The ambitious swing pricing rule proposed by the SEC would create widespread operational challenges and costs for fund advisers, boards and shareholders without solving the liquidity issues the SEC said it wants to address, industry observers warned.
The rule proposed Nov. 2 would require that open-end funds change the way they classify investments under the 2016 liquidity risk-management rule and require that all mutual funds use swing pricing to protect shareholders from having to bear steep costs for staying put during market panics.
Fund advisers, boards and intermediaries who are already up in arms over the rapid pace of other regulatory changes are likely to oppose the new rule with an intensity and scale not seen since 2014, when the commission passed sweeping money market fund reforms over vocal objections from parts of the industry, predicted Paul Delligatti, a partner at Goodwin.
“While not unprecedented, it certainly is going to be as significant as anything I recall in recent years,” he said.
“The breadth of [the proposal] is remarkable, and it’s fair to say that I think there’s going to be considerable industry pushback,” said Nathaniel Segal, a lawyer at Vedder Price who counsels fund boards. “And frankly, I believe, rightfully so.”
The proposal’s goal is to address what the SEC describes as underlying structural liquidity issues revealed in March 2020, when some investors pulled their money out of funds due to panic about the economic impact of the pandemic, which incurred transaction costs that diluted the holdings of remaining investors and incentivized more to pull out.
“We saw such systemic issues during the onset of the COVID-19 pandemic, when many investors sought to redeem their investments from open-end funds,” SEC chair Gary Gensler said in a statement accompanying the proposal. “Today’s proposal addresses these investor protection and resiliency challenges.”
Industry comments toward the swing pricing provision will be especially hostile, judging by the immediate negative reaction from some observers and the unhappy response during the public-comment period following a similar proposal the SEC aimed at money-market funds in December.
The two major associations representing fund directors told Fund Directions they were critical of the proposal, predicting that the proposal would disrupt fund operations and constrict the menu of options available to shareholders.
“Mandating a swing pricing requirement across mutual funds will inject uncertainty into the marketplace, create shareholder confusion, and disadvantage investors who buy and sell fund shares through intermediaries,” Thomas Kim, president of the Independent Directors Council, said in a statement.
“Given the overwhelming negative reaction to the swing pricing proposal for money market funds, we are surprised to see the SEC broadening the application to open-end funds,” Mutual Fund Directors Forum president Carolyn McPhillips said in a statement. “Swing pricing coupled with changes to liquidity classifications likely will have the ultimate effect of reducing the investment choices available to mutual fund investors.”
Unlike in most comment periods, the fund industry will accept no compromise over this proposal and will demand that the SEC withdraw it, according to Delligatti.
“It’s my prediction, in this instance, that — at least with respect to swing pricing and with respect to the elimination of the less-liquid bucket — you’re going to see engagement that is purely in opposition, as opposed to engagement that seeks to modify or amend the proposal,” he said.
Commenters will have 60 days to submit public feedback on the 444-page proposal once it has been published in the Federal Register, which it had not been as of Nov. 30.
Swing Pricing and the Hard Close
Swing pricing is a complex mechanism designed to discourage panic-selling by shareholders that can dilute the holdings of remaining investors.
When redemptions are high, a fund can “swing” its net asset value (NAV) higher to offset transaction costs incurred by having to sell assets quickly to satisfy redemption demands, thus ensuring that redeeming shareholders are the ones bearing the costs.
Many European mutual funds use swing pricing, but no U.S.-based mutual fund ever has despite having permission to do so since the enactment of the liquidity rule.
Asset managers often describe swing pricing as being incompatible with U.S.-based funds because it requires fund managers to be aware of all of a day’s orders before calculating their NAV. U.S. funds calculate their daily NAV at a “soft” closing time of 4 pm ET but allow orders placed with intermediaries before 4 pm to transact at that price until the following morning.
To make swing pricing possible, the SEC’s proposal mandates a “hard close,” requiring funds themselves to have received a customer order by 4 pm for the customer to qualify for that day’s NAV.
The hard close would require intermediaries to change how they fill orders for mutual fund customers, a change that would reverberate across the entire industry, according to Delligatti.
“The repapering exercise at minimum, with the vast relationships you see between fund companies and their distribution partners, will be herculean,” he said, referring to the process of rewriting existing contracts between intermediaries and fund sponsors.
The SEC argued in its proposal that swing pricing had not caught on in the U.S. partly because the cost of implementing it had prevented individual firms from making the switch, which left to regulators the responsibility of requiring that the whole industry make the leap at once.
“We believe that a regulatory requirement, rather than a permissive framework, would accrue benefits to investors that justify the implementation costs and would overcome these collective action problems that may have prevented swing pricing implementation,” the SEC said in its proposal.
Implementing swing pricing would force fund boards to grapple with new challenges, according to Wilshire Mutual Funds independent director Liz Levy-Navarro.
The most obvious is an increase in the workload of fund boards, who are required by the current version of the proposal to review swing-pricing policies and procedures to ensure their “effectiveness at mitigating dilution.”
“It adds additional burdens to funds, in terms of compliance costs and additional oversights, and for boards to ensure that they are able to do everything that’s required as a fiduciary to make sure that they’re providing the kind of oversight needed,” said Levy-Navarro, who clarified that she did not necessarily speak for her whole board. “It’s really concerning.”
A question within the proposal also floats the idea of requiring even greater board involvement, asking commenters, “Should we require board involvement in the day-to-day administration of a fund’s swing pricing program in addition to its compliance oversight role?”
The wording of the proposal suggests that a three-year effort to roll back board duties under former SEC chair Jay Clayton and Division of Investment Management head Dalia Blass has ended, Delligatti noted.
“The question in and of itself, to me, is a real shift and a real signal as to how the current staff of the SEC is not as focused on the important oversight role that a fund board plays in maintaining the distinction between oversight and management,” he said.
Contrasting points of view
Much of the conflict over the proposal appears to depend on philosophical differences that create very different impressions about what lessons the industry should draw from the pandemic-induced panic of March 2020.
Many of those opposed to swing pricing describe the market panic as a rare event that stressed the industry but did not cause damage serious enough that funds were unable to meet redemption requests.
Swing-pricing supporters in the SEC, however, saw the liquidity crisis as a near-miss made possible by an underprepared fund system that could have suffered much worse had regulators not intervened to provide emergency liquidity.
“Fundamentally, we believe funds should be better prepared for future stressed conditions, which can occur suddenly and unexpectedly, and should have well-functioning tools for managing through stress without significantly diluting the interests of their shareholders,” according to the proposal.
The proposal does describe the impact of swing pricing on European markets, but cites no data about U.S. fund redemptions in March 2020 as evidence that swing pricing could have helped stave off calamity among U.S. funds, McPhillips said.
“We are concerned that the SEC is proposing rules that would fundamentally change trading in mutual funds without evidence that such changes are necessary,” McPhillips said.
The lack of arguments based on a solid analysis of empirical data about U.S. fund redemptions in March 2020 makes it look as if the SEC is trying to force a solution on the industry without having even made a good-faith effort to fully diagnose the problem, Segal said.
“There’s this significant element of the premise of this proposal that appears to be unfounded,” he said.
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