SEC Proposes Changes to Liquidity Risk Management Practices Used by Open-End Funds
On September 22, 2015, the SEC or Commission voted unanimously to propose rule changes to liquidity risk management practices used by open-end funds including mutual funds and exchange-traded funds (“ETFs”) (but excluding money market funds). The proposed changes are part of the SEC’s ongoing reforms of the Investment Company Act of 1940 and are designed to address a perceived increase in liquidity risk following the growth in mutual funds’ investments in illiquid assets and fixed income securities over the last 20 years and since the SEC last provided guidance on liquidity in this area.
The proposed changes would require mutual funds and ETFs to (i) implement liquidity risk management programs in order to reduce the risk that funds are unable to meet shareholder redemption requests; and (ii) enhance disclosures and reporting regarding fund liquidity and redemption practices. The proposed changes would also permit, but not require, mutual funds to use “swing pricing” to pass on costs associated with subscription or redemption activity.
According to SEC Chair Mary Jo White, “promoting stronger liquidity risk management is essential to protecting the interests of the millions of Americans who invest in mutual funds and exchange-traded funds….These significant reforms would require funds to better manage their liquidity risks, give them new tools to meet that requirement, and enhance the Commission’s oversight.”
Liquidity Risk Management Programs
Key elements of proposed liquidity risk management programs identified by the SEC include:
- Classification of the liquidity of fund portfolio assets;
- Assessment, periodic review and management of a fund’s liquidity risk;
- Establishment of a 3-day liquid asset minimum; and
- Board, including a majority of independent directors, approval and review of written liquidity management programs.
In addition, the proposed changes would codify the 15% limit on illiquid assets included in current SEC guidelines and define a “15% standard asset” as positions which may not be sold within 7 days at their approximate carrying value.
The classification of the liquidity of fund portfolio assets would be based on the number of days in which positions would be convertible to cash at a price that does not materially affect the value of the asset immediately prior to sale. Each portfolio position would be categorized into one of 6 different liquidity buckets. This information would be disclosed on the new Form N-Port (see below) and reviewed on an ongoing basis.
Liquidity risk would be defined as the risk that a fund could not meet redemption requests under normal or under stressed conditions, without materially affecting the fund’s net asset value (“NAV”).
In order to satisfy immediate liquidity needs, funds would be required to determine a minimum percentage of their net assets that must be invested in cash and assets that are convertible to cash within 3 business days at a price that does not materially affect the value of the asset immediately prior to sale. Current rules require funds to make redemptions within 7 days of receiving redemption requests. The proposed 3-day liquidity rule will therefore make it easier for funds to fulfill redemption requests within 7 days.
Formal liquidity risk management programs should be approved by boards. Adequacy of such programs should then be reviewed by boards at least annually.
Disclosure and Reporting Requirements
Proposed amendments to reporting requirements include changes to (i) Form N-1A (the registration form used by open-end investment companies); (ii) Form N-Port; and (iii) Form N-CEN (reporting forms proposed by the SEC in May 2015 pertaining to portfolio holdings reporting and census reporting respectively).
Proposed changes to Form N-1A include a requirement for funds to disclose swing pricing, if applicable, and the methods used by funds to meet redemption requests. Changes to Form N-Port would be to report the liquidity classification of fund assets based on the 6 liquidity buckets (see above) and the 3-day liquid asset minimum, in addition to the requirement that funds report whether an asset is a 15% standard asset. Changes to Form N-CEN would be to disclose information regarding committed lines of credit, inter-fund borrowing and lending, and swing pricing. ETFs would also be required to report whether they required an authorized participant to post collateral in connection with the purchase or redemption of ETF shares.
The Investment Company Act currently requires that shares are sold and redeemed at a price based on the current NAV next computed after receipt of an order to purchase or redeem shares.
When a fund trades its investments to satisfy purchase or redemption requests, costs associated with this trading activity can dilute the value of existing shareholders’ interests in the fund. Swing pricing is the process of reflecting in a fund’s NAV the costs associated with shareholders’ trading activity in order to pass those costs on to the purchasing and redeeming shareholders. It is designed to protect existing shareholders from dilution associated with shareholder purchases and redemptions.
A fund that chooses to use swing pricing would reflect in its NAV a specified amount, the “swing factor,” once the level of net purchases into or net redemptions from the fund exceeds a specified percentage of the fund’s NAV known as the “swing threshold.” The proposed changes include factors that funds would be required to consider to determine the swing threshold and swing factor (e.g. size, frequency and volatility of historical share purchase and redemption activity, fund strategy, liquidity of portfolio assets, cash and transaction costs), and to annually review the swing threshold. The swing threshold would be the same for both purchases and redemptions.
Impact & Timing
The greatest impact of these proposed changes is likely to be felt by portfolio management teams who will need to ensure existing liquidity risk management practices meet the rule changes or update them as necessary. Firms and their service providers may also need to make changes to their investor reports and possibly internal systems to ensure disclosure requirements are met.
Should the rules be finalized, the proposal is that larger fund complexes (related investment companies with net assets in excess of $1Billion) be compliant within 18 months, and smaller fund complexes be compliant within 30 months.