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Mr. Chambers is a partner and Mr. Wiggins is an associate at Wilmer Cutler Pickering Hale and Dorr LLP. The views expressed herein are those of Mr. Chambers and Mr. Wiggins and do not necessarily represent the views of Wilmer Cutler Pickering Hale and Dorr LLP or its clients, or the authors' colleagues.
On September 22, 2015, the Securities and Exchange Commission (the “SEC”) proposed a package of rule changes and disclosure requirements that it believes would improve liquidity risk management by open-end investment companies (or “mutual funds”) and exchange-traded funds.1 Rule 22e-4 under the Investment Company Act of 1940 (the “Investment Company Act”) would establish criteria for assessing portfolio liquidity and require, among other things, that mutual funds adopt written liquidity risk management programs.2 The SEC cites Investment Company Act Sections 22(e), 22(c), and 38(a) as statutory authority for Rule 22e-4. The text of those sections and related administrative history of the Investment Company Act, however, strongly suggest that the SEC lacks statutory authority to adopt Rule 22e-4. In the remainder of this article, we summarize the requirements of proposed Rule 22e-4, describe the SEC's historical treatment of mutual fund liquidity, and examine the text of the relevant provisions of the Investment Company Act.
Rule 22e-4 would require mutual funds to establish written liquidity risk management programs approved by fund boards. Under these programs, funds would be required to (i) assess and classify the liquidity of each of their assets; (ii) assess their ability to meet redemption requests under normal or reasonably foreseeable circumstances without materially affecting their net asset value (“NAV”); and (iii) manage the percentage of their assets that could be converted to cash within three business days.
The rule identifies six liquidity categories under which assets may be grouped. These categories group assets based on the number of days needed to convert the asset into cash at a price that does not materially affect the value of that asset immediately prior to sale. Each fund would be required to consider a list of factors when assessing its ability to meet redemption requests without materially affecting the fund's NAV. These factors include short-term and long-term cash flow projections, the investment strategy and liquidity of portfolio assets, the use of borrowings and derivatives for investment purposes, and holdings of cash and cash equivalents. Using these factors, a fund board would be required to determine a percentage of the fund's net assets that could be invested in three-day liquid assets and to maintain a written record indicating how the minimum was determined. The rule would prohibit funds from acquiring assets if their acquisition would cause a fund to fall below its established three-day liquid asset minimum. The rule also would codify the current 15% “guideline” on illiquid assets, discussed below.
When discussing the role of liquidity in open-end funds, the Proposing Release cites concerns regarding the indirect costs of providing liquidity borne by non-redeeming shareholders. According to the SEC, trading activity and other changes in portfolio holdings associated with meeting redemptions (including selling assets and rebalancing portfolios) may dilute the interests of non-redeeming shareholders. Funds selling liquid assets to meet redemption requests may become increasingly illiquid, adversely affecting the fund's risk profile. The SEC also cites potential for harm to a fund where the fund is forced to sell illiquid securities at a discount to meet redemption requests, causing material harm to the fund's NAV and to non-redeeming shareholders.
Comments on Rule 22e-4 generally have supported the SEC's intent to strengthen liquidity risk management, but have identified numerous practical problems with the proposals.3 Commenters also have noted, as the SEC admitted in the Proposing Release, that there have been very few instances in the 75-year history of the Investment Company Act where a fund was unable to meet redemption requests due to portfolio liquidity issues.4
Although an SEC Commissioner recently stated that liquidity has been “a foundational principle of the Investment Company Act since its inception,”5 for nearly three decades after enactment of the Investment Company Act, the SEC apparently made no statements about mutual fund liquidity. Moreover, with the exception of money market funds, the Proposing Release is the first attempt by the SEC to adopt a rule regulating mutual fund liquidity, more than 75 years after enactment.
In March of 1969, the SEC published proposed guidelines prepared by the Division of Corporate Regulation (the predecessor to today's Division of Investment Management) for the then registration form for open-end and closed-end investment companies. The guidelines stated, among other things, that the “usual limit on aggregate holdings by an open-end company of illiquid assets of all kinds, including restricted securities, is 15 per cent of the value of its net assets.”6 The SEC also stated that the guidelines “are not rules of the Commission although some may later be incorporated in various rules and forms as experience and needs suggest.”
