United States: New Liquidity And Swing Pricing Rules For US Mutual Funds

On October 13, 2016, a unanimous US Securities and Exchange Commission adopted far‑reaching rules intended to address mutual fund liquidity risks. On the same day and by a divided (two to one) vote, the SEC adopted new mutual fund reporting rules and an optional "swing pricing" rule.

Core elements of the liquidity rule package are:

  • Mandated liquidity risk management programs. Every mutual fund and open-end ETF (except for money market funds and unit investment trusts) will implement a formal liquidity risk management program, generally to include liquidity risk assessments, a "highly liquid investment minimum" (for many funds) and liquidity classifications.
  • Disclosure. There will be increased disclosure around policies for meeting redemptions. New Form N-PORT will require detailed liquidity information, notably position level liquidity classifications (that will not be made public) and aggregate liquidity information (that will be made public).
  • Breach reporting. Funds will report privately to the SEC on Form N-LIQUID each time they breach their 15% illiquid investment threshold or for breaches of their highly liquid investment minimum that continue for more than seven consecutive days. Parallel reports go to the fund's board of directors.

The new requirements come into force for larger entities (namely, funds that together with other investment companies in the same "group of related investment companies" have net assets of $1 billion or more as of the end of the most recent fiscal year) on December 1, 2018 and for smaller entities on December 1, 2019. New fund registration statement disclosure requirements are effective for filings on or after June 1, 2017.

This alert describes both the new liquidity rule and the optional swing pricing rule. A separate alert covers Form N-PORT and other new reporting requirements.

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 means a fund must be able to convert portfolio holdings to cash on a frequent basis to meet redemptions. Other requirements include:

  • Rule 15c6 1. For a fund whose shares are redeemed through a broker or dealer, there is the overlay of Rule 15c6 1 under the Securities Exchange Act, which establishes a three day trade settlement period.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 net asset value next computed after receipt of an order to purchase or redeem fund shares.
  • 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
  • Rule 2a 7. Under Investment Company Act Rule 2a 7, money market funds generally maintain 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. Rule 2a-7 limits illiquid securities to 5% of total assets. (Rule 2a 7 applies only to money market funds, which are not subject to the new rules described in this alert.)

LIQUIDITY RISK MANAGEMENT PROGRAMS – NEW RULE 22e-4

Open-end mutual funds and ETFs, but not money market funds, will be required to have a written liquidity risk management program, generally with at least these required elements:

  • Risk assessment – assessment, management and at least annual review of the fund's liquidity risk;
  • A highly liquid investment minimum – a set minimum to be determined by each fund, taking into account its individual circumstances, of investments that the fund believes are convertible to cash within three business days at a price that would not significantly change the market value of the investment; and
  • Portfolio liquidity classification – classification, and at least monthly review of the classification, of the liquidity of each of the fund's investments; and

For funds organized as part of multi-series vehicles, each series would need a liquidity risk management program tailored to its own liquidity risk.

Exchange traded funds are treated differently from other funds in two ways. First, ETFs are required in assessing liquidity risk to look at several ETF-specific risk factors. Second, the rule exempts certain "In-Kind ETFs" from the liquidity classification and highly liquid investment minimum requirements. We cover ETF-specific elements of the rule in more detail below.

The role of the fund's board of directors in overseeing the liquidity risk management program was modified meaningfully in the course of the rulemaking, with generally fewer specific responsibilities in the final rule versus as proposed. Board responsibilities are covered in their own section of this alert.

ASSESSING, MANAGING AND REVIEWING A FUND'S LIQUIDITY RISK

Integral to the rulemaking is a definition of "liquidity risk," and regulatory thinking on what that might mean evolved over time. "Liquidity risk" is now defined by the rule 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." By contrast, this was proposed earlier in the rulemaking as the risk that redemptions could not be met "without materially affecting the fund's net asset value."

What does "significant dilution" – the term embedded in the final rule – mean? Per the SEC, such dilution is more than "slight" and rises to the level of "harm" to shareholder interests. The agency also says "fire sale" price impacts are by definition significant, but harm can arise at "much lower levels" than fire sale prices.

The question of "significance in turn flows into the liquidity classification process discussed later in this alert, in that each of the rule's four classification categories turns on whether an investment can be converted to cash within a given period without "significant change" in the market value of the investment. In that context, the SEC offers reassurance that significance of price impacts need not be "estimated with precision," while also saying that each fund's procedures should have a view on what a "significant change" might mean.

