REPORTS OF THE DEATH OF MONEY MARKET MUTUAL FUNDS: GREATLY EXAGGERATED?

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1 REPORTS OF THE DEATH OF MONEY MARKET MUTUAL FUNDS: GREATLY EXAGGERATED? The SEC has significantly changed the rules governing the $2.7 trillion money market mutual fund industry, with far reaching impacts for investors. This program explains the new rules, how funds are implementing these changes and how banks, insurance companies, and other intermediaries are responding. ALEX KYMN Wells Fargo ROBERT A. ROBERTSON Dechert LLP CLAIR PAGNANO K&L Gates JANIS PENTON (moderator) MUFG Union Bank

2 REPORTS OF THE DEATH OF MONEY MARKET MUTUAL FUNDS: GREATLY EXAGGERATED? TABLE OF CONTENTS Highlights of the Amended Regulatory Framework for Money Market Mutual Funds I. Structural Changes to MMMFs... 1 A. Floating NAV... 1 B. Retail Funds... 2 C. Liquidity Fees and Redemption Gates... 3 D. Permanent Gate and Fund Liquidation... 4 II. Disclosure and Material Event Reporting... 4 A. Disclosure in Prospectuses and Statements of Additional Information... 4 B. Website Disclosure... 5 C. Material Event Reporting... 5 III. Enhanced Stress Testing and Diversification Standards... 6 A. Stress Testing... 6 B. Diversification... 7 Intermediaries - Banks, Insurance Companies, and Retirement Plans I. Background... 8 A. July 2014 Rule Amendments Institutional Funds and Floating NAV Liquidity Fees and Redemption Gates Summary Chart SEC Money Market Fund Final Rule Compliance Dates... 9 II. Banking Issues A. Uses of Money Funds by Banks B. Bank Trust Departments and Investment of Fiduciary Assets Trust Powers and Fiduciary Activities Fiduciary Standards Applicable to Trust Departments C. Opposition to Floating NAV D. Opposition to Fees and Gates E. Alternatives to Money Market Funds i

3 F. Effects of Final Money Market Fund Rule Discretionary (Managed) Accounts Client Directed Accounts Beneficial Owners III. Insurance Issues A. Structure of Variable Annuity Contracts B. Opposition to Fees and Gates Redemption Gates Liquidity Fees C. Final Amendment Accommodations Liquidity Fees and Redemption Gates Government Fund Alternative D. Insurance Industry Operation Response Move to Government Money Funds Government Short Supply and IRS Diversification IV. Retirement Plan Issues A. Defined Contribution Plans B. Defined Benefit Plans V. Chart: Treatment of Ordinary Trusts Under the Retail Money Market Fund Definition SPEAKER BIOS ii

4 REPORTS OF THE DEATH OF MONEY MARKET MUTUAL FUNDS: GREATLY EXAGGERATED? Highlights of the Amended Regulatory Framework for Money Market Mutual Funds By Alexander Kymn Senior Counsel, Wells Fargo Law Department San Francisco, California Tel: (415) On October 14, 2014, the Securities and Exchange Commission ( SEC ) adopted sweeping reforms to the regulations governing the operation of money market mutual funds ( MMMFs ) under the Investment Company Act of 1940 (the 1940 Act ). 1 According the SEC, the amendments were enacted to mitigate risks associated with the susceptibility of MMMFs to heavy redemptions, or runs, following the collapse of a MMMF that broke the buck during the 2008 financial crisis. The amendments include significant structural changes that will require certain types of MMMFs to conduct purchase and sale transactions using a floating, rather than fixed, net asset value per share ( NAV ) based on the current, market-based values of a MMMF s portfolio. Unless exempt, MMMFs that experience impaired liquidity below the regulatory minimum levels also may become subject to the potential imposition of liquidity fees and/or temporary suspensions of redemptions, or redemption gates. Other changes will include updated standards or new requirements in the areas of website disclosure, material event reporting, portfolio diversification and stress testing, regulatory and advertising disclosure and public reporting of portfolio data to the SEC. These amendments have rolling compliance dates that first took effect in July 2015 and require final compliance with structural changes no later than October 14, This discussion highlights selected key aspects of the SEC s amendments, with a focus on the structural changes, disclosure and reporting and portfolio management. I. Structural Changes to MMMFs A. Floating NAV The amendments will require any MMMF that is not a government money market fund 2 or a retail money market fund 3 to calculate its NAV for purposes of subscriptions and redemptions in the MMMF s shares by rounding its current NAV to a precision of a basis point (i.e., a minimum of the fourth decimal place) for a fund with a $ NAV (such MMMFs without exemptions are referred to as Institutional Prime 1 See Money Market Fund Reform; Amendments to Form PF Release No. IC [79 FR 47736] available at (the Release ). 2 Under the amendments, a government MMMF is defined as a MMMF that invests at least 99.5% of its total assets in cash, government securities backed by the full faith and credit of the U.S. government (as defined in Section 2(a)(16) of the 1940 Act), and/or repurchase agreements that are collateralized fully by cash or government securities. See amended Rule 2a-7(a)(16) under the 1940 Act. 3 Under the amendments, a retail MMMF is defined as a MMMF that has policies and procedures reasonably designed to limit all beneficial owners of the fund to natural persons. See amended Rule 2a-7(a)(25). SEC staff studies supported the proposition that retail investors historically have been less likely to quickly make large redemptions during market stress and did not create the same risks of destabilizing runs on MMMFs.

