dropping below the 30% threshold, MMF managers sought to maintain weekly liquid asset levels above the 30% threshold (e.g., by selling longer-term portfolio securities) rather than use weekly liquid assets to meet redemptions. As a result, the 30% threshold in effect became a liquidity “floor” instead of a buffer.
The SEC considered proposing to remove the tie between weekly liquid assets and the possibility of fees and gates but preserving a MMF’s ability to impose fees and gates (e.g., giving a board discretion to impose fees and gates at any time it determines doing so is in the best interests of the fund). However, the SEC expressed concern that a lack of transparency about how close a MMF may be to imposing fees and gates could lead risk-averse investors to redeem during times of liquidity stress, which could lead to runs on more liquid and less liquid MMFs alike (including MMFs that are less likely to impose fees or gates).
Even if the fees and gates provisions are eliminated as proposed, a MMF would not be precluded from suspending redemptions or imposing redemption fees in certain limited circumstances. For example, a MMF would still be permitted to suspend redemptions to facilitate an orderly fund liquidation pursuant to Rule 22e-3 or, in theory, to impose redemption fees (up to 2% of the value of the shares redeemed) to mitigate dilution arising from shareholder transaction activity pursuant to Rule 22c-2, in each case subject to certain determinations by the MMF’s board.
Amendments to the Portfolio Liquidity Requirements
MMFs are subject to minimum liquidity requirements designed to support a MMF’s ability to meet redemptions even in market conditions in which the MMF cannot rely on a secondary or dealer market to provide liquidity. The reforms would increase the minimum liquidity requirements for all MMFs, including prime MMFs and government MMFs alike, by raising the “daily liquid asset” minimum from 10% to 25% of the fund’s total assets and raising the “weekly liquid asset” minimum from 30% to 50% of the fund’s total assets. The SEC believes the increased thresholds will provide a stronger liquidity buffers during periods of market stress. The SEC noted that the proposed thresholds are generally consistent with the average liquidity levels that prime MMFs have maintained over the past several years. The SEC also believes that these increases are appropriate in light of the elimination of fees and gates.
The minimum liquidity requirements would continue to apply to “acquisitions” of portfolio assets, so the consequences of passively falling below either of these minimums would be the same as under the current framework. Specifically, if a MMF’s portfolio does not meet the proposed new minimum daily or weekly liquid asset thresholds, the MMF would not be able to acquire any assets other than daily or weekly liquid assets, respectively, until it meets these minimum thresholds.
The reforms also would impose new reporting obligations on MMFs for certain liquidity threshold events. Specifically, when a MMF’s daily liquid assets fall below 12.5% or its weekly liquid assets fall below 25%, the fund would be required, within one business day after the occurrence, to notify its board of directors and file a public report with the SEC.
In addition, the reforms would amend the stress testing provisions in Rule 2a-7 by replacing the requirement that a MMF must test its ability to maintain 10% weekly liquid assets under specified hypothetical events with a requirement to test its ability to maintain “sufficient minimum liquidity” under such specified hypothetical events. Each fund would be permitted to determine the minimum level of liquidity that it considers sufficient instead of using a bright-line 10% threshold.
“Swing Pricing” Requirement
The reforms would require institutional prime and institutional tax-exempt MMFs (“institutional MMFs”), but not government or retail MMFs, to use “swing pricing” on each day they have net redemptions. Swing pricing is the process of adjusting an institutional MMF’s net asset value (“NAV”) to effectively pass on the costs stemming from redemption activity (e.g., trading costs and costs of depleting a fund’s daily or weekly liquid assets) to the redeeming shareholders. In effect, when the NAV “swings” down, redeeming shareholders would receive less for their shares. Swing pricing is a cost allocation tool that the SEC believes will help mitigate the risk of redemptions motivated by a perceived “first mover advantage” and reduce the potential for dilution of non-redeeming shareholders’ interests in the institutional MMF. If adopted as proposed, the swing pricing requirement could cause some institutional MMF shareholders to move their assets to government MMFs to avoid the possibility of paying liquidity costs from a downward NAV swing upon redemption. The swing pricing process would be applied in connection with each NAV calculation when a MMF has net redemptions, but not when it has net subscriptions. The magnitude of the swing would be determined by a “swing factor,” which would differ based on the amount of the net redemptions. The swing factor calculation would be based on certain specified parameters and would reflect (i) the spread costs and other transaction costs the institutional MMF would incur by selling a pro rata amount of each security in its portfolio to satisfy the amount of net redemptions and (ii) if net redemptions exceed a certain defined threshold (generally 4% of the fund’s NAV divided by the number of NAV strikes the institutional MMF has in a business day), the estimated market impact costs of such portfolio security sales.