Assessing Liquidity Risk

Each fund will take at least the following factors into account, as applicable, in assessing the fund's liquidity risk:

  • Strategy and liquidity. The fund's investment strategy and liquidity of portfolio assets during both normal and reasonably foreseeable stressed conditions, including
    • whether a fund's investment strategy is suitable for an open-end (meaning daily redemption) product;
    • the extent to which the strategy involves a relatively concentrated portfolio or large positions in particular issuers; and
    • the use of borrowings for investment purposes and derivatives;
  • Cash flows. Short term and long term cash flow projections during both normal and reasonably foreseeable stressed conditions; and
  • Cash on hand. Holdings of cash and cash equivalents, as well as borrowing arrangements and other funding sources.

The requirement to formally, and in a documented way, assess whether a fund's strategy is suitable for an open-end structure is new. While careful not to state a view on which strategies might not be suitable, the SEC suggests examples where some heightened review may be appropriate. These include highly concentrated strategies, strategies that are especially sensitive to stressed conditions and strategies involving instruments with longer than seven-day settlement periods.

The requirement to assess a fund's strategy and portfolio liquidity both in normal and reasonably foreseeable stressed conditions remains somewhat ambiguous and presumably will be developed by each fund over time. The SEC offers only limited guidance on what types of stresses are reasonably foreseeable, but indicates a fund should think beyond market stresses and might consider, for example, geopolitical stresses as well.

The proposed rule would have required cash flow assessments to address a variety of sub-factors, such as

  • Size, frequency and volatility of historical purchases and redemptions of fund shares during normal and stressed periods;
  • The fund's redemption policies;
  • The fund's shareholder ownership concentration;
  • The fund's distribution channels; and
  • The degree of certainty associated with the fund's short term and long term cash flow projections.

While those sub-factors are no longer in the final rule itself, their consideration is encouraged in a section of the accompanying rule release titled "Guidance on Evaluating a Fund's Cash Flow Projections." The SEC encourages development of historical data to identify potential patterns in flows relating to seasonality, tax considerations, advertising, changes in fund performance ratings, and the like. The SEC also considers relevant any notification procedures under which significant shareholders might commit to signal redemption plans to the fund in advance, as well as any redemption fee practices. As a related point from the swing pricing rule release, the SEC comments there that a wider variety of redemption fee terms than are common today might be developed (such as fees that apply only to larger redemptions or only to larger redemptions presented to a fund without advance notice).

Periodic Review of Liquidity Risk

The rule requires each fund to periodically review the fund's liquidity risk. The rule does not include prescribed review procedures, except that the review must be performed at least annually and must take into account the same factors used in the original assessment. A fund's highly liquid investment minimum also is required to be reviewed annually, so both reviews will be performed together in many cases. The SEC suggests a fund's liquidity risk management program also might specify circumstances that trigger reviews more frequently than annually.

The Highly Liquid Investment Minimum

Setting the Minimum

Each fund subject to this element of the rule will determine its own highly liquid investment minimum, taking into account the liquidity risk factors described above (investment strategy, fund flows, etc.). "In-Kind ETFs" – as defined in the ETF discussion later in the alert – are exempt, as are funds that invest primarily in highly liquid investments.

The required minimum will be specified as a percentage of the fund's net assets to be invested in "highly liquid investments" – meaning cash held by a fund and any investment that the fund reasonably believes is convertible into cash in current market conditions within three business days without significantly changing the market value of the investment.

A fund is required to maintain a written record of how the fund's highly liquid investment minimum is determined (including how it is reset over time). The record should reflect an assessment of each of the listed factors that go into setting the minimum.

Compliance with the Minimum

The proposed version of the minimum generated considerable industry question as to how it would be applied in practice. Would it be a kind of buffer, a "rainy day" account, or the first source in meeting redemptions? And how would the minimum interact with ordinary portfolio management decisions; are investments represented by the minimum managed differently from the rest of the portfolio?

The answers to these questions might vary somewhat fund to fund, but the SEC is clear that redemptions can be satisfied from any source. There is no presumption that the minimum should be the first source of liquidity.

The agency also made the minimum modestly more flexible when breached by dropping a proposed requirement that a fund not acquire any less liquid asset when doing so would put (or keep) the fund below the minimum. Under the final rule, a fund is permitted to operate in breach of its minimum so long as it reports the breach. A breach will be reported promptly to the SEC on new Form N-LIQUID (with those reports treated confidentially), with corresponding fund board reporting.

