At an open meeting (the “Meeting”) held on July 23, 2014, the Securities and Exchange Commission (the “SEC” or the “Commission”) adopted, by a vote of 3-2, amendments to Rule 2a-7 (the “Rule”) under the Investment Company Act of 1940, as amended (the “Act”), as well as other rules and forms under the Act, the Securities Act of 1933, as amended (the “Securities Act”), and the Investment Advisers Act of 1940, as amended (the “Advisers Act”).1 The release reflecting the amendments was issued that same day.2 Designed to supplement the money market fund reforms the Commission had previously adopted in 2010,3 the Rule Amendments attempt to address the susceptibility of certain money market funds to heavy redemptions, improve their ability to manage such redemptions, and increase the transparency of the risks in money market funds, while preserving their benefits for investors and issuers alike.
The Rule Amendments comprise two main components. While the proposing release4 contemplated that each component could be adopted individually or in combination with the other component, the Rule Amendments combine both components into one reform package.
Component One - Floating NAV:
- Institutional prime money market funds and institutional municipal money market funds will be required to “float” their net asset value (“NAV”) and sell and redeem shares based on the current market value of the securities in their underlying portfolios, similar to other open-end funds.
- Institutional prime money market funds and institutional municipal money market funds will be required to price and transact their shares to the fourth decimal place (e.g., $1.0000), a level of precision greater than they (or other types of funds) maintain currently.
- Government and retail money market funds will be exempt from the floating NAV requirement and will continue to be permitted to use the penny rounding method and/or amortized cost method of valuation to value their shares.
- Under proposed guidance5 from the U.S. Department of the Treasury and the Internal Revenue Service, investors in floating NAV money market funds will (i) be permitted to use a simplified tax accounting method to track gains and losses, (ii) no longer need to track individual purchase and sale transactions for tax reporting purposes and (iii) be granted relief from the “wash sale” rules for any losses on shares of a floating NAV money market fund.
Component Two - Fees and Gates:
- All money market funds will be permitted to impose a liquidity fee of up to 2% on each shareholder’s redemption or temporarily suspend (“gate”) redemptions for up to 10 business days in a 90-day period, in each case if (i) weekly liquid assets fall below 30% of total assets and (ii) the fund’s board of directors determines that imposing a fee or suspending redemptions, as applicable, is in the best interests of the fund.
- All money market funds except for government funds will be required to impose a 1% liquidity fee on each shareholder’s redemption if weekly liquid assets fall below 10% of total assets, unless the fund’s board of directors determines that imposing such a fee would not be in the best interests of the fund.
- Government funds may, but are not required to, impose similar liquidity fees and gates on shareholder redemptions.
The Rule Amendments also adopt, largely as proposed, new disclosure requirements for money market funds and other similar funds, changes to Form N-MFP, the introduction of new Form N-CR, tightening of existing diversification requirements under the Rule, new stress testing requirements and certain “clarifying” amendments to the Rule’s existing requirements.
Lastly, at the Meeting, the Commission unanimously voted to re-propose earlier amendments6 to remove references to credit ratings in the Rule and Form N-MFP. The release relating to these re-proposed amendments was issued by the Commission the same day.7
These Rule Amendments and other proposals are discussed in further detail below.
The floating NAV requirements, a centerpiece of the Rule Amendments, are designed to achieve two objectives: (i) reduce the “first mover advantage” inherent in a stable NAV fund due to the Rule’s current valuation and pricing methods, by dis-incentivizing redemption activity that can result from investors attempting to exploit the possibility of redeeming shares at the stable share price even if the portfolio has suffered a loss; and (ii) reduce the chance of “unfair investor dilution,” which would be inconsistent with a core principle of the Investment Company Act.8
The Rule Amendments adopt many of the elements of the floating NAV proposal included in the Proposing Release, with certain distinctions as described below.
Floating NAV and Pricing Amendments
The Rule Amendments eliminate the exemption that currently permits institutional prime money market funds (and institutional municipal money market funds) to maintain a stable NAV through amortized cost valuation and/or penny rounding pricing. Rather, the Rule Amendments require that such funds “float” their NAV, that is, sell and redeem shares at prices that reflect the value of their portfolio assets using market-based factors. Funds subject to the floating NAV requirement will only be able to use the amortized cost convention to the extent that other mutual funds are able to do so.9
Institutional prime money market funds (and institutional municipal money market funds) will also be required to price their shares using the more precise “basis point” rounding (i.e., to the nearest 1/100th of one percent),10 an amendment the Commission believes reflects “the level of sensitivity that would be required if gains and losses were to be regularly reflected in the share price of money market funds in all market environments, including relatively stable market conditions.”11 While the Proposing Release included the option for institutional prime money market funds to use “10 basis point rounding” (i.e., equivalent to rounding to three decimal places at a $1.000 share price) as an alternative to basis point rounding, this alternative was not included in the Rule Amendments due to the Commission’s concern that 10 basis point rounding may not be sufficient to ensure that investors can regularly observe the investment risks that are present in money market funds.12 While the Commission acknowledges that 10 basis point rounding could provide consistency in pricing among all floating NAV mutual funds, in their view, a further level of pricing precision should be required of institutional prime money market funds because of, among other things, their regulatory structure, purpose and investor risk tolerance.13
While the Proposing Amendments would have eliminated the use of the amortized cost method of valuation for all money market funds, the Commission was persuaded by commenters that argued that the prohibition on the amortized cost method would hinder a fund’s ability to provide for intraday purchases and redemptions and same-day settlement.14 Accordingly, the Rule Amendments permit government and retail money market funds to continue using the amortized cost method as an alternative to, or combined with, the penny-rounding method of valuation.
