Introduction

On September 22, 2015, the Securities and Exchange Commission (“SEC”) proposed a set of broad and sweeping rules mandating that open-end mutual funds and exchange-traded funds (“ETFs”) develop and implement formalized and written liquidity risk management programs (“LRMPs”). In proposing this new program, the SEC stated that its goal was to enhance effective liquidity risk management practices by Funds and thereby reduce the risk that Funds will be unable to meet redemptions under reasonably foreseeable stressed market conditions. The proposed rules would also impose significant new duties and responsibilities on Boards of Directors.

A key element of any LRMP would involve the classification of each Fund holding into one of six “liquidity buckets” based on how quickly each asset could be liquidated. The proposed rules identify nine specific factors which must be considered in determining an instrument’s liquidity. The consideration of each factor must also be documented. The liquidity of each position would need to be “continuously monitored”. The rules would then require Funds to assess their liquidity risk using another set of eight mandated factors and then to develop a program, based on this liquidity risk assessment, to meet liquidity needs under “current and foreseeably” stressed market conditions. As part of an LRMP, Funds would need to consider maintaining a minimum percentage of assets in cash or in positions that can be liquidated within three days.

At the same time, in an effort to reduce the potential dilution that non-redeeming Fund shareholders may experience in time of heightened fund flows, the SEC is also proposing a new rule that would permit, but not require, open-end funds (but not money market funds or ETFs) to employ “swing pricing”. Swing pricing would allow a Fund to adjust its net asset value (“NAV”), up or down on a given day, to take into account the expected costs that the Fund might be forced to incur in selling Fund positions to meet unexpected redemptions or in investing unexpected cash infusions.

I. Liquidity Risk Management Program

A. Overview

Proposed Rule 22e-4 would require registered open-end funds, including ETFs but excluding money market funds, to establish a written LRMP to assess and manage a Fund’s liquidity risk. Liquidity risk would be defined as the risk that a Fund could not meet redemption requests that are expected under normal conditions, or that are reasonably foreseeable under stressed market conditions, without materially affecting the Fund’s NAV. Importantly, the proposed rule does not alter, and indeed codifies, the current SEC staff (“Staff”) guidance that open-end funds categorize each position broadly as either liquid or illiquid and not invest in an illiquid asset if, as a result of such investment, more than 15% of the Fund’s net assets would consist of illiquid assets.[1]

Each LRMP must include the following program elements, each of which are discussed further below:

  • Classification, and ongoing review, of the liquidity of each of the Fund’s positions into one of six “liquidity buckets”;
  • Based on this classification, assessment and periodic review of the Fund’s liquidity risk;
  • Based on a Fund’s liquidity risk, establish means and mechanisms to manage the Fund’s liquidity risk, including the establishment of a minimum percentage of the Fund that must be convertible to cash within three business days at a price that does not materially affect the value of that asset immediately prior to sale.

B. Classification and Monitoring of Each Portfolio Position

The liquidity buckets. Under the proposed rule 22e-4, each Fund would be required to assess the liquidity of each position (or each portion of a position) based on the number of days within which the entire position would be “convertible to cash”[2] at a price that does not materially affect the value of that asset immediately prior to sale. In making this assessment, the person who makes the classification (which cannot solely be the portfolio manager) must use information obtained after reasonable inquiry and may determine that different portions of a position could be converted to cash over different periods of time. However, the liquidity assessment must assume that the entire position is liquidated.

The proposed rule requires each Fund to classify each position into one of six “liquidity buckets”:[3]

  1. Convertible to cash within 1 business day;
  2. Convertible to cash within 2–3 business days;
  3. Convertible to cash within 4–7 calendar days;
  4. Convertible to cash within 8–15 calendar days;
  5. Convertible to cash within 16–30 calendar days;
  6. Convertible to cash in more than 30 calendar days.

