On July 23, 2014, the Securities and Exchange Commission (the SEC) adopted final rules governing the structure and operation of money market funds. These rules are discussed in a release adopting amendments to Rule 2a-7 under the Investment Company Act of 1940, as amended (the 1940 Act), and other related changes (the Adopting Release). [1] The SEC also re-proposed rule amendments that would remove references to credit ratings from the money market fund rules. This client alert is a summary of the main elements of the adopted amendments. We expect to issue more detailed analyses of the various components of the amended and proposed rules in the near future. The amendments will become effective 60 days after their publication in the Federal Register, although the compliance dates for the amendments are substantially farther in the future, as discussed below.

In general, the new money fund rules provide for the following:

• Floating NAV — Institutional money market funds (including institutional tax-exempt money market funds) will have to price their shares using the market values of portfolio securities rather than the currently permitted amortized cost and/or penny rounding methods, and calculate their net asset values per share (NAVs) to the nearest 1% (e.g., $1.0000 for a fund with a current stable NAV of $1.00). Government and retail funds are exempt from this requirement.
  
  The U.S. Department of the Treasury (Treasury) and the Internal Revenue Service (the IRS) have proposed rulemaking that seeks to mitigate the accounting burden on investors in floating NAV funds, and the Treasury and the IRS issued a revenue procedure intended to exempt such investors from the “wash sale” rules under the Internal Revenue Code of 1986, as amended. We will be addressing this tax rulemaking in greater detail in a future client alert.
  
  Compliance Date — Two years after publication in the Federal Register.

• Liquidity Fees and Redemption Gates — A money fund board will have two new tools to assist in stemming the potential for heavy redemptions. First, a money fund board (with the approval of a majority of the independent directors) may authorize the fund to impose a liquidity fee of up to 2% if the fund’s “weekly liquid assets” fall below 30% of total assets. Second, the board (with the approval of a majority of the independent directors) may authorize the fund to suspend redemptions for up to 10 business days under the same circumstances (a redemption gate). In addition, if a fund’s weekly liquid assets fall below 10%, the fund must impose a 1% liquidity fee on all redemptions. A board may decide that the fund should not impose a liquidity fee or redemption gate (or impose a lower fee or shorter gate) if the board (including a majority of the independent directors) determines that doing so is not in the best interests of the fund.
  
  Compliance Date — Two years after publication in the Federal Register. (The compliance date in the SEC release proposing these rule changes (the Proposing Release) [2] was one year after publication.)

• Portfolio Diversification, Disclosure, and Stress Testing — The SEC also adopted amendments relating to money fund portfolio diversification, stress testing, and disclosure; the latter are intended to provide additional transparency with regard to portfolio holdings, including recent event disclosure in a new Form N-CR. In addition, investment advisers to certain large private liquidity funds must provide additional information about those funds to the SEC on Form PF.
  
  Compliance Dates — For Form N-CR, nine months after publication in the Federal Register. For diversification, stress testing, and other disclosure, including revised Form PF, 18 months after publication in the Federal Register.

The SEC also re-proposed rule amendments that would remove references to credit ratings from the money market fund rules, in accordance with the Dodd-Frank Wall Street Reform and Consumer Protection Act (the Dodd-Frank Act). We will be addressing these proposed amendments in a future client alert.

Summary of the Key Reform Provisions

Floating NAV
Money market funds offered to institutional investors will be required to offer shares at a floating NAV. Prime and tax-exempt money market funds will be impacted based on the type of investors in the fund. Government and retail money funds will continue to be able to offer shares at a stable NAV.

• A “government” money fund will have to invest at least 99.5% of its total assets in cash, government securities, and/or repurchase agreements that are collateralized solely by government securities or cash. (This represents a higher threshold than was included in the Proposing Release, which was 80%.)
• A “retail” money fund will have to have policies and procedures reasonably designed to limit all beneficial owners of the fund to natural persons. This standard represents a change from the Proposing Release, which defined a retail money fund as a fund that limited daily redemptions to $1 million per investor. (Many fund sponsors objected to the proposed definition of retail money funds. A “natural person” standard was suggested in a joint comment letter submitted by a number of money fund sponsors.)

In addressing an omnibus account holding money fund shares, the Adopting Release explains that, because the omnibus account is the shareholder of record (and not the beneficial owner), retail funds will need to determine that the underlying beneficial owners of the omnibus account are natural persons. The Adopting Release does not prescribe the ways in which a money fund may seek to qualify as a retail fund, but rather it notes that funds may attempt to so qualify by effectively managing their relationships with omnibus intermediaries in the manner that best suits their circumstances (including contractual arrangements or periodic certifications). In a related action, the SEC proposed to grant exemptive relief from Rule 10b-10 under the Securities Exchange Act of 1934 to broker-dealers from the immediate confirmation delivery requirement for transactions in floating NAV money funds.

