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SEC Proposes Fund Liquidity Management Programs, Swing Pricing

The SEC yesterday issued a proposal to address liquidity management in open-end funds. The proposal would require funds (other than money market funds) to establish a liquidity risk management program, require certain disclosures regarding each fund’s program and the liquidity of the fund’s holdings, and codify current guidelines that limit illiquid holdings to fifteen percent of a fund’s net asset value.  In addition, proposed rule amendments would allow funds to adopt swing pricing.

In her statement, SEC Chair Mary Jo White noted that “[w]e have seen all too clearly in recent years the very real impact that disruptions in the financial markets can have not just on individual investors and markets, but on the country as a whole.” She highlighted the growing popularity of less liquid bond, emerging market, and alternative funds that bring challenges because they “increase the complexity and potential risks of fund portfolios and operations.” She described the Commission’s action as “a strong but versatile proposal that responds to current developments and enhances the ability of open-end funds to manage liquidity risks in a modern market environment.”

Under the proposal, a fund’s liquidity risk management program would include:

  • Classification of the liquidity of fund portfolio assets;
  • Assessment, periodic review and management of a fund’s liquidity risk;
  • Establishment of a fund’s three-day liquid asset minimum; and
  • Board approval and review.

In addition to fund liquidity management programs, the proposal would also allow a fund (other than an ETF of money market fund) to impose swing pricing “to effectively pass on the costs stemming from shareholder purchase or redemption activity to the shareholders associated with that activity.” The fund would set a “swing threshold,” and once net purchases or redemptions exceeded that amount, the NAV would be adjusted by a “swing factor” also set by the fund.

The proposal includes updates to Forms N-1A, which would require funds to disclose swing pricing details and “the methods used by funds to meet redemptions.” The fund would also “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.” The proposal would update forms N-PORT and N-CEN which were proposed under the recent rule to modernize reporting. On Form N-PORT, the fund would add the liquidity classification and an indication of whether the holding is part of the fund’s fifteen percent illiquid holdings, as well as the fund’s three-day liquid asset minimum. The proposal would update Form N-CEN with “information regarding committed lines of credit, interfund borrowing and lending, and swing pricing.” ETFs would report on the form 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.”

Although the proposal passed unanimously, several commissioners expressed reservations. Commissioner Kara Stein argued that the proposal may actually not go far enough and reiterated her previous comments that perhaps certain alternative strategies should be restricted to the closed-end or private fund space rather than offered in open-end mutual funds.

Commissioner Dan Gallagher worried that the proposed rule may have a disproportionate effect on retail investors who may inadvertently seek to transact shares on a day when a large institutional investor is also transacting. He noted that some investors may use automatic payment schedules and thus “run a continual risk of their purchase orders being placed on a day that the swing threshold is met.” Commissioner Michael Piwowar questioned whether swing pricing is the appropriate method to address liquidity issues and instead suggested that liquidity or redemption fees to achieve a similar result without changing the NAV. Piwowar also worried that swing pricing could increase the incentive to attempt to game a fund’s NAV, potentially resulting in increased volatility.

Gallagher suggested that the three-day liquid asset minimum would be of “limited relvance” to some funds such as those that already seek to pay redemption proceeds in three days or less or those funds that only invest in equity securities of S&P 500 companies. Piwowar also questioned the three-day liquid asset minimum, arguing instead that the proposed rule should track the statutory requirement of making payment within seven days.

With the proposal, the Commission also reopened the comment period for the reporting modernization proposal. The concurrent comment period will last 90 days, starting from the proposal’s publication in the Federal Register. Next on the Commission’s rulemaking agenda are rules addressing “the growth in the use of derivatives by registered funds and the impact on investors of a market stress event or when an investment adviser is no longer able to serve its clients,” according to Piwowar.