STROOCK SPECIAL BULLETIN

Transcription

1 STROOCK & STROOCK & LAVAN LLP STROOCK SPECIAL BULLETIN Effective Date for Money Market Fund Reforms Arrives: Implications for Funds, their Boards and Advisers October 14, 2014 Introduction As the industry is well aware, the Securities and Exchange Commission (the SEC ) adopted amendments to rules under the Investment Company Act of 1940, as amended (the 1940 Act ), and related requirements that govern money market funds ( money funds ) (collectively, the Amendments ). 1 The Amendments, adopted by a 3-2 vote of the SEC Commissioners, follow a protracted discussion among the SEC, other financial regulators and the money fund industry regarding the systemic risks posed by money funds and the need for additional reform in light of the SEC s reforms in 2010 in the aftermath of the 2008 financial crisis Money Market Fund Reform; Amendments to Form PF, Investment Company Act Release No (July 23, 2014), available at (the Adopting Release ); 79 FR (Aug. 14, 2014). Money Market Fund Reform, Investment Company Act Release No (Feb. 23, 2010), available at Summary of Contents Institutional Prime Money Funds..4 Implications for Other Money Funds...12 Tax and Accounting Implications 17 Other Rule Amendments 19 Valuation Guidance...29 Related SEC Proposals 31 Compliance Dates...33 Appendix A Disclosure Changes..35 Appendix B Form Changes..43 STROOCK & STROOCK & LAVAN LLP NEW YORK LOS ANGELES MIAMI WASHINGTON, DC 180 MAIDEN LANE, NEW YORK, NY TEL FAX

2 The Amendments are effective October 14, 2014 (the Effective Date ), which means that money funds may begin complying with the new rules as of today, although few are expected to do so. 3 The compliance dates of the Amendments (i.e., the dates money funds must begin complying with the new rules) vary, and range from nine months to two years after today. The SEC explained that the Amendments are designed to address money funds susceptibility to shareholder runs, improve their ability to manage and mitigate potential contagion from such redemptions and increase the transparency of their risks, while preserving, as much as possible, their benefits. In adopting the Amendments, the SEC essentially combined the two separate regulatory alternatives it proposed in June The first proposed alternative would have required institutional prime money funds 5 to float their It may be more likely that newly-organized money funds may elect to comply with the Amendments in advance of the various compliance dates. For example, certain sponsors are looking to enter the money fund space with new funds that purport to already comply with the Amendments. See Ignites, Small Shop Sees Massive Opportunity in Money Fund Rule, Peter Ortiz (Sept. 8, 2014), available at _massive_opportunity_money_fund_rule?referrer_mo dule=categorylisting&module_order=28. Money Market Fund Reform; Amendments to Form PF, Investment Company Act Release No (June 5, 2013), available at (the Proposing Release ). In the Proposing Release, the SEC described institutional prime money funds as money funds that invest in a variety of short-term debt obligations issued by corporations and banks, as well as U.S. government securities, repurchase agreements and asset-backed commercial paper (commonly referred to as prime funds ) and that cater to institutional investors. Proposing Release at 10. net asset value ( NAV ) per share instead of using a stable NAV per share (generally, $1.00). The second proposed alternative would have permitted all money funds to continue to transact at a stable share price, but would have (i) required money funds (other than as-defined government money funds) to impose a liquidity fee in times of market and/or fund stress and (ii) authorized money fund boards of directors/trustees ( boards ) to temporarily suspend redemptions of fund shares (i.e., impose a gate ) in similar circumstances. These two proposed alternatives along with the SEC s other proposed rulemakings and the background leading up to the Proposing Release, are discussed in a prior Stroock Special Bulletin. 6 The Amendments require all money funds that do not qualify as retail money market funds 7 ( retail money funds ) or government money market funds 8 ( government money funds ) (collectively, institutional prime money funds ) to price and transact in their shares at NAVs reflecting current market-based values of their portfolio securities (i.e., at a floating NAV ) no later than October 14, The exclusion of See Potential Overhaul of Money Market Funds Regulation: A Summary of the SEC Proposal and Discussion of Its Potential Implications, Stroock Special Bulletin, July 19, 2013, available at A retail money market fund is a money fund that has policies and procedures reasonably designed to limit all beneficial owners of the fund to natural persons. Amended Rule 2a-7(a)(25). A government money market fund is a money fund that invests at least 99.5% of its total assets in cash, government securities (as defined in Section 2(a)(16) of the 1940 Act) and/or repurchase agreements that are collateralized fully (i.e., collateralized by cash or government securities). Amended Rule 2a-7(a)(16). 2

