On June 5, 2013, the Securities and Exchange Commission ("SEC") unanimously approved, and distributed for public comment, a proposal that sets forth two proposed alternative frameworks for additional regulation of money market funds. In doing so, the SEC stated that its goal was to: (i) preserve the ability of money market funds to function as effective and efficient cash management tools for investors, (ii) provide funds with better tools to manage and mitigate potential contagion from high levels of redemptions, and (iii) increase the transparency of their risks.1 These proposals would either:
A. divide the money market fund world into two camps; one the "Institutional Fund" camp and two the "Retail and Government Fund" camp. Under this alternative, Institutional Funds would be required to "float" their per share net asset value ("NAV") whereas Retail and Government Funds would be permitted to maintain a stable NAV, or
B. continue to permit all money market funds to maintain a stable NAV but require that all money market funds (except government money market funds) impose a liquidity fee of 2% on all redemptions made after a fund’s weekly liquid assets2 falls below 15% of its total assets (unless the fund’s board specifically determines otherwise). Under this second proposal, if a fund crosses this 15% threshold, the fund’s board would also have the ability to temporarily suspend redemptions (or "gate" the fund) for a limited period.
The Proposing Release also considers and asks for comment on whether a combination of these alternatives would be appropriate.
In addition, the Proposing Release includes a number of other amendments that would apply under either alternative intended to enhance the safety of money market funds and the disclosure of the risks of money market funds to investors. Certain of these proposals may vary depending on the alternative adopted (if any). These other amendments include: (i) stronger diversification limits, (ii) amendments to the stress testing requirements of Rule 2a-7, (iii) additional disclosure requirements for money market funds, (iv) a new current event reporting form that would require funds to make immediate public disclosure of certain events, (v) amendments to Form N-MFP, and (vi) amendments to Form PF for investment advisers for certain private liquidity funds.3
The proposed rules are subject to a 90-day comment period. We review these proposals and each alternative in more detail below.
I. Alternative One: Floating Net Asset Value ("NAV")
Under alternative one, money market funds are to be defined as either "Institutional Funds" or "Retail and Government Funds." Under the proposed definitions, a "Retail Fund" would be a money market fund that limits each shareholder’s redemptions to no more than $1 million per business day.4 A "Government Fund" would be a money market fund that invests at least 80% of its assets in cash, US government securities, or repurchase agreements collateralized by US government securities.5 "Institutional Funds" are any funds that are not Retail or Government Funds. Under this proposal, Institutional Funds would no longer be able to maintain a stable NAV. Such funds would be required to have their NAVs fluctuate along with changes in the value of their underlying portfolio holdings based on current market factors ("float").
The proposal would also amend Rule 2a-7’s provisions relating to the use, by all funds, of the amortized cost method and penny-rounding method of valuing their portfolios.6 Institutional Funds would no longer be able to use either the amortized cost method or penny-rounding method to value their portfolios and, as a result, would no longer be able to maintain a stable NAV. Institutional funds would, however, continue to be subject to the risk-limiting provisions of Rule 2a-7, requiring them to invest in short-term, high-quality, dollar-denominated instruments in order to hold themselves out as money market funds. The proposal would also require a specific bulleted statement, to the effect that the Fund does not maintain a stable NAV, to be provided by an Institutional Fund on its website, all advertising materials, and in its summary prospectus (if utilized) and statutory prospectus. Such disclosure would also emphasize that sponsors are not obligated to provide financial support to the fund.7
Institutional Funds would be required to price their shares at the fourth decimal place (i.e., $1.0000 for a fund with a $1.00 target price), which would increase the ability for investors to observe the sensitivity of a fund’s share price to changes in the market value of its portfolio holdings.
Retail and Government Funds would be permitted to continue to maintain a stable NAV but would no longer be permitted to use the amortized cost method of valuation (they would be required to use the penny-rounding method). While currently almost all money market funds use both amortized cost valuation and penny-rounding pricing together to maintain a stable NAV, either method alone effectively provides the same 50 basis points of deviation from a fund’s shadow price before the fund "breaks the buck." For those money market funds that currently have both investor and institutional classes, if the fund wants to be able to utilize a stable NAV for retail investors, the investment adviser will need to create a separate Institutional Fund and reorganize the institutional class shareholders into that new Institutional Fund.
