(Article from Registered Funds Alert, November 2015)
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On September 22, 2015, the Securities and Exchange Commission (“SEC”) proposed new rules that would require open-end funds and exchange-traded funds (“ETFs”) (other than money market funds) to develop and maintain liquidity management programs (the “Release”). The SEC stated that the proposed rules are intended to create a regulatory framework that will reduce the risk that a fund will be unable to meet its redemption obligations. If adopted, the proposed rules would impose a variety of new duties on advisers and fund boards. Additionally, under proposed amendments to Rule 22c-1 under the Investment Company Act of 1940 (“1940 Act”), open-end funds (other than money market funds and ETFs) would be permitted to utilize “swing pricing” under certain circumstances to adjust their net asset value per share (“NAV”), a practice common in non-U.S. jurisdictions that permits a fund to impose transaction costs on purchasing or redeeming shareholders, instead of diluting the value of shares held by all fund shareholders.
The Release has been summarized by many industry commentators, and this Alert does not attempt to summarize the proposed new rules and amendments. As we have previously discussed, the liquidity management proposal is part of a series of regulatory initiatives by the SEC that are part of a broader initiative by the SEC and the Financial Stability Oversight Council to impose risk-based and prudential standards on the asset management industry. This Alert focuses on the SEC’s claimed statutory authority to adopt one of its proposals and discusses how the Release raises questions regarding the relationship between liquidity and valuation in the context of the 1940 Act.
Questions Regarding the SEC’s Authority to Enact a Minimum Liquidity Requirement
Long-standing SEC guidance on liquidity standards for open-end funds has been based on Section 22(e) of the 1940 Act, which provides that the right of redemption or the payment of redemption proceeds may not be suspended for more than seven days, except in unusual circumstances. The SEC has very limited rulemaking authority under this section of the statute; it may only make rules to determine when trading on the New York Stock Exchange should be deemed to be restricted or an emergency exists (in which cases redemptions or payments may be suspended), or may issue orders to suspend redemptions or payments in other circumstances.
Proposed Rule 22e-4 would require open-end funds and ETFs (other than money market funds) to establish a minimum level of “three-day liquid assets” in their portfolios. “Three-day liquid assets” are defined in proposed Rule 22e-4(a)(8) as cash and any position that the fund believes is convertible into cash within three business days at a price that does not materially affect the value of the position. So how does the SEC go from a statute designed to provide for redemptions in seven days with limited rule-making authority to a prescriptive three-day liquidity determination requirement?
While SEC guidelines have espoused the position that open-end funds can hold no more than 15% of their assets in illiquid securities,[1] the Release acknowledges that there are “no requirements under the federal securities laws or Commission rules” that require open-end funds to maintain a minimum level of portfolio liquidity, other than Rule 2a-7 under the 1940 Act. However, Rule 2a-7 is an exemptive rule limited to money market funds, enacted to allow money market funds to operate on an amortized cost basis. Under any exemptive rule, a regulator has significant latitude to impose the conditions and requirements that it sees fit.
The Release goes on to state that the statutory authority for Rule 22e-4 comes from Sections 22(c) and (e) and 38(a) of the 1940 Act. As discussed, Section 22(e) provides no apparent basis for this rule-making. Section 22(c) is a stronger argument—the SEC, under that section of the statute, has the ability to adopt rules for the “purpose of eliminating or reducing so far as reasonably practicable any of the dilution of the value of other outstanding securities…[as a result of a] redemption….” However, the cited language modifies the granting of a right to adopt rules relating to computation of net asset value or minimum holding periods of a security, and a proper reading of the statute does not support the proposed Rule.
Finally, the SEC suggests that Section 38(a) grants it the power for this Rule, which states in relevant part, “[t]he [SEC] shall have authority from time to time to make, issue, amend, and rescind such rules and regulations and such orders as are necessary or appropriate to the exercise of the powers conferred upon the [SEC] elsewhere” in the 1940 Act. If 38(a) is properly read to allow the SEC to justify any prudential regulation, even when the statutory sections governing the subject matter at issue prescribe precisely the range and nature of permitted rule-making, there presumably is no practical limit on the SEC’s rule-making authority.
Even if one were to concede the SEC’s rule-making authority in this area, a second step is necessary to justify a three-day, as opposed to seven-day, liquidity requirement. The proposed rule does not explicitly impose any minimum level of liquidity, making it theoretically possible for a fund to determine that it does not need to maintain any minimum three-day liquid assets. However, the proposed rule does impose certain factors that funds are required to consider in this assessment and the Release states that “it would be extremely difficult to conclude, based on the factors it would be required to consider, that a zero three-day liquid asset minimum would be appropriate.”
