August 2014
Practice Group:
Investment
Management, Hedge
Funds and
Alternative
Investments
Board Responsibilities Under SEC’s Money Market
Fund Reforms
By Diane E. Ambler, Craig A. Ruckman
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 twentyfour 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
1
Money Market Fund Reform; Amendments to Form P-F, Investment Company Act Release No. 31166 (July 23,
2014).
Board Responsibilities Under SEC’s Money Market Fund
Reforms
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
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Board Responsibilities Under SEC’s Money Market Fund
Reforms
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
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.
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Board Responsibilities Under SEC’s Money Market Fund
Reforms
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.
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Board Responsibilities Under SEC’s Money Market Fund
Reforms
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 NCR 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
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Board Responsibilities Under SEC’s Money Market Fund
Reforms
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.
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Board Responsibilities Under SEC’s Money Market Fund
Reforms
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.
Authors:
Diane E. Ambler
Craig A. Ruckman
diane.ambler@klgates.com
+1.202.778.9886
craig.ruckman@klgates.com
+1.212.536.4810
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Board Responsibilities Under SEC’s Money Market Fund
Reforms
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