5 MMMFs ).4 In transacting with a variable NAV, Institutional Prime MMMFs will operate like all other mutual funds that price and transact in fund shares based on the current value of the portfolio. The requirement to calculate its NAV to the fourth decimal place is, however, unique to Institutional Prime MMMFs, as the SEC determined that this level of sensitivity would be necessary to produce regular fluctuations in MMMF share prices,5 and sought to reinforce the risks of investing in such funds through the requirement of a floating NAV. From a regulatory perspective, the use of a floating NAV in an Institutional Prime MMMF could be thought to reduce a perceived early mover advantage associated with the structure of a stable NAV MMMF (i.e., redeeming at $1.00 NAV at early signs of distress before a fund becomes more at risk of breaking the buck) that can trigger runs on MMMFs. Although transactions in an Institutional Prime MMMF will produce capital gains and losses as the NAV floats, the U.S. Treasury Department and the Internal Revenue Service ( IRS ) proposed regulations for simplified tax accounting that will eliminate the tracking of individual purchase and sale transactions in favor of reporting a single net short-term gain or loss computed over the investor s tax year.6 In addition, the SEC has clarified that investments in floating NAV MMMFs generally meet the definition of a cash equivalent on the balance sheet of an institutional investor under U.S. generally accepted accounting principles.7 B. Retail Funds Given the considerable benefits of continued operation with a stable NAV relative to a floating NAV, certain prime and municipal MMMFs will seek to qualify as retail MMMFs by adopting and implementing policies and procedures reasonably designed to limit all beneficial owners of the fund to natural persons. Demonstrable benefits of additional yield to qualifying investors holdings shares in retail MMMFs relative to investments in government MMMFs can also be expected in a more normalized interest rate environment. Beneficial ownership for purposes of qualifying as a retail MMMF generally means having sole or shared investment power under the SEC staff s interpretive guidance for a retail MMMF s determination of beneficial ownership. 8 Under Question and Response no. 21 in the SEC Staff FAQs, a fund may not 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 ( Exchange Act )), in lieu of the sole or shared voting and/or investment power test (as defined in rule 13d-3 under the 4 See amended Rule 2a-7(c)(1)(i) under the 1940 Act. Institutional Prime MMMFs are generally any MMMFs with portfolios invested in prime and/or municipal securities and the shares of which are beneficially owned by a nonnatural person. The definitions of government and retail MMMFs are described above. 5 See footnote 491 of the Release explain that SEC staff estimates of historical MMMF shadow prices showed that money market funds would have floated just over 50% of the time if priced to four decimal places. 6 See Notice of Proposed Rulemaking and Notice of Public Hearing - Method of Accounting for Gains and Losses on Shares in Certain Money Market Funds; Broker Returns with Respect to Sales of Shares in Money Market Funds [REG ] available at The IRS also proposed a revenue procedure that will exempt transactions in floating NAV money market funds from the application of wash sales rules. See Revenue Procedure available at 7 See Release at See 2014 Money Market Fund Reform Frequently Asked Questions ( SEC Staff FAQs ) available at 2

6 Exchange Act). The SEC staff stated its view that notwithstanding Rule 13d-3, policies and procedures would be deemed reasonably designed to limit all beneficial owners of the fund to natural person even if they do not use voting power as a basis for identifying beneficial owners of the fund [and that] such policies and procedures may also permit institutional decision makers to share investment power with a natural person. 9 Question and Response no. 21 in SEC Staff FAQs cites as an example accounts managed by an institutional decision maker on behalf of one or more natural persons may qualify to invest in a retail money market fund, provided that such natural persons have sole or shared investment power over the shares as defined in rule 13d Before the effective date of the structural changes, MMMFs seeking to qualify as retail MMMFs are expected to reorganize and/or take steps to cause shareholders other than natural persons that beneficially own shares of the MMMFs to redeem such shares. The general position of the SEC staff is that a retail MMMF (or a MMMF seeking to qualify as a retail MMMF) may involuntarily redeem investors who will no longer meet the eligibility requirements of the retail MMMF without separate exemptive relief, provided that the fund notifies in writing such investors who will become ineligible to invest at least 60 days before the redemption occurs. 11 As the final conformance date approaches, it is anticipated that shareholders holding shares directly on the books of a MMMF s transfer agent will receive such notices and that financial intermediaries holding shares of these funds for customers will receive requests to cause ineligible investors to be redeemed on or prior to a stated effective date of a fund s qualification. C. Liquidity Fees and Redemption Gates The amendments will vest with the board of directors of any MMMF that is not a government MMMF 12 the authority, based on required findings, to impose a liquidity fee charged on redemptions of up to 2% or temporarily suspend redemptions through a redemption gate, if the fund s weekly liquid assets 13 decline below the current regulatory minimum level of 30% of total assets (a potential indicator a Fund undergoing stress). 14 Thus, both Institutional Prime MMMFs that transact with a floating NAV and retail MMMFs that transact with a stable NAV will be subject to the potential imposition of liquidity fees or redemption gates. The SEC took a tiered approach to the potential 9 Id. 10 Id. 11 The SEC staff has stated that it would not object if a retail money market fund involuntarily redeemed investors who it determines do not meet eligibility requirements set forth in the retail fund s prospectus without obtaining separate exemptive relief, even outside the context of a one-time reorganization if the fund complies with all the other terms and conditions of the exemptive relief provided in the Release. See Question and Response no. 26 in SEC Staff FAQs. The SEC authorized reorganizations of a share class of a MMMF into a new fund in connection with qualifying as a retail fund without separate exemptive relief, subject to specified conditions. See Release at A government money market fund may voluntarily elect to opt in and have authority to impose liquidity fees and redemption gates, with appropriate advance disclosure to fund shareholders. Institutional Prime and retail MMMFs must operate subject to fees and gates. 13 Weekly liquid assets generally consist of cash, U.S. Treasuries, certain other government securities with remaining maturities of 60 days or less, or securities that convert into cash within one week. See amended rule 2a- 7(a)(34). 14 See amended Rule 2a-7(c)(2)(ii). 3

