On July 23, 2014, the Securities and Exchange Commission (the SEC) adopted final rules governing the structure and operation of money market funds (MMFs), in a release adopting amendments to Rule 2a-7 (Rule) under the Investment Company Act of 1940, as amended (the 1940 Act), and other related changes (the Adopting Release).[1] The amended Rule will involve new or expanded duties for MMF boards of directors (Boards). Significantly, the amended Rule creates two classes of MMFs, defined as Government MMFs and Retail MMFs, which can continue to seek to maintain a stable dollar price per share as under the current Rule. All other MMFs (referred to generally as institutional or prime MMFs) are not qualified to seek to maintain a stable dollar price per share and must price their assets daily, like other types of mutual funds, so that the net asset value (NAV) will reflect daily pricing changes (commonly known as a floating NAV). The determination of whether a fund qualifies as a Government MMF or a Retail MMF is based on considerations subject to the judgment of MMF Boards. Additionally, the amended Rule provides MMF Boards the discretion to impose temporary liquidity fees or to restrict redemptions in times of financial stress. Moreover, the SEC, in the Adopting Release, provides expanded guidance to Boards on the use of amortized cost valuation by all funds as well as other related valuation issues. Boards should also be aware that all MMFs will be subject to new disclosure requirements and revised requirements related to diversification and stress testing. Additional details regarding the changes imposed by the amended Rule are described in this series of K&L Gates Client Alerts. The Rule amendments will be phased in over a period of nine to twenty-four months.

GOVERNMENT MMFs AND RETAIL MMFs

Government MMFs and Retail MMFs may continue to rely on stable dollar pricing under generally the same terms, and subject to the same general Board considerations, as MMFs currently subject to the Rule.

Government MMFs

A Government MMF is defined by the amended Rule as any MMF that invests 99.5% or more of its total assets in cash, government securities or repurchase agreements collateralized solely by cash or government securities. Unlike existing government MMFs, which are permitted to invest up to 20% of total assets in non-government assets, a Government MMF under the amended Rule is permitted to invest only up to 0.5% of total assets in non-government eligible securities. Accordingly, the Board of an existing government MMF will be required to revise the fund’s principal investment policies to increase the percentage that must be invested in such investments to 99.5%, and the adviser will be required to change its investment procedures to meet this higher threshold. For MMFs that currently do not operate as government funds (even under the current more flexible 80% investment requirement) but want to do so under the amended Rule, the Board will need to consider whether a shareholder vote is necessary to amend fundamental investment policies or otherwise to revise the fund’s investment policies.

Retail MMFs

A Retail MMF is defined by the amended Rule as one that has policies and procedures reasonably designed to limit all beneficial owners of the fund to natural persons. A fund intending to satisfy this definition is required to “adopt and implement policies and procedures reasonably designed to restrict beneficial ownership to natural persons,” and would be expected to make appropriate disclosure in its prospectus. In the Adopting Release, the SEC noted that Retail MMFs have flexibility in how to comply with this restriction so long as the policies and procedures enable the fund to “look through” certain types of tax-advantaged accounts and “reasonably conclude that ownership is limited to natural persons.” By way of example, the SEC indicated that the policies and procedures can rely on information obtained directly, through receipt of information upon account opening, or indirectly, in the context of an affiliated recordkeeper for a retirement plan, and that the types of information obtained could include social security numbers or government issued identification such as a passport.   

Addressing omnibus accounts, the SEC noted that there are many ways for a Retail MMF to effectively manage its relationships with intermediaries. The SEC suggested that a Retail MMF’s policies and procedures could include contractual arrangements or periodic certifications regarding the nature of the beneficial owners, and it emphasized that Retail MMFs should oversee omnibus accounts in the manner that best suits their circumstances. The SEC also cautioned that, regardless of the specifics of the policies and procedures, a Retail MMF should periodically review the adequacy of such policies and procedures and the effectiveness of their implementation.

Organizational Matters

In order to qualify as a Retail MMF, an existing MMF with both retail and institutional investors, whether or not through separate share classes, might need to reorganize into two separate MMFs: one for retail and one for institutional investors. The SEC, in the Adopting Release, recognized a number of options for an existing MMF to transition into a Retail MMF and provided facilitating relief from certain specified regulatory limitations, which would involve Board oversight.

