The U.S. Securities and Exchange Commission (SEC) has approved sweeping amendments to Rule 2a-7 under the Investment Company Act of 1940 and other rules governing the operations of money market funds (money funds) (Amendments).1 The Amendments generally combine the two alternatives set forth in the proposing release issued in 2013 (Proposing Release)2 – (i) permitting (and under circumstances, requiring) certain money funds to impose a “liquidity fee” (up to 2%) and/or “redemption gate,” if weekly liquidity levels fall below the required regulatory threshold and (ii) requiring “institutional money funds” to operate with a floating net asset value (NAV) rounded to the fourth decimal place (e.g., $1.0000).
The Amendments also include other notable reforms, such as tightening diversification, disclosure, reporting and stress testing requirements, as well as clarifying other provisions of Rule 2a-7. The Amendments greatly impact the money fund industry and have significant implications for a money fund’s board of directors/trustees (Board). This article will review the Amendments and discuss potential issues that should be considered by Boards.
Liquidity Fees and Redemption Gates
The Amendments provide money funds with certain tools – specifically, liquidity fees and redemption gates – to enable them to better manage redemptions during periods of market stress or illiquidity.3 When the “weekly liquid assets”4 of a money fund fall below 10% of total assets, the fund would be required to impose a 1% liquidity fee on all redemptions, unless the Board determines that imposing such a fee would not be in the fund’s best interests or determines that a lower or higher fee (up to 2%) would be appropriate. When weekly liquid assets fall below 30% of total assets, a Board is permitted to temporarily impose a liquidity fee and/or a redemption gate.5 Liquidity fees and redemption gates are required to be suspended once a money fund’s weekly liquid assets rise to or above 30% of its total assets, or sooner, if determined by the Board.
The Amendments require money funds (other than “government” and “retail” money funds)6 to convert to a floating NAV, calculating their market-based NAV per share to the nearest basis point or equivalent level of precision (e.g., $1.0000 or $10.000).7 The Amendments exempt “government” and “retail” money funds from the floating NAV requirement. “Government” money funds are defined as money funds that maintain at least 99.5% of their total assets in cash, U.S. government securities and/or repurchase agreement agreements that are collateralized fully by cash or U.S. government securities.8 The Amendments define “retail” money funds as money funds that have “policies and procedures reasonably designed to limit all beneficial owners of the fund to natural persons.”9 Money funds that meet the requirements to be a government or retail money fund could continue to use penny-rounding pricing10 and the amortized cost method of valuation11 to price their shares and maintain a stable NAV. The floating NAV requirement aims to increase the transparency of institutional money funds’ pricing and reduce the incentive of fund shareholders to redeem shares in times of financial stress. By removing the ability of investors to redeem shares at a $1.00 per share price when the actual market-based NAV is below $1.00, the floating NAV requirement seeks to eliminate the “first mover advantage,” which some have credited with contributing to heavy redemptions from institutional prime money funds during the 2008 financial crisis.
Enhanced Disclosure Requirements
New Rule 30b1-8 and New Form N-CR
Under the Amendments, a money fund will be required under new Rule 30b1-8 to disclose on new Form N-CR: (i) any instances of default or an event of insolvency of a portfolio security that, immediately before the default or event of insolvency, accounted for ½ of 1% or more of the money fund’s total assets; (ii) any financial support by a sponsor or affiliate of the money fund;12 (iii) any instance in which the money fund’s market-based NAV per share falls below its intended stable price by more than ¼ of 1%; (iv) a decline in weekly liquid assets below 10% of total fund assets; (v) a decline in weekly liquid assets below 30% of total fund assets if the money fund imposes a liquidity fee; and (vi) when a money fund imposes or lifts a liquidity fee or redemption gate. Money funds will be required to file a “brief summary” on Form N-CR within one business day following the triggering material event. The Form will be publicly available on EDGAR immediately upon filing. Thereafter, the money fund will be required to make a follow-up filing on Form N-CR within four business days to report more complete information.