3 retail money funds from the Amendments floating NAV requirements reflects a major victory for sponsors of funds primarily offered to retail investors, who had argued that those investors did not participate in the 2008 runs on money funds and, as a result, their funds did not pose a systemic risk to the broader financial system. The Amendments, however, reflect a loss for sponsors of tax-exempt money funds that invest in municipal securities ( municipal money funds ), who had made similar arguments that failed to persuade the SEC. Under amended Rule 2a-7, municipal money funds must adopt a floating NAV unless they qualify as retail money funds. The Amendments also require both institutional money funds (which must use a floating NAV) and retail money funds (which may continue to use a stable NAV) that otherwise do not qualify as government money funds to make provision for imposing liquidity fees and gates in the event of a shortfall of fund liquidity no later than October 14, In a change from the Proposing Release, however, the SEC gave money fund boards discretion to impose liquidity fees and gates under the Amendments. This grant of broad discretion almost ensures that money fund boards will find themselves in the middle of any future money fund crisis. In addition, while the potential loss of the exemptions in Rule 2a-7 that facilitated money funds maintenance of stable NAVs animated much of the debate since the financial crisis in 2008, it was the liquidity fees and gates alternative in the Proposing Release that stirred the most controversy as the SEC was rounding the last turn of its marathon rulemaking effort. A number of economists, including staff of the Federal Reserve Bank of New York, and some money fund sponsors expressed concerns that investors seeking to avoid paying liquidity fees or having their assets locked up in a gated fund would engage in preemptive runs on money funds at the first indication of market or portfolio stress. 9 They argued that the liquidity fees and gates proposed by the SEC would operate to increase, rather than decrease, the instability of money funds. In the Adopting Release, however, the SEC asserted that the final version of the liquidity fees and gates requirements contained in the Amendments would address those concerns by making the imposition of liquidity fees less certain and permitting the imposition of gates for a shorter period. 10 The changes did not satisfy these critics, including SEC Commissioner Stein who voted against the Amendments citing similar concerns. 11 Subsequently, the Financial Stability Oversight Council (FSOC) issued a statement suggesting it had similar concerns about the SEC s adopted approach and stated that, while it would not take any current action on its proposed recommendations to the SEC, it would monitor the effectiveness of the Amendments to better understand any unintended consequences of liquidity fees and gates. 12 Former SEC Chair Mary 9 See Gates, Fees and Preemptive Runs, Federal Reserve Bank of New York Staff Report No. 670 (Apr. 2014), available at r670.pdf; Adopting Release at 56 nn (citing various comment letters received by the SEC). 10 Adopting Release at Statement of Kara M. Stein (July 23, 2014), available at See Financial Stability Oversight Council Meeting July 31, 2014, U.S. Treasury Department Office of Public Affairs Release, available at 3

4 Schapiro also recently echoed those concerns. 13 A chart summarizing which money funds are (or may elect to be) subject to the liquidity fees and gates and floating NAV requirements is below. Liquidity Fees and Gates Floating NAV Government Money Funds n/a 14 n/a Retail Money Funds n/a Institutional Prime Money Funds (including municipal money funds that do not qualify as retail money funds) As both sets of requirements apply to institutional prime money funds, they are summarized below with respect to those funds. The implications of the Amendments for government money funds and retail money funds follow that discussion. For purposes of this bulletin, references to amended Rule 2a-7 include changes to the rule as a result of the Amendments. Institutional Prime Money Funds Liquidity Fees and Gates The Amendments require institutional prime money funds (as well as retail money funds, i.e., all non-government money funds), their sponsors and other service providers and intermediaries to 13 Ignites, Money Fund Reforms Miss the Mark: Mary Schapiro, Joe Morris (Sept. 4, 2014), available at forms_miss_mark_mary_schapiro?referrer_module=ca tegorylisting&module_order= A government money fund is permitted, but not required, to impose a liquidity fee or gate if (i) the ability to do so is disclosed in the fund s prospectus and (ii) the fund complies with the relevant Amendments, including the related disclosure obligations. develop the infrastructure necessary to permit those funds to impose a liquidity fee or gate should the fund experience a sufficient loss of liquidity. 15 Government money funds may impose a liquidity fee or gate under the same conditions, but only if the fund has disclosed such ability in its prospectus. 16 As a consequence, sponsors and boards of government money funds will need to discuss whether they want (or need) to have the ability to impose liquidity fees and gates and weigh the potential benefits of those additional regulatory tools against the costs of compliance. The SEC describes liquidity fees and gates as new tools for money fund boards to use in times of stress to help stem heavy redemptions and prevent the type of run on money funds that occurred in The SEC anticipates that a money fund could use liquidity fees to force redeeming investors to bear some of the fund s liquidity costs, thus reducing the incentive to redeem and slowing redemptions while the fund rebuilds liquidity. If the liquidity fees do not work, the fund s board can impose a temporary gate. The Amendments do not, however, mandate that sequence; a money fund s board, upon making the required findings, could determine to gate a 15 Amended Rule 2a-7(c)(2). In order to permit money funds to institute liquidity fees and/or gates, the SEC also adopted exemptions from certain provisions of the 1940 Act and the rules thereunder. In the absence of these exemptions, imposing gates could violate Section 22(e), which generally prohibits a fund from suspending the right of redemption or postponing the payment of redemption proceeds for more than seven days, and imposing liquidity fees could violate Rule 22c-1, which (together with Section 22(c) and other provisions of the 1940 Act) requires that redeeming investors receive their pro rata portion of the fund s net assets. 16 Amended Rule 2a-7(c)(2)(iii). 17 Adopting Release at 38. 4