7 imposition of fees and gates, establishing a higher threshold for discretionary liquidity fees and redemption gates and a lower threshold for default liquidity fees. With a decline in in weekly liquid assets below the 30% regulatory minimum, the fund board would have discretion, if determined to be in the best interests of a fund taking into account relevant factors, to impose a liquidity fee in an amount determined by the board not to exceed 2%, or a redemption gate. Redemption gates may be imposed for up to 10 business days in a 90-day period. 15 If weekly liquid assets decline below 10%, a default 1% liquidity fee is required to be imposed unless the fund board determines that such a fee is not in the best interests of the fund or the imposition of a liquidity fee in a different amount (up to 2%) is in the best interest of the fund. 16 The liquidity fee is designed to deter runs and allocate liquidity costs associated with satisfying redemption requests to those shareholders who impose such costs on a MMMF through redemptions during times of stress. Any liquidity fee or redemption gate is automatically removed once a MMMF s weekly liquid assets have risen to or above 30% of total assets, and may be earlier removed with a MMMF board s approval. A redemption gate must be removed if the maximum permissible duration has been reached. D. Permanent Gate and Fund Liquidation A MMMF s board of directors will also be permitted to approve the permanent suspension of shareholder redemptions and the irrevocable liquidation of the fund if a fund s weekly liquid assets level falls below 10% of total assets. 17 Such flexibility is unique to MMMFs, as a permanent suspension of the right of redemption in any other mutual fund would require the issuance of an exemptive order from the SEC. The conformance date for structural changes to MMMFs is October 14, II. Disclosure and Material Event Reporting A. Disclosure in Prospectuses and Statements of Additional Information The amendments will require MMMFs to enhance disclosure in offering documents in conformity with the structural changes. In a MMMF s prospectus and advertising material, required legends, for both stable NAV and floating NAV MMMFs, will set out key risks and structural attributes, including statements regarding the potential imposition of liquidity fees or redemption gates (except for government MMMFs that have not voluntarily elected to adopt such features) and share price fluctuations for institutional prime MMMFs. 18 The SEC expects that the prospectuses of 15 See amended Rule 2a-7(c)(2)(i)(B). 16 See amended Rule 2a-7(c)(2)(ii)(A). 17 See amended Rule 22e-3 under the 1940 Act. 18 A stable NAV MMMF s legend would read as You could lose money by investing in the Fund. Although the Fund seeks to preserve the value of your investment at $1.00 per share, it cannot guarantee it will do so. The Fund may impose a fee upon the sale of your shares or may temporarily suspend your ability to sell shares if the Fund s liquidity falls below required minimums because of market conditions or other factors. An investment in the Fund is not insured or guaranteed by the Federal Deposit Insurance Corporation or any other government agency. The Fund s sponsor has no legal obligation to provide financial support to the Fund, and you should not expect that the sponsor will provide financial support to the Fund at any time. See Rule 482(b)(4)(ii); Form N-1A Item 4

8 MMMFs would be updated in light of the regulatory changes in the following respects, among other disclosures: (i) non-government MMMFs would disclose the effects of liquidity fees or redemption gates and the circumstances under which they may be imposed; (ii) floating NAV MMMFs would disclose the tax consequences of transacting in fund shares, and the associated changes from operating with a variable NAV, including the transition to a floating NAV; and (iii) retail MMMFs would disclose that investments must be held by accounts beneficially owned by natural persons. 19 MMMFs will be required to disclose in their statements of additional information any historical instances of liquidity fees and redemption gates and the provision of financial support by a sponsor or its affiliates during the last 10 years (but not before the conformance date of the amendments). 20 B. Website Disclosure The amendments will also require MMMFs to regularly report certain key items of information on the websites of MMMFs. These requirements are designed to promote transparency and reinforce market discipline in the management of a MMMF. MMMFs will be required to show, updated on a daily basis as of the end of the preceding business day, the following information: (a) the percentage of total assets that are invested in daily and weekly liquid assets, as of the end of each business day during the preceding six months; 21 (b) daily net inflows or outflows, as of the end of the previous business day, during the preceding six months; 22 and (c) the MMMF s current NAV (calculated to four decimals, based on the market value of all portfolio securities, including those with securities with a remaining maturity of 60 days or less that are valued through amortized cost) as of the end of the previous business day during the preceding six months Each of the foregoing items must be accompanied by a schedule, chart, graph, or other depiction of the historical information covering the preceding six-month period. In addition, in concert with certain material event reporting requirements discussed below, a MMMF will be required to make prominent disclosures on its website, within one business day, when it imposes or removes a liquidity fee or redemption gate or when a sponsor or its affiliated person provides financial support to the MMMF. 23 Such disclosures of material events must remain on a MMMF s website for at least one year. The conformance date for website disclosure is April 14, C. Material Event Reporting Under the amendments, MMMFs will also be subject to a material event reporting scheme on a new Form N-CR upon the occurrence of specified significant events. The general framework is similar in certain respects to current event reporting by public 4(b)(1)(ii)(B). A floating NAV MMMF s legend would replace the second sentence with the following statement: Because the share price of the Fund will fluctuate, when you sell your shares they may be worth more or less than what you originally paid for them. 19 See Release at See amended Form N-1A, Item 16(g)(1)-(2). 21 See amended Rule 2a-7(a)(4). 22 See Rule 2a-7(h)(10)(ii). 23 See Rule 2a-7(h)(10)(v). 5

