Last month, the Securities and Exchange Commission (SEC) proposed long awaited rule amendments to regulations that govern money market funds. The SEC proposals are designed to lessen money market funds’ susceptibility to heavy redemptions, improve the ability of money market funds to manage and mitigate potential contagion from high levels of redemptions and increase for investors the transparency of risks associated with money market funds. At the same time, the proposals are designed to preserve to some extent the current benefits of the stable net asset value of money market fund shares.
The SEC unanimously approved two alternatives:
- Prime institutional market money funds would be required to have a floating net asset value (NAV); or
- All money market funds would be permitted to maintain a stable NAV but the funds could impose liquidity fees and/or redemption gates under certain distressed market conditions.
Either proposal or a combination of these proposals could be approved by the SEC. Each proposal, and in particular proposal 2, if adopted, would require significant involvement by a fund’s board of directors. Moreover, each of the proposals will add significant costs to money market funds, which fund boards will need to consider in making strategic decisions for their funds. This Alert focuses on the board’s role in the SEC’s proposed money market reform.
I. Alternative Proposal 1 - Floating NAV for Prime Institutional Money Market Funds
Background on Proposal 1. The SEC proposes that all “prime” institutional money market funds (i.e., funds other than government and retail money market funds as defined in the SEC release) have a floating NAV. If this proposal is adopted, prime institutional money market funds would sell and redeem shares at NAVs that would fluctuate with changes in the market value of their portfolio securities. Moreover, these funds would not be permitted to use the amortized cost basis to value their portfolio securities and would instead be required to calculate their NAVs to the fourth decimal point ($1.0000). Debt securities with remaining maturities of 60 days or less, however, may continue to be priced at amortized cost where the fund’s board of directors has determined, in good faith, that the securities’ fair value is their amortized cost (good faith determination).
Under proposal 1, government and retail money market funds would not be required to have floating NAVs. Government and retail funds would be permitted to continue to use the penny rounding method, but not the amortized cost method, to value their portfolio securities, except for debt securities with remaining maturities of 60 days or less for which the board has made the good faith determination. “Government funds” are defined under the proposal as those money market funds that maintain at least 80% of their total assets in cash, government securities or repurchase agreements that are collateralized fully. Funds that invest in state and municipal securities would not be considered to be government funds.
A “retail fund” is defined under proposal 1 as a money market fund that does not permit a shareholder to redeem more than $1 million in a single business day (referred to below as a redemption cap). The proposal raises certain questions as to how the redemption cap would be enforced with respect to omnibus accounts in which the funds have no transparency to the individual shareholders. A fund would not be required to enforce the redemption cap with respect to omnibus record account shareholders if the fund has policies and procedures in place reasonably designed to conclude that an omnibus account holder who is the shareholder of record does not permit any beneficial owner in the omnibus account to directly or indirectly (e.g., through chains of intermediaries) to redeem more than permitted by the redemption cap.
Board’s Role. The distinction between retail and institutional funds under proposal 1 would create a number of issues for funds and would need significant involvement and oversight by a money market fund’s board of directors. First, retail fund boards would be required to adopt a redemption policy and related policies and procedures with respect to omnibus account holders and the redemption cap. The SEC proposal does not require that a fund enter into specific agreements with omnibus account intermediaries, but permits the board of a retail fund to determine the method for compliance that would be best suited for the fund. However, boards of retail funds will be required to monitor compliance with the redemption cap and approve policies and procedures to address implications of any non-compliance. The retail exemption is predicated on a fund’s policies and procedures being reasonably designed to allow the conclusion that the fund’s redemption cap is applied to beneficial owners all the way down any chain of intermediaries. The SEC’s release acknowledges that transparency down to individual shareholders within omnibus accounts for purposes of monitoring the redemption cap will be a challenge for boards to monitor. And it is questionable whether omnibus intermediaries will accept liability for monitoring redemptions unless obligated to do so by the SEC.
Second, significant changes in prospectus and other disclosure will be needed to effectuate proposal 1. The board would be responsible for overseeing the disclosure changes and monitoring ongoing disclosure for compliance with applicable law.
