The SEC responded on April 22, 2015, to industry questions regarding its 2014 money market reform rules (Rules) through a frequently asked questions (FAQ) format. The 15-page release answers 53 questions on various topics. Set forth below are some of the more significant issues settled by the SEC.
Retail Money Market Fund Questions
- Beneficial ownership for retail money market funds (Retail Funds) tested by sole or shared investment/voting power not solely pecuniary interest: The SEC believes that investment power in particular is the most important factor in analyzing the likelihood of redemptions. Accordingly, the definition of a “natural person” under the Rules is tested based on whether the person has sole or shared voting and/or investment power. Left open is the question of whether 401(k) and other similar retirement plans can qualify under this test, because plan sponsors – who are not natural persons – generally choose the investment options offered to plan participants.
- Estates qualify as natural persons: Estates will qualify as “natural persons” for purposes of the Retail Fund investor test; however, distributions to beneficiaries may result in disqualifications if a beneficiary is not a natural person.
- Forfeiture/suspense accounts in DC plans do not disqualify plans from investing in Retail Funds: Defined contribution (DC) plans often carry accounts that have been forfeited by plan participants or suspense accounts that hold money for temporary periods of time. The SEC confirmed that the existence of these accounts within a DC plan does not disqualify the plan from investing in Retail Funds; however, the accounts themselves may not invest in a Retail Fund. This result suggests that DC plans and Retail Funds need to have policies and procedures in place with respect to these kinds of accounts.
- Life insurance separate account contract owners qualify as “natural persons:” Consistent with the SEC’s look through policy for determination of beneficial ownership, a Retail Fund can look through life insurance separate accounts to the contract owners for purposes of the natural person test. However, insurance company funds of funds do not qualify as “natural persons.”
- Master funds can qualify as Retail Funds if all feeder funds qualify as Retail Funds: The SEC confirmed that Retail Funds must have policies and procedures to look through to the beneficial owners. Therefore, a master Retail Fund must look through all of its feeder funds for purposes of determining whether all of the feeder funds’ beneficial owners are “natural persons.” If all of the retail feeder funds qualify as “natural persons,” then the master will qualify as well. The SEC also confirmed that a master fund may rely on the policies and procedures of the feeder funds to ensure that all of the feeder fund’s beneficial owners are natural persons.
- Retail Funds may involuntarily redeem ineligible investors: Retail Funds may involuntarily redeem ineligible investors subject to 60 days’ prior written notice. However, an ineligible investor may not have his or her shares automatically reinvested into shares of another money market fund as that fund’s investment policies may not be consistent with those of the current investment. In that case, the SEC recommended outreach to the investor.
- Non-natural persons can seed Retail Funds: Non-natural persons, such as investment advisers and their affiliates, can seed Retail Funds as long as the sole purpose is for administrative and operational purposes.
Government Money Market Fund Questions
- “Government security” does not need to be backed by full faith and credit: The Rules require that government money market funds (Government Funds) hold at least 99.5 percent of their portfolios in government securities. The FAQ confirmed that a “government security” may be issued or guaranteed by the United States or a person controlled or supervised by and acting as an instrumentality of the U.S. government. Accordingly, government agency securities, such as Fannie Mae and Freddie Mac securities, which are issued but not guaranteed by the U.S. government, qualify as “government securities.” In addition, the New York Federal Reserve Bank, which issues overnight reverse repurchase agreements (Repos), may be considered an instrumentality of the U.S. government and its Repos will therefore meet the definition of “government security.” Trade receivables (i.e., receivables arising from the sale of government securities) will also qualify as “government securities.” However, FDIC guaranteed certificates of deposit will not qualify as “government securities.”
- Test for 99.5 percent requirement is at acquisition for Government Funds: The FAQ confirmed that the time of acquisition of a security is the point at which the 99.5 percent government securities investment minimum is tested. Therefore, a sale of securities that results in a Government Fund falling below the 99.5 percent government security threshold will not disqualify the fund as a Government Fund, but such a fund may not purchase additional non-qualifying securities until it has reached the 99.5 percent minimum threshold.
Capital Support Questions Answered
- NAV errors requiring adviser capital support may not need to be reported on Form N-CR: The FAQ confirms that Part C of Form N-CR contains exceptions to capital support reporting requirements — among them is an action that the fund’s board of directors finds is not reasonably intended to increase or stabilize the value or liquidity of a money market fund’s portfolio. In the case of a net asset value (NAV) error, in order to avoid reporting a capital contribution intended to make a fund whole, the fund board would need to make a finding that the action is to remedy an operational error, and not to stabilize the value or liquidity of the fund’s portfolio due to investment losses.
- Capital support in a one-time reorganization designed to comply with Rules not required to be reported on Form N-CR: Contributions designed to “top up” a fund that occur as part of a one-time reorganization designed to comply with the Rules need not be reported on Form N-CR if they occur before the end of the compliance period for the Rules. Contributions of capital support in a reorganization after the compliance period would be required to be reported.
