Sidley Austin provides this information as a service to clients and other friends for educational purposes only. It should not be construed or relied on as legal advice or to create a lawyer-client relationship. Attorney Advertising - For purposes of compliance with New York State Bar rules, our headquarters are Sidley Austin LLP, 787 Seventh Avenue, New York, NY 10019, 212.839.5300; One South Dearborn, Chicago, IL 60603, 312.853.7000; and 1501 K Street, N.W., Washington, D.C. 20005, 202.736.8000. DECEMBER 21, 2015 SIDLEY UPDATE SEC Proposes a New Rule and Rule Amendments for Liquidity Risk Management Programs and Swing Pricing On September 22, 2015, the Securities and Exchange Commission (SEC) announced proposals relating to liquidity risk management by registered investment companies. Comments on the proposals are due by January 13, 2016. The SEC’s proposals include the following:1 • New Rule 22e-4. Proposed new Rule 22e-4 under the Investment Company Act of 1940 (the Act) would require each registered open-end investment company, other than money market funds, to adopt and implement a liquidity risk management program reasonably designed to assess and manage the fund’s liquidity risk.2 • Amendments to Rule 22c-1. As proposed, amended Rule 22c-1 under the Act would permit, but not require, registered open-end investment companies, other than exchange-traded funds (ETFs) and money market funds, to use “swing pricing” under certain circumstances. • Amendments to Form N-1A. Proposed amendments to Form N-1A would require disclosure of fund policies regarding share redemptions and the fund’s use of swing pricing. • Amendments to proposed Form N-PORT and proposed Form N-CEN. These amendments to the new data reporting forms proposed by the SEC on May 20, 2015,3 would require disclosures relating to the liquidity classification of each of a fund’s portfolio assets and the fund’s use of lines of credit, interfund lending, interfund borrowing and swing pricing. Reports on Form N-CEN, which would be publicly available, would be filed annually. Reports on Form N-PORT would be filed monthly, with the information reported for the third month (but not the first two months) made publicly available 60 days after the end of the quarter. The proposals are part of a broader rule-making agenda announced by SEC Chair Mary Jo White in December 2014 to address the risks of the “increasingly complex” asset management industry, including strengthening the 1 Open-End Fund Liquidity Risk Management Programs; Swing Pricing; Re-Opening of Comment Period for Investment Company Reporting Modernization Release, Investment Company Act Release No. 31835 (September 22, 2015) (the Release), available at: https://www.sec.gov/rules/proposed/2015/33- 9922.pdf. 2 “Liquidity risk” is defined in the proposed rule to mean “the risk that the fund could not meet requests to redeem shares issued by the fund that are expected under normal conditions, or are reasonably foreseeable under stressed conditions, without materially affecting the fund’s net asset value.” 3 See Sidley Update, “SEC Proposes Amendments to Modernize and Enhance Reporting by Investment Companies” (June 2, 2015), available at: http://www.sidley.com/news/06-02-2015-investment-funds-advisers-and-derivatives-update-2. SIDLEY UPDATE Page 2 management of fund liquidity.4 In her statement at the September 22, 2015 open meeting announcing the proposals, Chair White stated that the proposed reforms will “improve the [SEC’s] ability to supervise funds and to monitor and address any liquidity risks that their activities may pose to the overall stability of the U.S. financial system.”5 The Release notes concerns raised by the Financial Stability Oversight Council (FSOC) regarding the potential risks to the U.S. financial system that may be posed by asset management products and activities in the areas of liquidity and redemptions.6 The SEC takes the position that while the FSOC provides an important forum for studying and identifying systemic risks across different markets and participants, the SEC is the appropriate agency to monitor and address any risks associated with the asset management industry. The focus of the proposals, according to the Release, is to mitigate the adverse effects of liquidity risks of funds on fund investors and to promote the “fair, efficient and orderly operation of the markets.” 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, such as fixed income or alternative investment strategies,7 that are focused on less liquid asset classes. Investments in non-U.S. securities, some of which are subject to long settlement times and trading restrictions, also have grown. A 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 full fair value of the asset may not be realized, resulting in dilution of the remaining shareholders. Another source of potential dilution noted in the Release is the transaction costs that a 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. The potential dilution creates an incentive for investors to make early redemptions in times of perceived liquidity stress. 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 (the Exchange Act), which was adopted in 1993. Because Rule 15c6-1 requires a broker-dealer to settle a trade in 4 SEC Chair Mary Jo White, Enhancing Risk Monitoring and Regulatory Safeguards for the Asset Management Industry (December 11, 2014). As noted above, in May 2015 the SEC proposed two rulemakings intended to modernize and enhance data reporting for registered funds and investment advisers. On December 11, 2015, the SEC proposed new Rule 18f-4 under the Act designed to modernize the regulation of the use of derivatives by registered investment companies. Future rulemakings will address new requirements for stress testing by large investment advisers and large funds and provisions for transition plans after a major disruption in an investment adviser’s operations. 