SEC Releases Frequently Asked Questions Related to Valuation Guidance and to Money Market Fund Reforms Adopted in July 2014

April 30, 2015

BY THE INVESTMENT MANAGEMENT PRACTICE

Overview

On April 22, 2015, the staff of the Division of Investment Management (the “Staff”) released responses to frequently asked questions (“FAQs”) related to the money market fund reforms adopted in July 2014[1] and to the valuation guidance for all mutual funds provided in that Release. The Staff expects to update the FAQs from time to time as additional questions arise. While most of the FAQs closely track language in the Release, certain ones provide important additional clarity. In this Client Alert, we summarize certain of the more relevant FAQs. A complete set of the FAQs can be found on the SEC’s website at the address set forth in footnote 1 below.

The “Question” addressed in the FAQ is listed in bold below, with a summary of the response following.

Valuation Guidance Frequently Asked Questions

The Release[2] provided additional guidance regarding the use of evaluated prices. Under this guidance, what are a mutual fund’s board of directors’ responsibilities when determining whether an evaluated price provided by a pricing service, or some other price, constitutes a fair value for a fund’s portfolio security? (FAQ #1)

The Staff clarified that the guidance in the Release was not intended to change the general nature of the board’s responsibility to oversee the process of determining whether an evaluated price provided by a pricing service, or some other price, constitutes a fair value for a fund’s portfolio security or limit a board’s ability to appropriately appoint others to assist in its duties. The Staff also clarified that a board of directors may delegate to an appointee (that may be the investment adviser or a valuation committee), subject to adequate oversight, the responsibility of performing due diligence of pricing services. In doing so, the FAQ notes, it is incumbent on the board to satisfy themselves that all appropriate factors relevant to the fair value of securities have been considered and to determine the method for determining the fair value of each security.

In the adopting Release, the Commission stated its belief that a fund may only use the amortized cost method to value a portfolio security with a remaining maturity of 60 days or less when it can reasonably conclude, at each time it makes a valuation determination, that the amortized cost value is approximately the same as the fair value of the security valued without the use of amortized cost. Does this mean that funds using amortized cost to value portfolio securities must, in most cases, calculate their shadow price daily? (FAQ #2)

No. The FAQ states that daily shadow pricing is not required but that a fund should have policies and procedures in place that allow the fund to reasonably conclude that the security’s amortized cost approximates its fair value. These procedures could include a description of the market-based factors (e.g., existing credit, interest rate, liquidity, and issuer specific conditions) as well as how such factors are reviewed and monitored each time a valuation decision is made.

2014 Money Market Fund Reform Frequently Asked Questions[3]

Should a floating NAV money market fund continue to rely on the instruction in Item 11(a)(1) of Form N-1A allowing a money market fund to omit an explanation of how it uses fair value? (FAQ #4)

No. The instruction to Item 11(a)(1) of Form N-1A states that “funds other than a money market fund should provide a brief explanation of the circumstances under which it will use fair value pricing and the effects of using fair value pricing.” The Staff states that a stable value money market fund (such as a government money market fund as defined in Rule 2a-7(a)(16) or a retail fund as defined in 2a-7(a)(25)) need not include such an explanation as it generally will use the amortized cost valuation method for valuating all of its portfolio holdings. However, the Staff states that a floating NAV fund that regularly uses fair value pricing as part of its valuation procedures should include such an explanation in its Form N-1A filing.

May a retail money market fund disclose in the summary section of its statutory prospectus (i.e., Items 2-8 of Form N-1A) that investments in the fund are limited to retail persons? (FAQ #5)

Yes. The Staff refers to the Release, which stated that a retail money market fund may disclose in its prospectus that it limits investments to accounts beneficially owned by natural persons. This statement in the Release contained a footnote that provided a citation to Item 6 of N-1A, which is the “Purchase and Sales of Fund Shares” section of the summary prospectus. Therefore, the Staff believes that a retail money market fund would be permitted to disclose that investments in the fund are limited to accounts beneficially owned by natural persons pursuant to Item 6.

