United States: Significant SEC Rulemaking To Address Liquidity Of Mutual Fund Portfolios

On September 22, 2015, a unanimous US Securities and Exchange Commission proposed far-reaching rule reforms intended to address liquidity risks in the mutual fund industry. The agency's preamble indicates it was prompted by a number of factors: increasing complexity of fund portfolios, the continued rise of mutual funds and ETFs as vehicles for retail participation in the markets and the simple passage of time since the SEC last addressed these topics.

Core elements of the package are:

  • Mandated liquidity risk management programs. Every mutual fund and open-end ETF (except for money market funds and unit investment trusts) would implement a formal liquidity risk management program. The program would center around:

    • A three-day liquidity band under which every fund will select and maintain a fund-specific "three-day liquid asset minimum," plus
    • Publicly reported position-level liquidity classifications.
  • Optional "swing pricing." Mutual funds (but not money market funds or ETFs) would have the option of establishing swing pricing – a process for adjusting a fund's net asset value to pass on to purchasing or redeeming shareholders more of the costs stemming from the fund's trading activity prompted by purchases or redemptions.
  • Disclosure. A fund would be required to increase disclosure around its policies for meeting redemptions, including specifying the typical payment period. New Form N-PORT (itself proposed only in May) would be expanded to include detailed, public liquidity information, notably the new position level liquidity classifications.

The comment period for the proposed rules runs for 90 days after the proposal's publication in the Federal Register.

Current Regulatory Framework

Section 22(e) of the Investment Company Act generally requires an open-end SEC-registered investment company – often referred to as a mutual fund – to pay shareholders for securities of the fund tendered for redemption within seven days of their tender. This is a hallmark feature of mutual funds and necessarily means that a fund must be able to convert some portion of its portfolio holdings into cash on a frequent basis as needed to meet redemptions. Related requirements include:

  • Rule 15c6-1. For a fund whose shares are redeemed through a broker dealer, there is the overlay of Rule 15c6-1 under the Securities Exchange Act, which establishes a three-day settlement period for security trades effected by a broker or a dealer.1
  • Rule 22c-1. Often called the "forward pricing" rule, Rule 22c-1 under the Investment Company Act requires funds, their principal underwriters and dealers to sell and redeem fund shares at a price based on the current NAV next computed after receipt of an order to purchase or redeem fund shares. As the SEC notes as one basis for its emphasis on short-term liquidity, this is notwithstanding that fund assets may be bought or sold in subsequent days in order to implement the share purchase or redemption.
  • 15% guideline. Longstanding SEC guidelines generally limit a mutual fund's aggregate holdings of "illiquid assets" to 15% of the fund's net assets.2  Under this guidance, a portfolio security or other asset is considered illiquid if it cannot be sold or disposed of in the ordinary course of business within seven days at approximately the value at which the fund has valued the investment.
  • Rule 2a-7. Under Investment Company Act Rule 2a-7, money market funds must maintain sufficient liquidity to meet reasonably foreseeable redemptions, generally at least 10% of their portfolios in assets that provide daily liquidity and at least 30% of their portfolios in assets that provide weekly liquidity. The rule also requires that a money market fund may not acquire any illiquid security if, immediately after the acquisition, the fund would have invested more than 5% of its total assets in illiquid securities. (Rule 2a-7 is applicable only to money market funds. Since those funds are not subject to the current proposed rules, it is discussed here only for context.)

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1. In a 1995 staff no action letter, the SEC staff expressed the view that because rule 15c6 1 under the Exchange Act applies to broker dealers and does not apply directly to funds, the implementation of T+3 pursuant to Rule 15c6 1 did not change the standards for determining liquidity, which were based on the requirements of Section 22(e) of the Investment Company Act. The staff noted, however, that as a practical matter, many funds have to meet redemption requests within three business days because a broker dealer is often involved in the redemption process. See Letter from Jack W. Murphy, Associate Director and Chief Counsel, Division of Investment Management, SEC, to Paul Schott Stevens, General Counsel, Investment Company Institute (May 26, 1995), available at http://www.sec.gov/divisions/investment/noaction/1995/ici052695.pdf, ("May 1995 Staff No Action Letter").

2. Revisions of Guidelines to Form N-1A, Investment Company Act Release No. 18612 (Mar. 12, 1992) [57 FR 9828 (Mar. 20, 1992)].

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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