9 operating companies on Form 8-K. In general, a MMMF must file with the SEC a summary report on Form N-CR within one business day of the occurrence of the specified event, and must make a more detailed follow-up filing within four business days. The information contained in Form N-CR would be publicly available upon filing. There are four events the occurrence of which would trigger a requirement for a MMMF to file and report on Form N-CR: (i) the default or insolvency of an issuer or guarantor of a security that makes up more than one-half of one percent of a fund s total assets; (ii) the provision of financial support 24 by sponsors or other affiliates to a MMMF; (iii) a decline in the market-based NAV of a stable NAV MMMF of more than one quarter of 1 percent (i.e., below $0.9975); and (iv) the imposition or removal of a liquidity fee or redemption gate or a determination to not impose a default liquidity fee after the MMMF s weekly liquid assets has declined below 10%. 25 Form N-CR also contains a category for optional disclosure that MMMFs can use to discuss other material events. The compliance date for Form N-CR was first effective on July 1, 2015, although reporting related to structural changes with later conformance dates (e.g., liquidity fees and redemption gates) is not required until such changes are implemented. III. Enhanced Stress Testing and Diversification Standards A. Stress Testing The amendments will adjust the current requirements for MMMFs to periodically test their portfolios to maintain constant NAVs based on certain assumed hypothetical events to account for the structural changes to MMMFs. As revised, Rule 2a-7 will require MMMFs to adopt procedures to periodically test: (1) the ability to minimize principal volatility; and (2) maintain weekly liquid assets of at least 10%. 26 The four hypothetical stress scenarios on which the periodic tests must be performed, in addition to testing for any combination(s) of events deemed relevant, are as follows: (i) an increase in the general level of short-term interest rates in combination with various levels of an increase in shareholder redemptions; (ii) a downgrade or default of a portfolio security position each representing various portions of the fund s portfolio, in combination with various levels of an increase in shareholder redemptions; and (iii) a correlated increase in the credit spreads for certain portfolio securities, in combination with various levels of an increase in shareholder redemptions The SEC defines financial support to include (i) any capital contribution, (ii) purchase of a security from the fund in reliance on rule 17a-9, (iii) purchase of any defaulted or devalued security at par, (iv) execution of letter of credit or letter of indemnity, (v) capital support agreement (whether or not the fund ultimately received support), (vi) performance guarantee, (vii) or any other similar action reasonably intended to increase or stabilize the value or liquidity of the fund s portfolio; excluding, however, any (i) routine waiver of fees or reimbursement of fund expenses, (ii) routine inter-fund lending, (iii) routine inter-fund purchases of fund shares, or (iv) any action that would qualify as financial support as defined above, that the board of directors has otherwise determined not to be reasonably intended to increase or stabilize the value or liquidity of the fund s portfolio. Release at See Form N-CR Parts B-H. 26 See amended Rule 2a-7(g)(8)(i). 27 See amended Rule 2a-7(g)(8)(i)(A)-(D). 6

