Investment Funds, Advisers and Derivatives Update
On October 13, 2016, the Securities and Exchange Commission (the SEC) adopted new rules and rule amendments relating to liquidity risk management and swing pricing.1 The new and amended rules are part of an effort to promote effective liquidity risk management across the registered open-end investment company (open-end fund or fund) industry, reduce the risk of dilution of open-end fund shareholders resulting from purchases and sales of fund shares by other shareholders, and enhance disclosure regarding fund liquidity and redemption practices. The rules will have a significant impact on registered open-end funds, including exchange-traded funds (ETFs), and are designed to reduce the risk that funds will not be able to meet shareholder redemptions and to mitigate potential dilution of the interests of fund shareholders.
In summary, the SEC adopted the following new or amended rules and forms:
- New Rule 22e-4. New Rule 22e-4 under the Investment Company Act of 1940, as amended (the Act), requires registered open-end funds,2 including ETFs and In-Kind ETFs,3 but excluding money market funds,4 to:
- Adopt and implement, with initial board approval, a written liquidity risk management program (the Program) reasonably designed to assess and manage the fund’s liquidity risk.5 Required components of the Program include:
- A requirement that open-end funds assess, manage and periodically review (at least annually) their liquidity risk using various factors;
- A requirement that open-end funds (but not In-Kind ETFs) classify the liquidity of each of their investments as "highly liquid," "moderately liquid," "less liquid" or "illiquid";
- A requirement that open-end funds (but not In-Kind ETFs) determine and periodically review a minimum percentage of fund net assets that must be invested in "highly liquid" investments and adopt policies and procedures for responding to a shortfall below the minimum percentage;
- A limitation on any open-end fund investing in the "illiquid investment" category if immediately after such acquisition, the fund would have invested more than 15% of its net assets in illiquid investments that are assets; and
- A requirement that open-end funds that reserve the right to engage in redemptions in kind adopt and implement written policies and procedures regarding how and when they will use redemptions in kind.
- Designate, with board approval, person(s) to administer the Program.
- Prepare, for board review, a written report prepared by the person(s) designated to administer the Program, that addresses the operation of the Program and assesses its adequacy and the effectiveness of its implementation.
- Adopt and implement, with initial board approval, a written liquidity risk management program (the Program) reasonably designed to assess and manage the fund’s liquidity risk.5 Required components of the Program include:
- Amendments to Rule 22c-1. Amended Rule 22c-1 under the Act permits, but does not require, open-end funds, other than ETFs and money market funds, to use "swing pricing" (as defined below) under certain circumstances.
- New Form N-LIQUID. Open-end funds, excluding money market funds and only including In-Kind ETFs when applicable, are required to file new Form N-LIQUID within one business day upon the occurrence of certain liquidity triggers.
- New requirements for Form N-CEN. New requirements provide that open-end funds are required to report on Form N-CEN, among other things, information on the use of credit facilities, interfund lending, interfund borrowing and swing pricing. N-CEN requires disclosure of whether the fund engaged in swing pricing during the applicable reporting period, and if so, the swing factor upper limit.
- New requirements for Form N-PORT. As applicable, open-end funds are required to report on Form N-PORT, among other things, information relating to the liquidity classification of a fund's portfolio investments and the use of highly liquid investments to cover derivatives transactions.
- Amendments to Form N-1A. Open-end funds are required to provide additional information in their registration statements on Form N-1A about their share redemption procedures and their use of swing pricing, if applicable.
- Amendments to Regulation S-X. Amendments to Regulation S-X require disclosure of the open-end fund's net asset value per share, as adjusted pursuant to the fund’s swing pricing policies and procedures (the Swung NAV) in the financial highlights section of the financial statements (in addition to the generally accepted accounting principles (GAAP) NAV). However, the SEC did not adopt the proposed amendment to Regulation S-X that would have required disclosure of the Swung NAV in the fund's Statement of Assets and Liabilities. The Swung NAV may be disclosed if the fund believes it beneficial for shareholders, but an explanation of the differences between Swung NAV and GAAP NAV must be included.
I. Background: Increased Liquidity Risks in an Evolving Fund Industry
The SEC's increased concern regarding liquidity risk is due in part to the growth of assets held by funds that are pursuing strategies that are focused on less liquid asset classes, such as certain fixed income or alternative investment strategies.6 An open-end fund that holds significant amounts of less liquid securities raises the concern that if significant redemptions occur, the more liquid assets will be disposed of first, exposing the remaining shareholders to a fund with even less liquid assets. If such less liquid assets are sold to fund redemptions, the fund may only be able to sell such assets at prices that incorporate a significant discount to the assets' stated value, and such sales may materially affect the fund's NAV. The SEC believes that these factors can create incentives in times of liquidity stress for shareholders to redeem quickly to avoid further losses (otherwise known as a "first-mover advantage"). Whether motivated by first-mover advantage or other factors, a fund that fails to adequately manage liquidity may not be able to meet redemption obligations without causing significant dilution of the remaining shareholders.
Another source of potential dilution noted in the Liquidity Release are the transaction costs that an open-end fund bears when significant fund redemptions or purchases are made, as the fund acquires portfolio assets with the proceeds of purchases of fund shares or disposes of portfolio assets to fund redemptions. Those costs are born indirectly by all the fund's remaining shareholders, thus potentially diluting the interests of non-redeeming shareholders.