Swing pricing would be new to institutional MMFs, but a similar swing pricing framework currently exists for open-end mutual funds other than MMFs (“non-MMFs”). In connection with the SEC’s adoption of the liquidity risk management rule in 2016, the SEC adopted regulatory changes permitting, but not requiring, non-MMFs to use swing pricing. The SEC declined to extend swing pricing to MMFs at that time due to the existing liquidity fee regime that is permitted under Rule 2a-7. Given that the proposed reforms would remove the fees and gates provisions, the SEC is now proposing swing pricing for institutional MMFs. Unlike the voluntary swing pricing regime for non-MMFs, swing pricing would be mandatory for institutional MMFs, which is intended to address what the SEC believes would be a reluctance to voluntarily impose swing pricing by institutional MMFs (or their boards) and a perceived “collective action” problem in which no fund would want to be the first to adopt such an approach. Non-MMFs have yet to implement swing pricing, partly due to the need for a reconfiguration of current order-processing practices to address operational complexities.
The SEC acknowledges that swing pricing will introduce new operational complexities for institutional MMFs, which will need to receive sufficient and timely shareholder flow data in order to complete the swing pricing process. The swing factor calculation process would require an institutional MMF to determine whether it has net redemptions and the size of those net redemptions, prior to striking its NAV, and this determination would need to be completed multiple times per day for an institutional MMF that strikes its NAV multiple times per day. While non-MMFs may receive purchase and redemption requests from financial intermediaries even after striking their NAVs, the SEC believes institutional MMFs would not be subject to significant operational impediments with respect to having timely flow information to inform swing pricing decisions because such funds often impose order cut-off times that ensure they receive flow data prior to striking their NAVs. An institutional MMF that does not currently impose order cut-off times may face additional operational complexity and costs to implement a cut-off time or otherwise gather the necessary information to determine whether it has net redemptions and the amount of net redemptions. In addition, while gathering such information could delay an institutional MMF’s ability to strike its NAV, the SEC believes it is unlikely that these delays would result in institutional MMFs having to settle transactions on T+1, instead of T+0. If necessary to maintain its ability to offer same-day settlement, an institutional MMF could choose to move its last NAV strike to an earlier point in the day or reduce the number of NAV strikes it offers each day to ease the implementation of swing pricing.
To facilitate board oversight of swing pricing, the proposed reforms would require the board of directors of an institutional MMF to: (i) approve the fund’s swing pricing policies and procedures; (ii) designate a “swing pricing administrator” to administer the policies and procedures on a day-to-day basis (the administrator would have to be reasonably segregated from the fund’s portfolio management); and (iii) review, no less frequently than annually, a written report prepared by the swing pricing administrator describing the adequacy and effectiveness of the swing pricing program.
Given that the proposed swing pricing would apply to institutional MMFs but not government MMFs, the swing pricing requirement, if adopted as proposed, could cause some institutional MMF shareholders to move their assets to government MMFs to avoid the possibility of paying liquidity costs of redemptions.
Amendments Related to the Operation of Stable NAV MMFs in a Negative Interest Rate Environment
Government and retail MMFs (“stable NAV MMFs”) seek to maintain a stable share price (e.g., $1.00 share price) by using amortized cost and/or penny-rounding accounting methods. Extra income from a stable NAV MMF over the stable share price is distributed to shareholders on a daily basis. In a negative interest environment, a stable NAV MMF’s net income likely would turn negative. Without a mechanism to distribute or account for the negative yield, the negative yield would cause the stable NAV MMF’s shadow price to deviate from its stable share price. If such deviation was to exceed ½ of 1%, the stable NAV MMF’s board of directors would be required to consider what action, if any, should be taken, including whether to re-price the fund’s securities below the $1.00 share price (an event known as “breaking the buck”).