5 fund without first imposing a liquidity fee. Moreover, once imposed a gate does not have to be temporary; under the Amendments, money fund boards retain the authority to permanently suspend redemptions and liquidate the fund under Rule 22e-3. The Amendments authorize a money fund s board to impose a liquidity fee not to exceed 2% on all redemptions or temporarily suspend redemptions (i.e., impose a gate ) if the fund s weekly liquid assets 18 fall below 30% of its total assets and the fund s board (including a majority of its independent directors) determines that imposing a liquidity fee or gate is in the best interests of the fund. 19 In the event that a fund s weekly liquid assets fall below 10%, the fund must impose a 1% liquidity fee on all redemptions, unless the fund s board of directors (including a majority of its independent directors) determines that such a fee would not be in the best interests of the fund or determines that a lower (or no) or higher fee (not to exceed 2%) would be in the best interests of the fund. 20 Under the Amendments, any liquidity fee or gate imposed must be lifted automatically after a money fund s weekly liquidity reaches 30%. Any liquidity fee or gate also may be amended or lifted at any time by a money fund s board (including a 18 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 will mature in five business days (i.e., convert to cash in one week). Amended Rule 2a-7(a)(34). 19 Amended Rule 2a-7(c)(2)(i). The proceeds of the liquidity fee are payable to the fund. 20 Amended Rule 2a-7(c)(2)(ii). In a change from the Proposing Release, a money fund may impose a liquidity fee (or gate) at any point throughout the day after the fund s weekly liquid assets drop below 30%. majority of independent directors) if the board determines to impose a different liquidity fee or other redemption restriction or if the board determines that imposing a fee or gate is no longer in the best interests of the fund. 21 Whether liquidity fees or gates will be successfully deployed by a money fund (as they have been by some hedge funds) was a matter of some debate during the SEC s rulemaking. Although non-government money funds will have the ability (and infrastructure) to employ them, for compelling business reasons their boards may be unlikely to utilize these new tools, except as a last resort. Unlike investors in hedge funds, investors in cash vehicles such as money funds are unlikely to respond well to lack of access to their cash even for a short period of time. Liquidity Fees Rule 2a-7 requires money funds to maintain at least 30% of their assets in weekly liquid assets. 22 In adopting the same percentage for the initial liquidity threshold under the Amendments, the SEC used a shortfall in a fund s weekly liquid assets as an indicator that the fund may be in distress and that liquidity has become costly. However, the Amendments leave it to the board s discretion to determine whether (and when) the imposition of a liquidity fee is in the best interests of the fund. The SEC s initial proposal would have required a money fund to impose a default liquidity fee of 2%, although not until its weekly liquid assets fell below 15%. The change in approach in the amended rule was intended by the SEC to address concerns that a default liquidity fee would make money funds susceptible to runs by investors 21 Amended Rule 2a-7(c)(2)(i)(A)-(B) and (ii)(a)-(b). 22 Amended Rule 2a-7(d)(4)(iii). 5

6 seeking to redeem their shares before fund liquidity fell below the specified threshold. The SEC s theory is that providing boards with greater discretion will result in more investor uncertainty about when (or if) a liquidity fee might be imposed and serve to curb the possibility that preemptive runs will start as a money fund nears the liquidity threshold. 23 Any liquidity fee imposed by a money fund must apply to all redemptions. The SEC rejected arguments that a money fund s board should be permitted to exempt redemptions of small amounts (which might reduce hardships on smaller investors) or newly purchased shares (which could provide the fund with an important source of liquidity). Unlike gates, however, there is no limit on how long a liquidity fee may remain in place, so long as the fund s weekly liquid assets remain below 30% and the fund s board (including a majority of independent directors) has not determined that lifting the fee (or lowering the amount) is in the best interests of the fund. Temporary Gates The Amendments also authorize a money fund s board to temporarily suspend redemptions (i.e., impose a gate ) when the fund s weekly liquid assets fall below 30% of its total assets and the board (including a majority of its independent directors) determines that imposing a gate is in the best interests of the fund. 24 The board can lift the gate at any time if the board determines the gate is no longer in the best interests of the fund. Once a board decides to impose a gate, it must impose it on all redemptions, including any new 23 Adopting Release at Amended Rule 2a-7(c)(2)(i). investments. 25 Unlike a liquidity fee, a gate may be imposed for no more than 10 business days in a 90-day period. If the fund s weekly liquidity assets rise to or above 30%, the gate must be lifted the following business day. When determining whether a money fund has been gated for more than 10 business days in a 90-day period, the fund must account for any multiple separate gating periods and assess compliance with the 90-day limit on a rolling basis, calculated daily. The SEC shortened the maximum gating period from the proposed 30-day limit to 10 business days to reduce the likelihood of preemptive runs (under the theory that institutional investors would know that any gate would be lifted relatively soon after it was imposed) and to reduce hardships on investors denied access to their assets. The SEC expects that this 10-day period will provide a sufficient pause from redemption pressures as the fund s liquidity buffer will grow as its portfolio securities mature during the gating period. 26 Under the Amendments, however, a money fund s board also retains the authority to suspend redemptions permanently and liquidate the fund if the fund s liquidity remains impaired. 27 That authority will, no doubt, influence many institutional investors cash management decisions. If institutional investors, seeking to avoid a long-term loss of access to their cash, submit redemption requests after a temporary gate is imposed at a rate greater 25 Amended Rule 2a-7(c)(2)(i)(B). It may be unlikely, however, that a gated fund would see material new investment inflows as the fund will have to announce the imposition of a gate by means of website disclosure and a related filing with the SEC on Form N-CR. The fund likely also would sticker its current prospectus to disclosure to current and potential investors the temporary gate. 26 Adopting Release at See Amended Rule 22e-3(a)(1). 6

