Update
Yesterday, on October 13, 2016, the U.S. Securities and Exchange Commission (SEC) unanimously adopted regulatory changes that require open-end funds, including mutual funds and exchange-traded funds (ETFs), to establish liquidity risk management programs. The SEC also adopted, by a 2-1 vote, rule and form amendments to permit certain open-end funds to use “swing pricing.”
A forthcoming Goodwin Client Alert will provide additional information about these regulatory changes. In the meantime, for additional information, please refer to the SEC’s “fact sheet” and press release, which also includes information relating to a separate SEC action to “modernize and enhance” fund reporting, and the SEC adopting releases for liquidity risk management and swing pricing.
Liquidity Risk Management
The SEC adopted Rule 22e-4 under the Investment Company Act of 1940 (the 1940 Act), which requires open-end funds, including certain ETFs but excluding money market funds, to adopt and implement formal, written liquidity risk management programs (Programs). Rule 22e-4 specifically excludes ETFs that qualify as so-called “in-kind ETFs” from certain requirements. The key components of a Program are summarized below.
Assessment, Management and Periodic Review. A fund will be required to assess, manage and periodically review its “liquidity risk,” considering certain specified factors. Liquidity risk is defined as the risk that a fund cannot meet redemption requests without significant dilution of remaining investors’ interests in the fund.
Liquidity Classifications. A fund will generally be required to classify each of its portfolio investments into one of four liquidity categories based on the number of days within which the fund reasonably expects an investment would be convertible to cash under current market conditions without significantly impacting the investment’s market value. These categories are: highly liquid, moderately liquid, less liquid and illiquid. In making this classification, a fund will be required to take into account relevant market, trading, and investment-specific considerations and the market depth of the investment. This represents certain changes from the initial proposal, including, among others, a reduction in the number of classifications from six “buckets” to four. In addition, under the final rule, a fund will be permitted to classify investments by asset class (as opposed to on an individual investment basis), unless the liquidity characteristics of a particular investment suggest a different classification for that investment as compared to the fund’s other portfolio holdings within that asset class.
“Highly Liquid” Investment Minimum. Based on a fund’s assessment of its liquidity risk, the fund will be required to determine, and review no less frequently than annually, its “highly liquid investment minimum,” which is the minimum percentage of the fund that must be invested in “highly liquid assets.” Highly liquid assets are generally defined as cash or investments that are reasonably expected to be converted to cash within three business days without significantly changing the market value of the investment. A fund must adopt procedures for responding to situations where the fund’s highly liquid assets fall below its “highly liquid investment minimum.” Such procedures must provide for reporting to the fund’s board in the event of a shortfall.
15% Illiquid Investment Limit. A fund will be prohibited from acquiring any “illiquid investment” if, immediately after the acquisition, the fund would have invested more than 15% of its net assets in illiquid investments. An “illiquid investment” is defined as any investment that a fund reasonably expects cannot be sold or disposed of in current market conditions in seven calendar days or less without the sale or disposition significantly changing the market value of the investment. A fund will be required to review its illiquid investments monthly and the board must be notified if a fund exceeds the 15% limit. This notification must include information regarding plans to bring the fund back into compliance within a reasonable period of time.
Form N-LIQUID. New Form N-LIQUID will require a fund to confidentially notify the SEC when the fund’s level of illiquid investments exceeds 15% of its net assets or when its highly liquid investments fall below the fund’s minimum for more than seven consecutive calendar days.
Board Oversight. A fund’s board, including a majority of its independent directors, will be required to approve a fund’s Program and the designation of the fund’s adviser or officer(s) to administer the Program. However, unlike in the proposed rule, a fund’s board will not be required to specifically approve the fund’s highly liquid investment minimum (except in limited circumstances) or to approve material changes to the Program. Instead, consistent with its current obligations under Rule 38a-1, a board will be required to review, no less frequently than annually, a written report that describes the administrator’s review of the Program’s adequacy and effectiveness.
Swing Pricing
The SEC also adopted amendments to Rule 22c-1 under the 1940 Act permitting, but not requiring, open-end funds (other than money market funds and ETFs) to use “swing pricing.” “Swing pricing” is the process of adjusting a fund’s net asset value (NAV) per share to, in effect, pass on the costs of shareholder purchases and/or redemptions to the shareholders associated with such activity. Consistent with the proposed rule, a fund using swing pricing would adjust its NAV by a specific amount – the “swing factor” – once the level of net purchases or net redemptions from the fund has exceeded a set, specific percentage of the fund’s NAV known as the “swing threshold.” A fund that opts to use “swing pricing” must adopt swing pricing policies and procedures that specify the process for determining the fund’s swing factor and swing threshold, taking into account certain considerations. The policies and procedures would also be required to establish a swing factor upper limit that may not exceed two percent of the fund’s NAV per share. A fund’s board would approve the fund’s swing pricing policies and procedures and review no less than annually a written report from the persons responsible for administering swing pricing – the fund’s adviser or officer(s) designated by the board.
Disclosure/Reporting Requirements Relating to Liquidity Risk Management and Swing Pricing
A fund will be required to disclose information regarding its liquidity risk management programs and, as applicable, its use of swing pricing.
Form N-1A. Form N-1A, a fund’s registration statement, will be amended to require additional disclosure regarding a fund’s procedures for redeeming fund shares, including the number of days in which the fund typically expects to pay redemption proceeds and the methods that the fund typically expects to use to meet redemption requests. A fund would also be required to disclose information regarding its use of swing pricing.
Form N-CEN. New Form N-CEN, an annual census reporting form, will require a fund to disclose information about the use of any lines of credit and interfund lending and borrowing. Funds will also be required to report information regarding the use of swing pricing, including the swing factor upper limit.
Form N-PORT. New Form N-PORT, a monthly portfolio holdings report, will require a fund to publicly report the aggregate percentage of the fund representing each of the four liquidity classifications and, on a confidential basis to the SEC, position-level liquidity and the fund’s “highly liquid investment minimum.”
Compliance Dates
With respect to liquidity risk management, the SEC provided a tiered set of compliance dates based on asset size. The compliance date for fund complexes with $1 billion or more in net assets is December 1, 2018, while the compliance date for fund complexes with less than $1 billion in net assets is six months later on June 1, 2019. The effective date of the amendments permitting funds to use swing pricing will be two years after publication of the release in the Federal Registrar (which has not occurred as of the date of this update).