In July 2014, the Securities and Exchange Commission (SEC) adopted long-awaited rule amendments to regulations that govern money market funds (Rules).  The Rules are designed to lessen money market funds’ susceptibility to heavy redemptions, improve the ability of money market funds to manage and mitigate potential contagion from high levels of redemptions and increase the transparency of risks associated with these funds.  At the same time, the Rules are designed to preserve to some extent the current benefits of a stable net asset value (NAV) for money market fund shares.  Regardless of their design, the Rules raise varying levels of uncertainty for money market fund boards.

Highlights of the Rule changes are reflected in our alert dated July 23, 2014.  The Rules will require action on the part of every board of a registered money market fund to some degree.  Some of the more important and more immediate considerations are highlighted below.

Implementation of Fees and Gates

The liquidity fee and redemption gate provisions are among the most controversial and nettlesome aspects of the Rules for money market fund boards.  These provisions are intended to provide a money market fund with the tools to manage and mitigate the contagion from high levels of redemptions; however, these tools are untested and their operation is unfamiliar to money market fund boards.

Generally, these provisions provide a money market fund board with the flexibility to impose liquidity fees of up to 2 percent and/or redemption gates of up to 10 business days in a 90-day period after a money market fund’s weekly liquid assets fall below 30 percent of total assets, if the board determines that such fees and/or gates would be in the best interests of the fund.  The Rules also require that a non-government money market fund impose a 1 percent liquidity fee if weekly assets fall below 10 percent of total assets unless the board determines that the fee would not be in the best interests of the fund or that a lower or higher fee (not more than 2 percent) would be in the best interests of the fund.  The provisions of the Rules on liquidity fees and redemption gates are not required for government money market funds, and it is anticipated that most government money market funds will not opt to have them; however, the boards of these funds can adopt some or all of these measures if they deem it to be in the best interests of their funds.  A liquidity fee or redemption gate must be lifted after a money market fund’s weekly liquid assets rise to or above 30 percent of total assets but can be lifted or changed before that point in time if the board determines such action to be in the best interest of the fund.

Factors for Board Consideration

The SEC has provided a number of factors that money market fund boards might consider as to whether to impose liquidity fees and redemption gates, making clear that boards have fairly wide discretion and flexibility under the Rules both as to when to impose and remove the fees and gates as well as the level of fees.  The SEC’s factors are not exhaustive and there may be other relevant factors that a board may consider.  The factors for board consideration are listed below.   

Factors Regarding the Imposition of Liquidity Fees and Redemption Gates

• Relevant indicators of liquidity stress in markets and why the fund’s weekly liquid assets have fallen (e.g., because of increased redemptions during times of market stress or a few large shareholders have redeemed);

• The liquidity profile of the fund and expectations as to how that 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 liquid assets is likely to be short-term (e.g., likely to be cured in the next day or two when securities currently held by the fund qualify as weekly liquid assets);

• For retail and government money market funds, whether the fall in weekly liquid assets has been accompanied by a decline in fund’s shadow price;

• The makeup of the fund’s shareholder base and previous shareholder redemption patterns; and

• The fund’s experience, if any, with the imposition of liquidity fees and/or redemption gates. 

Factors Regarding Liquidity Fee Amounts

• Changes in spreads for portfolio securities (e.g., based on actual sales, dealer quotes, pricing vendor mark-to-model or matrix pricing);

• 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 implementing a liquidity fee of a different amount from a previously set liquidity fee or the default liquidity fee;

• If the fund has a floating NAV, the extent to which liquidity costs are already built into the fund’s NAV; and

• The fund’s experience, if any, with the imposition of liquidity fees in the past.

The SEC cautioned that a blanket determination by a money market fund board not to impose liquidity fees and redemption gates without any knowledge or consideration of the particular circumstances of a fund at a given time would be “flatly inconsistent” with the new provisions on fees and gates.  The SEC noted, however, that the Rules do not require a fund board to impose liquidity fees and redemption gates when it is not in a fund’s best interests.  The SEC’s statements place additional responsibility on a board to obtain the information necessary to make this determination. 

Moreover, the SEC emphasizes that boards should direct their advisers and other service providers to provide the information they need to make their determinations under the provisions on liquidity fees and redemption gates.  In this regard, the SEC has stated that while advisers have an existing fiduciary duty to provide information to a fund board, other service providers, such as administrators, do not have such a duty.  Unlike Section 15(c) of the Investment Company Act of 1940, there is no specific provision in the Rules placing any responsibility on advisers or service providers to provide specific information to money market fund boards.^[1]

Additional Issues for Board Consideration

The provisions of the Rules dealing with liquidity fees and redemption gates will require money market fund boards to be provided with much more precise information about their funds on an ongoing basis than they may have received in the past, including information about portfolio holdings, fund liquidity, portfolio maturities and other information.  Given these new responsibilities, money fund boards may want to begin discussing with their advisers and service providers, as applicable, some or all of the following issues among others:

Training and Operations

Overall, does the adviser/service provider have the right people with the right training and education to manage the provisions of the Rules regarding liquidity fees and redemption gates and the related board information requirements?

