SEC Proposes New Liquidity Management Rules for Mutual Funds and ETFs

September 22, 2015

Earlier today, the U.S. Securities and Exchange Commission unanimously approved proposals that would require open-end funds, including mutual funds and exchange-traded funds, to comply with new liquidity management rules. The proposals are generally intended to limit the risks that funds would be unable to meet investor redemption requests and to potentially minimize the dilutive impact of fund shareholder transactions. According to SEC Chair Mary Jo White, “[p]romoting stronger liquidity risk management is essential to protecting the interests of the millions of Americans who invest in mutual funds and exchange-traded funds.” 

The proposals represent potentially significant changes to current liquidity principles that apply to funds, and, if adopted, will likely require significant changes to fund operations, disclosure and reporting requirements. The proposals are the second in a series of rule proposals this year by the SEC to address certain potential risks in the fund industry and modernize fund reporting and disclosure. A summary of the proposals is provided below. 

Liquidity Risk Management Programs 

The proposals would require open-end funds, including ETFs but excluding money market funds, to adopt liquidity risk management programs pursuant to proposed rule 22e-4. A fund’s liquidity risk management program must be approved by the fund’s board, and must include several elements: 

  • Classification of the Liquidity of Fund Portfolio Assets and Assessment of Liquidity Risk. The proposals would require a fund to classify each portfolio position, or portion of a position, into one of six liquidity categories based on the amount of time required to convert the position to cash without a market impact. This classification would be based on, among other factors, trading frequency and volume, bid/ask spreads, position size and price volatility. In addition, a fund would also be required to assess and periodically review its liquidity risk, based on specified factors. 
  • Determination of Three-Day Liquid Asset Minimum. Based on a fund’s assessment of its liquidity risk, the fund would have to determine a minimum amount of its portfolio that must be held in cash and assets that the fund believes are convertible to cash within three business days at a price that does not materially affect the value of the assets immediately prior to sale. The proposals would require a fund to consider and document certain liquidity risk factors as part of this determination, including cash flow projections and the fund’s investment strategy. 
  • Board Approval and Review. A fund’s board would be required to approve its liquidity risk management program, including the three-day liquid asset minimum described immediately above. A fund’s board also would be responsible for reviewing a written report that discusses the adequacy of the fund’s liquidity risk management program and the effectiveness of its implementation. This report would be provided to the board at least annually. 
  • Codification of Limitation of No More than 15% of Portfolio Holdings in Illiquid Assets. The SEC proposes to codify current SEC guidelines stating that funds should invest no more than 15% of their assets in “illiquid assets,” which is defined under the current guidelines as assets that cannot be sold within seven days at approximately the price at which the fund has valued the asset. For purposes of this test, a 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 sale proceeds or disposition of the asset. 

Disclosure and Reporting Requirements 

The proposals include new disclosure and reporting requirements regarding the liquidity risks and risk management practices of a fund. For example, the proposals would amend Form N-1A to enhance disclosure on how funds meet redemption requests and to disclose any line of credit agreements and the use of “swing pricing.” Amendments to proposed Form N-PORT would require funds to report, among other things, their liquidity classifications for each of their investments. The proposals would also amend proposed Form N-CEN. 

Swing Pricing 

The proposals would also permit funds, with the exception of money market funds and ETFs, to use “swing pricing” subject to board approval. Swing pricing refers to a mechanism that would adjust the net asset value of a fund’s shares to effectively pass on the costs associated with purchases or redemptions of fund shares to the purchasing or redeeming shareholder. A fund that uses swing pricing would reflect in its net asset value a specified amount (the “swing factor”), once the amount of net purchases or net redemptions exceeds a specified percentage of the fund’s net asset value (the “swing threshold”). According to the SEC, swing pricing “is designed to protect existing shareholders from dilution associated with shareholder purchases and redemptions and would be an additional tool to help funds manage liquidity risks.” 

Comment Period 

The comment period for the proposals will be 90 days after publication in the Federal Register. A copy of the SEC’s “fact sheet” that relates to the proposals is available here and a copy of the SEC’s proposing release is available here

An upcoming Dechert OnPoint will provide further analysis of the proposals, as well as potential issues for funds and their advisers and boards to consider.

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