SEC Issues Final Rule On Investment Company Swing Pricing
On October 13, 2016, the Securities and Exchange Commission (SEC) issued its final rule with respect to investment company swing pricing. The final rule includes amendments to Rule 22c-1 under the Investment Company Act of 1940, as amended (1940 Act) as well as certain other amendments, as discussed below. Under the amendments, an open-end management investment company, except a money market fund or exchange-traded fund (ETF), under certain circumstances will be permitted, but not required, to use swing pricing. “Swing pricing” is the process of adjusting a fund’s net asset value (NAV) per share to effectively pass on the costs stemming from shareholder purchase or redemption activity to the shareholders associated with that activity. If a fund decides to utilize swing pricing, then the fund’s board will need to initially approve the swing pricing policies and procedures, the fund’s swing threshold and any changes thereto, the fund’s swing factor upper limit and any changes thereto, and will need to designate and receive periodic reports from the fund’s investment adviser, fund’s officer, or fund’s officers responsible for administering the swing pricing program (Swing Pricing Administrator) all as discussed in more detail below. The effective date has been delayed until 24 months after the publication of the Adopting Release in the Federal Register.
Rule 22c-1 under the 1940 Act requires that fund shareholders purchase and redeem fund shares at a price based on the current NAV next computed after the receipt of an order to purchase or redeem (forward pricing). However, such forward pricing does not take into account any transaction costs that may arise when a fund purchases portfolio investments to invest proceeds for shareholder purchases or sells portfolio investments to meet shareholder redemption requests. The SEC believes that the ability for funds to use swing pricing is another tool in their toolbox to assist with potential dilution and to manage fund liquidity. Therefore, in the Adopting Release, the SEC adopted a new paragraph (a)(3) of Rule 22c-1, which provides an exception to the forward pricing rule to permit, but not require, swing pricing by registered investment companies, other than money market funds and ETFs, under certain circumstances.
Swing Pricing Policies and Procedures
As discussed below, if a fund decides to utilize swing pricing, then its swing pricing policies and procedures will need to be initially approved by a fund’s board. However, the board does not have to specifically approve changes to the swing pricing policies and procedures. For funds that choose to utilize swing pricing, the policies and procedures must provide that the fund is required to adjust its NAV once the level of net purchases or redemptions from the fund has exceeded a set, specified percentage of the fund’s NAV, known as the “swing threshold.” The swing policies and procedures must also specify the process for setting the swing threshold, swing factor, and swing upper limit. The “swing factor” is the amount, expressed as a percentage of the fund’s NAV, by which the fund will adjust its NAV when its net purchases or net redemptions cross the fund’s swing threshold. As discussed below, the board will also need to approve the swing threshold and any changes thereto as well as the swing upper limit and any changes thereto.
Swing Pricing Administrator
Administration of the swing pricing policies and procedures must be reasonably segregated from portfolio management of the fund and may not include portfolio managers. The Adopting Release does note that portfolio managers may, however, provide data or other input to be used by the Swing Pricing Administrator. The Adopting Release further notes that a fund board may want to consider having the swing pricing policies and procedures be administered by a committee, and to specify the officers or functional areas that comprise the committee, taking into account any possible conflicts for the fund and the adviser related to swing pricing.
In the Adopting Release, the SEC states that the swing threshold will generally reflect the estimated point at which net purchases or net redemptions would trigger the fund’s investment adviser to trade portfolio assets in the near term, to a degree or of a type that may generate material liquidity or transaction costs for the fund.
In determining what a fund’s swing threshold should be, a fund must consider:
The size, frequency, and volatility of historical net purchases or redemptions of fund shares during normal and stressed periods
The fund’s investment strategy and the liquidity of the fund’s portfolio investments
The fund’s holdings on cash and cash equivalents, as well as borrowing arrangements and other funding sources
The costs associated with transactions in the markets in which the fund invests
A fund may also consider other factors that it deems relevant in determining its swing threshold. For a fund with multiple classes, the net purchases or net redemptions of all share classes of the fund is part of the determination as to whether the fund has crossed its swing threshold.
