SEC Proposes Toughening Investment Fund Liquidity Requirements
Commentary by Steven Lofchie
The SEC proposed amendments to impose additional liquidity requirements on mutual funds and other SEC-registered open-end funds.
The proposal would amend Investment Company Act Rule 22e-4 ("Liquidity risk management programs") and Rule 22c-1 ("Pricing of redeemable securities for distribution, redemption and repurchase") to provide that investments that take more than seven days to settle would be classified as illiquid. The proposal would also require funds to ensure that at least 10 percent of their net assets are invested in assets considered "highly liquid" (deemed to be cash, and any investment the fund reasonably expects to be convertible to dollars in three business days without impacting the market value of the investment).
The proposal would also require funds, with the exception of money market funds and exchange-traded funds, to adopt procedures to adjust net asset value ("NAV") per share by a "swing factor" when the fund experiences net redemptions, or when net purchases exceed a predetermined threshold. The swing factor would incorporate a variety of factors including bid-ask spreads, transaction costs and estimated market impact.
Redemptions would only be treated as having been received on a particular day if the fund, a transfer agent or a clearing agency processes the order before the pricing time (as of which the fund's NAV is calculated) which is typically around 4 p.m. EST.
Additionally, the SEC proposed amending Form N-Port, Form N-1A and Form N-CEN to require more frequent reporting of monthly portfolio holdings, liquidity risk management and swing pricing information.
SEC Commissioner Statements
SEC Chair Gary Gensler supported the proposal, saying that it will improve transparency and bolster resiliency in the event of significant disruption events. SEC Commissioner Caroline A. Crenshaw emphasized the importance of maintaining high levels of liquidity and developing a robust risk management program. Commissioner Jaime Lizárraga also supported the proposal.
Commissioner Hester M. Peirce expressed concern that, considering the current level of rulemaking activity, market participants may not have the capacity to consider a proposal that would have significant and wide-reaching implications throughout the industry. She said that the comment period is too short to allow market participants to effectively analyze the proposal given the holidays during the submission period. Commissioner Mark T. Uyeda also dissented, warning that the proposal would ultimately pass any compliance costs on to investors.
Commentary
The economic ramifications of the proposal are not simple. The requirement that open-end funds hold a greater portion of their portfolios in highly liquid investments will force funds to keep more of their investments in cash and government securities, to hold more diversified portfolios and potentially to reduce their investments in small companies as the shares of such companies are less likely to be regarded as liquid under the SEC's standards. In short, the SEC's new proposals may reduce the risk of open-end funds, but they should accomplish this end by decreasing their returns and by discouraging their investments in small issuers. The additional reporting requirements will further increase costs. Maybe this trade-off of some additional safety is worth the costs, but it is a long way from obvious.
The cost-benefit analysis provided by the SEC appears to focus on the supposed savings by increasing a fund's liquidity, but says little or nothing as to the costs to a fund by reducing its investment opportunities. Notably, the release at 403 requests reflects deep concern about the size of the annual effect on the economy and on costs.
Further, given the amount of criticism the SEC has taken (including from members of the Democratic Party) on the compressed time it allows for market participants to respond to proposals, it is difficult to understand why the SEC refuses to allow at least 90 days to comment on major rule proposals. The limited timeframe to comment would also seem to make SEC rule proposals more vulnerable to legal challenge. This proposal allows for 60 days (better than the 30 days of many of the SEC's earlier proposals), but that period is within the holiday season.