The Release states that the SEC considered a seven-day liquidity requirement, but that “would not as well match regulatory requirements and disclosures that require most funds to meet redemption requests in shorter periods and market practices and investor expectations that effectively require all funds to meet redemption requests in shorter time periods.” In particular, the regulatory requirement that the Release cites to support this proposition is Rule 15c6-1 under the Securities Exchange Act of 1934, which requires open-end fund redemptions that are processed through broker-dealers be met within three business days.
Nonetheless, it is unclear whether any commenters or industry groups intend to challenge the SEC’s authority to enact proposed Rule 22e-4 and its three-day liquid asset requirement. Generally speaking, the asset management industry appears to take the broad-based view that the SEC is the appropriate regulator for the asset management industry, due to its deep understanding of the industry through 75 years of close examination and regulation. Frustrating the SEC’s ability to maintain that role may not, many believe, be ultimately to the industry’s benefit. Secondly, as a practical matter many industry participants already engage in close analysis of liquidity of portfolios in various circumstances. Many industry participants do in fact commit to a three-day (or fewer) period for payment of proceeds. As such, while we expect significant comment regarding the prescriptive nature of the liquidity “buckets” for portfolio securities, it may well be that no one raises a significant challenge to the statutory basis for the proposed Rule 22e-4 itself.
Redefining the Relationship Between Liquidity and Valuation
Another aspect that merits attention is how the concepts of liquidity and valuation will relate to one another in light of the proposed guidance and rule-making. Valuation is defined in the 1940 Act, and relies entirely on market quotations when those quotations are “readily available.” When market quotations are not readily available, boards (or, pursuant to guidance, their designees) must determine fair value in good faith. While there is no one standard for fair value, it is usually considered to be, based on prior SEC and accounting guidance, “the amount which the [fund] might reasonably expect to receive for [a security] upon [its] current sale”[2] and/or “the price that would be received [for the security] … in an orderly transaction between market participants at the measurement date.”[3] Neither market quotations nor these fair valuation standards permit or require that one consider whether an entire position in a security held by a fund can be currently sold. If a fund holds a large stake in a company, the value, particularly where there is a market quotation, is unaffected by that fact.
As noted above, the Release proposes that a liquidity category be assigned to a position based on the number of days it would take to convert the position into cash at a price that does not materially affect its value. The Release sets forth six liquidity categories:
- Convertible to cash within 1 business day.
- Convertible to cash within 2-3 business days.
- Convertible to cash within 4-7 calendar days.[4]
- Convertible to cash within 8-15 calendar days.
- Convertible to cash within 16-30 calendar days.
- Convertible to cash in more than 30 calendar days.
In assigning a liquidity category, the Release states that a fund must assess the liquidity of its entire position, or each portion of that position. This standard implies that some parts of a position can, or even should, be deemed to have differing levels of liquidity. If a fund holds a large position (or the fund’s adviser holds large positions across many funds, presumably), then it might be that some portion could be reduced to cash in three days without affecting the value, for example, but the rest would need another ten days. Thus, if one views an orderly sale as what would happen if a sale of an entire position were attempted today, then it might be that some portion should be carried at a lower value today. What is a fund supposed to do with that information? For securities with market quotations, there is no leeway in the statute to change the valuation of a security based on this information. But if a security is being fair valued, does this liquidity determination require the fund to consider using the same calculation for valuation of different portions of the same security? If not, why not?
The interplay of liquidity and valuation, in unprecedented ways, shows up in other parts of the Release as well. For example, the Release includes new interpretive guidance regarding the use of cross-trades. Section 17 of the 1940 Act generally prohibits transactions between affiliated funds. Rule 17a-7 under the 1940 Act allows cross trading between affiliated funds and accounts if certain conditions are met. In order to prevent a cross-trade from being consummated at a price that is unfair to a registered fund, one of the conditions of Rule 17a-7 is that market quotations be readily available to price exchange-traded securities, and that over-the-counter securities be priced at the average of the then-highest bid and lowest offer. In the Release, the SEC states that this condition may cause certain less liquid securities to be ineligible for cross-trading (presumably, focusing on over-the-counter securities). While the SEC has broad powers to interpret its own rules, the text of Rule 17a-7 and the guidance thereunder has previously been predicated on appropriate valuation mechanisms, not sufficient liquidity. To suggest that liquidity and valuation are completely separate concepts would be absurd, of course, but valuation plays a central role in the 1940 Act and any changes in the SEC’s understanding of the valuation responsibilities of funds should be explicit. In the context of the Rule 17a-7 guidance discussed here, the SEC has expressly invited comment.
Comments on the proposed rules are due January 13, 2016.
[1] The SEC would codify the 15% limit as part of the proposed rules.
[2] See Statement Regarding “Restricted Securities,” Inv. Co. Act Rel. No. IC-5847 (1969).
[3] See Financial Standards Accounting Board, Accounting Standards Codification: Fair Value Measurements and Disclosures (Topic 820) (Jan. 2010).
[4] Note that there may be overlap in the 2-3 business days and 4-7 calendar days categories.