SEC Adopts New Liquidity Risk Management and Reporting Rules for Investment Companies

On October 13, 2016, the Securities and Exchange Commission (“SEC” or the “Commission”) finalized rules requiring open-end funds, including mutual funds and exchange traded funds (“ETFs”), to adopt liquidity risk management programs and permit mutual funds to use “swing pricing,” subject to specific requirements.  The Commission also enhanced data reporting requirements for mutual funds and ETFs.

Liquidity Risk Management Rules Under Rule 22e-4 under the Investment Company Act of 1940 (“IC Act”), liquidity risk management programs are required to include the following elements:

• Assessment, Management and Periodic Review of Liquidity Risk:  Importantly, the SEC defined liquidity risk as “the risk that a fund could not meet requests to redeem shares issued by the fund without significant dilution of remaining investors’ interests in the fund.”  The SEC is concerned about liquidation at fire sale prices.
• Classifying Liquidity of Fund Portfolio Investments:  Under the new rule, funds will be required to classify investments based on the number of days they expect to be able to convert investments to cash under existing market conditions.  Funds would be required to classify investments into 1 of 4 categories:  (a) highly liquid; (b) moderately liquid; (c) less liquid; and (d) illiquid.  Subject to certain conditions, funds may use broad asset class categories when making liquidity classifications.
• Determination of a Highly Liquid Investment Minimum:  Highly liquid investments include cash or investments capable of being converted to cash within 3 business days without significantly changing the value of the fund investments.  Under the new rule, funds will be required to determine their minimum percentage of highly liquid assets while necessitating investment companies to implement policies and procedures which will enable them to respond to a shortfall from this percentage.
• Limitation on illiquid investments:  The new rule prohibits funds from holding more than 15% of their assets in illiquid investments.  Under Rule 22e-4, illiquid investments are defined as assets that cannot be expected to convert to cash within 7 business days without significantly altering the value of the investment.  
• Review and Reporting of Illiquid Investments:  Funds will be required to review illiquid investments at least monthly.  Any breaches of the 15% limit must be reported to the fund’s board with an explanation and plan for remediation within a reasonable time period.  If the breach is not resolved within 30 days, the board must determine whether the breach remediation plan is in the best interest of shareholders and investors.
• Board oversight:  The fund must review and approve (a) the fund’s liquidity risk management program; and (b) designation of an adviser or officer to administer the program at least annually.  The board must also receive and review annually a written report documenting the adequacy and effectiveness of the liquidity risk management program.
• Form N-LIQUID:  Funds will be required to file this new form if (a) highly illiquid assets breach the 15% maximum threshold; and/or (b) highly liquid investments fall below the minimum threshold for a brief period of time.

Key differences between the new Rule 22e-4 and the original proposal include:

1. The original proposal required 6 liquidity risk classifications which have been reduced to 4;
2. The new rule exempts “in kind” ETFs, where investor redemptions occur with a pro rata amount of the fund’s underlying assets rather than cash.
3. The original proposal prevented funds from buying assets to maintain the “highly liquid” minimum, whereas the new rule lets the board determine how to rectify threshold breaches.

Swing Pricing

Swing pricing is an anti-dilution tool used to adjust a fund’s net asset value (“NAV”) in order to protect existing shareholders from the purchases and redemptions.  Mutual funds can use swing pricing to help manage liquidity risks provided that their policies and procedures:

• Document the process for determining:
• Swing threshold – a pre-determined percentage of fund’s NAV based on asset class and capital activity of the fund;
• Swing factor – a specified amount to adjust the NAV once the level of inflows or outflows are determined;
• Establish an upper limit on the swing factor, not to exceed 2% of the NAV per share;
• Be approved by the fund’s board; and
• Be required to periodically review its swing policy for the adequacy and effectiveness of implementation. Any changes to the swing factor’s upper limit or the swing threshold must be approved by the board.

Reporting Requirements

The SEC has implemented new reporting requirements for registered investment companies with the purpose of enhancing the quality of information available to investors.  The SEC will also collect and use the reported data to perform more targeted examinations.

The following is a summary of the new reporting requirements:

• Form N-PORT:  This new form requires registered funds (except money market funds) to provide monthly reporting via a structured data format of the fund’s investments. The information collected will cover topics such as:
  • Pricing of portfolio securities;
  • Repurchase agreements;
  • Securities lending agreements;
  • Counterparty exposures;
  • Derivatives contract terms;
  • Discrete portfolio level risks, including portfolio holdings across the 4 liquidity risk categories; and
  • Position level risks including, confidentially to the Commission, position level liquidity classifications.
• Form N-CEN:  The new form would require all registered investment companies to report census information through a structured data format, including:
  • Deployment of lines of credit;
  • Inter-fund borrowing and lending; and
  • The use of swing pricing.
• Fund Financial Statements:  Funds will be required to provide enhanced reporting in financial statements, including information on derivatives; and
• Enhanced Securities Lending Disclosures:  Funds will need to disclose fees paid to securities lending agents in registration statements.  

Effective Dates of the Rule

Most funds will be required to comply with the liquidity risk management rule and file Forms N-PORT and N-CEN by December 1, 2018.  Fund complexes with less than $1 billion in net assets will be required to meet the liquidity risk management rules and file the Form N-PORT by June 1, 2019.