Third, a board may need to consider whether to restructure certain money market funds. This is because a fund that has both institutional and retail shareholders, even if in different share classes, will be unable to rely on the retail exemption unless the redemption cap is applicable to all shareholders, including institutional shareholders. This may not be feasible, and the board may need to determine whether to reorganize the fund into separate funds for retail and institutional shareholders.
Fourth, boards would need to oversee the technology and operational changes needed to implement proposal 1. This duty would extend to considering whether appropriately trained personnel were available to make these changes.
Finally, boards may also need to weigh fund costs under proposal 1 to determine whether to continue to offer money market funds. Money funds have experienced considerable economic pressure during the low interest rate environment since 2007, and this proposal will impose significantly more costs on already struggling funds and their advisers. The costs associated with this proposal include but are not limited to:
- extensive new prospectus, advertising and website disclosures regarding liquidity fees, redemption caps, pricing, tax ramifications, operational issues, etc.;
- conversions of systems to the four decimal place system of pricing;
- potential fund reorganizations and shareholder meeting costs, which can be quite costly with respect to money market funds;
- technological changes required to comply with tax reporting requirements, including identifying wash sale transactions and tracking security gains and losses and basis reporting to shareholders; and
- operational changes necessary to process transactions on a continuous basis at floating NAVs.
The substantial increase in fund costs resulting from proposal 1 will need to be considered by boards and advisers. For some funds, liquidations or mergers may be a more viable strategic alternative than operating under this proposal.
II. Alternative Proposal 2 – Standby Liquidity Fees and Gates
Background on Proposal 2. Under proposal 2, the SEC would permit all money market funds (including retail funds) to continue to price their shares at a stable NAV but would provide for the following (except for government funds):
- Liquidity fees. If a money market fund’s weekly liquid assets (as defined below) fall at the end of a business day below 15% of its total assets, the fund would be required to impose a liquidity fee of 2% of the value of the shares redeemed, effective as of the beginning of the next business day, on all redemptions unless the fund’s board of directors (including a majority of its independent directors) determine that (1) imposing a redemption fee is not in the best interest of the fund, or (2) a lower fee is in the best interest of the fund. Government funds would be not be required to impose liquidity fees but would be permitted to do so. “Weekly liquid assets” are defined as cash, direct obligations of the U.S. Government, certain other government securities with remaining maturities of 60 days or less and certain other short-term instruments.
- Redemption gates. If a money market fund’s weekly liquid assets fall below 15% of its total assets, the board of the money market fund would be permitted to temporarily suspend redemptions (or gate) for a limited period of time if the board (including a majority of independent directors) determines that doing so is in the fund’s best interest. All money market funds (including government funds) would be permitted to impose redemption gates.
If a fund’s weekly liquid assets fell below 15% of its total assets, a fund’s board could determine that the imposition of a 2% liquidity fee would not be in the fund’s best interest. In that case, the fund could impose a lower fee or no fee. The SEC’s proposing release identified certain factors a board may want consider in making a determination with respect to liquidity fees. These factors include the following:
- the reason for the fall in weekly liquid assets;
- whether the fund’s shadow price also has fallen; and/or
- whether the fall in weekly liquid assets is likely to be short-term.
On the other hand, if the fund’s board determines that the liquidity fee is insufficient to protect the interests of non-redeeming shareholders, the fund could temporarily suspend redemptions.
A liquidity fee would automatically be lifted if a fund’s level of weekly liquid assets rises to or above 30%, and it would lifted at any time by the board if the board determines (1) to impose a different fee, or (2) the fee is no longer in the best interest of the fund. Any redemption gate would automatically be lifted if the fund’s level of weekly liquid assets rises to or above 30%. The board (including a majority of the independent directors) could decide to lift the gate earlier. The maximum time that a gate could stay in place would be 30 days at a time and no more than 30 days within a 90-day period.
Under proposal 2, a money market fund would use the penny rounding method to price its shares to maintain a stable net asset value and would not be permitted to use the amortized cost method of valuing its portfolio securities (except for debt securities with remaining maturities of 60 days or less for which the board has made the good faith determination).