Government Fund Exemption
Government money market funds have unique portfolio compositions and, in turn, different redemption pressures and risk characteristics compared to other money market funds. Indeed, the Commission notes that while institutional prime money market funds experienced significant outflows during the 2007-2008 financial crisis, institutional and retail government money market funds experienced large inflows, reflecting a flight by investors to the stability and security of government money market funds.15
Accordingly, because government money market funds are not as susceptible to mass investor redemptions compared to other money market funds, such funds are exempt from the floating NAV requirement.16 The Rule Amendments define a “government money market fund” as a money market fund that invests at least 99.5% of its total assets in cash, government securities and/or repurchase agreements that are collateralized fully, thus lowering the percentage that a government money market fund may invest in non-government assets from 20% to 0.5% (the “non-conforming bucket”).17 Government funds that currently have a non-conforming bucket greater than 0.5% are expected to adopt such a policy in order to rely on the government fund exemption.18
Municipal (or tax-exempt) money market funds will not be permitted to rely on the government money market fund exemption because of the different credit and liquidity risk profile of their portfolio securities,19 but the Commission believes that the retail fund exemption (explained below) will likely cover at least some of these funds.
Retail Fund Exemption
In large part because of the different redemption risk profiles of retail investors, who “historically have behaved differently from institutional investors in a crisis, being less likely to make large redemptions quickly in response to the first sign of market stress,”20 the Rule Amendments exempt retail money market funds from the floating NAV requirement.
Under the Rule Amendments, a “retail” money market fund is defined as a money market fund that has policies and procedures reasonably designed to limit all beneficial owners of the fund to natural persons.21 The Commission believes that this natural person test is a simpler and more cost-effective way of accomplishing the Rule Amendments’ goals compared to the definition proposed in the Proposing Release, which would have defined a retail money market fund based on a $1 million daily redemption restriction.22
As noted in the Adopting Release, funds will have the flexibility to choose how to comply with the natural person test, although the Commission expects that most funds will rely on social security numbers to confirm beneficial ownership by a natural person.23 In the case of omnibus accounts, a retail fund will need to determine that the underlying beneficial owners of the omnibus account are natural persons, but money market funds typically lack the ability to look through omnibus accounts to determine the characteristics of their underlying investors.24 While not prescribing the ways in which a retail fund may satisfy the retail definition, the Commission notes that a fund’s policies and procedures could include, for example, relying on periodic certifications of an intermediary or contractual arrangements.25
While the government fund exemption is based on the nature of the fund’s underlying portfolio securities, the retail fund exemption is based on the identity of the fund’s shareholder base, which poses a practical problem for any money market fund that currently has both retail and institutional shareholders. In order to simultaneously rely on the retail fund exemption while preserving a money manager’s institutional shareholder base, such a manager that does not already have institutional money market fund options available will need to reorganize its existing funds into separate retail and institutional funds.26 In order to facilitate such reorganizations, the Commission is taking the position that a reorganization of a class of a fund into a new fund may take place without separate exemptive relief,27 provided that the fund’s board of directors, including a majority of the directors who are not interested persons of the fund, determines that the reorganization results in a fair and approximately pro rata allocation of the fund’s assets between the class being reorganized and the class remaining in the fund.28 Furthermore, in the context of a one-time reorganization to distinguish between retail and institutional money market funds (e.g., to ensure that an existing fund only has retail or institutional investors), the Commission is taking the position that a fund may involuntarily redeem investors who no longer meet eligibility requirements (either retail or institutional) without separate exemptive relief, provided that the fund notifies in writing such investors who become ineligible to invest in a particular fund at least 60 days before the redemption occurs.29
Floating NAV – Tax Implications
To address concerns about how to determine and report the multiple gains and losses arising from frequent purchases and redemptions of shares in floating NAV money market funds, the IRS and Treasury have proposed regulations allowing a simplified method of accounting for gain and loss on shares in such funds.30 Under the simplified method, gains and losses are based on two factors: (A) changes in the aggregate value of a taxpayer’s shares during a computation period (usually the taxable year) and (B) the taxpayer’s net investment in such shares during the computation period. Specifically, the taxpayer’s net gain or loss from shares in a floating NAV money market fund equals the difference of A minus B, where A equals (1) the aggregate value of its shares at the end of the computation period minus (2) the aggregate value of its shares at the end of the prior computation period, and (B) equals (1) the aggregate cost of shares purchased (including by dividend reinvestment) during the computation period minus (2) the aggregate amount received during the computation period in taxable redemptions.
Example: Shareholder X uses a floating NAV money market fund (“Fund-1”) for cash management purposes and adopts the calendar year as its computation period. At the end of 2013, the aggregate value of X’s shares in Fund-1 is $100,000. At the end of 2014, the aggregate value of X’s shares in Fund-1 is $125,000. During 2014, X pays $25,000 to purchase Fund-1 shares and receives $15,000 from redeeming Fund-1 shares. Under the simplified method, X reports $15,000 of income from Fund-1 for 2014, computed as $25,000 ($125,000 minus $100,000) minus $10,000 ($25,000 minus $15,000).
Even if a taxpayer does not adopt the simplified method of accounting, the proposed regulations provide some relief by suspending application of the so-called “wash sale” rules to frequent purchases and redemptions of floating NAV money market fund shares. Unless the wash sale rules were suspended, they would prevent the immediate deduction of any losses from floating NAV money market fund share redemptions and would require the amount of such losses to be added to the basis of any new shares purchased, thereby deferring such losses.
Intraday Liquidity and Same-Day Settlement
Many institutional money market funds permit share transactions to settle on the same day that an investor places a purchase or sell order, an accommodation facilitated by order management systems that rely upon a stable NAV. Funds and transfer agents that do not have systems that can support same day settlement for a floating NAV fund may need to make adjustments or build upgrades. However, the Commission recognizes that because it may take several hours to strike a market-based NAV price, floating NAV funds may no longer be able to offer trading times for same day settlement late in the day (i.e., after 4 p.m.).31 The Commission also believes that floating NAV funds should be able to continue to provide shareholders with intraday liquidity by pricing fund shares periodically during the day (e.g., at 11 a.m. and 4 p.m. each day).32
Valuation and Pricing Services
The Adopting Release includes certain guidance relating to valuation of money market securities and other securities that do not frequently trade in secondary markets and use of pricing services.
