SEC Proposes Money Market Funds Reforms

On December 15, 2021, the SEC issued a release (the “Release”) proposing amendments to certain rules that govern money market funds under the 1940 Act. The proposed changes to Rule 2a-7, new reporting requirements and form changes (the “Proposals”) are intended to address problems experienced by certain money market funds in connection with the economic shock at the onset of the COVID-19 pandemic. The summary section below provides an overview of the principal changes that the Release would effect if adopted in its current form. A more detailed discussion of the Release follows the summary.

SUMMARY Increase Minimum Liquidity Requirements. For all money market funds, the Proposals would increase (i) the daily liquid asset minimum to 25% of total assets (formerly 10%) and (ii) the weekly liquid asset minimum to 50% of total assets (formerly 30%). Elimination of Liquidity Fees and Gates. The Proposals would eliminate the liquidity fee and redemption gate provisions from Rule 2a-7 for all money market funds. Swing Pricing. The Proposals would impose a swing pricing requirement on institutional prime and institutional tax-exempt money market funds (“institutional funds”) that would apply when an institutional fund experiences net redemptions, such that redeeming investors would bear the liquidity costs of their decisions to redeem. If an institutional fund has net redemptions for a pricing period, the fund would adjust its current per-share NAV by a “swing factor” that incorporates the spread and transaction costs. If an institutional fund has net redemptions for a pricing period greater than the “market impact threshold” – usually 4% of the fund’s NAV or such smaller amount of net redemptions as the “swing pricing administrator” determines – the swing factor must also include market impacts. An institutional fund’s swing pricing policies and procedures would be implemented by a board-designated “swing pricing administrator.” An institutional fund’s board would be required to (i) approve the fund’s swing pricing policies and procedures, (ii) designate the swing pricing administrator and (iii) review, at least annually, a written report prepared by the swing pricing administrator that reviews the adequacy and effectiveness of the fund’s swing pricing policies and procedures. Disclosure. The Proposals would require institutional funds to comply with existing swing pricing-related requirements within Form N-1A. The Release would amend Form N-CR and Form N-MFP to reflect new filing and reporting requirements.

I. Amendments to Portfolio Liquidity Requirements

Increase of the Minimum Daily and Weekly Liquidity Requirements. At present, Rule 2a-7 requires that every money market fund, immediately after 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.”¹

• The Release would increase the minimum liquidity requirements to 25% daily liquid assets and 50% weekly liquid assets.
• The minimum daily liquid asset test and weekly liquid asset test would remain time-of-purchase tests. Thus, a money market fund would be prohibited from acquiring any portfolio investments other than daily liquid assets or weekly liquid assets, respectively, until it meets these minimum thresholds.

Consequences for Falling Below Minimum Daily and Weekly Liquidity Requirements. The Proposals would amend Rule 2a-7 to require a money market fund to notify its board within one business day when the fund has less than 12.5% of its total assets invested in daily liquid assets or less than 25% of its total assets invested in weekly liquid assets (each, a “liquidity threshold event”).

Following a liquidity threshold event, the Proposals would require a fund (i) to notify the board within one business day of the liquidity threshold event and (ii) to provide the board with a brief description of the facts and circumstances that led to the liquidity threshold event within four business days of the liquidity threshold event.

II. Elimination of Liquidity Fee and Redemption Gate Provisions

Rule 2a-7 currently permits a money market fund to impose liquidity fees or redemption gates (“fees and gates”) after crossing a specified liquidity threshold. The Release states that fees and gates were intended to temper the effects of a short-term investor panic and preserve liquidity levels in times of market stress, as well as better allocate the costs of providing liquidity to redeeming investors. However, the Release reports that, in March 2020, no money market fund imposed a fee or gate, and the possibility of such an imposition “created incentives for investors to redeem and for money market fund managers to maintain weekly liquid asset levels above the threshold,” instead of using those assets to satisfy redemptions.

Accordingly, the Proposals would eliminate fees and gates from Rule 2a-7.² Nonetheless, the Release explains the SEC’s position that institutional funds still need a tool to address shareholder dilution and potential institutional investor incentives to redeem quickly in times of liquidity stress to avoid further losses. In the place of fees and gates, the Proposals would therefore require institutional funds to implement swing pricing. The Proposals would implement the swing pricing requirement by amending Rule 2a-7 to require that each institutional fund must design and implement swing pricing policies and procedures, approved by the fund’s board and administered by a “swing pricing administrator,” as discussed in more detail below. The Proposals do not require retail money market funds or government money market funds to implement swing pricing.