There are several potential options that may currently be available to a stable NAV MMF in a negative yield environment. With input from the Investment Company Institute, the MMF industry has generally identified the reverse distribution mechanism (“RDM”) as among the most operationally feasible options. An RDM involves offsetting the daily negative yield accrued through the proportional reduction of the total number of outstanding fund shares. There are other devices similar to an RDM that would reduce the number of the fund’s outstanding shares to maintain a stable share price (e.g., a reverse stock split), but these other devices present significant operational challenges due to a combination of current system capabilities, operational risks and the costs and time needed to scale them for widespread use. It has become an increasingly common practice for MMFs to have provisions in their governing documents authorizing the ability to use an RDM and similar devices. Certain MMFs specifically added such provisions to their governing documents within the past two years in light of the low interest rate environment. While these MMFs have the ability to use an RDM under their governing documents, no MMF has implemented (or faced the need to implement) an RDM.
Neither the SEC nor its staff have affirmatively approved or disapproved of the use of an RDM. However, that would change if the proposed reforms are adopted. The reforms would prohibit a stable NAV MMF from reducing the number of the fund’s outstanding shares, which would include the implementation of an RDM, as a means of maintaining its stable share price. As a result of this prohibition, a stable NAV MMF that has to apply a negative yield likely would have no viable option other than converting to a “floating” NAV, which would enable the fund to absorb the negative yield into its share price. A floating NAV is based on the current market-based value of the securities in the portfolio and is rounded to the fourth decimal place (e.g., $1.0000).
Converting to a floating NAV, however, would present a variety of operational challenges and costs. In particular, a floating NAV may be incompatible with cash sweep arrangements and popular cash management tools (e.g., check-writing and write transfers) that are currently offered for many stable NAV MMF accounts, or there could be significant costs involved in order to modify such arrangements to be able to accommodate a floating NAV. Such conversions also would likely impact the intra-day settlement processes for MMFs that offer multiple NAV strikes during the day, as requiring a MMF to obtain market values and strike a market-based NAV during the day can be more costly and time consuming than using a stable share price to settle intra-day share transactions. Finally, for some retail investors, there may be accounting and tax complexities associated with conversions to a floating NAV.
To ensure stable NAV MMFs would be operationally prepared to convert to a floating NAV, the reforms would require a stable NAV MMF to determine that its financial intermediaries have the capacity to redeem and sell its shares at a floating NAV. This determination would be required under normal circumstances, even if the stable NAV MMF is not currently operating in a negative yield environment and there is no present intention to convert to a floating NAV. If this determination cannot be made as to any intermediary, the reforms would require the stable NAV MMF to prohibit the relevant intermediary from purchasing its shares in nominee name on behalf of others. Stable NAV MMFs would have flexibility in how they make this determination for each financial intermediary but would be required to maintain records identifying the intermediaries that are able to process orders at a floating NAV.
Stable NAV MMFs and their transfer agents (but not intermediaries) are already required by Rule 2a-7 to be able to process orders at a floating NAV, so the proposed reforms, in the SEC’s view, would effectively expand these existing requirements to all financial intermediaries. To the extent intermediaries are currently unable to process transactions in stable NAV MMFs at a floating NAV, they would need to upgrade their processing systems to be able to continue to transact in stable NAV MMFs. To the extent intermediaries are unable or unwilling to do so (e.g., for cost reasons), the proposed requirement may adversely impact the size of intermediary distribution networks of some stable NAV MMFs.
Amendments to Specify the Calculations of WAM and WAL
The reforms would require each MMF to calculate its “dollar-weighted average portfolio maturity” (WAM) and “dollar-weighted average life maturity” (WAL), which are important determinants of interest rate risk in a fund’s portfolio, based on the percentage of each security’s market value. This specificity would eliminate a discrepancy that currently exists as a result of some MMFs choosing to base these calculations on the amortized cost of each portfolio security. The SEC proposes to choose market value instead of amortized cost for this calculation because all types of MMFs already determine the market values of their portfolio holdings (for shadow pricing purposes in the case of stable NAV MMFs), while only certain MMFs use amortized cost.
Amendments to Certain Reporting Requirements
The reforms would amend Form N-MFP, which is a monthly portfolio holdings report used to assist the SEC in monitoring and analyzing MMFs, to provide certain new information about a fund’s shareholders and disposition of non-maturing portfolio investments, to improve the accuracy and consistency of currently reported information, and to increase the frequency of certain data point reports.
Marco E. AdelfioPartnerChair, Investment Management
Andrew L. ZutzPartner
Paul J. DelligattiPartnerDC Business Law Leader