On October 13, 2016, the Securities and Exchange Commission (the "SEC") adopted three sets of final rules and rule amendments, as well as new forms and form amendments, relating to liquidity risk management, reporting modernization and swing pricing for funds. This Stroock Bulletin is meant to provide you with a brief and timely summary of the SEC's rulemakings. We are preparing a subsequent Stroock Bulletin with more detail about these new and amended rules and forms, as well as the potential impact for funds and their boards.
Liquidity Risk Management
New Rule 22e-4
The SEC adopted new Rule 22e-4 under the Investment Company Act of 1940, as amended (the "1940 Act"), which requires each registered open-end management investment company, including exchange-traded funds ("ETFs") but not including money market funds, to establish a liquidity risk management program. The following highlights the key requirements:
- Assessment, management and periodic review of a fund's liquidity risk. "Liquidity risk" is the risk that a fund could not meet requests to redeem fund shares without significant dilution of the remaining investors' interests in the fund. In conducting this review, the following factors, as applicable, must be considered: (i) investment strategy and liquidity of portfolio investments during both normal and reasonably foreseeable stressed conditions; (ii) short-term and long-term cash flow projections during both normal and reasonably foreseeable stressed conditions; and (iii) holdings of cash and cash equivalents, as well as borrowing arrangements and other funding sources. ETFs also must consider the relationship between the ETF's portfolio liquidity and its trading activity as well as the effect of the composition of baskets on the overall liquidity of the ETF's portfolio.
- Classification of the liquidity of fund portfolio investments. Funds will be required to classify the liquidity of portfolio investments based on the number of days in which the fund reasonably expects the investment would be convertible to cash in current market conditions without significantly changing the market value of the investment, and the determination would have to take into account the market depth of the investment. The four classifications are: highly liquid, moderately liquid, less liquid and illiquid. Importantly, a fund may classify its portfolio investments by asset class (instead of on a per-investment basis), unless market, trading or other investment-specific factors may significantly affect the liquidity characteristics of an investment compared to other investments in the same asset class.
- Determination of a highly liquid investment minimum. A fund will be required to determine a minimum percentage of its net assets that must be invested in highly liquid investments (i.e., 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). The fund must implement policies and procedures for this purpose, which must include board reporting of any shortfall of the fund's highly liquid investments compared to its minimum and actions taken in response thereto.
- Limitation on illiquid investments. A fund will not be permitted to purchase additional illiquid investments if more than 15% of its net assets are illiquid. Generally, if a fund holds more than 15% of its net assets in illiquid investments, it must report such an occurrence to its board along with a plan of action to reduce illiquid investments to 15% or lower within a reasonable period of time.
- Board oversight. A fund's board will have certain oversight responsibilities including: (1) approving (including a majority of the fund's independent directors) the fund's liquidity risk management program and the designation of the fund's adviser or officer(s) to administer the program; and (2) reviewing, at least annually, a written report on the adequacy of the program and the effectiveness of its implementation.
Other New Rules and Forms and Amendments to Forms
The SEC also adopted:
- amendments to Form N-1A regarding the disclosure of fund policies concerning the redemption of fund shares;
- new Rule 30b1-10 under the 1940 Act and Form N-LIQUID that generally will require a fund confidentially to 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 its minimum for more than a specified period of time; and
- certain sections of new Forms N-PORT and N-CEN (discussed below) requiring disclosure of certain information regarding the liquidity of a fund's holdings and the fund's liquidity risk management practices.
Most funds will be required to comply with the liquidity risk management program requirements on December 1, 2018; fund complexes with less than $1 billion in net assets will be required to do so on June 1, 2019.
New Forms N-PORT and N-CEN
Under the SEC's new reporting regime, all open-end funds (except for money market funds and small business investment companies) and ETFs structured as unit investment trusts must provide additional and more frequent reports of portfolio holdings and other data monthly on new Form N-PORT. In addition, funds must file census information annually on new Form N-CEN. On each new form, funds will need to report the required information in a structured data format.
- On Form N-PORT, funds must report portfolio-wide and position-level holdings data on a monthly basis. Such data will include certain portfolio-level metrics, including certain risk metrics, as well as specific information about a fund's use of derivatives (similar to that required in fund financial statements under amended Regulation S-X (discussed below)). The form must be filed with the SEC no later than 30 days after the end of the month, and the SEC will make public information on reports every third month, 60 days after the end of a fund's fiscal quarter.
- On Form N-CEN, funds must annually report certain census-type information to the SEC. The required information will vary depending on the type of fund (e.g., open-end fund, closed-end fund, ETF). The form must be filed with the SEC no later than 75 days after a fund's fiscal year end and will be publicly available upon filing.
With the adoption of Forms N-PORT and N-CEN, the SEC will rescind current Forms N-Q and N-SAR.
- The SEC adopted amendments to Regulation S-X that will require standardized, enhanced disclosure about derivatives in fund financial statements. Such information will include the derivative type, the counterparty to the derivative, the notional amount of the derivative contract and any unrealized appreciation or depreciation.
- The SEC adopted amendments to Forms N-1A, N-3 and N-CSR to require certain disclosures regarding a fund's securities lending activities in a standardized format and will require a fund to disclose income and fees from securities lending activities and the fees paid to securities lending agents in the prior year .
Most funds will be required to begin filing reports on new Forms N-PORT and N-CEN after June 1, 2018; fund complexes with less than $1 billion in net assets will be required to begin filing reports on Form N-PORT after June 1, 2019.
Notably absent from the SEC's final rulemaking was a proposed rule (Rule 30e-3) that would have permitted funds to satisfy their shareholder report delivery obligations through website posting, subject to certain conditions. One of the three SEC Commissioners voted against the "modernized" reporting regime due to the omission, and explicitly refused to work on any non-emergency rulemakings or projects until a final rule addressing electronic delivery of shareholder reports is complete.
The SEC adopted amendments to Rule 22c-1 under the 1940 Act to permit an open-end fund (except a money market fund or ETF), under certain circumstances, to use "swing pricing," the process of adjusting the fund's net asset value per share to effectively pass on the costs stemming from shareholder purchase or redemption activity to the shareholders associated with that activity. Funds that seek to employ swing pricing will need to, among other things, have their boards approve policies and procedures governing the fund's swing pricing.
The SEC also adopted amendments to Rule 31a-2 to require funds to preserve certain records related to swing pricing, amendments to Form N-1A and Regulation S-X and a new item in Form N-CEN, all of which address a fund's use of swing pricing.
The amendments that would permit funds to use swing pricing will become effective 24 months after publication in the Federal Register.
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.