United States: SEC Approves New Liquidity Risk Management Rules; Swing Pricing Rules

The SEC also approved a swing pricing rule by a vote of 2-1, with Commissioner Piwowar voting against it.

The SEC made several significant changes to the proposal rules to address concerns that the rules would improperly hamstring funds in meeting their objectives.

Here are the highlights:

  • Liquidity risk management programs

    • New rule 22e-4 will require all mutual funds (other than money market funds and ETFs that qualify as "in-kind ETFs") to establish liquidity risk management programs.The programs must address:

      • Assessment, management and periodic review of a fund's liquidity risk
      • Classification of the liquidity of fund portfolio investments
      • Determination of highly liquid investment minimum
      • Limitation on illiquid investments
      • Board oversight
    • Assessment, management and periodic review of a fund's liquidity risk

      • Liquidity risk is defined as the risk that a fund could not meet requests to redeem shares issued by the fund without significant dilution of remaining investors' interests in the fund
      • Classification of liquidity

        • Funds must classify each of the investments in its portfolio based upon 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
        • The determination would take into account the market depth of the investment
        • The SEC voted to create four categories, as compared to six categories, as originally proposed: highly liquid, moderately liquid, less liquid and illiquid
        • Funds may classify investment by asset class, unless market-, trading- or investment-specific considerations with respect to a particular investment are expected to significantly affect the liquidity characteristics of that investment as compared to the fund's other portfolio holdings within that asset class
      • Determination of a highly liquid investment minimum

        • Funds must determine a minimum percent of net assets that it must invest in highly liquid investments

          • Highly liquid investments mean cash or investments that are reasonably expected to be converted to cash within three days without significantly changing the market value of the investment (the three-day liquidity rule)
          • Funds must adopt policies and procedures for responding to a highly liquid investment minimum shortfall, which must include board reporting in the event of a shortfall
        • Funds may not buy additional illiquid investments if more than 15 percent of its net assets are illiquid
        • An illiquid investment means an investment that the fund reasonably expects cannot be sold in current market conditions in seven days without significantly changing the market value of the investment
        • Funds must review illiquid investments at least monthly
        • If a fund breaches the 15 percent limit, it must report the occurrence to the board and explain how the fund plans to bring illiquid investments back within the limit within a reasonable period of time

          • If not resolved within 30 days, the board must assess whether the plan presented is in the best interests of the fund and its shareholders
        • Board oversight

          • A fund's board, including a majority of the independent directors, must approve the fund's liquidity risk management program and the designation of the fund's adviser or officer to administer the program
          • The board must review, at least annually, a written report on the adequacy and effectiveness of the program
        • Form N-LIQUID
          • This form will require a fund to confidentially notify the SEC when the fund's level of illiquid assets exceeds 15 percent of its net assets or when its highly liquid investments fall below its minimum for more than a brief period of time
        • Other Forms

          • Form N-1A – require reporting on redemption procedures
          • Form N-PORT – require funds to report aggregated percentage of portfolio representing each of the four classification categories, and position-level liquidity classification, and information regarding highly liquid investment minimums (on a confidential basis)
          • Form N-CEN – require funds to disclose information regarding the use of lines of credit and inter-fund borrowing and lending, and require each ETF to report if it is an in-kind ETF under the rule
  • Swing pricing

    • The SEC approved the option to use swing pricing
    • The purpose is to allow funds to adjust their net asset value to per share to pass on to purchasing or redeeming shareholders certain costs associated with trading activity
    • Open-end funds (other than money market funds or ETFs) can use swing pricing
    • Funds that use swing pricing must adjust the NAV by a specified amount – the swing factor – once the level of net purchases into or net redemptions from the fund has exceeded a specified percentage of the fund's assets (the "swing threshold")

      • Must disclose the upper limit on the swing factor used, which may not exceed two percent of NAV (a change from the proposal)
    • Fund boards must approve the swing pricing policies and procedures and periodically review a written report addressing the adequacy and effectiveness of the program

      • Boards must also approve the swing factor upper swing pricing threshold and any changes
    • Implementation

      • Most funds must comply with the liquidity risk management program requirements on December 1, 2018
      • Fund complexes with less than $1 billion in net assets would be required to comply by June 1, 2018

Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

© Morrison & Foerster LLP. All rights reserved

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