United States: US Securities And Exchange Commission Proposes Liquidity Management Reforms For Open-End And Exchange-Traded Funds

Keywords: SEC, rule reforms, ETFs, mutual funds.

The US Securities and Exchange Commission (SEC or Commission) has approved certain proposed rule reforms designed to enhance effective liquidity risk management by open-end funds, including mutual funds and exchange-traded funds (ETFs). With an estimated more than $15 trillion in such funds, these proposed rules are potentially significant to many markets.

Under the proposed reforms, mutual funds and ETFs would be required to implement liquidity risk management programs and enhance disclosure regarding fund liquidity and redemption practices. The proposal is designed to better ensure that investors can redeem their shares and receive their assets in a timely manner.

A fund's liquidity risk management program could be required to contain multiple elements, including: classification of the liquidity of fund portfolio assets based on the amount of time an asset would be able to be converted to cash without a market impact; assessment, periodic review and management of a fund's liquidity risk; establishment of a fund's three-day liquid asset minimum (although some Commissioners expressed concerns regarding this requirement); and board approval and review. In addition, the proposal would codify the 15 percent limit on illiquid assets included in current Commission guidelines.

The proposed reforms also would provide a framework under which mutual funds could elect to use "swing pricing" to effectively pass on the costs stemming from shareholder purchase or redemption activity to the shareholders associated with that activity. The swing pricing proposal would enable mutual funds, subject to board approval and oversight, to reflect in a fund's net asset value (NAV) costs associated with shareholders' trading activity. It is designed to protect existing shareholders from dilution associated with shareholder purchases and redemptions and would be an additional tool to help funds manage liquidity risks. 

Highlights of the proposed reforms include the following.

Liquidity Risk-Management Programs

A key feature of open-end funds is that they allow investors to redeem their shares daily. Funds must maintain sufficiently liquid assets that will likely be adequate to meet shareholder redemptions while also minimizing the impact of those redemptions on the fund's remaining shareholders. 

Proposed rule 22e-4 would require mutual funds and other open-end management investment companies, including open-end exchange-traded funds (ETFs), to have a liquidity risk-management program. The proposed rule would exclude money market funds from the requirements. The liquidity risk-management program would be required to include multiple elements, including:

  • Classification of the liquidity of fund portfolio assets;
  • Assessment, periodic review and management of a fund's liquidity risk;
  • Establishment of a three-day liquid asset minimum; and
  • Board approval and review.

Classification of the Liquidity of Fund Portfolio Assets: Each fund would be required to classify, and engage in an ongoing review of, each of the assets in its portfolio. The classification would be based on the number of days in which the fund's position would be convertible to cash at a price that does not materially affect the value of that asset immediately prior to sale. Proposed rule 22e-4 would include factors that a fund would be required to take into account when classifying the liquidity of each portfolio position.

Funds would be required to classify each asset position, or portion of a position, into one of six liquidity categories that would be convertible to cash within a certain number of days: 1 business day; 2-3 business days; 4-7 calendar days; 8-15 calendar days; 16-30 calendar days; and more than 30 calendar days.

Assessment, Periodic Review and Management of a Fund's Liquidity Risk: Funds would be required to assess and periodically review their liquidity risk, based on specified factors. Liquidity risk would be defined as the risk that a fund could not meet redemption requests that are expected under normal conditions or under stressed conditions, without materially affecting the fund's NAV per share. Proposed rule 22e-4 would codify the 15 percent limit on illiquid assets included in current Commission guidelines.

Determination of a Three-Day Liquid Asset Minimum: A fund would be required to determine a minimum percentage of its net assets that must be invested in cash and assets that are convertible to cash within three business days at a price that does not materially affect the value of the assets immediately prior to sale.

Board Approval and Review: A fund's board, including a majority of the fund's independent directors, would be required to approve the fund's liquidity risk management program, including the fund's three-day liquid asset minimum. The board also would be responsible for reviewing a written report that reviews the program's adequacy, provided at least annually from the fund's investment adviser or officer administering the program.

Swing Pricing  

The Commission will consider proposed amendments to Investment Company Act rule 22c-1 that would permit, but not require, open-end funds (except money market funds or ETFs) to use "swing pricing." 

Swing pricing is the process of reflecting in a fund's NAV the costs associated with shareholders' trading activities in order to pass those costs on to the purchasing and redeeming shareholders. Swing pricing is designed to protect existing shareholders from dilution associated with shareholder purchases and redemptions and would be another tool to help funds manage liquidity risks. Pooled investment vehicles in certain foreign jurisdictions currently use forms of swing pricing.

A fund that chooses to use swing pricing would reflect in its NAV a specified amount (the swing factor) once the level of net purchases into or net redemptions from the fund exceeds a specified percentage of the fund's NAV—known as the swing threshold. The proposed amendments include factors that funds would be required to consider to determine the swing threshold and swing factor, and to annually review the swing threshold. The fund's board, including the independent directors, would be required to approve the fund's swing pricing policies and procedures.

Disclosure and Reporting Requirements

The Commission will consider proposed amendments to the registration form used by open-end investment companies and two recently proposed reporting forms, N-PORT and N-CEN.

Form N-1A

Proposed amendments to the registration form used by open-end investment companies (Form N-1A) would require funds to disclose swing pricing, if applicable, and the methods used by funds to meet redemptions. Funds also would be required to file agreements related to lines of credit and reflect, as applicable, the use of swing pricing in the fund's NAV per share in the financial highlights section of fund financial statements. 

Proposed Form N-PORT

Proposed amendments to the portfolio holdings reporting form the Commission proposed in May 2015 (Form N-PORT) would require a fund to report the liquidity classification of each of the fund's assets based on the categories in proposed rule 22e-4. Funds also would be required to disclose the three-day liquid asset minimum, in addition to the requirement proposed in May that funds report whether an asset is a 15 percent standard asset.

Proposed Form N-CEN

Proposed amendments to the census reporting form the Commission proposed in May 2015 (Form N-CEN) would require funds to disclose information regarding committed lines of credit, interfund borrowing and lending, and swing pricing. The proposed amendments also would require ETFs to report whether they required an authorized participant to post collateral to the ETF or any of its designated service providers in connection with the purchase or redemption of ETF shares.

The proposed rule is available at: http://www.sec.gov/rules/proposed/2015/33-9922.pdf on the Commission's website and will be published in the Federal Register. The comment period for the proposed rules will be 90 days after its publication in the Federal Register.

Originally published September 28, 2015

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This Mayer Brown article provides information and comments on legal issues and developments of interest. The foregoing is not a comprehensive treatment of the subject matter covered and is not intended to provide legal advice. Readers should seek specific legal advice before taking any action with respect to the matters discussed herein.

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