Money Market Fund FAQs Raise More Questions
Sometimes attempts to bring clarity raise more questions.
So it may be with the SEC staff’s recent issuance of a large set of answers to frequently asked questions about its July 2014 money market fund amendments and a smaller set of FAQs involving related valuation issues. "Many fund groups were holding back reorganizing their funds until these FAQs came out. Unfortunately, the FAQs have raised as many additional issues," said Stroock partner and former SEC Division of Investment Management deputy director Robert Plaze.
While many of the FAQs relate to highly technical Rule 2a-7 issues, one theme in particular that Plaze pointed to is "the SEC staff’s efforts to slam shut doors left open by the rules to organize a fund in a way to avoid a floating NAV, and how those efforts will affect all mutual funds."
This deals with not only the issue of a floating NAV vs. a fixed NAV money market fund, but an accounting method known as "amortized cost." Historically, the SEC has permitted all mutual funds to use amortized cost to value high-quality debt obligations that are within 60 days of maturing on the theory that amortized cost is a good approximation of fair market value, Plaze said, but the FAQs appear to be "slamming the door" on this method.
"Although the SEC adopting release stated that the SEC would continue to permit use of amortized cost methodology for 60-day obligations," he said, "one of the staff FAQs seems to make it impossible as a practical matter."
The 2014 reform
The Commission adopted the 2014 amendments in an effort to prevent runs on money market funds, such as those that occurred in 2008, when one fund "broke the buck" and dropped below $1.00, setting off a cash run. The SEC also wanted to disincentivize redemption activity that can result when a "first mover" attempts to exploit the possibility of redeeming shares at a stable share price when a portfolio has suffered a loss. And the agency wanted investors to realize that money market funds are not as stable as bank deposits, which are protected by government insurance.
The most significant changes were:
Floating NAV. Institutional prime money market funds were required to conduct daily transactions using a net asset value that floats with changes in the market-based value of their portfolio securities. Retail funds and government funds were exempted. What this meant was that institutional prime money market funds are no longer able to use amortized cost to value, nor "penny round" (the $1.00 share price), to determine their net asset values. They instead need to round the share price "to the nearest 1/100th of 1 percent," according to the Commission, which means the fourth decimal point for a fund with a $1.0000 share price.
Liquidity fees. One of the tools fund managers were given last year was the ability to charge liquidity fees to discourage runs. Fees of up to 2 percent on all redemptions may be charged if a fund’s level of weekly liquid assets falls below 30 percent of its total assets. If a fund’s level of weekly liquid assets falls below 10 percent, the fund would be required to impose a liquidity fee of 1 percent on all redemptions, although the fund board can raise or lower the fee in such cases. Government money market funds could not charge such fees unless they voluntarily opt into them after disclosure to investors.
Redemption gates. This reform allows a fund to temporarily suspend redemptions. Like a liquidity fee, a redemption gate may be put into effect if a fund’s level of weekly liquid assets falls below 30 percent of its total assets. Any imposed gate is required to be lifted within 10 business days. Funds are not allowed to impose a gate for more than 10 business days in any 90-day period.
It’s no surprise that these and other changes from the 2014 reforms raised questions, and the SEC staff issued answers to 55 FAQs to answer them. Fifty-three deal specifically with the money market fund reforms, while two deal with related valuation questions that affect all mutual funds.
Following is a summary of some of the FAQs with the broadest-expected impact:
Valuation. The 2014 adopting release suggested that a fund’s board of directors, before deciding to use evaluated prices from a pricing service to assist it in determining fair values of a fund’s portfolio securities, may want to consider the "inputs, methods, models and assumptions used by the pricing service … and how they are affected (if at all) as market conditions change," according to one of the FAQ answers. This raised a concern among funds that "this suggestion was too technical for a fund board," said Stradley Ronon counsel Joan Ohlbaum Swirsky. The FAQ answer somewhat relieves that concern by stating that a fund board "may appoint others, such as the fund’s investment adviser or a valuation committee," to assist it in considering these factors in determining fair value. In other words, a fund board "can leave it up to its adviser as its delegate to do the day-to-day work on the pricing reviews," said Sidley Austin counsel Douglas McCormack. At the same time, however the SEC staff makes clear that it remains "incumbent upon the fund’s board to satisfy themselves that all appropriate factors relevant to the fair value of securities for which market quotations are not readily available have been considered and to determine the method for determining the fair value of each such security." What this means, said Shearman & Sterling partner Nathan Greene, is that "you can’t take what a service does on its own. You have to do due diligence."
Floating NAV and amortized cost method. There are several FAQs in this area, but one of particular interest to funds states that even though the 2014 reforms allow a floating NAV fund to use, under certain circumstances, the amortized cost method – which held that a fund maintain a fixed NAV – to value a portfolio security with a remaining maturity of 60 days or less, this would not be appropriate if it resulted "in a difference in the fund’s NAV used to transact in fund shares." The amortized cost method may be used only when the fund can reasonably conclude that the amortized cost value of a portfolio security "is approximately the same" as its fair value as determined without the use of amortized cost valuation, the staff said.
Floating NAV and advertising. A floating NAV money market fund may not state in its advertising, sales literature or prospectus that it will seek to maintain a stable NAV by limiting its portfolio securities to only those securities with a remaining maturity of 60 days or less and valuing those securities at amortized cost, the answer to another FAQ said. "Such a statement would be misleading to investors," the staff said, as it believes that "there will be circumstances that may require a floating NAV money market fund’s share price to fluctuate, regardless of how it limits its investment duration or its use of amortized cost for certain portfolio securities." "But," Plaze asked, "what if such a statement was followed by another one that explains that there is no guarantee that the fund will be able to maintain a stable NAV because the value of its portfolio securities will fluctuate?" Lots of mutual fund prospectuses state that a fund will "seek" to achieve an investment objective that cannot be guaranteed, but the SEC staff has never before suggested that such statements when appropriately qualified are inherently misleading, he said.
Beneficial ownership determination. While this answer provides some clarity, it also may mean more work for funds and the advisers managing them. A retail money market fund may not determine beneficial ownership by using the direct or indirect pecuniary interest test as defined in Rule 16a-1(a)(2) of the Securities Exchange Act in lieu of the sole or shared voting and/or investment power test as defined in Rule 13d-3, the SEC staff said. This is because, it said, investment and/or voting power is more appropriate for investors in determining beneficial ownership.
Redeemed shares. The staff said that, when there is an involuntary redemption, a money market fund may not choose to exchange redeemed shares for shares of another money market fund that maintains a stable NAV, rather than sending the shareholder a check. "The investment goals and risk tolerances of a shareholder in a money market fund that is converted to a floating NAV fund may not align with the risks and investment goals provided by a stable value government money market fund or other investment option," according to the FAQ answer.
Fee and gate delays. The SEC staff wants any delay in implementing a fee or gate to be as brief or possible. "Any delay in implementation beyond that required to take into account practical considerations … would raise significant concerns," it said in response to a question as to whether a fund board may determine to impose a fee or gate at a later time if a money market fund’s weekly liquid assets fall below 30 percent of the fund’s total assets. "Given the potential for material developments to occur between a board’s determination and a delayed fee or gate, directors should consider whether it would be consistent with their fiduciary duties to allow for a material lapse of time between their determination and implementation," the staff said.