Later that same year, addressing concerns surrounding increased holdings of restricted securities, the SEC acknowledged both the valuation and liquidity difficulties caused by significant holdings of restricted securities. Funds' redemption obligation, “requires a high degree of liquidity in the assets of open-end companies because the extent of redemption demands or other exigencies are not always predictable…The Commission, however, is of the view that a prudent limit on any open-end company's acquisition of restricted securities, or other assets not having readily available market quotations, would be 10 per cent.”7
In 1972, the SEC again published guidelines prepared by the Division of Corporate Regulation, including virtually the same statement regarding a prudent limit on illiquid assets, again articulating a 10% limit.8 The SEC again acknowledged that the guidelines were not rules of the SEC.
In 1982, the SEC proposed a new registration form for mutual funds, Form N-1A, and again published proposed staff guidelines that included the same 10% formulation regarding a limit on illiquid assets. The next year, the SEC adopted Form N-1A and again published its views regarding Form N-1A in the form of staff guidelines, despite concerns of commenters that the publication “would give the Guidelines the status of formal rules, even though they [had] not been formally adopted as such by the Commission.”9 The 1983 guidelines included references to liquidity in Guideline 12 – Purchase and Sale of Real Estate, and Guideline 13 – The Making of Loans to Other Persons, both of which stated “[t]he usual limit on aggregate holdings by open-end companies of illiquid assets … is 10 percent of the value of its net assets.”
In 1992, in an attempt to free up capital for small business, the SEC revised the guidelines, increasing from 10% to 15% the amount of illiquid assets that open-end investment companies may hold. Citing Guidelines 12 and 13, new Guideline 4 stated “[t]he usual limit on aggregate holdings by an open-end investment company of illiquid assets is fifteen percent of its net assets.” The SEC also stated that “[e]xperience has shown that mutual funds generally have not had difficult in meeting redemption requests from available cash reserves, even during times of abnormally high selling activities in the securities market.”10 The SEC defined an illiquid asset to be “any asset which may not be sold or disposed of in the ordinary course of business within seven days at approximately the value at which the mutual fund has valued the investment.”11
Since 1992, until the Proposing Release, the SEC has not addressed liquidity in any releases, except as to money market funds.
As illustrated by the SEC's limited history of statements on the topic, liquidity was not a “foundational principle” of the Investment Company Act. In fact, one could read the Investment Company Act from front to back without realizing that liquidity is an important concept, because, among other things, nowhere in the Investment Company Act are the words “liquid,” “illiquid,” or “liquidity” used.12 A close reading of Sections 22(c), 22(e), and 38(a), the three sections advanced by the SEC as authority for Rule 22e-4, shows that the SEC does not have authority to adopt the rule.
Section 22(c)’s structure is a bit complicated, but essentially it allows the SEC to prescribe by rule methods for computing minimum and maximum prices at which a mutual fund may purchase or sell securities.13 Needless to say, Rule 22e-4 does not prescribe a method of computing minimum and maximum prices for acquisition or sale of securities and therefore does not fall within the authority provided by Section 22(c).
Section 22(e) provides that no registered investment company may suspend the right of redemption or postpone the date of payment or satisfaction upon redemption of any redeemable security for more than seven days after the tender of the security. It provides exceptions for (1) any period when the New York Stock Exchange is closed or during which trading on that exchange is restricted; (2) any period during which an emergency exists as a result of which a company cannot dispose of securities it owns or it is not reasonably practicable to fairly determine the value of the company's assets; or (3) such other periods as the SEC may by order permit for the protection of security holders. The section also directs the SEC, by rules and regulations, to determine the conditions under which trading will be deemed to be restricted and an emergency will be deemed to exist. This is the only rulemaking authorized by Section 22(e). Obviously, Rule 22e-4 does not address when trading shall be deemed to be restricted or when and emergency shall be deemed to exist.