An additional stress on fund liquidity is the decrease over time in the trade settlement period for fund shares. Most open-end funds are redeemed through broker-dealers. Pursuant to Section 22(e) of the Act, funds generally have up to seven days to pay redemption proceeds after tender of the security. However, fund shares that are traded through a broker-dealer must comply with Rule 15c6-1 under the Securities Exchange Act of 1934. Because Rule 15c6-1 requires a broker-dealer to settle a trade in three business days (T+3), fund shares redeemed through a broker-dealer must be settled in three business days. In addition, as noted in the Liquidity Release, some funds disclose in their prospectuses that they generally satisfy redemption requests in less than three business days.
The Liquidity Release notes that while standard settlement periods for securities trades in the markets have generally fallen significantly over the past several decades, and investor expectations that redemption proceeds will be paid promptly have risen, settlement periods for other securities held in large amounts by certain funds (e.g., some bank loans and loan participations) have not fallen correspondingly. This creates a potential timing mismatch between the timing of the receipt of cash upon sale of these assets and the payment of cash for shareholder redemptions.
"Overall, the evolution of the market towards shorter settlement periods — and corresponding investor expectations — combined with open-end funds holding certain securities with longer settlement periods have raised concerns for us about whether fund portfolios are sufficiently liquid to support a fund's ability to meet its redemption and other legal obligations," the SEC stated in the Liquidity Release.
II. Investment Company Liquidity Risk Management Programs – Final Rule 22e-4
A. Scope of Final Rule
Final Rule 22e-4 is designed to promote effective liquidity risk management throughout the open-end fund industry, thereby reducing the risk that funds will be unable to meet their redemption obligations and mitigating dilution of shareholder interests. The SEC also adopted a new form and form amendments that are intended to enhance reporting and disclosure regarding fund liquidity practices.
Many commenters objected to certain aspects of Rule 22e-4 as originally proposed,7 especially the liquidity classification requirement, the three-day liquid asset minimum and the requirement that funds publicly disclose the liquidity of each portfolio position. After consideration of the many comments received, the SEC adopted the proposed new rule with a number of modifications.
B. Written Liquidity Risk Management Program – Required Elements
As adopted, Rule 22e-4 requires open-end funds, including ETFs but not including money market funds, to adopt and implement a Program, which must be reasonably designed to assess and manage the fund's liquidity risk. "Liquidity risk" is defined as "the risk that the fund could not meet requests to redeem shares issued by the fund without significant dilution of remaining investors' interests in the fund." Although the term "significant dilution" is not defined in the final rule, the Liquidity Release explains that the term "significant" is not meant to reference slight NAV movements, but rather, a level of dilution that would harm remaining investors' interests, although not necessarily to the level of harm that would be caused by a fire sale. The Program must be initially approved by the fund's board and must include policies and procedures reasonably designed to incorporate the following five elements:
1. Assessment, Management and Periodic Review of Liquidity Risk
As part of their Program, funds must assess, manage and periodically review (at least annually) their liquidity risk. The following liquidity risk factors (the Liquidity Risk Factors) must be considered, to the extent they are applicable:
- Strategy considerations. Investment strategy and liquidity of portfolio investments during both normal and reasonably foreseeable stressed conditions; the appropriateness of the investment strategy for an open-end fund; the extent to which the strategy involves a relatively concentrated portfolio or large positions in particular issuers; the use of borrowings for investment purposes; and the use of derivatives;
- Cash flow considerations. Short-term and long-term cash flow projections during both normal and reasonably foreseeable stressed conditions (for which the Liquidity Release lists five cash flow guidance considerations, including: the size, frequency and volatility of historical purchases and redemptions during normal and reasonably foreseeable stressed periods; the fund's redemption policies; the fund’s shareholder ownership concentration; distribution channels; and the degree of certainty associated with such cash flow projections);
- Available cash. Holdings of cash and cash equivalents, as well as borrowing arrangements and other funding sources; and
- ETF considerations. With respect to ETFs only, (i) the relationship between the ETF's portfolio liquidity and the way in which, and the prices and spreads at which, ETF shares trade, including the efficiency of the arbitrage function and the level of active participation by market participants (including authorized participants); and (ii) the effect of composition of creation and redemption baskets on the overall liquidity of the ETF’s portfolio.
A fund may take into account considerations in addition to the Liquidity Risk Factors set forth above, and must do so to the extent necessary to adequately assess and manage its liquidity risk. The Liquidity Release states that stress tests that analyze the Liquidity Risk Factors could be particularly useful in evaluating a fund's liquidity risk.
2. Classifying the Liquidity of a Fund’s Portfolio Positions
Funds (excluding In-Kind ETFs), after taking into account relevant market, trading and investment-specific considerations, must classify each of their portfolio investments, including derivatives, into one of four classification categories as follows:
- Highly liquid investment category: includes cash and any investment that the fund reasonably expects to be convertible to cash in current market conditions in three business days or less without the conversion to cash significantly changing the market value of the investment;
- Moderately liquid investment category: includes any investment that the fund reasonably expects to be convertible to cash in current market conditions in more than three calendar days but in seven calendar days or less, without the conversion to cash significantly changing the market value of the investment;
- Less liquid investment category: includes any investment that the fund reasonably expects to be able to sell or dispose of in current market conditions in seven calendar days or less without the sale or disposition significantly changing the market value of the investment but where the sale or disposition is reasonably expected to settle (i.e., the fund will receive its cash) in more than seven calendar days; and
- Illiquid investment category: includes any investment that the fund reasonably expects cannot be sold or disposed of in current market conditions in seven calendar days or less without the sale or disposition significantly changing the market value of the investment.
