The Securities and Exchange Commission (SEC) recently proposed amendments (Proposed Amendments) to certain rules and forms that govern money market funds under the Investment Company Act of 1940, as amended (1940 Act).1 The Proposed Amendments, designed to improve the resilience and transparency of money market funds, come in response to the significant outflows that some types of money market funds experienced in connection with the economic shock attributable to the COVID-19 pandemic in March 2020 and that contributed to stress on short-term funding markets.
The Proposed Amendments would, among other things, (i) increase minimum daily and weekly liquidity requirements; (ii) remove liquidity fee and redemption gate provisions; (iii) require institutional prime and institutional tax-exempt money market funds to implement swing pricing policies and procedures; (iv) address potential negative interest rates; and (v) implement other amendments, such as changes to the calculation of dollar-weighted average portfolio maturity (WAM) and dollar-weighted average life maturity (WAL), and enhancements to certain reporting requirements.
The Proposed Amendments are clearly directed at the crisis events of March 2020, but this is also the most significant reexamination of the money market fund reform amendments adopted in 2010 and 2014, in response to the financial crisis of 2008. As a result, the proposed changes are targeting issues that were identified in the 2020 crisis and seek to improve upon the prior reforms.
Key aspects of the Proposed Amendments are summarized below.
Portfolio Liquidity Requirements
Current Rule 2a-7 under the 1940 Act, the principal rule governing money market funds, requires that a money market fund, immediately after the acquisition of an asset, hold at least 10% of its total assets in daily liquid assets and at least 30% of its total assets in weekly liquid assets. These thresholds, which were added to the rule in 2010 in response to the 2008 financial crisis, are designed to support a fund’s ability to meet redemption requests, particularly during times of market stress. The Proposed Amendments would increase the daily liquid asset requirement to 25% and the weekly liquid asset requirement to 50%, which, among other things, would potentially allow money market funds to better manage significant and rapid investor redemptions during times of market stress. The Proposed Amendments would also impose triggers for Board notifications, enhance stress testing requirements up to each Fund’s approved minimum level of liquidity, and mandate some information to be included in reports to fund Boards.
Removing the Liquidity Fee and Redemption Gate Provisions
Currently, a money market fund has the ability to impose a liquidity fee of up to 2% or temporarily suspend redemptions (i.e., impose a redemption “gate”) if the fund’s weekly liquid assets fall below 30% of its total assets and the fund’s Board determines that imposing a fee or gate is in the best interests of the fund. In addition, a non-government money market fund is required to impose a liquidity fee of 1% on redemptions if its weekly liquid assets fall below 10% of its total assets, unless the fund’s Board determines that imposing that fee would not be in the best interests of the fund.
The Proposing Release notes that it is possible that these fee and gate provisions incentivized investors to redeem assets from money market funds during March 2020, which caused fund managers to maintain weekly liquid asset levels above the required threshold and to sell longer-maturity assets to meet their desired liquidity levels (instead of selling shorter maturity assets which could have impacted their ability to comply with Rule 2a-7), both of which contributed to downward pricing on assets. Redemption fees and liquidity gates were added in response to the 2008 market crisis and were disfavored then and now; the Proposed Amendments would eliminate these fee and gate provisions from Rule 2a-7 entirely.
Swing Pricing Requirement
The Proposed Amendments would implement a “swing pricing” requirement specifically for institutional prime and institutional tax-exempt money market funds that would apply when a fund experiences net redemptions. Swing pricing is a process of adjusting a fund’s current net asset value (NAV) such that the transaction price effectively passes on costs stemming from shareholder transaction flows out of the fund to the fund shareholders associated with that activity. Trading activity and portfolio management techniques used when meeting redemptions may impose costs, including trading costs and costs of depleting a fund’s daily or weekly liquid assets. To ensure that the costs stemming from net redemptions are fairly allocated and do not create a first-mover advantage or dilution under either normal or stressed market conditions, the Proposed Amendments would require institutional prime and institutional tax-exempt money market funds to adopt swing pricing policies and procedures to adjust a fund’s current NAV per share by a swing factor when the fund has net redemptions. Swing pricing is viewed as a way of associating liquidity costs — costs incurred in selling portfolio assets to fund redemptions — with those shareholders generating the redemption activity.2
Amendments Addressing Negative Interest Rates
The Proposed Amendments would add a new requirement that government or retail money market funds must either (i) determine that financial intermediaries can process transactions if a fund moves to a floating share price or (ii) prohibit them from transacting in street name.3 The Proposing Release reviews how funds, including stable value funds, operate, and the implications for funds if interest rates are negative. The Proposing Release discusses the impact of negative yields on the pricing provisions of Rule 2a-7, noting that stable NAV funds must convert to a floating share price because amortized cost and penny rounding accounting would likely not be available in a negative yield market. Although the Proposing Release does not include changes to the Rule 2a-7 pricing provisions, the proposed determination or prohibition requirement is essentially a verification that funds can continue to process transactions if a negative yield environment results in money market funds converting to floating share prices.
The Proposed Amendments would add a prohibition on using a reverse distribution, routine reverse stock split or other mechanism that would maintain a fund’s stable value (thus avoiding floating share prices) by reducing the fund’s share issuance.4 The Proposing Release explains that this concept is prohibited because it is not “intuitive” to investors and could be misleading.
Other Key Proposed Amendments
Amendments to Calculations of WAM and WAL. The Proposed Amendments would modify the definitions of WAM (weighted average maturity) and WAL (weighted average life) so that funds would use the percentage of each security in a fund’s portfolio; although most funds already use this convention, some funds use amortized cost. By making this change, comparisons among funds would be more accurate, and data reported to regulators would be more useful.
Reporting Requirements. The Proposed Amendments include certain enhanced reporting requirements on Forms N-CR and N-MFP to improve the availability of information about money market funds.5 For example, a money market fund would now file a report on Form N-CR when the fund falls below a specified liquidity threshold (i.e., the fund has invested less than 25% of its total assets in weekly liquid assets or less than 12.5% of its total assets in daily liquid assets). Form N-MFP would be amended to require, among other things, additional information about specific types of securities, as well as the composition and concentration of a money market fund’s shareholders, and whether the fund is designed to be a cash management vehicle.
The comment period will end 60 days after publication of the Proposed Amendments in the Federal Register (which has not occurred as of the date of this Client Alert).
S&K Observations and Insights
If adopted, the Proposed Amendments would represent the continuing evolution of money market fund regulations since the 2008 financial crisis. The changes would be significant, but they are by no means certain: the proposal was approved by a 3-2 vote. Some aspects of the proposal reflect the nuances of operating under the 2010 and 2014 amendments; others, like the removal of liquidity fees and gates, show that the SEC is able to pull back when its solutions are not effective to address a crisis; and others, like the prohibition of using reverse distributions, seek to address issues that have arisen in money markets since the 2014 amendments.
Arguably, the most contentious portion of the Proposed Amendments is likely to be the adoption of swing pricing for institutional prime and institutional tax-exempt money market funds. Swing pricing has never been popular in U.S. funds, and the earlier proposal generated significant industry opposition. The potential operational challenges of swing pricing and costs of implementing these changes in a competitive environment could result in reducing further the number of money market fund providers. With 145 separate requests for comment, the SEC apparently expects these Proposed Amendments will elicit a significant number of comments.
Seward & Kissel LLP will continue to provide insight on any related developments.
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If you have any questions regarding the matters covered in this memo, please contact any member of our Registered Funds Group.