Introduction

On September 22, 2015, the Securities and Exchange Commission (“SEC”) proposed a comprehensive package of rule reforms under the Investment Company Act of 1940 (the “Proposals”) to require liquidity risk management programs and related disclosures for open-end management investment companies, including mutual funds and exchange-traded funds (ETFs) (collectively, “funds”). The Proposals would also permit, though not require, a fund (other than a money market fund and ETF) to engage in “swing pricing” under certain circumstances and would amend a number of investment company regulatory forms.

The Proposals

Proposed Investment Company Act Rule 22e-4

Proposed Rule 22e-4 would require each fund to establish a written liquidity risk management program tailored to its specific portfolio and reasonably designed to assess and manage its liquidity risk. Key elements of a liquidity risk management program would include the following:

1. Portfolio Position Assessment. The fund would be required to classify and engage in an ongoing review of the liquidity of each of the fund’s positions in portfolio assets (or portions of a position in a particular asset), based on the following six specified liquidity categories distinguished by the number of days in which the position would be convertible to cash at a price that does not materially affect the value of that asset immediately prior to sale:

• 1 business day;
• 2-3 business days;
• 4-7 calendar days;
• 8-15 calendar days;
• 16-30 calendar days; and
• more than 30 calendar days.

•The liquidity category of each portfolio position would be determined after considering certain specified market, trading, and asset-specific factors, as applicable.

2. Redemption Liquidity Assessment. The fund would be required to assess and periodically review the fund’s liquidity risk, defined as the risk that the fund would be unable to meet redemption requests expected under normal conditions or reasonably foreseeable under stressed conditions without materially affecting its net asset value (NAV);

• Proposed Rule 22e-4 codifies current SEC 15% illiquid asset guideline by prohibiting a fund from acquiring any “15% standard asset” if, immediately after the acquisition, the fund would have invested more than 15% of its net assets in 15% standard assets.

• A 15% standard asset is any asset that cannot be sold or disposed of in the ordinary course of business within seven calendar days at approximately the value ascribed to it by the fund.

3. Liquidity Risk Management.

• The fund would be required to determine a minimum percentage of net assets that must be invested in cash or holdings convertible to cash within three business days at a price that does not materially affect the value of the assets immediately prior to sale.

• Three-day liquid asset minimum would be determined by reference to a number of prescribed factors, including cash flow projections, investment strategy, use of derivatives, and current holdings of cash and cash equivalents.

• The fund would be required to adopt policies and procedures regarding redemptions in kind, to the extent that the fund engages in redemptions in kind.

4. Board approval and oversight.

• The fund’s board, including a majority of its independent directors, would be required to approve the fund’s liquidity risk management program, including the three-day liquid asset minimum, and any changes thereto.

• The fund’s board would be required to review a written report that addresses the adequacy of the fund’s liquidity risk management program, prepared by the fund’s investment adviser or officer administering the program at least annually.

• The fund’s board would be required to approve the designation of the fund’s investment adviser or officers as responsible for administering the fund’s program (which cannot be solely portfolio managers of the fund).

Proposed Rule 22e-4 would also require funds to maintain a written copy of their liquidity risk management policies and procedures, copies of materials provided to the board in connection with its approval of the program and annual reporting requirement, and a written record of how the three-day liquid asset minimum, and any changes thereto, was determined.

Proposed Rule 22c-1(a)(3)

The Proposals would amend current Rule 22c-1 to permit, but not require, mutual funds (but not ETFs or money market funds) to engage in “swing pricing” under certain circumstances. Swing pricing is the process of adjusting a fund’s NAV per share to effectively pass on the costs stemming from shareholder purchase or redemption activity to the shareholders associated with those purchases or redemptions, as applicable.

Swing pricing would be a voluntary tool for funds, allowing funds to weigh the potential advantages and disadvantages of swing pricing in relation to its particular circumstances and risks, as well as the other tools the fund uses to manage dilution and liquidity risks. To use “swing pricing,” a fund would be required to adopt swing pricing policies and procedures that:

• Provide for the fund to adjust its NAV per share by a “swing factor” once the level of net purchases or redemptions exceeds a specified percentage of the fund’s NAV known as the “swing threshold”;
• Specify the fund’s swing threshold based on certain specified factors;
• Provide for review of the fund’s swing threshold at least annually; and
• Specify how the swing factor would be determined and whether the swing factor would be subject to an upper limit, each taking into account certain specified factors.

A fund’s swing pricing policies and procedures (and any material changes thereto) would have to be approved by the fund’s board, including a majority of its independent directors. The board would also be required to designate the fund’s adviser or officers responsible for administering the swing pricing policies and procedures.

A fund that engages in swing pricing would be subject to certain recordkeeping requirements, including maintaining a written copy of its policies and procedures and records supporting each adjustment to the fund’s NAV made based on these policies and procedures. The fund would also be required to make certain financial statement disclosures regarding swing pricing.

Proposed Disclosure and Reporting Requirements Regarding Liquidity Risk Management

The Proposals would amend current SEC Form N-1A, Regulation S-X, proposed SEC Form N-PORT and proposed SEC Form N-CEN.

Proposed amendments to Form N-1A:

• Funds would be required to disclose (i) the number of days following receipt of shareholder redemption requests in which redemption proceeds will be paid and (ii) the methods used by the fund to meet redemption requests, and whether those methods are used regularly or only in stressed market conditions. A fund also would be required to file any credit agreements for the benefit of the fund as registration statement exhibits.
• Funds that engage in swing pricing would be required to disclose the circumstances under which they will use swing pricing and the effects of using swing pricing. Funds that invest in other registered funds would be required to disclose that the circumstances under which those funds use swing pricing and the effects of using swing pricing can be found in the prospectuses for those funds.
• Funds would be required to disclose their NAV (for purposes of the financial highlights and performance data sections of Form N-1A) as adjusted pursuant to swing pricing policies and procedures, if applicable.

Proposed amendments to Regulation S-X would require funds to disclose the NAV as adjusted pursuant to its swing pricing policies and procedures (if applicable) on their financial statements.

Proposed amendments to proposed Form N-PORT would require funds to report the liquidity classification of each portfolio asset in accordance with proposed Rule 22e-4 and the three-day liquid asset minimum.

Proposed amendments to proposed Form N-CEN would require funds to disclose certain information regarding lines of credit, interfund borrowing and lending, and swing pricing. ETFs would also be required to report whether they required authorized participants to post collateral to the ETF or authorized service providers in connection with the purchase or redemption of ETF shares.

Comment Period

The comment period for the Proposals is 90 days after publication in the Federal Register.

The SEC’s has also prepared a “Fact Sheet” relating to the Proposals.

Conclusion

The Proposals represent potentially significant changes to the liquidity principles currently applicable to funds. If the Proposals are adopted, they will likely have a significant impact on fund operations and disclosure and reporting requirements.

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If you have any questions regarding the matters covered in this memo, please contact any of the partners and counsel listed below or your primary attorney in Seward & Kissel’s Investment Management Group.