U.S. Money Market Fund Reform: Diversification, Stress Testing and Disclosure Compliance Deadline Quickly Approaching; SEC Staff Issues New FAQs
The April 14, 2016 compliance date for certain new money market fund (money funds) requirements adopted by the U.S. Securities and Exchange Commission (SEC) is quickly approaching1. In particular, money funds will be required to:
- Comply with new diversification and stress testing requirements;
- Report new information on their websites; and
- Incorporate new disclosure into their registration statements and advertisements.
Money funds and their advisers should consider updating their policies and procedures, registration statements and advertisements and adopting new systems and controls to address these requirements in advance of the upcoming compliance date. Certain of these changes may need to be approved or ratified by the money fund’s board of directors/trustees (board).
In addition, the SEC Staff recently updated its 2014 Money Market Fund Reform Frequently Asked Questions (FAQs). The updated FAQs include important guidance for money funds and their advisers.
This OnPoint provides an overview of the new requirements that have an April 14, 2016 compliance date, as well as the updated FAQs. The compliance date for the remaining new money fund requirements adopted by the SEC – namely, liquidity fees, redemption gates, floating net asset value (NAV) and retail eligibility – is October 14, 2016. Money funds and their advisers should consider whether changes to any agreements with intermediaries are necessary to incorporate the requirements with an October 14, 2016 compliance date.
April 14, 2016 Compliance Date Requirements
Rule 2a-7 under the Investment Company Act of 1940 (1940 Act) currently requires that money fund portfolios be diversified as to the issuers of securities they own, as well as to any guarantors and demand feature providers related to those securities. The amendments to Rule 2a-7 (Amendments) include changes to these diversification provisions of Rule 2a-7.
Grouping of Affiliates for 5% Issuer Diversification Limitation
Under Rule 2a-7, a money fund generally may not invest more than 5% of its total assets in a single issuer. The Amendments will require a money fund to aggregate affiliates of issuers for purposes of applying this 5% issuer diversification limit. Under the Amendments, entities will be “affiliates” if one is controlled by the other or they are under common control. For this purpose only, “control” is defined to mean ownership of more than 50% of an entity’s voting securities.
Sponsor of Asset-Backed Securities as Guarantor
Currently, Rule 2a-7 requires that a money fund limit its investments in securities subject to demand features or guarantees from any one institution to no more than 10% of the fund’s assets. The Amendments will require that a money fund include the sponsor of a special purpose entity that issues asset-backed securities (ABS) as a guarantor for purposes of diversification calculations. Under the Amendments, there will be an exemption from this requirement if the money fund’s board (or its delegate) finds that the fund is not relying on the ABS sponsor’s financial strength or ability to provide support, when determining the quality or liquidity of the ABS.
Removal of the 25% Basket
Prior to the Amendments, Rule 2a-7 provided an exception to the general limitation that a money fund not invest more than 10% of its total assets in demand features and guarantees issued by any one institution, allowing up to 25% of a fund’s total assets to be subject to guarantees or demand features from a single institution (25% basket). The Amendments will eliminate this 25% basket for taxable money funds, although tax-exempt money funds will have a 15% basket.
The Amendments will enhance stress testing requirements. Specifically, effective April 14, 2016, money funds will be required to periodically test their ability: (1) to have invested at least 10% of their total assets in weekly liquid assets; (2) to minimize principal volatility; and (3) for stable NAV money funds, to maintain a stable NAV per share,2 based upon certain hypothetical events.3 In addition, money funds will be required to test their ability to maintain these conditions not only in response to such hypothetical events, but also in combination with various levels of shareholder redemptions.
Money fund advisers also will be required to include additional information in the stress testing reports to money fund boards, including: (1) a summary of the significant assumptions made when performing the stress tests; (2) various assessments of a money fund’s ability to withstand certain hypothetical events; and (3) any such other information as may be reasonably necessary for a money fund’s board to evaluate the stress tests and the results of such tests.
The Amendments will require a money fund to “prominently” disclose on its website the following information as of the end of each business day during the preceding six months: (1) the percentage of total assets invested in daily liquid assets and weekly liquid assets; (2) the daily net inflows and outflows; and (3) the current NAV per share rounded to four decimal places. This information, which would include fund data from the six-month period preceding the compliance date (i.e., information for the period commencing October 14, 2015), must be presented in the form of a schedule, chart, graph or other depiction. The Amendments also will: (1) revise the categories of investments that are currently required to be reported on a money fund’s website; and (2) require that money funds disclose certain events on their website, which money funds must also report on Form N-CR (e.g., when the money funds receives financial support from its sponsor or other fund affiliate).
