What do mutual fund boards of directors need to know about the SEC's money market reform rules? There are several provisions that directly impact fund boards, particularly with regard to fees and gates and stress testing. According to the new SEC rules concerning fees and gates, fund boards are charged with determining whether or not to impose fees and gates on prime MMFs under certain circumstances. States the SEC's final rules, "Today's amendments will allow a money market fund to impose a liquidity fee of up to 2%, or temporarily suspend redemptions (also known as "gate") for up to 10 business days in a 90-day period, if the fund's weekly liquid assets fall below 30% of its total assets and the fund's board of directors (including a majority of its independent directors) determines that imposing a fee or gate is in the fund's best interests. Additionally, under today's amendments, a money market fund will be required to impose a liquidity fee of 1% on all redemptions if its weekly liquid assets fall below 10% of its total assets, unless the board of directors of the fund (including a majority of its independent directors) determines that imposing such a fee would not be in the best interests of the fund." It continues, "In addition, under our proposal, a fund's board (including a majority of independent directors) could have determined not to impose the liquidity fee or to impose a lower fee."
The fees and gates rules are designed to address issues stemming from the 2008 financial crisis. "In particular, the amendments should allow funds to moderate redemption requests by allocating liquidity costs to those shareholders who impose such costs on funds through their redemptions and, in certain cases, stop heavy redemptions in times of market stress by providing fund boards with additional tools to manage heavy redemptions and improve risk transparency. Although no one can predict with certainty what would have happened if money market funds had operated with fees and gates during the financial crisis, we believe that money market funds would have been better able to manage the heavy redemptions that occurred and limit contagion, regardless of the reason for the redemptions."
Another important function of boards relates to stress testing. The newly adopted stress testing provisions require MMF funds to periodically test their ability to maintain weekly liquid assets of at least 10%. "The fund adviser must report the results of such stress testing to the board, including such information as may be reasonably necessary for the board of directors to evaluate the stress testing results."
On stress testing, the SEC established rules in 2010 that require funds to adopt procedures providing for periodic testing of the fund's ability to maintain a stable price per share based on certain hypothetical events: "Funds are currently required to provide the board with a report of the results of stress testing, which must include the dates of testing, the magnitude of each hypothetical event that would cause a fund to "break the buck," and an assessment of the fund's ability to withstand events that are reasonably likely to occur within the following year. We proposed modifications to these reporting requirements. First, we proposed adding a requirement that the fund report to the board the magnitude of each hypothetical event that would cause the fund to have invested less than 15% of its total assets in weekly liquid assets. Second, we proposed requiring funds to include in their assessment "such information as may reasonably be necessary for the board of directors to evaluate the stress testing ... and the results of the testing."
The SEC had several opportunities to observe the effectiveness of stress testing in recent years, including the 2011 Eurozone crisis and the 2013 U.S. debt ceiling impasse. "Our staff has observed that funds that had strong stress testing procedures were able to use the results of those tests to better manage their portfolios and better understand and minimize the risks associated with these events," said the SEC in the final rules. Considering this information, the SEC proposed certain enhancements to strengthen the stress testing requirements.
The final rules say: "We are adopting modifications to the proposed reporting requirements to boards regarding stress testing in response to comments we received on the proposal. Specifically, we are adopting a requirement that the board of directors be provided at its next annual meeting, or sooner if appropriate, a report that includes the dates on which the testing was performed and an assessment of the fund's ability to maintain at least 10% in weekly liquid assets and to limit principal volatility. Some commenters had concerns that the proposed requirement that funds report to the board the magnitude of each hypothetical event that would cause the fund to have invested less than 15% in weekly liquid assets was not feasible. We believe that requiring funds to provide an assessment of the fund's ability to maintain liquidity, rather than requiring the funds report a specific value for each hypothetical event, addresses such concerns."
On minimizing principal volatility, the rules explain: "We have also added the requirement for an assessment of the fund's ability to minimize principal volatility because, as discussed above, we have added this metric to the stress testing requirements in response to comments. We believe that requiring funds to provide an assessment of their ability to maintain liquidity and minimize principal volatility (and in the case of stable NAV funds, to maintain a stable share price), rather than the more prescriptive requirements proposed and that are in the rule currently, is also appropriate because we have modified the rule so that each "hypothetical event" is a combination of two events. We want to clarify that funds are not required to separately test for interest rate increases, a downgrade or default, a spread shift, or shareholder redemptions in isolation."
It continues, "We understand that under the current requirements, many funds, in addition to reporting the magnitude of each event that would cause the fund to "break the buck," provide a table showing how the fund's shadow NAV is affected by different combinations of events and different values. Some funds include information regarding, for example, the concentrations of several of the funds' largest portfolio holdings, both by individual issuer and by sector, and of historical redemptions rates, as points of reference. Several funds also include narratives to help explain the results. In some instances, for example, fund advisers used the narrative to compare results among funds or to explain results that they considered to be unusual. Some narratives also assessed the likelihood of the hypothetical events. We are not including requirements for any of these specific items in the rule because we recognize that there is no one set of factors that will be relevant for all funds, but we believe these are examples of items that we encourage fund advisers to consider when developing the required report assessing stress test results."
The amendments give boards oversight. "We are adopting as proposed the requirement that a fund's adviser provide "such information as may reasonably be necessary for the board of directors to evaluate the stress testing conducted by the adviser and the results of the testing." One commenter supported this requirement, noting that it is a common practice to provide directors with information that helps to place stress-testing results in context. Some commenters opposed this requirement, arguing that the provision of additional information could be burdensome for boards and would not provide useful information to fund boards. We disagree. As we noted in the Proposing Release, the staff's examination of stress testing reports revealed disparities in the quality of information regarding stress testing provided to fund boards. We believe that this requirement will allow boards of directors to receive information that is useful for understanding and interpreting stress testing results."
However, it does not require a fund adviser to provide the details and supporting information for every stress test that the fund administered. "To the contrary, a thoughtful summary of stress testing results with sufficient context for understanding the results may be preferable to providing details of every test. For example, information about historical redemption activities, as mentioned above, and the fund's investor base could help boards evaluate the potential for shareholder redemptions at the levels that are being tested. Additionally, information regarding any contemporaneous market stresses to particular portfolio sectors could be helpful to a board's consideration of stress testing results."
Finally, the SEC final rules added a requirement that the adviser include in the report a summary of the significant assumptions made when performing the stress tests. "We have, in response to comments, modified the required hypothetical events from the proposal to reduce the number and complexity of the assumptions funds are required to make. We recognize, however, that funds will need to make some basic assumptions when conducting the stress tests. These assumptions would include, for example, how the fund would satisfy shareholder redemptions (e.g., through weekly liquid assets or by selling certain portfolio securities, including any assumption of haircuts such securities can be sold at) and the amount of loss in value of a downgraded or defaulted portfolio security. We believe that having a summary of such assumptions will help the board better understand the stress testing results, and particularly the sensitivity of those results to given assumptions. We believe this information will allow the board to better understand money market fund risk exposures, and thus allow it to provide more effective oversight of the fund and its adviser."
