Overview

Proposed Amendments to Liquidity Risk Management (Rule 22e-4)

• Funds would have to incorporate stress into their liquidity classifications by assuming the sale of a stressed trade size rather than the current assumption of a “reasonably anticipated trade size” in current market conditions.
• Establishment of a minimum value impact standard that defines more specifically what constitutes a significant change in market value.
• Removal of ability to use asset class classification.
• Removal of the “less liquid investment” category with those investments treated as illiquid. This part of the Proposal would directly impact many floating rate or bank loan funds.
• Amendments to the definitions of highly liquid, moderately liquid and illiquid investments.
• Daily, rather than monthly, liquidity classification.
• Requiring all funds to determine and maintain a “highly liquid investment minimum” (“HLIM”), which must be at least 10% of net assets.
• Amendments to how the HLIM and illiquid investments calculations take into account the value of assets that are posted as margin or collateral for certain derivatives transactions.

In-Kind ETFs would continue to be exempt from the liquidity classification and HLIM requirements.  However, the exclusion from the HLIM requirement for funds that primarily invest in highly liquid investments would be eliminated.

Proposed Amendments to Swing Pricing (Rule 22c-1)

• Any open-end fund, other than a money market fund or an ETF, would be required to use swing pricing to adjust its net asset value (“NAV”) per share to pass on costs stemming from shareholder purchase or redemption activity to those shareholders engaged in that activity, under certain circumstances.
• Amendments to the swing pricing framework relating to when and how a fund would adjust its NAV.
• A specific method by which funds would calculate the swing factor price adjustment.
• Impose a “hard close” requirement for funds required to use swing pricing whereby an order to purchase or redeem a fund’s shares would be executed at the current day’s price only if the fund, its designated transfer agent, or registered securities clearing agency, receives the order before the pricing time when the fund calculates its NAV (typically, 4pm EST).

The Proposal also includes more frequent and detailed reporting by funds on Form N-PORT to the SEC and the public.

The Proposal is subject to a 60-day comment period after the Proposing Release’s publication in the Federal Register.

Proposed Amendments to Liquidity Risk Management Programs

The Proposal includes certain amendments to the liquidity classification framework:

• In order to determine an investment’s liquidity classification, the fund must measure 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, while assuming the sale of 10% of the fund’s net assets by reducing each investment by 10%.
• Establishment of a minimum value impact standard that defines more specifically what constitutes a significant change in market value, which would vary depending on the type of investment.
  • For shares listed on a U.S. or foreign exchange, selling or disposing of more than 20% of the security’s average daily trading volume would indicate a level of market participation that is significant. To calculate the average daily trading volume, a fund would measure the average daily trading volume over the preceding 20 business days.  
  • For any other investment, a significant change in market value would be defined as any sale or disposition that a fund reasonably expects would result in a decrease in sale price of more than 1%.
• Removal of the ability to utilize asset class classification.
• Removal of the less liquid investment category, which would result in those investments being classified as illiquid.
  • The Proposing Release notes that this will primarily impact floating rate or bank loan funds. The Proposing Release seems to indicate that either: (1) these types of funds would no longer be able to operate as open-end funds, but would have to operate as closed-end fund or private funds that don’t have to comply with the 15% limit on illiquid investments, or (2) would have to work to reduce settlement time for those types of investments so that they can be classified as moderately liquid.
• Definition changes for the remaining liquidity categories:
  • “highly liquid investment” would be any U.S. dollars held by a fund and any investment that the fund reasonably expects to be convertible to U.S. dollars in current market conditions in three business days or less without significantly changing the market value of the investment.
  • “moderately liquid investment” would be any investment that is neither a highly liquid investment nor an illiquid investment.
  • “illiquid investment” would be any investment that the fund reasonably expects not to be convertible to U.S. dollars in current market conditions in seven calendar days or less without significantly changing the market value of the investment and any investment whose fair value is measured using an unobservable input that is significant to the overall measurement.
• The term “convertible to cash” would be changed to “convertible to U.S. dollar”.
• In determining classification, a fund must count the day of the classification when determining how many days it will reasonably take to convert the investment to U.S. dollars.

