Calfee, Halter & Griswold LLPSwinging with Mutual Funds

October 26, 2016

On October 13, 2016 the U.S. Securities and Exchange Commission (SEC) adopted or amended rules designed to promote effective liquidity risk management by mutual funds, and to mitigate dilution of the value of a fund’s outstanding redeemable securities as a result of shareholder purchase or redemption activity.

A new rule requires mutual funds and other “open-end management investment companies” (“open-end funds”) to establish liquidity risk management programs that, among other things, require assessment, management, and periodic review of a fund’s liquidity risk, as well a placing a limit on illiquid investments. To protect existing mutual fund shareholders from dilution associated with other shareholders’ purchases and redemptions, the SEC amended its Rule 22c-1 under the Investment Company Act of 1940 on pricing of redeemable securities for purchases and redemptions.

When the amended rule becomes effective, certain mutual funds may implement “swing pricing” for share purchases and redemptions by investors. Swing pricing permits a fund to adjust its net asset value (NAV) per share for purchases and redemptions by a specified amount --the “swing factor”-- once the level of net purchases into or net redemptions from the fund has exceeded a specified percentage of the fund’s NAV --the “swing threshold.” Implementation of swing pricing represents a fundamental change designed to pass on to purchasing or redeeming shareholders certain of the fund’s costs associated with their trading activity.

As historically mandated by the SEC, investors have purchased and redeemed mutual fund shares at the fund’s current NAV per share, typically calculated once each day at 4:00 P.M. Eastern Time. Prior to the October 13, 2016 amendment, SEC Rule 22c-1 required that investors who purchase or redeem fund shares receive the NAV per share next calculated by the fund after receipt of an order to purchase or redeem (the “forward price”). That will now change. Mutual funds incur transaction costs stemming from shareholder transaction flows into and out of the fund, particularly redemption costs, which may occur over multiple business days following an executed redemption request, and which are necessarily reflected thereafter in the fund’s NAV. Such costs include trading costs and changes in market prices that may arise when a fund buys portfolio investments to invest proceeds from purchasing shareholders or sells them to meet shareholder redemptions. These costs, and others subsequently incurred by the fund over multiple days following redemption requests are costs of providing liquidity to redeeming shareholders which are only reflected in NAV in days following redemption requests, not concurrently taken into account in the NAV price per share received by a purchasing or redeeming shareholder, and which thus dilute the interest of non-transacting fund shareholders who bear the costs through a reduced NAV.

Managing fund liquidity is also an important consideration in permitting swing pricing. Leaving the fund to bear transaction costs increases the risk that the fund will be unable to meet its obligations to redeeming shareholders or other obligations under applicable law while mitigating investor dilution. When it proposed to allow mutual fund swing pricing, the SEC took note of its successful employment in parts of Europe for several years, and the general recognition abroad that swing pricing is both an efficient mechanism to protect non-transacting shareholders from dilution, and a tool to help funds manage liquidity risks. The SEC also recognized that existing means of addressing potential shareholder dilution from fund redemptions in the U.S., such as the imposition of redemption fees under certain circumstances, were uniformly disfavored by investors and intermediaries, and were used only by a limited number of mutual funds.

On the other hand, swing pricing was seen as a tested and effective tool for mitigating mutual fund shareholder dilution. In operation, swing pricing will permit a fund to adjust the NAV per share when the amount of net purchases or net redemptions, expressed as a percentage of the fund’s NAV, exceeds the swing threshold set by the fund’s board of directors. Crossing the swing threshold then triggers application of the swing factor set by the board, which is the amount, also expressed as a percentage of the fund’s NAV, by which the NAV per share is adjusted, either up or down, for purchase and redemption activity. The use of swing pricing is subject to the fund’s board of directors establishing and implementing “swing pricing policies and procedures” meeting specific requirements now spelled out in the amended SEC rule.

Swing policies and procedures must, for example, set out the process for how the fund’s swing threshold shall be determined, and the factors to be taken into account. Board-approved policies and procedures must also specify the process for determining the fund’s swing factor, which must, among other things, establish an upper limit on the swing factor, not to exceed two percent of NAV per share.

Importantly, the swing factor must be reasonable in relation to the near term costs expected to be incurred by the fund as a result of net purchases or net redemptions that occur on the day the swing factor is used. Such costs include spread cost, transaction fees, and charges arising from asset purchases or asset sales resulting from shareholder purchases or redemptions, and borrowing-related costs associated with satisfying redemptions.

There are additionally specific disclosure and recordkeeping requirements, and on-going board review requirements. For example, new recordkeeping requirements are established to include all schedules evidencing and supporting each computation of an adjustment to NAV based on swing pricing policies and procedures. Swing pricing is available only to open-end funds, which continuously issue redeemable securities, and incur costs associated with shareholder purchases and redemptions.

In contrast, closed-end funds, for which swing pricing may not be implemented, issue a finite number of traded rather than redeemable securities, and do not incur the same costs as open-end funds associated with shareholder purchase and redemption activity. Exchange traded funds (ETFs), which are open-end funds, but which normally internalize costs through a more complex process of charging fees to intermediaries actually involved in purchases and sales of the fund shares, are likewise not permitted to use swing pricing. Swing pricing will not be an easily implemented.

Indeed, in its adopting Release, the SEC acknowledged that most current systems for funds and intermediaries are not set up to accommodate it, and that changes need to be made before swing pricing can be adopted in the United States. Heeding concerns that implementation will present significant operational challenges and costs, the SEC has delayed the effective date of the amended NAV pricing rule for two years.

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For additional information and discussion on this topic, please get in touch with your regular Calfee contact or one of the attorneys listed below: Robert N. Rapp 216-622-8288 rrapp@calfee.com Arthur C. Hall 216-622-8667 ahall@calfee.com  

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