On June 5, 2013, the U.S. Securities and Exchange Commission voted unanimously to propose significant changes to the regulation of money market funds. The SEC’s proposal, which is lengthy and extremely detailed, includes two key alternative changes along with a number of other reforms. The SEC asks for comment on a large number of issues raised by the proposal. With the proposal the SEC may well have consolidated its position as the primary regulator of money market funds. It also appears that the SEC Commissioners, formerly divided as to whether further money market reforms are needed, have now united around the need for further action, making the adoption of some version of the proposal more likely.
The proposal suggests two alternative amendments to the rule governing money market funds, Rule 2a-7 under the Investment Company Act of 1940. Each alternative could be adopted alone or in combination with the other. Under either alternative, all money market funds would be prohibited from using the amortized cost method to value their investments (except as permitted for all mutual funds in the case of securities maturing within 60 days). Instead, each money market fund would be required to calculate its net asset value per share (“NAV”) using market prices on a daily basis and to disclose this information on its website.
The first alternative (“Alternative 1”) would require a non-government institutional money market fund to round to the nearest 1/100th of a penny (“basis point round”) its market-based NAV (e.g., to $1.0004 or $0.9997). Alternative 1 would effectively require these funds to float their NAVs. However, “government” and “retail” money market funds could continue to round to the nearest penny (“penny round”) under Alternative 1. The market-based NAVs of government and retail money market funds could drop up to one-half of one penny (50 basis points) and still round to an NAV of $1.00. This would allow shareholders of government and retail money market funds to continue to make purchases and redemptions at a constant $1.00 under normal circumstances – currently a key feature of money market funds.
The second alternative (“Alternative 2”) would require a non-government money market fund whose “weekly liquid assets” fall below 15% of the fund’s total assets to impose a liquidity fee of 2% on all future redemptions. Under Alternative 2, the board of a fund whose assets fall below this threshold may decide to impose a smaller liquidity fee, or no liquidity fee, if the board determines that doing so would be in the best interest of the fund. In addition, when the fund falls below the 15% threshold the board would have the ability to temporarily suspend redemptions if the board determines that doing so would be in the best interest of the fund.
The proposal makes clear that the SEC will also consider implementing both Alternative 1 and Alternative 2 together. In addition, the proposal would make certain other changes to existing regulations regardless of the alternative adopted.
The proposed money market fund reforms follow several years of back-and-forth among the SEC, various other government entities, and the fund industry. In September 2008, one day after Lehman Brothers Holdings Inc. announced its bankruptcy, The Reserve Primary Fund “broke the buck” and priced its securities at $0.97 per share, causing runs on other money market funds. Shortly thereafter, the U.S. Department of the Treasury announced a temporary guarantee program for money market funds, which effectively stopped those runs.
In January 2010, the SEC adopted various amendments to money market fund regulations, which focused on raising the credit quality, increasing the liquidity, and reducing the maturity of money market fund portfolios. Even so, the SEC continued to explore more fundamental reform of money market funds. For example, the SEC requested comments on a report released in October 2010 by the President’s Working Group on Financial Markets that summarized various money market fund reform options.
In 2012, then-SEC Chairman Mary Schapiro sought to propose rules that would require all money market funds to adopt a floating NAV or, in the alternative, to combine a capital buffer with redemption holdbacks. However, later in 2012, Chairman Schapiro announced that she was unable to obtain support for these proposals from a majority of the SEC Commissioners. In response, the Financial Stability Oversight Council (the “FSOC”), a regulatory panel tasked with monitoring and responding to threats to the U.S. financial system, proposed to recommend to the SEC certain money market reform alternatives. The FSOC’s proposed alternatives included requiring all money market funds to adopt a floating NAV, imposing mandatory capital buffers with redemption holdbacks, or requiring a variable-level capital buffer (click here for Bingham’s alert on the FSOC proposal).
In November 2012, the staff of the SEC’s Division of Risk, Strategy, and Financial Innovation released a report in response to questions posed by three SEC Commissioners on, among other things, the effectiveness of the 2010 amendments. One important conclusion of the report was that The Reserve Primary Fund “would have broken the buck even in the presence of the 2010 liquidity requirements.”1 Following that report, and based on public comments by multiple SEC Commissioners, it became clear that a proposal for further reforms would be forthcoming from either the SEC or the FSOC.