5 Chair Mary Jo White, Statement on Open-End Fund Liquidity Risk Management Programs and Swing Pricing (September 22, 2015), available at: http://www.sec.gov/news/statement/open-end-fund-liquidity-risk-management-programs--sept-22-2015.html. 6 In December 2014, FSOC issued a notice seeking public comments regarding the potential risks posed to the U.S. financial system by asset management products and activities in several areas, including liquidity and redemptions. 7 The Release notes that while there is no set definition of an “alternative” open-end fund, it is generally viewed as “a fund whose primary investment strategy falls into one or more of the three following buckets: (i) non-traditional asset classes (for example, currencies or managed futures funds), (ii) non-traditional strategies (such as long/short equity, event-driven), and/or (iii) less liquid assets (such as private debt). Their investment strategies often seek to produce positive risk-adjusted returns that are not closely correlated to traditional investments or benchmarks, in contrast to traditional mutual funds that historically have pursued long-only strategies in traditional asset classes.” SIDLEY UPDATE Page 3 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 Release, some funds disclose in their prospectuses that they generally satisfy redemption requests in less than three business days. The 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 and certain foreign securities) have not fallen correspondingly. As a result, the settlement periods associated with certain securities may extend beyond the period of time the fund would be required to meet shareholder redemptions, creating a potential timing mismatch. “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 obligations,” the SEC stated in the Release. II. Liquidity Risk Management Program – Proposed Rule 22e-4 A. Scope of Proposed Rule According to the Release, the SEC staff found great diversity during its outreach to both large and small fund complexes in an effort to better understand funds’ liquidity risk management practices. While some funds and their managers have developed comprehensive liquidity risk management programs, the staff found, others have dedicated “significantly fewer resources” to managing liquidity risk in a formalized manner. Chair White, in her statement, stated that: “Promoting stronger and more effective liquidity risk management is essential to reduce the risk that a fund will be unable to meet its redemption obligations, to minimize dilution of shareholder interests, and to address variations in practices among funds.”8 Proposed new Rule 22e-4 under the Act would require each registered open-end fund, including open-end ETFs but excluding money market funds,9 to: • Classify the liquidity of each of the fund’s positions in a portfolio asset or portions of a position in a particular asset. • Assess and periodically review the fund’s liquidity risk. • Implement a written liquidity risk management program reasonably designed to manage the fund’s liquidity risk based on this assessment (referred to herein as a Written Risk Management Program), which must be approved and monitored by the fund’s board. Required components of the Written Risk Management Program include: 8 Supra note 5. 9 Each series of an open-end registered investment company would be required to establish its own liquidity risk management program tailored to such series’ liquidity risk. Unit investment trusts (UITs), including ETFs structured as UITs, are not proposed to be subject to proposed Rule 22e-4. SIDLEY UPDATE Page 4 o Determining a minimum percentage of fund net assets that must be invested in assets the fund believes is convertible to cash within three business days (the three-day liquid asset minimum); and o Prohibiting the fund from acquiring “illiquid” assets if, immediately after such acquisition, the fund would have invested more than 15% of its total assets in illiquid assets. B. Classifying the Liquidity of a Fund’s Portfolio Positions Under proposed Rule 22e-4, a fund would be required to classify each of its portfolio positions (or portions of a position) based on the number of days that would be required to convert a position to cash, at a price that does not materially affect the value of that asset immediately prior to the sale, and settle the sale (i.e., receive the cash proceed of the sale). The six proposed liquidity classification categories are based on whether the positions could be converted to cash, at a price that does not materially affect the value of that asset immediately prior to sale: within 1 business day, within 2-3 business days, within 4-7 calendar days, within 8-15 calendar days, within 16- 30 calendar days or in more than 30 calendar days. A fund may determine that portions of a portfolio position may be converted to cash within different time periods than other portions of the position—for example, the fund may determine that it could convert half of a portfolio position to cash in one day, but that it would take three days to convert the remainder of the position. In such cases, the fund may classify the appropriate portions of the portfolio assets accordingly. The proposed rule would require a fund to review, on an ongoing basis, the liquidity classification of each of its portfolio positions. The proposed rule sets forth specific factors to be considered in classifying the