While Rule 22e-4 currently requires classification to take place monthly, the Proposal would require classification to take place each business day.

The Proposal also would make changes to the HLIM requirements:

• All funds, other than In-Kind ETFs, would be required to have a HLIM, which must be at least 10% of the fund’s net assets.
• There would no longer be an exclusion for funds that primarily invest in highly liquid investments.
• In calculating a fund’s assets that would go towards the HLIM, a fund must (1) subtract the value of any highly liquid assets that are posted as margin or collateral in connection with any derivatives transaction that is classified as moderately liquid or illiquid; and (2) subtract any fund liabilities.

Additionally, in calculating a fund’s illiquid investments, a fund must treat as illiquid nay margin or collateral it has posted in connection with a derivatives transaction that is classified as an illiquid investment and that the fund would receive if it exited the derivatives transaction.

Proposed Amendments to Swing Pricing

Under the Proposal, every registered open-end fund (other than money market funds and ETFs[2]) would be required to establish and implement swing pricing policies and procedures that adjust the fund’s current NAV per share by a swing factor if the fund has: (1) net redemptions or (2) if it has net purchases that exceed an identified threshold. 

The framework for determining swing thresholds under the Proposal includes the following:

• If a fund has net redemptions: the fund would be required to apply a swing factor.
  • All funds would need to assess whether market impact costs would occur when net redemptions exceed 1% and, if they do occur, then those costs must be included in the swing factor when net redemptions exceed 1% of the fund’s net assets (“market impact threshold”).
• If a fund has net purchases that exceed 2% of its net assets (“inflow swing threshold”), then the fund would be required to apply a swing factor .
• A fund’s swing price administrator (the “administrator”) may use smaller thresholds for both the market impact threshold and inflow swing threshold, provided that the administrator include in its written report to the board the data and information justifying the decision to use the lower threshold.

Determining Investor Flows

Under the Proposal, and consistent with the existing rule, the swing price administrator must review investor flow information to determine: (1) if the fund has net purchases or net redemptions; and (2) the amount of such net purchases or net redemptions. Although the “Hard Close” aspect of the Proposal (discussed below) should help the fund to get timely flow information, Rule 22c-1 would continue to permit the swing price administrator to make these determinations based on reasonable, high confidence estimates as to whether it has crossed a swing threshold.

Calculating the Swing Factor

The Proposal would require the swing price administrator to make good faith estimates of the costs incurred by the fund if it purchased or sold a pro rata amount of each investment in its portfolio to satisfy the amount of net purchases or net redemptions (a “vertical slice”) to satisfy that day’s redemptions or to invest the proceeds from that day’s purchases. The Proposing Release notes that analyzing costs based on an assumed purchase or sale of a vertical slice of the fund’s portfolio would more fairly reflect the costs imposed by redeeming or purchasing investors then selecting specific investments.  

The swing factor calculation would differ depending on whether the fund is experiencing net purchases or net redemptions.

• In the case of net redemptions, the good faith estimates must include, for selling a pro rata amount of each investment in the fund’s portfolio to satisfy the amount of net redemptions:
  • spread costs;
    • If the fund values its portfolio holdings at the bid price, it would not need to include spread costs.
    • If the fund uses mid-market pricing, the spread cost component would reflect half of the bid-ask spread.
  • brokerage commissions, custody fees and any other charges, fees and taxes associated with portfolio investment sales; and
  • the market impact of selling a vertical slice of a fund’s portfolio to satisfy the amount of net redemptions (if the amount of the fund’s net redemptions exceeds the market impact threshold).

• In the case of net purchases, swing pricing would only be applied if the amount of the fund’s net purchase exceeds 2%. The good faith estimates must include, for purchasing a pro rata amount of each investment in the fund’s portfolio to invest the proceeds from the net purchases:
  • spread costs;
    • If the fund values its portfolio holdings at the bid price, the spread cost would reflect the full bid-ask spread.
    • If the fund uses mid-market pricing, the spread cost component would reflect half of the bid-ask spread.
  • brokerage commissions, custody fees, and any other charges, fees, and taxes associated with portfolio investment purchases; and
  • the market impact of purchasing a vertical slice of the fund’s portfolio to satisfy the amount of net purchases.

