WASHINGTON - The Securities and Exchange Commission's five members unanimously agreed on Tuesday to propose a rule and amendments that would require open-end mutual funds and exchange traded funds to take steps to manage liquidity risks so they could handle redemptions during periods of financial stress.
The proposal would apply to mutual funds and other open-end management investment companies, with the exception of money market funds. The SEC has asked for public comments to be filed on the proposal during the 90 days after it is published in the Federal Register.
Open-end mutual funds and exchange-traded funds currently hold about $590 billion in tax-exempt muni bonds, according to data from Morningstar Inc.
The SEC said the proposal is designed to ensure funds keep enough liquid assets "to meet shareholder redemption requests while also minimizing the impact of those redemptions on the fund's remaining shareholders."
The Treasury Department addressed a similar liquidity issue in 2008 when it allowed tax-free money market funds to participate in a temporary federal insurance program to prevent a run on these funds by shareholders after Reserve Primary Fund suffered numerous redemptions and broke the buck during the financial crisis. MMFs strive to maintain a net asset value (NAV) of $1 per share. The SEC adopted rules to prevent this from happening again, which is why MMFs were exempt from this proposal.
Mary Jo White, chair of the SEC, said during the meeting before the commission vote on this proposal: "Promoting stronger and more effective liquidity risk management is essential to reduce the risk that a fund will be unable to meet its redemption obligations, to minimize dilution of shareholder interests, and to address variations in practices among funds."
The proposed rule would ensure liquidity by requiring funds to have a liquidity risk management program, which would classify the liquidity of a fund's portfolio assets into six different categories based on how quickly the assets could be converted to cash. The categories would include: one business day; two to three business days; four to seven calendar days; eight to 15 calendar days; 16 to 30 calendar days; and more than 30 calendar days.
The fund's board would be tasked with approving the program and reviewing a written annual or more frequent report of the program's adequacy. The fund would additionally have to periodically monitor its liquidity risk, maintain no more than 15% of illiquid assets, and report the liquidity classifications for their assets by category to the SEC on a revised form.
The SEC is also proposing to require funds to determine the minimum percentage of their net assets that can be converted into cash within three business days.
Commissioners Daniel Gallagher and Michael Piwowar criticized that portion of the proposal, saying it would alter the already imposed requirement under Section 22(e) of the Investment Company Act of 1940, which requires funds to pay their redemptions within seven days of a shareholder's request.
Gallagher called it a "one-size-fits-all" approach and asked commenters to weigh in when writing their letters.
The other controversial portion of the proposal would amend the Investment Company Act to allow open-end funds (not ETFs), with their board's approval, to use "swing pricing" when net purchases into, or net redemptions from, a fund exceed a previously determined percentage of the fund's NAV. Swing pricing is designed to allow the fund to pass the costs associated with trading off onto the investors buying or selling shares so that non-trading shareholders are protected from the dilution associated with the trading.
Piwowar asked commenters to weigh in on the swing pricing provision, saying he is "not convinced that swing pricing is the best way to allocate the costs stemming from a shareholder's purchase or redemption activity to that shareholder."
In response to the SEC proposal, the Investment Company Institute said: "For 75 years, mutual funds have successfully managed liquidity and met redemptions under SEC rules and guidance."
ICI said the SEC's proposal "raises a number of complex issues to funds, their directors, and their investors," and that the group looks forward to working with the commission "to ensure that any final rules in this area are well-founded, practicable, and effective."