In a significant departure from the Liquidity Proposing Release, the number of classification categories has been reduced to four from six. Also, contrary to the Liquidity Proposing Release, final Rule 22e-4 specifically permits funds to make liquidity classifications according to asset class (e.g., high credit quality corporate bonds), except that if the fund learns that a particular investment has been affected by adverse events at the issuer such that the investment has different liquidity characteristics than the asset class as a whole, the fund is required to treat that investment as an exception and classify it separately. The SEC cautioned against using very general asset class categories (e.g., equities, fixed income and other).
Final Rule 22e-4 requires a fund to determine whether trading varying portions of a position in a particular investment or asset class, in sizes that the fund would reasonably anticipate trading, would reasonably be expected to significantly affect its liquidity, and if so, take this into account when making a liquidity classification. However, in a departure from the Liquidity Proposing Release, a fund must apply each category to the entirety of the fund's position in that investment, rather than assign multiple categories to multiple portions of the same position depending upon the length of time it would take to convert each portion to cash.
With respect to each of the four categories, the Liquidity Release does not define what it means for a fund to convert to cash or dispose of an investment without "significantly changing the market value" of the investment, instead leaving it to funds to address in their policies and procedures what the fund would consider to be a significant change in market value. The SEC expressed its belief, however, that a standard of "fire sale discounting" would be too high of a value impact threshold whereas very small movements in price arising from a sale would be too low a threshold.
The Liquidity Release clarifies that funds are only required to consider the market value impact of a hypothetical sale of each investment, and may disregard the effects of general market movements between the time of each investment's last valuation and the time the investment is categorized.
The Liquidity Release discusses specific factors that a fund may find useful in conducting its required review of relevant market, trading and investment-specific considerations in classifying the liquidity of each of its investments. The Liquidity Release explains that these factors, along with the new regulatory requirements discussed therein, are meant to replace earlier SEC guidance8 on identifying illiquid assets, including the guidance that boards are responsible for determining if a security is liquid or illiquid. These factors, in a departure from the Liquidity Proposing Release, are offered as guidance and not as mandatory parts of Rule 22e-4, include the following:
- Existence of an active market;
- Frequency of trades or quotes and average daily trading volume;
- Volatility of trading prices;
- Bid-ask spreads;
- Whether the investment has a relatively standardized and simple structure;
- For fixed income securities, maturity and date of issue; and
- Restrictions on trading and limitations on transfer.
Funds must review the classifications at least monthly in connection with reporting them on Form N-PORT, and must review them more frequently with respect to particular investments if changes in relevant market, trading and investment-specific considerations are reasonably expected to materially affect one or more of the investments' classifications. If a fund's highly liquid investments are segregated to cover, or pledged as margin for, derivatives transactions that the fund has classified as moderately liquid investments, less liquid investments or illiquid investments, it must report the percentage of its highly liquid investments used for this purpose monthly on Form N-PORT.
3. Highly Liquid Investment Minimum
Although the SEC has stated that open-end funds have a general responsibility to maintain an appropriate level of portfolio liquidity, no requirements under the federal securities laws or SEC rules specifically obligate open-end funds (with the exception of money market funds) to maintain a minimum level of portfolio liquidity.9 In the Liquidity Release, the SEC stated its belief that codifying a highly liquid investment minimum requirement will "increase the likelihood that a fund would be prepared to meet redemption requests without significant dilution of remaining investors' interests in the fund."
Under this element of Rule 22e-4, open-end funds, other than In-Kind ETFs, are required to:
- Determine a minimum percentage of fund net assets that the fund invests in the highly liquid investments liquidity category (i.e., the highly liquid investment minimum). In making this determination, a fund must consider the Liquidity Risk Factors, as applicable.
- Periodically review (no less frequently than annually) the adequacy of the highly liquid investment minimum.
- Adopt and implement policies and procedures for responding to a shortfall of the fund's highly liquid investments below the minimum, which must include:
- A report from the person(s) designated to administer the Program (See Section II.C. below) to the fund's board at its next regularly scheduled meeting with a brief explanation of the extent and causes of the shortfall; and
- If the shortfall lasts more than seven consecutive calendar days, a report from the person(s) designated to administer the Program to the board within one business day with an explanation of how the fund plans to restore its minimum within a reasonable period of time. A filing on Form N-LIQUID would also be required to be made within one business day of such occurrence (See Section II.H.1. below).
Although funds have flexibility to determine their own highly liquid investment minimums and the assets (within a fairly broad range) they will hold to satisfy their minimums, the SEC cautioned that it would be "extremely difficult" for a fund to conclude that a highly liquid investment minimum of zero would be appropriate, given the factors that a fund is required to consider. Although fund boards are not required to set the highly liquid investment minimums, final Rule 22e-4 does not permit a fund to change its highly liquid investment minimum during any period of time that the fund's highly liquid investments are below the minimum without board approval, including the approval of a majority of directors who are not interested persons of the fund. Only investments that are assets of the fund may be considered when determining whether a fund is in compliance with its highly liquid investment minimum. The written annual report to the board relating to the fund’s liquidity risk management program must include a discussion of the operation of the highly liquid investment minimum.