liquidity of a fund’s portfolio asset, including, for example, with respect to the asset: • Existence of an active market; • Frequency of trades or quotes and average daily trading volume; • Volatility of trading prices; • Bid-ask spreads; • Whether the asset has a relatively standardized and simple structure; • For fixed income securities, maturity and date of issue; • Restrictions on trading and limitations on transfer; • Size of the fund’s position relative to the asset’s average daily trading volume and, as applicable, the number of units of the asset outstanding (the analysis of the position size should consider the extent to which the timing of disposing of the position could create any market value impact); and • Relationship of the asset to another portfolio asset. It is proposed that detailed reporting and disclosure of a fund’s liquidity classifications of its assets would be included in the fund’s disclosure of portfolio holdings on proposed Form N-PORT. See Section IV.C. below. 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). Under the 15% guideline, an asset is considered illiquid if it cannot be SIDLEY UPDATE Page 5 sold or disposed of in the ordinary course of business within seven days at approximately the value at which the fund has valued the investment.10 The proposed liquidity categorization process would be in addition to the existing 15% guideline (which would be retained, as discussed below) and would require a fund to evaluate the liquidity of its portfolio positions individually, as well as the fund’s aggregate liquidity profile. C. Assessing a Fund’s Liquidity Risk Proposed Rule 22e-4 envisions a two-pronged liquidity risk assessment and risk management process, whereby a fund would be required to assess and periodically review its liquidity risk, based on certain specified factors, and then develop a liquidity risk management program tailored to the fund’s liquidity risk. The liquidity risk assessment would be required to take into account, at a minimum, the fund’s: • Short-term and long-term cash flow projections (including the degree of certainty associated with such projections); redemption policies; shareholder ownership concentration; and distribution channels; • Investment strategy and liquidity of portfolio assets; • Use of borrowings and derivatives for investment purposes; and • Holdings of cash and cash equivalents, as well as borrowing arrangements and other funding sources. D. Written Liquidity Risk Management Program Proposed Rule 22e-4 would require funds to adopt and implement a Written Liquidity Risk Management Program reasonably designed to manage the fund’s liquidity risk, including determining the fund’s three-day liquid asset minimum. Proposed Rule 22e-4 also would codify the current 15% limit on illiquid assets. The Written Liquidity Risk Management Program must be approved by the fund’s board. 1. Three-Day Liquid Asset 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 openend funds (with the exception of money market funds) to maintain a minimum level of portfolio liquidity. In the Release, the SEC stated its belief that codifying a three-day liquid asset minimum requirement would result in a portfolio liquidity standard that “fosters consistency in funds’ consideration of the factors relevant to their liquidity risk management, while simultaneously permitting flexibility in implementation, which we believe is appropriate in light of the significant diversity of holdings and strategies within the fund industry.” Under this component of proposed Rule 22e-4, a fund would be required to: • Determine a minimum percentage of fund net assets that must be invested in cash or other assets that the fund believes is convertible to cash within three business days at a price that does not materially affect the value of that asset immediately prior to the sale (i.e., the three-day liquid asset minimum). The fund must consider specified factors, including: 10 The 15% guideline is distinguishable from the proposed liquidity classification categories as it does not include consideration of when the asset can be converted to cash. SIDLEY UPDATE Page 6 o Short-and long-term cash flow projections; o The liquidity of the fund’s assets; o The fund’s investment strategy; and o The use of borrowings and derivatives for investment purposes. • Periodically review (no less frequently than semi-annually) the adequacy of the three-day liquid asset minimum. • Not acquire any less liquid asset if immediately after the acquisition, the fund would have invested less than its three-day liquid asset minimum in three-day liquid assets. The Release noted that, consistent with the provision in Section 22(e) of the Act under which funds generally have up to seven days to pay redemption proceeds, the SEC considered requiring that a fund determine a minimum amount of liquid assets based on assets convertible to cash within seven days at a price that does not materially affect the value of that asset immediately prior to sale (seven-day liquid assets). However, the SEC stated in the Release that it was concerned that requiring a minimum amount of seven-day liquid assets would not comport with regulatory requirements and disclosures that require most funds to meet redemption requests in shorter time periods, as well as market practices and investor expectations that effectively require all funds to meet redemption requests in shorter time periods. “We thus believe,” the SEC stated, “that a three-day liquid asset minimum more effectively advances our goals of reducing the risk that funds will be unable to meet redemptions and mitigating dilution.” Although each of the SEC