Periodic Review of the Minimum

A fund will periodically (and at least annually) review the adequacy of the fund's highly liquid investment minimum, and in conducting its review will take into account the factors required whenever considering minimum. A fund can establish a more frequent review period than annual if it chooses, and in addition could review the minimum on an ad hoc basis as conditions demand. The fund's investment adviser or officers administering the fund's liquidity risk management program will be required to submit written reports to the fund's board concerning the adequacy of the fund's liquidity risk management program, including the fund's highly liquid investment minimum, and the effectiveness of its implementation.

15% Limit on Illiquid Investments

Largely codifying the existing 15% illiquid test established by past SEC guidance, the new rule prohibits a fund from acquiring an illiquid investment if, immediately after the acquisition, the fund would have invested more than 15% of its net assets in illiquid investments. The provision does not require a fund to divest any holdings if illiquid investments rise above the 15% threshold.

An illiquid investment will be defined as any investment that the fund reasonably expects cannot be sold or disposed of in current market conditions in seven calendar days or less "without significantly changing the value of the investment." In what will be one of the most important changes flowing from the rulemaking, the SEC will require a fund to consider whether "the size of a fund's holdings could significantly impact the fund's ability to manage its liquidity risk" and to carry that consideration through to classifying an investment's liquidity. In other words, going forward, a fund will take into account the size of a fund's position and the depth of the trading market for the investment in determining whether an investment is liquid versus illiquid. The SEC acknowledges that funds often do not take these factors into account under the current 15% test and that, accordingly, for some funds the percentage of their investments treated as illiquid will go up as the new requirements go into effect.

That change in approach will require new judgment calls. Notably, must a fund assume that it will sell out of its position in full when considering whether a sale will "significantly change" an investment's value or can the fund plan for only a partial sale? Per the SEC, the answer is that a fund should assume it will trade a "reasonably anticipated" portion of its position. What is reasonably anticipated then appears to reflect both historical trading patterns for the fund and its expectations for how cash flows or market conditions might affect its trading. For example, the SEC says a fund with stable cash flows and significant cash holdings operating in stable conditions might assume it has less need to sell out of its positions in size, while the opposite conclusion might be reached for a fund with concentrated and/or relatively illiquid holdings, unpredictable cash flows and operating in deteriorating market conditions.

Policies and Procedures Regarding Redemptions In-Kind

The SEC believes a fund that engages in or reserves the right to engage in in-kind redemptions should adopt and implement written policies and procedures for those redemptions, and this requirement has been included in the rule. The SEC expects these policies and procedures to address circumstances under which the fund would consider redeeming in-kind and the process for redeeming in-kind. Among other suggestions, the SEC would like funds to discuss the mechanical aspects of redemptions in-kind with their larger shareholders in advance of actually needing to process such a distribution. The SEC also would like funds to have a defined view on how securities will be selected for distribution in-kind (e.g., a pro rata distribution versus a non-pro rata distribution).

Policies and Procedures Regarding Cross-Trades

The SEC offered new guidance on cross-trades, which the agency believes can be a "useful liquidity risk management tool" while also having "significant potential for abuse." At bottom, the agency appears to believe that a fund's policies and procedures might put a cross involving a less liquid security to greater scrutiny than a cross involving a more liquid security. That is so both in terms of testing availability and reliability of pricing and, at least by implication, considering how such a cross might affect a fund's relative liquidity profile.

CLASSIFYING LIQUIDITY OF A FUND'S PORTFOLIO POSITIONS

A fund will classify the liquidity of each of the fund's investments, including derivatives, on an at least monthly basis. In doing so, the fund will consider the number of days within which the investment is convertible to cash without significantly changing the market value of the investment. Four classifications will be used: highly liquid, moderately liquid, less liquid and illiquid. As proposed, there would have been six classifications instead of four, and a more precise assessment as to value impact on sale would have been required. The final rule tests whether the sale of the investment would "significantly change" market value while the proposed test would have been whether the sale would "materially affect" value. In-Kind ETFs are exempt from the classification requirements.

Liquidity Categories

Based on a determination of market impact under this standard, the fund will classify each of its investments into one of these four categories:

  • Highly liquid investments – Convertible to cash within 3 business days.
  • Moderately liquid investments – Convertible to cash in more than 3 business days but within 7 calendar days.
  • Less liquid investments – Saleable within 7 calendar days, but with cash settlement taking longer than that.
  • Illiquid investments – Not saleable within 7 calendar days.