The liquidity factors. When classifying the liquidity of each portfolio position, the proposed rule sets forth a minimum set of nine factors that a Fund must consider.[4] These factors are as follows:

  • The existence of an active market, including whether the asset is listed on an exchange, and the number, diversity, and quality of market participants. The release proposing the new rules (the “release”) notes that the fact that an asset is exchange-traded does not necessarily mean it can be converted to cash in a short period of time, noting that small cap equity stocks can be less liquid.
  • The frequency of trades or quotes and average daily trading volume. The release notes that the frequency of trades should be considered in conjunction with typical trade size and that Funds should also consider the number of days where an asset shows zero trading volume.
  • The volatility of trading prices. The release states there is typically an inverse relationship between liquidity and volatility.
  • Bid-ask spreads. The release states that high bid-ask spreads relate to reduced liquidity.
  • Standardization and simplicity of structure.
  • Maturity and date of issue.
  • Restrictions on trading and limitations on transfer.
  • Size of a position in an asset relative to the asset’s average daily trading volume and, as applicable, number of units of the asset outstanding. As noted earlier, a Fund must assume the sale of the entire position, not just a normal trading lot and therefore must consider the size of the Fund’s entire position in relation to the asset’s average daily trading volume.
  • Relationship of the asset to another portfolio asset. Of particular note, the consideration of the relationship of an asset to another portfolio asset in connection with derivatives transactions may pose a unique classification problem. Although an asset may be liquid when assessed alone, if such an asset is used to cover a derivative exposure or as segregated collateral, the Fund would be required to consider this otherwise liquid asset as being temporarily frozen or unavailable for sale. Because such an asset can only be sold to meet redemptions once the derivatives position is disposed of or unwound or covered by another liquid asset, a Fund must therefore classify the liquidity of these assets by the liquidity of the derivatives they are covering.

The duty to continuously monitor the buckets. Each Fund would be required to review the liquidity classifications of each position on an “ongoing” basis to ensure that adequate levels of liquidity are being maintained and revise the classification if warranted. The proposed rule does not establish a mandated review period, leaving that determination to the Fund and its Board. The release notes that for some Funds the review may be daily, or even hourly, while for other Funds it might be less frequently. The release also notes that because of the need to report the Fund’s liquidity positions on proposed Form N-PORT, the reviews would need to be performed at least monthly.

C. Assessment and Management of a Fund’s Liquidity Risk

In light of the position-by-position assessment of liquidity, the proposed rule requires a Fund to assess and review its liquidity risk, and each Fund would be required to manage its liquidity risk based on this assessment. The LRMP must include requiring the Fund to determine a minimum percentage of the Fund’s net assets that must be invested in three-day liquid assets (the “three-day liquid asset minimum”).

Assessing a Fund’s liquidity risk. Under the proposed rule, each Fund would be required to assess the Fund’s liquidity risk based on the following minimum set of eight factors:[5]

  • Short and long-term cash flow projections, including consideration of:
    • Size, frequency and volatility of historical purchases and redemptions of Fund shares during normal and stressed periods. The Fund must consider both expected requests to redeem (shareholder flows due to seasonality or tax considerations) as well as redemption requests that are not expected but are reasonably foreseeable under stressed market conditions or in light of significant developments, such as the departure of the Fund’s portfolio manager. For new Funds with little operating history, the Fund should consider purchase and redemption activity of Funds with similar strategies.
    • A Fund’s redemption policies. Particularly, a Fund should consider whether its policies and prospectus disclosure indicate that redemption payments will be made in a specified period of time.
    • A Fund’s shareholder ownership concentration. Funds with a concentrated shareholder base have a higher liquidity risk.
    • A Fund’s distribution channels. Funds should consider that if the Fund has a large presence in the broker-dealer channel, then under the Securities Exchange Act of 1934, redemption proceeds must be paid within a T+3 settlement framework. Funds reliant on the omnibus channel must consider that they may have little knowledge of the characteristics and make-up of the underlying shareholder base and may not know if a particular Fund’s shareholder base is concentrated.
    • The degree of certainty associated with the Fund’s short-term and long-term cash flow projections. Here, the release states that a Fund should take into account any advance notice arrangements a Fund may have with intermediaries as well as its operating experience under different market conditions.
  • Investment strategy and liquidity of portfolio assets. The LRMP should consider the nature of the Fund, whether it is passively or actively managed, the degree to which it is designed to track an index, whether or not it is diversified and the tax impact of significant redemptions.
  • Use of borrowings and derivatives for investment purposes. The cost of unwinding derivative positions and repaying outstanding borrowings due to covenant or legal requirements must be considered. In such cases, the Fund may be required to redeem liquid positions in order to repay a counterparty or a bank, leaving fewer liquid assets available to meet unexpected redemptions.
  • Holdings of cash and cash equivalents, as well as the availability of borrowing arrangements and other funding sources.