Registration Statement and Advertisement Risk Disclosure
Money funds will be required to include a mandated paragraph-long risk disclosure in their prospectus summary section and sales materials, which discloses the following: (1) investors may lose money by investing in a money fund; (2) the fund cannot guarantee to preserve the value of a share at $1.00 (or, in the case of institutional money funds, that the share price will fluctuate); (3) the fund may impose redemption fees and gates (unless it is a government money fund that has not elected the ability to use fees and gates); (4) the fund is not guaranteed by the Federal Deposit Insurance Corporation; and (5) the fund’s sponsor has no legal obligation to, and should not be expected to, provide financial support to the fund at any time.4
Money funds also will be required to disclose in their Statements of Additional Information historical instances (within the past 10 years, but not before the compliance date of the Amendments) of (1) imposing liquidity fees and redemption gates5; and (2) financial support provided by an affiliate, promoter or principal underwriter (or an affiliated person of such person).6 Money funds will also be required to disclose in their SAIs certain information that is required to be disclosed on new Form N-CR.7
The compliance date for the new disclosure requirements that relate to liquidity fees, redemption gates and floating NAV is October 14, 2016, unless a money fund chooses to comply earlier.
The Amendments also will codify a number of revisions to clarify certain provisions of Rule 2a-7. The Amendments revise the definitions of daily liquid assets and weekly liquid assets to make clear that money funds: (1) cannot use the maturity-shortening provisions of Rule 2a-7 regarding interest rate readjustments when determining whether a security satisfies the maturity requirements of a daily liquid asset or a weekly liquid asset; and (2) can include in the definitions of daily liquid assets and weekly liquid assets amounts receivable that are due unconditionally within one or five business days, respectively, pending sales of portfolio securities. In addition, the Amendments will eliminate the 30-day notice requirement for a demand feature, as well as redefine a demand feature to be a feature permitting the holder of a security to sell the security at an exercise price equal to the approximate amortized cost of the security plus interest, if any, at the time of exercise, paid within 397 calendar days of exercise. The Amendments also will provide that, for the purposes of determining weighted average life, a short-term floating rate security that is subject to a demand feature shall have a maturity equal to the period remaining until the principal amount of the security can be recovered through demand. Further, the Amendments will revise Rule 2a-7 to state that the 45-day maturity limit applicable to second tier securities must be determined without reference to the maturity-shortening provision of Rule 2a-7 regarding interest rate readjustments.
Possible Changes to Policies and Procedures and Possible Supplements to Money Fund Registration Statements
In light of the rapidly-approaching April 14, 2016 compliance date, a money fund and its adviser should consider updating existing policies and procedures (or developing new policies and procedures) to ensure that the fund has updated its diversification and stress testing requirements, revised its website disclosure policies and implemented the various clarifying amendments to Rule 2a-7. Changes to existing policies and procedures (or new policies and procedures) may need to be approved or ratified by the money fund’s board. In addition, with respect to the new registration statement disclosure requirements, money funds may need to amend or supplement their disclosure documents to incorporate the new disclosure requirements prior to April 14, 2016.
Updated Money Fund FAQs from the SEC
On January 13, 2016, the SEC Staff updated the FAQs that it originally released on April 22, 2015.8 Among the revisions made to the FAQs were the addition of questions regarding reverse stock splits, private money funds, multi-class money funds and government money funds.
Regarding reverse stock splits, the Staff stated that a money fund that engages in a reverse stock split to reduce a deviation of at least ¼ of 1% from its intended stable price per share, must report this deviation on Form N-CR (calculated as if the reverse stock split had not occurred), since the fund would have experienced the deviation without engaging in the reverse stock split. The Staff also stated that a private money fund, in which registered investment companies invest in reliance on Rule 12d1-1 under the 1940 Act, must comply with the requirements of Form N-CR. Although the EDGAR system is not able to accept electronic Form N-CR filings on behalf of private money funds, the Staff indicated that such a private money fund should instead submit a paper copy to the SEC, as well as email a PDF copy to the Director of Investment Management (or the Director’s designee) on the same date the paper filing was postmarked.