In a departure from the Liquidity Proposing Release, a fund that falls below its highly liquid investment minimum would still be allowed to acquire investments other than highly liquid investments, so long as the other investments were consistent with the fund’s shortfall policies and procedures. The SEC explained that the highly liquid investment minimum is not intended to serve as a guarantee for a fund "to hold a certain level of cash or highly liquid investments at all times."
Final Rule 22e-4 specifies that a fund that primarily holds assets that are highly liquid investments is not required to determine a highly liquid investment minimum. For example, for a fund that invests solely in large cap equity securities that can be settled to cash in three days or less, the highly liquid investment minimum has little functional value. The SEC expressed the view, however, that if a fund held "less than 50% of its assets in highly liquid investments it would be unlikely to qualify as 'primarily' holding assets that are highly liquid investments." In considering whether a fund primarily holds highly liquid investments, final Rule 22e-4 requires the fund to exclude highly liquid assets that it has segregated to cover all derivatives transactions that the fund has classified as moderately liquid investments, less liquid investments and illiquid investments, or pledged to satisfy margin requirements in connection with those derivatives.
4. Limitation on Illiquid Investments
Long-standing SEC guidelines generally limit an open-end fund’s aggregate holdings of "illiquid assets" to 15% of the fund's net assets (the 15% guideline). Historically, under the 15% guideline, an asset was considered illiquid if it could not be sold or disposed of in the ordinary course of business within seven days at approximately the value at which the fund valued the investment.10 In a departure from the Liquidity Proposing Release, which would have retained and codified the long-standing 15% guideline, final Rule 22e-4 withdraws the 15% guideline and replaces it with a new limit on illiquid investments and a new definition of "illiquid investments" that encompasses additional elements for determining that an investment is illiquid. Under the new standard adopted in Rule 22e-4, no open-end fund, including In-Kind ETFs, may acquire any investment in the illiquid investment category if immediately after such acquisition, the fund would have invested more than 15% of its net assets in illiquid investments.11 The 15% test would need to be considered each time the fund acquires a new asset.
The new standard differs from the old 15% guideline in two principal respects. First, the value impact standard in final Rule 22e-4 has been changed from whether a fund could sell an investment at "approximately the value at which the fund has valued the investment," to whether, as discussed above, an open-end fund could sell the investment "without the sale or disposition significantly changing the market value of the investment." Second, whereas some funds under the 15% guideline would make determinations of whether a portfolio investment is liquid based on whether a single trading lot for the investment could be sold within seven days under normal market circumstances, final Rule 22e-4, as discussed above, requires a fund to consider market depth — that is, to consider whether trading varying portions of a position, in sizes that the fund would reasonably anticipate trading, would reasonably be expected to significantly affect its liquidity, and if so, to take this into account when making a liquidity classification. Since the new standard requires consideration of market depth, it may no longer be appropriate for a fund to consider the sale of only a single trading lot.
An open-end fund will be permitted to hold more than 15% of its net assets in illiquid investments if it does so due to redemptions or market events. However, if illiquid investments that are assets rise above 15%, the person(s) designated to administer the program must report the occurrence to the fund's board within one business day of the occurrence, along with an explanation of the extent and causes of the occurrence and how the fund plans to bring illiquid investments that are assets below 15% of net assets within a reasonable period of time. Such occurrence would also need to be reported, on a confidential basis, on Form N-LIQUID within one business day of the occurrence (See Section II.H.1. below). If illiquid investments that are assets remain above 15% of net assets 30 days from the occurrence, the board, including a majority of the directors who are not interested persons of the fund, must assess whether the plan presented to it regarding bringing the fund's illiquid investments that are assets to or below 15% of net assets continues to be in the best interests of the fund.
5. Redemptions in Kind
Rule 22e-4 requires funds that engage in or reserve the right to engage in in-kind redemptions, as well as In-Kind ETFs, to adopt and implement written policies and procedures regarding such redemptions as part of their management of liquidity risk. The Liquidity Release notes that effective policies and procedures will increase the likelihood that in-kind redemptions would be used as a risk management tool and provides guidance on certain characteristics of effective policies and procedures. For funds and In-Kind ETFs, as applicable, the SEC expects that such policies and procedures will address:
- when to employ in-kind redemptions (i.e., at all times or only under stress);
- what types of events may lead to the use of in-kind redemptions;
- whether policies and procedures should be tailored to provide for different types of investors, such as retail investors redeeming for cash and institutional investors redeeming in-kind, as well as the different operational concerns for different types of investors;
- how to determine which securities to use for an in-kind redemption; and
- whether to redeem in-kind on a pro rata basis.
To the extent the policies and procedures do not require redemptions on a pro rata basis, the Liquidity Release states that such policies and procedures should provide for fair security selection and distribution so as to not disadvantage either the redeeming shareholder or remaining investors.
