The U.S. Securities and Exchange Commission (“SEC”) has proposed sweeping amendments to Rule 2a-7 under the Investment Company Act of 1940 (“1940 Act”) and other rules relating to money market funds (“money funds”).1 The Proposal included two main alternatives, to be adopted separately or in combination: (1) requiring “institutional money funds” to operate with a floating net asset value (“NAV”), rounded to the fourth decimal place (e.g., $1.0000) (“Alternative 1”), and/or (2) requiring money funds (other than government money funds) to impose a two percent liquidity fee during times of stress and allowing them temporarily to suspend redemptions using “redemption gates” during such times (“Alternative 2”). The SEC also proposed additional reforms to be adopted under either Alternative, including more stringent disclosure, diversification, reporting and stress testing requirements.
If adopted, the Proposal would 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 Proposal and discuss potential issues presented that should be considered by Boards.
Alternative 1 – Floating NAV
Alternative 1 would require money funds (other than “government” and “retail” money funds)2 to convert to a floating NAV, calculating their market-based NAV per share to the nearest basis point. In addition, an institutional money fund would be required to calculate its share price to the fourth decimal place if it prices its shares initially at one dollar per share (for example, $1.0000).3
Alternative 1 would exempt government and retail money funds from the floating NAV requirement. Government money funds would be defined under the Proposal as money funds that maintain at least 80 percent of their total assets in cash, U.S. government securities or repurchase agreements that are “collateralized fully” (as defined in Rule 2a-7). The Proposal would define retail money funds as those that restrict redemptions to no more than $1 million of fund shares for any single shareholder on any one business day. Money funds that meet the requirements to be a government or retail money fund could continue to use the penny rounding method4 to price their shares and maintain a stable NAV. Notably, however, under Alternative 1, all money funds would no longer be permitted to use the amortized cost method of valuation, except with respect to valuing securities that mature in 60 days or less.5
Alternative 1 aims to increase the transparency of institutional money funds’ pricing and reduce the incentive for fund shareholders to redeem their shares during 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, Alternative 1 seeks to remove the perceived “first mover advantage,” which some have credited with contributing to the heavy redemptions from institutional prime money funds during the 2008 financial crisis.
Alternative 2 – Liquidity Fees and Redemption Gates
Alternative 2 would provide money funds with certain tools, specifically liquidity fees and redemption gates, to enable them to better manage redemption requests during periods of market or fund illiquidity. When “weekly liquid assets”6 (currently required by Rule 2a-7 to constitute at least 30 percent of a money fund’s assets) of a money fund (other than a government money fund) fall below 15 percent of total assets, the fund would be required to impose a two percent liquidity fee on all redemptions, unless the Board determines that imposing such a fee would not be in the fund’s best interests. Liquidity fees would be required to be suspended once a money fund’s weekly liquid assets rise to or above 30 percent of its total assets, or sooner, if determined by the Board. When weekly liquid assets fall below 15 percent of total assets, a Board also would be permitted to temporarily impose “redemption gates,” suspending redemptions for a limited period of time.7
Under Alternative 2, all money funds would continue to be permitted to maintain a stable price per share through the use of the penny rounding method of pricing. However, as with Alternative 1, money funds would no longer be permitted to use amortized cost to value their holdings, except for securities with maturities of 60 days or less. Furthermore, under Alternative 2, government money funds would be permitted, but not required, to impose liquidity fees and redemption gates when their weekly liquid assets fall below the 15 percent threshold.
Combination of Alternatives
Any final rule could combine features of the Alternatives by, for example, permitting a money fund to choose to either be able to impose liquidity fees and gates or transact with a floating NAV. Another possible combination might be to require institutional money funds to convert to a floating NAV and require all money funds to impose liquidity fees (and permitting them to impose gates).
