On September 22, 2015, the SEC unanimously approved a proposal that is intended to promote effective liquidity risk management by open-end investment companies, reduce the risk that funds will be unable to meet redemption obligations and mitigate the dilution of shareholder interests.
Under the proposal, mutual funds and exchange-traded funds (ETFs), but not money market funds, would be required to establish a liquidity risk management program and disclose fund liquidity and redemption practices, such as the methods that a fund uses to meet redemption requests and the number of days in which a fund will pay redemption proceeds to redeeming shareholders. If the number of days in which a fund will pay redemption proceeds differs by distribution channel (e.g., broker-dealer channel, omnibus account channel, retirement plan channel, etc.), a fund also would be required to disclose the number of days for each distribution channel. Additionally, the proposal would provide a framework in which funds could elect to use “swing pricing” to reflect in their net asset value costs associated with shareholder trading activity during periods of heavy redemptions or purchases.
In connection with the proposed disclosure and reporting reforms, the SEC is re-opening the comment period for the proposed investment company reporting reforms announced earlier this year because the new proposal includes amendments to the previously proposed Form N-PORT and Form N-CEN.
Liquidity Risk Management Programs
Proposed Rule 22e-4 under the 1940 Act would require funds to adopt and implement written liquidity risk management programs, including the following elements:
- Liquidity Classification of Portfolio Investments: Funds would be required to indicate the liquidity classification of each of the fund’s positions in a portfolio asset using the following specified categories: (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; and (6) convertible to cash in more than 30 calendar days. For portfolio assets with multiple liquidity classifications, the proposed rule would require funds to indicate the dollar amount attributable to each classification. Such information would be made available to the public quarterly on proposed Form N-PORT.
- Determination of Three-Day Liquid Asset Minimum: The proposed rule would require each fund to determine its “three-day liquid asset minimum,” which is the percentage of the fund’s net assets to be invested in three-day liquid assets. The proposed definition of three-day liquid asset is any cash held by a fund and any position of a fund in an asset (or portion of the fund’s position in an asset) that the fund believes is convertible into cash within three business days at a price that does not materially affect the value of that asset immediately prior to sale. The three-day liquid asset minimum would be determined based on an assessment of short-term and long-term cash flow projections, the investment strategy and liquidity of the fund’s portfolio assets, the use of borrowings and derivatives for investment purposes, holdings of cash and cash equivalents, as well as borrowing arrangements and other funding sources. A fund’s board would be required to approve the fund’s three-day liquid asset minimum and a fund would be required to maintain a written record of how the fund’s three-day liquid asset minimum was determined.
- Assessment, Review and Management of Liquidity Risk: The proposed rule would require a fund to assess and periodically review its liquidity risk and manage such risk based on this assessment. In this connection, a fund would be prohibited from acquiring any less liquid asset if the fund would have invested less than its three-day liquid asset minimum in three-day liquid assets. In addition, the proposal codifies current SEC guidance that limits a mutual fund’s ability to invest in illiquid assets to 15% of the fund’s net assets.
- Reports to Fund Boards: A fund’s investment adviser or officers administering the fund’s liquidity risk management program would be required to submit written reports to the fund’s board concerning the adequacy of the fund’s liquidity risk management program, including the fund’s three-day liquid asset minimum, and the effectiveness of its implementation. Board approval would be required for any changes to the fund’s three-day liquid asset minimum.
The requirements of proposed Rule 22e-4, including the liquidity risk assessment requirements, are applicable to each series of a registered open-end investment company, meaning that each series requires a liquidity risk management program tailored to its own liquidity risk. The proposing release acknowledges that it may be appropriate for multiple series to adopt the same or a similar liquidity risk management program to the extent that such series are “substantially similar in terms of cash flow patterns, investment strategy, portfolio liquidity, and the other factors a fund would be required to consider in assessing its liquidity risk.”
The SEC also is proposing amendments to Rule 22c-1 under the 1940 Act that would allow, but not require, mutual funds (excluding ETFs and money market funds) to adjust their net asset value when the level of purchases or redemptions exceed certain pre-approved “swing thresholds.” Under the proposal, a fund’s board would be required to: (i) approve the methodologies for calculating the swing threshold and the adjustment factor and (ii) conduct an annual review of swing pricing policies and procedures. The SEC notes that the proposed amendments to Rule 22c-1 are designed to protect existing shareholders from dilution associated with shareholder purchases and redemptions.
Disclosure and Reporting Requirements
The SEC is proposing several amendments to Form N-1A and proposed Form N-PORT and Form N-CEN, including:
- Form N-1A: Funds would be required to disclose their liquidity risk management practices, including the methods used to meet shareholder redemptions and the use of “swing pricing,” if applicable. In addition, the proposal would require a fund to file any agreements related to lines of credit for the benefit of the fund as exhibits to its registration statement. (The specific fees paid in connection with credit agreements need not be disclosed in the exhibit proposed to be filed with the SEC.)
- Form N-PORT: Funds would be required to report the liquidity classifications assigned to individual portfolio securities and the three-day liquid asset minimum.
- Form N-CEN: Funds would be required to disclose information regarding committed lines of credit, swing pricing and interfund borrowing and lending, to the extent applicable.
Comments on the proposed rules will be accepted by the SEC for a period of 90 days after publication in the Federal Register. The proposing release is available at: http://www.sec.gov/rules/ proposed/2015/33-9922.pdf.