With respect to debt securities held by money market funds in general, many of which are thinly-traded, the Commission provides specific guidance that funds should not fair value debt securities at par or amortized cost (on the expectation that the funds will hold these securities until maturity) if the funds could not reasonably expect to receive approximately that value upon the current sale of such securities under current market conditions.33
The Commission also cautions boards of directors against over-reliance on third-party pricing services. Noting that a fund’s board of directors has a “non-delegable responsibility to determine whether an evaluated price. . . constitutes a fair value for a fund’s portfolio security,”34 the Commission sets out a range of factors that boards may want to consider when evaluating prices from pricing services.35
Standby Liquidity Fees and Gates
While the floating NAV Rule Amendments are designed to increase the transparency of money market fund pricing, the Rule Amendments relating to liquidity fees and gates are designed to give money market funds the tools to better manage heavy redemptions and limit the extent of a run. In particular, the Commission explains in the Adopting Release that the new liquidity fees and gates requirements are designed to moderate redemption requests by allocating liquidity costs to those shareholders who impose such costs on funds through their redemptions.36
Under the fees and gates Rule Amendments, if the weekly liquid assets of a money market fund fall below 30% of its total assets, such fund may impose at any point throughout the day, up to a 2% liquidity fee on each shareholder’s redemption. A fund, however, may only impose such a liquidity fee if its board of directors (including a majority of its independent directors) determines that such a fee is in the best interest of the fund.37 The Rule Amendments also require a money market fund (other than a government fund) to impose, effective as of the beginning of the next business day, a 1% liquidity fee on each shareholder’s redemption if weekly liquid assets fall below 10% of its total assets at the end of any business day, unless the board of directors (including a majority of its independent directors) determines that imposing such a fee is not in the best interests of the fund.38 “Weekly liquid assets” generally include cash, U.S. treasury securities, certain other government securities with remaining maturities of 60 days or less, securities that convert into cash within one week, and receivables due unconditionally within one week on pending sales of portfolio securities.39
The applicable liquidity fee must be lifted, effective as of the beginning of the next business day, once a fund restores its weekly liquid assets to 30% or more of its total assets at the end of a business day.40 A fund’s board of directors (including a majority of its independent directors) may also lift a liquidity fee at any time if the board determines to impose a different fee or if it determines that imposing the fee is no longer in the best interests of the fund.41
In the case of omnibus accounts, the Commission expects that money market funds, like existing mutual funds that have imposed redemption fees to deter market timing, will rely on contractual arrangements with financial intermediaries to require the financial intermediary to impose any redemption fees on beneficial holders holding through that intermediary. The Commission understands that money market funds will want to review their contracts with financial intermediaries to determine whether any modifications are necessary or advisable to ensure that any liquidity fees are appropriately applied.42
The Rule Amendments also include a provision that permit a master fund and its board, but not the related feeder funds, to impose and set the terms of any applicable fee or gate.43 Under the Rule Amendments, a feeder fund may only pass through to its investors the fees and gates imposed by the related master fund and on the same terms and conditions imposed by the master fund.44
The new gate Rule Amendments are designed to provide fund boards with a direct and immediate tool for delaying redemptions long enough to allow: (i) fund managers time to assess the condition of the fund and determine the appropriate strategy to meet redemptions; (ii) liquidity buffers to grow organically as securities in the portfolio mature and produce cash; and (iii) shareholders to assess the liquidity and value of portfolio holdings in the fund.45 Under these Rule Amendments, a money market fund’s board of directors may temporarily suspend redemptions (thus “gating” the fund) at any time after the fund’s weekly liquid assets fall below 30% and the board (including a majority of its independent directors) determines that imposing a gate is in the best interest of the fund.46
Any gate must be lifted, as of the beginning of the next business day, following a business day that ended with the fund’s having invested 30% or more of its total assets in weekly liquid assets (although the gate may be lifted earlier by the board of directors).47 A fund may not impose a gate for more than 10 days in any rolling 90-day period.48 This time limit is designed to protect a fund in times of stress without unduly limiting the redeemability of its shares, a hallmark of open-end investment company shares under the Act.49
Government Fund Exemption
As described above, because government money market funds historically experience inflows, rather than outflows, in times of stress, government funds are exempt from the fees and gates Rule Amendments. However, a government money market fund is permitted to voluntarily impose a fee or gate under the same regime provided that its prospectus affirmatively permits it to do so.50
Other Rule Amendments
Rule 10b-10 under the Securities Exchange Act of 1934, as amended (the “Exchange Act”), requires broker-dealers to immediately confirm customers’ securities transactions. The Rule contains an exemption for transactions of money market funds that attempt to maintain a stable net asset value and where no sales load or redemption fee is charged.51 Under this exemption, broker-dealers are permitted to provide money market fund transaction information to shareholders on a monthly basis in lieu of individual, immediate confirmations. The adoption of the floating NAV Rule Amendments now technically requires broker-dealers to provide investors in floating NAV money market funds with immediate confirmations of their transactions and may significantly impact broker-dealers’ confirmation systems and operations. Accordingly, contemporaneous with the Adopting Release, the Commission provided notice of, and requested comment on, a proposed order52 that would grant exemptive relief from the immediate confirmation delivery requirements of Rule 10b-10 for transactions effected in shares of any money market fund subject to the floating NAV Rule Amendments.
