On July 12, 2023, the US Securities and Exchange Commission ("SEC") voted, by a 3-2 vote, to adopt money market fund reforms that will significantly impact the regulatory framework governing money market funds ("money funds" or "funds"). According to the SEC, the reforms are designed to improve the resiliency of money funds by reducing the risk of shareholder “runs” on money funds during periods of market stress. The adopting release highlighted heavy outflows from institutional prime money funds in March 2020 at the onset of the COVID-19 pandemic. The reforms consist of amendments to Rule 2a-7 under the Investment Company Act of 1940 (the "1940 Act"), the primary rule governing the operation of money funds, and related recordkeeping, reporting, and disclosure form amendments (collectively, the final rules). This Client Alert summarizes key aspects of the final rules.
As a preliminary matter, it is significant that the SEC did not adopt certain elements of the proposed rulemaking that received broad opposition in the comment letter process. In particular, the SEC had initially proposed a mandatory swing pricing requirement for institutional prime and institutional tax-exempt money funds ("institutional money funds"), but it ultimately did not adopt this requirement in the final rules. Instead, the SEC adopted a new liquidity fee framework, which includes a mandatory requirement for institutional money funds to apply liquidity fees when they experience certain large net redemptions — specifically, if daily net redemptions exceed 5% of net assets (subject to a de minimis exception). This alternative resembles swing pricing in many respects while lessening, but not eliminating, the operational challenges, feasibility concerns, and costs that generated so much criticism in comments on the proposed rulemaking.
Certain of the reforms apply to all categories of money funds, while others apply only to certain categories. For ease of reference, the following is a high-level overview of key reforms under the final rules and their applicability to categories of money funds:
- Government money funds may elect to be subject to the fees and gates provisions under current Rule 2a-7. However, in practice, government money funds have rarely, if ever, opted into these provisions. Under the final rules, government money funds will continue to be permitted to opt into the discretionary liquidity fee provision but not the mandatory liquidity fee provision.
- Similar to the current rule, tax-exempt money funds will not be subject to daily liquid asset requirements under the final rules.
Amendments to Liquidity Fees and Redemption Gates Provisions
Currently, a money fund has the ability to impose liquidity fees or temporarily suspend redemptions (i.e., impose a "gate") after dropping below certain specified liquidity thresholds. Specifically, Rule 2a-7 gives the board of directors of a money fund discretion to impose liquidity fees (up to 2%) and/or gates (for up to 10 business days during any 90-day period) if the fund’s weekly liquid assets fall below 30% of its total assets. In addition, a non-government money fund is required to impose a liquidity fee of 1% on all redemptions if its weekly liquid assets fall below 10% of its total assets, unless the board determines that imposing such a fee would not be in the best interests of the fund.
Removal of Ability to Impose Redemption Gates
The final rules remove the ability of a money fund to impose a temporary redemption gate. According to the SEC, this removal will eliminate the incentive under the current rule for investors to preemptively redeem to avoid the possibility of a board using its discretion to impose a redemption gate if the 30% threshold under the current rule is reached. Money funds will continue to be able to impose redemption gates to facilitate an orderly fund liquidation pursuant to Rule 22e-3 under the 1940 Act.
New Liquidity Fee Framework
In lieu of adopting mandatory swing pricing for institutional money funds, the SEC adopted a new liquidity fee framework that includes elements of both mandatory liquidity fees for institutional money funds and discretionary liquidity fees for all non-government money market funds, as discussed in further detail below. Whether the fee is mandatory or discretionary, the imposition of a liquidity fee under the final rules will not be tied to a fund’s weekly liquid assets.
The SEC had initially proposed mandatory swing pricing for institutional money funds with the goals of ensuring that the costs stemming from net redemptions are fairly allocated to redeeming shareholders and do not give rise to redemptions motivated by a “first mover advantage.” After receiving many comment letters expressing broad concerns about the swing pricing proposal and its potential effects on institutional money funds and investors, the SEC stated that it was “persuaded by commenters that these same goals are better achieved through a liquidity fee mechanism, particularly given that current rule 2a-7 includes a liquidity fee framework that funds are accustomed to and can build upon.”