The SEC originally proposed that classification be on a share-by-share basis. For example, under that approach, if a fund held a block of an issuer's shares, it might determine that a number of those shares (e.g., the first 50%) were convertible to cash in one period with the remainder convertible to cash in a longer period. That share-by-share analysis is no longer required. As noted above, however, the rule now requires that market depth and position size track into a fund's classification methodologies, with outcomes that may be similar in some cases to the proposed share-by-share test.

While position level liquidity classifications will be reported to the SEC on new Form N-PORT, that information will – in a change from the rule proposal – be kept confidential by the SEC. Aggregate information on a fund's holdings in each of the four liquidity classifications still will be reported publicly.

Factors to Consider in Classifying Liquidity of a Position

The agency proposed a required list of factors to consider when classifying the liquidity of a position, as follows:

  • Existence of an active market for the asset, including whether the asset is listed on an exchange, as well as the number, diversity and quality of market participants;
  • Frequency of trades or quotes for the asset and average daily trading volume of the asset (regardless of whether the asset is a security traded on an exchange);
  • Volatility of trading prices for the asset;
  • Bid-ask spreads for the asset;
  • Whether the asset has a relatively standardized and simple structure;
  • For fixed income securities, maturity and date of issue;
  • Restrictions on trading of the asset and limitations on transfer of the asset;
  • The size of the fund's position in the asset relative to the asset's average daily trading volume and, as applicable, the number of units of the asset outstanding; and
  • Relationship of the asset to another portfolio asset.

While these factors no longer appear in the final rule, most are discussed in detail in the accompanying rule release, suggesting that as a whole they continue to provide an important framework for the SEC – and thus for funds – in making liquidity classifications.

The release also outlines factors to consider in classifying the liquidity of derivatives. In this regard, the proposal would have treated otherwise liquid assets as encumbered when held on a fund's books as "cover" against its derivatives liabilities under applicable asset segregation procedures. That is no longer the case, but a fund will disclose the percentage of its highly liquid investments that are held as cover, or pledged to satisfy margin requirements, in connection with any of the fund's derivatives that are not themselves classified as highly liquid. The release also clarifies that an interest in a derivative must be classified by a fund whether it is currently showing as an asset or a liability.

Asset Class Liquidity Classifications

While a number of observers requested it, the SEC will not be publishing so-called "asset class liquidity maps." Put differently, the agency is not presuming that certain asset classes will fall within particular liquidity categories.

The new rule does, however, permit a fund to develop its own asset class liquidity maps and to rely on them "as a starting point" in the fund's regular, monthly classification exercise. This is intended to make the effort more operationally efficient and assumes that a fund or its adviser can reach relatively broad generalizations at the asset class level, unless "after reasonable inquiry" there is cause to treat an individual investment within the asset class differently. For an example of how this might work in practice, the release offers the possibility that a fund might treat all high-quality corporate debt in one fashion, but would need to react to information that suggests some subset is more volatile than the broader asset class. The release also cautions that asset classes consisting of "bespoke" or "complex structured" investments generally will not be suitable for asset class level analysis.

Ongoing Review

The proposed rule would have required a fund to review the liquidity classification of each of the fund's portfolio positions on an ongoing basis. This prompted considerable debate as to what an "ongoing" review would look like both in terms of detail and frequency.

The final rule drops the "ongoing review" terminology and instead requires that classifications be reviewed at least monthly and more frequently as needed based on market conditions or other developments. A fund would monitor both market-wide developments and security and asset class specific developments that could demonstrate a need to change the liquidity classification of a portfolio position. Per the SEC, the test is whether these developments would "materially affect" a fund's classification decisions; if so, the classifications – at least those deemed materially affected – warrant revisiting.

BOARD APPROVAL AND DESIGNATION OF PROGRAM ADMINISTRATIVE RESPONSIBILITIES

The SEC opens its discussion of the role of a fund's board of directors as follows: "the role of the board under the [liquidity] rule is one of general oversight" and, in that role, boards will "exercise their reasonable business judgment in overseeing [a fund's liquidity risk management program] on behalf of the fund's investors."