10 B. Diversification The amendments will tighten current diversification standards that apply to the construction of a MMMF s portfolio in four primary respects. The first change will eliminate or reduce an existing exception to the current requirement that caps at 10% a MMMF s investment in securities subject to a demand feature or a guarantee from a single provider (the Single Guarantor/Demand Feature Provider 10% Limit ). The current exception to the Single Guarantor/Demand Feature Provider 10% Limit that allows up to 25% of a MMMF s securities to be subject to demand features or guarantees of one institution will be eliminated for all MMMFs other than tax-exempt MMMFs and will be reduced to 15% for tax-exempt MMMFs. 28 The second change will require MMMFs to treat the sponsor of an asset-backed security ( ABS ) as a guarantor of the security for purposes of the Single Guarantor/Demand Feature Provider 10% Limit, unless the MMMF s board of directors makes certain findings. 29 The third change will mandate the treatment of affiliated entities as a single issuer for purposes of the current requirement that generally limits at 5% a MMMF s investment in a single issuer (the 5% Issuer Diversification Limit ). 30 Finally, the fourth change will eliminate an existing exclusion to the 5% Issuer Diversification Limit with respect to an issuer that is subject to a guarantee by a non-controlled person. 31 The conformance date for the amended stress testing and the first three diversification requirements is April 14, The conformance date for the fourth diversification requirement is October 14, See amended rule 2a-7(d)(3)(iii)(B). 29 See amended Rule 2a-7(a)(18)(ii). The findings required to support an exception to the treatment of the sponsor of the ABS as a guarantor are that the MMMF is not relying on the sponsor s financial strength or its ability or willingness to provide liquidity, credit or other support to determine the quality or liquidity of the ABS. 30 See amended Rule 2a-7(d)(3)(ii)(F). Issuers are deemed affiliated persons of each other for purposes of 5% Issuer Diversification Limit if one entity controls, is controlled by or under common control with the other. Solely for this purpose, control is defined as ownership of more than 50% of an entity s voting securities, but specifically excludes certain equity owners of asset-backed commercial paper conduits. See amended Rule 2a-7(d)(3)(ii)(F). 31 See Removal of Certain References to Credit Ratings and Amendment to the Issuer Diversification Requirement in the Money Market Fund Rule Release No. IC [80 FR 58123] (available at at page 45, amending current rule 2a-7(d)(3). 7

11 REPORTS OF THE DEATH OF MONEY MARKET MUTUAL FUNDS: I. Background GREATLY EXAGGERATED? Intermediaries Banks, Insurance Companies, and Retirement Plans A. July 2014 Rule Amendments By Robert A. Robertson Partner, Dechert LLP Orange County In July 2014, the SEC approved amendments to Rule 2a-7 and other rules ( Amendments ) that govern money market funds sometimes referred to as money funds under the Investment Company Act of 1940 (the 1940 Act ). Money Market Fund Reform; Amendments to Form PF, Investment Company Act Release No (July 23, 2014) ( Adopting Release ). The Amendments generally combine the two regulatory alternatives set forth in the SEC s proposing release issued in 2013 ( Proposal ). Money Market Fund Reform; Amendments to Form PF, Investment Company Act Release No (June 5, 2013) ( Proposing Release ). In general, the Amendments: Require institutional money market funds to operate with a floating net asset value ( NAV ); and Allow the imposition of liquidity fees and redemption gates. 1. Institutional Funds and Floating NAV The Amendments require that certain money market funds operate with a floating NAV. Specifically, the floating NAV requirement applies to those money market funds that do not meet the definition of a government or retail money market fund (i.e., institutional money market funds). o Government money market funds are defined as funds that invest 99.5% or more of their assets in cash, government securities and/or repurchase agreements that are collateralized solely by government securities or cash. o Retail money market funds are defined as funds that have policies and procedures reasonably designed to limit all beneficial owners of the money market fund to natural persons. Beneficial ownership typically means having voting and/or investment 8

12 power. See, e.g., Rules 13d-3 and 16a-1(a)(2) under the Securities Exchange Act of Liquidity Fees and Redemption Gates Liquidity Fees. The Amendments permit a board of directors of a nongovernment money market fund to impose a liquidity fee of up to 2% if the fund s weekly liquid assets fall below 30% of the fund s total assets. The Amendments also require that a non-government money market fund impose a 1% liquidity fee if the fund s weekly liquid assets fall below 10% of total assets, unless the fund s board of directors determines that it would not be in the fund s best interest to impose the fee or determines to impose a lower or higher (up to 2%) liquidity fee. Redemption Gates. In addition, if the fund s weekly liquid assets fall below 30% of the fund s total assets, the fund s board of directors is permitted to temporarily suspend shareholder redemptions for up to 10 business days in a 90-day period (i.e., redemption gates ). Government Funds. Government money market funds are permitted, but not required, to impose liquidity fees and redemption gates. In practice, government money market funds have not opted to impose theses fees or gates. 3. Summary Chart SEC Money Market Fund Final Rule Type Government Funds NAV Stable Permissible Investors All Liquidity Fees & Redemption Rules Apply? Permissible, not required Retail Prime Funds Institutional Prime Funds Stable Floating Retail Investors All Yes Yes 4. Compliance Dates The compliance date for the new Form N-CR is July 14, The compliance date for the diversification, stress testing, disclosure, Form PF, Form N-MFP, and clarifying amendments is April 14,

13 The compliance date for the floating NAV and liquidity fees and gates amendments is October 14, II. Banking Issues A. Uses of Money Funds by Banks Banks utilize money market funds for a variety of reasons such as for sweep accounts, wealth management and personal and corporate trustee services. The main issue for banks was whether, in their capacity as fiduciaries in connection with trust services, banks could still meet their fiduciary requirements while investing in floating NAV money market funds. B. Bank Trust Departments and Investment of Fiduciary Assets 1. Trust Powers and Fiduciary Activities Both national and state charted banks may engage in trust activities. However, these activities are subject to strict fiduciary standards. To engage in trust activities, a bank must have specific trust powers granted to it in its charter, which is approved by the bank s regulator for de novo banks. If trust powers are not in a bank s charter, then its regulator must specifically approve the bank s ability to engage in trust activities. For national banks this would be the OCC, and for state-member and state non-member banks this would be the state regulator. 2. Fiduciary Standards Applicable to Trust Departments Trust Instrument. Investment authority over discretionary accounts are first governed by the trust instrument. If the trust instrument is silent on what the bank may invest the trust assets in, then the Bank must follow applicable law. Part 9 Regulations. For national banks, applicable law is the OCC s Part 9 regulations and for state banks it is state law. However, although Part 9 provides certain principles and guidelines related to a bank s trust activities, there is no federal fiduciary standard. Therefore, all fiduciary principles are governed by state law. Varying State Approaches. The majority of states follow the Prudent Investor Act (adopted in the Restatement of Trusts 3d). A small minority of states still follow the Prudent Man Rule (adopted in the Restatement of Trusts 2d). Prudent Investor Act. Adopted in 1990, the statute uses the modern portfolio theory and total return approach to the exercise of 10

