(Article from Registered Funds Regulatory Update, January 2023)
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The SEC voted to propose amendments to the liquidity risk management rule (Rule 22e-4 under the 1940 Act) and other related amendments to address alleged weaknesses in liquidity risk management programs for open-end funds (e.g., mutual funds and ETFs) and to seek to prevent potential share dilution. The proposal would not apply to closed-end funds and BDCs, including interval funds and tender offer funds, since such funds are not subject to Rule 22e-4. The proposal comes in response to the liquidity concerns that arose during the March 2020 market volatility and targets two main areas: liquidity classifications and swing pricing.
Liquidity Classifications. The proposal would amend liquidity classification requirements for open-end funds, other than money market funds and certain ETFs. The current approach to liquidity classification requires a fund to classify its investments into one of four liquidity categories, or “buckets”—highly liquid, moderately liquid, less liquid, and illiquid. The liquidity classification is based on the number of days it would take to convert an investment into cash, in a “reasonably anticipated trade size,” without significant changes to the investment’s market value (the “value impact”).
The proposed amendments would change this framework in several significant ways. First, the amended rule would require funds to classify the liquidity of an investment by measuring the number of days in which the investment is reasonably expected to be convertible to U.S. dollars without significantly changing the market value of the investment, while assuming the sale of 10% of the fund’s net assets by reducing each investment by 10%.
Second, the proposed amendments would define the value impact standard with more specificity as to when a sale or disposition would significantly change the market value of an investment. Under the current rule, a fund may determine value impact in a variety of ways, depending on the type of asset, vendor, model, or system used. The proposed definition of a significant change in market value would require a fund to consider the size of the sale relative to the depth of the market for the instrument, which would vary depending on the type of investment. For shares listed on an exchange, for example, the sale or disposition of more than 20% of the security’s average daily trading level (measured over the preceding 20 business days) would constitute a significant change in that security’s market value. For investments other than shares listed on an exchange, any sale or disposition that is reasonably expected to decrease the sale price more than 1% would constitute a significant change in market value.
The proposed amendments would also prohibit funds from classifying investments according to their asset class and would increase the frequency of these liquidity classifications from monthly to daily. In the proposing release, the SEC claimed asset class-level classifications are not widely used by many funds, noting that such classifications run the risk of over-estimating the liquidity of a fund’s investments. Instead, the proposed amendments would require a fund to classify each individual investment according to its liquidity characteristics. For funds that invest in dozens if not hundreds of securities and currently engage in asset class-level classifications on a monthly basis, the proposed changes could impose a consequential administrative burden.
In another significant change, the proposed amendments would eliminate the bucket for “less liquid” investments thereby reducing the number buckets from four to three. These investments that a fund reasonably expects not to be convertible to U.S. dollars in seven calendar days or less without significantly changing their market value would instead be treated as illiquid investments under the proposed amendments. For open-end funds that invest heavily in less liquid investments, such as bank loan funds, this change could require the fund to convert to a closed-end fund structure or change its investment strategy given that open-end funds are restricted from investing more than 15% of their assets in illiquid investments.
The amendments would also require funds to maintain a minimum of 10% of net assets in highly liquid investments. Finally, the proposed amendments make several adjustments to the definitions of liquidity classification categories and related terms, including an expansion of the term “illiquid investment” to include any investment whose fair value is measured using an unobservable input that is significant to the overall measurement.
Swing Pricing. Another controversial aspect of the proposal would amend Rule 22c-1 under the 1940 Act to mandate swing pricing for all open-end funds other than money market funds and ETFs, despite the industry consistently providing feedback that swing pricing is not operationally feasible. Swing pricing is currently optional, and no funds have elected to implement swing pricing since the current rule’s implementation.
Under the proposed amendments, funds would need to adjust a fund’s NAV by a “swing factor” when experiencing net redemptions or net purchases in excess of 2% of net assets. In determining the swing factor price adjustment, a fund would be required to make good faith estimates of the transaction costs of selling or purchasing a pro rata amount of its portfolio investments to satisfy that day’s redemptions or to invest the proceeds from that day’s purchases. The good faith estimate must include spread costs, brokerage commissions, custody fees, and any other fees associated with portfolio investment sales. Additionally, if net redemptions exceed 15% of assets, a fund would also be required to include market impact costs in its swing factor. The proposed rule includes additional guidance for estimating the market impact. Furthermore, funds would have to report publicly their swing factor adjustments on Form N-PORT.
The proposal would also establish a “hard close,” which the SEC believes would aid in the operational implementation of swing pricing by providing funds with more adequate order flow information. Specifically, orders for purchases or redemptions would be eligible for that day’s price only if the order is received by the fund, transfer agent or clearing agency before the time as of which the fund calculates its NAV, typically 4:00 p.m. Alternatively, intermediaries could, as a matter of practice, choose to process orders at the next day’s price. The SEC’s proposed “hard close” rule could have significant practical implications for intermediaries, who would likely need to make extensive changes to their business practices to ensure that order flow information is received before 4:00 p.m. The intermediary and retirement plan channels, in particular, would be significantly impacted by the proposed changes because they frequently do not transmit order flow details to a fund’s transfer agent or the clearing agency until after a fund has calculated its daily NAV and publicly disseminated the NAV. This would
require certain intermediary channels to submit orders earlier in the day that then could be negatively impacted by market events prior to the 4:00 p.m. close.
Form N-PORT. In connection with the two categories of changes above, the proposed rule would require more frequent and expansive reporting. Form N-PORT would be amended to require public reporting of aggregate liquidity classifications as well as frequency and amount of swing pricing adjustments. Funds would also be required to file monthly reports within 30 days after month-end, which would become public 60 days after month-end.
Comments on the proposal are due 60 days after the release is published in the Federal Register.
Open-End Fund Liquidity Risk Management Programs and Swing Pricing; Form N-PORT, SEC Release Nos. 33-11130; IC-34746 (Nov. 2, 2022), available at: https://www.sec.gov/rules/proposed/2022/33-11130.pdf.