Ability to Suspend Redemptions and Liquidate Preserved
Under the Rule Amendments, all money market funds, including floating NAV funds, will continue to be able to rely on Rule 22e-3 under the Act to suspend redemptions and liquidate in times of fund and market distress. Under the new Rule, a money market fund will be permitted to permanently suspend redemptions and liquidate if, among other requirements, the fund, at the end of a business day, has invested less than 10% of its total assets in weekly liquid assets.53 Additionally, stable value funds will continue to be able to suspend redemptions and liquidate if the board determines that the deviation between its amortized cost price per share and its market-based NAV per share may result in material dilution or other unfair results to investors or existing shareholders.54
Affiliated Purchases Preserved
All money market funds, including floating NAV funds, will continue to be permitted to rely on Rule 17a-9 to allow affiliated persons of the money market fund to purchase portfolio securities from the fund under certain circumstances.55
New Disclosure Requirements
Required Disclosure Statements. The Rule Amendments require all money market funds to include new disclosures in advertisements and sales materials and in their summary prospectuses (or in the summary section of the statutory prospectus if no summary prospectus is used).56
Generally, all money market funds will be required to make some new disclosures, including specific risk factor disclosures and disclosure that fund sponsors have no legal obligation to provide financial support to the fund.57 Among other things, government money market funds will be required to include disclosure regarding the new 0.5% non-conforming bucket while retail money market funds will be required to include disclosure regarding the limitation of beneficial ownership to natural persons.58
Floating NAV money market funds will be required to include disclosure regarding, among other things, new pricing and settlement procedures, the implications of transitioning to a floating NAV, the tax consequences of a floating NAV and new, specific risk factor disclosures. With respect to the fees and gates Rule Amendments, all money market funds (except for government funds) will be required to include the following specific, disclosure items: (i) the means of notifying shareholders about the imposition and lifting of fees and/or gates; (ii) timing of the imposition and lifting of fees and gates; (iii) use of liquidity fee proceeds by the fund, including any possible return to shareholders in the form of a distribution; (iv) the tax consequences to the fund and its shareholders of the fund’s receipt of liquidity fees; and (v) a general description of the process of fund liquidation.59 The Rule Amendments also require all money market funds to disclose historical instances of the imposition of fees and gates in their SAIs.60
Sponsor Support. The Rule Amendments require a money market fund to disclose historical instances of sponsor support in its SAI, including financial support provided to a predecessor fund.61 A money market fund also will be required to disclose on new Form N-CR (see discussion below) present instances of sponsor support and, on the same day as the Form N-CR filing, to disclose the same information on its website. Such disclosure, the Commission believes, will help money market fund investors understand the nature and extent that a sponsor has supported the fund, and allow them to fully appreciate the risks of investing in such fund. “Financial support” includes:63
i. any capital contribution;
ii. purchase of a security from the fund in reliance on Rule 17a-9;
iii. purchase of any defaulted or devalued security at par;
iv. execution of a letter of credit or letter of indemnity;
v. capital support agreement (whether or not the fund ultimately received support);
vi. a performance guarantee; or
vii. any other similar action reasonably intended to increase or stabilize the value or liquidity of the fund’s portfolio.
While the Proposing Amendments were silent on this point, the definition of “financial support” in the Rule Amendments clarifies that certain routine actions, and actions not reasonably intended to increase or stabilize the value or liquidity of a fund’s portfolio, do not need to be reported as financial support. Accordingly, Form N-CR and Form N-1A specifically exclude any routine waiver of fees or reimbursement of fund expenses, routine inter-fund lending, routine inter-fund purchases of fund shares, or any action that would qualify as financial support as defined above, that the board of directors has otherwise determined is not reasonably intended to increase or stabilize the value or liquidity of the fund’s portfolio.
Website Disclosure. Under the Rule Amendments, all money market funds will be required to disclose prominently on their websites, on a daily basis, the following information, in each case as of the end of the previous business day:64
- the percentage of daily and weekly liquid assets;
- the net inflows and outflows; and
- the current NAV per share calculated based on current market factors before applying the amortized cost or penny rounding method, if used (rounded to the fourth decimal place for funds with a $1.0000 share price or an equivalent level of accuracy).
The Rule Amendments require that the fund maintain on its website six months of historical records of such information.65
Amendments to Form N-MFP. Money market funds are currently required to file information about their portfolio holdings on Form N-MFP within five days after the end of each month.66 The Commission makes this information publicly available with a 60-day delay. Money market funds are also required to disclose much of the portfolio holdings information that Form N-MFP requires on the fund’s website each month no later than the fifth business day of each month. Under the Rule Amendments, Form N-MFP will be amended to make conforming changes related to the floating NAV and fees and gates Rule Amendments discussed above and require funds to report some additional new items, including the following:67
- Identification of portfolio securities (CUSIP, Legal Entity Identifier (“LEI”) and at least one other security identifier relating to each portfolio security).
- Whether a security is categorized as a level 3 measurement in the fair value hierarchy of U.S. Generally Accepted Accounting Principles.
- Additional portfolio security information (the yield as of the Form N-MFP reporting date).
- Amount of cash holdings.
- Daily Liquid Assets (to be reported on a weekly basis on both a dollar and percentage basis).
- Weekly Liquid Assets (to be reported on a weekly basis on both a dollar and percentage basis).
- Weekly gross redemptions and subscriptions for each share class.69
- Waivers and/or reimbursements of operating expenses or management fees.
- New investment categories used to describe portfolio securities (e.g., U.S. Treasury Debt, U.S. Government Agency Debt, Non-U.S. Sovereign, Sub-Sovereign and Supra-National debt; Asset Backed Commercial Paper, Investment Company, Tender Option Bond, among other categories).
- Maturity dates of each portfolio security (using the maturity date used to calculate the dollar-weighted average life maturity (“WAL”), the maturity date used to calculate the dollar-weighted average maturity (“WAM”) and the ultimate legal maturity date).
- The number of shares outstanding at both the series and class levels.
- The period remaining until the principal amount of a security may be recovered through a demand feature and whether the demand feature is conditional.
In addition, the Rule Amendments eliminate the 60-day delay on public availability of the information filed on Form N-MFP and make such information immediately available to the public upon filing.70 The 60-day delay was originally adopted in 2010 to address concerns regarding potential reactions of investors to the disclosure of funds’ portfolio information and shadow NAVs.71 Although the Commission then believed that the shadow price data should not be made public immediately, the Commission now believes that the immediate release of the shadow price data will not be harmful.72 The Rule Amendments also harmonize the specific portfolio holdings information that Rule 2a-7 currently requires funds to disclose on their websites with the corresponding portfolio holdings information proposed to be reported on Form N-MFP73 as well as make further clarifying amendments to the form.