The Amendments require a money fund to disclose on its website substantially the same information that is required in the “brief summary” on Form N-CR, as well as the following information as of the end of each business day during the preceding six months: (i) the percentage of total assets invested in daily and weekly liquid assets; (ii) net inflows and outflows; and (iii) current NAV per share and market-based NAV per share, each rounded to the fourth decimal place or equivalent level of precision. This information, which will include money fund data that occurred prior to the compliance date (as discussed below), must be presented in the form of a schedule, chart, graph or other depiction.
The Amendments require money funds to include a new generic risk statement in their registration statements relating to the risks associated with money funds. Among other things, a money fund will be required to state that: (i) the fund cannot guarantee to preserve the value of a share at $1.00 (or, in the case of institutional money funds, a statement that the share price will fluctuate); (ii) the fund may impose liquidity fees or redemption gates (unless it is government money fund that has not elected the ability to do so); and (iii) the fund’s sponsor has no legal obligation to provide support to the fund and an investor should not expect that the sponsor will provide financial support to the fund at any time. Also, the Amendments require a money fund to include in its Statement of Additional Information (SAI) disclosure regarding any occasion over the past 10 years in which: (i) the fund’s weekly liquid assets have fallen below 10 % of its total assets and, with respect to each occasion, whether the fund’s Board determined to impose a fee or gate; and (ii) any financial support received.
The Amendments also amended Rule 482 under the Securities Act of 1933 to require disclosure of the risks of the floating NAV requirement and liquidity fees and redemption gates.
Money funds must file a monthly report on Form N-MFP. Form N-MFP is currently not made public until 60 days after the end of the month for which the filing is made. The Amendments will eliminate the 60-day publication delay and require money funds to file additional information, including certain portfolio information, as of the end of each week in the filing month.
Enhanced Diversification Requirements
Grouping of Affiliates
A money fund generally may not invest more than five percent of its assets in any one issuer. Under the Amendments, money funds will be required to aggregate affiliates for purposes of applying this limit. Entities would be “affiliates” if one is controlled by the other or if they are under common control. For this purpose, “control” would be defined as ownership of more than 50% of an entity’s voting securities.
Asset-Backed Securities (ABS) Sponsors
Rule 2a-7 currently requires that a money fund limit its investments in securities subject to demand features or guarantees from any one provider to no more than 10% of the fund’s assets, subject to a 25% basket exception (discussed below). Under the Amendments, a money fund will be required to include the sponsor of a special purposes entity (SPE) that issues asset-backed securities as a guarantor of the ABS, unless the Board or its delegate determines that the fund is not relying on the sponsor’s financial strength or ability to provide support when determining the ABS’s quality or liquidity. Absent such a finding, this restriction limits a money fund to investing no more than 10% of its assets in ABS issued by any one sponsor’s SPEs.
Removal of the 25% Basket
Rule 2a-7 currently provides an exception to the 10% limitation described above, under which 25% of a money fund’s assets may be subject to guarantees or demand features from a single institution (25% basket). The Amendments will eliminate the 25% basket for all money funds except for municipal money funds, for which the 25% basket has been reduced to 15%.
Changes to Form PF
The Amendments change Form PF, the form used by registered investment advisers to report information regarding the private liquidity funds13 they advise. Under the Amendments, certain “large liquidity fund advisers” will be required to file substantially the same information on Form PF that is required to be filed on Form N-MFP.
Enhanced Stress Testing
Under the Amendments, the SEC has enhanced the stress testing requirements. In particular, the Amendments will require a money fund to consider a number of additional, specific factors when determining whether the fund can minimize principal volatility. Additionally, a money fund will be required to test these factors at varying levels of redemptions, and money fund advisers must increase their reporting to money fund Boards to include a summary of the significant assumptions made when performing fund stress tests.
The SEC, noting questions that have arisen regarding the application of certain provisions under Rule 2a-7, adopted a number of amendments to clarify those provisions. These included clarifications to the definition of daily and weekly liquid assets, the definition of demand feature, the treatment of short-term floating rate securities for certain maturity determination purposes, and the treatment of the maturity-shortening provision of Rule 2a-7 for purposes of the limitations on second-tier securities.