Liquidity Stress Monitoring

• What indicators of liquidity stress are currently monitored, how are they monitored and by whom?

• How are weekly liquid assets monitored and who monitors them?

• What is the fund’s current liquidity profile?  How has it changed in the past in different markets and as a result of market events?

• How does the adviser/service provider currently monitor shadow pricing?  Are any changes needed in order to comply with the Rules?

• How does the adviser/service provider currently monitor spreads in and maturities of portfolio securities?  What changes, if any, should be made in light of the Rules?

• How does the adviser/service provider currently monitor the liquidity profile of the fund(s) in light of redemptions and expectations for future redemptions?  How might that monitoring change in the future in light of the provisions in the Rules on liquidity fees and redemption gates?

Redemption Activity

Existing know your customer rules already require money market funds to monitor redemption characteristics of their shareholders.  Money market boards may consider, however, whether there are ways to improve the fund’s knowledge of shareholder redemption characteristics.  Boards should have a good understanding of how redemptions will be monitored and by whom; how the adviser/service provider will be able to discern/analyze shareholder reasons for redemptions; and how well the fund knows its shareholder base.  Additionally boards may ask: Should the fund’s redemption policies change?  What are shareholders’ previous redemption patterns and how have they changed?

Liquidity Fees and Redemption Gates

• What operational or other factors are involved both at the fund and intermediary level if the board should set a liquidity fee in a different amount from that set previously?

• For floating NAV funds, how will the adviser/service provider determine if the liquidity costs are already built into the NAV?

• Are there other metrics that the board should consider to determine the appropriate level of liquidity fees?  If so, what are they?

• A liquidity fee or redemption gate must be lifted automatically after the money market fund’s weekly liquid asset level rises to or above 30 percent; however, the fee can be lifted or changed before this time.  What information will the board be provided to make a determination to lift or otherwise change a liquidity fee or redemption gate at an earlier time?

• Would scenario and contingency planning assist the board and adviser/service provider in being prepared for the implementation of the new Rules dealing with liquidity fees and redemption gates?

• Should there be trigger points before weekly liquid assets fall below 30 percent for the board and adviser/service provider to begin preparing for possible liquidity fees and/or redemption gates?  If so, what should those trigger points be?

• What kinds of redemption or liquidity events should trigger notice to the board? Or require a meeting?

• Would the board benefit in overseeing the implementation of the Rules dealing with liquidity fees and redemption gates by the hiring of a consultant?

• How will a board analyze the effectiveness of any potential liquidity fees or redemption gates?

• What other factors would the adviser/service provider suggest are relevant to a board’s decision with respect to the imposition and removal of liquidity fees and redemption gates?

Intermediary Contracts

• Many standard intermediary contracts prohibit the imposition of redemption fees and may contain other provisions that conflict with the Rules.  Therefore, boards may consider asking: Do any intermediary contract terms involving redemption fees need to be changed?  Are there other contractual provisions that need to be changed?

Director Liability

The provisions of the Rules with respect to the imposition and removal of liquidity fees and redemption gates pose potential new liability issues for boards.  There is considerable discretion in these provisions for boards as to when to impose a liquidity fee or redemption gate, how large a redemption fee should be imposed within the limits set by the SEC, and for what length of time the liquidity fee or redemption gate should be imposed (although there are limits imposed by the Rules in the length of the gates).  While the SEC has provided factors that a board may consider in making these determinations, the Rules are new and untested and boards may likely be making these decisions in very stressed markets and under considerable pressure.  Boards may want to review their liability insurance coverage in light of these uncertainties.

Floating/Stable NAV Considerations

Government Money Market Funds

The Rules permit government money market funds to continue to operate with a stable NAV provided they invest at least 99.5 percent of their total assets in cash, government securities, and/or repurchase agreements that are collateralized by cash or government securities.  Boards of government money market funds will need to monitor the necessity for changes in investment policies and related disclosure in order to comply with the 99.5 percent requirement, as the current fund name requirement has a lower threshold of 80 percent.  The boards of these funds will also need to monitor changes to compliance policies and procedures to effect these changes.