C. Written Liquidity Risk Management Program - Board Oversight
The Liquidity Release confirms the board's role in the liquidity risk management program as one of "general oversight" and that directors should use their "reasonable business judgment" in such oversight. The role of the fund's board, including a majority of the independent directors, is to:
Designate Administrative Responsibilities to the Fund's Investment Adviser, Officer or Officers. The board will be responsible for approving the fund's designation of the fund's investment adviser or officers as person(s) responsible for administering the Program. Rule 22e-4 prohibits the program from being administered solely by portfolio managers of the fund, but the Liquidity Release clarifies that the input of portfolio managers, traders, risk managers and others is allowed. The Liquidity Release also allows for portfolio managers to be members of a committee designated to administer the Program. Further, a fund's service providers may assist by providing information relevant to liquidity risk, but the primary parties responsible for the fund’s liquidity risk management are the fund and any parties to whom the fund has delegated responsibility for administering the program.
Oversee the Liquidity Risk Management Program. The board will be responsible for initial approval of the Program. In addition, the board is required to review, no less than annually, a written report prepared by the person(s) administering the Program, assessing the adequacy of the Program and the effectiveness of its implementation. In a significant change from the Liquidity Proposing Release, the Liquidity Release does not require that the board approve any material changes to the liquidity risk management program, but instead that any material changes be described to the board in the written report.
The Liquidity Release notes that directors may satisfy their responsibilities with respect to the initial approval by reviewing summaries of the program prepared by the fund’s investment adviser or officers administering the program, legal counsel or other persons familiar with the program.
Oversee the Highly Liquid Investment Minimum. In a significant change from the Liquidity Proposing Release, Rule 22e-4 does not require the board to approve the highly liquid investment minimum or any changes to such minimum, except in limited circumstances. The Liquidity Release indicates the importance of flexibility in the approval of, and changes to, the highly liquid investment minimum. However, in a case where the fund is below its highly liquid investment minimum, the board must approve any changes, as discussed above. In addition, Rule 22e-4 requires that the board receive a report: (i) at its next scheduled meeting whenever a fund goes below its highly liquid investment minimum; or (ii) within one business day if the fund is below its highly liquid investment minimum for more than seven consecutive days.
Oversee the Illiquid Investment Limit. The SEC has adopted new Form N-LIQUID as discussed further below, which requires a fund to file a current report when the fund’s holdings of illiquid investments exceed 15% of its net assets. In connection with this and as a change from the Liquidity Proposing Release, Rule 22e-4 also requires that the board be notified within one business day if the fund's holdings of illiquid investments exceed 15% of its net assets, as discussed above. The board should be informed of the "extent and causes of the occurrence" and how the fund plans to bring its illiquid assets below 15% of net assets "within a reasonable time."
D. Written Liquidity Risk Management Program – Recordkeeping
Rule 22e-4 requires that a fund maintain a copy of its Program for five years in an easily accessible place. In addition, funds are required to maintain copies of any materials provided to the board in connection with its initial approval of the Program, copies of any written reports given to the board in connection with their review of the effectiveness and adequacy of the Program, and records of any materials given to the board in connection with a fund dropping below its highly liquid investment minimum, each for five years and for two years in an easily accessible place. Lastly, funds are required to maintain a written record of how their highly liquid investment minimums were determined, as well as any changes to such minimums, for five years and for two years in an easily accessible place after the determination or change to the minimum.
E. Guidance Regarding Cross Trades
The Liquidity Release provides guidance on how Rule 22e-4 will impact an adviser's analysis of its ability to use cross trades in compliance with Rule 17a-7 under the Act. Rule 17a-7 together with applicable guidance requires cross trades to satisfy certain requirements, one of which is for a fund to obtain readily available market quotations for traded securities.12 The SEC has stated in the past that "[r]eliance upon such market quotations provides an independent basis for determining that the terms of the transaction are fair and reasonable to each participating investment company."13 Although the Liquidity Proposing Release noted that less liquid assets are less likely to satisfy Rule 17a-7, the Liquidity Release states that "an assessment of an asset’s liquidity, without more, would not determine whether the asset is eligible for a cross trade transaction" under Rule 17a-7, although given the particular risks involved in cross trading less liquid assets, it could be appropriate for an adviser to give less liquid assets a more careful or heightened review as compared to more liquid assets.
The Liquidity Release provides guidance on how a fund's policies and procedures may address cross-trading less liquid assets, including:
- reviewing less liquid assets prior to cross trades to ensure that market quotations are readily available, that there is an available current market price, that the transaction is in line with both funds' investment objective, policies and risk profile, and otherwise satisfies Rule 17a-7;
- specifying the sources of the market quotations, including potential back-up sources, establishing criteria for determining whether market quotations are readily available and current, establishing a periodic review of such sources, and reviewing the quality of market quotations; and
- establishing compliance monitoring to ensure the cross trades are appropriate for both funds and in line with both funds' investment objective, policies and risk profile.
F. Exchange Traded Funds
Rule 22e-4 provides certain tailored liquidity risk management requirements for ETFs, including In-Kind ETFs. The Liquidity Release indicates the Staff's recognition of the different liquidity risks faced by In-Kind ETFs, as the investor trading ETF shares in-kind bears the risk of converting the assets to cash. All ETFs will be required to limit their investment in illiquid investments to 15% of their net assets and adopt a liquidity risk management program, but, as discussed above, In-Kind ETFs will not be required to classify their investments by liquidity or set a highly liquid investment minimum. However, the Liquidity Release states that In-Kind ETFs must still maintain sufficient liquidity and assess liquidity-related risks. As discussed above, In-Kind ETFs must also adopt and implement written policies and procedures on redemptions in-kind.