Commissioners voted to approve the proposals for public comment, several of the Commissioners voiced some concerns regarding the three-day liquid asset minimum. Commissioner Daniel M. Gallagher noted, for example, that whereas the theory behind the “three-day bucket” is that most funds must meet redemptions within three business days as a result of Rule 15c6-1 under the Exchange Act, there appears to be a potentially sizable portion of the industry that is not restricted by Rule 15c6-1 and would only be required to pay redemptions within seven days. On the other hand, some funds endeavor to pay redemption proceeds in less than three days. In each of these cases, he stated, the three-day minimum has limited relevance. Gallagher asked commenters to consider, among other questions, whether there are ways the rule can be more appropriately tailored or whether it should match up with the seven-day requirement statutorily mandated by Section 22(e).11 2. Codification of 15% Standard As noted above, the proposals would retain and codify the long-standing SEC “15% guideline” that generally limits an open-end fund’s aggregate holdings of “illiquid assets” to 15% of the fund’s net assets. Specifically, proposed Rule 22e-4 would mandate that a fund not acquire any asset that may not be disposed of in the ordinary course of business within seven calendar days at approximately the value assigned to it by the fund (the 15% standard) if immediately after such acquisition, the fund would have invested more than 15% of its total 11 Commissioner Daniel M. Gallagher, Statement on Open-End Fund Liquidity Risk Management Programs and Swing Pricing (September 22, 2015), available at: http://www.sec.gov/news/statement/gallagher-liquidity-risk-management.html. SIDLEY UPDATE Page 7 assets in 15% standard assets.12 The 15% standard would be tested each time the fund acquires new assets. A fund would be permitted to hold more than 15% of its net assets in 15% standard assets if it does so due to redemptions or market events. The Release notes that although the 15% guideline involves determining whether an asset can be sold or disposed of within seven days at approximately its stated value, it does not (i) consider whether the fund can actually receive the proceeds of any sale within seven days, (ii) take into account any market or other factors in considering an asset’s liquidity or (iii) consider whether the fund’s position size in a particular asset affects the liquidity of that asset. In contrast, the Release states, the proposed liquidity categorization approach incorporates each of these aspects, which the SEC believes are critical to “comprehensively assessing” the liquidity of a fund’s position in a particular portfolio asset. “We thus have come to consider the 15% guideline alone to be insufficient to limit a fund’s liquidity risk given the fund’s obligations to meet shareholder redemptions,” the SEC stated. 3. Board Approval of Written Liquidity Risk Management Program The fund’s board, including a majority of the independent directors, would be required to: • Initially approve the Written Liquidity Risk Management Program. The Release indicates 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. The Release also notes, however, that the board may wish to consider the (i) nature of the fund’s liquidity risk management program, (ii) nature of the fund’s liquidity risk exposure and (iii) adequacy of the fund’s liquidity risk management considering any recent fund experiences relating to liquidity, including any redemption pressures.13 • Approve any material changes to the Written Liquidity Risk Management Program, including any change to the fund’s three-day liquid asset minimum. • Approve the fund’s designation of the fund’s investment adviser or officers as responsible for administering the program. The proposed rule would prohibit the program from being administered solely by portfolio managers of the fund. • Review, no less than annually, a written report prepared by the investment adviser or officers administering the program describing the adequacy of the program, including the three-day liquid asset minimum, and the effectiveness of its implementation. 4. Additional Liquidity Risk Management Tools The Release indicates that a fund’s liquidity risk management program could incorporate liquidity risk management tools in addition to the requirements of proposed Rule 22e-4. Additional tools that may be used to 12 The definition of “15% standard asset” is “an asset that may not be sold or disposed of in the ordinary course of business within seven calendar days at approximately the value ascribed to it by the fund.” For purposes of this definition, the fund does not need to consider the size of the fund’s position in the asset or the number of days associated with receipt of proceeds of sale or disposition of the asset. 