7 than the money fund can generate liquidity, the pressure on the fund from this pent-up demand on its liquid assets may increase and ultimately could require the fund s board to impose a permanent gate and liquidate the fund. Such a draconian outcome would need to be considered by a money fund s board when considering whether the imposition of a temporary gate is in the best interests of the fund. Board Considerations The Adopting Release set out factors that the SEC suggested a money fund s board may want to consider in determining whether to impose a liquidity fee and/or gate. 28 The SEC explained that the best interests standard employed by the Amendments is meant to recognize that each fund is different and that the SEC believes that a money fund s board in consultation with the fund s adviser is best suited to determine when (and if) a liquidity fee or gate is in the best interests of the fund. 29 Nonetheless, the SEC stated that a money fund s board may want to use the factors it suggested as guideposts when determining whether a fund should impose a liquidity fee or gate. Those factors include, but are not limited to: (i) relevant indicators of liquidity stress in the markets and why 28 Adopting Release at Id. at 87. The SEC also stated that because a money fund s board is the entity charged with overseeing the fund and determining whether a liquidity fee and/or gate is in the fund s best interests, the board should control the information and analysis it needs from the fund s adviser in order to inform its decision. The SEC did not charge a money fund s adviser with specify duties, but noted that the adviser should provide the board with necessary and relevant information to enable the board to make the required determinations. Id. at 92. 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 (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); (iii) for stable NAV money funds, whether the fall in weekly liquid assets has been accompanied by a decline in the fund s shadow price (for a floating NAV money fund, a board may want consider any drops in the fund s NAV); (iv) the make-up of the fund s shareholder base and previous shareholder redemption patterns; and/or (v) the fund s experience, if any, with the imposition of liquidity fees and/or gates in the past. 30 When determining the level of a liquidity fee, additional factors that a money fund s board may want to consider include, but are not limited to: (i) changes in spreads for portfolio securities (whether based on actual sales, dealer quotes, pricing vendor mark-to-model or matrix pricing, or otherwise); (ii) the maturity of the fund s portfolio securities; (iii) changes in the liquidity profile of the fund in response to redemptions and expectations regarding that profile in the immediate future; (iv) whether the fund and its intermediaries are capable of rapidly putting in place a liquidity fee of a different amount from a previously set fee or the default liquidity fee; (v) if the fund is a floating NAV money fund, the extent to which liquidity costs already are built into the NAV of the fund; and/or (vi) the fund s experience, if any, with the imposition of liquidity fees in the past Id. at Id. at 98. 7

8 Overall, the factors outlined by the SEC suggest that a money fund s board will need to consider (i) whether a liquidity fee or gate is actually necessary and appropriate to address the current problems (if any) of the fund, (ii) whether a liquidity fee or gate can be expected to effectively address those problems and (iii) the operational capabilities of the fund and its intermediaries with respect to imposing a liquidity fee or gate. Further, as noted above, the level of depletion of a money fund s weekly liquidity (i.e., below 30%) is designed by the SEC to be an indicator to the board that the fund may be in distress. The board, however, could determine that the fund is not, in fact, in distress because, for example, weekly liquid assets will be quickly replenished by action taken by the fund s investment adviser to restructure the fund s portfolio or through actions by the adviser or an affiliate to provide financial support to the fund. Once a liquidity fee or gate is imposed, a money fund s board will need to continue to be highly engaged to monitor the impact of the liquidity fee or gate and be able to determine whether that particular fee or gate continues to be in the best interests of the fund. As noted above, the board may lift the liquidity fee or gate, or change the amount of the fee, at any time if it determines that it is in the best interests of the fund to do so. The board s authority to remove or change the amount of a liquidity fee extends to the 1% default liquidity fee. The SEC noted that this default fee should not create a presumption that a liquidity fee should be 1%. In fact, the SEC encouraged boards, if practicable, to consider the actual cost of providing liquidity when determining if the 1% default fee is in a money fund s best interests. 32 Both the Adopting Release and amended Rule 2a-7 are clear that a money fund board s analysis must, by necessity, focus on the best interests of the fund rather than the interests of individual investors who may be subject to a liquidity fee or gate. Left out of the factors suggested by the SEC, but undoubtedly critical to any board evaluation of a fund s best interests, is the potential response of investors to imposition of a liquidity fee or gate. Large scale redemptions would not affect the liquidity profile of the fund in the immediate future a consideration factor suggested by the SEC but would certainly affect the fund s liquidity profile in, for example, 10 business days when a gate must be lifted. Accordingly, money fund boards may wish to consider, in addition to the immediate future of a fund, the long-term viability of the fund when deciding whether (and when) to impose a liquidity fee or gate. The debate over the efficacy of liquidity fees and gates and the consequences of their imposition, which was never really resolved by the SEC s rulemaking, now will find its way into fund boardrooms. Some commenters suggested that fund boards might decide, as a way of preventing heavy redemptions in anticipation of the imposition of a liquidity fee or gate, to commit to their investors that they will not impose such a fee or gate. The SEC, however, ruled this option out, declaring that such a decision without any knowledge or consideration of the particular circumstances of a money fund at a given time would be flatly inconsistent with the Amendments. 33 The SEC also declined requests from commenters to affirm that a money fund board s deliberations would be protected by the 32 Id. at Id. at 89. 8