The Proposing Release provides that the market impact for each investment is determined by:

• Estimating the market impact factor, which is the percentage change in the value of the investment if it were purchased or sold, per dollar of the amount of the investment that would be purchased or sold.
• Multiplying the market impact factor by the dollar amount of the investment that would be purchased or sold if the fund purchased or sold a pro rata amount of each investment in its portfolio to meet the net redemptions or net purchases.

The Proposing Release also notes that the swing price administrator may apply the same estimate costs and market impact factors for all investments with the same or substantially similar characteristics.  The swing price administrator would be required to keep records documenting the market impact factors. 

Funds would be required to report their swing factor adjustments publicly on Form N-PORT.

The Proposal would also remove the upper limit on the swing factor from Rule 22c-1.

Hard Close

The Proposal includes amendments to Rule 22c-1 under the Act to require a hard close for funds that are required to implement swing pricing.  Under the Proposal, purchase or redemption orders are only eligible to receive the current day’s prices if the fund or its designated transfer agent, or a registered securities clearing agency (collectively, “designated parties”) receives the order before the time the fund computes its NAV, which is typically 4pm EST.

Pricing Requirements

The Proposal establishes the following defined terms:

• “Pricing time” means the time or times of day, established by the board, as of which the fund calculates the current NAV of its redeemable shares pursuant to the rule.
• “Eligible order” means the direction to purchase or redeem a specific number or value of fund shares (including exchange orders, which is when an investor initiates an order to purchase shares of a fund using the proceeds from a contemporaneous order to redeem shares of another fund).

Under the Proposal, eligible orders would receive the price based on the current NAV as of the next pricing time. Funds would calculate investor flows in part by using the required information in the eligible order about the size of an investor’s intended trade. Eligible orders would be irrevocable as of the next pricing time after a designated party receives the order, primarily to avoid the cancellations of orders, and thereby modifications to the investor flow information used to make swing pricing decisions. The Proposing Release further notes that the irrevocability provision will prevent late trading that might otherwise occur when investors learn of new market information after the pricing time. Orders received after the fund’s established pricing time would receive the next day’s price.

Effects of the Proposed Hard Close Rule

The Proposing Release predicts that the Proposal would change the way in which funds and intermediaries process orders. For example, some intermediaries may opt to discontinue one-time batch processes for submitting orders and instead adopt more frequent submissions throughout the business day, or near-real-time submissions. The Proposing Release notes that having earlier and more frequent submissions would improve operational resilience across all market participants and will also help funds make portfolio and risk management decision based on more complete and accurate flow information than is currently available.

The Proposing Release does acknowledge that complying with these new requirements would be difficult and result in additional costs for intermediaries as well as substantial changes in their business and operating practices. 

Other Proposed Amendments to Rule 22c-1

The Proposal would also reorganize and re-word the existing provisions relating to the current rule concerning the frequency and time for determining the NAV.

• Use the phrase “based on the current net asset value of such security established for the next pricing time” instead of the phrase “based on the current net asset value of such security which is next computed” to reflect that those orders received after the pricing time now do not receive same day pricing.
• Reorganize the existing exceptions to the rule’s forward pricing requirement.

Amendments to Form N-1A

The Proposal would also make changes to the disclosure requirements under Form N-1A. The Proposal would require funds to disclose on Form N-1A that if an investor places an order with a financial intermediary, the financial intermediary may require the investor to submit its order earlier than the fund’s pricing time to receive the next calculated NAV. Such a disclosure requirement would ensure that investors understand the potential variability in the time by which intermediaries may require an order to be placed to receive a particular day’s price.

[1] Release IC-34746, Open-End Fund Liquidity Risk Management Programs and Swing Pricing; Form N-PORT Reporting (November 2, 2022) at https://www.sec.gov/rules/proposed/2022/33-11130.pdf  (“Proposing Release”).

[2] Also would not apply to feeder funds in a master-feeder structure.