Retail Money Market Funds

Retail money market funds may operate with a stable NAV if they have “reasonable” policies and procedures in place to limit all beneficial owners to natural persons.  The SEC defines beneficial ownership to include voting and/or investment power.  Money market fund boards will therefore want to monitor, and would be expected to approve, investor eligibility policies and procedures as required by the Rules.  Further, boards will need to understand the procedures used by service providers to qualify an investor as a natural person so that they have a reasonable basis for approving such policies and procedures.  In that regard, an important issue will be a fund’s ability to obtain information from omnibus account (record) holders to determine whether the beneficial owners of those accounts are natural persons.  Many omnibus account holders have been reticent to provide information about their customers to funds and their service providers, and there is no provision in the Rules requiring them to provide any information to money market fund boards.  Therefore, absent cooperation by omnibus account holders, this area may prove challenging for funds and their directors.

Another potential area of uncertainty is whether IRA and 401(k) accounts can qualify as “natural persons.”  The SEC’s release suggests this may be the case.  But an analysis will need to be performed to ensure that no person other than the natural person account holder has voting or investment power.

Floating NAV Money Market Funds

The Rules require prime and municipal money market funds that do not limit all of their beneficial owners to natural persons to float their NAVs.  In addition, these funds will be required to round their prices and transact in fund shares to a more precise level of accuracy – i.e., for a fund that transacts at $1.00, the new price would be $1.0000.  The new system is known as “basis point rounding” and replaces the prior penny rounding system.  The SEC believes that this change will reduce the benefit to shareholders who attempt to redeem ahead of others to at most one half of a hundredth of a penny per share.  Boards of floating NAV money market funds will want to consider inquiring, among other things, whether the funds’ service providers are operationally capable of transacting under the new basis point rounding system and, if not, when they might be ready.

Floating NAV money market boards will also be required to oversee the disclosure and compliance policy and procedure changes applicable to floating NAV funds.

Restructuring Considerations

• The Rules will likely result in fund directors facing a number of restructuring decisions regarding their money market funds, including but not limited to:

• Whether certain funds will need to be liquidated;

• Whether certain funds will need to be merged;

• Whether prime money market funds will need to be reorganized into both floating and stable NAV funds to accommodate institutions and natural persons, respectively; and

• Whether certain investors will need to be involuntarily redeemed, which the SEC permits as long as adequate notice (60 days) is given to those shareholders.

A money market fund that has shareholders who are both natural persons and institutions may have to be reorganized into two separate funds (one a floating NAV fund and one a stable NAV fund) in order to comply with the Rules.  In this regard, the SEC has provided relief to facilitate the reorganization of funds to comply with the Rules, but the board will be required to make a determination that the reorganization results in a “fair and approximately pro rata allocation” of the fund’s assets as between the class(es) being reorganized and the class(es) that remain in the fund.  In other words, boards must monitor to make sure there is no cherry picking of securities.

Disclosure Changes

An important duty of fund directors is overseeing fund disclosures.  The Rules will require many new disclosure changes in both a money market fund’s registration statement and advertising.  These changes will vary depending on the type of money market fund and the Rules that apply to the fund.  Boards may want to consider discussing and reviewing with their chief compliance officers and counsel what changes will apply to the funds they oversee.

Valuation Considerations

We highlighted the valuation guidance contained in the SEC’s release in an earlier alert along with associated board considerations.

Board Workload

We think money market fund boards will have significantly more responsibilities under the Rules, including but not limited to:  whether and under what conditions to impose liquidity fees and redemptions gates; monitoring weekly liquid assets; possible restructuring and/or liquidation or merger of funds; review of more frequent and enhanced stress tests; and monitoring additional registration statement and advertising disclosure and increased SEC filing requirements.

Governance

The board may need to consider in the first instance whether any governance issues are raised by the Rules.  For example, a board may consider what, if any, aspects of the Rules should be handled by a committee, rather than the full board.  The board may also want to consider, if any aspects of the oversight of money market funds are delegated to a committee, whether the board has existing committees that are appropriate or whether a new committee should be formed.  It might also be appropriate to consider whether additional expertise or other resources should be added to or engaged by the board.  Money market fund boards may also consider developing contingency plans for various scenarios involving decreases in liquidity levels.

Conclusion

The foregoing considerations are by no means all of the considerations that money market fund boards will face in connection with the implementation of the Rules.  Lurking not too far in the background are a host of other more practical business issues for boards resulting from the likely consolidation of money market funds into fewer fund groups, and the accompanying competition for assets that is likely to occur as a result of the Rules.

^[1] _{Section 15(c) places responsibility on an investment adviser to provide information to a fund board as may be reasonably necessary to allow a fund board to evaluate an investment advisory agreement.}