14 fiduciary investment discretion. This approach judges the fiduciaries performance by the total performance of the portfolio, not just by the performance of one investment. Diversification is explicitly required and investments must be suitable in light of the beneficiary s objectives. Prudent Man Rule. The Prudent Man Rule directs trustees to observe how men of prudence, discretion and intelligence manage their own affairs, not in speculation, but in regard to the permanent disposition of their funds, considering probable income, as well as probable safety of capital to be invested. When the trust instrument is silent, the trustee must invest the beneficiaries money as a prudent man would. Investments must be suitable for the trust account. Performance is judged on an investment by investment basis (it is irrelevant how the rest of the portfolio does). Appropriate Fiduciary Investments under state and federal law. o Fiduciary funds awaiting investment or distribution OCC Rule With respect to a fiduciary account for which a bank has investment discretion, the bank shall obtain for funds awaiting investment or distribution a rate of return that is consistent with applicable law. Applicable law means pursuant to the trust instrument or state fiduciary law. o State-Approved Funds. Most state statutes specifically approve of the use of mutual funds as appropriate investments for trust departments. In addition, the third Restatement of Trusts specifically states in the absence of statute or trust provisions authorizing or restricting their use, mutual funds and other pooling arrangements are permissible investments for trustees under the principles of the prudent investor rule. Restatement of Trusts 3d sec. 227 cmt. m. o Uninvested Cash. Use of money market funds by trust departments Trust departments usually invest trust money into money market funds so the uninvested cash does not sit idly without earning a reasonable rate of return. 11

15 C. Opposition to Floating NAV The American Bankers Association ( American Bankers ), on behalf of the banking industry, expressed concerns with the Proposal, specifically that imposing a floating NAV on prime money market funds would limit investment options for banks acting as trustees. See Cecelia A. Calaby, Letter of American Bankers Association (Sept. 17, 2013) (commenting on the Proposal) (the American Bankers Letter ). Reasonable Rate of Return. As discussed above, many trust instruments and OCC Rule 9.10 and state law generally require uninvested cash to earn a reasonable rate of return while preserving principal. In line with this requirement, the American Bankers and other industry participants expressed concerns with the following: Bank Trust departments generally must account for principal and interest separately; a floating NAV would result in an investment with features that require extensive additional recordkeeping. See William J. Farrell, Letter of M&T Bank (Sept. 17, 2013) (commenting on the Proposal). Imposing a floating NAV on prime money market funds would mean that most bank trust departments would move their client s cash to government or treasury funds, which generally have a lower rate of return than prime money market funds. See American Bankers Letter. The SEC did not respond specifically to banking industry concerns in any meaningful way. For example, consider the retail prime funds exception. o This exception allows prime money market funds to keep a stable NAV if they limit daily redemptions to $1M per investor. In addition, the SEC allowed trust departments to redeem over $1M a day for omnibus accounts, provided the $1M daily redemption limit would be applied at the account level. o Banks opposed this exception because they often cannot tell, or do not have systems in place to apply redemptions from money market funds by omnibus accounts at the individual account level. D. Opposition to Fees and Gates The American Bankers also expressed concern with fees and gates, citing the following: o Hinder Liquidity. Fees and gates would hinder bank trust departments ability to maintain liquidity in their clients portfolios. Generally, trust departments must ensure that they can redeem their investments in money market funds in full, on demand to meet beneficiary distributions. Fees and gates would be inconsistent with this principle. 12

16 o Bond Holders. In addition, corporate trustees would not be able to use prime money market funds with fees and gates because they would need to be able to pay bond holders on a given date and therefore could not accept the risk that the funds would be unavailable. E. Alternatives to Money Market Funds Bank Deposits. Although a safe alternative to preserving principal, banks may be unwilling to take large deposits because of new regulatory capital rules, therefore making depositors unable to realize a reasonable rate of return required under fiduciary standards. Short-Term Investment Funds ( STIFs ). STIFs are common investment funds that operate similar to money market funds. STIFs seek a stable NAV by investing in short-term high quality instruments. STIFs are exempt from SEC regulation pursuant to Section 3(c)(3) under the 1940 Act. o STIFs are regulated by the OCC under 12 CFR 9.18, which requires that STIFs operate pursuant to a Plan and can only be offered to authorized fiduciary accounts. STIFs value their assets on an amortized cost basis. o As of June 30, 2012, there were approximately $118 billion in STIFs OCC Amendment to o STIFs could be an alternative for fiduciary assets seeking a stable NAV. However, the OCC has often followed the SEC s rulemaking governing money market funds. In 2012, the OCC adopted amendments to 12 CFR 9.18 to closely align STIF rules with that of the 2010 money market fund reforms. o Although there has been no public plans to further amend the STIF rules, it is possible that the OCC could seek to further align the two regimes in the near future. F. Effects of Final Money Market Fund Rule 1. Discretionary (Managed) Accounts To date, it is unclear what the full impact of the new SEC money market fund rules will be on banks and their trust departments, especially in the context of fiduciary responsibilities. However, we are aware that for managed accounts, certain banks are only placing fiduciary customer assets in stable NAV money funds, and they have no plans to place these assets in floating NAV money funds. 2. Client Directed Accounts For client directed accounts, such as those in many bank custody and corporate trust accounts, there may be an issue of a short supply of desired money funds. Corporate 13