New Form N-CR. The Rule Amendments include new Form N-CR, which the Commission believes will enhance its oversight of money market funds and its ability to respond to market events.74 Similar to Form 8-K under the Exchange Act, a filing on Form N-CR will be required upon the occurrence of certain events, such as instances of portfolio security default, sponsor support of funds (see “—Sponsor Support” above), a deviation of ¼ of 1 percent in the market-to-market NAV of a fund permitted to transact at a stable price (e.g., to $0.9975 from $1.0000), when the fund’s weekly liquid assets have fallen below 10% of total assets, when liquidity fees or redemption gates are imposed (including the fund’s weekly liquid assets at the time of the imposition of the fees or gates) or lifted, a brief discussion of the primary considerations or factors taken into account by the fund’s board of directors in its decision to impose (or not impose) a liquidity fee or suspend the fund’s redemptions and certain other details related to these significant events.75 Unless otherwise specified in the form, money market funds will be required to file a report on Form N-CR within one business day of the event that triggered the filing, and make a follow-up filing within four business days that includes a more complete description and more detailed information.76 The Rule Amendments also require that funds disclose on their website, for at least one year, summaries of certain information that they are required to report on Form N-CR, such as instances of sponsor support, the fact that the fund’s weekly liquid assets have fallen below 10% of total assets, the imposition of liquidity fees, temporary suspension of fund redemptions and the removal of liquidity fees and/or resumption of fund redemptions.77 The Rule Amendments further require funds to disclose historical instances of, and details related to, such significant events in their SAIs to the extent they occurred in the past 10 years.78
Amendments to Form PF. To address the systemic risk that may result from investors seeking alternatives, such as private funds, to money market funds as a result of the Rule Amendments,79 large liquidity fund advisers80 will be required to file on Form PF largely the same information with respect to their liquidity funds’ portfolio holdings as money market funds are required to file on Form N-MFP.81
Tightening of Diversification Requirements
In an effort to limit further money market fund risk exposure, the Rule Amendments include measures to tighten the Rule’s existing diversification requirements.
Treatment of Affiliates. Under the Rule Amendments, money market funds will be required to aggregate affiliates when applying the Rule’s 5% issuer diversification limit.82 An issuer will be affiliated with another issuer for this purpose if it controlled, is controlled by or is under common control with the other issuer. “Control” for this purpose only will be defined as ownership of more than 50% of an issuer’s voting securities.83 The Rule Amendments, however, exclude certain majority equity owners of asset-backed commercial paper (“ABCP”) conduits from the requirement to aggregate affiliates.84 With respect to SPEs financed by a single ABCP conduit, it is common for multiple SPEs to be owned by a common originator parent entity. The Commission clarified in the Adopting Release that the new affiliate aggregation rule will require a money market fund to aggregate such SPEs in determining whether such entities are a 10% obligor of the ABCP conduit. If so, the money market fund will need to aggregate its exposure to such SPEs for purposes of applying the Rule’s 5% issuer diversification limit.85 The Commission acknowledges that this treatment of 10% obligors may cause some ABCP conduits to restructure their programs, which could result in reduced funding capacity from money market funds.86
Asset-Backed Securities. To help address the substantial losses that money market funds suffered during the 2007-2008 financial crisis due to investments in certain types of asset-backed securities (“ABS”), the Rule Amendments require that money market funds treat the sponsor of the SPE that issues the ABS as a “guarantor” of the ABS for the purposes of the Rule’s 10% diversification limitation relating to guarantors and demand feature providers.87 Practically, this means that a fund may not invest in an ABS if, immediately after the investment, such fund would have invested more than 10% of its total assets in securities issued by, or subject to demand features or guarantees from (which would include all ABS securitizations sponsored by), the ABS sponsor.88 The only exception is where a fund’s board of directors (or its delegate) determines that the fund is not relying (at all) on the ABS sponsor’s financial strength or its ability or willingness to provide liquidity, credit or other support to determine the quality or liquidity of the ABS.89 The Commission stated its belief that for ABCP conduits, the “sponsor” for these purposes will typically be the financial institution that provides explicit liquidity and/or credit support and also provides administrative services to the ABCP conduit.90
Elimination of 25% Basket For Demand Features and Guarantees. Under the current Rule, as much as 25% of a money market fund’s portfolio may be subject to guarantees or demand features from a single institution.91 To address the risks that money market funds faced during the 2007-2008 financial crisis as a result of their exposure to providers of demand features and guarantees,92 the Rule Amendments (i) eliminate this 25% basket for all funds other than tax-exempt money market funds and (ii) reduce to 15%, rather than eliminate, the 25% basket for tax-exempt money market funds, including single state money market funds.93
Under the Rule Amendments, all funds will be required to periodically test, at such intervals as the board of directors determines appropriate and reasonable in light of current market conditions, their ability to maintain weekly liquid assets of at least 10%94 and to minimize principal volatility in response to specified hypothetical events.95 The Rule Amendments do not prescribe specific limitations or thresholds against which funds should test principal volatility. In the Commission’s view, funds and fund boards are best suited to determine such limitations or thresholds.96
The Rule Amendments specify the following minimum hypothetical events that funds are required to incorporate in their stress testing, each such event in combination with various levels of an increase in shareholder redemptions: (i) increases in the general level of short-term interest rates; (ii) a downgrade or default of particular portfolio security positions; and (iii) a widening of spreads compared to the indexes in which portfolio securities are tied in various sectors in the fund’s portfolio. The Rule Amendments also require funds to test for any “additional combinations of events that the adviser deems relevant.”97 Funds are required to report the results of such stress testing to their boards at their next regularly scheduled meeting, or sooner if appropriate.98 The fund’s adviser must include a summary of the significant assumptions made when performing the stress tests.99
The Rule Amendments include numerous other amendments and clarifications to the existing stress testing provisions of the Rule.
