Swing Pricing: Board Responsibilities and Operational Considerations

Transcription

1 Swing Pricing: Board Responsibilities and Operational Considerations Fatima Sulaiman, Partner, Washington D.C. June 22, 2017 Copyright 2016 by K&L Gates LLP. All rights reserved.

2 SUMMARY OF FINAL RULE Amended Rule 22c-1(a)(3) under the 1940 Act Permits, but does not require, mutual funds (other than money market funds or ETFs) to use swing pricing during times of increased purchase or redemption activity Swing pricing adjusts a fund s NAV to pass on costs of heightened shareholder purchase or redemption activity to transacting shareholders Effective November 19, 2018 for all funds klgates.com 2

3 TERMINOLOGY OF FINAL RULE Board must appoint swing pricing administrator to oversee program Separate from portfolio management Swing pricing administrator must set swing pricing policies and procedures, board must approve Swing pricing applies only when net purchases or redemptions exceed the swing threshold set by the swing pricing administrator SEC did not adopt full swing pricing klgates.com 3

4 TERMINOLOGY OF FINAL RULE Once swing threshold is exceeded, funds adjust the NAV by the swing factor for all customers Purchases exceed swing threshold NAV swings up Redemptions exceed swing threshold NAV swings down Swing pricing policy must include a swing factor upper limit, the maximum the NAV could be adjusted 2% klgates.com 4

5 BACKGROUND klgates.com 5

6 BACKGROUND & SEC GOALS 1. Help funds manage liquidity risks from purchases and redemptions Growth in less liquid investments fixed income funds, alternative funds FSOC comments regarding fund liquidity referenced in proposing release SEC intends use in conjunction with liquidity risk management programs 2. Mitigate dilution of fund for long-term shareholders Reflects trading costs related to purchases or redemptions not currently reflected in NAV next calculated klgates.com 6

7 BACKGROUND & SEC GOALS 3. Alleviate first mover advantage during stressed markets Funds will likely have to sell more liquid holdings first to meet shareholder redemptions Results in less liquid assets to meet future redemptions Encourages early redemption, creates liquidity risk Used in UK, Ireland, Luxembourg, other European countries for over 15 years to counteract dilution and liquidity risks klgates.com 7

8 FINAL RULE Adopted at open meeting on October 13, 2016 Proposed in the same release with liquidity risk management program, but broken out for Final Rule SEC also adopted: Amendments to recordkeeping requirements of Rule 31a-2 under the 1940 Act Disclosure requirements of Form N-1A, Regulation S- X, Form N-CEN klgates.com 8

9 FINAL RULE Commissioner Piwowar dissented from adoption of the Final Rule Concerns: Conceal from investors the true costs of purchases and redemptions Harmful investor timing of purchases and redemptions Artificially-enhanced returns if funds swing by greater factor than transaction costs klgates.com 9

10 SWING PRICING IN DETAIL klgates.com 10

11 SWING PRICING POLICIES AND PROCEDURES Funds using swing pricing must do so according to established swing pricing policies and procedures written by swing pricing administrator and approved by the board Fund complexes can apply swing pricing to some, all, or none of their funds Funds not subject to volatile market movements may choose not to use swing pricing klgates.com 11

12 SETTING THE SWING THRESHOLD The net purchase or net redemption activity that triggers a fund s use of swing pricing (% of NAV) Considerations: 1. Size, frequency, and volatility of historical net purchases or redemptions during normal and stressed periods 2. Fund s investment strategy and liquidity of the fund s portfolio investments 3. Cash and cash equivalent positions, borrowing arrangements, and other funding sources 4. Transaction costs in the relevant market klgates.com 12

13 SETTING THE SWING THRESHOLD Proposed vs. Final Proposed Rule Final Rule Only discusses one swing threshold Allows funds to set multiple swing thresholds linked to multiple swing factors Example: Redemptions exceed 0.50% swing threshold 0.10% swing factor Redemptions exceed 1.00% swing threshold 0.20% swing factor Etc. klgates.com 13

14 APPLYING THE SWING FACTOR The amount by which a fund s NAV will swing, expressed as percentage of NAV Purchases exceed swing threshold NAV adjusted upward by swing factor amount Redemptions exceed swing threshold NAV adjusted downward by swing factor amount A fund can have multiple escalating swing thresholds, each linked to a different swing factor (but not separate thresholds for purchases and redemptions) klgates.com 14

