SEC Proposes Mandated Swing Pricing, Hard Close and Fundamental Changes to Liquidity Rule

The Securities and Exchange Commission on November 2, 2022 proposed significant revisions to its rules governing open-end investment company liquidity risk management and swing pricing. The proposal would also update related reporting and disclosure requirements.¹ The proposal’s key features include:

• Mandated swing pricing for all registered open-end funds other than money market funds (MMFs) and exchange-traded funds (ETFs) based on a complex framework set forth in the proposal²
• Imposition of a “hard close” for funds required to implement swing pricing under which purchase and sale orders receive the current day’s price only if the fund (or its transfer agent or a registered securities clearing agency (i.e., NSCC)) receives the order before the fund’s net asset value (NAV) pricing time
  • This would represent a stark change from current practice, where executing at a given day’s price is available if the order is received by the intermediary by the pricing time, and where funds (or other designated parties) may receive order information later than the pricing time³
• Several major changes to the liquidity risk management framework, including:
  • Broadened illiquid investment category and elimination of less liquid investment category
  • Mandated highly liquid investment minimums (HLIM) of at least 10% of fund net assets and certain exclusions when determining compliance
  • Expansion of illiquid investment limit to include margin or collateral posted for illiquid derivatives
  • Changes to fundamental aspects of liquidity classification, including certain key inputs and timing
• Forms N-1A, N-PORT and N-CEN amendments related to the swing pricing, hard close and liquidity rule-related amendments, including swing factor reporting and reporting of aggregate liquidity classifications
• Increased Form N-PORT filing and publication frequency

These proposed changes reflect significant, fundamental changes to core aspects of the open-end fund product and may have a substantial impact on fund management and certain investment strategies. The potential compliance costs and burdens also would be considerable.

This Dechert Newsflash provides a brief overview of the SEC’s proposed liquidity and swing pricing rulemaking package. An upcoming Dechert OnPoint will provide a more detailed discussion of the proposal.

Proposal to Mandate Swing Pricing and Impose “Hard Close”

The SEC’s proposal to mandate swing pricing for all registered open-end funds other than MMFs and ETFs breaks sharply from the current permissive regime⁴ that has garnered little industry interest (indeed, the SEC acknowledged in the Proposing Release that “at present no U.S. funds have implemented swing pricing”). Key features of the swing pricing proposal include:

• Policies and Procedures. Funds other than MMFs and ETFs would be required to establish and implement swing pricing policies and procedures, which must: (i) require the fund to adjust its NAV by a swing factor if the fund has net redemptions⁵ or if the fund has net purchases exceeding its “inflow swing threshold;”⁶ and (ii) specify the process for determining the swing factor in accordance with the rule’s requirements (below).
• Swing Factor Determination. The SPA must make good faith estimates, supported by data, of the costs the fund would incur if it purchased or sold a pro rata amount of each investment in its portfolio equal to the amount of net purchases or net redemptions. These estimates are subject to certain required considerations, in some cases including a “market impact” determined according to specified estimates and calculations.⁷
• Board Responsibilities. Board approval would be required for the swing pricing policies and procedures. The board would also designate the fund’s SPA and review, at least annually, a written report prepared by the SPA (described below).
• Swing Pricing Administration: Definition; Reasonable Segregation; Annual Written Report.
  • “Swing pricing administrator” means the fund’s investment adviser, officer or officers responsible for administering the swing pricing policies and procedures.
  • The administration of swing pricing would be required to be reasonably segregated from fund portfolio management and would not be permitted to include portfolio managers.
  • The SPA would be required to prepare, at least annually, a written report to the fund board. The report would describe the SPA’s review of the adequacy of the policies and procedures and effectiveness of their implementation (including effectiveness at mitigating dilution), any material changes to the policies and procedures, and the SPA’s review and assessment of the fund’s swing factors.
• Records. In addition to maintaining the swing pricing policies and procedures and board reports, funds would be required to maintain schedules evidencing and supporting each computation of an adjustment to NAV of the investment company shares based on swing pricing policies and procedures.
  