Discontinued Use of Amortized Cost for All Money Market Funds
Currently, Rule 2a-7 permits a money market fund to value its portfolio using the amortized cost method. Under the amortized cost method, a security is valued at its cost, with any premium or discount amortized over the period remaining until the security matures. Market value fluctuations are not reflected in a fund’s amortized cost NAV, but Rule 2a-7 requires that a money market fund’s board periodically review the extent of deviation between the fund’s amortized cost NAV and its NAV calculated using market quotations.
Regardless of the alternative adopted, the SEC’s proposal would prohibit all money market funds from using the amortized cost method of valuation (except to the extent permitted for all mutual funds).2 Instead, a money market fund would strike its NAV based on the market-based value of its portfolio.3
Alternative 1 – Floating NAV for Non-Government Institutional Money Market Funds
Alternative 1 would require a money market fund (other than “government” and “retail” money market funds) to “basis point round” (e.g., $1.0004 or $0.9997) its market-based NAV. In effect, Alternative 1 would require these funds to float their NAVs. However, “government” and “retail” money market funds could continue to penny round under Alternative 1, which would allow these funds’ market-based NAVs to drop up to 50 basis points and still round to a NAV of $1.00.4
“Government” money market funds would be exempt from the requirement of basis point rounding. As defined in the proposal, government money market funds are those that invest at least 80% of their assets in cash, government securities, or repurchase agreements collateralized by government securities.
“Retail” money market funds would also be exempt from the requirement of basis point rounding. The proposal defines retail money market funds as those funds that limit redemptions by any shareholder to no more than $1 million per business day.5 (We refer below to funds that are not “retail” funds as “institutional” funds.)
Although municipal (or tax-exempt) money market funds are not specifically excluded from the requirement of basis point rounding, the proposal notes that, because the tax advantages offered by these funds are enjoyed mainly by individuals, “most could continue to offer a stable share price” under the “retail” exemption.6
The different treatment of “retail” funds and “institutional” funds, as proposed, would effectively prohibit a money market fund from offering separate share classes for retail and institutional investors. The proposal acknowledges that, if a fund wishes to offer a stable NAV to retail investors while allowing redemptions for institutional investors above the $1 million daily limit, the fund must reorganize the share classes into separate funds.
Alternative 1 is designed primarily to address the incentive of money market fund shareholders to redeem shares in times of fund and market stress. Requiring non-government institutional money market funds to basis point round would, according to the proposal, increase the observed sensitivity of a fund’s share price to changes in the market values of the fund’s portfolio securities, and should better inform shareholders of the floating nature of the fund’s value. Under a floating NAV, investors would have a reduced incentive to redeem money market fund shares of a fund that may have experienced losses, because they would receive the actual market-based value of their shares.
While the SEC believes that a floating NAV may reduce investors’ incentives to redeem fund shares during periods of economic stress, it asks for comment on whether basis point rounding would in fact eliminate incentives for investors to redeem shares ahead of other investors when prices are less than $1.0000. That incentive seems unlikely to be greatly reduced, unless an investor believes that all the losses that will occur are already reflected in the NAV. One might also ask whether in fact such a floating NAV could create or exacerbate incentives to redeem ahead of other investors, for example under circumstances when an investor perceives the likelihood of further decline in a fund’s basis point-rounded NAV, even when there is little likelihood of a decline that would cause a reduction in the fund’s penny-rounded NAV. This could conceivably occur when interest rates are rising rapidly, thus reducing the market value of a fund’s investments, but when the fund is not experiencing credit-related losses and could reasonably expect to collect the full value of its holdings upon their maturity.
If the SEC were to adopt Alternative 1, the compliance date would be two years after the effective date of the adoption. The two-year compliance date would also apply to any amendments related to disclosures required by Alternative 1, and to the elimination of the use of the amortized cost method.
Alternative 2 – Liquidity Fees and Redemption Gates
Under Alternative 2, money market funds would be required to impose a 2% liquidity fee (unless its board determined that a liquidity fee was not in the fund’s best interest, or a lower liquidity fee was in the fund’s best interest) and would also have the ability to impose redemption gates, in either case if a fund’s “weekly liquid assets” fell below 15% of the fund’s total assets. Under Alternative 2, fund boards would be faced with significant new responsibilities in times of stress, as discussed in greater detail below.
Under Alternative 2, as in the case of Alternative 1, money market funds would not be permitted to use the amortized cost method of accounting (except as permitted for all mutual funds as noted above), but, unless the SEC also adopts Alternative 1, they would be permitted to penny round (e.g., to $1.00).
