(Article from Registered Funds Alert, February 2016)
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As discussed in our last Alert, the SEC recently proposed new Rule 22e-4, which would require open-end funds and ETFs (other than money market funds) to adopt liquidity management programs. Separately, the SEC also proposed revisions to Rule 22c-1 to permit open-end funds (other than money market funds and ETFs) to implement “swing pricing,” which would allow a fund the option to adjust the net asset value applicable to purchasing or redeeming shareholders to pass along expenses associated with their trading activity. The SEC received more than 75 comment letters on the proposed rules, including a letter from Simpson Thacher. This Alert summarizes notable themes presented in comments from industry participants.
General Comments
Many industry commenters expressed support for the SEC as the appropriate regulator to address this issue (as opposed to the FSOC or another member of FSOC). The Investment Company Institute (“ICI”) and a number of other commenters stressed that open-end funds have successfully and consistently managed liquidity for over 75 years. While commenters acknowledged that there have been a few exceptions to the industry’s otherwise sterling reputation in this regard, there has been no indication that open-end fund liquidity poses systemic risks to the U.S. financial system, even during periods of significant market stress.
A major theme of comment letters was that the proposed liquidity requirements were overly rigid, expensive and prescriptive. The historical ability of funds to meet liquidity needs caused the ICI and others to question the SEC’s basis for proposing such prescriptive requirements. Several commenters expressing views on behalf of independent board members echoed this sentiment, and noted that such an approach fails to recognize that investors know that liquidity considerations can impact the value of their investment. A letter from the chair of the independent trustees of the Fidelity Fixed Income and Asset Allocation Funds noted that the goal of liquidity management should be to ensure daily liquidity—not to eliminate liquidity risk. An editorial in the Wall Street Journal recently made a similar point.
As an alternative, commenters urged the SEC to consider a more risk-oriented, principles-based approach akin to the compliance rule (Rule 38a-1). They argued that this approach, which would require funds to adopt written liquidity management policies and procedures, would allow funds to develop more flexible programs designed to address individual fund needs (subject to board oversight).
While commenters did not appear to oppose universally the reporting of position-level liquidity assessments to the SEC, they generally pushed back against the idea of disclosing such information to the public. Many commenters emphasized that liquidity determinations are inherently subjective, suggesting that there should be a safe harbor from liability for reasonable determinations and expressing concern that liquidity determinations lack the degree of confidence that usually attaches to data that is reported (and certified) in regulatory filings. As another argument against public disclosure, some commenters pointed out that liquidity information could be deemed to be proprietary or competitively sensitive.
Liquidity Categories
One of the SEC’s main proposals would require funds to assess whether each portfolio position (or part of a position) would fall into one of six liquidity categories, based primarily on the expected number of days it would take to convert that position into cash at a price that does not materially impact its value. With respect to the SEC’s proposed liquidity categories, commenters suggested a variety of alternative approaches (e.g., the ICI suggested three categories, the Asset Management Group of the Securities Industry and Financial Markets Association (“SIFMA AMG”) suggested four categories and JPMorgan Asset Management (“JPMorgan”) suggested five categories). Critiques of the SEC’s proposed categories were often based on the notion that the SEC’s categories and methodology assume a level of precision and certainty in liquidity determinations that is not realistically possible—especially with respect to determining whether selling a position would materially impact its value. Echoing this sentiment, commenters such as Wells Fargo Asset Management emphasized that liquidity determinations are not an exact science, and JPMorgan asked the SEC to consider listing liquidity factors as guidance in the adopting release, as opposed to the text of the new rule, because the proposed factors may not apply to all funds/instruments. Several commenters suggested that liquidity categories should be based on relative liquidity, as opposed to absolute liquidity, to reflect more accurately how funds generally treat different types of assets. The ICI and Invesco also pointed to another potentially flawed assumption underpinning the SEC’s proposals—that portfolio managers will sell their most liquid assets first in order to meet redemptions. They noted that portfolio managers often take a different approach, such as selling a representative slice of a fund’s overall portfolio in order to maintain the fund’s existing investment allocations. The ICI and OppenheimerFunds also expressed the view that fund advisers are unlikely to replace their existing methodologies with the new classifications, meaning the SEC’s categories would become merely “a prescriptive regulatory requirement that exists alongside industry best practices.”