Hard Close. The SEC proposes to mandate a “hard close” for funds required to implement swing pricing. Under the proposal, a purchase or redemption order would be eligible for a given day’s price only if the fund, its transfer agent, or a registered clearing agency receives an “eligible order” before the time as of which the fund calculates its NAV (pricing time), which is often 4:00pm Eastern Time. Although the SEC proposed similar changes in the early 2000s, this would represent a stark change from current practice, where executing at a given day’s price is available so long as the order is received by an authorized intermediary to whom the order is submitted by the pricing time. Under current practice, the fund may not receive order information until after the fund’s pricing time (and, in some cases, the following morning). While the SEC’s stated goals for the hard close proposal are facilitating mutual funds’ ability to operationalize swing pricing by ensuring that funds receive timely flow information, modernizing and improving order processing, and helping to prevent late trading, it is unclear how this may be implemented in practice or the costs of doing so.

Eligible orders, as defined in the proposal, would be irrevocable as of the next pricing time after receipt by the fund, its transfer agent or a registered clearing agency. Eligible orders generally would be required to supply certain information about the size of the trade (specific number of shares or specific value) and would include exchange orders.

The Proposing Release includes discussion of, and solicits comments on, various alternatives to the swing pricing and hard close proposals.

Proposed Changes to Liquidity Rule

The SEC also proposed significant revisions to the current liquidity risk management regime for open-end funds (including ETFs).⁹ Notable proposed changes include:

• Liquidity Classification Changes. The proposal would alter liquidity classifications in several ways, including:
  • Expansion of “Illiquid Investment” Category.
    • Under the proposal, the definition of “illiquid investment” would be expanded to (i) encompass the current “less liquid investment” category and (ii) define assets priced using Level 3 inputs under U.S. GAAP that are significant to the overall measurement as per se illiquid.¹⁰
    • With respect to the second noted change, the SEC acknowledged in the Proposing Release that the “proposed amendment would require those funds not already classifying investments valued using unobservable inputs that are significant to the overall measurement as illiquid to change their classification practices and may change the liquidity profile for those funds under the rule to be less liquid.”
    • Both changes could have far-reaching consequences on open-end fund portfolio management, especially when considered together with other proposed changes that would expand the illiquid investment limit (discussed below).
  • Elimination of “Less Liquid Investment” Category. The proposal would eliminate the “less liquid investment” classification category, which currently captures investments the fund reasonably expects to be able to sell or dispose of in current market conditions in seven calendar days or less without significantly changing the market value, but where the sale or disposition is reasonably expected to settle in more than seven calendar days.
  • Imposition of Uniform Definition of “Significantly Changing the Market Value of an Investment.”
    • Under the proposal, the key phrase in liquidity category definitions, “significantly changing the market value of an investment” (value impact standard), would be defined as: (i) for shares listed on a national securities exchange or foreign exchange, any sale or disposition of more than 20% of the average daily trading volume of those shares, as measured over the preceding 20 business days; (ii) for any other investment, any sale or disposition reasonably expected to result in a decrease in sale price of more than 1%.
    • This definition would be the standard against which funds would be required to estimate the number of days necessary for settlement in U.S. dollars when determining liquidity classifications.¹¹ The current rule does not define the value impact standard, and SEC staff guidance recognizes considerable flexibility and subjectivity in interpreting the phrase.¹²
  • Replacement of RATS with Stressed Trade Size (a 10% Presumption). The proposal would require funds to assume, in classifying an investment, the sale of 10% of the fund’s net assets by reducing each investment by 10%. This proposal would replace the current requirement to consider a reasonably anticipated trade size (or RATS) of a position.
  • Daily Classifications. Under the proposal, liquidity classifications would be required to be done on a daily basis, rather than no less frequently than monthly as currently required.
  • Method for Counting Number of Days. Under the proposal, the measurement of the number of days in which an investment is reasonably expected to be convertible to U.S. dollars without significantly changing the market value of the investment will include the day on which the liquidity classification is made. For example, if a fund is classifying an investment on Monday, it can only classify that investment as highly liquid if it reasonably expects that the investment could be sold and settled in U.S. dollars by Wednesday.
  • Elimination of Asset Class Classifications. Currently, funds are permitted to classify investments according to asset class. This flexibility would be eliminated under the proposal.
• Mandated HLIM of at least 10%; Exclusions in Determining Compliance.
  • The proposal would require all funds to determine and maintain an HLIM and would mandate that each fund’s HLIM be at least 10% of fund net assets.
  • When determining compliance with the HLIM, the proposal would require exclusion of: (i) the value of highly liquid investments posted as margin or collateral in connection with moderately liquid or illiquid derivatives; and (ii) fund liabilities.
• Illiquid Investment Limit: Inclusion of Margin or Collateral Posted for Illiquid Derivatives. Under the proposal, a fund would be required to count toward the 15% illiquid investment limit the value of margin or collateral posted in connection with derivatives classified as illiquid that the fund would receive if it exited the transaction.
  