9 business judgment rule because it was a question of state law. The SEC also rejected requests to relax the proposed quorum requirement for board action to require only the approval of a majority of independent directors available rather than all of a fund s independent directors. 34 Compliance Implications and Operational Matters Money fund boards, along with fund sponsors, service providers and intermediaries, should consider taking various actions to build the infrastructure necessary to impose liquidity fees and gates for the funds they oversee starting well in advance of October Those actions may include: Working with the fund s investment adviser to develop a plan of action in response to various liquidity scenarios (which will vary depending on the type of funds overseen by a board). For example, a board might consider implementing internal early-warning liquidity thresholds that would require a fund s adviser to provide the board with enhanced reporting about portfolio composition and investor redemptions. Boards may consider asking fund sponsors to develop response plans that have contingencies in place to create additional fund liquidity (e.g., sell portfolio securities, extend portfolio maturity, draw on a line of credit, interfund lending, etc.). Amending the fund s policies and procedures to facilitate compliance with the Amendments and, among other things, specify the 34 The Amendments do not, however, require a best interests determination to be made at an in-person board meeting. Money fund boards (including a majority of the independent directors) could hold meetings telephonically or through any other permissible means by which all participants could hear and be heard. Id. at 91. conditions under which enhanced board engagement is appropriate. For example, the enhanced board engagement that today is typically mandated at certain breakpoints in shadow pricing (e.g., when the shadow price of a fund share falls below $0.9975) may need to be replaced or supplemented by similar fund weekly liquid asset thresholds. Overseeing the review of the fund s contractual arrangements with financial intermediaries and service providers to determine whether any modifications are necessary or advisable to ensure that liquidity fees can be appropriately applied to beneficial owners of their shares. 35 Funds also may want to consider obtaining certifications or other assurances that their intermediaries and service providers will apply any liquidity fees to the beneficial owners of their shares. Discussing arrangements to seek to ensure a sufficient number of the fund s independent directors are reachable, as boards will need to convene a meeting whenever a determination must be made of whether liquidity fees and/or gates are in the best interests of a fund both at the time of any initial determination and as an ongoing matter (e.g., if a board imposes a temporary gate, it will need to establish a process to oversee fund liquidity and redemption demands during the 10 business day period and be in a position at the end of that period to make an informed decision to lift the temporary gate or to permanently suspend redemptions and liquidate the fund in accordance with Rule 22e-3). As the SEC was not willing to provide any guidance or affirmation that a board s deliberations and actions would be protected by the business judgment rule, directors should be particularly attentive to overseeing revisions to their funds compliance programs, as the SEC has brought 35 Id. at

