SEC Proposes Liquidity Management Rules for Mutual Funds and ETFs
On September 22, the Securities and Exchange Commission proposed a comprehensive package of rule reforms designed to enhance effective liquidity risk management by open-end funds, including mutual funds and exchange-traded funds (ETFs). Under the proposal, mutual funds and ETFs would be required to implement liquidity risk management programs and enhance disclosure regarding fund liquidity and redemption practices. The proposal is designed to better ensure investors can redeem their shares and receive their assets in a timely manner.
Liquidity Risk Management Programs. Proposed new Rule 22e-4 would require mutual funds and other open-end management investment companies, including ETFs but excluding money-market funds, to have a liquidity risk management program. A fund’s liquidity risk management program would be required to contain multiple elements, including: (1) classification of fund portfolio assets based on the amount of time an asset would be able to be converted to cash without a market impact; (2) assessment, periodic review and management of a fund’s liquidity risk; (3) establishment of a fund’s three-day liquid asset minimum; and (4) board approval and review.
Asset Classification. Funds would be required to classify each asset position into one of six liquidity categories that would be convertible to cash within a certain number of days: one business day; two to three business days; four to seven calendar days; eight to15 calendar days; 16 to 30 calendar days; and more than 30 calendar days. The proposed rule includes factors that would have to be addressed when classifying fund assets. In addition, Rule 22e-4 would codify the 15 percent limit on illiquid assets included in current SEC guidelines.
Ongoing Assessment. Funds would be required to assess and periodically review their liquidity risk, based on specified factors. Liquidity risk would be defined as the risk that a fund could not meet redemption requests that are expected under normal conditions or under stressed conditions, without materially affecting the fund’s net asset value (NAV) per share.
Three-Day Liquid Asset Minimum. A fund would be required to determine a minimum percentage of its net assets that must be invested in cash and assets that are convertible to cash within three business days at a price that does not materially affect the value of the assets immediately prior to sale.
The Board’s Role. A fund’s board, including a majority of the fund’s independent directors, would be required to approve the fund’s liquidity risk management program, including the three-day liquid asset minimum. The board also would annually review a written report concerning the program’s adequacy prepared by the fund’s investment adviser or officer administering the program.
Mutual Fund Swing Pricing. Proposed changes to Rule 22c-1 would provide a framework under which mutual funds, but not ETFs, could elect to use “swing pricing” to effectively pass on the costs stemming from shareholder purchase or redemption activity to the shareholders associated with that activity. Subject to board approval and oversight, a fund that chooses to use swing pricing would reflect in its NAV a specified amount, the “swing factor,” once the level of net purchases into or net redemptions from the fund exceeds a specified percentage of the fund’s NAV known as the “swing threshold.”
Proposed Disclosure Changes. The SEC also is proposing amendments to the Form N-1A registration statement and two reporting forms proposed in May 2015—N-PORT and N-CEN. The proposed Form N-1A amendments would require disclosure of fund policies concerning the redemption of fund shares and the use of swing pricing. Amendments to proposed Form N-PORT would require disclosure of each fund asset’s Rule 22e-4 classification and the fund’s three-day liquid asset minimum. Amendments to N-CEN would require disclosure of committed lines of credit, interfund borrowing and lending, and swing pricing. ETFs also would be required to report on Form N-CEN whether they required an authorized participant to post collateral in purchase or redemption transactions. In connection with these proposed form amendments, the SEC is re-opening the comment period for its prior proposed reform entitled “Investment Company Reporting Modernization,” Investment Company Act Release No. 31610 (May 20, 2015).
White Paper and Comment Period. The proposed liquidity rules are supported by a white paper prepared by the SEC’s Division of Economic and Risk Analysis staff entitled, “Liquidity and Flows of U.S. Mutual Funds,” which will be available on the SEC’s website. The comment period for the proposed liquidity rules will be 90 days after publication in the Federal Register.
The proposing release may be found here.