Reporting Proposal

Together with the proposals for a swing pricing mandate, hard close and liquidity rule amendments, the SEC proposed certain Form N-PORT and Form N-CEN reporting changes. These include:

• Swing Factor Reporting. The proposal would remove a separate Form N-CEN swing pricing-related reporting requirement and replace it with new Form N-PORT reporting requiring information about the number of times the fund applied a swing factor during the period and the amount of each swing factor applied (positive or negative).
• Public Reporting of Aggregate Liquidity Classifications. Under the proposal, Form N-PORT would include a requirement to provide the aggregate percentage of fund assets falling into each of the three liquidity categories (highly liquid, moderately liquid or illiquid).¹³ This information is not currently publicly available.
• Conforming Edits Related to Liquidity Rule Proposed Changes. Various liquidity rule terms and references on Form N-PORT are proposed to be changed to conform to the proposed liquidity rule changes. For example, the liquidity category references would be updated, references to reasonably anticipated trade size would be replaced with references to stressed trade size, and certain reporting related to highly liquid investment minimums and the illiquid investment limit would be updated.
• Filing and Publication Frequency. Under the proposal, reports on Form N-PORT would be filed with the SEC within 30 days of month-end, with public availability of most data 60 days after each month-end. This would replace the current requirement to file monthly reports with the SEC 60 days after fiscal quarter-end, where only the report for the third month of every quarter is made public.¹⁴ Current items that are non-public, including individual portfolio investment liquidity classifications, would remain non-public in individual reports under the proposal.
• Liquidity Service Providers. Under the proposal, Form N-CEN would be amended to require the following disclosure concerning liquidity service providers: (i) name; (ii) identifying information; (iii) affiliation information; (iv) the asset classes for which the liquidity service provider provided classifications; and (v) whether the provider was hired or terminated during the period.

Transition Periods and Timing

24 Months for Swing Pricing and Hard Close. The SEC proposed a 24-month transition period after the effective date of the amendments for funds (as well as transfer agents, registered clearing agencies and intermediaries, as applicable) to comply with the swing pricing changes, hard close requirement and related Forms N-PORT and N-1A disclosure requirements.

12 Months for Liquidity Rule, Form N-PORT and Form N-CEN Changes. The SEC separately proposed a 12-month transition period after the effective date of the amendments for the liquidity rule-related changes and amendments to Forms N-PORT and N-CEN, other than the swing pricing-related disclosure on Form N-PORT.

Comments on the SEC’s proposals are due 60 days after publication in the Federal Register. In light of the breadth of the SEC’s proposals and the relatively short comment period, which spans the winter holiday season in the United States, fund firms are encouraged not to delay beginning work on comments.

