Part One of this series of posts explained how intermediaries could avoid calculating, collecting and remitting liquidity fees to money market funds by (1) having the transfer agent (“TA”) calculate and retain the fees from the redemption proceeds paid to the intermediary and (2) prorating the proceeds received from the TA among the intermediary’s clients based on the dollar or share amount of each client’s redemption. This method should address an intermediary’s concern that it might need to impose multiple and constantly changing liquidity fees for various money market funds during a financial crisis. The only question is how to handle contemporaneous purchases by the intermediary’s clients, which ordinarily would be netted against the other clients’ redemptions.
Why Would Anyone Buy Shares Subject to a Liquidity Fee?
Before addressing this question, we should consider how unlikely it would be for anyone to purchase shares subject to a liquidity fee. Who would put money in a mutual fund knowing they could only get less money back upon redemption? When the best outcome is breaking even (when the liquidity fee is removed), and the worst outcome is paying a liquidity fee, what incentive is there to purchase more shares?
Purchases of shares subjec to liquidity fees may be unintentional. Shareholders who automatically purchase shares, through a payroll deduction or sweep arrangement for example, might fail to turn off the purchase program after a liquidity fee is imposed. Such purchases may pose a litigation risk, both to the fund (for failure to adequately notify shareholders of the liquidity fee) and intermediaries (for continuing to purchase shares after the fund imposed the fee). At a minimum, continuing to allow automatic purchases will not enhance the reputation of the fund or the intermediary.
Alternative 1—Stop Selling Shares
If selling shares subject to a liquidity fee is apt to be more trouble than it is worth, the simple solution is to suspend sales while the fee is in place. Nothing in the Investment Company Act requires a fund to offer its shares for sale. The Board may discontinue sales at any time for any reason. Thus, a Board may want to consider suspending sales of a fund’s shares at the same time as it imposes a liquidity fee. Such a suspension would eliminate the possibility that an intermediary had netted purchases from redemption orders submitted to the TA.
Alternative 2—Stop Netting Orders
Curtailing sales is anathema to some fund executives. If the Board is unwilling to suspend sales, then the next alternative would be for intermediaries to settle on a “gross” basis: that is, to submit their aggregate purchase and redemption orders separately to the TA. For example, suppose an intermediary has two clients, A and B, who each redeem $1 million from Fund X and another client, C, who invests $100,000 in Fund X. The intermediary would send to the TA an aggregate redemption order of $2 million and an aggregate purchase order of $100,000. If Fund X charged a 1% liquidity fee, the TA would reduce the redemption proceeds by $20,000, net the $100,000 due for the purchase order, and wire $1,880,000 back to the intermediary.
The intermediary would take the $1,880,000, add the $100,000 in cash debited from Client C, and prorate the resulting $1,980,000 between Clients A and B. Each client would receive $990,000, which would represent their $1 million redemption order net of a 1% liquidity fee.
Even if converting to gross settlement involves some manual processing, as noted before, purchases will probably be rare while a liquidity fee is in place. Thus, implementing this work around should not require too much effort by the intermediary or the TA.
What if intermediaries simply refuse to settle on a gross basis? The final part of this series will explain the counter-intuitive consequences of allowing netted orders from intermediaries.