10 enforcement actions against independent directors for causing violations of Rule 38a-1 in various circumstances (e.g., valuation of portfolio holdings, advisory contract approvals) over the last two years. 36 Service providers and intermediaries also will need to modify or establish new systems to administer liquidity fees and/or gates, including updating systems for confirmations and account statements to reflect the deduction of a liquidity fee from redemption proceeds, and develop procedures and controls for the imposition of liquidity fees and/or gates. Similarly, a money fund s transfer agents, sub-transfer agents, recordkeepers, accountants, portfolio accounting departments and custodians may need to establish or modify systems, procedures and controls relating to these Amendments. 37 The SEC acknowledged and sought to address the concerns of many commenters that the liquidity fees and gates requirements may present significant operational challenges to sweep accounts, omnibus accounts, intermediaries and the investors that use them. With respect to sweep accounts, the SEC believes that until they are imposed, liquidity fees and gates should not affect sweep accounts investment in a money fund. In the SEC s view, because a money fund s board may institute a liquidity fee or gate intraday under the Amendments, to the extent a sweep account s 36 See, e.g., In the Matter of J. Kenneth Alderman, CPA, et al., Investment Company Act Release No (June 13, 2013); In the Matter of Northern Lights Compliance Services, LLC, et al., Investment Company Act Release No (May 2, 2013). 37 Certain investors in money funds, such as institutions that invest directly with a fund, also may be required to modify their own systems to anticipate and manage liquidity fees and/or gates. Adopting Release at 114. daily investment is made at the end of the day, the sweep account holder may be more likely to find out about the imposition of a liquidity fee or a gate before it makes its daily investment (and thus would be subject to such fee or gate). The SEC expects that this fact may lessen the difficulty and costs related to developing a trading system that can ensure a sweep account has sufficient funds to cover the trade itself plus the possibility of any liquidity fee. 38 The SEC did not address other operational issues and costs associated with sweep accounts, including those related to a floating NAV, instead noting that sweep account assets invested in institutional prime money funds likely will move into government money funds. 39 With respect to omnibus accounts, the SEC anticipates that liquidity fees could be handled in a manner similar to the redemption fees that currently may be imposed pursuant to Rule 22c-2 to deter market timing of mutual fund shares. 40 Floating NAV The Amendments require all institutional prime money funds to transact with investors at share values based on the market-based value of their portfolio securities (i.e., using a floating NAV). For these funds, the SEC rescinded the provisions of Rule 2a-7 that since 1983 have permitted all money funds to use the amortized cost method of valuing portfolio securities and the penny rounding method of share valuation in order to maintain a stable NAV per share. 41 The effect of 38 Id. at Id. at Id. at Money funds and/or their transfer agents could elect to contract with intermediaries to have them impose liquidity fees. 41 Contrary to the SEC s proposal in the Proposing Release, government money funds and retail money 10

11 the Amendments will be to require institutional prime money funds to revert to the pricing requirements applicable to other types of mutual funds so that their share prices will, at least from time to time, change or float, as the market values of the securities in which these funds invest fluctuate due to changes in interest rates, credit conditions or other factors. 42 The floating NAV requirements are designed to achieve three objectives. First, the SEC sought to reduce the first mover advantage that encourages money fund investors to redeem shares in order to exploit any differences between a fund s $1.00 share price and the current market value of the fund s portfolio securities (i.e., the fund s shadow price ). This first mover advantage may have contributed to investor decisions to participate in the runs on money funds that occurred in Second, the SEC sought to reduce the likelihood of unfair dilution of the value of shares held by a fund s remaining investors, which [is] inconsistent with a core principal of the [1940] Act. 43 Third, the SEC sought to reduce investor expectations that they will not experience investment losses, to which the SEC believes that the $1.00 stable NAV may contribute. The money fund industry offered many arguments over the last several years as to why the funds are permitted to continue to price their shares at a stable NAV per share using the amortized cost method and/or the penny rounding method to price portfolio securities. 42 The SEC anticipates that floating NAV money funds should be able to continue to provide investors with intraday liquidity and same-day settlement by pricing fund shares periodically during the day (e.g., at 11:00 a.m. and 4:00 p.m.) by October Adopting Release at Id. at 138. SEC should permit money funds to maintain a stable NAV, one of which was that the share price of a floating NAV fund would not, in fact, float, and thus investor expectations would not change. In response, the Amendments require institutional prime money funds to price their shares by rounding the fund s current NAV per share to four decimal places. Thus, a fund with a target share price of $1.00 will be required to transact in its shares at $ The SEC s expectation is that use of basis point rounding (i.e., to the nearest 1/100 th of 1%), will result in more frequent and thus noticeable changes to a money fund s share price as a result of small changes in the valuation of portfolio securities. Stable NAV Funds (Government Money Funds and Retail Money Funds) 1.00 Mutual Funds (Other than Money Funds) Transaction Price ($) Floating NAV Funds (Institutional Prime Money Funds) Rounding Method Penny Rounding Traditional Rounding Basis Point Rounding Institutional prime money funds still will be subject to the other risk-limiting conditions of amended Rule 2a-7 (i.e., credit quality, diversification and disclosure), and, assuming compliance with those conditions, may continue to call themselves money market funds. These funds, however, will be relieved of complying with the periodic testing and other procedural requirements associated with maintaining a stable per share NAV. 11