In-Kind ETFs will be required to report on Form N-CEN their designation as such. To the extent market conditions change and an ETF begins redeeming with more than a de minimis amount of cash, the ETF would no longer qualify as an In-Kind ETF.
G. Unit Investment Trust Liquidity
Although UITs are exempt from most provisions of Rule 22e-4, the SEC is requiring a "limited liquidity review" for UITs. Due to their lack of active management and fixed set of assets, the Liquidity Release recognizes that UITs will not need to regularly assess their portfolio's liquidity and change its composition. UITs are now required to have their principal underwriter or depositor make an initial determination upon initial deposit that the liquidity of their portfolios is consistent with the redeemable nature of their issued securities. The Liquidity Release indicates that if a UIT holds more than 15% of its assets in illiquid investments, this would likely be inconsistent with the redeemable nature of its issued securities.
H. Disclosure and Reporting
The SEC is adopting a new Form N-LIQUID and amendments to Forms N-CEN and N-1A.
1. Form N-LIQUID
Under new Rule 30b1-10, open-end funds, excluding money market funds and only including In-Kind ETFs when applicable, will be required to file a nonpublic current report on Form N-LIQUID within one business day as follows:
- if a fund's illiquid investments go above the 15% threshold, the fund will report the date(s) when such threshold was breached, the current percentage of the fund's portfolio in illiquid investments and certain identifying information on the illiquid investments;
- if a fund was previously above the 15% threshold and has now gone below the threshold, the fund will report the date(s) when the portfolio went back below the 15% threshold and the current percentage of the fund’s portfolio in illiquid investments; and
- if a fund's portfolio is below its highly liquid investment minimum for seven consecutive calendar days, the fund will report the date(s) when such minimum was breached.
2. Form N-CEN
Pursuant to a new item in Form N-CEN, funds will be required to report, among other things, information on the use of credit facilities, interfund lending and interfund borrowing. Funds will be required to report the size of the credit facility, the lending institution(s), whether the facility is committed or uncommitted, whether the facility is shared among multiple funds and whether the fund accessed the credit facility during the reporting period and, if so, the number of days that the facility was in use and the average dollar amount outstanding during the period of use. For interfund lending and interfund borrowing, funds will be required to report whether a fund engaged in interfund lending or borrowing and, if so, the number of days that the facility was in use and the average dollar amount outstanding during the period of use. As discussed above, In-Kind ETFs will also be required to identify themselves as such on Form N-CEN.
3. Amendments to Form N-1A
Pursuant to amendments to Form N-1A, funds will be required in their registration statements to provide additional information on their redemption procedures, including the methods the fund will use to meet redemptions in both stressed and non-stressed conditions and the number of days in which a fund typically would expect to pay redemption proceeds. To the extent that the timing of a fund's redemption payments depends on the payment method, the fund should disclose the typical number of days or estimated range of days for each method. The disclosure should focus on when payments are made, rather than when payments are received by the investor, as the fund does not have control over receipt of payment among different distribution channels and payment methods. Lastly, in a change from the Liquidity Proposing Release, the final amendments do not require funds to file their credit agreements as exhibits to their registration statements.
III. SEC Adopts Rule Amendments to Permit Swing Pricing
On October 13, 2016, the SEC adopted, with a two-year extended effective date, amendments to Rule 22c-1 under the Act to permit, but not require, open-end funds, other than ETFs and money market funds, to use "swing pricing" under certain circumstances. "Swing pricing" refers to the process of adjusting a fund's NAV per share to effectively pass on the costs relating to purchase or redemption activity to the shareholders associated with that activity. The SEC believes swing pricing could be an effective tool to assist funds in mitigating potential shareholder dilution14 and managing liquidity risk. The amendments to Rule 22c-1 were adopted substantially as proposed, with certain modifications to respond to commenters' suggestions and concerns.15
In addition to amending Rule 22c-1, the SEC also adopted the following rule and form amendments relating to swing pricing:
- Amendments to Rule 31a-2 under the Act will require funds to maintain records evidencing and supporting swing pricing policies and procedures and each computation of an adjustments to a fund's NAV based on swing pricing policies and procedures.
- Amendments to Form N-1A and Regulation S-X, and a new item in Form N-CEN will require funds to publicly disclose specific information regarding their use of swing pricing, including their swing factor upper limit and a description of the effects of swing pricing on their performance.
B. Scope and Requirements
All registered open-end funds other than money market funds and ETFs may elect to use swing pricing.16 Funds that use swing pricing must implement board approved swing pricing policies and procedures, that may be included in the fund's liquidity risk management program. Some funds in a fund complex may adopt swing pricing while others may not, and those that do may establish different swing thresholds; however, a fund that elects to use swing pricing must apply it to all classes of the fund — i.e., a fund that elects to use swing pricing must adjust its NAV whenever net purchases or net redemptions, collectively for all share classes offered by the fund, exceed the swing threshold. Rejecting comments to permit funds to elect to apply swing pricing only if net redemptions exceed the swing threshold, as adopted, amended Rule 22c-2 provides that swing pricing, if utilized by a fund, must apply to both net redemptions and net purchases.
A fund's swing pricing policies and procedures must require the fund to adjust its NAV by a "swing factor"when the level of the fund’s net purchases or net redemptions exceeds the applicable "swing threshold." The policies must specify:
- the process, including consideration of certain factors, for determining the swing factor;
- the process, including consideration of certain factors, for setting the swing threshold; and
- the process for setting the swing factor upper limit. In addition, a fund that uses swing pricing should address market timing concerns relating to swing pricing in the funds' market timing policies and procedures.