III. Institutional Funds’ Swing Pricing

In General. The Release notes that trading activity and changes in portfolio holdings in connection with meeting redemptions “may impose costs, including trading costs and costs of depleting a fund’s daily or weekly liquid assets.” These costs, which currently are borne by the fund’s remaining investors, can dilute the interests of non-redeeming shareholders. In turn, this can create an incentive for shareholders to redeem quickly to avoid losses – i.e., there is a first mover advantage – particularly in times of market stress.

Swing pricing refers to the process of adjusting a fund’s current NAV so that the transaction price passes on costs arising from the transaction to the shareholder engaging in the transaction, instead of the fund’s remaining investors bearing the costs of the transaction. While the term “swing pricing” is usually thought to include adjusting a fund’s current per-share NAV in both net redemption and net subscription situations, the Release’s proposed swing pricing for institutional funds applies only in the case of net redemptions. The proposed swing pricing is intended to cause redeeming shareholders to internalize the transaction costs that their redemptions otherwise would impose on non-redeeming shareholders and thereby reduce the potential for dilution of investors who choose to remain in the fund.

To avoid a collective action problem in which no fund wants to be the first to adopt such an approach, the Proposals would amend Rule 2a-7 to require institutional funds to implement a swing pricing regime for net redemptions when an institutional fund experiences a specified level of net redemptions. Further, the Proposals include several requirements related to the administration of the swing pricing regime, including adopting swing pricing policies and procedures to be implemented by a board-designated administrator, as described below.

The Proposals do not affect the requirement that institutional funds must use a “floating” per-share NAV for share transactions, rounded to the fourth decimal place (e.g., $1.0000). The Proposals would prohibit any fund (a “feeder fund”) that invests, pursuant to section 12(d)(1)(E) of the 1940 Act, in another fund (a “master fund”) from using swing pricing.³

Swing Pricing Administrator. The Proposals would amend Rule 2a-7 to require that an institutional fund’s swing pricing policies and procedures are implemented by a board-designated “swing pricing administrator” (the “Administrator”). The Administrator may be the institutional fund’s investment adviser, or officer or officers responsible for administering the swing pricing policies and procedures, and the Administrator may consist of a group of persons. However, amended Rule 2a-7 would require that the administration of the swing pricing program is “reasonably segregated from portfolio management of the fund and may not include portfolio managers.”

Mechanics. The Proposals would amend Rule 2a-7 to require that an institutional fund adopt swing pricing policies and procedures that provide that the fund will adjust its current per-share NAV by a “swing factor” that incorporates the spread and transaction costs if the fund has net redemptions for the “pricing period.”

• A “swing factor” is the amount, expressed as a percentage of the fund’s NAV and determined as prescribed by the fund’s swing pricing policies and procedures, by which a fund adjusts its per-share NAV to reflect, for example, spread and transaction costs.
• When determining whether the fund has net redemptions for a pricing period and the amount of net redemptions, the Administrator is permitted “to make such determination based on receipt of sufficient investor flow information for the pricing period to allow the fund to reasonably estimate whether it has net redemptions and the amount of net redemptions.” Moreover, “investor flow information”⁴ may “consist of individual, aggregated, or netted orders, and may include reasonable estimates where necessary.”
• If an institutional fund has net redemptions for a pricing period greater than the “market impact threshold” – defined as 4% of the fund’s NAV divided by the number of pricing periods the fund has in a business day, or such smaller amount of net redemptions as the Administrator determines⁵ – the swing factor must also include market impacts (described below).
• The “pricing period” is defined as the period of time during which an order to purchase or redeem securities issued by the fund must be received to be priced at the next computed NAV. This is intended to accommodate institutional funds that compute their NAVs more than once each day.
• An institutional fund with multiple share classes would be required to determine whether it experienced net redemption activity across all share classes in the aggregate, instead of determining net redemption activity on a class-by-class basis.

Determination of the Swing Factor. The Proposals would amend Rule 2a-7 to require that an institutional fund’s swing pricing policies and procedures include certain provisions that specify the process for determining the swing factor.