Approval of Liquidity Risk Management Program

The rule requires a fund to obtain initial approval of its written liquidity risk management program from the fund's board of directors, including a majority of independent directors. Directors may satisfy their obligations with respect to this initial approval by reviewing summaries of the liquidity risk management program prepared by the fund's investment adviser or officers administering the program, legal counsel or other persons familiar with the liquidity risk management program. The summaries should familiarize directors with the salient features of the program and provide them with an understanding of how the liquidity risk management program addresses the required assessment of the fund's liquidity risk, including how the fund's investment adviser or officers administering the program determined any fund's highly liquid investment minimum. The SEC suggests that a board will consider the adequacy of the fund's liquidity risk management program in light of the fund's assessed liquidity risk and recent experiences regarding the fund's liquidity, including any redemption pressures experienced by the fund.

It was proposed that a fund would need board approval of any material changes to the fund's liquidity risk management program. That is no longer required; changes will be summarized in an annual report to the board.

It also was proposed that a fund's board would directly approve the fund's highly liquid investment minimum, including changes to the minimum over time. That is no longer the case; the board now approves the overall liquidity risk management program, of which the highly liquid investment is (for many funds) a component, but it generally need not make any explicit finding as to the minimum itself. The exception to that principle is that, while management can reset the minimum over time (subject to describing resets in annual board reporting or more frequently), it can effect a reset when the fund is in breach of the minimum only with the board's agreement.

Designation of Administrative Responsibilities to a Fund's Investment Adviser or Officers

The rule requires a fund to designate the fund's investment adviser or an officer or officers (who, for this purpose, may not be solely portfolio managers of the fund) as persons responsible for administering the fund's liquidity risk management program. Designation must be approved by the fund's board of directors. The SEC encourages fund boards to understand the role of portfolio managers in the course of implementing a fund's liquidity risk management program and any related checks and balances.

Board Reporting

Those responsible for administering the fund's liquidity risk management program are required to prepare an at least annual written report to the board that reviews the adequacy of the program, including any highly liquid investment minimum, and the effectiveness of its implementation. The report also will cover material changes to the program.

The board also receives required breach reports. A breach of the highly liquid investment minimum will be reported at the next regularly scheduled board meeting, unless the shortfall lasts more than seven calendar days in which case current reporting is required. The report will include a brief explanation of the shortfall, the extent of the shortfall, actions taken in response and, for continuing breaches, an explanation of how compliance will be achieved in a reasonable period.

A breach of the 15% limit on illiquid securities is treated even more seriously. For that, board reporting is required within one business, with the report required to cover the extent and causes of the breach and an explanation of how compliance will be achieved in a reasonable period. If the breach continues for 30 days, the board, including a majority of independent directors, is required to assess whether the remedial plan originally presented continues to be in the best interest of the fund. The board must reassess the plan for each 30-day period in which the breach continues. The SEC acknowledges that requiring these board findings is burdensome, but says the risks of "serious consequences" for shareholders in the event of a continuing breach warrants the requirements.

EXCHANGE TRADED FUNDS AND UNIT INVESTMENT TRUSTS

As already noted, the liquidity rule treats ETFs differently from other funds in several ways. First, ETFs are required in assessing liquidity risk to look at several ETF-specific risk factors. Second, the rule exempts "In-Kind ETFs" from the liquidity classification and highly liquid investment minimum requirements. Also, ETFs do not have the option of adopting swing pricing, a concept discussed in the next section of this alert.

An In-Kind ETF is one which processes redemption blocks (often called "creation units") through the distribution of assets to the redeemer in-kind with only a de minimis cash component and which publishes its portfolio to the public daily. In deciding whether one is an In-Kind ETF, the SEC says each ETF will draw its own judgment on what constitutes a de minimis cash component and will take into account both the size of the cash piece and its purpose. The SEC also says an In-Kind ETF must reasonably believe it will be able to deliver in-kind redemptions with only de minimis cash in all market conditions. These judgments are expected to be memorialized in written policies and procedures that provide for periodic reassessments over time.

