November 3, 2022 - updated Nov. 4, 2022. The SEC Wednesday voted to propose a sweeping new rule that addresses Open-End Fund Liquidity Risk Management Programs and Swing Pricing as well as Form N-PORT Reporting.  The proposed rule, if passed in its current form, would have very significant – possibly existential – negative implications for loan mutual funds and ETFs.  Beyond the loan market, the proposal could fundamentally alter the way all open-end funds operate, how investors interact with them, and the infrastructure surrounding them.  Comments on the proposal are due 60 days from publication in the Federal Register.  Given the complexity and breadth of this proposal, and its potential negative consequences for the mutual fund business, it will undoubtedly attract robust opposition from many stakeholders and its ultimate resolution is uncertain.

Below, we focus on how the rule would affect loan mutual funds and ETFs before we briefly outline some of the other difficult aspects of the proposal.  Please note that the rule was published late Wednesday morning and this summary is based on a quick preliminary review.

What does the rule say that directly impacts loan funds and ETFs?

Currently, the SEC’s liquidity management rules have four categories, the third of which is “less liquid”.  The less liquid category consists of investments that can be sold in seven calendar days but that take longer to settle. That is where most loans fall today.  There are no restrictions on the ownership by funds of Category 3 assets.  The proposal would remove the “less liquid” investment category and treat these investments as “illiquid”. Since there is a 15% limit on open end funds holding illiquid assets, the proposal, if adopted, would effectively render open end loan funds not viable unless settlement times can be made to conform to the statutory seven-day timeframe.

What else does the proposed rule do?

The proposal would require the calculation of the liquidity classification of mutual fund assets on a daily, rather than a monthly, basis.

The proposal would require all funds to determine and maintain a minimum amount of highly liquid assets of at least 10% of net assets. This aspect of the proposal is designed to ensure that funds have sufficient liquid investments for managing heightened levels of redemptions.

The proposal would set fund stress tests to 10% of each portfolio investment rather than using the current rule’s approach of assuming the sale of a “reasonably anticipated trade size” in current market conditions.

Perhaps the most far-reaching part of the proposal is the requirement for mandatory swing pricing.  The stated aim of swing pricing is to reduce dilution of non-transacting fund shares and lower potential first-mover advantages, especially when the market is volatile.  These provisions would impact all mutual funds and are beyond the scope of this note but are very complex and potentially disruptive.  For a brief summary of some of the concerns, please consult Commissioner Peirce’s dissent, available here.

Timing.

We expect the comment period to end in late January 2023.  Given the stakes of this rule, we anticipate that there will be intense pushback from many stakeholders, as well as significant pressure from members of Congress.  It is also likely that many comments and cost-benefit analyses will be submitted, which will take the SEC staff months to process.

Transition Periods. 

Open end funds will have 24 months from the finalization of the rule to transition into compliance with the swing pricing aspects of the proposed rule and 12 months to comply with the changes to the liquidity management rules (including the removal of the “less liquid” category).

What is the LSTA’s plan?

• We intend to submit a comment letter by the deadline and to execute an integrated advocacy effort that will include engagement with the SEC Commissioners and staff as well as members of Congress.
• We and our outside counsel are continuing to work our way through analyzing this very complex 444-page proposal and endeavor to have a deeper understanding of the proposal in the coming days.
• We are currently in the process of re-forming the LSTA working group that responded to the SEC’s revision in 2016 of the liquidity management rules for mutual funds.  We expect to begin meeting shortly after Thanksgiving.
• We have already connected with the staff of the Investment Company Institute (ICI) the trade association for the mutual fund industry.  We have agreed to cooperate and coordinate our efforts, as well as with other interested trade associations and stakeholders.

Links:

This a link to the proposal:  https://www.sec.gov/rules/proposed/2022/33-11130.pdf.  This a link to the SEC’s related press release: SEC.gov | SEC Proposes Enhancements to Open-End Fund Liquidity Framework. 

Please feel free to reach out to Elliot Ganz or Meredith Coffey if you have questions or comments.