Board’s Role. Proposal 2 will arguably require more continuous monitoring and decision-making by a board than proposal 1, and thereby imposes potentially increased liability on directors for their decisions. For example, a board would need to monitor weekly liquid assets to determine whether to impose a liquidity fee, and, if so, the amount of the fee. The board would also be charged with determining whether to impose a redemption gate and the term of the gate if less than the 30-day limit under the proposed rule. The board may also become involved in decisions as to whether to increase the level of weekly liquid assets.
The SEC believes that board discretion with respect to liquidity fees and redemption gates can allow boards to tailor the tools to those that in their judgment are the most effective for the funds they oversee. Although discretion in these matters may provide the board with increased flexibility, appropriate guidance from the SEC staff is critical to ensure that boards have sufficient information to exercise such discretion effectively and in the best interests of the funds and their shareholders.
In addition to the foregoing issues:
- omnibus agreements will need to be reviewed and potentially amended to ensure that intermediaries impose the liquidity fees and redemption gates; and/or certifications would need to be obtained from intermediaries with regard to compliance with these conditions;
- systems will potentially need to be modified to administer liquidity fees and redemption gates, and personnel will need to be appropriately trained to manage a fund’s operations with respect to liquidity fees and redemption gates;
- fund accounting will need to track the tax basis of money market fund shares as a result of any return of capital distributions resulting from the payment of liquidity fees and reporting on same to shareholders;
- there will be a need for increased and timely website disclosure and prospectus supplements with respect to imposition of liquidity fees and redemption gates and the status thereafter; and
- fund disclosure will need to be modified to effectuate proposal 2.
The Board will need to exercise oversight over all of the foregoing.
III. Proposed Combination of Alternative Proposals 1 and 2
Background on Combination of Proposals. The SEC recognizes that proposals 1 and 2 may not individually address the contagion risk within money market funds. The SEC therefore also proposes to combine the proposals into one package − that is, requiring money market funds (other than government funds and retail funds with respect to the floating NAV) to both float their NAVs and potentially impose liquidity fees or gates during a market stress event. The SEC is also proposing that fund boards be permitted to choose whether to operate under a floating rate NAV structure or with liquidity fees and gates.
Board Role. The Board’s role under the combination of these proposals would appear to be similar to that described under proposals 1 and 2, although with the potential additional decision of whether to choose to operate a fund with a floating NAV or to impose liquidity fees and redemption gates. If given these choices, it is not clear how a board would determine which of the choices would best prevent a shareholder run on assets or contagion risk.
IV. Additional Proposals
Regardless of which of the alternative proposals discussed above are adopted, the SEC has proposed the following additional disclosure and rule changes:
- Daily website disclosure of market-based NAV. Many money market funds are already voluntarily providing this disclosure.
- Daily website disclosure of daily and weekly liquid assets. At least one money market fund sponsor has announced that it will voluntarily start providing this disclosure.
- New Form CR to be filed with the SEC for reporting certain significant events (for example, a default or triggering of liquidity fees or redemption gates).
- Disclosure in the fund’s Statement of Additional Information of circumstances under which a fund sponsor may offer any form of support to the fund, any limits on such support, past instances of support and public notification to the SEC regarding current instances of support.
- Elimination of 60-day lag time for public availability of SEC Form N-MFPs, as well as additional information collected on this form, and more frequent reporting.
- Enhanced disclosure regarding risks of money market funds.
- Additional requirements for stress testing for both floating and stable NAV funds.
- More stringent diversification requirements.
Board Role. The foregoing changes will require amendments to fund compliance policies and procedures pursuant to Rule 2a-7, as amended, as well as Rule 38a-1. The board would need to review and approve all of these procedures and monitor fund personnel’s implementation of them. The board would also be responsible for overseeing the increased disclosure requirements as well as reviewing the results of the more comprehensive stress tests required under the proposals. Finally, the additional calculation of daily market NAVs and daily and weekly liquid assets will require the board to monitor whether appropriate resources are being devoted to these tasks.
The SEC’s money market reform package represents the most comprehensive overhaul of money market rules since the 1980s. Boards of money market funds will have numerous decisions to make under the foregoing proposals, including whether to continue to offer money funds.