On October 13, 2016, the SEC adopted new Rule 22e-4 under the 1940 Act (the liquidity rule), which will require open-end funds, including ETFs but excluding money market funds, to adopt and implement comprehensive liquidity risk management programs, and an amendment to Rule 22c-1 under the 1940 Act (the swing pricing rule), which will permit open-end funds, excluding ETFs and money market funds, to use "swing pricing," a mechanism by which a fund may adjust the net asset value per share at which purchases and redemptions are effected to mitigate the dilutive effect purchase and redemption activity may have on the interests of continuing investors. While the final swing pricing rule was adopted largely as proposed in September 2015, the final liquidity rule, in response to industry comments, reflects significant changes from the proposal.
For a more detailed discussion of the liquidity rule and the swing pricing rule, please see the Vedder Price White Paper, "SEC Adopts New Rules Mandating Open-End Fund Liquidity Risk Management Programs and Permitting Swing Pricing," published on October 28, 2016 and available at: http://www.vedderprice.com/SEC-Adopts-New-Rules-Mandating-Open-EndFund-Liquidity-Risk-Management-Programs-and-Permitting-Swing-Pricing-10-28-2016/.
Background. The SEC has long provided guidance to open-end funds regarding investments in illiquid securities for the primary stated goal of ensuring that funds have sufficient liquid assets to satisfy redemption requests within required periods, including the seven-day period required by the 1940 Act. Citing this and other concerns, such as the growth of funds using relatively less liquid investment strategies (e.g., high-yield and alternative strategies) and the promotion of efficient ETF trading and operations, and following a two-year staff review of industry practices concerning liquidity risk management, the SEC proposed and adopted the liquidity rule. The rule was "designed to promote effective liquidity risk management throughout the open-end fund industry and thereby reduce the risk that funds will not be able to meet redemption or other legal obligations and mitigate potential dilution of the interests of fund shareholders." The liquidity rule replaces current SEC guidance regarding open-end funds' investments in illiquid securities.
Liquidity Risk Management Program. The liquidity rule requires each registered open-end fund, including ETFs but excluding money market funds, to adopt and implement a written liquidity risk management program. ETFs that satisfy redemptions solely in kind using no more than a de minimis amount of cash (In-Kind ETFs) are exempt from certain requirements of the liquidity rule. The policies and procedures constituting a liquidity risk management program must incorporate the following five elements:
1. Assessment, Management and Review of Fund Liquidity Risk. Based on a consideration of specified factors, a fund (including In-Kind ETFs) must assess, manage and review at least annually its "liquidity risk," which is defined as the risk that the fund could not meet requests to redeem shares without significant dilution of remaining investors' interests.
2. Liquidity Classification of Portfolio Investments. A fund (excluding In-Kind ETFs) must classify its portfolio investments, including derivative instruments, into the following four liquidity categories:
- Highly liquid investments--cash and investments that may be converted into cash within three business days without a significant change in market value.
- Moderately liquid investments--investments that may be converted into cash within seven calendar days, but in more than three calendar days, without a significant change in market value.
- Less liquid investments--investments that may be sold or disposed of within seven calendar days without a significant change in market value, but which settle in more than seven calendar days.
- Illiquid investments--investments that cannot be sold or disposed of within seven calendar days without a significant change in market value.
Classifications must be based on information obtained after reasonable inquiry and take into consideration relevant market, trading and investment-specific considerations, as well as market depth. Classifications may be based, by default, on asset class, unless a fund or its investment adviser is aware of a reason a particular investment should be classified differently. Classifications must be reviewed at least monthly and reported on Form N-PORT.
3. Highly Liquid Investment Minimum. A fund (excluding In-Kind ETFs) that does not "primarily" hold highly liquid investments must set a minimum percentage of net assets that will be invested in such investments and review this minimum at least annually. Any shortfall of the highly liquid investment minimum must be reported to the board at its next regular meeting. If a shortfall continues for more than seven days, both the board and the SEC, in a confidential filing on new Form N-LIQUID, must be immediately notified, and a plan must be prepared to return the fund to compliance.
4. Illiquid Investments. Similar to current SEC guidance, a fund (including In-Kind ETFs) may not acquire an illiquid investment if, immediately after the acquisition, more than 15 percent of its net assets would be invested in illiquid investments. In addition, if a fund's illiquid investments exceed 15 percent at any time, both the board and the SEC, in a confidential filing on new Form N-LIQUID, must be immediately notified, and a plan must be prepared to return the fund to compliance.
5. Redemptions In Kind. Any fund (including In-Kind ETFs) that satisfies, or reserves the right to satisfy, redemptions in kind, must establish policies and procedures regarding how and when redemption requests will be satisfied in kind.
Board Responsibilities. The role of the board under the liquidity rule is one of general oversight. The board, including a majority of independent board members, must initially approve a fund's liquidity risk management program and designate either the fund's investment adviser or one or more officers as the person or persons responsible for administering the program. The board must also review at least annually a written report from the program administrator addressing the operation of the program and assessing its adequacy and effectiveness.