Other exceptions to reporting on Form N-CR include: routine fee waivers and expense reimbursements; routine inter-fund lending; routine inter-fund purchase of shares; and any other financial support that the fund board determines is not reasonably intended to increase or stabilize the value or liquidity of a fund. These determinations, we believe, should be memorialized in the board’s minutes.
- Retail Fund summary prospectuses may disclose natural persons limitation: The SEC has interpreted Items 6 and 11 of the Form N-1A rules to permit Retail Fund summary prospectuses to state that the fund limits investors to beneficial owners who are natural persons.
- Floating money market funds (Floating Funds) must disclose fair value policies in prospectus: Form N-1A currently permits “money market funds” to omit disclosure regarding its fair value practices. The staff believes that only stable NAV funds such as Government or Retail Funds can continue to rely on this exception and that Floating Funds should disclose in their prospectuses the circumstances under which they will use fair value pricing.
- Updating a money market fund’s registration statement: The FAQ confirms that imposing (or removing) a fee or gate can be disclosed pursuant to a prospectus supplement filed pursuant to Rule 497 of the Securities Act of 1933 (1933 Act), because of the need for immediacy in communicating such an action. However, with respect to a fund’s transition to a floating NAV structure and ability to impose fees and gates, the staff believes that a registration statement filed pursuant to Rule 485(a) of the 1933 Act – i.e., a material amendment — is appropriate. A Rule 485(a) filing would also be required for N-1A Item 16 disclosure (capital support and imposition of fees and gates).
Amortized Cost Questions
- Floating Funds cannot use amortized cost to value a security if this value is not “approximately the same” as its fair value: Floating Funds can use amortized cost to value securities with a remaining maturity of 60 days or less, but not their shares, under the Rules. Consistent with the Rules release's valuation guidance, however, Floating Funds can only use the amortized cost value of a security when they can reasonably conclude that the amortized cost value is “approximately the same” as the fair value of the security (without the use of amortized cost).
- Floating Funds that invest only in securities with remaining maturities of 60 days or less must state that their share prices will fluctuate: Floating Funds that invest only in securities with remaining maturities of 60 days or less must use care in sales material and prospectus disclosure. They may not state that they seek to maintain a stable NAV as the SEC considers such a statement to be misleading. As has been pointed out by others, this position may make short term Floating Funds less attractive to investors.
- Amortized cost valuation guidance not applicable to stable NAV funds: The FAQ reminds the industry that stable NAV funds (i.e., Government and Retail Funds) may continue to value their entire portfolios using amortized cost; accordingly, the amortized cost valuation guidance provided in the Rules release is not applicable to these funds except when they are shadow pricing their securities or portfolio. The guidance is applicable, however, to Floating Funds as well as all other types of fixed income and equity funds that use this valuation method.
- Amortized cost securities not required to be shadow priced daily: The SEC clarified in a companion FAQ that its guidance on amortized cost in the Rules release was not intended to force funds to shadow price amortized cost valued securities daily. Instead, the FAQ states that funds should have adequate policies and procedures in place that include a description of factors used in determining the fair value of the security and how these factors are reviewed and monitored each time a valuation decision is made.
Fee and Gate Questions
- Funds must implement board-approved fee/gate immediately: The FAQ emphasized that a fund should implement a fee or gate immediately after a board’s determination to impose one. However, the staff did recognize that it may take some time to notify shareholders and intermediaries regarding a fee and/or gate and that the transfer agent and intermediaries may need some time to implement the gate. Therefore, the staff believes that the board should take these considerations into account in imposing the fee or gate. There were a series of other technical questions regarding fees and gates also addressed by the FAQ.
- Rules' exemptive relief doesn’t apply to merging two retail share classes of similar prime funds into new or existing retail funds with multiple classes: The FAQ states that the exemptive relief provided in the Rules for mergers and reorganizations is not applicable to combinations of share classes. A fund that wishes to combine share classes that have already been split into new funds under the exemptive relief, however, may use Rule 17a-8 under the Investment Company Act of 1940 if the transaction meets the requirements of the rule.
In addition, the Rules relief does apply to the reorganization of a single fund owned by both retail and institutional shareholders into two or more funds, such as a Retail and a Government or Floating Fund if the conditions of the relief are met (e.g., pro rata distribution of assets). The FAQ points out, however, that shareholder approval may be required in certain circumstances. The performance record of the original fund may be used by each of the new funds in this scenario.
Board Valuation Monitoring
- The Board may delegate specific valuations responsibilities, such as due diligence of pricing vendors, to others subject to appropriate oversight: A companion valuation FAQ issued by the SEC states that fund boards have a non-delegable duty to determine that evaluated prices provided by pricing vendors represent the fair values of the fund’s portfolio securities. The FAQ clarified, however, that the fund board may use others to assist it in making this determination. Fund boards may therefore consider whether their policies and procedures sufficiently specify the duties and reporting obligations of their delegates.
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The FAQ also covered certain diversification and asset backed security questions, which will be the subject of a subsequent Alert. Should you have any questions about the Rules or this Alert, please feel free to call or email your contact within our Investment Management Group.