13 The Release notes the potential conflict of interest between the investment adviser to the fund and the fund regarding the liquidity risk management program, and notes that the requirement of board oversight “is designed to facilitate independent scrutiny by the board of directors of the liquidity risk management program.” SIDLEY UPDATE Page 8 enhance fund liquidity include, for example, lines of credit or other borrowing arrangements and investing in ETFs. The SEC also requested comment regarding whether, in addition to money market funds, other open-end funds should be permitted to suspend redemptions and postpone payment of redemption proceeds in an orderly liquidation of the fund under certain circumstances, and whether the SEC should consider proposing rules that would permit a fund to suspend redemptions under other circumstances not involving the liquidation of the fund. III. Swing Pricing - Proposed Rule 22c-1(a)(3) A. Scope of Proposed Rule The SEC noted in the Release that even with improved liquidity risk management, circumstances could arise in which shareholder purchases and redemptions could dilute the value of existing shareholders’ interests in the fund. For this reason, the SEC also proposed amendments to Rule 22c-1 that would permit, but not require, registered open-end funds, other than ETFs and money market funds, to use “swing pricing” under certain circumstances.14 Swing pricing, which is currently used by certain foreign funds,15 refers to the process of adjusting a fund’s net asset value (NAV) to effectively pass on the market impact costs, spread costs and transaction fees and charges stemming from net capital activity (i.e., flows in or out of the fund) to the shareholders associated with that activity, in order to protect other shareholders from dilution arising from these costs. Under the proposed amendments, a fund that elects to use swing pricing would be required to implement swing pricing policies and procedures, as approved by the fund board, providing for the fund to increase or decrease its NAV per share by an amount designated as the “swing factor” once the level of net redemptions or net purchases has exceeded a specified percentage of the fund’s NAV (including all share classes together). That specified percentage is known as the “swing threshold.”16 The amendments thus envision partial swing pricing (i.e., an NAV adjustment would not be permitted unless net purchases or net redemptions exceed a specified threshold) and not full swing pricing (i.e., an NAV adjustment any time the fund experiences net purchases or net redemptions), which is employed by some foreign funds. The Release notes that funds would be able to adopt swing pricing policies and procedures in their discretion; but that once these policies and procedures are adopted, a fund would be required to adjust its NAV when net purchases or net redemptions cross the swing threshold, unless the fund’s board approves a change to the swing threshold. 14 The Release notes that “dual pricing” had been considered as an alternative to swing pricing. A fund using dual pricing would quote two separate prices—one for purchases, which would reflect the cost of buying portfolio securities, and one for redemptions, which would reflect the proceeds the fund would receive from selling portfolio securities. However, the SEC considered that swing pricing was preferable because it would be simpler to implement and simpler for investors to understand. 15 The Release notes that certain European funds utilize swing pricing and references a survey conducted by the Association of the Luxembourg Fund Industry several years ago that “confirmed a strong directional trend towards the adoption of swing pricing among major market participants in that jurisdiction, which is a significant jurisdiction for the organization of UCITS funds in Europe.” 16 The person(s) responsible for making this determination would be permitted to make the determination on the basis of information obtained after reasonable inquiry, and purchases or redemptions made in kind (not in cash) would be excluded. SIDLEY UPDATE Page 9 B. Determining the Swing Threshold and the Swing Factor In determining its swing threshold, a fund would be required to consider: • The size, frequency and volatility of historical net purchase or net redemptions of fund shares during normal and stressed periods; • The fund’s investment strategy and the liquidity of its portfolio assets; • The fund’s holdings of cash and cash equivalents, as well as borrowing arrangements and other funding sources; and • The costs associated with transactions in the markets in which the fund invests. The SEC indicated in the Release that in order to effectively mitigate possible dilution, a fund’s swing threshold should “generally reflect the estimated point at which net purchases or net redemptions would trigger the fund’s investment adviser to trade portfolio assets in the near term, to a degree or of a type that may generate material liquidity or transaction costs for the fund.” In the SEC’s view, the factors set forth above would permit a fund to estimate this point. The fund would be required to periodically review the swing threshold (no less frequently than annually). The swing pricing policies and procedures also would be required to specify how the swing factor to be used to adjust the fund’s NAV will be determined. The swing factor would be required to take into account: • Any near-term costs expected to be incurred as a result of net purchases or net redemptions on the day the swing factor is used, including 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 • The value of the assets purchased or sold by the fund due to net purchases or redemptions occurring on the day the swing factor is used to adjust the fund’s NAV per share, if that information is not reflected in the current NAV of the fund computed that day. The SEC stated in the Release that because these considerations could vary depending on the facts and circumstances, the swing factor that a fund would determine appropriate to use in adjusting its NAV also could vary and would be based to a certain extent on near-term costs that must be estimated. A fund would be permitted (but not required) to adopt an upper limit of the swing factor it would apply. The SEC noted that it was not proposing to require a fund to publicly disclose its swing threshold, because of concerns that certain shareholders may attempt to time