What method(s) should a money market fund use to update its registration statement to reflect the disclosure requirements of the 2014 Reforms? (FAQ #6)

The Release noted that the Securities and Exchange Commission (“SEC”) expects that a money market fund would update its registration statement, by means of a post-effective amendment or a prospectus supplement, to reflect: (a) relevant disclosure related to the fund’s transition to a floating NAV (applicable to institutional prime money market funds); (b) relevant disclosure related to the fund’s ability to impose fees and gates, as well as disclosure of any fee or gate currently in place (applicable to all money market funds except government money market funds); and (c) historical disclosure of financial support received after the compliance date of the reforms (applicable to all money market funds).

The Staff states that based on the materiality and breadth of the disclosure related to a money market fund’s transition to a floating NAV and its ability to impose fees and gates, it may be appropriate to update the registration statement by filing a post-effective amendment pursuant to Rule 485(a) under the Securities Act of 1933, as amended (the “Securities Act”). The Staff further states that a fund imposing a fee or gate would generally find it appropriate to file a prospectus supplement pursuant to Rule 497 of the Securities Act disclosing that a fee or gate is currently in place or that a fee or gate has been removed, as there is a more immediate need to get this information out to shareholders. With respect to including historical disclosure of the use of fees and gates and/or receipt of financial support, the Staff states that this would be considered a routine update as part of the annual Form N-1A filing for a money market fund.

Can a money market fund that is subject to a floating NAV 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 using amortized cost? (FAQ #9)

No. The Staff does not believe that a floating NAV money market fund may 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 using amortized cost as it would be considered misleading to investors. The Staff additionally states that it believes a floating NAV money market fund may encounter market circumstances that would cause its NAV to fluctuate, regardless of how it limits the maturity of its portfolio securities or its use of amortized cost valuation for certain holdings. Additionally, the Staff states that while a floating NAV money market fund may use amortized cost to value individual securities under certain circumstances as discussed in the Release, if a large enough disparity arises between the amortized cost of a security that matures in 60 days or less and the fair value of such security, such that the fund’s NAV would be impacted, then the fund cannot use amortized cost for that security.

For purposes of qualifying as a retail money market fund, may a fund determine beneficial ownership using the direct or indirect pecuniary interest test (as defined in Rule 16a-1(a)(2) under the Securities Exchange Act of 1934, as amended (the “Exchange Act”)), in lieu of the sole or shared voting and/or investment power test (as defined in Rule 13d-3 under the Exchange Act)? (FAQ #15)

No. The Staff states that the definition of beneficial owners for purposes of qualifying as a retail money market fund must comply with the definition in Rule 13d-3 under the Exchange Act. The Staff states that the SEC exempted retail money market funds from the floating NAV requirement because past experience has shown that retail investors are less likely to redeem quickly in times of market stress. The Staff further states that it believes it is the exercise of an investor’s investment power when such investor decides to redeem securities and that, therefore, the rationale and purpose behind exempting retail money market funds from the floating NAV requirement would be undercut if beneficial ownership could be determined based on entitlement to funds alone (i.e., using the direct or indirect pecuniary interest test).

May a retail money market fund have a non-natural person affiliate beneficially own shares of the fund in order to facilitate fund operations (e.g., providing initial seed capital or financial support? (FAQ #18)

Yes. The Staff states that it would not object if a non-natural person affiliate beneficially owns shares of a retail money market fund to provide initial seed capital or financial support, so long as the investments are solely intended to facilitate fund administration and operations. The determination as to whether an investment is solely intended to facilitate fund administration and operations would depend on the particular facts and circumstances of each separate investment.

Would the Staff object if a retail money market fund involuntarily redeemed investors who no longer met the disclosed eligibility requirements of the fund, even outside the context of the exemptive relief provided by the Commission in the Adopting Release for involuntary redemptions as part of a one-time reorganization? (FAQ #20).

No. If the retail money market fund complies with all the terms and conditions of the exemptive relief provided in the Release, the staff would not object to the involuntary redemption of investors who do not meet the eligibility requirements set forth in the retail fund’s prospectus.

If a shareholder of a money market fund submits a redemption order while a gate is in effect, must that shareholder submit a new redemption order after the gate is lifted for the order to be effective? (FAQ #24)

Yes. While redemptions are suspended, the fund and its agents may not accept redemption orders. Once the gate is lifted, any redemption orders will be cancelled without further notice and a shareholder that wishes to redeem will need to submit a new order.