When determining a swing factor, the Administrator would be required to make “good faith estimates, supported by data, of the costs the fund would incur if it sold a pro rata amount of each security in its portfolio to satisfy the amount of net redemptions for the pricing period.”⁶

• If the fund has net redemptions for the pricing period, the Administrator’s good faith estimates are required to include, for each security in the fund’s portfolio (i) spread costs, such that the fund is valuing each security at its bid price and (ii) brokerage commissions, custody fees and any other charges, fees, and taxes associated with portfolio security sales.
• If the amount of the fund’s net redemptions for the pricing period also exceeds the market impact threshold, the Administrator’s good faith estimates also are required to include, for each security in the fund’s portfolio, market impacts, which the fund determines by:
  • establishing a “market impact factor” for each security (i.e., an estimate of the percentage change in the value of the security if it were sold, per dollar of the amount of the security that would be sold, under current market conditions)⁷ and
  • multiplying the market impact factor for each security by the dollar amount of the security that would be sold if the fund sold a pro rata amount of each security in its portfolio to meet the net redemptions for the pricing period.
• The Administrator is permitted to “estimate costs and market impact factors for each type of security with the same or substantially similar characteristics and apply those estimates to all securities of that type rather than analyze each security separately.”

The Board’s Role. Amended Rule 2a-7 would require each institutional fund’s board, including a majority of directors who are not interested persons of the fund, to:

• Approve the fund’s swing pricing policies and procedures,
• Designate the Administrator, and
• Review, at least annually, a written report prepared by the Administrator that describes:
  • The Administrator’s review of the adequacy of the fund’s swing pricing policies and procedures and the effectiveness of their implementation, including their effectiveness at eliminating or reducing any liquidity costs associated with satisfying shareholder redemptions,
  • Any material changes to the fund’s swing pricing policies and procedures since the date of the last report, and
  • The Administrator’s review and assessment of the fund’s swing factors and market impact threshold, including the information and data supporting the determination of the swing factors and the Administrator’s determination to use a smaller market impact threshold, if applicable.

Amended Rule 2a-7 would prohibit an institutional fund’s board from delegating any of these responsibilities. However, the Proposals generally contemplate board oversight (rather than board involvement in the day-to-day administration) of a fund’s swing pricing program.

Recordkeeping Requirements. Amended Rule 2a-7 would require new recordkeeping consistent with the SEC’s current swing pricing rules. Specifically, an institutional fund would be required to maintain a written copy of the reports provided by the Administrator to the board for six years, the first two in an easily accessible place. Similarly, existing recordkeeping requirements would require a fund to maintain its swing pricing policies and procedures for six years, the first two in an easily accessible place.

IV. New Disclosure Requirements

Form N-1A Disclosure Requirements. The Proposals would require institutional funds to comply with the existing swing pricing-related requirements within Form N-1A. Thus, an institutional fund would be required to:

• Include a general description of the effects of swing pricing on the fund’s annual total returns as a footnote to its risk/return bar chart and table. Items 4(b)(2)(ii) and (iv).
• In its description of its procedures for pricing fund shares, include a description of swing pricing. Item 11(a)(1).
• Explain the fund’s use of swing pricing, including its meaning, the circumstances under which the fund will use it, and the effects of swing pricing on the fund and investors. Item 6(d).

Form N-1A Item 6(d) currently requires other types of funds that use swing pricing to disclose their swing factor upper limit. The Proposals would exclude money market funds from this requirement because the Proposals do not require an upper limit on an institutional fund’s swing factor.

Form N-MFP. The Proposals would amend Form N-MFP to require institutional funds to use their adjusted NAVs, as applicable, for purposes of reporting the series- and class-level per-share NAV and to provide series- and class-level NAVs per share as of the close of each business day. Institutional funds also would be required to report the number of times the fund applied a swing factor during the reporting period, and each swing factor that was applied. The remaining changes that the Release would make to Form N-MFP are summarized in the Appendix.

Website Disclosure. Institutional money market funds are now required to provide on their websites their per-share NAV as of the end of each business day during the preceding six months. This disclosure is required to be updated each business day, as of the end of the preceding business day. The Proposals would amend this provision to require institutional funds to disclose their adjusted per-share NAV, taking into account the application of a swing factor.

V. Amendments to Liquidity Metrics in Stress Testing

At present, periodic stress testing includes a money market fund’s ability to have invested at least 10% of its total net assets in weekly liquid assets under specified hypothetical events described in Rule 2a-7. For all money market funds, the Release would eliminate testing at this 10% level. Instead, each fund would be required to determine the minimum level of liquidity it seeks to maintain during stress periods, identify that liquidity level in its written stress testing procedures, periodically test its ability to maintain such liquidity, and provide the fund’s board with a report on the results of such testing.

