In the second step of its five-part plan to enhance registered funds regulations, the SEC has proposed new requirements on portfolio liquidity, risk monitoring, and board oversight.
At an open meeting held on September 22, the US Securities and Exchange Commission (SEC) unanimously approved a proposal that is designed to strengthen the management of liquidity risk by certain registered open-end investment companies, including mutual funds and ETFs. The SEC’s proposal creates new Rule 22e-4 under the Investment Company Act of 1940 (1940 Act), which would require funds to establish a liquidity risk management program and determine a minimum percentage of net assets that must be convertible to cash within three days. The SEC’s proposal would also enhance liquidity disclosure requirements, codify SEC guidance that limits a fund’s illiquid investments to 15% of the fund’s net assets, and amend Rule 22c-1 under the 1940 Act to permit certain funds to use “swing pricing,” which would allow managers to adjust the price at which shareholders transact in fund shares during periods of heavy redemptions or purchases. The proposal seeks to enhance a fund’s ability to meet redemption requests while mitigating dilution of shareholders, particularly during periods of market disruption.
SEC Chair Mary Jo White noted that the proposed rule is the next step in the SEC’s five-part plan to enhance the regulation of risks that arise from portfolio composition and the operations of funds and investment advisers. This plan includes measures to (1) enhance data reporting (as proposed this past May), (2) strengthen the management of fund liquidity, (3) better address risks from funds’ use of derivatives (a proposal is anticipated by the end of this year), (4) plan for the transition of client assets, and (5) “stress test” funds and advisers.
Chair White explained the necessity for improved liquidity risk management rules by emphasizing the rise of fund strategies that rely on securities that tend to be less liquid, such as high-yield bonds, emerging market securities, and alternatives. She stated that SEC staff economists have found that foreign bond funds and alternative strategy funds have historically experienced more unpredictable purchases and redemptions than average mutual funds.
The SEC’s package of proposals would require open-end funds—including mutual funds and ETFs, but not money market funds—to take the following actions:
Although the proposal received unanimous approval, Commissioners Gallagher and Piwowar expressed concerns regarding the imposition of a three-day asset minimum and the use of swing pricing. Both Commissioners advocated that a seven-day asset minimum would be more appropriate given its statutory basis in Section 22(e) of the 1940 Act and the fact that many funds are not required to deliver assets to redeeming shareholders in three days or less. With respect to swing pricing, Commissioner Gallagher suggested that funds should have the flexibility to approve different swing thresholds for large redemptions and large purchases or only apply swing thresholds to large redemptions. Commissioner Piwowar expressed his concern that swing pricing would cause investors to employ “gaming behavior” as investors try to predict how large redemptions will affect NAV. He also sought out comments on alternative methods for mitigating shareholder dilution from large redemptions and questioned if liquidity or redemption fees, like those proposed as part of the new money market fund reform rules, would offer a better solution. In addition, he asked that academic economists weigh in on how swing pricing affects the use of market investment tools like alpha, beta, sharp ratios and tracking error.
Commissioner Stein, on the other hand, asked commenters to consider whether the proposed rules go far enough and whether the rules should be tailored specifically to those funds that raise the greatest liquidity concerns. She asked if such funds would be better classified as closed-end funds or private funds.
If adopted as proposed, new Rule 22e-4 and the amendments to Rule 22c-1 would impose even more burden on funds’ compliance personnel, portfolio managers, and operations personnel. Similar to the money market fund enhancements that were adopted in 2014, the proposals would also add to the responsibility of the board of directors and require new assessments and determinations.
Once the proposed rule is published in the Federal Register, commenters will have ninety days to provide comments, which is thirty days more than the usual 60-day comment period.
 Open-End Fund Liquidity Risk Management Programs; Swing Pricing; Re-Opening of Comment Period for Investment Company Reporting Modernization Release, SEC Release No. 33-9922 (Sept. 22, 2015), available here.
 See our May 2015 LawFlash“SEC Proposes Rules Affecting Funds and Advisers.”
 This requirement extends from the SEC’s initial proposal to establish Form N-PORT, which would have required all funds to report whether fund investments are illiquid assets in Item C.7 of Form N-PORT. See Investment Company Reporting Modernization, SEC Release No. 33-9776 (May 21, 2015), available here.