The Treasury and the IRS have proposed rulemaking to permit a simplified aggregate accounting method for floating NAV funds. Under this method, instead of tracking and reporting the cost or tax basis and redemption price of all shares purchased and redeemed, floating NAV fund taxpayers would calculate taxable gain or loss on an aggregate basis at the end of the tax year.

In addition, the Treasury and the IRS issued a revenue procedure exempting floating NAV taxpayers from the “wash sale” rules, which prohibit a taxpayer from recognizing a loss on the sale of a security if the taxpayer buys a substantially identical security within 30 days, effective on the same day as the Rule 2a-7 and form amendments.

Liquidity Fees and Redemption Gates
Liquidity fees and redemption gates apply to all money funds other than government money funds. These rules are triggered if a money fund’s level of “weekly liquid assets” falls below 30% of total assets (the minimum under Rule 2a-7). In the Proposing Release, this threshold was 15% of total assets.

Liquidity Fees
A money fund may impose a liquidity fee of up to 2%, if the board (including a majority of the independent directors) determines that such a fee is in the best interests of the fund. If a fund’s weekly liquid assets fall below 10%, the fund will have to impose a 1% liquidity fee on all redemptions. However, the board (with the approval of a majority of the independent directors) may determine that the fee is not in the best interests of the fund or that a lower or higher (up to 2%) fee is in the fund’s best interests.

Redemption Gates
If a money fund’s weekly liquid assets fall below 30%, the fund may suspend redemptions for up to 10 business days, if the fund’s board (including a majority of the independent directors) finds that doing so is in the fund’s best interests. The fund may impose the gate for fewer than 10 business days, or lift the gate earlier than the 10th business day. A money fund may not impose a gate for more than 10 business days in any 90-day period.

As compared to the proposed rule changes, the final rules arguably give money fund boards more flexibility in authorizing a fund to impose fees and gates. The amendments as proposed would have required funds (absent a board determination otherwise) to impose a 2% liquidity fee on all redemptions, and would have permitted the imposition of redemption gates for up to 30 days in a 90-day period, after a fund’s weekly liquid assets fell below 15% of its total assets. As in the Proposing Release, any fee or gate must be lifted automatically after the fund’s weekly liquid assets rise to at least 30%, and it can be lifted at any time by the fund’s board (including a majority of the independent directors) if the board decides to authorize the fund to impose a different redemption restriction (or, with respect to a liquidity fee, a different fee) or if it determines that imposing a redemption restriction is no longer in the fund’s best interests. As amended, Rule 22e-3 under the 1940 Act permits the permanent suspension of redemptions and liquidation of a money market fund if the fund’s weekly liquid assets fall below 10%. The new provisions regarding the imposition of liquidity fees and/or redemption gates appear to be intended to impose on a money fund board a duty to consider taking such steps during periods when the fund’s weekly liquid assets approach 30%.

Board Considerations — As in the Proposing Release, the Adopting Release notes that there are a number of factors a board may consider in determining the level of a liquidity fee, including, for example:

• Changes in spreads for portfolio securities (based on actual sales; dealer quotes; pricing vendor, mark-to-model, or matrix pricing; or otherwise);
• The maturities of the fund’s portfolio securities;
• Actual or expected changes in the fund’s liquidity profile in response to redemptions;
• The capability of the fund and its intermediaries to rapidly impose a liquidity fee differing from a previous or default fee;
• For a floating NAV fund, the extent to which the fund’s NAV reflect liquidity costs; and
• The fund’s past experience, if any, with imposing liquidity fees.

The Adopting Release warns that boards should not consider the 1% default liquidity fee as creating a presumption that such a fee should be 1%, and it notes that if a board believes, based on prevailing market liquidity costs or otherwise, that imposing a higher or lower (up to 2%) liquidity fee is more appropriate, it should consider doing so. The SEC further notes that, once a liquidity fee is imposed, the board must monitor the imposition of such fee to determine whether it continues to be in the fund’s best interests.

Government Fund Exemption — Government money funds are not subject to the liquidity fees and redemption gates provisions but may voluntarily opt to be bound by these rules, subject to prior disclosure to investors.

Money Funds Underlying Insurance Products — For money market funds held through insurance company separate accounts, the Adopting Release clarifies that the fees and gates provisions of the final rules apply to such funds, notwithstanding Section 27(i) of the 1940 Act, which prohibits any registered separate account funding variable insurance contracts or the sponsoring insurance company of such account to sell a variable contract that is not a “redeemable security.”

Disclosure
The new disclosure rules are designed to increase transparency with regard to fund holdings, operations, and risks.

Form N-CR
Funds will be required to promptly disclose material events on a new Form N-CR within one business day of the triggering event. These events include (a) the imposition or removal of fees or gates, as well as a description of the primary considerations the board took into account in taking the action; (b) sponsor support (including the amount of and reason therefor); (c) security defaults; and, (d) for retail and government funds, a decline in the fund’s NAV below $0.9975. Reports on Form N-CR will not have to include past occurrences of sponsor support, although, as discussed below, changes to Form N-1A require Statement of Additional Information (SAI) disclosure of such cases that occurred over a 10-year period.