Enhanced Disclosure Requirements
Rule 30b1-8 and Form N-CR
Under either Alternative, a money fund would be required under proposed Rule 30b1-8 to disclose on proposed Form N-CR: (i) any instances of default (other than an immaterial default unrelated to the issuer’s financial condition) or an event of insolvency of a portfolio security that, immediately before the default or event of insolvency, accounts for one-half of one percent or more of the fund’s total assets; (ii) any “financial support”8 by a fund sponsor or its affiliates; and (iii) any instance in which the fund’s market-based NAV per share falls below $0.9975. Money funds generally would be required to file a Form N-CR, which would be publicly available on EDGAR immediately upon filing, within one business day following the triggering event. With respect to the reporting requirement relating to when a money fund’s weekly liquid assets fall below 15 percent of total assets or when the fund has imposed or removed a liquidity fee and/or redemption gate, the money fund also would be required to file an amendment to the Form N-CR by the fourth business day following the event in order to provide additional detailed information about the event.
The Proposal would require a money fund to disclose on its website substantially the same information regarding financial support that would be required on Form N-CR, as well as the following items: (i) the percentage of total assets that are invested in daily and weekly liquid assets; (ii) net inflows and outflows; and (iii) daily market-based NAV per share, rounded to the fourth decimal place in the case of a fund with a $1.00 share price.
The Proposal would require money funds to include new bulleted statements in their registration statements relating to the risks associated with the Alternatives. Among other things, a money fund would also be required to state: (i) that the fund’s sponsor has no legal obligation to provide financial support to the fund and that an investor should not expect that the sponsor will provide financial support to the fund at any time; and (ii) any financial support received during the last 10 years.
The Proposal would update Rule 482, a rule that requires money funds to include certain risk disclosure in advertisements, to require disclosure of the risks of the Alternatives.
Money funds 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 SEC proposes to eliminate the current 60-day delay and make other changes to Form N-MFP.
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 Proposal, money funds would 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 only, “control” would be defined as ownership of more than 50 percent 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 percent of the fund’s assets, subject to the 25 percent basket exception discussed below. Under the Proposal, a money fund would be required to include the sponsor of a special purpose entity (“SPE”) that issues ABS 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 would limit a money fund to investing no more than 10 percent of fund assets in ABS issued by any one sponsor’s SPEs.
Removal of the 25 Percent Basket
Rule 2a-7 currently provides an exception to the 10 percent limitation described above, under which 25 percent of a fund’s assets may be subject to guarantees or demand features from a single institution (“25 percent basket”). The Proposal would eliminate this 25 percent basket.
Changes to Form PF
The Proposal recommends changes to Form PF, the form used by registered investment advisers to report information regarding the private money funds they advise. “Large liquidity fund9 advisers” would be required to file portfolio holdings information on Form PF similar to the information required to be filed on Form N-MFP.
Enhanced Stress Testing
Under the Proposal, the SEC would enhance stress testing requirements and specifically require a money fund to consider a number of additional, specific factors in determining whether the fund could maintain a stable share price under heavy redemption pressure.
Potential Issues Raised by the Proposal, to be Considered by Money Fund Boards
Potential Issues Raised by Both Alternatives 1 and 2
Removal of the Amortized Cost Method of Valuation
Under either Alternative, money funds would no longer be able to use the amortized cost method of valuation to value portfolio securities. If money funds are no longer able to use amortized cost, a Board would have to approve 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.
Updated Systems and Compliance Procedures
The new requirements of either Alternative will require the adoption of new compliance procedures and the implementation of technology systems for compliance. These 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 for compliance.
Currently, money fund organizational documents might not provide for limitations on redemptions. A money fund’s governing documents may in fact contemplate an absolute right of redemption for a shareholder. The Proposal does not address this potential conflict with the Alternatives. A Board may need to approve changes to the money fund’s organizational documents to allow for redemption limitations and/or liquidity fees and gates.
Potential Issues Raised by Alternative 1
Floating NAV for Institutional Funds
Under Alternative 1, institutional money funds must operate with a floating NAV. This would have a drastic impact on these funds and have many implications of which a Board should be aware. Initially, there likely would be significantly reduced demand for the fund. Additionally, new systems would have to be implemented, including a system to monitor for tax gains/losses and wash sales. A floating NAV money fund also would likely be unable to offer intra-day settlement to shareholders. Boards of these funds would have to consider and/or oversee these and other necessary changes.