12 Implications for Other Money Funds Under Amended Rule 2a-7 Government Money Funds Under the Amendments, only government money funds will continue to be able to maintain a stable NAV without the potential imposition of a liquidity fee or gate, as the SEC concluded that these funds are not as susceptible to investor runs as other types of money funds. Despite the meager yields government money funds currently offer, these features can be expected to increase their attractiveness to institutional investors that would otherwise be exposed to both a floating NAV and potential liquidity fees or gates. The preservation of the current regulatory structure for government money funds was an important part of the Amendments as it permitted the SEC to respond to many criticisms by noting that investors unwilling to tolerate a floating NAV or the potential for liquidity fees or gates could invest in those funds. Under amended Rule 2a-7, a government money fund is a money fund that invests at least 99.5% of its total assets in cash, government securities 44 and/or repurchase agreements that are collateralized fully (i.e., collateralized by cash or government securities). 45 Government money 44 Amended Rule 2a-7(a)(16). A government security is any security issued or guaranteed as to principal or interest by the United States, or by a person controlled or supervised and acting as an instrumentality of the Government of the United States pursuant to authority granted by Congress, or any certificate of deposit for any of the foregoing. See amended Rule 2a-7(a)(17) (defining government security by reference to Section 2(a)(16) of the 1940 Act). 45 See amended Rule 2a-7(a)(5) (defining collateralized fully as having the meaning as defined in Rule 5b- 3(c)(1) under the 1940 Act, except that Rule 5b- 3(c)(1)(iv)(C) and (D) shall not apply). funds may invest only a de minimis amount in nongovernment assets. 46 This definition is substantially more narrow than the SEC s proposed definition that relied on the 80% test of the names rule 47 and, as many commenters pointed out, would have permitted government money funds to maintain a stable NAV while taking on significantly greater investments in commercial paper and other riskier securities than they historically have held. It appears that a government money fund must meet the 99.5% requirement at all times, not only at the time a security is acquired. As a result, managers of government money funds will need to carefully manage their funds by, for example, avoiding selling only government securities to meet redemptions if the sale of such securities would cause a fund to violate the 99.5% requirement. A government money fund presumably could qualify as a retail money fund, in which case the fund would not need to meet the 99.5% test in order to maintain a stable NAV, but would need to 46 Non-government assets include all eligible securities permitted under amended Rule 2a-7 other than cash, government securities (as defined in Section 2(a)(16) of the 1940 Act) or repurchase agreements that are collateralized fully within the meaning of amended Rule 2a Under Rule 2a-7 (and as proposed in the Proposing Release), a government money fund is defined based on the portfolio holdings test used for determining the accuracy of a fund s name (the names rule ). See Proposing Release at 65 & n Rule 35d-1 under the 1940 Act states that a materially deceptive and misleading name of a fund includes, among other things, a name suggesting that the fund focuses its investments in a particular type of investment or in investments in a particular industry or group of industries, unless, among other requirements, the fund has adopted a policy to invest, under normal circumstances, at least 80% of the value of its assets in the particular type of investments or industry suggested by the fund s name. 12

13 have in place the ability to impose liquidity fees and gates. In the Adopting Release, the SEC stated that such a fund could not hold itself out as a government money fund, citing the new definitional provision of Rule 2a Our reading of the amended rule suggests that no provision of the rule so restricts a government money fund that otherwise meets the requirements to be a retail money fund. 49 Retail Money Funds As proposed, retail money funds will continue to be able to maintain a stable NAV under the Amendments. They will, however, be subject to compliance with the liquidity fees and gates requirements summarized in the previous section of this bulletin. Retail investors, the SEC observed, largely did not participate in the 2008 runs on money funds and did not appear to present the same risk as institutional investors. The SEC acknowledged that these investors may behave differently in a future market event, but suggested that retail money funds would be able to use liquidity fees and gates to address problems stemming from heavy redemptions. 50 A retail money fund is defined as a money fund that has policies and procedures reasonably designed to limit all beneficial owners of the fund to natural persons. 51 There are no limits on the size of the account or the amount that can be redeemed at one time. As urged by sponsors of retail money 48 Adopting Release at See Amended Rule 2a-7(b). 50 Adopting Release at Amended Rule 2a-7(a)(25). A stray investor not qualifying as a natural person will not automatically cause a money fund to breach the rule s requirements so long as the fund has policies and procedures in place that are reasonably designed to prevent such person from investing in the fund. funds, the SEC substantially changed the definition of a retail money fund in response to concerns about the complexity and workability of the proposed definition that would have compelled retail money funds to limit redemptions to $1 million a day to any single investor. 52 Compliance Implications Identifying Retail Investors The SEC acknowledged that retail money funds will face operational challenges in determining whether their investors are natural persons. The SEC anticipates that most retail money funds will use social security numbers as part of their compliance process to limit beneficial ownership to natural persons, although it noted that funds will have flexibility in how they choose to comply with the natural person test. 53 Regardless of the specific policies and procedures adopted by a fund, the SEC expects that boards of retail money funds will periodically review the adequacy of their funds policies and procedures and the effectiveness of their implementation. 52 Adopting Release at 217. The definition of a retail money fund in the Proposing Release was a money fund that restricted a shareholder of record from redeeming more than $1 million in any one business day. Proposing Release at Adopting Release at Social security numbers are often obtained as part of the accountopening process (for natural persons) and are maintained in transfer agent and intermediary recordkeeping systems. For intermediaries using omnibus account registrations where the beneficial owners are natural persons (e.g., retail brokerage accounts, certain trust accounts and defined contribution plan accounts), a social security number also likely is a condition of the customer accountopening procedures and should allow intermediaries to distinguish retail from institutional investors. 13