their transactions based on this information, as well as concerns that disclosure could be confusing or potentially misleading insofar as it could give an inaccurate view of a fund’s relative risks and benefits. C. Board Approval and Oversight of Swing Pricing Policies and Procedures It is proposed that in order for a fund to utilize swing pricing, the fund’s board, including a majority of independent directors, would be required to: SIDLEY UPDATE Page 10 • Initially approve the fund’s swing pricing policies and procedures, including the swing threshold and any specified upper limit to the swing factor, and any material changes thereto;17 and • Designate the fund’s investment adviser or officers responsible for administering the policies and procedures and determining the swing factor that would be used to adjust the fund’s NAV when the swing threshold is breached. The proposed rule would require that the determination of the swing factor be reasonably segregated from the portfolio management function of the fund. The board would not be required to manage the administration of the fund’s swing pricing policies and procedures nor to approve each swing factor that would be used. D. Potential Issues Regarding Swing Pricing 1. General At the open meeting, certain of the Commissioners expressed certain broad reservations regarding the use of swing pricing. Commissioner Michael S. Piwowar indicated, for example, that he is “not convinced that swing pricing is the best way to allocate the costs stemming from a shareholder’s purchase or redemption activity to that shareholder” and called for comments regarding the general appropriateness of this approach. There are other means by which a fund could mitigate dilution and ensure that redeeming shareholders bear the brunt of the costs associated with their redemptions without affecting the fund’s NAV, he stated, such as the use of liquidity or redemption fees.18 Commissioner Gallagher stated that requiring funds to set a single swing threshold that would apply equally to both net purchases and net redemptions may greatly reduce “the utility of swing pricing as a tool to mitigate dilution.” Noting that funds are in the best position to understand their portfolios, shareholder base and fund flows, he suggested that if final rules permitting swing pricing are ultimately adopted, those rules should accord funds the flexibility to craft their swing pricing procedures, as appropriate. For example, Gallagher indicated, one fund may find it beneficial to adopt swing pricing only in the case of net redemptions. Another fund may find it beneficial to adopt swing pricing on both the purchase and redemption sides, but may wish to adopt different thresholds for each side of net flows.19 The SEC also requested comment on similar questions regarding the swing threshold. The SEC also requested comment on a number of broad points, including whether: • Certain shareholders should be exempt from swing pricing. These might include (i) small shareholders whose purchases or redemptions are unlikely to create significant liquidity costs for the fund or (ii) purchasing shareholders when the fund’s NAV is adjusted downward. • Dual pricing would be more or less effective to mitigate potential dilution than swing pricing. 17 Requests for comment in the Release include inquires regarding whether (i) commenters agree that the board should not be required to approve each swing factor used and (ii) the SEC should provide guidance regarding material NAV errors due to a misapplication of the firm’s swing pricing policy—for example, when the fund makes estimates under its swing pricing policy but the final information, such as shareholder flows, changes materially. 18 Commissioner Michael S. Piwowar, Statement on Open-End Fund Liquidity Risk Management Programs and Swing Pricing (September 22, 2015), available at: http://www.sec.gov/news/statement/open-end-fund-liquidity-risk-management.html. 19 Supra note 11. SIDLEY UPDATE Page 11 The Commissioners also raised more specific concerns, and the SEC acknowledged in the Release that swing pricing may involve potential disadvantages as well as potential advantages to funds. 2. NAV Volatility The SEC acknowledged that swing pricing could increase the volatility of a fund’s NAV in the short term, which might increase benchmark tracking error during the period of NAV adjustment. Volatility and tracking error related to swing pricing therefore could result in investors incorrectly perceiving the short-term relative performance of a fund. However, the SEC noted its belief that the use of partial (rather than full) swing pricing would significantly reduce potential performance volatility and that swing pricing should have a minimal effect on longer-term volatility and tracking error. The SEC requested comment on the potential effects of swing pricing on funds’ performance volatility and any potential market distortions that could result if some funds adopt swing pricing but other similarly situated funds do not. 3. Swing Pricing Would Affect All Shareholders Application of a swing factor would affect all purchasing and redeeming shareholders equally, regardless of whether the size of a particular shareholder’s purchases or redemptions alone would create material trading costs for the fund. The SEC acknowledged in the Release that this could cause certain shareholders to experience benefits or costs, relative to the other shareholders in the fund, that otherwise would not exist. Commissioner Gallagher expressed particular concern that swing pricing could cause disproportionate harm to retail investors, stating that “if the applicable threshold is met because