If a money market fund’s weekly liquid assets have fallen below 30% (but not below 10%) of the fund’s total assets, may the board of directors determine to impose a fee or gate at a later time in the future, whether it is the next day’s opening or another specified time? (FAQ #26)

The staff believes that a fund should implement a fee or gate immediately after the board’s determination to impose one. However, the staff recognizes that it may take some time to notify shareholders and intermediaries that a fee or gate is in place and that the transfer agent and intermediaries may need some time to implement the fee or gate. Directors will need to consider whether it would be consistent with their fiduciary duty to allow for a material lapse of time between their determination and the implementation of the fee or gate.

If a liquidity fee is imposed intraday, may an intermediary that receives both purchase and redemption orders from a single underlying accountholder apply the liquidity fee to the net amount of redemptions made by that same accountholder, even if the purchase order was received before the time the liquidity fee was implemented? (FAQ #27)

Yes. Although the final rule did not require that the liquidity fee be applied on a net redemption basis, intermediaries may choose to collect a liquidity fee on a shareholder’s net redemption amounts, even if orders for some purchases netted against the redemptions were received prior to the time the liquidity fee went into effect.

If a redemption request was verifiably submitted to the fund’s agent before a gate or fee is imposed, but is received by a money market fund (or its agent) after such an action is taken, may the fund pay the proceeds of the redemption request despite the gate, or similarly, not impose a liquidity fee on the redemption associated with the payment? (FAQ #28)

Yes. The Staff would not object if a fund board determines to honor checks or redemption orders or not impose a liquidity fee if the fund can verify that the order was submitted to the fund’s agent before the suspension of redemptions or imposition of the liquidity fee. The Staff would not object if the fund relied on an endorsement or coding showing the time or date the check was received or on a postmark on an envelope for a redemption order.

When should a fund test to ensure that it meets the definition of a “government money market fund” as defined in rule 2a-7(a)(16)? (FAQ #32)

The Fund should test that it meets the definition of a “government money market” fund each time it acquires a portfolio security.

Are bank certificates of deposit, which are insured up to the $250,000 FDIC insurance limit, “government securities” for purposes of the definition of a government money market fund? (FAQ #34)

No. The Staff does not view FDIC-insured bank certificates as “government securities.”

In the Adopting Release, the Commission provided money market funds exemptive relief from sections 17, 18, and 22 of the Investment Company Act, allowing involuntary redemptions in the context of a one-time reorganization transaction designated to allow a fund to comply with the amendments. Is this relief also applicable to a one-time involuntary redemption in order to comply with the definition of retail money market fund in the absence of a specific reorganization transaction? (FAQ #36)

Yes. The staff would not object if a fund were to engage in an involuntary redemption of such shareholders, provided that the other requirements of the exemptive relief were followed (e.g., 60 days prior written notice).

Under the exemptive relief provided by the Commission in the Adopting Release, in connection with an involuntary redemption, may a money market fund exchange the redeemed shares for shares of another money market fund that maintains a stable NAV (such as a government money market fund), rather than sending the shareholder a check for the redemption proceeds? FAQ #37)

No. The investment risk and goals of the two funds may be different.

Does the exemptive relief from section 17, 18, and 22 of the Investment Company Act provided by the Commission in the Adopting Release also apply to reorganizing a single fund currently owned by both retail and institutional shareholders into two or more new funds, such as a retail fund and a government or floating NAV fund? (FAQ #39)

Yes.

If a money market fund is reorganizing into a separate retail fund (with a stable NAV) and institutional fund (with a fluctuating NAV) solely for purposes of the rule 2a-7 reforms, may both funds continue to include the original fund’s performance in their performance disclosures and marketing materials? (FAQ #46)

Yes.

***

[1] See Investment Company Act Release No. IC-31166 (July 23, 2014) (the “Release”).

[2] The full text of the Valuation Guidance FAQs can be found at: http://www.sec.gov/divisions/investment/guidance/valuation-guidance-frequently-asked-questions.shtml.

[3] See http://www.sec.gov/divisions/investment/guidance/2014-money-market-fund-reform-frequently-asked-questions.shtml.

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