The 2% liquidity fee would be imposed on all redemptions commencing with the business day following the day on which the fund’s level of “weekly liquid assets” falls below 15% of its total assets. (Rule 2a-7 requires a money market fund to maintain weekly liquid assets of at least 30% of the fund’s total assets.) However, such a fee would not be imposed if the fund’s board (including a majority of the independent board members) determines that such a fee is not in the best interest of the fund or that a lower liquidity fee is in the best interest of the fund. SEC Chairman Mary Jo White indicated, in remarks at the SEC open meeting approving the proposal, that the board’s determination “would be subject to the board’s fiduciary duty, and we believe it would be a high hurdle.” However, the proposal indicates that the board’s determination not to impose a liquidity fee might be reasonable if, for example, “a few large shareholders unexpectedly redeemed for idiosyncratic reasons unrelated to current market conditions.” The proposal also expects the board’s decision on whether to impose a liquidity fee or gate to take account of how soon securities in the fund’s portfolio are expected to mature and whether a drop in the market-based NAV of the fund accompanied the drop in liquidity.
“Weekly liquid assets” generally include cash, U.S. Treasury securities, certain other government securities with remaining maturities of 60 days or less, and securities that convert into cash within one week.
In addition to the liquidity fee, a fund’s board would also have the flexibility to impose a temporary suspension of redemptions (a “gate”) for a fund with weekly liquid assets of less than 15%. A money market fund that imposed a gate would, except as noted below, need to lift that gate within 30 days, although the board could determine to lift the gate earlier. Money market funds would not be able to impose a gate for more than 30 days in any 90-day period.
The proposal would require that any fee or gate be lifted automatically once the fund’s weekly liquid assets have risen back above the required 30% level. Moreover, a fund’s board could determine to lift the fee or gate even before the fund reaches the 30% level.
Alternative 2 would require the prompt and public disclosure (on a new SEC form, as discussed below) when a fund falls below the 15% weekly liquid asset threshold or imposes or removes any liquidity fee or gate, and a discussion of the board’s analysis in determining whether or not to impose a fee or gate.
Alternative 2 would also amend Rule 22e-3 to permit (but not require) the permanent suspension of redemptions and liquidation of a money market fund if the fund’s level of weekly liquid assets falls below 15% of its total assets. This would allow a money market fund that imposes a fee or a gate, but determines that it would not be in the best interest of the fund to continue operating, to suspend redemptions permanently and to liquidate.
Government money market funds would be exempt from any fee or gate requirement but would be permitted to impose such a fee or gate under the regime described above if the ability to impose such fees and gates were disclosed in the fund’s prospectus.
If the SEC were to adopt Alternative 2, the compliance date would be one year after the effective date of the adoption. The one-year compliance date would also apply to any amendments related to disclosures required by Alternative 2, and to the elimination of the use of the amortized cost method.
Combination of Both Principal Reforms
The proposal makes clear that the SEC will also consider implementing both of the principal reform alternatives. Under this regime, non-government institutional money market funds would be required to transact at a floating NAV, and all non-government money market funds would be required to impose liquidity fees and would be able to impose gates in certain circumstances.
Other Proposed Reforms
The proposal includes additional disclosure and diversification measures that would apply regardless of whether the SEC adopts Alternative 1, Alternative 2, or both.
New Form N-CR – Material Event Disclosure
Revised Form N-MFP
Revised Form PF
Disclosure of Historical Sponsor Support
Stronger Diversification Requirements
Enhanced Stress Testing
If the SEC were to adopt Alternative 1 or Alternative 2, the compliance date for the other reforms detailed in this section would match the compliance period of the adopted Alternative, if related. (Related reforms include, for example, the new Form CR, the amendments to Form N-MFP and the amendments to Form N-1A.) All other reforms unrelated to the implementation of the adopted Alternative would have a compliance period of nine months after the effective date of the adoption.
* * *
By its proposal, the SEC may have staved off a formal recommendation for money market reform by the FSOC and consolidated the SEC’s position as the primary regulator of money market funds. It is noteworthy that the SEC has rejected all but the floating NAV alternative suggested by the FSOC, and even that alternative has been narrowed to apply only to non-government institutional money market funds. But it also appears that the SEC Commissioners, formerly divided on the subject of further money market reforms, have united around the need for further money market fund reform, making it more likely that some version of the proposal will be adopted. Whether reform will include the floating NAV suggested by the FSOC, even as limited under Alternative 1 under the proposal, remains to be seen.