Because Section 22(e) is concerned with the redemption of shares, it is worth considering whether the definition of redeemable security somehow gives the SEC authority to promulgate Rule 22e-4. As the SEC points out, the right of redemption of shares is a hallmark of mutual funds.14 That right, however, does not require mutual funds to be able to raise cash, because the Investment Company Act does not require that a mutual fund provide investors cash on redemption. Instead, a mutual fund may distribute securities to investors. The Investment Company Act defines a redeemable security as one that entitles a holder to receive “approximately his proportionate share of the issuer's current net assets, or the cash equivalent thereof.”15 Given the definition's primary emphasis on distribution of assets rather than cash, even the broadest interpretation would not extend the SEC's authority under Section 22(e) to authorize Rule 22e-4.
As for Section 38(a), that section only authorizes the SEC to “make, issue, amend, and rescind such rules and regulations and such orders as are necessary or appropriate to the exercise of the powers conferred upon the Commission elsewhere in this title … For the purposes of its rules or regulations, the Commission may classify persons, securities, and other matters within its jurisdiction and prescribe different requirements for different classes of persons, securities, or matters.” Thus, Section 38(a) does not give the SEC plenary authority to adopt any rules it thinks desirable; rather this general rulemaking authority must be tied to a statutorily provided power.16
Although we are not aware of any cases construing the SEC's authority under Section 38(a), there are instances in which courts have construed similar provisions under the federal securities laws and other laws. For example, the U.S. Court of Appeals for the District of Columbia Circuit considered a similar provision giving the Federal Communications Commission (“FCC”) rulemaking authority.17 Referring to this power as the FCC's “ancillary” authority, the Supreme Court established a two-part test for determining when this authority may be exercised. First, the agency's general jurisdictional grant must cover the regulated subject. Second, the regulations must be reasonably ancillary to the agency's effective performance of its statutorily mandated responsibilities.
This test is instructive when considering the limits of the SEC's authority under Section 38(a). For the regulation to be considered “reasonably ancillary to the … effective performance of its statutorily mandated responsibilities,” the SEC must refer to the provisions of the Investment Company Act expressly providing regulatory authority. Though the SEC references the authority in Sections 22(e) and 22(c) in support of the Proposed Rule, as discussed above neither section gives the SEC any responsibilities as to liquidity. Section 22(c)’s authority is limited to rules prescribing methods for calculating minimum and maximum prices. Section 22(e) does not specifically delegate any power to the SEC, other than determining when trading on the New York Stock Exchange is restricted or when an emergency exists. Accordingly, Section 38(a) does not provide statutory authority for Rule 22e-4.
As the U.S. Court of Appeals for the District of Columbia Circuit stated in striking down an SEC rule under the Investment Advisers Act of 1940 and construing the agency's authority under that act:
Based on a careful reading of the provisions cited by the SEC in support of Rule 22e-4, it appears that the agency does not have authority to promulgate the rule. Nowhere in the Investment Company Act does any requirement for portfolio liquidity appear and nowhere is the SEC authorized to prescribe any such requirements. That may explain why the SEC has never adopted any requirements regarding portfolio liquidity, apart from the special circumstances of money market funds.
1 Open-End Fund Liquidity Risk Management Programs; Swing Pricing; Re-Opening of Comment Period for Investment Company Reporting Modernization Release, Investment Company Act Release No. 31835 (Sept. 22, 2015) (the “Proposing Release”).
2 In addition to Rule 22e-4, the Proposing Release includes amendments to Form N-1A, amendments to an earlier proposal regarding mutual fund reporting on proposed Form N-PORT, and amendments to Rule 22c-1 that would permit swing pricing, which would allow funds to adjust their net asset value to pass on the costs of shareholder purchases or redemptions to the investors associated with that activity. In this article, we focus solely on the effect of proposed Rule 22e-4 on mutual funds.