The Rule Amendments include the following clarifications to certain 2010 Amendments to the Rule:
Definition of Daily Liquid Assets and Weekly Liquid Assets.
- Money market funds will not be able to use the maturity-shortening provisions in current paragraph (d) of the Rule regarding interest rate adjustments when determining whether a security satisfies the maturity requirements of a daily liquid asset or weekly liquid asset.100
- An agency discount note with a remaining maturity of 60 days or less will qualify as a “weekly liquid asset” only if the note is issued without an obligation to pay additional interest on the principal amount.101
- The definitions of daily and weekly liquid assets will be amended to include amounts receivable that are due unconditionally within one or five business days, respectively, on pending sales of portfolio securities.102
Definition of Demand Feature. The definition of “demand feature” under the Rule is amended to mean a feature permitting the holder of a security to sell the security at an exercise price equal to the approximate amortized cost of the security plus accrued interest, if any, at the time of exercise paid within 397 calendar days of exercise.103 This amendment effectively eliminates the requirement that a demand feature be exercisable at any time on no more than 30 calendar days’ notice.
Short-Term Floating Rate Securities. Under the Rule Amendments, for the purposes of determining WAL, a short-term floating rate security will be deemed to have a maturity equal to the period remaining until the principal amount can be recovered through demand.104
Second Tier Securities. The Rule Amendments clarify that the 45-day remaining maturity limit applicable to second tier securities must be determined without reference to the maturity-shortening provisions in the Rule for interest rate adjustments.105
Removal of References to Credit Ratings
Contemporaneous with the Rule Amendments, the Commission re-proposed certain amendments, initially proposed in March 2011,106 related to the removal of credit rating references in the Rule and Form N-MFP. The Credit Ratings Re-Proposing Amendments would implement certain provisions of the Dodd-Frank Wall Street Reform and Consumer Protection Act that require the Commission to remove any reference to, or requirement of reliance on, credit ratings in its regulations. In the Credit Ratings Re-Proposing Release, the Commission also proposed to eliminate from the issuer diversification requirement of Rule 2a-7 the exclusion for securities subject to a guarantee issued by a non-controlled person
The current Rule requires that money market funds be invested only in “eligible securities,” that is, securities that have received one of the two highest short-term ratings or, if they are not rated, of comparable quality.107 Under the Credit Ratings Re-Proposing Amendments, an eligible security would be a security with a remaining maturity of 397 calendar days or less that the fund’s board of directors (or its delegate) determines presents minimal credit risks, which determination includes a finding that the security’s issuer has an exceptionally strong capacity to meet its short-term obligations.108 This change would have the effect of eliminating the distinction between first and second tier securities and would eliminate the Rule’s current limitations on investments in second tier securities. The Credit Ratings Re-Proposing Amendments include a list of factors for a board to consider when determining the credit risk of a portfolio security.109 The Credit Ratings Re-Proposing Amendments also remove references to credit ratings in: (i) the determination of whether a security is a first tier security; (ii) credit quality standards for securities with a conditional demand feature; (iii) requirements for monitoring securities for ratings downgrades and other credit events; and (iv) stress testing.110 Under the Credit Ratings Re-Proposing Amendments, fund boards would no longer be required to designate NRSROs.111 However, fund boards (or their delegates) may continue to take into account analyses provided by third parties, including ratings provided by ratings agencies, when making the credit quality determinations required under the Credit Ratings Re-Proposing Amendments.112
The Credit Ratings Re-Proposing Amendments also impact certain Form N-MFP reporting obligations, which currently require that money market funds report certain credit ratings assigned to each portfolio security. Rather than eliminate these credit rating references entirely, the Commission in the Credit Ratings Re-Proposing Amendments is proposing that a money market fund must disclose for each portfolio security (i) each rating assigned by any NRSRO if the fund or its adviser subscribes to that NRSRO’s services, as well as the name of the agency providing the rating and (ii) any other NRSRO rating that the fund’s board of directors (or its delegate) considered in making its minimal credit risk determination, as well as the name of the agency providing the rating.113
Under the current Rule, a money market fund is not required to be diversified with respect to issuers of securities that are subject to a guarantee by a non-controlled person.114 The current Rule requires funds to comply with the 10% guarantor diversification requirement, but exempts them from compliance with the 5% issuer diversification requirement with respect to such guaranteed security. In the Credit Ratings Re-Proposing Release, the Commission would require each money market fund that invests in securities subject to a guarantee (including asset-backed securities with a presumed sponsor guarantee) to comply with both the 10% guarantor diversification requirement as well as the 5% issuer diversification requirement, whether or not the guarantor is a non-controlled person.115 The Commission believes that this change would more appropriately limit money market fund risk exposures by limiting the concentration of exposure that a money market fund could have otherwise had to a particular issuer.116
Comment Periods – Proposing Amendments
Public Comments on the Treasury Guidance must be received by Department of the Treasury on or before October 27, 2014.
Public comments on the Confirmation Rule Proposed Order must have been received by the SEC on or before August 19, 2014.
Public comments on the Credit Ratings Re-Proposing Amendments must be received by the SEC on or before October 14, 2014.
Compliance Periods – Proposing Amendments and Adopting Amendments
The compliance date for the floating NAV and liquidity fees and gates amendments is October 14, 2016 to allow money market funds, intermediaries and other service providers to make system modifications necessary to implement such amendments. The compliance date for new Form N-CR is July 14, 2015 and the compliance date for the diversification, stress testing, disclosure, Form PF, Form N-MFP and clarifying amendments is April 14, 2016.
The compliance date for the Credit Ratings Re-Proposing Amendments is April 14, 2016.
1 Under the Rule Amendments, the following provisions and forms are being added to, or amended under, the securities laws referenced above: Rule 419 and Rule 482 under the Securities Act; Rule 2a-7, Rule 12d3-1, Rule 18f-3, Rule 22e-3, Rule 31a-1, Rule 30b1-7 and new Rule 30b1-8 under the Act; Form N-1A under the Act and the Securities Act; Form N-MFP under the Act; Form N-CR under the Act; and Section 3 of Form PF under the Advisers Act.