Footnotes

1) Open-End Fund Liquidity Risk Management Programs and Swing Pricing; Form N-PORT, SEC Rel. No. IC-34746 (Nov. 2, 2022) (Proposing Release); see also Fact Sheet: Open-End Fund Liquidity Risk Management and Swing Pricing (Nov. 2, 2022) (Fact Sheet). At times, this Dechert Newsflash tracks the Proposing Release or Fact Sheet without the use of quotation marks. Terms not defined in this Dechert Newsflash have the meaning assigned to them in the Proposing Release.
2) The SEC separately proposed swing pricing for MMFs last year. See Money Market Fund Reforms, SEC Rel. No. IC-34441 (Dec. 15, 2021). In her statement relating to the Proposing Release, Commissioner Peirce stated “[a]nd then there is mandatory swing pricing . . . . This part of the proposal is stunning in light of the stone-cold reception the proposal to require swing pricing for money-market funds received.”
3) For example, retirement plan recordkeepers currently do not process orders until they receive the fund’s NAV, with funds receiving these intermediaries’ orders the next morning. See Proposing Release at 249.
4) See Investment Company Swing Pricing, SEC Rel. No. IC-32316 (Oct. 13, 2016); see also SEC Adopts New Rules and Rule Amendments to Require Registered Open-End Investment Companies to Establish Liquidity Risk Management Programs and Permit Them to use “Swing Pricing,” Dechert OnPoint (Nov. 8, 2016).
5) Swing pricing would always be required in the case of net redemptions.
6) The swing pricing administrator (SPA) would be required to review investor flow information on a daily basis to determine if the fund has net purchases or net redemptions and the amount of net purchases or net redemptions. See proposed rule 22c-1(b)(1)(i).; Proposing Release at 113. “Inflow swing threshold” means an amount of net purchases equal to 2% of a fund’s net assets, or such smaller amount of net purchases as the SPA determines is appropriate to mitigate dilution. See proposed rule 22c-1(d).
7) Certain cost and market impact estimates may be made for categories of investments with the same or substantially similar characteristics, rather than at the individual investment level. See proposed rule 22c-1(b)(2)(iv).
8) Currently, NSCC is the only registered clearing agency for fund shares.
9) MMFs are not subject to the liquidity risk management rule. See Investment Company Liquidity Risk Management Programs, SEC Rel. No. IC-32315 (Oct. 13, 2016).
10) The proposal would define “illiquid investment” as follows: “[A]ny investment that the fund reasonably expects not to be convertible to U.S. dollars in current market conditions in seven calendar days or less without significantly changing the market value of the investment . . . . Any investment whose fair value is measured using an unobservable input that is significant to the overall measurement is an illiquid investment.” See proposed rule 22e-4(a). The SEC also noted that “[e]xamples of particular assets and liabilities that may be measured using Level 3 inputs include long-dated currency swaps, three-year options on exchange-traded shares, interest rate swaps, asset retirement obligations at initial recognition, and reporting units,” and “[w]e observed that the investments classified as highly liquid that were [valued using Level 3 inputs significant to the overall measurement] primarily were mortgage-backed securities.” Proposing Release at nn.112 – 113.
11) Under the proposal, similar to the current rule, liquidity categories are determined by estimating the number of days necessary to convert a holding to U.S. dollars in current market conditions “without significantly changing the market value of the investment.” The proposed definition for the value impact standard would, thus, standardize this metric for all holdings and funds.
12) See Investment Company Liquidity Risk Management Programs Frequently Asked Questions at Question 22 (“The staff believes that a fund has the flexibility to establish the meaning(s) of what constitutes a “significant change in market value” in its policies and procedures. The staff recognizes that these price impact assumptions are subjective, due to the variety of inputs that may reasonably be used by any fund or portfolio manager. Accordingly, the staff believes that what constitutes a significant change in market value may vary by fund, asset class, or investment. Therefore, the staff believes that a fund does not need to employ as a price impact assumption a fixed amount or percentage, and a fund may have differing standards for different investments and/or asset classes, although a fund may also choose to use a fixed number if reasonably determined.”).
13) Consistent with proposed changes to the liquidity rule: (1) the highly liquid investment entry would be reduced by: (i) the value of highly liquid investments posted as margin or collateral in connection with moderately liquid or illiquid derivatives; and (ii) fund liabilities; and (2) the illiquid investment entry would be reduced by the value of margin or collateral posted in connection with derivatives classified as illiquid that the fund would receive if it exited the transaction.
14) These changes would apply to all registered investment companies that report on Form N-PORT, including open-end funds (other than MMFs), registered closed-end funds and ETFs registered as unit investment trusts. Conforming edits are proposed to be made to items that currently require funds to report certain return and flow information for each of the preceding three months, as well as to Part F, which currently requires a fund’s complete portfolio holdings for the first and third quarters within 60 days after the end of the period, and Part D.

*The authors would like to thank Olivia Sedita and Mykel Skinner for their contributions to the Newsflash.