Periodic review of a Fund’s liquidity risk. A Fund must periodically review its liquidity risk using each of the factors discussed above to ensure that adequate liquidity levels are being maintained. The proposed rule permits each Fund to institute individualized procedures to review the Fund’s liquidity risk, tailored to reflect the Fund’s particular facts and circumstances. The proposed rule does not include specific review procedures, a required risk review period or developments that a Fund should consider as part of the review. Generally, the SEC proposes that a Fund could consider regulatory, market-wide and Fund-specific developments affecting each of the proposed risk factors.

D. Other Elements of the LRMP — the Minimum Three-Day Liquid Asset Requirement

Currently, Funds are not required to maintain a minimum level of portfolio liquidity other than the maximum 15% illiquid security Staff guideline discussed above. This would change under the proposed rule as the SEC has proposed that each Fund affirmatively determine, as part of its LRMP, the minimum amount of its assets that should be held in positions that could be readily liquidated within three days, the “three-day liquid asset minimum”. In determining this minimum, the Fund would be required to consider the same factors that it uses to assess its liquidity risk and would be required to maintain a written record of how the minimum was determined. In particular, the release notes that cash flow projections, stress testing and historic redemption experiences might be key elements in setting the three-day liquid asset minimum.

The release points out that, in the SEC’s view, it would be extremely difficult for a Fund to conclude, based on a review of these factors, that a zero three-day liquid asset minimum was appropriate.[6] A Fund’s Board would be required to approve the three-day liquid asset minimum and any changes thereto.

The SEC acknowledges that three-day liquid asset minimums may vary among Funds, depending on the factors each Fund considers. However, the SEC believes that documentation of the factors considered, Board oversight and public disclosure of the determined minimum should prohibit a Fund from setting a minimum too low.[7]

Like the current 15% illiquid asset test, the three-day liquid asset minimum would be an “invest” test, not a “hold” test. In other words, a Fund would not be permitted to acquire a less liquid asset if, immediately after acquisition, the Fund would have invested less than its three-day liquid asset minimum in three-day liquid assets. The rule would not require the Fund to divest less liquid assets if it falls below the three-day minimum due to reasons other than the purchase of a less liquid asset.

Periodic review of a Fund’s three-day liquid asset minimum. A Fund would be required to periodically review, no less frequently than semi-annually, the adequacy of the Fund’s three-day liquid asset minimum, taking into account the factors used to determine that minimum. The adviser administering the Fund’s LRMP would be required to submit written reports to the Board regarding the adequacy of the program, the three-day liquid asset minimum and implementation thereof. Board approval would be required for any changes to the three-day liquid asset minimum. Each Fund would also be required to maintain a copy of the reports to the Board and a written record of the Fund’s assessment of the factors used in the determination of that minimum as well as any reviews or adjustments to the minimum. Again, the proposed rule does not set forth review procedures or incorporate specific developments a Fund must take into consideration in conducting its review.

E. Role of the Board

Proposed rule 22e-4 would require a Fund to obtain initial approval of its written LRMP as well as the Fund’s three-day liquid asset minimum from the Board of Directors, including a majority of independent Directors. The release notes that Directors may satisfy their obligation with respect to the initial approval of the LRMP by reviewing summaries of the program prepared by the adviser, legal counsel or others. Any such summary should familiarize the directors with the salient features of the program and provide them with an understanding of how the LRMP addresses the required assessment of the Fund’s liquidity risk, including how the three-day liquid asset minimum was established.

