What you need to know • The SEC adopted a rule that requires registered open-end funds, including mutual

funds and exchange-traded funds but not money market funds, to establish a liquidity risk management program and expand their disclosures about their liquidity and redemption practices.

• The SEC also gave open-end funds (except for money market funds and exchange-traded funds) the option to use swing pricing to adjust their net asset value for costs associated with satisfying requests for shareholder purchases or redemptions (e.g., trading costs) in certain circumstances.

• The compliance date for the rule requiring liquidity risk management programs is 1 December 2018, for fund complexes with $1 billion or more in net assets or 1 June 2019, for smaller fund complexes. The effective date for the swing pricing rule will be two years after it is published in the Federal Register.

Overview The Securities and Exchange Commission (SEC) adopted final rules for registered open-end funds, including mutual funds and exchange-traded funds (ETFs) but not money market funds, that are intended to minimize the risk that a fund would not be able to satisfy its obligations without negatively affecting its net asset value (NAV) if it is hit with a high number of redemptions during periods of market turmoil.

No. 2016-47 20 October 2016

To the Point SEC — final rules

Rules on fund liquidity risk management and swing pricing

The rules are intended to minimize the risk that a mutual fund would not be able to meet requests for redemptions in times of stress without negatively affecting its NAV.

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2 | To the Point Rules on fund liquidity risk management and swing pricing 20 October 2016

The SEC noted that the fund industry has grown significantly in the past 20 years and that funds today pursue more complex investment strategies, such as fixed income and alternative investment strategies, than they did in the past. These strategies focus on less liquid assets that in times of market stress may be hard to sell without diluting the value of fund shares.

Mutual funds allow investors to redeem their shares daily and are required by law to pay shareholders within seven days. ETFs allow daily redemptions from the fund only for certain large market participants.

Key considerations Liquidity risk management programs The new rule requires registered open-end funds, including mutual funds and ETFs but not money market funds, to adopt and implement a written liquidity risk management program. Liquidity risk is defined as the risk that a fund could not meet redemption requests without significantly diluting the interests of remaining investors.

The rule requires the funds to assess, manage and review their liquidity risk at least annually considering applicable factors such as (1) investment strategy and liquidity during normal and foreseeable stressed conditions, including whether the strategy is appropriate for an open-end fund and whether the fund has a relatively concentrated portfolio or large positions in particular issuers and uses borrowings and derivatives, (2) short-term and long-term cash flow projections in normal and stressed conditions, (3) holdings of cash and cash equivalents and borrowing arrangements and other funding sources and (4) additional factors that affect only ETFs. The funds also must maintain certain records relating to their liquidity risk management programs.

The rule also requires funds (except in-kind ETFs) to classify investments as highly liquid, moderately liquid, less liquid or illiquid and to review their classifications at least monthly or more often under certain conditions. The categories reflect the number of days a fund expects it to take to convert the investment to cash without significantly changing the market value. The periods range from three business days or less for a highly liquid investment (HLI) to more than seven calendar days for settlement of a less liquid investment. Illiquid investments are those a fund doesn’t expect to be able to sell or dispose of within seven calendar days without significantly changing the market value.

Classification may be done by asset class except under certain circumstances, and a fund must determine whether a trade of the size it would expect to make would significantly affect the liquidity of the investment and therefore the classification. For derivatives they classify as moderately liquid, less liquid or illiquid, funds must identify and disclose the percentage of HLIs segregated to cover them or pledged to satisfy margin requirements.

Funds (except in-kind ETFs) must set a minimum percentage of net assets to be invested in HLIs that are assets based on certain factors if they don’t primarily invest in these types of assets. Funds must review this “highly liquid investment minimum” at least annually.

A fund also will be prohibited from acquiring an investment if, after the acquisition, its illiquid investment assets will exceed 15% of its net assets. In addition, the rule requires funds that are permitted to redeem in kind to establish policies and procedures regarding how and when they will engage in such redemptions.

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3 | To the Point Rules on fund liquidity risk management and swing pricing 20 October 2016

The rule requires that a fund’s board (and in some cases, also a majority of the independent directors):

• Initially approve the liquidity risk management program and the person(s) designated to administer the program (e.g., the fund’s investment adviser or officer(s))

• Review, at least annually, a written report prepared by the program administrator that addresses the operation of the program, assesses its adequacy and effectiveness and describes any material changes made to the program

• Approve a change to the HLI minimum during any period in which a fund’s HLI assets are below the minimum

• Be notified by the program administration no later than its next regularly scheduled meeting if the fund falls below its HLI minimum and be given a brief explanation of the causes and extent of the shortfall and the actions taken in response, or be notified by the program administrator within one business day if the shortfall lasts longer than seven consecutive days and given an explanation of how the fund plans to achieve the minimum within a reasonable time period

• Be notified by the program administrator within one business day if the fund’s holdings of illiquid investment assets exceed 15% of net assets and be given an explanation of the extent and causes and how the fund plans to bring its illiquid investment assets to 15% or less of its net assets within a reasonable period of time

• Assess whether the plan to bring illiquid investment assets to a maximum of 15% of net assets continues to be in the best interest of the fund if illiquid assets still exceed that threshold 30 days after they first exceeded the threshold and repeat the assessment every 30 days if illiquid assets continue to exceed 15% of net assets.

