Earlier today, the U.S. Securities and Exchange Commission (SEC) unanimously adopted a new rule and amendments to certain rules and forms that will require registered open-end investment companies, including mutual funds and exchange-traded funds (ETFs), to establish liquidity risk management programs. In addition, the SEC adopted, by a 2-to-1 vote, (1) new rules and forms, as well as amendments to certain rules and forms, to modernize the reporting of information by registered investment companies; and (2) rule and form amendments that will permit registered open-end investment companies to use “swing pricing” under certain circumstances.
The new rules and rule and form amendments represent significant changes to current liquidity management practices and reporting requirements and will require significant changes to fund operations, as well as disclosure and reporting requirements. A summary of the new rules and rule and form amendments is provided below.1
A copy of the SEC’s “fact sheet,” as well as the press release, is available here; a copy of the liquidity risk management release is available here; a copy of the reporting modernization release is available here; and a copy of the swing pricing release is available here.
LIQUIDITY RISK MANAGEMENT
The new rule – Rule 22e-4 – is generally intended to: (1) promote effective liquidity risk management for open-end funds; (2) limit the risks that open-end funds would be unable to meet shareholder redemption requests; and (3) minimize the potential dilutive impact of shareholder transactions. According to SEC Chair Mary Jo White, “[m]anaging the liquidity of an investment portfolio is a core responsibility” of open-end funds, and “careful management of portfolio liquidity is essential for meeting” their obligations to satisfy shareholder redemption requests on a daily basis.
Liquidity Risk Management Programs
The new rule will require open-end funds, including ETFs but excluding money market funds, to adopt liquidity risk management programs. However, ETFs that qualify as so-called “in-kind ETFs” will be excluded from certain requirements. An open-end fund’s liquidity risk management program must be approved by the fund’s board, and must include several elements:
- Assessment, Management and Periodic Review of Fund’s Liquidity Risk. Relying on certain specified factors, open-end funds will be required to assess, manage and periodically review their liquidity risk. Under the new rule, liquidity risk is defined as the risk that an open-end fund could not meet shareholder redemption requests without significant dilution to remaining shareholders.
- Liquidity Classification of Fund Investments. The new rule will require an open-end fund to classify each of its portfolio investments into one of four liquidity categories – highly liquid investments, moderately liquid investments, less liquid investments and illiquid investments – based on the number of days in which the fund reasonably expects the investment would be convertible to cash under current market conditions without significantly changing the investment’s market value. In making this determination, open-end funds must consider, among other factors, the depth of the market for the investment. Notably, open-end funds will be permitted to classify investments by asset class (rather than on an investment-by-investment basis), unless market, trading or investment-specific considerations with respect to a particular investment are expected to significantly affect the liquidity characteristics of that investment. This represents a departure from the proposed rule, which would have required that funds classify each portfolio position (or portion of a position) into one of six liquidity categories, based on the amount of time required to convert that position to cash without a market impact.
- Determination of Highly Liquid Investment Minimum. Open-end funds will be required to determine a minimum percentage of net assets that must be invested in highly liquid investments. Highly liquid investments are generally defined as cash or investments that are reasonably expected to be converted to cash within three business days without significantly changing the investment’s market value. Open-end funds will also be required to implement policies and procedures for responding to a shortfall in the highly liquid investment minimum. These procedures must require board reporting in the event of such a shortfall. The final rule is, in some respects, more flexible than the proposed rule. For example, under the proposed rule, open-end funds would have been prohibited from acquiring any less liquid asset if, immediately after the acquisition, the three-day liquid asset minimum (the analog of the final rule’s highly liquid investment minimum) would be violated.
- Board Approval and Review. An open-end fund’s board will be required to approve its liquidity risk management program and the designation of the fund’s adviser or officer to administer the program. In addition, an open-end fund’s board will be responsible for reviewing a written report that discusses the adequacy of the fund’s liquidity risk management program and the effectiveness of its implementation. This report must be provided to the board at least annually.
- 15% Limitation on Illiquid Investments. The SEC adopted a 15% limitation on open-end funds’ purchases of illiquid investments (largely as proposed). However, the definition of investments considered illiquid and subject to this 15% limit has been enhanced and substantially harmonized with the classification system described above. Under the new rule, an illiquid investment is an investment that an open-end fund reasonably expects cannot be sold under current market conditions in seven calendar days without significantly changing the market value of the investment. Open-end funds must review their illiquid investments at least monthly. If an open-end fund breaches the 15% limit, the occurrence must be reported to the board, together with an explanation of how the fund intends to bring its illiquid investments back into compliance with the 15% limit within a reasonable period of time. Further, if the breach it is not resolved within 30 days, the board must assess whether the plan presented to it is in the best interest of the fund and its shareholders.
- New Form N-LIQUID. In a departure from the proposed rule, an open-end fund will be required to file with the SEC on new Form N-LIQUID when the fund’s level of illiquid assets exceeds the 15% limit or when the fund’s highly liquid investments fall below its minimum for more than a brief period of time. This filing would be confidential.