of trading by a large institutional investor, a small investor that had the unfortunate luck to trade in the same direction as the institutional investor that day would likewise bear the impact from the amended price.” Gallagher also noted that many retail investors invest in funds through paycheck debits and other automatic payment schedules and thus would run a continual risk of their purchase orders being placed on a day that the swing threshold is met. 20 4. Potential Gaming Behavior The SEC noted its recognition that a fund’s adoption of a swing threshold could create the potential for gaming behavior, because a fund’s shareholders could attempt to time their purchases and redemptions based on the likelihood that the fund would or would not adjust its NAV. However, the SEC stated that it does not regard potential gaming as a significant concern, because it would be difficult for shareholders to determine when the fund’s net purchases or net redemptions cross the swing threshold. As noted above, a fund would not be required to publicly disclose its swing threshold.21 Also, funds are not required to disclose their daily net flows and do not usually do so. 20 Supra note 11. 21 The SEC noted that, to the extent a fund does decide to disclose its swing threshold, “we believe it would not be appropriate for a fund to disclose it selectively to certain investors (e.g., to only disclose the fund’s swing threshold to institutional investors), as we believe this could assist certain groups of shareholders in strategically timing purchases and redemptions of fund shares, potentially disadvantaging shareholders who do not know the fund’s swing threshold.” SIDLEY UPDATE Page 12 In his statement, Commissioner Piwowar expressed his hope that commenters, including academic economists, will discuss the potential for gaming behavior and how swing pricing would affect comparisons of common riskadjusted measures of mutual fund performance, such as alpha, beta, Sharpe ratio and trading error.22 IV. Proposed Disclosure Requirements The SEC proposed (i) form amendments designed to require fuller disclosure of information regarding the liquidity of fund portfolios and how funds manage liquidity risk and redemption obligations and (ii) disclosure and reporting requirements regarding swing pricing designed to assist shareholders in understanding whether a particular fund has implemented swing pricing procedures and has used swing pricing. A. Form N-1A Proposed modifications of Form N-1A would require: • A fund that uses swing pricing to disclose the circumstances where it will use swing pricing and the effects of swing pricing. • A fund that invests in other funds that use swing pricing to disclose that its NAV is calculated based upon the NAVs of the other funds in which the fund invests. The prospectuses for those other funds would be required to explain the circumstances under which those funds will use swing pricing and the effects of swing pricing. • Disclosure of the number of days following the receipt of a shareholder redemption request that the fund will pay redemption proceeds, the methods used by the fund to meet redemption requests (e.g., sales of portfolio assets, holdings of cash/cash equivalents, lines of credit, interfund lending, redemptions inkind) and whether such methods are used regularly or only in stressed market conditions. • Changes to the fund’s performance presentation and calculation to take into account swing pricing. B. Form N-CEN Proposed modifications of proposed Form N-CEN would add questions regarding lines of credit, interfund lending and borrowing, and swing pricing. The Release indicates that the proposed changes are intended to allow the SEC and other users to “track certain liquidity risk management practices that we expect funds to use on a less frequent basis than the day-to-day portfolio construction techniques captured by proposed Form NPORT.” It is proposed that Form N-CEN replace Form N-SAR and be filed annually within 60 days of the end of the fund’s fiscal year. C. Form N-PORT Proposed modifications of proposed Form N-PORT would require disclosure of the three-day liquid asset minimum, the liquidity classification for each portfolio asset (or portion thereof) and whether an asset is a 15% Standard Asset. Under proposed Form N-PORT, information would be required to be reported on a monthly basis 30 days after the end of each month. The data reported with respect to the first two months of each quarter 22 Supra note 18. SIDLEY UPDATE Page 13 would not be made public; however the data relating to the third month of the quarter would be made public 60 days after the quarter end. Proposed Form N-PORT has been the subject of a number of comment letters arguing against, among other things, the public disclosure of liquidity determinations, noting that liquidity determinations are subjective and may reasonably differ between funds, and that the disclosure will be confusing to investors.23 V. Proposed Compliance Dates A. Proposed Rule 22e-4 The SEC indicated that it expects to provide for a tiered set of compliance dates based on asset size, to allow smaller entities extra time to establish and implement the requirements of proposed Rule 22e-4. • For larger entities—i.e., funds that, together with other investment companies in the same “group of investment companies”24 have net assets of $1 billion or more as of the end of the most recent fiscal year—the SEC proposed a compliance date of 18 months after the effective date of the Rule. • For smaller entities, the SEC proposed to provide for an extra 12 months (i.e., 30 months after the effective date) for compliance with the