The proposal, just shy of 700 pages in length, addresses almost all aspects of money market fund regulation, including many technical areas.11 It is important to note that this alert summarizes only certain aspects of the proposal.
The SEC has asked for comments on many different issues raised by the proposal. However, the deadline for submission of public comments on the proposal is only 90 days after its publication in the Federal Register. In light of the far-reaching nature of the proposal, the alternatives presented, and their likely impact on the money market fund industry, interested parties may wish to start preparing their comments as soon as possible.
If you have any questions or would like more information on the issues discussed in this LawFlash, please contact any of the following Morgan Lewis lawyers:Copenhefer-Lea-Anne
1In reaching that conclusion, the report looks at The Reserve Primary Fund as it then existed in 2008, unable to assume any changes to the portfolio holdings as a result of the stress testing and SEC reporting required by the 2010 amendments. Interestingly, the SEC proposal makes no attempt to measure what would have happened to The Reserve Primary Fund if either of the alternatives in the current proposal had been in place in 2008. Presumably, under Alternative 1, as an institutional fund, The Reserve Primary Fund would have first seen a reduction in its NAV, then suffered from a run on assets, and finally seen an even bigger decrease in its NAV. Under Alternative 2, whether combined with Alternative 1 or on its own, it is likely that The Reserve Primary Fund would have first seen a reduction in NAV, followed by implementation of a redemption fee, and ultimately would have suspended redemptions.
2Currently, mutual funds are allowed to value securities maturing in 60 days or less at amortized cost where the fund’s board determines, in good faith, that the fair value is their amortized cost. In doing so, however, the fund’s board must take account of circumstances in which market-based factors would affect the security’s fair value.
3“Market-based values” may in many cases reflect vendor estimates of fair value that are not based on actual transactions in the particular securities being valued. It may therefore be worth asking whether basis point rounding implies a degree of precision in valuation that may not be realistic and whether perhaps there are other implications of that.
4Because Rule 2a-7 currently requires a money market fund’s board to consider taking action if the fund’s market-based NAV per share deviates from the fund’s amortized cost per share by more than 50 basis points, the SEC believes that penny rounding, even without the ability to value at amortized cost, achieves an equivalent level of price stability.
5Retail money market funds would nonetheless be permitted to allow an omnibus account holder (a broker, dealer, bank or other person that holds securities issued by the fund in nominee name) to redeem more than $1 million in a single day, provided that the omnibus account holder similarly restricts each beneficial owner in the omnibus account to no more than $1 million in daily redemptions. All funds utilizing the “retail” exemption would be required to adopt policies and procedures reasonably designed so that the fund’s redemption limit is applied to beneficial owners “all the way down any chain of intermediaries.”
6The proposal also notes that municipal money market funds, unlike other money market funds, are not currently subject to the 10% “daily liquid asset” minimum. The SEC asks for comment on whether it should apply the daily liquid asset requirement to municipal money market funds that wish to take advantage of the proposed retail exemption.
7For example, Form N-MFP would, as amended, require the reporting of (i) whether a portfolio security is categorized as a level 1, level 2, or level 3 measurement in the fair value hierarchy under U.S. Generally Accepted Accounting Principles; (ii) each portfolio security’s purchase price and date, the yield at purchase, and the yield as of the reporting date; (iii) a fund’s daily and weekly liquid assets, whether each security is a daily or weekly liquid asset, and the amount of cash the fund holds; and (iv) the weekly gross subscriptions and redemptions for each share class.
8The term “financial support” includes, for example, any capital contribution, purchase of a security from the fund in reliance on Rule 17a-9, purchase of any defaulted or devalued security at par, purchase of fund shares, execution of letter of credit or letter of indemnity, capital support agreement (whether or not the fund ultimately received support), or performance guarantee, or any other similar action to increase the value of the fund’s portfolio or otherwise support the fund during times of stress.
9Entities would be affiliated for this purpose if one controlled the other entity or was controlled by it or under common control with it. For this purpose only, control would be defined to mean ownership of more than 50% of an entity’s voting securities.
10The proposal would require the fund’s investment adviser to provide not only an assessment, but also 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.
11For example, the SEC’s proposal acknowledges that adopting either principal alternative could have large tax and accounting implications and increase compliance and reporting burdens, some of which may be lessened if the U.S. Department of the Treasury and the Internal Revenue Service make conforming changes to current requirements.