In addressing sponsor support, funds must disclose the nature, amount, and terms of such support, as well as the relationship between the person providing the support and the fund. The Adopting Release notes that certain routine actions, and actions not reasonably intended to increase or stabilize the value or liquidity of the fund’s portfolio, do not need to be reported as financial support on Form N-CR. The term “financial support” includes any:

• Capital contribution;
• Purchase of a security from the fund in reliance on Rule 17a-9 under the 1940 Act;
• Purchase of any defaulted or devalued security at par;
• Execution of letter of credit or letter of indemnity;
• Capital support agreements (whether or not the fund ultimately received support);
• Performance guarantee; or
• Other similar action reasonably intended to increase or stabilize the value or liquidity of the fund’s portfolio; excluding, however, any:
  • Routine fee waiver or expense reimbursement;
  • Routine inter-fund lending;
  • Routine inter-fund purchases of fund shares; or
  • Any action qualifying as financial support that the board has otherwise determined not to be reasonably intended to increase or stabilize the value or liquidity of the fund’s portfolio.

Statements of Additional Information
A money fund must disclose in its SAI any support that the fund received from a sponsor or other affiliate during the last 10 years (but not for cases that occurred prior to the 18-month compliance date for disclosures other than in Form N-CR).

Form N-MFP
Form N-MFP (on which money funds report portfolio holdings each month) will require reporting of additional information relevant to the assessment of fund risk. In addition, Form N-MFP will be publicly available immediately upon filing (rather than the current 60-day delay of public availability). The amendments to Form N-MFP include:

• Reporting NAV (and shadow price), daily and weekly liquid assets, and shareholder flows on a weekly basis within the monthly filing of the Form;
• Reporting NAV (and shadow price) reported to the fourth decimal place (or equivalent level of accuracy for funds with a different share price); and
• Including exempt government funds as a category option.

Private Funds
Private Liquidity Fund Reporting — Under amended Form PF (on which private fund advisers report information about certain private funds they advise) a large liquidity fund adviser (which manages at least $1 billion in combined money market fund and private liquidity fund assets) must report substantially the same portfolio information on Form PF as registered money market funds are required to report on Form N-MFP, as amended. We will address the Form PF amendments in a future client alert.

Unregistered Money Funds Operating Under Rule 12d1-1 — Certain registered funds invest in unregistered money funds in reliance on Rule 12d1-1 under the 1940 Act, which provides an exemption from the limitations of Section 12(d)(1) of the 1940 Act. Accordingly, an unregistered money fund that seeks to operate under Rule 12d1-1 must comply with the amendments to Rule 2a-7 adopted by the SEC, including the floating NAV and the fees and gates requirements. In many cases, the adviser to an unregistered money market fund performs the function of a fund’s board, which under the new rules will include determinations with respect to fees and gates.

Website
Funds will be required to disclose daily on their websites levels of daily and weekly liquid assets, net shareholder inflows and outflows, market-based NAVs, sponsor support, and any imposition of fees and gates.

Stress Testing
Money funds will be required to test the ability to maintain weekly liquid assets of at least 10% and minimize principal volatility under certain specified scenarios. The new rules increase board reporting requirements.

Diversification

• Affiliate Aggregation for Issuers — Money funds will have to treat certain entities that are affiliated with each other as single issuers for the 5% issuer diversification test.
• Removal of 25% Basket — Money funds, other than tax-exempt funds, will have to meet the 10% diversification limit for guarantors and demand feature providers. For tax-exempt funds, the limit will be 15%.
• Asset-Backed Securities — Money funds will have to treat the sponsors of asset-backed securities as guarantors subject to the 10% diversification limit for guarantors, unless the board (or its delegate) determines that the fund is not relying on the sponsor to determine the security’s quality or liquidity.
• Proposed Amendment to Issuer Diversification — The SEC proposed to amend Rule 2a-7 to eliminate an exclusion from the issuer diversification provisions for securities with certain guarantees.

Removal of Credit Ratings References
The SEC re-proposed amendments to Rule 2a-7 to implement Section 939A of the Dodd-Frank Act requiring the SEC to remove references to or requirement of reliance on credit ratings and establish appropriate creditworthiness standards. Under the proposed amendments to Rule 2a-7, a money fund will be able to invest in a security only if the board (or its delegate) determines that it presents minimal credit risks, i.e., that the issuer has an exceptionally strong capacity to meet its short-term obligations. Under the proposed revisions to Form N-MFP, a money fund would have to disclose any credit rating that the board considered in determining that a security presents minimal credit risk.

Notes:
[1] Money Market Fund Reform; Amendments to Form P-F, Investment Company Act Release No.31166 (July 23, 2014).

[2] Money Market Fund Reform; Amendments to Form P-F, Investment Company Act Release No.30551 (June 5, 2013).