2 See “Money Market Fund Reform; Amendments to Form PF,” Investment Company Act Release No. 31166 (July 23, 2014) (the “Adopting Release”; the related rule amendments, the “Rule Amendments”).
3 See “Money Market Fund Reform,” Investment Company Act Release No. 29132 (February 23, 2010) (the “2010 Adopting Release”; the related rule amendments, the “2010 Amendments”).
4 See “Money Market Fund Reform; Amendments to Form PF,” Investment Company Act Release No. 30551 (June 5, 2013) (the “Proposing Release”; the related proposing amendments, the “Proposing Amendments”).
5 See “Method of Accounting for Gains and Losses on Shares in Certain Money Market Funds; Broker Returns with Respect to Sales of Shares in Money Market Funds,” Internal Revenue Service Regulation No. 107012-14 (July 23, 2014) (the “Treasury Guidance”).
6 See “References to Credit Ratings in Certain Investment Company Act Rules and Forms,” Investment Company Act Release No. 29592 (March 3, 2011).
7 See “Removal of Certain References to Credit Ratings and Amendment to the Issuer Diversification Requirement in the Money Market Fund Rule,” Investment Company Act Release No. 31184 (July 23, 2014) (the “Credit Ratings Re-Proposing Release”; the related proposing amendments, the “Credit Ratings Re-Proposing Amendments”).
8 See the Adopting Release at 138.
9 See the Adopting Release at 270. Specifically, a non-money market mutual fund is able to use amortized cost when the fund’s board of directors determines, in good faith, that the fair value of debt securities with remaining maturities of 60 days or less is their amortized cost, unless the particular circumstances warrant otherwise. See “Valuation of Debt Instruments by Money Market Funds and Certain Other Open-End Investment Companies,” Investment Company Act Release No. 9786 (May 31, 1977).
10 See new Rule 2a-7(c)(1)(ii).
11 See the Adopting Release at 154.
12 See the Adopting Release at 154-155.
13 See the Adopting Release at 157-158.
14 See the Adopting Release at 165.
15 See the Adopting Release at 611.
16 The Commission notes in the Adopting Release that the floating NAV requirement may have implications for local government investment pools (“LGIPs”), which many states have established to invest in short-term securities and which are required by law or by investment policies to maintain a stable NAV per share. In order to continue to manage LGIPs, the Commission explains, state statutes and policies may need to be amended to permit the operation of LGIPs that adhere to the Rule Amendments. See the Adopting Release at 252-254.
17 See new Rule 2a-7(a)(16). The Commission specifically rejected the 20% non-conforming basket permitted under the current Rule and the Proposing Amendments due to concerns that it may “promote a type of hybrid money market fund that presents new risks that are not consistent with the purposes of the money market reforms adopted today.” See the Adopting Release at 202.
18 See the Adopting Release at 207.
19 See the Adopting Release at 237 and 247-248.
20 See the Adopting Release at 209.
21 See new Rule 2a-7(a)(25).
22 See the Adopting Release at 217.
23 See the Adopting Release at 219.
24 See the Adopting Release at 226-227.
25 See the Adopting Release at 227.
26 See the Adopting Release at 223.
27 I.e., from Sections 17(a), 18(f)(1) and 18(i) of the Act.
28 See the Adopting Release at 224. Funds may incur costs to obtain shareholder approval to the extent that a money market fund’s charter documents and/or applicable state law require shareholder approval to effect a reorganization into separate retail and institutional money market funds.
29 See the Adopting Release at 225-226.
30 See the Treasury Guidance.
31 See the Adopting Release at 192-193.
32 See the Adopting Release at 190.
33 See the Adopting Release at 278.
34 See the Adopting Release at 279.
35 Such factors include, for example, the inputs, methods, models and assumptions used by the pricing service, the quality of the evaluated prices, the time when the pricing service determines evaluated prices, and the extent to which the fund’s board of directors believes in good faith that the evaluated prices reflect what the fund could reasonably expect to obtain in a sale under current market conditions. See the Adopting Release at 280-281.
36 See the Adopting Release at 42.
37 See new Rule 2a-7(c)(2)(i). The Proposing Release outlines certain factors that a board may want to consider when making a “best interests” determination (see the Proposing Release at 178-179). The Adopting Release, by contrast, provides specific “guideposts” that boards may want to keep in mind when making such determinations. These guideposts include: (i) relevant indicators of liquidity stress in the markets and why the fund’s weekly liquid assets have fallen; (ii) the liquidity profile of the fund and expectations as to how the profile might change in the immediate future; (iii) the make-up of the fund’s shareholder base and previous shareholder patterns; (iv) for retail and government money market funds, whether the fall in weekly liquid assets has been accompanied by a decline in the fund’s shadow NAV; and/or (v) the fund’s experience with the imposition of fees and/or gates in the past. See the Adopting Release at 88-89. The Adopting Release further clarifies that the applicable standard for a best interests determination is whether a fee or gate is in the fund’s best interests; the broader systemic effects of a board’s decision are secondary. See the Adopting Release at 88.
38 See new Rule 2a-7(c)(2)(ii). The Proposing Amendments would have required money market funds (except for government funds) to impose a 2% liquidity fee if weekly liquid assets fell below a 15% threshold.
39 See new Rule 2a-7(a)(34).
40 See new Rule 2a-7(c)(2)(i)(A) and (ii)(B).
41 See Id.
42 See the Adopting Release at 118-119.
43 See new Rule 2a-7(c)(2)(v).
44 See Id.
45 See the Adopting Release at 50.
46 See new Rule 2a-7(c)(2)(i). See also related exemption from Section 22(e) of the Act discussed at 109-111 of the Adopting Release.