An existing MMF offering separate retail and institutional classes may consider reorganizing into separate MMFs, a floating NAV MMF for the institutional share class and a Retail MMF whose shareholders all would be natural persons. In the Adopting Release, the SEC recognized potential legal issues in such a reorganization, including restrictions on affiliated transactions and material differences among the rights of shareholders in a fund, and it took the position that exemptive relief would not be necessary “in the context of distinguishing between retail and institutional MMFs when implementing the reforms we are adopting today... provided that the fund’s [Board], 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.” The SEC concluded that “this [B]oard determination, in the context of a one-time reorganization related specifically to effectuating a split of separate share classes in order to qualify as a [Retail MMF], addresses the primary concerns [certain provisions of the 1940 Act] are intended, in part, to address -- to ensure that shareholders in a fund are treated fairly and prohibit overreaching by affiliates.”

In the Adopting Release, the SEC also recognized that an existing MMF may also consider an involuntary redemption of unqualified shareholders in order to become a Retail MMF. The SEC removed certain legal impediments to such involuntary redemptions, stating that it would not view “a one-time reorganization to distinguish between retail and institutional [MMFs] (either in separating classes into new funds or in ensuring that an existing fund only has retail or institutional investors),” as an involuntary redemption of investors who no longer meet the eligibility requirements requiring SEC relief, provided that the affected investors are given at least 60 days’ advance notice of the redemption.

As an alternative to reorganizing an existing Retail MMF, an existing MMF with both retail and institutional shareholders could also decide to operate the fund as a Government MMF and continue to seek to offer stable dollar value shares and to retain both types of shareholders.

FEES AND GATES

Overview

Under the amended Rule, the Boards of all MMFs will have the discretion to impose liquidity fees or restrict redemptions (known as redemption gates) in times of stress.[2] If an MMF’s level of weekly liquid assets falls below 30% (the minimum required by Rule 2a-7), and the fund’s Board (including a majority of its independent directors) determines that it is in the fund’s best interests, an MMF will be permitted to impose a liquidity fee of up to 2% on all redemptions, or temporarily to halt redemptions. If the MMF’s level of weekly liquid assets falls below 10%, it will be required to impose a liquidity fee of 1% on all redemptions unless the fund’s Board (including a majority of its independent directors) determines that imposing such a fee would not be in the best interests of the fund, or determines that a lower or higher fee (not to exceed 2%) would be in the best interests of the fund. An MMF that imposes a liquidity fee or redemption gate will be required to lift that fee or gate once the fund’s weekly liquid assets have risen to or above 30%, and a fund will be required to lift a redemption gate within 10 business days. MMF Boards will be permitted to lift any fee or gate prior to those thresholds if it determines lifting the fee or gate is in the best interests of the fund. An MMF Board may not impose a redemption gate for more than 10 days in any 90-day period.

Board Considerations

The SEC adopted an approach mixing the use of liquidity fees and redemption gates to provide MMFs and their Boards with maximum flexibility to address periods of heavy redemptions. Once the weekly liquid asset thresholds have been triggered, MMF Boards will have the discretion to determine whether to impose a liquidity fee or redemption gate, the duration of such fee or gate, and how great a liquidity fee to charge, in order to tailor the fund’s response to its particular circumstances. The SEC adopted a “best interests of the fund” standard for making these determinations. The SEC noted its standard “recognizes that each fund is different and that, once a fund’s weekly liquid assets have dropped below the minimum required by Rule 2a-7, a fund’s Board is best suited, in consultation with the fund’s adviser, to determine when and if a fee or gate is in the best interests of the fund.” The SEC declined to provide an exhaustive list of factors for Boards to consider when making these best interests determinations, instead leaving it to the Board’s discretion to “consider any factors it deems appropriate.” After indicating that it was offering “certain guideposts that [B]oards may want to keep in mind,” the SEC suggested that Boards consider the following factors:

• relevant indicators of liquidity stress in the markets and why the fund’s weekly liquid assets have fallen (e.g.,whether weekly liquid assets have fallen because the fund is experiencing mounting redemptions during a time of market stress or because a few large shareholders unexpectedly redeemed shares for idiosyncratic reasons unrelated to current market conditions or the fund);
• the liquidity profile of the fund and expectations as to how the profile might change in the immediate future, including any expectations as to how quickly a fund’s liquidity may decline and whether the drop in weekly liquid assets is likely to be very short-term (e.g.,whether the decline in weekly liquid assets will be cured in the next day or two when securities currently held in the fund’s portfolio qualify as weekly liquid assets);
• for Retail MMFs and Government MMFs, whether the fall in weekly liquid assets has been accompanied by a decline in the fund’s shadow price;
• the make-up of the fund’s shareholder base and previous shareholder redemption patterns; and/or,
• the fund’s experience, if any, with the imposition of fees and/or gates in the past.