The ETF-specific liquidity risks that the SEC contemplates will be considered are principally (a) the relationship between the ETF's portfolio and trading of its shares, including through the arbitrage function, and (b) whether the ETF distributes assets in the course of its redemption in-kind activity on a pro rata versus non-pro rata basis. As to the first factor, the SEC is concerned that an ETF's underlying assets might be or become illiquid, which could put pressure on the arbitrage function. The SEC says an impaired arbitrage function could result, in turn, in widening spreads between the price at which the ETF's shares trade on the exchange and the underlying net asset value. Also as to the first factor, the SEC expects an ETF will consider the level of participation in the arbitrage function by the ETF's "authorized participants" (or market makers) and the number of such authorized participants. As to the second factor, the SEC suggests in-kind contributions to and redemptions from the ETF on a largely pro rata basis relative to the ETFs portfolio are more likely to provide for a constant liquidity profile than will in-kind activity that is not conducted pro rata to the portfolio.

Also treated differently are unit investment trusts (UITs). The only requirement for a UIT will be that its principal underwriter or depositor assess at the outset its appropriateness as a vehicle to offer redeemable securities, taking into account the nature of its portfolio and the expected frequency of redemptions. The lighter touch reflects that UITs, like ETFs, often benefit from a trading market in their shares (so that shareholders often can sell their shares on the market for cash rather than relying solely on redemption by the issuer) and the reality that UITs typically are unmanaged after launch, so ill-suited to continuing requirements.

SWING PRICING – NEW RULE 22C-1

"Swing pricing" refers to a process for adjusting a fund's NAV to effectively pass on dealer spreads and transaction fees and charges stemming from net capital activity (i.e., flows into or out of the fund) to the shareholders associated with that activity. The pricing adjustments are intended to protect other shareholders from dilution arising from these costs.

Under the swing pricing rule, mutual funds (but not ETFs or money market funds) are permitted – not required – to establish and implement swing pricing policies and procedures that adjust a fund's NAV under certain circumstances. Before doing so, the fund's board, including a majority of independent directors, must have approved policies and procedures that include certain specified elements, as follows:

  • A specified percentage of the fund's NAV known as the "swing threshold," which, when net purchases or redemptions exceed the threshold, will trigger application of swing pricing; and
  • A "swing factor" amount by which the fund will adjust its NAV either upward (in the event net purchases exceed the threshold) or downward (in the event net redemptions exceed the threshold). The swing factor might vary depending on the degree to which the swing threshold is exceeded, but is always subject to an upper limit not to exceed an impact of 2% of NAV per share.

The upward adjustment when net purchases exceed the swing threshold is intended to cause purchasing shareholders to cover near term costs associated with the fund investing in additional portfolio assets. Conversely, the downward adjustment when net redemptions exceed the threshold is intended to cause redeeming shareholders to cover near term costs associated with the fund selling portfolio assets. In-kind purchases and in-kind redemptions are excluded from the calculation of net purchases and net redemptions for purposes of determining whether a fund's net purchases or net redemptions exceed its swing threshold.

In specifying its swing threshold(s), a fund would consider:

  • The size, frequency and volatility of historical net purchases or net redemptions of fund shares during normal and stressed periods;
  • The fund's investment strategy and the liquidity of the fund's portfolio assets;
  • The fund's holdings of cash and cash equivalents, as well as borrowing arrangements and other funding sources; and
  • The near-term spread, execution and borrowing costs associated with transactions in the markets in which the fund invests (not including market impact costs and with "near term" unspecified but apparently meaning no more than several days).

Note that a fund can have multiple swing thresholds and multiple swing factors so as to fine-tune impacts on the fund depending on different net flow levels or other circumstances. The agency declined to set a swing threshold "floor" (minimum levels to trigger swing pricing), but is clear the floor is greater than zero and swing pricing is not intended to apply each day. A swing factor must be "reasonably related" to anticipated transaction costs.

A fund will be required to review its swing pricing policies and procedures no less frequently than annually, with any material changes reported to the board. Under the procedures, the board is required to designate the fund's adviser or officers responsible for administering the policies and procedures. The fund board also is specifically required to approve the swing threshold(s) and any upper limit on the swing factors used and to review an annual report on swing pricing. The SEC considered not requiring the board to approve upper limits on swing thresholds, but says this is an important fiduciary judgment that must balance shareholder interests in redeemability of the fund's shares with competing shareholder interests in a fair allocation of transaction costs.

Industry Concerns

Swing pricing requires the net cash flows for a fund to be known, or estimated using information obtained after reasonable inquiry, before determining whether to adjust the fund's NAV on any particular day. Funds are directed to apply their swing thresholds only if the requisite flow information is known with "high confidence" based on "reasonable estimates."