The compliance dates for the Amendments are as follows:
- Floating NAV/Liquidity Fees and Gates Requirements: October 14, 2016;
- Adoption of Form N-CR: July 14, 2015; and
- Diversification, Stress Testing, Disclosure, Form PF, Form N-MFP and Clarifying Amendments: April 14, 2016.
Potential Issues Raised by the Amendments to be Considered by Money Fund Boards
General Issues – Updated Compliance Procedures and Systems
The Amendments will necessitate the adoption of new compliance procedures and the implementation of technology systems for compliance with the various new requirements. These compliance systems will add costs that may be borne, directly or indirectly, by the money fund. A Board will have to consider any new compliance procedures and oversee the implementation of new systems of compliance, to make sure that the procedures and systems are reasonably designed to prevent violations of the new requirements.
Issues Raised by the Floating NAV Requirement
Impact on Institutional Money Funds
Under this requirement, institutional money funds must operate with a floating NAV. This will have a dramatic impact on those funds and will have many implications of which a Board should be aware. For example, there may be significantly reduced demand for floating NAV institutional money funds. In addition, under the Amendments, institutional money funds will no longer able to use the amortized cost method to value portfolio securities (except for securities with maturities of 60 days or less). As a result, institutional money funds will need to incorporate changes to, among other things: (i) Rule 2a-7 procedures; (ii) valuation procedures; (iii) arrangements with pricing services; and (iv) intra-day and, potentially, same-day redemption features. New accounting systems also will have to be implemented, including systems that permit the transactions of shares using basis point rounding and that monitor for tax gains/losses and wash sales.14 Boards of institutional money funds will need to consider these potential issues.
Government Money Fund Definition
A Board will need to consider whether a money fund will be able to qualify under the government money fund definition. Currently, a money fund that holds itself out as a “government” fund under Rule 35d-1 is required to invest at least 80% of its net assets (plus borrowings for investment purposes) in government securities. As a result of the Amendments, a Board will need to consider the recommendations of the money fund’s investment adviser as to whether to change the money fund’s principal investment strategies to provide that the fund will invest 99.5% of its assets in cash, government securities and/or repurchase agreements collateralized fully by cash or government securities.
Retail Money Fund Issues
Retail Money Fund Definition. Based on the recommendation of the money fund’s investment adviser, a Board will first need to consider whether the fund will be able to qualify under the retail money fund definition. This will involve implementing policies and procedures reasonably designed to limit all beneficial owners of the fund to natural persons. The Board will then need to oversee the creation and implementation of procedures to enforce the natural person limit, as well as ongoing compliance with any policies and procedures.
Omnibus Account Issues for Retail Money Funds. Many investors hold shares of money funds through omnibus accounts held in the name of a financial intermediary. As a result, most money funds are not able to “look through” those accounts to determine the underlying investors. Retail money funds must implement policies and procedures reasonably designed to allow the conclusion to be drawn that the financial intermediary with an omnibus account will not permit any non-natural persons to be beneficial owners of the fund. The Amendments did not set forth a specific method to address the issues associated with omnibus accounts, but a retail money fund will likely need to put in place procedures that involve requesting certifications and/or entering into agreements with financial intermediaries in order to assist the fund in confirming that only natural persons are beneficial owners.
Fund Reorganizations for Retail Money Funds. If a money fund has both institutional and retail share classes, the fund’s investment adviser may recommend the approval of the reorganization of the fund’s institutional share class into a separate fund in order for the fund to comply with the retail money fund definition. Money fund reorganizations can be costly and complex because of, among other things, the difficulty of soliciting proxies from money fund shareholders. Accordingly, a Board may wish to consider these potential issues when determining whether to approve the reorganization of an institutional share class into a separate fund.