When determining the level of a liquidity fee, the SEC suggested that Boards consider the following factors:

• changes in spreads for portfolio securities (whether based on actual sales, dealer quotes, pricing vendor mark-to-model or matrix pricing, or otherwise);
• the maturity of the fund’s portfolio securities;
• changes in the liquidity profile of the fund in response to redemptions and expectations regarding that profile in the immediate future;
• whether the fund and its intermediaries are capable of rapidly putting in place a fee of a different amount from a previously set liquidity fee or the default liquidity fee;
• if the fund is a floating NAV fund, the extent to which liquidity costs are already built into the NAV of the fund; and,
• the fund’s experience, if any, with the imposition of fees in the past.

Boards should be aware that the SEC refused to affirm that a Board’s deliberations concerning the imposition of fees and gates would be protected by the business judgment rule, declining to comment on what the SEC deemed to be the application of state law.

Amended Rule 22e-3

Currently, Rule 22e-3 under the 1940 Act permits an MMF to permanently suspend redemptions and liquidate if the fund’s Board determines that the deviation between the fund’s amortized cost price per share and its market-based NAV per share may result in material dilution or unfair results to investors or existing shareholders. The SEC amended Rule 22e-3 to permit (but not require) any MMF, including those with a floating NAV, to permanently suspend redemptions and liquidate if the fund’s level of weekly liquid assets falls below 10% of its total assets, regardless of whether the fund has previously imposed a liquidity fee or redemption gate. Neither amended Rule 22e-3 nor the Adopting Release specifically requires that the Board determine that permanently suspending redemptions and liquidating the fund are in the best interests of the fund.

Other Considerations

MMF Boards should also note that the fees-and-gates regime adopted by the SEC will require increased coordination between the adviser and the Board and should begin considering steps for implementation. For example, the amended Rule permits an MMF’s Board to impose a liquidity fee or redemption gate at any point throughout the day after the fund’s weekly liquid assets have dropped below 30%. In order to maximize this flexibility, advisers and Boards may want to develop protocols to monitor those levels in real time and address communication as an MMF’s weekly liquid assets approach 30%. Boards should be aware that the Adopting Release specifically contemplates MMF Boards making the relevant determinations under the amended Rule telephonically or through any other technological means by which all directors can be heard. In addition, the Adopting Release notes that although an MMF may impose a redemption gate for up to 10 business days, a fund is not required to impose it for that long. “Rather, a fund can lift a gate before 10 business days have passed, and [the SEC] would expect a [B]oard would promptly do so if it determines that it is in the best interests of the fund.” MMF Boards can anticipate holding regular, if not daily, meetings throughout any period of stress in which liquidity fees or redemption gates are imposed, and may want to identify in advance the appropriate standards to analyze a fund’s liquidity.

Finally, Boards should be aware that MMFs will be required to file a report on new Form N-CR when, among other events, a fund imposes or lifts a liquidity fee or redemption gate, or if a fund does not impose a liquidity fee despite passing certain liquidity thresholds. MMFs will be required to disclose a brief discussion of the primary considerations or factors taken in account by the Board in its decision to impose or not impose a liquidity fee or gate.

VALUATION GUIDANCE

The SEC noted that the amended Rule permits Government MMFs and Retail MMFs to seek to maintain a stable NAV by using amortized cost valuation, provided that the Board of the fund “believes that the amortized cost method of valuation fairly reflects the market-based NAV and does not believe that such valuation may result in material dilution or other unfair results to investors.” The SEC also stated that all funds (including institutional MMFs, bond and all other funds) could continue using amortized cost to value debt securities with remaining maturities of 60 days or less if the fund Board, in good faith, determines that the fair value of the debt securities is their amortized cost value. Acknowledging that its existing valuation guidance was not clear on how frequently funds should compare a debt security’s amortized cost value to its fair value, the SEC explained that each time a valuation determination is made based on amortized cost, for a portfolio security with a remaining maturity of 60 days or less, a fund must be able to “reasonably conclude... that the amortized cost value of the portfolio security is approximately the same as the fair value of the security [taking into account]... [e]xisting credit, liquidity, or interest rate conditions in the relevant markets and issuer specific circumstances at each such time.” To accommodate this practice, the SEC also suggested that funds could design their policies and procedures “to ensure that the fund’s adviser is actively monitoring both market and issuer-specific developments that may indicate that the market-based fair value of a portfolio security has changed during the day, and therefore indicate that the use of amortized cost valuation for that security may no longer be appropriate.”