Disclosure and Reporting Requirements
The final rules include new disclosure and reporting requirements relating to liquidity risk management and swing pricing. For example, Form N-1A is amended to enhance disclosure regarding fund practices for meeting redemption requests and to address swing pricing in the context of performance reporting. Open-end funds will be required to report on Form N-PORT the percentages of their portfolios represented by each of the four liquidity categories. Open-end funds will also be subject to confidential reporting requirements regarding position-level liquidity and their highly liquid investment minimums. New Form N-CEN (see discussion below) will require that open-end funds make certain disclosures relating to their lines of credit and interfund lending, as well as swing pricing. In addition, ETFs will be subject to certain reporting requirements on Form N-CEN, including whether they are an “in-kind ETF.”
The compliance date is December 1, 2018 (for fund complexes with $1 billion or more in net assets) and June 1, 2019 (for fund complexes with less than $1 billion in net assets). This relatively long compliance period is likely intended to allow the industry to put in place the necessary elements to comply with this far-reaching new rule.
The SEC adopted new rules and forms, as well as amendments to current rules and forms, which are designed to modernize the reporting of information provided by funds and to improve the quality and type of information that funds provide to the SEC and investors. David Grim, Director of the Division of Investment Management, described these amendments as “transformational” and a “game changer.” The new rules and forms, as well as the amendments to current rules and forms, will require that portfolio and census information be provided in a “structured data format,” in order to allow the SEC to efficiently analyze data to respond to market- and fund-specific events.
New Form N-PORT
Consistent with the proposal issued in 2015 (Modernization Proposal), the SEC adopted a new form, Form N-PORT, which will require all funds (with certain exceptions) to provide portfolio-wide and position-level holdings information, which will include, according to the SEC “fact sheet”: (1) data related to the pricing of portfolio securities; (2) information regarding repurchase agreements, securities lending activities, and counterparty exposures; (3) terms of derivatives contracts; and (4) discrete portfolio- and position-level risk measures to better understand fund exposure to changes in market conditions. Although a fund will be required to file Form N-PORT with the SEC on a monthly basis, only information contained on Form N-PORT for the last month of the fund’s fiscal quarter will be made public, on a 60-day delay. The amendments rescind Form N-Q, the form on which funds currently report their quarterly portfolio holdings for their first and third fiscal quarters.
New Form N-CEN
The SEC adopted new Form N-CEN, a form that will require funds to provide census-type data similar to the data reported on current Form N-SAR, including: information regarding service providers, new disclosures relating to matters submitted to shareholders and securities lending information. The amendments rescind Form N-SAR. Form N-CEN will be required to be filed annually rather than semi-annually as is currently required for Form N-SAR for most funds. In response to comments relating to the proposed 60-day filing deadline, the SEC extended the filing deadline, which will require funds to file Form N-CEN within 75 days of a fund’s fiscal year-end.
Amendments to Regulation S-X and Form N-1A
The amendments make certain modifications to Regulation S-X that will require enhanced and standardized disclosures in financial statements, including schedules of derivative holdings as well as other derivatives information that historically has been disclosed in the notes to the financial statements. Additionally, the amendments will require that registration statements contain disclosure relating to funds’ securities lending activities (including income and fees from securities lending and payments made to securities lending agents for the previous fiscal year).
Delay of Potential Rulemaking with Respect to Rule 30e-3
The Modernization Proposal included new Rule 30e-3, which would have permitted, but not required, funds to provide shareholder reports on their websites (subject to certain notice requirements) in lieu of the current shareholder report mailing requirement, unless a shareholder requested to receive the reports by mail. The SEC determined not to take action at this time with respect to this rule proposal. SEC Chair Mary Jo White explained that the staff continues to study proposed Rule 30e-3: “Among other considerations, the staff is exploring ways to better protect investors who prefer to receive printed shareholder reports in the mail and the processing fees that funds, and ultimately their investors, must pay to broker-dealer intermediaries.” In voting against the amendments, Commissioner Michael Piwowar noted that Rule 30e-3 was a key component of the Modernization Proposal and stated that he believed it should have been included in the amendments.
Fund complexes with net assets of $1 billion or more will be required to begin filing reports on new Forms N-PORT and N-CEN after June 1, 2018, while 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. The changes to Regulation S-X and Form N-1A will take effect on August 1, 2017.
SWING PRICING PROPOSAL
A rule amendment will permit (but not require) open-end funds (with the exception of money market funds and ETFs) to use “swing pricing” subject to board approval and review. Swing pricing refers to a mechanism that would adjust the net asset value of an open-end fund’s shares to effectively pass on the costs associated with purchases or redemptions of fund shares to the purchasing or redeeming shareholder. An open-end fund that uses swing pricing will reflect in its net asset value a specified amount (swing factor), once the amount of net purchases or net redemptions exceeds a specified percentage of the fund’s net asset value (swing threshold). An open-end fund’s swing pricing policies and procedures must specify the process for how the fund’s swing factor and swing threshold will be determined (taking into account certain considerations) and establish and disclose an upper limit on the swing factor used (which may not exceed 2% of net asset value per share). Open-end funds will not be permitted to use swing pricing until two years after publication of the amendment in the Federal Register. During the comment period, industry participants had questioned whether swing pricing would be feasible because of the costs and operational challenges associated its implementation. It remains to be seen whether these potential obstacles can be overcome.