Disclosure, Reporting and Recordkeeping Requirements. In connection with the liquidity rule, the SEC amended Form N-1A to require disclosure of certain matters relative to redemption practices in the prospectus, and amended new Form N-CEN to require the annual disclosure of various liquidity-related matters. The SEC also amended new Form N-PORT to require funds to report the liquidity classifications of their portfolio investments, as well as, if applicable, their highly liquid investment minimums and information regarding shortfalls of the highly liquid investment minimum. (For a more detailed discussion of the new reporting requirements, please see "SEC Adopts Rules to Modernize and Enhance Investment Company Reporting" below.) In addition, the SEC adopted certain recordkeeping requirements relating to the liquidity risk management program.
Compliance Date. Funds in groups of related investment companies with $1 billion or more in net assets must comply with the liquidity rule by December 1, 2018; other funds must comply by June 1, 2019.
The adopting release for the liquidity rule, Investment Company Liquidity Risk Management Programs, Investment Company Act Release No. 32315 (Oct. 13, 2016), is available at https://www.sec.gov/rules/final/2016/33-10233.pdf.
Swing Pricing Rule
What Is Swing Pricing? The 1940 Act generally requires that open-end fund shares be priced at the net asset value per share next computed after the receipt of a purchase or redemption request. The swing pricing rule provides an exception to this requirement that permits, but does not require, an open-end fund, excluding ETFs and money market funds, to use "swing pricing" to adjust the net asset value per share at which purchases and redemptions are effected in order to mitigate the dilution of continuing investors' interests resulting from purchase and redemption activity. Under swing pricing, if net redemption activity on a particular day exceeds a certain threshold, a fund's net asset value per share for that day is adjusted downward; if net purchase activity on a particular day exceeds a certain threshold, a fund's net asset value per share for that day is adjusted upward. Swing pricing is currently used by collective investment vehicles in certain non-U.S. jurisdictions.
Swing Pricing Policies and Procedures. Under the swing pricing rule, the use of swing pricing will be optional. However, if a fund elects to use swing pricing, the fund must establish swing pricing policies and procedures that require the fund to adjust its net asset value per share by a stated percentage (a Swing Factor) once the level of net purchases into, or net redemptions from, the fund has exceeded a stated threshold amount (a Swing Threshold). A fund may establish multiple Swing Thresholds at differing levels of net purchases or net redemptions and have different Swing Factors that are triggered when net purchases or net redemptions exceed these Swing Thresholds. The policies and procedures must also specify the process for determining a fund's Swing Threshold(s) and Swing Factor(s), in each case based on a consideration of specified factors. A fund must establish an upper limit on its Swing Factor(s), which may not exceed 2 percent of net asset value per share. In the operation of a fund's swing pricing, a determination of whether daily net purchases or net redemptions have exceeded a Swing Threshold may be made based on a "reasonable high-confidence estimate" of daily investor flows.
Role of the Board and Administration of Swing Pricing. Under the swing pricing rule, the board, including a majority of independent board members, must approve a fund's swing pricing policies and procedures, as well as the fund's Swing Threshold(s) and the upper limit on the Swing Factor(s) used and any changes to the Swing Threshold(s) or upper limit. The board, including a majority of independent board members, must also designate the fund's investment adviser or one or more fund officers as the person or persons responsible for administering the swing pricing policies and procedures.
In addition, the board, including a majority of independent board members, must review at least annually a written report from the swing pricing administrator reviewing the adequacy of the fund's swing pricing policies and procedures and the effectiveness of their implementation, including the impact on mitigating dilution.
Disclosure and Recordkeeping Requirements. In connection with the swing pricing rule, the SEC amended Form N-1A to require certain disclosure in the summary prospectus regarding swing pricing, including a discussion of when swing pricing is used and the effect of swing pricing on performance. The SEC also amended the financial highlights requirements to require disclosure of the effect of swing pricing adjustments on net asset value per share and per-share amounts retained by a fund pursuant to swing pricing. The SEC amended Regulation S-X to require certain swing pricingrelated disclosures in financial statements, and amended new Form N-CEN to require a fund to disclose whether it actually used swing pricing during the reporting period and the fund's Swing Factor upper limit. The SEC also adopted certain recordkeeping requirements relating to swing pricing policies and procedures and the calculation of swing pricing-related adjustments to net asset value per share.
Compliance Date. The effective date of the swing pricing rule will be 24 months after publication in the Federal Register. The delayed effective date is intended to allow for the creation and implementation of efficient and cost-effective solutions to the operational challenges presented by swing pricing.
The adopting release for the swing pricing rule, Investment Company Swing Pricing, Investment Company Act Release No. 32316 (Oct. 13, 2016), is available at https://www.sec.gov/rules/final/2016/33-10234.pdf.