14 When an omnibus accountholder is the shareholder of record, retail money funds will need to reasonably conclude that the underlying beneficial owners of the omnibus account are natural persons. One way of accomplishing this would be for a fund to enter into an information agreement (or revise an existing agreement) pursuant to Rule 22c-2 that would give the fund access to underlying accounts. The SEC also suggested that funds could rely on periodic (e.g., quarterly) certifications by sponsors of omnibus accounts that all subaccounts are beneficially owned by natural persons, if the fund periodically reviewed the effectiveness of those procedures. 54 Such certifications could include representations that the intermediary has itself received certifications from intermediaries with which it deals so that the fund could form the required conclusions when ownership is held through a chain of intermediaries. The SEC s use of the term beneficial owner in amended Rule 2a-7 may present issues for retail money funds when designing their compliance policies and procedures with respect to confirming ownership by natural persons. The SEC indicated that defined contribution plans, IRAs, custodial accounts, 529 plans and medical savings accounts likely would qualify under the natural person test (i.e., would be retail accounts ), while defined benefit plans and small businesses would not. The SEC, in a footnote in the Adopting Release, suggested that a trust or an estate could be considered a retail account only if the retail money fund reasonably concluded that beneficial owner(s) were natural persons, 55 which may not be clear at the time the account is opened. The SEC 54 Id. at Id. at 222 n suggested that advisory accounts managed on behalf of natural persons would be treated as retail accounts if there are social security numbers associated with the accounts, but that a pooled investment vehicle owned by natural persons would be treated as an institutional account. As a practical matter, a retail money fund s inability to determine that a beneficial owner is a natural person would mean that the investor would not be eligible to invest in the fund. Fund Reorganizations and Alternatives Sponsors of non-government money funds that currently have separate retail and institutional classes (or a single class with both retail and institutional investors) will need to create separate retail money funds by October 2016 in order to continue to offer retail investors a money fund that seeks to maintain a stable NAV per share. The Amendments, however, do not compel those investors to own shares of retail money funds. Under the Amendments, retail investors will be able to own shares of institutional prime money funds, but a fund (or class) with any investors that are not natural persons (including small businesses and charitable, educational and religious institutions) will have to transition to a floating NAV by October In the Adopting Release, the SEC anticipates the reorganization of a money fund with retail and institutional investors into two separate money funds in order to create a stand-alone retail money fund. To facilitate that approach, the SEC provided one-time no-action relief necessary for a money fund with retail and institutional investors to reorganize into two funds without obtaining an exemptive order from the SEC, provided that the money fund s board (including a majority of the 14

15 independent directors) determines that the reorganization results in a fair and approximately pro rata allocation of the fund s assets between the class(es) being reorganized and the class(es) remaining in the fund. 56 As an alternative to a reorganization, the SEC also will permit a money fund to involuntarily redeem certain investors that will no longer be eligible to invest in the newly established or existing money fund, provided that the fund provides written notification to the soonto-be ineligible investors at least 60 days before the involuntary redemption occurs. 57 There is perhaps a more appealing alternative not discussed by the SEC in the Adopting Release an exchange program similar to those that are commonplace in the fund industry as part of the basic package of privileges available to investors. A sponsor simply could create a new retail money fund through the standard SEC registration process and make an exchange offer to qualifying investors of the existing money fund. The new retail money fund could have identical investment objectives, policies and restrictions, and the same expense structure as the existing retail class(es), so the investment experience for retail investors would not change. No formal reorganization or forced investor redemption 56 Id. Separate exemptive relief from the prohibitions in Section 17(a) (prohibitions on affiliated transactions) and Section 18(f) (prohibitions on differences in shareholder rights) of the 1940 Act would not be required prior to effecting any reorganization. The basis for the money fund board s determination would need to be documented fully in the fund s minutes. The SEC noted, however, its expectation that money funds choosing to rely on this relief would do so only where the fund s adviser believes it would result in cost savings as compared with the costs of establishing entirely new funds. Id. at 226 & n Id. at 226. would be necessary. Investors who failed to accept the exchange offer (many as a result, no doubt, of inertia) would remain in the existing money fund, which would be treated as an institutional prime money fund and would transition to a floating NAV. Those investors could move (or not) to the retail money fund thereafter. An exchange offer would avoid the time and expenses associated with a reorganization (and avoid the need to make the board findings required under the one-time exemptive relief granted by the SEC), which would be compounded for larger fund families. In addition, an exchange offer could be for a definite period (if a fund sponsor wanted to involuntarily redeem remaining retail investors at some future date) or an indefinite period (no different than current exchange programs offered by money funds and other mutual funds alike). Depending on asset flows, a sponsor eventually may decide to close and liquidate the existing money fund (or a class thereof), which would then force remaining investors to accept the exchange offer or a check. Of course, before deciding how to proceed, money fund sponsors will need to review their funds organizational documents and applicable state law requirements to ensure appropriate compliance with any non-1940 Act requirements in effecting an exchange offer, forced redemption, reorganization or any other restructuring. Municipal Money Funds Municipal money funds will not qualify as government money funds under the Amendments, nor are they explicitly included in the definition of retail money fund. As a result, municipal money funds will need to develop the infrastructure to impose liquidity fees and gates and will only be 15