While the final rules demonstrate that the SEC can be persuaded to refrain from adopting a proposed mandatory swing pricing regime for money funds, it remains to be seen whether the SEC will follow a similar approach in the context of the pending proposal to mandate swing pricing for open-end mutual funds (other than money funds). In his public statement supporting the final rules, SEC Chair Gary Gensler addressed the new liquidity fee framework, stating that he “believe[s] that liquidity fees, compared with swing pricing, offer many of the same benefits and fewer of the operational burdens.” Also, as noted by the two dissenting SEC commissioners, the new liquidity fee framework was not included in the proposed rulemaking, which precluded the SEC from having the benefit of receiving and considering informed public comments to guide the design of this aspect of the final rules.
Mandatory Liquidity Fees
Under the mandatory liquidity fee requirement, institutional money funds will be required to apply a liquidity fee to redeeming shareholders when net redemptions for the business day exceed 5% of net assets (or such lower threshold as may be determined by the fund board or its delegate), unless the liquidity fee amount is de minimis. In determining whether a fund has crossed the 5% threshold, the fund must use flow information that is available within a reasonable period of time after the last pricing time of that day. The SEC recognized that there will be circumstances in which the flow information a fund uses to determine whether it has crossed the 5% threshold does not reflect the fund’s full flows for that day.
The amount of the liquidity fee will be determined by making a good-faith estimate, supported by data, of the costs the fund would incur if it sold a pro rata amount of each security in its portfolio (a "vertical slice") to satisfy the amount of net redemptions, including (1) spread costs and any other charges, fees, and taxes associated with portfolio security sales, and (2) market impacts for each security. There is no cap on the mandatory liquidity fee amount, but the SEC recognized that, as a general matter, it is unlikely a fund’s calculated liquidity costs would exceed 2% of the value of shares redeemed.
The SEC acknowledged commenters’ concerns that market impact factors may be difficult or costly to estimate and stated that it specifically tailored the final rules to address these concerns. For example, if a fund cannot make a good-faith estimate of liquidity costs, the final rules require the fund to apply a default liquidity fee of 1%. The SEC also provided guidance in the adopting release on one method that funds could use to implement its market impact calculations, which involves using pricing grids that rely on historical data. In addition, the final rules provide that funds will be able to pool similar securities into categories for purposes of the market impact analysis rather than analyzing each security separately and that a fund may assume a market impact of zero for its daily and weekly liquid assets.
Significantly, institutional money funds will not be required to impose a liquidity fee when the estimated costs are de minimis. Estimated costs will be de minimis if they are less than one basis point (0.01%) of the value of the shares redeemed. This de minimis exception is designed to reduce the frequency of triggering mandatory liquidity fees when institutional funds may cross the 5% threshold under normal market conditions and outside of stress. The SEC stated that it anticipates that a fund’s estimated liquidity costs generally will be de minimis under normal market conditions and, therefore, institutional money funds typically will not impose mandatory liquidity fees under those circumstances under this de minimis exception.
Discretionary Liquidity Fees
Recognizing that a discretionary liquidity fee provides money fund boards with an additional tool to manage liquidity in times of stress, the SEC decided to largely retain the discretionary liquidity fee provision in the current rule, but without the tie between liquidity fees and weekly liquid assets. Under the final rules, all non-government money funds will be permitted to impose liquidity fees on redeeming shares of up to 2% of the value of shares redeemed. Like the current rule, the discretionary liquidity fee provision under the final rules will not apply to government money funds, but a government money fund will be permitted to opt into this provision, giving it the ability to impose discretionary liquidity fees.
Instead of tying discretionary liquidity fees to a weekly liquid asset threshold, the final rules give the fund’s board (or its delegate) the flexibility to determine when a fee is necessary based on current market conditions and the specific circumstances of the fund. Irrespective of weekly liquid asset levels or redemption levels, a non-government money fund may apply a discretionary liquidity fee if the board (or its delegate) determines that such fee is in the best interests of the fund. Once imposed, the liquidity fee must remain in effect until the board (or its delegate) determines that imposing such fee is no longer in the best interests of the fund.
Institutional money funds, which will be subject to both the mandatory and discretionary liquidity fee provisions, may impose discretionary liquidity fees on days with net redemptions at or below 5% of net assets. On days when net redemptions exceed 5%, institutional money funds cannot impose discretionary liquidity fees and must apply only the mandatory liquidity fee provision.