Notably, several commenters, including the Mutual Fund Directors Forum, voiced concern that certain aspects of the SEC’s proposal might increase systemic risk. For example, the proposing release expects that funds will look to vendors to aid in determining the liquidity of individual positions, but that practice could create systemic risk by concentrating judgment in a small number of vendors. Commenters such as T. Rowe Price also raised questions about whether the proposed regime might create a perverse illusion that allows funds that push the envelope, by assigning a more-liquid category to portfolio positions, to appear to be more liquid (and therefore less risky) than funds that choose to be more conservative in their liquidity determinations.
Three-Day Liquid Asset Minimum
A second key aspect of the SEC’s proposal was that funds be required to maintain a minimum amount of “three-day liquid assets,” with such amount to be approved by the fund’s board. This would require funds to maintain a minimum amount of assets in the two most-liquid categories proposed by the SEC. If a fund fell below the minimum, it would be prohibited from investing in assets that fall within lower-liquidity categories until the fund’s portfolio resumes compliance with the minimum.
Commenters expressed significant opposition to the SEC imposing such a minimum, often citing it as a “one-size-fits-all” approach representing regulatory overreach by the SEC.[1] They expressed concern that the minimum requirement could unduly restrict portfolio management operations for funds, forcing them to deviate from their stated investment strategies. For example, the Independent Directors Council noted that a fund that seeks to maintain weightings in certain sectors, countries, securities or other asset types could be restricted in its ability to pursue that strategy any time it fell below the three-day liquid asset minimum.
Several commenters also argued that the proposed minimum could create an effect akin to cash drag on fund performance, and that the board approval requirement would limit the flexibility of portfolio managers to adapt to rapidly changing market conditions and fund flows. Alternative suggestions included setting a liquidity range or a liquidity target, without the prohibition on investing in less liquid assets if a fund falls below its range/target, or allowing the fund’s board to delegate its authority to approve a change in the liquidity minimum to a committee of the adviser’s employees.
Closed-End Funds and ETFs
Our comment letter focused on supporting one aspect of the proposed liquidity management rules—that closed-end funds should be excluded from the requirements. As closed-end funds do not issue redeemable securities, they do not need to meet continuous redemptions from the public. Additionally, when Congress enacted the 1940 Act, and Section 22(e)’s requirement to pay redemptions within seven days, the closed-end fund structure had existed for almost 50 years and it was acknowledged that closed-end funds offer investors a vehicle that is designed to make longer-term investments than open-end funds. The SEC acknowledged that it has historically recognized that the liquidity needs of closed-end funds are different from open-end funds, and we offered support for that position. Comment letters from Invesco and State Street Global Advisors urged the SEC to carve ETFs out of the liquidity management requirements, noting that they typically redeem in-kind and, in the case of index funds, may have difficulty maintaining a minimum amount of liquid assets while seeking to track an index.
Swing Pricing
Commenters expressed a variety of opinions regarding whether swing pricing should be permitted and what types of costs should be passed on to transacting shareholders. A common thread in comments on all sides of these issues, however, was that there are significant operational differences between the United States and jurisdictions that currently utilize swing pricing, and it would be nearly impossible for U.S. funds to implement swing pricing without significant systemic changes. For example, the ICI and several commenters who currently manage European UCITS funds pointed out that European funds have several hours after the market closes to receive and process flow information from intermediaries (such as omnibus accounts) prior to the deadline for finalizing a fund’s net asset value. U.S. funds generally publish their net asset value prior to receipt of flow information from intermediaries. Commenters generally requested that the SEC consider these operational impediments and provide more nuanced guidance in any adopting release.
[1] The regulatory authority for the SEC to adopt the three-day minimum was not directly challenged by any commenter, although three comment letters (ICI, SIFMA AMG and Invesco) cited to our prior Alert questioning the SEC’s authority to adopt a three-day minimum.