15 APPLYING THE SWING FACTOR Swing factor considerations 1. Only near-term costs expected in connection with purchases or redemptions on the day the swing factor is used, including: 1. Spread costs 2. Transaction fees from asset purchases or sales resulting from purchases or redemptions, and 3. Borrowing costs associated with satisfying redemptions 2. Swing pricing administrator must determine swing factor is reasonably related to near-term costs Funds must set a swing factor upper limit, which may not be greater than 2% of NAV klgates.com 15

16 APPLYING THE SWING FACTOR Proposed vs. Final Proposed Rule Administrator to consider market impact costs or changes in asset values Guidance that swing factor be related to near-term costs No swing factor upper limit Final Rule Administrator to consider only nearterm costs Swing factor must be related to nearterm costs Swing factor upper limit required, maximum 2% NAV klgates.com 16

17 BOARD RESPONSIBILITIES Designate swing pricing administrator May be the fund s investment adviser or one or more fund officers Must be reasonably segregated from portfolio management May not include portfolio managers Approve swing pricing policies and procedures Board does not have to approve material changes, but must review them at least annually Approve swing threshold(s), swing factor upper limit(s), any changes thereto klgates.com 17

18 BOARD RESPONSIBILITIES Review report at least annually, including: The Administrator s review of the adequacy of the fund s swing pricing policy and its effectiveness in aiding liquidity and mitigating dilution The Administrator s review and assessment of the fund s swing threshold(s), swing factor(s), and swing factor upper limit, including the data that supported their determination Any material changes to the policies and procedures since last report klgates.com 18

19 BOARD RESPONSIBILITIES The SEC emphasized the importance of the board s oversight, and its review and approval of a fund s determination of its swing threshold, to ensure that the swing threshold is in shareholders best interests The SEC noted that a board can serve as an important check on the discretion afforded to the Administrator in determining the swing threshold klgates.com 19

20 BOARD RESPONSIBILITIES Proposed vs. Final Proposed Rule Board required to approve all material changes to policy Board required to periodically review swing threshold Final Rule Board only needs to review material changes in annual report Board only required to review annually; however, must review more comprehensive report Prohibition on portfolio managers participating in the swing pricing process klgates.com 20

21 DISCLOSURES Form N-1A A fund using swing pricing will be required to disclose: Whether fund uses swing pricing, and explain swing pricing Circumstances under which fund will use swing pricing Effects on fund and investors Swing factor upper limit The per share impact of amounts retained by the fund due to swing pricing should be included in the fund s disclosures of per share operating performance klgates.com 21

22 DISCLOSURES Regulation S-X Financial Statements General methods used to determine whether to swing NAV General description of swing pricing effects on the fund s financial statements Whether NAV has swung during reporting period Form N-CEN annual census report to SEC Whether NAV has swung during reporting period Swing factor upper limit klgates.com 22

23 DISCLOSURES Proposed vs. Final Proposed Rule Required disclosing swung NAV on statement of assets and liabilities Final Rule No Form N-1A Item 4 requirements Added Form N-1A Item 4 requirements Swing factor upper limit not required to be disclosed on Form N-1A or Form N-CEN Form N-1A and Form N-CEN amended to require disclosure of swing factor upper limit klgates.com 23

24 RECORDKEEPING Maintain policy and any changes in effect during past 6 years in easily accessible place Keep written copy of administrator s report for 6 years, first 2 in easily accessible place Preserve records evidencing and supporting any swing pricing for 6 years, first 2 in easily accessible place, including: Unswung NAV Level of net purchases or net redemptions Swing factor + supporting data Any back-testing to assess swing factor klgates.com 24

25 EFFECTIVE DATE & SEC STAFF REVIEW Effective November 19, 2018 Proposal made it available immediately SEC delayed in order to address concerns about operational difficulties from commenters Intended to allow funds to implement on equal footing SEC staff directed to review market practices two years after swing pricing becomes effective and report findings to SEC klgates.com 25

26 EFFECTIVE DATE & SEC STAFF REVIEW Proposed vs. Final Proposed Rule Available immediately Final Rule Effective two years after Federal Register publication November 19, 2018 SEC staff to conduct review of swing pricing programs two years after rule goes effective klgates.com 26

27 SWING PRICING IN ACTION klgates.com 27

28 SWING PRICING IN ACTION Assume: Fund Assets: $ NAV Per Share: $10.00 Swing Threshold: 2% of NAV Swing Factor: 0.10% of NAV Example #1 Investor redemptions and purchases predicted to result in net flow of -$1.00. Net flow does not exceed 2% of NAV ($2.00). NAV does not swing. NAV remains $ klgates.com 28