Board Oversight of Liquidity Fee Determinations
A money fund’s board will be responsible for making liquidity fee determinations under the mandatory and discretionary liquidity fee requirements. However, in contrast to the current rule, a board will be permitted to delegate this responsibility to the fund’s investment adviser or officers, subject to certain board oversight requirements. The board will be required to adopt and periodically review written guidelines (including guidelines for determining the application and size of liquidity fees) and procedures under which a delegate makes liquidity fee determinations. According to the SEC, such written guidelines generally should specify the manner in which the delegate is to act with respect to any discretionary aspect of the liquidity fee mechanism. The board will also need to periodically review the delegate’s liquidity determinations.
The final rules amend the recordkeeping rule under the 1940 Act (Rule 31a-2) to require money funds to preserve records that document how they determine the amount of any liquidity fee.
Increases to Minimum Portfolio Liquidity Requirements
Money funds are subject to minimum liquidity requirements designed to support a money fund’s ability to meet redemptions even in market conditions in which the money fund cannot rely on a secondary or dealer market to provide liquidity. The final rules increase the minimum liquidity requirements for a money fund by raising the daily liquid asset minimum from 10% to 25% of the fund’s total assets and raising the weekly liquid asset minimum from 30% to 50% of the fund’s total assets. These liquidity requirements will continue to apply immediately following “acquisitions” of portfolio assets, meaning that a money fund that passively falls below a minimum would not be able to acquire any assets other than daily or weekly liquid assets, as applicable, until the fund meets the minimum threshold.
If a money fund’s daily liquid assets fall below 12.5% or its weekly liquid assets fall below 25%, the fund will be required to notify its board and file a public report with the SEC (Form N-CR) within one business day after the occurrence. In addition, within four business days after the occurrence, the board must receive a brief description of the facts and circumstances that led to the liquidity threshold event.
Changes to Liquidity Metrics in Stress Testing
Under the current stress test provisions of Rule 2a-7, a money fund is required to test, among other things, its ability to maintain 10% weekly liquid assets under specified hypothetical events. The final rules replace this bright-line 10% threshold with a requirement for a money fund to test its ability to maintain “sufficient minimum liquidity” under such hypothetical events. Each fund will be permitted to determine the minimum level of liquidity that it considers sufficient in stress periods, which the SEC acknowledged may differ among money funds for a variety of reasons.
Amendments Related to Negative Interest Rates
In a negative interest environment, the gross yield for government and retail money funds ("stable NAV funds") that seek to maintain a stable share price (e.g., $1.00 share price) likely would turn negative. Without a mechanism to distribute or account for the negative yield, it would cause the stable NAV fund’s market-based shadow price to deviate from its stable share price, as the fund would begin to lose money. This deviation could cause the fund to re-price its securities below the $1.00 share price (an event known as “breaking the buck”). The current rule was amended to explicitly address the options available to a stable NAV fund when interest rates are negative.
Conversion to Floating NAV
Under the final rules, if a stable NAV fund has negative gross yield, the fund will retain the ability it has under the current rule to convert to a floating NAV, which would enable the fund to absorb the negative yield into its share price. A floating NAV is based on the current market-based value of the securities in the portfolio and is rounded to the fourth decimal place (e.g., $1.0000).
Reverse Distribution Mechanism
In a change from the SEC’s proposal, the final rules will also permit a stable NAV fund to use a reverse distribution mechanism ("0RDM" or "share cancellation"), subject to board oversight and disclosure requirements. An RDM involves offsetting the daily negative yield accrued through the proportional reduction of the total number of outstanding fund shares. As contrasted with a conversion to a floating NAV, which would result in the stable NAV fund’s losses being reflected through a declining share price, the use of an RDM will maintain the stable share price, despite losing value, by reducing the number of its outstanding shares. Shareholders in such a stable NAV fund would observe a stable share price but a declining number of shares for their investment.
Although the SEC initially proposed a prohibition on the use of an RDM, the SEC ultimately chose to expressly permit the use of an RDM, noting that it was “persuaded by commenters that the concern that investors may find share cancellation misleading or confusing can be addressed by establishing conditions for a fund’s use of share cancellation, including required disclosures” and that the RDM “may be less disruptive or costly than converting to a floating NAV in some cases.” Prior to the proposed rulemaking, the money fund industry, with input from the Investment Company Institute, had generally identified the RDM as among the most operationally feasible options available in a negative yield environment.
