The Securities and Exchange Commission recently proposed amendments to its current rules for open-end management investment companies regarding liquidity risk management programs and swing pricing.
If adopted as proposed, the amendments would likely lead to significant operational changes for open-end funds and their intermediaries and could upend long-established share pricing methods for investors.
The SEC would amend Rule 22e-4, rule 22c-1, and certain reporting and disclosure forms under the Investment Company Act of 1940 to:
- Require open-end funds, except money market and exchange-traded funds, to use swing pricing and to implement a “hard close” for share transactions.
- Change how open-end funds classify the liquidity of their investments and require a minimum amount of highly liquid assets of at least 10 percent of net assets. (Again, the changes do not apply to money market funds and ETFs.)
- Compel funds to provide more frequent and more detailed public reporting of fund information, including information about funds’ liquidity and use of swing pricing.
The SEC says the amendments are designed to better prepare open-end management investment companies for stressed conditions and mitigate dilution of shareholders’ interests.
“These concerns are heightened in times of stress or for funds invested in less liquid investments,” the SEC said in a statement. “The market disruptions of March 2020 reinforced the fact that liquidity can deteriorate rapidly and significantly.”
Swing Pricing and a Hard Close
Currently, funds may voluntarily determine their own swing pricing thresholds for net purchases and net redemptions under a framework laid out in rule 22c-1.
Under the proposed amendments, open-end funds would be required to adjust their net asset value (NAV) by a swing factor so transaction prices effectively pass on costs from inflows and outflows to the investors engaged in that activity. This, according to the SEC, would prevent those transactions from diluting other shareholders.
The swing factor, the SEC says, would reflect bid-ask spread and certain other costs of selling or purchasing a vertical slice of the fund’s portfolio. It would also include an estimate of market impact costs when net redemptions or net purchases exceed a threshold.
The proposal would also require a “hard close” for these funds. An investor’s order to purchase or redeem a fund’s shares would be eligible for a given day’s price only if the fund, its transfer agent, or a registered clearing agency receives the order before the time the fund calculates its NAV, typically 4 p.m. ET.
The SEC asserts that a hard close would help operationalize swing pricing by ensuring that funds receive timely flow information, help prevent late trading of fund shares, and improve order processing.
Managing Liquidity Risk
Under the proposed amendments, most open-end funds would be required to incorporate stress into their liquidity classifications by assuming the sale of a stressed trade size, similar to an ongoing stress test.
The proposed amendments also would establish other minimum standards for liquidity classifications, a move the SEC says is designed to prevent funds from overestimating the liquidity of their investments and provide clearer guideposts. In addition, the proposal would amend the existing liquidity categories, including removing the less liquid investment category. (The less liquid category includes investments that take longer than seven days to settle.)
Funds would be required to maintain a minimum amount of highly liquid investments of at least 10 percent of net assets. The SEC contends the proposal would help funds prepare for and manage stressed conditions. “As liquidity classifications would be more objective and comparable, the proposal would provide investors with aggregate information about a fund’s liquidity profile and information related to its use of service providers for liquidity classification,” the SEC says.
Reporting Changes
Under the current rules, funds prepare monthly reports and file them at the end of each quarter. Only the report for the third month of the quarter is made public.
The proposed amendments would require funds to file each month’s report within 30 days after month-end, with the report becoming public 60 days after month’s end. This change would apply to all registrants that report on Form N-PORT, including open-end funds other than money market funds, registered closed-end funds, and ETFs organized as unit investment trusts.
The SEC says the changes in reporting would provide investors with timelier portfolio information, “which is particularly useful in times of changing market conditions.”
What Comes Next?
The proposals were approved on 3-2 vote by the SEC in November 2022. A brief, 60-day comment period running from Dec. 16 to Feb. 14 followed.
As some legal commentators have noted, the rules are likely to generate significant lobbying activity and litigation and may not take full effect in their current form. The SEC is proposing a transition period of 12 months for the rules on liquidity and 24 months for swing pricing and hard close rules. Congress will have an opportunity to review the rules when the Congressional Review Act lookback period begins, probably sometime in 2024. And the next presidential election could result in changes to the makeup of the SEC.
If the amendments are adopted as is, however, open-end funds would need to conduct a significant review of their operations and reporting obligations. To learn more about the proposed rules, how your business could be affected, and what you can do to prepare, contact us for a consultation.