Board approval, including the approval by a majority of independent Directors, would also be required for any material changes to the LRMP, including any change to the three-day liquid asset minimum. The Board must also approve the designation of individuals to administer the LRMP. Importantly, the portfolio manager of the Fund cannot be the sole person designated to administer the program. Under the proposed rule, the Board would be required to review a written report provided at least annually from the Fund’s investment adviser and/or officers administering the Fund’s LRMP. The written report would have to include the Fund’s three-day liquid asset minimum and the effectiveness of its implementation.

F. Compliance Dates

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 SEC is proposing a compliance date of 18 months after the effective date of the proposed rule. For smaller entities (Funds that have net assets of less than $1 billion as of the end of the most recent fiscal year), the SEC is proposing a compliance date of 30 months after the effective date of the proposed rule.

II. Swing Pricing

While proposed rule 22e-4, and the required LRMP, are focused on ensuring that Funds assess and manage their liquidity in order to meet redemption obligations, proposed rule 22c-1(a)(3), which would permit the use of swing pricing, is focused on mitigating shareholder dilution that might result from unexpected redemptions or subscriptions into Funds. Conceptually, swing pricing, used by certain Funds in Europe and in other foreign markets, permits a Fund to adjust its NAV up or down in the event that net purchases or redemptions exceed a specified percentage of the Fund’s NAV on any given day, known as the “swing threshold”. During periods of relatively high net purchases or net redemptions, the use of swing pricing would allow the costs resulting from such activity to be reflected immediately in the Fund’s NAV, thereby passing on the costs stemming from shareholder purchase or redemption activity to all shareholders, including those associated with that activity. The goal of swing pricing is to mitigate dilution to those shareholders that were not involved in the subscription or redemption activity.

The proposed rule would permit, but not require, open-end funds (except ETFs or money market funds) to use swing pricing, so long as certain requirements are met.[8] To use swing pricing, a Fund would be required to adopt policies and procedures specifying its swing threshold and method of determining the swing factor,[9] with such policies and procedures further providing that the Fund must adjust its NAV by the swing factor once net purchases or net redemptions exceed the specified swing threshold.[10]Further, a Fund’s adopted policies and procedures must provide for the periodic review of its swing threshold, no less frequently than annually.

A. Swing Threshold

A Fund’s swing threshold should represent a level beyond which net purchases or net redemptions would trigger portfolio trading activity that may generate material liquidity or transaction costs for the Fund. Accordingly, proposed rule 22c-1(a)(3)(i)(B) would require that a Fund must consider a set of factors largely similar to those used in assessing a Fund’s overall liquidity risk, in order to determine a Fund’s swing threshold, which include:

  1. The size, frequency, and volatility of historical net purchases or net redemptions of Fund shares during normal and stressed periods
  2. The Fund’s investment strategy and the liquidity of the Fund’s portfolio assets;
  3. The Fund’s holdings of cash and cash equivalents, as well as borrowing arrangements and other funding sources; and
  4. The costs associated with transactions in the markets in which the Fund invests.

While the first three factors focus primarily upon liquidity elements, the fourth factor allows the Fund to consider a range of costs that may be attributable to trading activity specific to a Fund. In considering this factor, a Fund may take into account, as applicable, market impact costs, spread costs, transaction fees such as brokerage and custody fees, as well as other charges, fees and taxes resulting from the purchase or sale of securities following Fund share purchases or redemptions.

Once a Fund has implemented swing pricing, it must make an ongoing determination on each business day as to whether the specified swing threshold has been exceeded.[11] Making this determination may present an operational challenge for Funds, since determining whether the swing threshold has been exceeded may need to occur sometime prior to the time the Fund strikes its NAV, so as to allow time for the determination of that day’s swing factor. In certain cases a Fund would base its determination of whether the swing threshold has been exceeded upon estimates using information obtained after a reasonable inquiry. The level of the swing threshold would not be publicly disclosed.