New reporting requirements Funds are also required to report certain information about their liquidity to shareholders and make certain confidential disclosures to the SEC as follows:

• A fund must include monthly position-level liquidity classification information, its HLI minimum and other information on new Form N-PORT that will be submitted confidentially to the SEC and publicly disclose at the end of every quarter certain information, including the aggregate percentage of its portfolio in each of the four liquidity categories.

• A fund must confidentially report certain information to the SEC on new Form N-LIQUID within one business day if (1) it exceeds the 15% illiquid investments limit, (2) it mitigates such a situation or (3) the amount of HLIs falls below the fund’s minimum for more than seven consecutive days.

• A fund must include public disclosure of its policies concerning the time period for expected payment of redemptions and methods used to meet redemption requests on Form N-1A.

• Funds must publicly disclose their use of lines of credit, interfund lending and interfund borrowing, and whether the fund is an in-kind exchange-traded fund, on new Form N-CEN.

How we see it While funds will need to consider certain factors when setting an HLI minimum, they will have the flexibility to base the minimum on their unique circumstances. That is, the rule does not prescribe a minimum percentage of net assets.

Funds will be required to report certain information about their liquidity to the SEC.

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4 | To the Point Rules on fund liquidity risk management and swing pricing 20 October 2016

Swing pricing The rule gives registered open-end funds, except for money market funds and ETFs, the option to establish policies and procedures to adjust their NAV per share by swing factors expressed as a percentage of NAV when the level of net purchases or net redemptions exceeds a specified percentage of NAV called the swing threshold.

Funds could use “swing pricing” to pass along to purchasing and redeeming shareholders the costs of trading and mitigate dilution to other shareholders. Swing pricing could go into effect only if the person or persons responsible for administering a fund’s swing policies determine with “high confidence” that daily purchase and redemption activity (based on orders and reasonable estimates) crossed the fund’s swing pricing threshold or thresholds, if the fund chooses to establish multiple thresholds.

A fund must have policies and procedures for determining the swing threshold(s) that consider factors such as historical investor flow in normal and stressed periods, the fund’s investment strategy, liquidity, holdings of cash and cash equivalents, borrowing arrangements and other funding sources, and transaction costs. A fund must establish an upper limit for its swing factor(s), which may not exceed 2% of the fund’s NAV per share. When determining the swing factor(s) and upper limit, the administrator must only take into account expected near-term costs stemming from net purchases or net redemptions that occur on the day the swing factor(s) is used (e.g., spread costs, transaction fees, borrowing-related costs).

A fund’s board, including a majority of independent directors, must (1) approve swing pricing policies and procedures, (2) approve the swing threshold(s) and upper limit on the swing factor(s) and any changes to these amounts, (3) designate the person(s) responsible for administering swing pricing and (4) review at least annually a written report prepared by the administrator that describes the adequacy and effectiveness of the fund’s swing pricing policies and procedures and any material changes to those policies and procedures, among other things. Funds also must keep certain records about swing pricing.

A fund will need to reflect its use of swing pricing in its financial statements and disclosures. For example, capital share transactions will be based on the adjusted NAV if swing pricing has been used. Funds will disclose the per-share effect of swing pricing in the NAV per share rollforward, and the adjusted NAV will be disclosed as a separate line item in the financial highlights. Funds will also have to disclose in the notes to the financial statements how they determine whether the fund’s NAV per share will swing and the effects of swing pricing, including the diference between ending US GAAP NAV and adjusted NAV, if applicable.

Funds will be required to disclose their US GAAP NAV in their balance sheets. However, if they use swing pricing at period end, funds will be permitted to disclose adjusted NAV in their balance sheets if they believe this information would be meaningful to users. In addition, US GAAP NAV will be used when calculating total return in the financial statements, but funds will be permitted to disclose total return calculated based on adjusted NAV or unadjusted NAV outside of the financial statements, in other performance information.

Funds will be required to report certain information about their use of swing pricing and the effect of swing pricing on total return on Form N-1A and the upper limit for swing factor(s) on Form N-CEN.

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