The Proposing Release also includes a requirement that all money market funds disclose their market price on a daily basis (see "Amendments to Disclosure Requirements" below). As a result, all money market funds will have to value their portfolio holdings using market factors instead of amortized cost on a daily basis. The proposal would also require a specific bulleted statement to be provided by a Retail and Government Fund on its website, all advertising materials, and in its summary prospectus (if utilized) and statutory prospectus. Such disclosure would emphasize that sponsors are not obligated to provide financial support to the fund.8
Issues Relating to Daily Redemptions Limits: Retail Funds will have to ensure that adequate disclosure is contained in their prospectus and advertising materials to make clear that those funds are intended for retail investors and to inform shareholders of the $1 million daily redemption limits.9 If a particular shareholder holds multiple accounts within a retail money market fund, the fund will be required to match such accounts where there is reasonably available identifying information at the fund or its transfer agent to apply the $1 million daily redemption limit on the shareholder’s total daily redemptions.
The Proposing Release also discusses other issues that may arise with respect to applying the daily redemption limit to omnibus accounts. A Retail Fund would either have to require that intermediaries with omnibus accounts provide greater transparency regarding underlying shareholders, require that the fund arrange for the intermediary to carry out the fund’s policies and impose the redemption limit, or require the fund to impose the $1 million daily redemption limit on the omnibus account as a whole. The SEC notes that the challenges of implementing fund policies through omnibus accounts would not be unique to this situation as funds already rely on intermediaries to collect redemption fees and for compliance with other fund policies.
Other Issues: The SEC proposal also addresses tax and accounting considerations of implementing a floating NAV because Institutional Fund transactions will no longer be taking place at $1.00 per share. A floating NAV will require both Institutional Funds and shareholders to track all purchases and sales for the reporting of capital gains and losses. The Proposing Release notes that SEC staff has had discussions with IRS and Treasury Department staff who are considering modifications to certain tax forms as well as some de minimis relief from the "wash sale" rules as they would relate to Institutional Funds.
Lastly, under alternative one, the SEC requests comment on whether new terminology should be required in money market fund names to reduce investor confusion that might result from some money market funds using a floating NAV while others maintain a stable price.
II. Alternative Two: Liquidity Fees and Redemption Gates
Under alternative two, the SEC is proposing to allow all money market funds to continue transacting at a stable NAV. Under this proposal, all funds, other than Government Funds, would be required to impose a liquidity fee in certain circumstances and would be allowed to impose redemption limitations ("gates") in certain circumstances.10 A liquidity fee would be imposed in circumstances where a money market fund’s weekly liquid assets fell below 15% of its total assets ("liquidity threshold"). The amount of the liquidity fee would be 2% on all redemptions made beginning the next business day after the liquidity threshold is meet, unless the fund’s board, including a majority of the independent directors, determines that imposing such a fee would not be in the fund’s best interest. The board may also determine that a lower fee would be in the best interest of the fund. Any liquidity fee would be lifted automatically once the fund’s weekly liquid assets were at or above 30% of its total assets and it could be changed or lifted at any time by the board of directors, including a majority of the independent directors. In addition, if a fund’s weekly liquid assets fell below the liquidity threshold, the fund’s board would have the ability to impose a temporary suspension on redemptions (or "gate") for a limited period of time, if they determined that it would be in the fund’s best interest. The gate would also be automatically lifted once the fund’s weekly liquid assets rose to or above 30% of its total assets or if the board of directors, including a majority of independent directors, determined to lift it. Any fund that imposes a gate would be required to lift the gate within thirty days and a fund could not impose a gate for more than thirty days in any ninety-day period.11
Under this alternative, as in Alternative One, money market funds would continue to be allowed to use penny-rounding pricing but would no longer be able to use amortized cost valuation.
This alternative would place substantial new responsibilities on independent directors of money market funds. The boards’ analysis and determinations with respect to imposing or not imposing a liquidity fee and/or gate will be publicly disclosed on new Form N-CR (see "New Form N-CR" below). The SEC notes that establishing thresholds that result in the imposition of a liquidity fee, unless the board makes a finding otherwise, gives some guidance to boards as to when a fee or a gate might be appropriate. However, at the same time, it allows boards to not impose the liquidity fee or gate if it would be inappropriate given the nature and circumstances of the particular fund and the market conditions.
Certain factors that the SEC states a board may want to consider in determining whether to impose the liquidity fee once weekly liquid assets have fallen below the liquidity threshold include:
- Why have weekly liquid assets fallen – are there heavy redemptions during a time of market stress or did a few large shareholders unexpectedly redeem for reasons unrelated to the market conditions?
- Has the fund’s shadow price also fallen?
- Is the fall in weekly liquid assets likely to be cured within a day or two when other securities will qualify or is this likely to be a long-term situation?