Involuntary Redemptions for Retail Money Funds. If a money fund has institutional and retail shareholders in the same share class, the fund’s investment adviser may recommend the involuntary redemption of all institutional investors, in order for the fund to meet the retail money fund definition. The Adopting Release noted that a money fund should notify investors who become ineligible to invest in the fund, at least 60 days before any redemption occurs.
Issues Raised by Liquidity Fees and Redemption Gates
Under the Amendments, a non-government money fund will be required to impose a 1% liquidity fee on all redemptions when weekly liquid assets fall below 10% of the fund’s total assets, unless the Board determines that imposing such a fee would not be in the fund’s best interests or decides that a lower or higher (up to 2%) fee would be appropriate. The Amendments also will permit a Board to impose liquidity fees or redemption gates when weekly liquid assets fall below 30% of a money fund’s total assets. Board findings relating to both the liquidity fees and redemption gates under the Amendments would have to be approved by the Board as a whole, as well as by a majority of the independent Board members. The “trigger” to impose liquidity fees is based on the level of weekly liquid assets as of the end of a business day. Therefore, Boards may be required to determine on short notice whether to impose liquidity fees.15
The Adopting Release described certain guideposts that Boards may wish to consider in determining whether to impose or lift liquidity fees or redemption gates, including: (i) relevant indicators of market stress and reasons why the money fund’s weekly liquid assets have fallen; (ii) whether the fall in weekly liquid assets is accompanied by a decline in the fund’s shadow NAV (for retail and government funds); (iii) the current and expected liquidity profile of the fund; (iv) the composition of the fund’s shareholder base and historical redemption patterns; and (v) the fund’s experience, if any, with fees and gates.
For imposing or lifting a liquidity fee and/or a redemption gate, a Board’s determinations will involve highly fact-specific considerations. After determining to impose a liquidity fee and/or a redemption gate, a Board may need to meet multiple times during the period when the fees or gates are in effect, in order to monitor their operation and consider whether the fees or gates continue to be appropriate. Also, the SEC expects that the investment adviser to the money fund will provide the Board with all the relevant information it would need to evaluate whether to continue fees or gates. Finally, the events that led to the imposition of a fee or a gate will need to be documented carefully and reported to the SEC in the follow-up Form N-CR filing.
Monitoring of Weekly Liquid Assets and Early Notification and Other Procedures
A Board may wish to consider adopting self-imposed trigger points at which the money fund’s investment adviser would notify the Board (for example, when the fund’s weekly liquid assets fall below 35% of total assets), so that the Board would be prepared to meet immediately and consider all of the relevant facts and circumstances. These early warning triggers could be put in place for both the mandatory 10% threshold for liquidity fees, as well as the discretionary 30% threshold for liquidity fees and redemption gates. Although there is no requirement for a Board to meet once the discretionary 30% threshold has been breached, the Board may wish to adopt policies and procedures that provide that the investment adviser will notify the Board or certain Board members of such occurrence, in order to determine whether a full Board meeting is necessary to consider the imposition of liquidity fees and/or redemption gates.
A Board may also wish to discuss with the investment adviser whether the adviser has in place policies and procedures to monitor and address shareholder concentration and shareholder flows, to reduce the possibility that the money fund breaches the discretionary or mandatory thresholds. A Board could also implement internal investment policies to maintain, under normal market conditions, weekly liquid assets above a particular threshold (such as 40%), in order to reduce the chance that the fund may have to impose liquidity fees and/or redemption gates.
Issues Raised by Other Reforms (including Disclosure, Diversification, Reporting and Stress Testing)
Boards will need to oversee the implementation of policies and procedures to comply with the Amendments’ enhanced disclosure, diversification, reporting, stress testing and other requirements. For example, a Board should oversee the review and potential enhancement of stress testing procedures to make sure such procedures include the specific items required by the Amendments, such as policies the investment adviser has in place to inform the Board of the assumptions the adviser made in conducting these tests. A Board should also ensure that the money fund’s investment adviser or other service provider develops a system to accurately and in a timely manner disclose on the fund’s website or report to the SEC the additional information required by the Amendments.