VI. Amendments Related to Negative Interest Rates or Negative Yields

The Release acknowledges that Rule 2a-7 currently does not explicitly address how money market funds must operate when interest rates are negative. The Release states that if interest rates turn negative, “the board of a stable NAV fund could reasonably require the fund to convert to a floating share price to prevent material dilution or other unfair results to investors or current shareholders.”

To help assure the operation of government or retail constant-NAV funds (“CNAV funds”) that have converted to a floating share price due to negative interest rates, the Proposals would amend Rule 2a-7 to expand CNAV funds’ obligations to confirm that they can complete transactions if they convert to a floating share price.⁸ The following requirements would apply:

• For each financial intermediary that submits orders to purchase or redeem shares directly to a CNAV fund, its principal underwriter or transfer agent or to a registered clearing agency, the CNAV fund (or, on the fund’s behalf, the principal underwriter or transfer agent) must either:
  • Determine that the financial intermediary has the ability to redeem and sell securities issued by the fund at a price based on the current per-share NAV, including per-share NAVs that float, or
  • Prohibit the financial intermediary from purchasing shares in nominee name on behalf of other persons.
• Each CNAV fund must maintain and keep current records identifying the financial intermediaries the fund has determined have the capacity described above and the financial intermediaries for which the fund was unable to make this determination. These records must be preserved a written copy of these records for a period of not less than six years following each identification of a financial intermediary (the first two years in an easily accessible place).

Separately, the Release addresses “reverse distribution mechanisms,” proposing amendments to Rule 2a-7 to prohibit money market funds from engaging in a reverse distribution scheme, wherein a fund maintains a stable share price by reducing the number of its outstanding shares, despite losing value in the negative interest rate environment. The Release notes that, under a reverse distribution mechanism, investors would observe a stable share price and may be misled to believe that their investment is holding its value while, in fact, their investment is losing value over time in a fund that is generating a negative gross yield.

VII. Amendments Specifying Calculation of WAM and WAL

The Release notes that the SEC has found that money market funds are employing different methodologies to calculate the “dollar-weighted average portfolio maturity” (“WAM”) and “dollar-weighted average life maturity” (“WAL”) under Rule 2a-7’s existing definitions. The Proposals would amend Rule 2a-7 to require that money market funds calculate WAM and WAL based on the percentage of each security’s market value in a fund’s portfolio. This would prohibit the practice employed by some money market funds of calculating WAM and WAL using the amortized cost of each portfolio security.

VIII. Amendments to Form N-CR Reporting Requirements

Form N-CR Amendments – Reporting of Liquidity Threshold Events. Money market funds are currently required to file reports on Form N-CR upon the occurrence of certain specified events. The Proposals would amend Form N-CR to require a money market fund to report when a liquidity threshold event has occurred.

• When reporting a liquidity threshold event, the fund’s report on Form N-CR would be required to include (i) the initial date on which the fund falls below either the 12.5% daily liquid asset threshold or the 25% weekly liquid asset threshold, (ii) the percentage of the fund’s total assets invested in both daily liquid assets and weekly liquid assets on the day of a liquidity threshold event and (iii) a brief description of the facts and circumstances leading to the liquidity threshold event.
• Consistent with the existing timing requirements for Form N-CR, the amended form would require that a Form N-CR must be filed within one business day after the occurrence of a liquidity threshold event. However, a fund would be permitted to file an amended report providing the required brief description of the facts and circumstances leading to the liquidity threshold event up to four business days after the event.⁹

Form N-CR Format. Reports on Form N-CR are now required to be filed in HTML or ASCII. The Proposals would require money market funds to file reports on Form N-CR in a custom eXtensible Markup Language (“XML”) -based structured data language created specifically for reports on Form N-CR.

Other Form N-CR Amendments. To improve the identifying information for the registrant and series reporting an event using Form N-CR, the Proposals would require the registrant name, series name and legal entity identifiers (“LEIs”) for the registrant and series. The Proposals would remove the reporting events that relate to liquidity fees and redemption gates.

The Release also would amend Part C of Form N-CR with respect to the provision of financial support to a money market fund. In particular, when the support involves the purchase of a security from the fund, amended Form N-CR would require the date that the fund acquired the security to be reported.

IX. Comment Deadline.

Comments on the Release must be received by the SEC no later than 60 days from the date of publication of the Release in the Federal Register.¹⁰

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If you would like to learn more about the issues in this Alert, please contact your usual Ropes & Gray attorney contacts.