On November 2, 2022, the U.S. Securities and Exchange Commission (“SEC”), by a vote of 3-2, proposed amendments to rules under the Investment Company Act of 1940 that would modify the existing liquidity risk management program requirements for open-end funds other than money market funds (“open-end funds” or “funds”) and mandate that open-end funds (excluding exchange-traded funds (ETFs)) engage in swing pricing. The proposed amendments reflect the SEC’s experience with the current liquidity rules since they were adopted in 2016, as well as the SEC’s assertion that the market events of March 2020 at the outset of the pandemic warrant further regulatory requirements to enhance open-end fund liquidity in future stressed conditions.
Currently, open-end funds are required by Rule 22e-4 to adopt and implement liquidity risk management programs that incorporate various elements, some of which are tailored for ETFs (this article does not seek to include details on those nuances, but please see Goodwin’s previous Client Alert for an overview of Rule 22e-4). In determining liquidity classifications under its current program, a fund must analyze the number of days it reasonably expects it would take to sell portions of a position in a particular investment that the fund would reasonably anticipate trading (RATS) without significantly changing its market value (value impact standard). Funds currently have considerable discretion in defining these key inputs.
As proposed, the amendments to Rule 22e-4 would provide objective minimum standards that open-end funds must use to classify investments, specifically by requiring funds to assume the sale of a set stressed trade size (at 10% of a fund’s net assets) and by defining the value impact standard with more specificity on when a sale or disposition would significantly change the market value of an investment (e.g., for non-exchange listed investments, a decrease in sale price of more than 1%). This more prescriptive approach is designed to prevent open-end funds from overestimating the liquidity of their investments, and may result in funds classifying fewer investments as highly liquid and more investments as illiquid.
The proposed amendments would also eliminate one of the four liquidity classification categories—the “less liquid” category—which would leave three liquidity classification categories: highly liquid, moderately liquid, and illiquid. Significantly, investments that funds currently classify as less liquid, which typically include bank loans, would become illiquid investments under the proposed amendments. In addition, the amendments would broaden the scope of the illiquid category to include investments whose fair value is measured using an unobservable input that is significant to the overall measurement, reflecting the SEC’s view that such unobservable inputs may indicate an active and liquid market for the investment does not exist. The proposed amendments would also require open-end funds to classify the liquidity of all of their investments each business day instead of at least monthly, which would replace the current process by which funds are required to perform intra-month reviews if certain standards are met.
The SEC proposed requiring all open-end funds to establish and maintain a highly liquid investment minimum (HLIM), and to set a uniform floor for the minimum at 10% of the fund’s net assets. Currently, most funds do not have HLIMs, instead relying on an exclusion available for funds that primarily invest in highly liquid investments. This exclusion would be removed. The SEC acknowledged that imposing an HLIM of at least 10% on all funds would require some funds to hold a larger amount of highly liquid assets than they currently do, which the SEC stated may affect these funds’ strategies or performance.
Significantly, the proposed rulemaking would require open-end funds (except ETFs) to engage in swing pricing. Swing pricing refers to the pricing mechanism whereby a fund adjusts the transaction price for shareholders above or below the fund’s net asset value (NAV) in an attempt to pass on the costs of purchases and redemptions of fund shares to the purchasing and redeeming shareholders. Trading activity associated with purchases and redemptions may impose costs, including brokerage commissions and other transaction costs from selling portfolio investments to meet redemptions or purchasing portfolio investments with proceeds from net subscriptions, as well as the costs of depleting a fund’s liquid investments to satisfy those redemptions. Swing pricing is intended to mitigate the risk that shareholder purchase and redemption activities could have a dilutive effect on the value of the shares held by the fund’s non-transacting shareholders.
Rule 22c-1 currently permits the use of swing pricing, but no fund has implemented swing pricing to date. Indeed, many fund sponsors have questioned the operational feasibility of, and other consequences associated with, imposing a swing pricing regime in the United States. While a full recitation of such opposition is outside the scope of this article, one reason funds have not implemented swing pricing is that they lack timely investor flow information on a daily basis to operationalize this process. Currently, if an investor submits an order to an intermediary to purchase or redeem fund shares, that order will be executed at the current day’s price as long as the intermediary receives the order before the time the fund has established for determining the value of its holdings and calculating its NAV—typically, 4 pm EST. However, the fund may not receive information about that order until much later because an intermediary can submit an order it received before 4 pm to the fund after 4 pm for execution at that day’s NAV.
To address this lag, the SEC proposed a “hard close” requirement for funds subject to swing pricing. This would facilitate the more timely receipt of order flow information by requiring that a purchase or redemption order be received by the fund or its transfer agent prior to the pricing time in order to receive that day’s NAV. The SEC acknowledged the hard close would require funds and intermediaries to change their current order processing practices and likely would cause some intermediaries to set their own internal cut-off time for receiving purchase or redemption orders earlier than the pricing time, thereby providing enough time to transmit order flow information to the fund or its transfer agent so those orders receive that day’s NAV.
Unlike the principles-based framework for swing pricing established in 2016, which permits a fund to determine the level of net purchases or net redemptions that would trigger swing pricing, the proposed new iteration of the framework would specify when a fund must use swing pricing to adjust its NAV. In the case of net redemptions, the proposed amendments would require a fund to apply swing pricing each day regardless of the size of net redemptions. When a fund has net purchases, swing pricing would be required if the amount of net purchases exceeds 2% of the fund’s net assets. The amount by which the fund would have to adjust its NAV (referred to as the swing factor) would require making good faith estimates of the costs associated with dilution, which calculation takes into account the costs the fund would incur if it purchased or sold a pro rata amount of each investment in its portfolio to satisfy the amount of net purchases or net redemptions. The proposed framework would not include an upper limit on the swing factor.
Finally, the SEC proposed amendments to reporting and disclosure requirements on N-PORT, N-1A, and N-CEN that apply to certain registered funds, including open-end funds, registered closed-end funds, and unit investment trusts. The proposed amendments would require more frequent reporting of monthly portfolio holdings and related information to the SEC and the public (monthly instead of quarterly). They would also require additional information about funds’ liquidity risk management and use of swing pricing, including the aggregate percentage of a fund’s portfolio represented in each of the three proposed liquidity categories.
The SEC proposed a 24-month compliance date with respect to the proposed swing pricing and hard close requirements and related disclosure requirements, and a 12-month compliance date with respect to all other aspects of the proposed rulemaking. The comment period for the proposal will remain open for 60 days after publication in the Federal Register, which has not occurred yet as of the date of this article.