Certain factors that the SEC states a board may want to consider in determining whether to impose a smaller liquidity fee include:
- The current shadow price of the fund
- Relevant market indicators of liquidity stress in the markets
- Changes in spreads for portfolio holdings
- Changes in the liquidity profile of the fund in response to redemptions
Additional disclosure requirements would be required in money market fund prospectuses and advertising materials to make shareholders are aware of the possibility of liquidity fees and gates. Form N-1A would also be amended to require that money market funds disclose in their statement of additional information any time in the last ten years (although not before the compliance period) where the fund’s weekly liquid assets have fallen below the liquidity threshold, and whether the board imposed a liquidity fee and/or suspended redemptions, as well as other information.
III. Stronger Diversification Requirements and Enhanced Stress Testing
Diversification Requirement - Currently, money market funds are required to limit their investment in any one issuer of a first tier security (other than government securities) to no more than 5% of fund assets; investments in securities subject are to a demand feature or guarantee of no more than 10% of fund assets from any one provider, except that there is a so-called "twenty-five percent basket" under which as much as 25% of the value of securities held in a fund may be subject to guarantees or demand features from a single institution. The SEC is proposing stronger diversification requirements to further reduce money market fund risk exposure.
- Require money market funds to treat certain entities that are affiliated with one another as single issuers when applying the 5% issuer diversification test. Under this proposed amendment, issuers would be deemed affiliates for this purpose if one entity controls the other entity or is controlled by it or under common control with it.12
- Require money market funds to treat sponsors of asset-backed securities as guarantors, subject to the 10% diversification rule, unless the fund’s board makes certain findings. Under this proposed amendment, subject to an exception, money market funds investing in asset-backed securities may rely on the asset-backed securities’ sponsors’ financial strength or their ability or willingness to provide liquidity, credit, or other support to the asset-backed security. Subject to the exception, the amendments would require funds to treat the sponsor as a guarantor of the asset-backed security, subject to the 10% diversification limitation applicable to guarantors and demand feature providers. However, an asset-backed security sponsor would not be deemed to guarantee the asset-backed security if the fund’s board of directors (or their delegate) determines that the fund is not relying on the sponsor’s financial strength or its ability or willingness to provide liquidity, credit, or other support to determine the asset-backed securities’ quality or liquidity. The SEC notes that they believe the additional burden to make this determination would be minimal since the fund would have already performed its credit analysis of the security.
- Remove the twenty-five percent basket. The SEC is also proposing to eliminate the twenty-five percent basket, under which as much as 25% of a money market fund’s assets may be subject to guarantees or demand features from a single institution.
Enhanced Stress Testing - The Proposing Release also proposes certain amendments to enhance the stress testing requirements adopted in 2010. The amendments would be identical under the adoption of either alternative being proposed, except that floating NAV money market funds would not have to test against preserving a stable share price.
- Stress Testing under the Floating NAV Alternative. Although the floating NAV for Institutional Funds may mitigate heavy shareholder redemptions in times of financial crisis, it will not eliminate the possibility of such redemptions. Therefore, the SEC believes that stress testing is still important for the fund’s board to understand the risks of liquidity for these funds. The stress testing requirements would be amended to require that Institutional Funds test the impact of certain conditions on liquidity rather than on the ability to maintain a stable share price. Specifically, Institutional Funds would need to test their ability to prevent weekly liquid assets from falling below the liquidity threshold. For Retail and Government Funds, the stress tests would need to be run on both the fund’s ability to prevent weekly liquid assets from falling below the liquidity threshold and on its ability to maintain a stable share price. Additionally, the proposal would require stress testing procedures to include testing of various combinations of events.
- Stress Testing under the Liquidity Fees and Gates Alternative. The proposed amendments would require that stress tests would need to be run on both the fund’s ability to prevent weekly liquid assets from falling below 15% of the fund’s assets and on its ability to maintain a stable share price, as well as the other amendments described under the floating NAV alternative.
IV. Amendments to Disclosure Requirements
The Proposing Release includes certain additional disclosure requirements discussed below.
Amendments to Form N-1A and Rule 2a-7 – The proposal would require additional disclosure in money market fund registration statements and on their websites about: (i) any type of financial support provided by the fund’s sponsor or an affiliated person of the fund; (ii) the fund’s daily and weekly liquidity levels, and (iii) the fund’s daily current NAV per share rounded to the fourth decimal place in the case of a fund with a $1.0000 per share price or an equivalent level of accuracy for funds with a different share price (i.e., $10.000 or $100.00 per share). The SEC is also considering more frequent disclosure of portfolio holdings.
New Form N-CR-The Proposing Release proposes new rule 30b1-8 under the Investment Company Act of 1940, which would require money market funds to file new Form N-CR with the SEC when certain events occur. This proposed rule could be adopted with either reform alternative although the Form N-CR would differ depending on the alternative adopted. Form N-CR would be filed with the SEC on EDGAR and be publicly available immediately upon filing.
- Proposed Form N-CR Disclosure Requirements under Either Reform Alternative.