B. Swing Factor

A Fund employing swing pricing would be required to adjust its NAV by applying a swing factor in the event that its swing threshold has been exceeded. Proposed rule 22c-1(a)(3)(i)(D) would require that the following factors be taken into account for purposes of calculating a Fund’s swing factor:

  1. Any 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 to adjust the Fund’s net asset value per share, including any market impact costs, spread costs, and transaction fees and charges arising from asset purchases or asset sales to satisfy those purchases or redemptions, as well as any borrowing-related costs associated with satisfying redemptions; and
  2. The value of assets purchased or sold by the Fund as a result of net purchases or net redemptions that occur on the day the swing factor is used to adjust the Fund’s net asset value per share, if that information would not be reflected in the current net asset value of the Fund computed that day.

Unlike the swing threshold, the exact percentage of which is specified in the adopted policies and procedures, the amount of the swing factor may vary from one day to the next. In effect, the swing factor would vary depending on the facts and circumstances taken into consideration in accordance with the prescribed factors. The proposed rule would allow for a Fund to take a variety of approaches to determining its swing factor. For example, a Fund could set a “base” swing factor, and adjust it as needed if certain aspects required for consideration deviate from a range of pre-determined norms.

The release notes that when a Fund experiences net purchases, the use of the swing factor will adjust the Fund’s NAV upward, to cover the costs to be incurred in investing the additional cash proceeds. When the Fund experiences net redemptions, use of the swing factor will adjust the NAV downward, to cover the cost associated with liquidating portfolio positions.

For Funds electing to use swing pricing, the rule proposal would require the determination of the swing factor to be reasonably segregated from the Fund’s portfolio management function. Although a Fund’s portfolio manager would be able to provide input, the amount of the swing factor should ultimately be determined independent from portfolio management to avoid potential conflicts of interest. For example, a portfolio manager may for Fund performance purposes wish to minimize the amount of the downward NAV adjustment on a day in which significant net redemptions caused a breach of the swing threshold.

C. Role of the Board

Under the proposed rules, a Fund’s Board of Directors, including a majority of its independent Directors, must approve the swing pricing policies and procedures, the Fund’s swing threshold and any swing factor upper limit, as well as any material change thereto. The Board would also bear the responsibility of designating the Fund’s investment adviser or officers responsible for administering the swing pricing policies and procedures, and for determining the swing factor that will be used each time the swing threshold is breached, on the condition that determination of the swing factor would be reasonably segregated from the portfolio management function of the Fund. A Fund’s Board, however, would not be required to manage the administration of the Fund’s swing pricing policies and procedures, nor would it be required to approve each swing factor calculation.

D. Compliance Date

Since a Fund’s prospective use of swing pricing is optional, a compliance date is not applicable. Rather a Fund would be able to rely on the rule after the effective date as soon as the Fund could comply with proposed rule and related records, financial reporting and prospectus disclosure requirements.

III. Disclosure Amendments and Reporting

A. Form N-1A

Proposed amendments to Form N-1A would require Funds to disclose information regarding their swing pricing program, if applicable, and the methods used by Funds to meet redemptions. Funds also would be required to file agreements related to lines of credit and reflect, as applicable, the use of swing pricing in the Fund’s NAV per share in the financial highlights section of Fund financial statements.

B. Proposed Form N-PORT

Proposed Form N-PORT would be further amended to require a Fund to report the liquidity classification of each of the Fund’s assets based on the six categories in proposed rule 22e-4. Funds also would be required to disclose their three-day liquid asset minimum.

C. Proposed Form N-CEN

Proposed Form N-CEN would be further amended to require disclosure of information regarding committed lines of credit, interfund borrowing and lending, and swing pricing. The proposed amendments also would require ETFs to report whether they required an authorized participant to post collateral to the ETF or any of its designated service providers in connection with the purchase or redemption of ETF shares.

D. Compliance Dates

All initial and post-effective registration statements filed on Form N-1A filed six months or more after the effective date would be required to comply with the proposed amendments to Form N-1A. Larger entities would be afforded 18 months, and smaller entities 30 months, after the effective date to comply with the new Form N-PORT reporting requirements. All Funds would be required to comply with Form N-CEN reporting requirements 18 months after the effective date.