(Article from Registered Funds Alert, November 2016)
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The SEC’s 2014 money market fund reforms went into effect on October 14, 2016. These reforms created three categories of money market funds. The categories of money market funds, and certain key features, are summarized in the table below.
| | Retail Prime
Funds | Government Funds | Institutional Prime
Funds |
| Net asset value (“NAV”) calculation | Stable $1 NAV | Stable $1 NAV | Floating NAV |
| Potential restrictions on shareholder redemptions | May impose liquidity fees and redemption gates in times of market stress | Generally will not impose liquidity fees or redemption gates | May impose liquidity fees and redemption gates in times of market stress |
| Investor base | Limited to individual investors (or accounts whose beneficiaries are individual investors) | Available to all investors | Available to all investors |
| Implications for operating companies | Not an investment option for operating companies | Potential yield limited by requirement to invest 99.5% of assets in cash, US government securities and repurchase agreements collateralized solely by US government securities or cash | Can chase yield to a greater extent than government funds, but floating NAV creates potential for loss of principal |
Money market funds have historically been a key tool for operating companies to manage their corporate treasuries, as they can offer yield with a stable $1 NAV. Now that the reforms are in effect, however, prime money market funds cannot offer a stable $1 NAV to corporate entities. As a result, in the weeks leading up to the October 14, 2016 effective date, it was widely reported that prime money market funds were rapidly transitioning their portfolios to government assets in order to qualify as government funds. Setting aside any broader effect on the financial markets, this shift to lower-yielding government assets has caused some corporate treasurers to look for other ways to achieve safe but meaningful yield on cash reserves. By moving corporate cash from money market funds to other types of investments, however, corporate treasurers may accidentally walk into a 1940 Act minefield.
Traditional operating companies must always be mindful of the 1940 Act’s definition of an “investment company.” Generally speaking, if more than 40% of a company’s total assets (excluding cash items and government securities) are “investment securities,” the company could be deemed to be an inadvertent investment company and might need to register with the SEC. For purposes of this 40% test, cash items and government securities are neutral, investment securities are commonly referred to as “bad assets” and all other assets are “good assets.”
Because money market funds are registered investment companies, they would be treated as investment securities for purposes of evaluating a company’s investment company status but for a no-action letter the SEC issued in 2000 that allows money market funds that seek to maintain a stable $1 NAV to be treated as “cash items” instead. In its FAQs related to money market reform, the SEC clarified that this no-action relief extends to institutional prime money market funds that will have a floating NAV as a result of the reforms. Accordingly, money market fund shares are neutral in the 40% test, instead of being bad assets.
Other forms of “safe” investments, such as ultra short term bond funds, could be bad assets. In addition, a private fund that relies on an exemption from the 1940 Act, such as Section 3(c)(7), may commit to following the investment limitations imposed on money market funds under Rule 2a-7 under the 1940 Act. Such a fund is simply a privately offered money market fund. The SEC’s 2000 no-action letter, however, does not extend “cash item” treatment to such a private fund (although the SEC acknowledged that such funds were interchangeable with 1940 Act-registered funds in a rule relaxing some of the pyramiding limitations under Section 12(d) in 2006), and therefore it would be a bad asset unless the SEC issues additional guidance.
Until now, corporate treasurers have been able to park cash reserves in money market fund shares with a stable $1 NAV and achieve some yield (albeit negligible over the past few years) without any impact on the company’s 40% test. As yields on government money market funds, which are now the only stable $1 NAV option for operating companies, have declined, treasurers may be considering other options and should be mindful of the impact those options could have on the company’s inadvertent investment company status.