Rule. On or before the applicable compliance date, a fund must have adopted and implemented compliance policies and procedures that satisfy the requirements of the Rule. These policies and procedures must have been approved by the board on or before the applicable compliance date. B. Swing Pricing The SEC stated in the Release that because reliance on Rule 22c-1(a)(3) permitting the adoption of swing pricing would be optional, it believed a compliance period would not be necessary. Therefore, a fund would be able to rely on the Rule after the effective date as soon as the fund could comply with the Rule and related records, financial reporting and prospectus disclosure requirements. C. Amendments to Disclosure Documents Except with respect to the proposed amendments to Form N-1A related to swing pricing, the SEC indicated that, if the other proposed amendments to Form N-1A are adopted, it expects to require all initial registration statements on Form N-1A, and all annual updates to effective registration statements on Form N-1A, filed six months or more after the effective date, to comply with the proposed amendments to Form N-1A. 23 See, e.g., Comment Letter of the Investment Company Institute on Investment Company Reporting Modernization Release (August 11, 2015) (stating “[i]lliquidity determinations and determinations of country of risk require considered judgment, and different firms reasonably can arrive at different conclusions. Public disclosure likely will stifle today’s robust processes of making independent determinations, instead incenting firms to seek homogenized determinations from third-party service providers.”) and Comment Letter of Charles Schwab Investment Management on Investment Company Reporting Modernization Release (August 11, 2015) (stating “While Funds and advisers each can have sound methodologies and processes for determining illiquidity, they may reasonably differ in the determination for any particular security. Due to the subjectivity of these determinations, publicly disclosing liquidity determinations could lead to confusion among investors. Also, it is important that Funds and their advisers be able to use sound methodologies and processes to make liquidity determinations as appropriate in individual Fund circumstances without public confusion.”). 24 The Release indicates that it is expected that this term will be based on the definition of “group of related investment companies” as defined in Rule 0-10 under the Act. SIDLEY UPDATE Page 14 The SEC indicated that similar to the tiered compliance dates for proposed Rule 22e-4, it expects to provide for a tiered set of compliance dates based on asset size for the proposed amendments to proposed Form N-PORT (18 months and 30 months after the effective date for larger entities and smaller entities, respectively). If Form N-CEN and the proposed amendments to the form are adopted, the SEC proposed a compliance date of 18 months after the effective date to comply with the new reporting requirements. If you have any questions regarding this Sidley Update, please contact the Sidley lawyer with whom you usually work, or John A. MacKinnon Partner email@example.com +1 212 839 5534 Frank P. Bruno Partner firstname.lastname@example.org +1 212 839 5540 James C. Munsell Partner email@example.com +1 212 839 5609 Laurin Blumenthal Kleiman Partner firstname.lastname@example.org +1 212 839 5525 Douglas E. McCormack Counsel email@example.com +1 212 839 5511 Jesse C. Kean Associate firstname.lastname@example.org +1 212 839 8615 Carla G. Teodoro Associate email@example.com +1 212 839 5969 Investment Funds, Advisers and Derivatives Practice Sidley has a premier, global practice in structuring and advising investment funds and advisers. We advise clients in the formation and operation of all types of alternative investment vehicles, including hedge funds, fund-of-funds, commodity pools, venture capital and private equity funds, private real estate funds and other public and private pooled investment vehicles. We also represent clients with respect to more traditional investment funds, such as closed-end and open-end registered investment companies (i.e., mutual funds) and exchange-traded funds (ETFs). Our advice covers the broad scope of legal and compliance issues that are faced by funds and their boards, as well as investment advisers to funds and other investment products and accounts, under the laws and regulations of the various jurisdictions in which they may operate. In particular, we advise our clients regarding complex federal and state laws and regulations governing securities, commodities, funds and advisers, including the Dodd-Frank Act, the Investment Company Act of 1940, the Investment Advisers Act of 1940, the Securities Act of 1933, the Securities Exchange Act of 1934, the Commodity Exchange Act, the USA PATRIOT Act and comparable laws in non-U.S. jurisdictions. Our practice group consists of approximately 120 lawyers in New York, Chicago, London, Hong Kong, Singapore, Shanghai, Tokyo, Los Angeles and San Francisco. To receive Sidley Updates, please subscribe at www.sidley.com/subscribe. BEIJING ∙ BOSTON ∙ BRUSSELS ∙ CENTURY CITY ∙ CHICAGO ∙ DALLAS ∙ GENEVA ∙ HONG KONG ∙ HOUSTON ∙ LONDON LOS ANGELES ∙ NEW YORK ∙ PALO ALTO ∙ SAN FRANCISCO ∙ SHANGHAI ∙ SINGAPORE ∙ SYDNEY ∙ TOKYO ∙ WASHINGTON, D.C. Sidley Austin refers to Sidley Austin LLP and affiliated partnerships as explained at www.sidley.com/disclaimer. www.sidley.com
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SEC Proposes a New Rule and Rule Amendments for Liquidity Risk Management Programs and Swing Pricing
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