The SEC also provided guidance on the use of matrix pricing and evaluated prices from third-party pricing services and stated: “[W]e do not agree that market-based prices of portfolio securities do not provide meaningful information or that amortized cost generally provides better or more accurate values of securities that do not frequently trade or that may or may not be held to maturity.” Recognizing that MMF portfolio securities that are not frequently traded and for which market quotations are not readily available are fair valued in good faith by the fund Board, the SEC noted that fair value determinations must be made “taking into account market conditions existing at that time.” Thus, the SEC concluded that “funds holding debt securities generally should not fair value these securities at par or amortized cost based on the expectation that the funds will hold those securities until maturity, if the funds could not reasonably expect to receive approximately that value upon the current sale of those securities under current market conditions.”

After noting that requiring all MMFs to perform daily market-based valuations may cause fund Boards to rely more heavily on third parties, such as pricing services, for market-based valuation data, the SEC provided guidance to funds and their Boards regarding reliance on pricing services, as follows:

• Before deciding to use the assistance of a pricing service for fair value determinations, the Board may want to consider the inputs, methods, models, and assumptions used by the pricing service to determine its evaluated prices, and how those inputs, methods, models, and assumptions are affected (if at all) as market conditions change.
• In choosing a particular pricing service, a Board may want to assess, among other matters, the quality of the evaluated prices provided by the service and the extent to which the service determines its evaluated prices as close as possible to the time as of which the fund calculates its net asset value.
• The fund’s Board should generally consider the appropriateness of using evaluated prices provided by pricing services as the fair values of the fund’s portfolio securities where, for example, the fund’s Board does not have a good faith basis for believing that the pricing service’s pricing methodologies produce evaluated prices that reflect what the fund could reasonably expect to obtain for the securities in a current sale under current market conditions.

DIVERSIFICATION

The SEC also adopted amendments to the Rule 2a-7 diversification provisions. Under the current Rule, MMFs generally must limit their investments in (i) the securities of any one issuer of a first tier security (other than with respect to government securities and securities subject to a guarantee issued by a non-controlled person) to no more than 5% of fund assets; and (ii) securities subject to a demand feature or a guarantee to no more than 10% of fund assets from any one provider. Under the amended Rule, MMFs will be required to, among other things, treat the sponsors of asset-backed securities (ABS) as guarantors subject to Rule 2a-7’s 10% diversification limit applicable to guarantees and demand features, unless the fund’s Board (or its delegate) makes certain findings. If the Board determines that the fund is not relying on the sponsor’s financial strength or its ability or willingness to provide liquidity, credit, or other support to determine the ABS’s quality or liquidity, then the fund will not be required to treat the sponsors of asset-backed securities (ABS) as guarantors subject to Rule 2a-7’s 10% diversification limit applicable to guarantees and demand features. Under the amended Rule, the Board is permitted to delegate this responsibility, subject to establishing procedures and providing oversight.

STRESS TESTING

Under the amended Rule, MMFs will be required to test their ability to maintain a minimum level of weekly liquid assets and to minimize principal volatility under certain specified scenarios. The amended Rule will require Boards to revise the policies and procedures relating to stress testing to implement the newly adopted scenarios. In addition, the amended Rule will require that the Board be provided at its next annual meeting, or sooner if appropriate, a report that includes the dates on which the stress testing was performed and an assessment of the fund’s ability to maintain at least 10% in weekly liquid assets and to limit principal volatility. The fund’s adviser will be required to provide such information as may reasonably be necessary for the Board to evaluate the stress testing conducted by the adviser and the results of the testing. The amended Rule also will require the adviser to provide the Board with a summary of the significant assumptions made when performing the stress tests. The SEC noted that it believes that having a summary of such assumptions will help the Board better understand the stress testing results, and particularly the sensitivity of those results to given assumptions, and will allow the Board to provide more effective oversight of the fund and its adviser.

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

[2] Government MMFs are not required to impose liquidity fees or restrict redemptions but may do so, consistent with the amended Rule, provided that there is appropriate disclosure in the prospectus.