C. Swing Threshold
An open-end fund that implements swing pricing must set a "swing threshold," which is a specified percentage of the fund's NAV. Once the level of net purchases or net redemptions of a fund on a day has exceeded the swing threshold, an adjustment to the fund’s NAV must be made. The Swing Pricing Release notes that, generally, a swing threshold should reflect the estimated point at which the net purchases or net redemptions in the fund's shares would result in the fund’s investment adviser trading portfolio assets in the near term, to a degree or of a type that may generate material liquidity or transaction costs for such fund. Like the proposed Rule 22c-1 included in the Liquidity Proposing Release, the amended Rule 22c-1 does not set a minimum "floor" for the swing threshold; however, the SEC indicated that it believes that that after considering the swing threshold factors, a fund would not be able to set the swing threshold at zero. Noting comments to the Liquidity Proposing Release arguing that multiple thresholds should be permitted because costs associated with redemptions may increase as the amount of redemptions increases, amended Rule 22c-1 permits a fund, at its election, to set multiple, escalating, swing thresholds — each associated with a different swing factor.
In determining the swing threshold(s), amended Rule 22c-2 requires a fund to consider, among other factors it deems relevant, the following factors, unchanged from the proposal:
- the size, frequency and volatility of historical net purchases or net redemption of fund shares during normal and stressed periods;
- the fund's investment strategy and the liquidity of the fund's portfolio investments;
- the fund's holdings of cash and cash equivalents, and borrowing arrangements and other funding sources; and
- the costs associated with transactions in the markets in which the fund invests.
A fund's imposition of swing pricing must be based on the timely receipt of sufficient information to reasonably estimate with high confidence whether the fund's net shareholder flows have crossed the applicable swing threshold. The shareholder flow information considered may be individual, aggregate or netted orders and may include reasonable estimates where necessary and shall exclude any purchases or redemptions are made in kind rather than in cash. The Swing Pricing Release notes that most current systems used by funds to evaluate shareholder flows are unable to provide appropriate data in a timely basis to enable the use of swing pricing. The SEC has provided for an extended effective date for the implementation of swing pricing to enable the fund industry to develop and implement operational solutions to enable funds to implement swing pricing.
The SEC indicated that a fund generally should not disclose its swing threshold(s) unless it has determined that doing so is in the best interests of the fund, and if it is disclosed, it would not be appropriate to disclose it selectively to certain shareholders (e.g., institutional investors). The Swing Pricing Release notes that disclosure of a fund’s swing threshold(s) could result in shareholders attempting to time transactions in fund shares based on the likelihood that the fund will or will not adjust its NAV.
D. Swing Factor
A fund's swing factor is the amount, expressed as a percentage of a fund's NAV and determined pursuant to the fund’s swing pricing policies and procedures, by which the fund must adjust its NAV per share when the level of net purchases into, or net redemptions from, the fund has exceeded the fund’s swing threshold. A fund that sets multiple, escalating, swing thresholds must set a different swing factor for each such swing threshold.
The process for determining the swing factor(s) must include:
- the establishment of an upper limit, which may not exceed two percent of fund's NAV per share, and which must be publicly disclosed in the fund’s prospectus17; and
- the determination that the swing factor(s) used are reasonable in relationship to the costs expected to be incurred by the fund as a result of net purchases or net redemptions that occur on the day the swing factor is used.
When determining a fund's swing factor(s), the swing pricing administrator must take into account only the near-term costs expected to be incurred by the fund as a result of net purchases or net redemptions that occur on the day the swing factor is used, including (i) spread costs; (ii) transaction fees and charges arising from asset purchases or asset sales to satisfy those purchases or redemptions; and (iii) borrowing-related costs associated with satisfying redemptions. The final rule amendments eliminated "market impact" costs or changes in the value of assets purchased or sold as a result of net purchases or net redemptions as considerations to be taken into account when setting a swing factor.
E. Investor Flows Information
Because the time at which an open-end fund must determine its NAV may precede the time at which it receives final data regarding net investor transactions flows for that day, funds may include reasonable estimates made by such funds and their intermediaries when necessary (and should exclude any purchases or redemptions made in kind and not in cash). The information received by funds may be individual, aggregated or netted orders. A fund may request different levels or types of information from different types of intermediaries depending on various factors, e.g., the size of the orders and the nature of the orders (e.g., subscriptions or redemptions) that typically come through the intermediary.
The Liquidity Release notes that funds should consider establishing policies and procedures regarding the use of estimates, including the use of regular back-testing of daily estimated net flows, which could then be used to update the process to improve accuracy.
F. Disclosure and Reporting
1. Amendments to Form N-1A
Form N-1A has been amended to require disclosure regarding an open-end fund's use of swing pricing. Such amendments require:
- if the fund uses swing pricing, disclosure regarding the fund's use of swing pricing, including what swing pricing is, the circumstances under which it will be used, the effects of the use on the fund and its shareholders, and the applicable swing factor upper limit;
- if swing pricing policies and procedures were applied during any of the applicable periods, the fund must include, in connection with the risk/return bar chart and table, a general description of the effects of swing pricing on the fund's total returns and average annual total returns for the applicable periods;
- if a fund invests in other open-end funds, the fund must include a statement that the fund's NAV is calculated based on the net asset values of the funds in which it invests, and if applicable, that the prospectuses for those funds explain the circumstances under which those funds will use swing pricing and the effects of using swing pricing; and
- a fund's financial highlights information must include: (i) the per share impact of any amounts retained by the fund pursuant to its swing pricing policies and procedures; and (ii) the fund's net asset value per share as adjusted pursuant to its swing pricing policies and procedures on the last day of the reporting period, if applicable.