Money market funds would be required to file Form N-CR if any of the following events occur:
- the issuer of one or more of the fund’s portfolio securities, or the issuer of a demand feature or guarantee, experiences a default or event of insolvency (other than an immaterial default unrelated to the financial condition of the issuer), and immediately before the default or event of insolvency the portfolio security (or the security subject to the demand feature or guarantee) accounted for at least ½ of 1% of the fund’s total assets.13 Form N-CR would require certain information about these events, including the nature and financial effect of the default or event of insolvency, as well as the security affected. Funds would be required to file Form N-CR disclosing these events within one business day after the occurrence of the event.
- the money market fund receives financial support from a sponsor or other fund affiliate which includes, but is not limited to, any capital contribution, purchase of a security from the fund in reliance on Rule 17a-9 of the Investment Company Act of 1940 ("Rule 17a-9"), purchase of a defaulted or devalued security at par, purchase of fund shares, execution of a letter of credit or letter of indemnity, a capital support agreement (whether or not the fund ultimately receives support), performance guarantee, or any other similar action to increase the value of the fund’s portfolio or otherwise support the fund during times of stress. The money market fund would be required to disclose on Form N-CR the nature, amount and terms of the support, as well as the relationship between the person providing the support and the fund. Funds would be required to file Form N-CR disclosing such support within one business day after a fund receives financial support.14
- if the money market fund is permitted to transact at a stable NAV and its current NAV (rounded to the fourth decimal place) deviates downwards ¼ of 1%, (or falls below $0.9975) the fund would have to file Form N-CR within one business day of the deviation. If the floating NAV alternative is adopted, then this scenario would only apply to Retail and Government funds, whereas if the liquidity fees and gates alternative is adopted, this scenario would apply to all money market funds.
- Additional Disclosure Requirements under the Liquidity Fees and Gates Alternative.
If a money market fund reaches the threshold triggering board consideration of a liquidity fee or redemption gate, then Form N-CR would have to be filed to describe the fund’s response, including a short discussion of the board of directors’ analysis supporting its decision that imposing a liquidity fee or not imposing a liquidity fee would be in the best interests of the fund as well as any decision to suspend the fund’s redemptions. Additionally, the fund would have to file Form N-CR when the board lifts the liquidity fee or resumes redemptions of fund shares. An initial report on Form N-CR would have to be filed on the first business day following any occasion when the fund’s weekly liquid assets falls below the liquidity threshold, the fund’s board imposes (or removes) a liquidity fee, or the fund’s board temporarily suspends (or resumes) the fund’s redemptions. An amendment to the initial report on Form N-CR would have to be filed by the fourth business day following any of these events to provide additional detailed information about the event, specifically a description of the facts and circumstances leading up to the event as well as a discussion of the board’s analysis supporting its decision with respect to the imposition of a liquidity fee or gate.
Amendments to Form N-MFP Reporting Requirements. Currently, money market funds must file Form N-MFP with the SEC on EDGAR within five business days after the end of each month. The Proposing Release proposes amendments to Form N-MFP to not only reflect the proposed amendments to Rule 2a-7, but also to make other improvements based on the use of the Form for the past two and a half years. While currently Form N-MFP is not publicly available for 60 days after filing, the SEC is proposing to make the Form publicly available immediately after filing.
The proposed amendments to Form N-MFP are generally designed to assist the SEC better identify certain risk characteristics that the Form currently does not capture. These amendments would require, among other things, that funds report the amount of cash they hold, their daily liquid assets and weekly liquid assets (on a weekly basis), their weekly gross subscriptions and redemptions for each share class, whether any person paid for or waived all or part of the fund’s operating expenses or management fees, and the total percentage of shares outstanding held by the largest twenty shareholders of record.
Amendments to Form PF Reporting Requirements. The SEC is also proposing to amend Form PF, which certain SEC-registered investment advisers use to report information regarding the private funds they manage, including liquidity funds (private funds that seek to maintain a stable NAV). The proposal would require large liquidity fund advisers (registered advisers with $1 billion or more in combined money market fund and liquidity fund assets) to file virtually the same information with respect to their liquidity funds’ portfolio holdings on Form PF that Rule 2a-7 money market funds are required to file on Form N-MFP. This information would have to be filed on a quarterly basis. The investment advisers would also have to identify any Rule 2a-7 money market fund advised by the adviser or its related persons that pursues substantially the same investment objective and strategy and invests side-by-side in substantially the same positions as the liquidity fund being reported on Form PF.
The SEC anticipates proposing a compliance date of two years for the floating NAV alternative, one year for the liquidity fees and gates alternative, and nine months for all other proposed amendments that are not specifically related to the implementation of either alternative.