On November 2, 2022, the SEC proposed wide-ranging changes to how open-end investment companies (other than exchange traded funds and money market funds, “Funds”) process and price shareholder transactions and manage their corresponding liquidity risks (the “Proposal”). This post attempts to summarize key elements of the Proposal as a precursor to our analysis of its merits. “Attempts” is the apt term, as the Proposal would involve substantial revisions to multiple rules and disclosure forms, which makes organizing our summary a challenge.
Swing Pricing for All
At the end of 2021, the SEC proposed to impose swing pricing on money market funds that do not seek to maintain a stable net asset value per share (“NAV”) whenever they have net redemptions. The Proposal would amend Rule 22c-1 to extend this swing pricing requirement to all fluctuating NAV mutual funds other than exchange traded funds. As this linked comparison of the Proposal’s swing pricing provisions to the proposed revisions to Rule 2a-7 shows, the proposals are largely the same. Our post on the 2a-7 proposal explains the fundamentals of swing pricing, so we won’t repeat them here.
The Proposal’s swing pricing requirements would differ substantively from the 2a-7 proposal in the following respects.
- A Fund must use a swing price higher than its current NAV if its net subscriptions equal or exceed 2% of its net assets or a smaller percentage determined by the swing pricing administrator.
- The market impact threshold for net redemptions would be 1% of net assets rather than 4%. The swing price factor for net subscriptions must include a market impact factor.
A “Hard” Close
To assure that Funds can determine whether to swing price at any pricing time, the Proposal would also amend Rule 22c-1 to require shareholder orders to be received by the Fund’s designated transfer agent (not a sub-transfer agent) or a registered clearing agency (i.e., the NSCC) before that pricing time. This will require intermediaries to cut-off orders from their customers before the close of the New York Stock Exchange, so they can process and transmit the orders before the pricing time. Orders received after the pricing time would be processed at the next day’s NAV.
Changes to the Liquidity Risk Management Rule
The Proposal would make substantial changes to Rule 22e-4. The principal changes would include the following.
- Investments could no longer be grouped into asset classes for purposes of liquidity classification. The classification of each investment must be reviewed every day.
- Liquidity classifications must assume the sale of 10% of each holding, rather than a reasonably anticipated trading size.
- “Significantly changing the market value” of a security would be defined as: (a) for listed shares, disposition of more than 20% of the average daily trading volume for the preceding 20 business days and (b), for other investments, a disposition reasonably expected to decrease the sale price by more than 1%.
- A Fund’s highly liquid investment minimum must be at least 10%. When calculating compliance with this minimum, the value of highly liquid investments must be reduced by (a) the Fund’s liabilities and (b) any highly liquid investment posted as margin or collateral for a non-highly liquid derivative transaction.
- The category of less liquid investments would be eliminated, and such investments would be classified as illiquid, which would reduce the current classification categories from four to three.
- Any investment with a Level 3 valuation (i.e., valued using significant unobservable inputs) must be classified as illiquid. Investments posted as margin or collateral for illiquid derivative transactions would count towards the 15% limitation on illiquid investments.
- Liquidity would be based on the time required to convert an investment into U.S. dollars, rather than cash.
Changes to N-PORT
Funds would be required to file monthly N-PORT reports within 30 days after the end of each month, rather than filing reports for each month in a fiscal quarter within 60 days after the end of the quarter. Each N-PORT would become publicly available 60 days after the end of the reporting period. The percentage of net assets in each liquidity classification would be included in the publicly available report.
Enhanced information regarding swing pricing would be added to N-PORT and removed from N-CEN. End-of-month portfolio holdings information would be included in every N-PORT except for the months corresponding to semi-annual and annual shareholder reports. The Proposal includes a number of other conforming and technical amendments to N-PORT and Form N-1A.
With this summary out of the way, we can begin to digest the most important elements of the Proposal.