29 SWING PRICING IN ACTION Assume: Fund Assets: $ NAV Per Share: $10.00 Swing Threshold: 2% of NAV Swing Factor: 0.10% of NAV Example #2 Investor redemptions and purchases predicted to result in net flow of -$3.00. Net flow exceeds 2% of NAV ($2.00). NAV swings downward to $9.99, or $10.00 (0.10% x $10.00), applied to all investors. klgates.com 29

30 SWING PRICING IN ACTION Assume: Fund Assets: $ NAV Per Share: $10.00 Swing Threshold: 2% of NAV Swing Factor: 0.10% of NAV Example #3: Investor redemptions and purchases predicted to result in net flow of +$3.00. Net flow exceeds 2% of NAV ($2.00). NAV swings upward to $10.01, or $ (0.10% x $10.00), applied to all investors. klgates.com 30

31 OPERATIONAL CHALLENGES klgates.com 31

32 OBTAINING ORDER FLOW INFORMATION Funds must know whether order flow exceeds the swing threshold to know whether to swing NAV Requires more order flow information than funds have previously had Swing pricing administrator must be able to reasonably estimate whether swing threshold has been crossed with high confidence However, SEC provided little substantive guidance on how to obtain order flow information or best practices for estimation SEC declined to extend safe harbor for estimates klgates.com 32

33 OBTAINING ORDER FLOW INFORMATION 1. Current relationship between funds and intermediaries limits information flow Many intermediaries transmit aggregated trades Prevalence of omnibus accounts and current processing workflows limit what order flow information funds have when striking NAV Some intermediaries retirement plan record keepers, insurance companies require calculated NAV before processing trades klgates.com 33

34 OBTAINING ORDER FLOW INFORMATION 2. Intermediary negotiations with funds Intermediaries could choose not to offer funds that use swing pricing to avoid increased processing burdens and re-engineering costs Large fund companies with greater influence over intermediaries could be more successful in negotiating to obtain order flow information 3. Liability for estimates Intermediaries could face liability if information they provide at order cutoff differs when NAV is struck or swung Funds must rely on estimates and back-testing, but SEC declined to offer safe harbor klgates.com 34

35 OBTAINING ORDER FLOW INFORMATION 4. Certain funds may have advantages Funds with pre-existing swing pricing operations Larger fund companies with greater influence over intermediaries Funds with investors that transact directly with the distributor or transfer agent Funds primarily distributed through affiliates or brokerdealers Funds without a significant number of retirement plan or insurance product investors klgates.com 35

36 EDUCATING INVESTORS Forward pricing at NAV is a central feature of mutual funds swing pricing alters that understanding Not all funds are required to use swing pricing Form N-1A requires disclosure of circumstances in which funds would use swing pricing Does not require disclosure of swing threshold or swing factor, so difficult to compare across funds Funds are free to set multiple swing thresholds, and free to set swing thresholds at any level circumstances could vary widely klgates.com 36

37 SEC RESPONSE SEC extended effective date Some funds with operations in UK, Ireland, Luxembourg have greater development of swing pricing SEC intends to provide opportunity for other players to make demands on intermediaries SEC encourages funds to develop procedures coordinating with intermediaries, back-testing estimates klgates.com 37

38 SEC RESPONSE High Confidence Estimation Standard SEC allows swing pricing administrators to estimate whether flows cross swing threshold with high confidence Clarified estimates should exclude in-kind purchases and redemptions Otherwise, few substantive guidelines SEC declined to adopt estimation safe harbor Established additional disclosures in the Final Rule aimed at educating investors klgates.com 38

39 IMPLEMENTATION CONSIDERATIONS Know your intermediaries capacity to provide order flow and the account structures they use Understand your account base and the timing of order flow Discuss intermediaries future capabilities to transmit order flow information and willingness to accommodate funds Evaluate swing pricing impact on cutoff times for the fund s acceptance of trades klgates.com 39

40 IMPLEMENTATION CONSIDERATIONS Conduct real-time simulations of swing pricing using current data Evaluate the fund s ability to obtain reasonable estimates of order flow Develop estimate capabilities and back-test against real order flows over time Determine swing pricing decision-making, notification, and information storage procedures Conduct board education related to swing pricing klgates.com 40

41 QUESTIONS klgates.com 41

42