47 See new Rule 2a-7(c)(2)(i)(B).
49 See the Adopting Release at 50-51.
50 See new Rule 2a-7(c)(2)(iii).
51 See Exchange Act Rule 10(b)-10b.
52 See “Notice of Proposed Exemptive Order Granting Permanent Exemptions Under the Securities Exchange Act of 1934 from the Confirmation Requirements of Exchange Act Rule 10b-10 for Certain Money Market Funds,” Exchange Act Release No. 34-72658 (July 23, 2014) (the “Confirmation Rule Proposed Order”).
53 See new Rule 22e-3(a)(1).
54 See Id.
55 See the Adopting Release at 308-309.
56 See the Adopting Release at 281-282.
57 See the Adopting Release at 289-291.
58 See the Adopting Release at 294.
59 See the Adopting Release at 298.
60 See the Adopting Release at 299.
61 See new Item 16(g)(2) of Form N-1A.
62 See the Adopting Release at 311.
63 See Instruction 1 to new Item 16(g)(2) of Form N-1A and Part C of Form N-CR.
64 See new Rule 2a-7(h)(10).
66 See current Rule 2a-7(c)(12)(ii).
67 See new Form N-MFP.
68 In contrast to the Proposing Amendments, money funds will not be required to report detailed security information separately for each lot purchased and for any security sold during the reporting period.
69 In contrast to the Proposing Amendments, money funds will not be required to report the percentage of fund shares held by the top 20 shareholders.
70 See new Rule 30b1-7 (eliminating subsection (b), public availability).
71 See the 2010 Adopting Release at note 92.
72 See the Adopting Release at 452.
73 See new Rule 2a-7(h)(10)(i)(B).
74 See the Adopting Release at 746.
75 See new Rule 30b1-8 and new Form N-CR.
76 See General Instruction A to new Form N-CR.
77 See new Rule 2a-7(h)(10)(v).
78 See new Item 16(g) of Form N-1A.
79 See the Adopting Release at 457.
80 Defined as registered advisers with $1 billion or more in combined money market fund and liquidity fund assets. See Form PF, Instruction 3, Section 3.
81 See new Question 63 in Section 3 of Form PF.
82 See new Rule 2a-7(d)(3)(ii)(F).
84 Specifically, a fund is not required to aggregate an ABCP conduit and its independent equity owners for purposes of the 5% issuer diversification limit provided that: (i) a primary line of business of such independent equity owners is owning equity interests in special purpose entities (“SPEs”) and providing services to SPEs; (ii) the independent equity owners’ activities with respect to the SPEs are limited to providing management or administrative services; and (iii) no qualifying assets of the ABCP conduit were originated by the equity owners. See new Rule 2a-7(d)(3)(ii)(F)(2).
85 See the Adopting Release at 482-483.
86 See Id.
87 See new Rule 2a-7(a)(18)(ii). The Commission makes clear, however, that while the sponsor is treated as a guarantor for purposes of this diversification limitation, such sponsor is not deemed to have provided a guarantee for the purposes of the following provisions of the Rule: (i) Rule 2a-7(a)(12)(iii) (the definition of eligible security); (ii) Rule 2a-7(d)(2)(iii) (credit substitution); (iii) Rule 2a-7(d)(3)(iv)(A) (fractional guarantees); and (iv) Rule 2a-7(e) (guarantees not relied on). See the Adopting Release at note 1629.
88 See the Adopting Release at note 1627.
89 See new Rule 2a-7(a)(18)(ii).
90 See the Adopting Release at 499.
91 See current Rule 2a-7(c)(4)(iii).
92 See the Adopting Release at 505.
93 The Proposing Amendments would have eliminated the 25% basket for all funds. The Commission decided to maintain a 15% basket for tax-exempt money market funds due to a concern that a complete elimination of the basket would force tax-exempt funds to invest in securities that have weaker credit due to the more limited availability of guarantors and demand feature providers for such funds compared to other money market funds. See the Adopting Release at 505-506.
94 The Proposing Amendments would have required funds to test against a 15% weekly liquid asset level.
95 See new Rule 2a-7(g)(8)(i) and (ii).
96 See the Adopting Release at 549-550.
97 See new Rule 2a-7(g)(8)(i).
98 See new Rule 2a-7(g)(8)(ii).
99 See new Rule 2a-7(g)(8)(ii)(B).
100 See new Rule 2a-7(a)(8) and new Rule 2a-7(a)(34).
101 See new Rule 2a-7(a)(34)(iii).
102 See new Rule 2a-7(a)(8)(iv) and new Rule 2a-7(a)(34)(v).
103 See new Rule 2a-7(a)(9).
104 See new Rule 2a-7(i)(4).
105 See new Rule 2a-7(d)(2)(ii).
106 See note 6.
107 See current Rule 2a-7(d)(2)(i).
108 See proposed Rule 2a-7(a)(11).
109 See the Credit Ratings Re-Proposing Release at 21-25.
110 See the Credit Ratings Re-Proposing Release at 10-11.
111 See the Credit Ratings Re-Proposing Release at 14. As defined in Section 3(a)(62) of the Exchange Act, an NRSRO is an organization that issues ratings that assess the creditworthiness of an obligor itself or with regard to specific securities or money market instruments, has been in existence as a credit rating agency for at least three years, and meets certain other criteria.
112 See the Credit Ratings Re-Proposing Release at 29.
113 See Form N-MFP, proposed Item C.10. The 2011 proposing amendments would have completely eliminated the requirement that a fund identify the “requisite NRSROs” for each portfolio security.
114 See new Rule 2a-7(d)(3)(i). A “Guarantee Issued by a Non-Controlled Person” means a guarantee issued by: (i) a person that, directly or indirectly, does not control, and is not controlled by or under common control with, the issuer of the security subject to the guarantee; or (ii) a sponsor of a special purpose entity with respect to an asset-backed security. See new Rule 2a-7(a)(19).
115 See proposed Rule 2a-7(d)(3)(i).
116 See the Credit Ratings Re-Proposing Release at 48.
If you have any questions regarding this update, please contact one of the following or the Sidley lawyer with whom you usually work.
|Douglas McCormack |
Sidley Investment Funds, Advisers and Derivatives Practice
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