On September 22, 2015, the SEC announced a proposed rule that would require open-end mutual funds (excluding money market funds) and exchange-traded funds to adopt liquidity risk management programs. Under proposed rule 22e-4, a fund would be required to develop a risk management program that is designed to assess and manage the fund’s liquidity risk – the risk that the fund could not meet requests to redeem shares issued by the fund under normal, or reasonably foreseeable stressed conditions, without materially affecting the fund’s net asset value (NAV). Additionally, the SEC announced proposed amendments to rule 22c-1 that would give funds the option to adopt “swing pricing,” whereby transacting shareholders would bear the costs associated with fund transactions made in connection with their purchases or sales of fund shares.
Portfolio Asset Classifications
Under proposed rule 22e-4, a fund would be required to classify and conduct an ongoing review of the liquidity of its portfolio assets based on the number of days the fund’s position could be converted into cash at a price that does not materially affect the value of the position immediately prior to its sale. The categories would be:
- One business day
- Two to three business days
- Four to seven calendar days
- Eight to 15 calendar days
- Sixteen to 30 calendar days
- More than 30 calendar days
Factors to be considered in determining an asset’s liquidity or a portion of its liquidity under proposed rule 22e-4 include:
- The existence of an active market, including whether it is listed on an exchange
- Frequency of trades or quotes and average daily trading volume
- Price volatility
- Bid-ask spreads
- The asset’s structure
- Maturity and date of issue (for fixed income securities)
- Restrictions on trading or transfer of the asset
- The size of the fund’s position relative to the asset’s average daily trading volume
- Relationship of the asset to another portfolio asset
Proposed rule 22e-4 would also codify the SEC’s guidelines that illiquid assets are limited to 15 percent of a fund’s assets. Classifications of a fund’s portfolio assets would be reported on Form N-PORT.
Assessment & Periodic Review of Liquidity Risk
A fund would be required to periodically assess its liquidity risk based on several factors outlined in the proposed rule. In the proposed rule release, the SEC states that it believes these factors are not meant to be exhaustive and that a fund may take into account other considerations. However, the enumerated factors should be considered as the minimum set of considerations under the proposed rule. The suggested factors to consider in determining a fund’s liquidity risk include:
- Short-term and long-term cash flow projections (taking into account historical purchase/redemption activity during normal and stressed periods, redemption policies, distribution channels and shareholder ownership concentration)
- Investment strategy and liquidity of portfolio assets
- Use of borrowings and derivatives for investment purposes
- Cash and cash equivalent holdings, as well as borrowing arrangements and other funding sources
Three-Day Liquid Asset Minimum
Using the liquidity risk factors listed above, a fund would also be required to establish a three-day liquid asset minimum. This amount would reflect the amount of assets that could be converted into cash within three business days at a price that would not materially affect the value of the assets immediately prior to sale. The SEC believes this three-day minimum is appropriate in light of the fact that shareholder transactions of fund shares are often effected by a broker-dealer. In such an instance, these trades are subject to the three-day settlement period under rule 15c6-1 of the Securities Exchange Act of 1934. Funds would be required to document their assessment of the suggested liquidity risk factors in determining the three-day liquid asset minimum and would need to review this determination at least annually. A fund’s three-day liquid asset minimum would be reported on Form N-PORT.
Board Approval & Review
A fund’s liquidity risk management program and the determination of its three-day liquid asset minimum would require initial approval by the fund’s board, including a majority of its independent members. The board may satisfy its obligations by reviewing summaries of a fund’s liquidity risk management program provided by the fund’s investment adviser or officers administering the program. Material changes to a fund’s liquidity risk management program and its three-day liquid asset minimum would also need board approval. In addition, the board would be required to review a summary report from the fund’s adviser or those officers administering the liquidity risk management program that discusses the adequacy and effectiveness of the fund’s liquidity risk management program and its three-day liquid asset minimum at least annually.
Under proposed amended rule 22c-1, a fund may elect to implement “swing pricing” under certain circumstances. Swing pricing involves adjusting a fund’s NAV per share upward for purchasing shareholders and downward for redeeming shareholders. The difference between the swing price and the fund’s NAV per share would be used to mitigate the dilution of existing shareholders resulting from the transaction-related costs incurred by a fund from investing additional proceeds received from share purchase orders or selling portfolio assets to meet redemptions. If using swing pricing, a fund would adjust its NAV per share by a specified swing factor once the level of net purchases into or net redemptions from the fund exceeds a certain threshold. Board approval of swing pricing policies and procedures along with any changes to such policies or procedures would be required. The board also would be required to designate the fund’s investment adviser or officers responsible for administering the swing pricing policies and procedures, and for determining the swing factor in the event the swing threshold is breached. If a fund adopts swing pricing, it would need to disclose the circumstances under which swing pricing would be used and its effects in the fund’s prospectus.
Comments to the proposed rules are due 90 days after they are published in the Federal Register. If adopted, the compliance dates for the proposed liquidity risk management program rule would be 18 months after the effective date for fund families with assets of $1 billion or more, and 30 months after the effective date for fund families with less than $1 billion in net assets.
The proposed swing pricing rule would be available for funds to consider after the effective date and would not have a compliance date because the use of swing pricing would be voluntary.