The final rules permit a stable NAV fund to use an RDM only if the fund has negative gross yield as a result of negative interest rates and only if the fund’s board determines that reducing the number of the fund’s shares outstanding is in the best interests of the fund and its shareholders. This board responsibility will not be delegable. In making this best interest determination, the SEC stated that it believes a board generally should consider: (1) the capabilities of the fund’s service providers and intermediaries to support the equitable application of the RDM across the fund’s shareholders, including considerations of whether the operational and recordkeeping systems of the service providers and intermediaries are able to process and apply a pro rata reduction of shares in shareholder accounts on a daily basis; and (2) any state law limitations on share cancellation. In addition, the SEC stated that it believes a board will also need to devote particular attention to questions concerning the applicable tax rules and generally should consider the tax implications of the RDM for the fund and its shareholders.
If a stable NAV fund plans to use share cancellation, the final rules require the fund’s prospectus to contain disclosure providing advance notice about these plans and their potential effects on shareholders. When an RDM is activated and the fund is canceling shares, the fund must provide information in each account statement (or in a separate writing accompanying each statement) identifying that such practice is in use and explaining its effects on shareholders.
SEC Guidance on Preparing for the Possibility of a Conversion to a Floating NAV
Given that the final rules permit the use of an RDM, the SEC decided not to adopt its initial proposal that would have required stable NAV funds to make determinations related to intermediaries’ capabilities of transacting at a floating NAV. Although the final rules do not include these requirements, the SEC stated that it believes stable NAV funds generally should engage with their distribution networks in considering how they would handle a negative interest rate environment, as intermediaries’ ability to apply a floating NAV or to process share cancellations in an RDM is an important consideration in determining an approach that is in the best interests of the fund and its shareholders.
Amendments Related to Calculations of WAM and WAL
Each money fund is currently required to calculate and publicly report its dollar-weighted average portfolio maturity (WAM) and dollar-weighted average life maturity (WAL), which are important determinants of interest rate risk in a fund’s portfolio. Money funds currently use different approaches when calculating WAM and WAL, with some basing these calculations on the percentage of each security’s market value and others basing them on the amortized cost of each security. The final rules require each money fund to make WAM and WAL calculations based on the percentage of each security’s market value in the portfolio.
Amendments to Certain SEC Reporting Requirements
The final rules modify certain reporting forms that are applicable to money funds, including the public report required to be promptly filed with the SEC upon the occurrence of certain specified events (Form N-CR), as well as the public monthly portfolio holdings report that is used to assist the SEC in monitoring and analyzing money funds (Form N-MFP). The final rules also modify a confidential reporting form applicable to certain private fund advisers (Form PF) to require additional information about liquidity funds they advise — i.e., unregistered private funds that seek to maintain a stable NAV and thus can resemble money funds.
Amendments to Prospectus/SAI Disclosure Requirements
The final rules amend the disclosure requirements for a money fund’s registration statement on Form N-1A to require disclosure reflecting the new liquidity fee framework and new disclosure regarding the potential use of an RDM.
The final rules will become effective 60 days after publication in the Federal Register (which has not yet occurred as of the date of this Client Alert), with the exception of the amendments to Forms N-MFP, N-CR, and PF, which have a delayed effective date of June 11, 2024.
The SEC adopted a tiered transition period for money funds to comply with the final rules, which is summarized in the chart below. Affected money funds may voluntarily choose to begin to rely on the mandatory and discretionary liquidity fee provisions at any time between the amendment’s effective date and the applicable compliance date.
For the amendments to Forms N-MFP, N-CR, and PF, the SEC adopted a simultaneous effective and compliance date of June 11, 2024, to provide for a uniform transition to the updated reporting requirements. Accordingly, all reports filed on or after June 11, 2024 must comply with the amendments, and filers will not be permitted to voluntarily provide the newly required information prior to then.
In addition, there is no separate compliance date for certain amendments to the final rules. As a result, funds must be in full compliance with these amendments by 60 days after publication in the Federal Register. In light of the extremely short period before these amendments become mandatory, money funds and their advisers should promptly begin to consider what actions would be necessary or appropriate to take prior to the effective date. The amendments subject to this short transition period include the removal of redemption gates, the removal of the tie between liquidity fees and liquidity thresholds, the new provision allowing the use of RDM in certain circumstances, the amendments to the registration statement disclosure requirements on Form N-1A, and the amendments to the recordkeeping rule to require money funds to preserve records regarding their liquidity fee computations.