While there is no minimum floor for a fund’s swing threshold, the Adopting Release notes that a fund may cannot choose a swing threshold of zero so that swing pricing would always be in effect. A fund may set multiple swing thresholds, each associated with a different swing factor and whichever threshold is triggered on a given day would determine the single swing factor used that day to adjust the fund’s NAV. Each swing threshold should be set using the factors described above.
The SEC states in the Adopting Release that the only factor that may be taken into account when setting the swing factor is the near-term costs expected to be incurred by the fund as a result of net purchases or net redemptions that occur on the day the swing factor is used, and these near-term cost considerations should be limited to:
Transaction-related fees and charges arising from effecting portfolio transactions as a result of the net redemptions or net subscriptions
Borrowing-related costs incurred by the fund in order to meet a redemption request
The Adopting Release notes that the phrase “near-term” is meant to reflect that investing proceeds from net purchases or satisfying net redemptions could involve costs that may not be incurred by the fund for several days.
Additionally, the Swing Pricing Administrator must determine that the swing factor is reasonable in relationship to the fund’s near-term costs. The Adopting Release notes that funds could take many different approaches to setting their swing factors, as long as the process includes the near-term costs considerations discussed above.
Swing Factor Upper Limit
A fund’s swing pricing policies and procedures must disclose the board-approved swing factor upper limit, which must not exceed 2 percent. The board must also approve any changes to the swing factor upper limit. This swing factor upper limit will be required to be disclosed in a fund’s registration statement on Form N-1A and shareholder report on Form N-CEN.
Utilizing Swing Pricing
If a fund determines to use swing pricing, then it will be required to adjust its NAV by the swing factor whenever net purchases or net redemptions exceed the board-approved swing threshold. In looking at such shareholder activity, any purchases or redemptions that take place in-kind should be excluded from determining if the swing threshold was crossed. A fund must be able to obtain reasonable estimates of investor flows daily, or the aggregate flows of money being invested in and redeemed out of the fund, for purposes of reasonably estimating with high confidence whether the fund’s net purchases or net redemptions have crossed the swing threshold. The SEC states in the Adopting Release that funds using swing pricing will need to make sure they have developed processes and procedures to gather sufficient investor flow information from transfer agents that include transactions being conducted by intermediaries on behalf of shareholders. The SEC further states in the Adopting Release that this information could include actual transactions orders received by the transfer agent as well as estimates of investor flows, which funds can use to reasonably estimate the aggregate daily net investor flows for swing pricing purposes. The Adopting Release notes that a fund’s swing pricing policies and procedures could describe the process by which the fund obtains shareholder flow information as well as the amount and kind of transaction data that the fund believes is necessary to obtain before making its estimate of total net flows in order to determine if the swing threshold has been crossed. In addition, the Adopting Release suggests that funds may want to consider regular back-testing of their daily estimated net flows used in determining whether a swing threshold has been crossed based on final data, and then enhance its estimation process over time.
Additionally, funds that utilize swing pricing should review their error correction policies and procedures to ensure they properly address swing pricing to the extent necessary to address the use of reasonable estimates related to swing pricing, including appropriate parameters around what constitutes an error with respect to their swing pricing policies and procedures. The SEC notes in the Adopting Release that it believes that, as long as a fund follows reasonable practices, policies, and procedures in gathering sufficient information in determining whether net investor flows, which may include reasonable estimates, have exceeded the applicable threshold used for swing pricing, such differences would not in and of themselves result in a determination of a material pricing error that would require reprocessing or financial statement adjustment.
The SEC points out in the Adopting Release that while a fund’s independent public accounting firm should not be responsible for assessing if the fund’s swing threshold and swing factor are reasonable, provided that there is no indication of noncompliance; nonetheless it will be within the scope of the auditor’s engagement to verify that the swing pricing policies and procedures have been approved by the fund’s board and have been consistently applied, in all material respects, throughout the period, including as of the balance sheet date.