17 clients are not eligible for stable NAV money funds, except for government money funds. Along with investors like insurance variable products, government money likely will be in high demand. 3. Beneficial Owners The SEC staff had provided important guidance regarding the test for determining beneficial ownership that would be relevant for bank trust accounts. SEC Staff FAQ (Revised January 13, 2016) #21. o 21. Q. 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), in lieu of the sole or shared voting and/or investment power test (as defined in Rule 13d-3 )? o Investment Power Focus. A. No. Rule 16a-1(a)(2) defines beneficial ownership using a pecuniary interest test. Rule 13d-3, however, looks to investment and/or voting power to define beneficial ownership. The staff believes it is an exercise of an investor s investment power when such investor decides to redeem securities. Accordingly, the staff believes that the rationale and purpose behind the retail money market fund exemption would therefore be undercut if beneficial ownership could be determined based on entitlement to funds alone (i.e., using the direct or indirect pecuniary interest test), without having sole or shared investment power. o Voting Power Not Relevant. Rule 13d-3 also treats a person as a beneficial owner based on the person having sole or shared voting power over securities. Voting power may be unrelated to the power to redeem securities, and therefore would not be significant when determining beneficial ownership of a retail money market fund. Accordingly, in the staff s view and notwithstanding Rule 13d-3, policies and procedures would be deemed reasonably designed to limit all beneficial owners of the fund to natural persons even if they do not use voting power as a basis for identifying beneficial owners of the fund. o Shared Investment Power Permissible. The staff believes that such policies and procedures may also permit institutional decision makers to share investment power with a natural person. For example, accounts managed by an institutional decision maker on behalf of one or more natural persons may qualify to invest in a retail money market fund, provided that such natural persons have sole or shared investment power over the shares as defined in Rule 13d-3. Attached to this outline is a chart that shows the legal treatment of ordinary trusts under the retail money market fund definition. The chart was prepared by Dechert LLP and the Investment Company Institute. 14

18 III. Insurance Issues A. Structure of Variable Annuity Contracts Separate Account. A variable annuity contract is typically organized as a two-tier structure. The top tier is an insurance company separate account, which is registered as a unit investment trust. The investor in (owner of) the contract is referred to as a contract owner. Mutual Fund. The separate account generally is divided into subaccounts, and each subaccount invests exclusively in a specified underlying mutual fund (the bottom tier), which is registered as a mutual fund. The contract owner allocates the premiums and cash value among the subaccounts, and therefore indirectly among mutual funds. SEC Registration. A variable annuity contract can be issued to retail investors or in connection with IRAs; these contracts are registered under the 1933 Act and the 1940 Act. A variable annuity contract also may be issued to certain types of qualified plans; these other contracts are exempt from SEC registration. B. Opposition to Fees and Gates The Committee of Annuity Insurers opposed the liquidity fees and redemption gates set forth in the Proposal. See Stephen E. Roth and Frederick R. Bellamy, Letter of Sutherland Asbill & Brennan LLP on behalf of the Committee of Annuity Insurers (Sept. 17, 2013) (commenting on the Proposal). 1. Redemption Gates Contract Rights. First, there is the problem that variable annuity owners have a contractual right to take withdrawals and to surrender their contracts, and generally to transfer their cash value out of any subaccount, including the money market subaccount, on a daily basis without any gate or other delay. Outstanding variable annuity contracts allow daily redemptions with no provision for redemption gates, so imposing any gates would violate the terms of outstanding contracts, subjecting insurers to potential 1iability for breach of contract. It would also be a violation of state insurance laws and regulations. Id. Redemption Rights. Second, variable annuity issuers provide a variety of programs that require periodic redemptions from money funds. These programs include dollar cost averaging, automatic rebalancing, and automatic periodic withdrawals. Variable annuity payouts can require monthly redemptions from money market subaccounts. In addition, some variable annuities provide for monthly (or quarterly) deductions of certain charges, which may also require redemptions 15