Accordingly, swing pricing will work only if there is sufficient access to flow information to meet that "high confidence" test. There are, however, broad-based doubts as to whether that is possible given the fragmented and delayed manner in which flows are reported to funds from their intermediaries in the field. The SEC acknowledges this point but declined to add any requirements for assistance from intermediaries.

The industry also believes swing pricing will work only if it lends itself to substantial automation. On this point, the SEC agrees. Swing thresholds and swing factors will require ongoing monitoring, but the agency sought to avoid a requirement to recalibrate those inputs too frequently.

The most significant change in the swing pricing rule relative to the version proposed is that it no longer goes into effect immediately. Effectiveness is delayed for two years to allow time to deal with industry-wide operational challenges. A related purpose for this period of delayed effectiveness is to address concerns that immediate adoption, likely by only a limited number of players, would have been confusing (or even inequitable if only particular types of firms were ready to move forward right away).

DISCLOSURE AND REPORTING REQUIREMENTS

Form N-1A (Fund Registration Statements)

Among other things, amendments to Item 11 of Form N-1A require a fund to disclose in its prospectus the number of days in which the fund will pay redemption proceeds to redeeming shareholders. No channel-specific disclosure is required. Amendments also require a fund to disclose the methods that the fund uses to meet redemption requests, specifying differences that might be applied in normal versus stressed market conditions.

The SEC also amended Item 6 of Form N-1A to require a fund that uses swing pricing to explain the circumstances under which swing pricing would be used as well as the effects of using swing pricing.

Credit agreements originally were proposed as new required exhibits to be filed with Form N-1A, but the SEC was convinced by industry comments that this risked revealing proprietary information that in any event was likely to be highly technical.

Form N-PORT (New Monthly Reporting)

The SEC adopted new Form N-PORT requiring registered management investment companies and ETFs organized as unit investment trusts, other than registered money market funds or small business investment companies, to electronically file with the SEC monthly portfolio investment information. Form N-PORT is also where a fund will report the liquidity classification of each of the fund's positions in a portfolio investment and where a fund will identify its highly liquid investment minimum.

Submissions on Form N-PORT are filed no later than 30 days after the close of each month. Only information reported for the third month of each fund's fiscal quarter on Form N-PORT is publicly available, and such information is not made public until 60 days after the end of the third month of the fund's fiscal quarter. Liquidity classification information and information on a fund's highly liquid investment minimum will be treated as confidential by the SEC, except that aggregate statements of a fund's holdings in each of the four liquidity categories will be publicly available.

Form N-CEN (New Annual "Census" Reporting)

All registered investment companies, including money market funds but excluding face amount certificate companies, are now required to file new Form N-CEN and provide "census type" information annually. Form N-CEN includes certain questions regarding the use of lines of credit, interfund lending, interfund borrowing and swing pricing – all of which the SEC views as relevant to a fund's liquidity position. Form N-CEN also will require In-Kind ETFs to self-identify themselves as such on the form.

Form N-LIQUID (New Breach Reporting)

Open-end registered investment companies, including In-Kind ETFs but not money market funds, will file nonpublic breach reports with the SEC. Breaches that will be reported cover the 15% illiquid investment limit and a fund's highly liquid investment minimum.

COMPLIANCE DATES

Liquidity Risk Management Program

For larger entities (funds that together with other investment companies in the same "group of related investment companies" have net assets of $1 billion or more as of the end of the most recent fiscal year), the Rule 22e-4 compliance date is December 1, 2018. The compliance date for smaller entities is December 1, 2019.

Swing Pricing

A fund is not allowed to engage in swing pricing until the rule becomes effective, which will be two years from the date of the rule's date of the publication in the Federal Register, so late 2018.

Amendments to Form N-1A

All initial registration statements on Form N-1A, and all post effective amendments that are annual updates to effective registration statements on Form N-1A, must comply with the new form provisions from June 1, 2017 forward.

Form N-PORT

Similar to the tiered compliance dates for the liquidity classification requirements for fund liquidity risk management programs under Rule 22e 4 (discussed above), the SEC provides for a tiered set of compliance dates based on asset size for new Form N PORT. For larger entities, reporting requirements apply for June 1, 2018 forward. For smaller entities, the SEC provides for an extra 12 months (until June 1, 2019).

Form N-CEN

Compliance with Form N-CEN is required from June 1, 2018 forward.

Footnotes

1 In a 1995 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).

2 Revisions of Guidelines to Form N 1A, Investment Company Act Release No. 18612 (Mar. 12, 1992).

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