The SEC notes in the Adopting Release that many commenters discussed the operational issues that funds will likely encounter in trying to implement swing pricing. While they acknowledge such difficulties, the SEC notes that it believes the two-year lead time up to the effective date will assist the industry in coming up with workable solutions.
Special Considerations in Fund Mergers
The Adopting Release notes that boards of merging funds, where one or both funds utilizes swing pricing, will need to consider whether swing pricing should be temporarily suspended ahead of the merger so that neither the target fund’s or acquiring fund’s NAV is adjusted to counter any dilution resulting from the merger rather than from shareholder purchase or redemption activity.
A fund’s board, including a majority of the independent directors, will be required to initially approve the fund’s swing pricing policies and procedures, and to designate the Swing Pricing Administrator. The board will also be required to review, no less frequently than annually, a written report prepared by the Swing Pricing Administrator, as discussed above.
The Swing Pricing Administrator’s report for the board must describe, among other things:
The Swing Pricing Administrator’s review of the adequacy of the fund’s swing pricing policies and procedures and the effectiveness of their implementation, including the impact on mitigating dilution
The Swing Pricing Administrator’s review and assessment of the fund’s swing pricing threshold(s), swing factor(s), and swing upper limit considering the requirements of Rule 22c-1(a)(3)(i)(B) and (C), including the information and data supporting these determinations
Any material changes to the swing pricing policies and procedures since the last annual report
The Adopting Release notes that the type of report the board will receive is similar to that received pursuant to Rule 38a-1 under the 1940 Act. Importantly, the Adopting Release notes that in fulfilling its duties, the board may choose, where consistent with the prudent discharge of its fiduciary duties, to make its determinations while relying on reports and other information as it determines appropriate from the Swing Pricing Administrator.
While the swing policies and procedures and swing threshold must be reviewed at least annually, a fund may want to assess its swing threshold more frequently or specify in its policies and procedures what circumstances may result in the need for an ad hoc review.
The board will also be required to approve the swing threshold(s) and the upper limit on the swing factor(s) used by the fund, and any changes thereto.
Amendments to Financial Statements, Form N-1A, and Form N-CEN
The Adopting Release contains certain amendments to the Statement of Changes in Net Assets, Financial Highlights, and Financial Statement Footnote Disclosure for funds that utilize swing pricing.
Funds that use swing pricing will need to explain in their prospectus what swing pricing is, the circumstances under which the fund will use it, and the effects of swing pricing on the fund and its shareholders. Also, as discussed above, funds that use swing pricing will need to disclose in their prospectus the swing factor upper limit. For funds of funds that invest in funds that use swing pricing, the fund will be required to include a statement that its NAV is calculated based on the NAV of the funds in which it invests, and that the prospectuses for those funds explain when they will use swing pricing and the impact such use may have. If a fund uses swing pricing during any periods presented in the prospectus, then that fund will be required to add disclosure in a footnote about the effects swing pricing has on the fund’s annual and average total returns for the periods presented.
Funds (other than money market funds and ETFs) will need to disclose in Form N-CEN whether they engaged in swing pricing during the reporting period and if so, what swing factor upper limit was set by the fund.
The effective date has been delayed to 24 months following publication in the Federal Register. In addition, the SEC has directed its staff to review, two years after the effective date, market practices associated with funds’ use of swing pricing.
 Release No. IC-32316: Investment Company Swing Pricing (the Adopting Release).
 Such transaction-related fees and charges could include mark-ups and mark-downs, brokerage commissions and custody fees, as well as other charges, fees, and taxes associated with portfolio asset purchases or sales (i.e., transfer taxes and repatriation costs for certain foreign securities, or transaction fees associated with portfolio investments in other investment companies).
 Such borrowing-related costs may include interest charges or other costs paid if a fund were to draw on a line of credit or engage in interfund borrowing in order to pay redemptions.