19 from money funds. Variable annuity prospectuses describe all of these features of the annuity; they are material aspects of the security as it was sold to investors (along with the right to make withdrawals and surrenders). Id. Therefore, the Committee of Annuity Insurers argued that imposing any type of redemption gate would present significant legal and operational problems for variable annuity issuers. Id. 2. Liquidity Fees Contract Rights. The Committee also maintained that liquidity fees pose the same problems. Outstanding variable annuity contracts generally would not permit the insurance company to impose such fees. The Committee understood the position that such fees, like redemption fees under Rule 22c-2 under the 1940 Act, could be viewed as being imposed by the fund and not the insurance company intermediary. However, that argument has not been ruled upon or accepted by a court or state insurance department, putting legal risk on any insurer that imposes liquidity fees on its contract owners. Id. Administrative Issues. More importantly, imposing liquidity fees and gates would be an immense administrative and operational burden for insurers. Variable annuity contracts are much more complicated than money funds. Many insurers utilize multiple administrative systems, some of which are legacy systems that are used for contracts sold years ago. The cost and effort to implement liquidity fees would be prohibitive. Id. C. Final Amendment Accommodations 1. Liquidity Fees and Redemption Gates Clarified for 1940 Act. To clarify the application of liquidity fees and redemption gates to variable contracts, the SEC also amended Rule 2a- 7 to provide that, notwithstanding Section 27(i) of the 1940 Act, a variable insurance contract may apply a liquidity fee or redemption gate to contract owners who allocate all or a portion of their contract value to a subaccount that invests in shares of a money fund. Section 27(i)(2)(A) makes it unlawful for any sponsoring insurance company of a separate account to sell a variable contract that is not a redeemable security. Adopting Release at n Government Fund Alternative No Special Treatment. The SEC determined not to provide special treatment for money funds underlying variable annuity contracts for 16

20 the fees and gates requirements. To the extent fees and gates are incompatible with contractual or state law, or with free look provisions, the SEC noted that an insurance company can instead offer a government money fund as an investment option under its contract(s). Adopting Release. Extra Costs. To the extent an insurance company determines to offer a government money fund as a new investment option under a contract, the SEC recognized that there may be costs associated with this process, including costs associated with disclosing a new investment option to contract-holders, negotiating arrangements with new government money funds, and filing a substitution application under Section 26(c). Adopting Release at n D. Insurance Industry Operation Response 1. Move to Government Money Funds No Fees or Gates. The 2014 money market reforms provided that only government money funds may maintain $1 per share and remain exempt from liquidity fees and redemption gates. In response, many insurance providers have converted or announced plans to convert prime retail and prime institutional funds to government products. Crane Data projects that at least $257 billion will move from prime to government money funds by October Peter Ortiz, ICI to IRS: Loosen Up on VA Money Market Regs, Ignites (Dec. 10, 2015) [ Ignites Dec Article ]. Industrywide Migration. In the fourth quarter of 2015, several Franklin and Dreyfus prime funds converted to government funds, kicking off an industrywide migration of an estimated $230 billion in assets slated to shift out of prime funds. Beagan Wilcox Volz, The Great Money Fund Migration Kicks Off, Ignites (Nov. 11, 2015). A number of midsize and smaller providers also announced conversions, joining the ranks of giants like Fidelity and BlackRock. Id. Invesco filed with the SEC to convert V.I. Money Market Fund in April The Atlanta-based firm manages about $55.2 billion in money fund assets, making it the 13th-largest sponsor. Nationwide stated in a September 2015 regulatory filing that it planned to convert two prime funds to government products. Collectively, the Nationwide Money Market and Nationwide VIT Money Market represented about $2.8 billion in assets. Pioneer disclosed in August 2015 that its Cash Reserves Fund will become the Pioneer U.S. Government Money Market Fund in November The fund represented $323.6 million in assets at the end of September. Id. 17

21 2. Government Short Supply and IRS Diversification ICI Request to IRS. The Investment Company Institute requested that the IRS provide relief for variable annuity products, loosening restrictions related to diversification requirements for government money funds. Letter from Karen Lau Gibian, Associate General Counsel Tax Law, ICI to Helen Hubbard, Associate Chief Counsel (Financial Institutions and Products), IRS (Dec. 3, 2015) [ ICI Dec Letter ]; see Ignites Dec Article. Section 817(h). Section 817(h) of the Internal Revenue Code contains a diversification test for segregated asset accounts with respect to variable insurance contracts. Treas. Reg (b)(1) provides that the investments of a segregated asset account are considered adequately diversified under Section 817(h) if: (A) No more than 55% of the value of the total assets of the account is represented by any one investment; (B) No more than 70% of the value of the total assets of the account is represented by any two investments; (C) No more than 80% of the value of the total assets of the account is represented by any three investments; and (D) No more than 90% of the value of the total assets of the account is represented by any four investments. In the case of government securities, each government agency or instrumentality is treated as a separate issuer. Only Five Issuers. The ICI is concerned about government money funds offered through variable annuities because they must have portfolio holdings from at least five issuers. IRS diversification requirements for variable annuities would mean that a government money fund will be the only type of money fund meeting those criteria and therefore now will be extremely important for variable insurance products. There are only five major issuers of government securities in which money funds invest: Treasuries, Federal Home Loan Bank, Federal National Mortgage Association (Fannie Mae), Federal Home Loan Mortgage Corporation (Freddie Mac); and the Federal Farm Credit Bank System (Farmer Mac). ICI Dec Letter. Short Supply. Variable insurance product funds that seek to qualify as government money market funds under Rule 2a-7 while satisfying the [IRS] diversification test are concerned that the supply for such securities will not meet the demand. ICI Dec Letter. 18