The SEC voted 3-2 to propose rules for open-end investment companies that, if adopted, would bring changes to how these funds calculate NAV, including the use of swing pricing. A Fact Sheet accompanying the proposing release indicated that the Commission was motivated by lessons learned following the market downturn that accompanied the onset of the COVID-19 pandemic. As a result, the proposed amendments would require funds to classify assets by assuming potentially stressed market conditions in order to not overestimate their degree of liquidity. The proposal also would require swing pricing in order to allocate costs to investors who are responsible for fund inflows and outflows rather than diluting fund shareholders generally. Swing pricing would be further paired with a required “hard close” (Open-End Fund Liquidity Risk Management Programs and Swing Pricing; Form N-PORT Reporting, Release No. 33-11130, November 2, 2022).
“[G]ummy bears” and fund rules. SEC Chair Gary Gensler suggested that the classification part of the proposal would keep funds honest about which of their assets are truly liquid, analogizing the problem to his inability to classify gummy bears as fruit. Gensler also more generally stated the financial and economic case for the proposal thus: “A defining feature of open-end funds is the ability for shareholders to redeem their shares daily, in both normal times and times of stress. Open-end funds, though, have an underlying structural liquidity mismatch. This is because they invest in securities across a range of liquidities, including securities that are costlier or take more time to sell.”
Commissioner Hester Peirce voted against issuing the proposal and questioned its timing given that the Commission already has many open proposals. She also suggested that investors could use ETFs to combat dilution and that open-end funds might compete on offering anti-dilution tools. “The Commission’s flaw is hubris—thinking we can redesign open-end funds to eliminate their purported flaws has only revealed our own,” said Peirce.
Commissioner Mark Uyeda likewise voted against issuance of the proposal, citing the proposed amendments as a way to hasten investors’ move out of open-end mutual funds and into ETFs and distinguishing the use of swing pricing in Europe as being unique to that region’s markets.
According to Commissioner Caroline Crenshaw, who supported the proposal, public comments should focus on several questions, including the rule’s potential unintended consequences, any operational challenges regarding implementation of the hard close, and whether alternatives to swing pricing such as liquidity fees or estimated fund flow information would be sufficient.
Commissioner Jaime Lizárraga, who also voted to issue the proposal, said the proposal emphasizes fund redemptions in time of stress. “The market instability and stressed conditions at the onset of the COVID-19 pandemic tested liquidity risk management programs and revealed weaknesses that warrant our attention,” said Lizárraga.
Swing pricing. The proposal would require open-end funds to mitigate the dilution of shares by using swing pricing to set funds’ net asset value (NAV). The swing pricing requirement would apply to most funds but would not apply to money market funds or ETFs.
Under the proposal, Investment Company Act Rule 22c-1 would be amended to provide that a fund’s board must set the time to calculate the fund’s NAV and to further provide that a fund could not do transactions at other than the current NAV. The amended rule also would require a fund to establish and implement swing pricing policies and procedures.
Among the several procedures to be required, a fund would have to adjust its NAV by a swing factor if either of two conditions occurs:
- The fund has net redemptions; or
- The fund has net purchases exceeding its inflow swing threshold.
A fund’s swing pricing administrator would have to review investor flow information and make certain determinations, which could be based on reasonable, high confidence estimates. “Investor flow information” would be defined to mean daily purchase and redemption activity (e.g., individual, aggregated, or netted eligible orders, but not in kind purchases or redemptions).
The proposal also would impose a “hard close” requirement under which an investor's order to purchase or redeem fund shares is eligible for a particular day’s price only if the order is received before the fund calculates it NAV (often 4 p.m. eastern time). The Fact Sheet explained that this requirement would “operationalize” the swing pricing requirement by facilitating better flow information.
Liquidity risk management. As proposed, amended Investment Company Act Rule 22e-4(b) would retain the general requirement that each fund and in-kind ETF adopt and implement a written liquidity risk management program that is reasonably designed to assess and manage its liquidity risk. The amendment, however, would delete existing text and notes regarding monthly reporting on Form N-PORT and classification methodology.
Under the amended rule, classification would be determined by: (1) 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 (a fund would include the day on which the liquidity classification is made in the measurement); and (2) assuming the sale of 10 percent of the fund’s net assets by reducing each investment by 10 percent.
With respect to the highly liquid investment minimum, the general requirement would be re-phrased as an explicit command as compared to the existing rule text, which speaks of funds that do not primarily hold assets that are highly liquid investments. Thus, the amended rule would require that a fund determine and maintain a highly liquid investment minimum that is equal to or higher than 10 percent of the fund’s net assets.
In the case of illiquid investments, the amended rule would retain the general requirement that no fund or in-kind ETF may acquire any illiquid investment if, immediately after the acquisition, the fund or in-kind ETF would have invested more than 15 percent of its net assets in illiquid investments that are assets. However, the amended rule would address the situation where a fund has posted margin or collateral in connection with a derivatives transaction that is classified as an illiquid investment. Thus, if applicable, a fund also would include as illiquid investments that are assets the value of margin or collateral posted in connection with the derivatives transaction that the fund would receive if it exited the transaction. In other respects, the rule would not change regarding a fund or in-kind ETF that holds more than 15 percent of its net assets in illiquid investments that are assets.
Reporting requirements. As explained by the SEC’s Fact Sheet, the proposal would require funds to file each month’s report within 30 days after month-end, such that the report would become public 60 days after month-end. The change would apply to all registrants that report on Form N-PORT, including open-end funds other than MMFs, registered closed-end funds, and ETFs organized as unit investment trusts.
The release is No. 33-11130.