$1 Million Redemption Limit and the Retail Exemption
A Board would first need to consider whether the money fund may be operated in such a way that it qualifies for the retail exemption. This will involve considerations of the best interests of the money fund and its shareholders and the effects of the imposition of a $1 million redemption limitation. The Board would then need to be involved with the creation and implementation of procedures to enforce the $1 million daily redemption limit as well as ongoing compliance with any policies and procedures.
Treatment of Omnibus Accounts
Many investors hold shares of money funds through omnibus accounts. As a result, most money funds are not able to look through those accounts to determine underlying investors’ redemptions. Retail money funds would not be required to impose the $1 million daily redemption limit on shareholders of record that hold omnibus accounts, if the money fund has implemented policies and procedures reasonably designed to allow the conclusion to be drawn that an omnibus account holder will not permit any beneficial owner to “directly or indirectly” redeem more than $1 million per day. The Proposal did not specifically require that retail money funds enter into agreements with, or request certifications from, omnibus account holders, but Boards would likely need to use such agreements or certifications or other means to support such a finding.
Money funds with both institutional and retail share classes (or both institutional and retail shareholders in a single class of shares) may have to reorganize into separate funds in order to rely on the retail money fund exemption. A Board should consider whether the fund should reorganize and in what fashion. The reorganization could be costly and complex, raising tax-related and other issues.
Potential Issues Raised by Alternative 2
Under Alternative 2, the money fund would be required to impose a two percent liquidity fee on all redemptions when weekly liquid assets fall below 15 percent of the fund’s total assets, unless the Board determines that imposing such a fee would not be in the fund’s best interests. Board findings relating to both liquidity fees and redemption gates under Alternative 2 would have to be approved by the Board as a whole, as well as by a majority of the disinterested board members. The “trigger” to impose liquidity fees and permit redemption fees is based on the level of weekly liquid assets as of the end of a business day. Boards would, therefore, be required to determine on short notice whether to impose liquidity fees and/or permit redemption fees (in some cases, by the following business day).
The Proposal described certain factors that a Board may consider in determining whether to impose or lift liquidity fees, including: (i) the reasons for the decline in weekly liquid assets (for example, did the decrease stem from financial stress or from unexpected shareholder redemptions?); (ii) the expected duration of the decline in weekly liquid assets (for example, will “staggered” maturities cause weekly liquid assets to increase in the short term?); and (iii) any corresponding changes in the money fund’s market-based NAV (for example, does the money fund have the capacity to absorb losses without “breaking the buck”?).
Alternative 2 also permits a Board to impose redemption gates when weekly liquid assets fall below 15 percent of a money fund’s total assets. Similar to the imposition of liquidity fees, this will be a highly fact-specific consideration. A Board would likely need to meet multiple times during a period when gates are in effect, in order to monitor their operation and consider whether gating continues to be appropriate. The events that led to the imposition of a gate would also need to be documented carefully and reported to the SEC on Form N-CR.
Monitoring of Weekly Liquid Assets and Early Notification Procedures
Boards may wish to consider adopting self-imposed trigger points at which the fund manager would notify the Board (for example, when the level of weekly liquid assets reaches 20 percent), so that the Board would be prepared to meet immediately and consider all of the relevant facts and circumstances.
Potential Issues Raised by the Other Proposed Reforms (including Disclosure, Diversification, Reporting and Stress Testing)
Boards will need to oversee the development of policies and procedures to comply with the Proposal’s enhanced disclosure, diversification, reporting and other requirements. For example, the Board should oversee the review and potential enhancement of stress testing procedures to include the specific items that would be required by the Proposal. A Board should also ensure that a system is developed to enable the money fund to accurately and in a timely manner disclose on its website or report to the SEC the additional information required by the Proposal.
Overall, the Proposal sets forth sweeping potential changes to money fund regulation, which would pose a number of issues for Boards, and Boards should closely monitor developments relating to the issuance of any final rule.