Overall, the Amendments set forth sweeping changes to money fund regulation, which pose a number of issues for Boards. Over the next several months, Boards should work with their money funds’ investment adviser to develop a plan to address the new requirements before the various compliance periods, taking into consideration the issues presented above.
1) Money Market Fund Reform; Amendments to Form PF, Investment Company Act Release No. 31166 (July 23, 2014) (Adopting Release). For a more detailed discussion of the Adopting Release, please refer to DechertOnPoint, U.S. SEC Approves Sweeping Amendments to Rules Governing Money Market Funds.
2) See Money Market Fund Reform; Amendments to Form PF, Investment Company Act Release No. 30551 (June 5, 2013). For further information regarding the Proposing Release, please refer to DechertOnPoint, SEC Proposes Sweeping Amendments to Rules Governing Money Market Funds.
3) “Government” money funds (as defined in the text) are permitted, but not required, to impose liquidity fees and redemption gates. Any government money fund that chooses to have the authority to impose liquidity fees and redemption gates must disclose this authority in its prospectus and give its shareholders at least 60 days’ notice, before reserving this authority.
4) “Weekly liquid assets” include cash, U.S. Treasury securities, certain other government securities with remaining maturities of 60 days or less and securities that convert into cash within one week.
5) Redemption gates may be imposed for no more than 10 business days at a time within any 90-day period.
6) Such money funds are referred to herein as “institutional money funds,” which include prime money funds and municipal/tax-exempt money funds (municipal money funds) that do not qualify as “retail funds.” As noted in the Adopting Release, the SEC did not specifically exempt municipal money funds from the floating NAV requirement, on the theory that most such funds should be able to qualify under the “retail” money fund definition.
7) This level of precision, “basis point rounding,” is ten times greater than that required for other mutual funds. Under valuation guidance from the SEC, many mutual funds that are not money funds price their shares at an initial NAV of $10 and round their NAV to the nearest penny. See Valuation of Debt Instruments by Money Market Funds and Certain Other Open-End Investment Companies, Investment Company Act Release No. 9786 (May 31, 1977).
8) The Proposing Release would have defined a government money fund by reference to an 80% threshold rather than a 99.5% threshold.
9) In the Proposing Release, a retail money fund would have been defined as a money fund that does not permit any of its shareholders to redeem more than $1 million of redeemable securities in any business day.
10) Under penny-rounding pricing, a money fund’s market-based NAV per share is rounded to the nearest cent on a share price of one dollar.
11) Under the amortized cost method of valuation, portfolio securities are valued by reference to their acquisition cost, as adjusted for amortization of premium or accretion of discount, rather than at their value based on current market factors. Under the Amendments, an institutional money fund may use amortized cost valuation to the same extent that other mutual funds do so – where the fund’s Board determines, in good faith, that the fair value of debt securities with remaining maturities of 60 days or less is their amortized cost, unless particular circumstances (such as the impairment of the creditworthiness of the issuer) warrant otherwise.
12) “Financial support” includes, but is not limited to: (i) a capital contribution; (ii) the purchase of a security from the fund in reliance on Rule 17a-9; (iii) the purchase of a defaulted or devalued security at par; (iv) the execution of a letter of credit or letter of indemnity; (v) a capital support agreement (whether or not the fund ultimately receives support); (vi) a performance guarantee; or (vii) other similar actions reasonably intended to increase or stabilize the value or liquidity of the fund’s portfolio during times of stress.
13) “Private liquidity funds” are similar to money funds but are not registered investment companies.
14) The U.S. Department of Treasury and the Internal Revenue Service have released guidance on relieving sales in shares of floating NAV money funds from the wash sale rules and have published a simplified aggregate accounting procedure for tracking gains and losses in transactions of floating NAV shares. An institutional money fund’s new systems will need to incorporate this simplified aggregate method of accounting for tracking gains and losses.
15) According to the Adopting Release, a Board would be permitted to meet in person, telephonically or through any other technological means by which all Board members could be heard.