With respect to the website disclosure requirements of Rule 2a-7, the Staff stated that a multi-class money fund may disclose its NAV per share separately for each class, rather than the NAV per share of the fund as a whole. Finally, the Staff noted that, notwithstanding the requirements of Rule 2a-7, a government money fund also must comply with Rule 35d-1 under the 1940 Act and adopt a policy to invest at least 80% of its net assets in the particular type of investments suggested by the fund’s name (e.g., for a money fund that includes the term “government” in its name, the 80% test would include government securities and repurchase agreements that are collateralized by government securities). The Staff noted that, although the 99.5% test under Rule 2a-79 is more stringent in some respects than the 80% test under Rule 35d-1, the 99.5% test permits a broader range of investments than just “government securities” (for example, it includes cash).
Compliance with the Amendments may involve revisions and additions to money fund policies and procedures, some of which may entail board consideration and approval. Therefore, it is important that money funds and their advisers plan in a timely manner for the relevant changes to the funds’ operations relating to diversification, stress testing and disclosure.
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 new requirements, please refer to Dechert OnPoint, US SEC Approves Sweeping Amendments to Rules Governing Money Market Funds, Dechert OnPoint, US SEC Approves Amendments to Rules Governing Money Market Funds: Implications for Boards and Dechert OnPoint, US Money Market Fund Reform: Form N-CR and Related Website Disclosure Compliance Deadline Quickly Approaching.
2) Following October 14, 2016, this stress testing requirement will only apply to money funds that are “retail” or “government” money funds that maintain a stable share price.
3) These hypothetical events will need to include: (1) increases in general level of short-term interest rates; (2) a downgrade or default of particular security positions, each representing various portions of a money fund’s portfolio (with varying assumptions about the resulting loss in the value of the security); (3) a widening of spreads compared to the indexes to which portfolio securities are tied, in various sectors in a money fund’s portfolio (in which a sector is a logically related subset of portfolio securities, such as securities of issuers in similar or related industries or geographic region or securities of a similar security type); and (4) any additional combination of events a money fund’s board (or its delegate) deems relevant.
4) The language of this mandated disclosure is set forth in Item 4 of Form N-1A and Rule 482 under the Securities Act of 1933, as amended.
5) This disclosure includes any occasion on which: (1) the fund’s weekly liquid assets have fallen below 10%, and with respect to each such occasion, whether the fund’s board determined to impose a fee or gate; or (2) the fund’s weekly liquid assets have fallen below 30% (but not less than 10%) and the board determined to impose a fee or gate. With respect to each such occasion, the Amendments require a money fund to disclose: (1) the dates and length of time for which the fund’s weekly liquid assets remained below 10% (or 30%, as applicable); (2) the dates and length of time for which the board determined to impose a fee or gate; and (3) the size of any fee imposed.
6) This disclosure includes: (1) the nature, date and amount of support; (2) the person providing the support and its relationship with the fund; and (3) the security supported and its value on the date the support began. The term “financial support” is defined to include any: (1) capital contribution; (2) purchase of a security from the fund in reliance on Rule 17a-9 under the 1940 Act; (3) purchase of any defaulted or devalued security at par; (4) execution of letter of credit or letter of indemnity for the benefit of the fund; (5) capital support agreement (whether or not the fund ultimately received support); (6) performance guarantee; or (7) similar action reasonably intended to increase or stabilize the value or liquidity of the fund’s portfolio. The definition excludes any: (1) routine waiver of fees or reimbursement of fund expenses; (2) routine inter-fund lending; (3) routine inter-fund purchases of fund shares; or (4) action that would qualify as financial support as defined above, that the board has otherwise determined not to be reasonably intended to increase or stabilize the value or liquidity of the fund’s portfolio.
7) The Adopting Release lists the types of information included on Form N-CR, which money funds will be required to disclose in their SAIs.
8) 2014 Money Market Fund Reform Frequently Asked Questions, Division of Investment Management (Revised January 13, 2016). For a more detailed discussion of the FAQs, please refer to Dechert OnPoint, SEC Staff Issues Money Market Fund Reform Frequently Asked Questions.
9) Rule 2a 7(a)(16) defines a “government money market fund” to mean a money fund that invests 99.5% or more of its total assets in cash, government securities and/or repurchase agreements that are fully collateralized by cash or government securities.