2. Form N-CEN
A new item on Form N-CEN will require funds (other than money market funds and ETFs) to report whether the fund engaged in swing pricing during the reporting period and, if so, the fund’s swing factor upper limit.
3. Changes in Financial Reporting
Addressing changes in financial reporting relating to the use of swing pricing, the Swing Pricing Release notes that:
- Financial highlights: A fund must disclose, if applicable: (i) the Swung NAV per share in addition to the GAAP NAV and (ii) the per share impact of amounts retained by the fund related to swing pricing;
- Balance sheet data: The proposed amendment to Regulation S-X that would have required fund's to disclose the Swung NAV on the fund's balance sheet was not adopted. GAAP NAV, which will include the effects of swing pricing throughout the entire reporting period, continues to be required to be included on a fund’s balance sheet; however, a fund is permitted to disclose the Swung NAV on its balance sheet or elsewhere in its financial statements, provided an explanation of the differences between the Swung NAV and the GAAP NAV is included; and
- Statement of changes in net assets: where a fund processes purchase and sale transactions using a Swung NAV, the disclosure of the number of shares and dollar amounts received for fund shares sold and paid for shares redeemed, to be based on the applicable transactional NAVs (including a Swung NAV, if applicable) used for such transactions.
- Financial statements: Amended Regulation S-X will require a fund that has adopted swing pricing policies and procedures to include a note to its financial statements disclosing: (i) the general methods used to determine whether the fund’s NAV will swing; and (ii) whether the fund's NAV has swung during the year; and (iii) a general description of the effects of swing pricing.
G. Board Approvals and Oversight
Amended Rule 22c-1 requires that the board of directors, including a majority of directors who are not interested persons, of a fund that utilizes swing pricing:
- approve the fund's swing pricing policies and procedures, which must specify the processes for determining the swing threshold(s), swing factor(s) and swing factor upper limit18;
- approve the fund's swing threshold(s) and the upper limit on the swing factor(s) used and any changes thereto;
- designate the fund's investment adviser, officer or officers responsible for administering the swing pricing policies and procedures (the administration of swing pricing must be reasonably segregated from the fund's portfolio management and may not include portfolio managers); and
- review, no less frequently than annually, a written report prepared by the person(s) responsible for administering the fund's swing pricing that describes (i) its review of the adequacy of the fund's swing pricing policies and procedures and the effectiveness of their implementation, including the impact on mitigating dilution; (ii) any material changes to the fund’s swing pricing policies and procedures since the date of the last report; and (iii) its review and assessment of the fund's swing threshold(s), swing factors(s) and swing factor upper limit considering the Rule 22c-1 requirements, including the information and data supporting the determinations.
The board is not required to specifically approve changes to the swing pricing policies and procedures, but must periodically review the administrator's written report described above.
H. Swing Pricing Recordkeeping Requirements
A fund is required to maintain its swing pricing policies and procedures that are in effect, or at any time within the past six years were in effect, in an easily accessible place, and is required to preserve records evidencing and supporting each computation of an adjustment to the fund's NAV pursuant to its swing pricing policies and procedures. The Swing Pricing Release indicates that records supporting a computation of an adjustment should generally include, at a minimum:
- the fund's unswung NAV;
- the level of net purchases or net redemptions that the fund encountered (and estimated) that triggered the application of swing pricing;
- the swing factor used, and relevant data supporting the calculation of the swing factor; and
- back-testing data used to assess the swing factor and its relationship to near term costs expected to be incurred by the fund as a result of net purchases or net redemptions occurring on the day the swing factor(s) is used.
The above records must be retained for at least six years from the date that the NAV adjustment occurred, the first two years in an easily accessible place. In addition, all periodic reports provided to the board pursuant to the requirements of Rule 22c-1 relating to swing pricing must be retained for at least six years, the first two years in an easily accessible place.
IV. Effective and Compliance Dates
Liquidity Risk Management Program (including Rule 22e-4, Rule 30b1-10 and Form N-LIQUID): Effective Date: January 17, 2017; Compliance Dates: adopt and implement a written risk management program that has been approved by the board by December 1, 2018 (June 1, 2019 for smaller entities (funds that, together with other investment companies in the same "group of related investment companies," have net assets of less than US$1 billion as of the end of its most recent fiscal year)).
Amendments to Form N-CEN: Effective Date: June 1, 2018; Compliance Dates: December 1, 2018 for larger entities – first filings will reflect data as of December 31, 2018 and file no later than January 31, 2019, and June 1, 2019 for smaller entities – first filings will reflect data as of June 30, 2018 and file no later than July 31, 2019.
Amendments to Form N-1A (relating to liquidity risk management programs): Effective Date: January 17, 2017; Compliance Date: June 1, 2017.
Swing Pricing related Amendments to Rule 22c-1, Form N-1A, Form N-CEN and Regulation S-X: Effective and Compliance Date: November 19, 2018.