3 Comments on the Proposing Release are available at https://www.sec.gov/comments/s7-16-15/s71615.shtml.
4 See, e.g.,R. Bram Smith, Executive Director, The Loan Syndications and Trading Association, Open-End Fund Liquidity Risk Management Programs; Re-Opening of Comment Period for Investment Company Reporting Modernization Release (File Number S7-16-15) (“we have identified only seven occasions in which a registered open-end fund was unable to satisfy redemption requests in accordance with Section 22(e) due to portfolio liquidity issues”); David Blass, General Counsel, Investment Company Institute, Open-End Fund Liquidity Risk Management Programs; Swing Pricing; Re-Opening of Comment Period for Investment Company Reporting Modernization Release (File Nos.S7-16-15 and S7-08-15) (“there is no evidence of an overarching failure or regulatory gap across the fund industry with respect to meeting redemptions”).
5 Commissioner Kara M. Stein, Mutual Funds - The Next 75 Years (June 15, 2015) (available at https://www.sec.gov/news/speech/mutual-funds-the-next-75-years-stein.html).
6 Investment Company Act Release No. 5633 (Mar. 11, 1969).
7 Accounting Series Release No 113, Investment Company Act Release No. 5847 (Oct. 21, 1969).
8 Investment Company Act Release No. 7221 (Jun. 9, 1972).
9 Investment Company Act Release No. 13436 (Aug. 12, 1983).
10 In recent years, the SEC has imposed separate liquidity requirements on money market funds. Investment Company Act Release No. 29132 (Feb. 23, 2010). Rule 2a-7, which governs the operations of money market funds, is an exemptive rule allowing funds to use the terminology “money market fund” and, under some circumstances, maintain a stable net asset value. The liquidity requirements of Rule 2a-7 are conditions to that rule. Accordingly, they do not stand for the proposition that the Investment Company Act authorizes the SEC to impose liquidity requirements on investment companies generally.
11 In 1986, in a release on money market funds, the SEC discussed the “position” taken regarding illiquid securities, and offered a definition: a “security is considered illiquid if a fund cannot receive the amount at which it values the instrument within seven days.” Investment Company Act Release No. 14983 (Mar. 12, 1986).
12 For a thoughtful discussion of liquidity and the Investment Company Act, see Stephen A. Keen, “Liquidity: An Afterthought to the Investment Company Act,” available at https://www.assetmanagementadvocate.com/2015/06/liquidity-an-afterthought-to-the-investment-company-act.
13 By its terms, Section 22(c) authorizes the SEC to make “rules and regulations applicable to registered investment companies and to principal underwriters of, and dealers in, the redeemable securities of any registered investment company … to the same extent, covering the same subject matter and for the accomplishment of the same ends as are prescribed in [Section 22(a)] in respect of the rules which may be made by a registered securities association governing its members.” Section 22(a) gives a registered securities association authority to prescribe rules for computing the price at which a member of the Association may purchase for many investment company any redeemable securities issued by such company and the maximum price at which a member may sell to such company any redeemable security … So that the price in each case will bear such relation to the current net asset value of such security computed as of such time as the rules may prescribe.“
14 See Proposing Release (“Investors in mutual funds can redeem their shares on each business day and, by law, must receive their pro rata share of the fund's net assets (or its cash value) within seven calendar days after delivery of a redemption notice”).
15 Investment Company Act Section 2(a)(32), 15 U.S.C.A. §80a-2(a)(31) (West). See also Investment Company Act Section 5(a)(1), 15 U.S.C.A. §80a-5(a)(1) (West) (“'Open-end company’ means a management company which is offering for sale or has outstanding any redeemable security of which it is the issuer”).
16 Investment Company Act Release No. 5519 (Oct. 16, 1968) ( “Section 38(a) of the Investment Company Act authorizes the Commission to issue such rules as are necessary or appropriate to the exercise of the powers conferred upon the Commission in that Act.” (emphasis added)).
17 Comcast Corp. v. FCC, 600 F.3d 642 (D.C. Cir., 2010) (“The Commission may perform any and all such acts, make such rules and regulations, and issue such orders, not inconsistent with this chapter, as may be necessary in the execution of its functions.” (citing 47 U.S. Code §154)). Bd. of Governors of the Fed. Reserve Sys. v. Dimension Fin. Corp., 106 S.Ct. 681 (1986) (“[T]he Board contends that it has the power to regulate these institutions under §5(b), which provides that the Board may issue regulations “necessary to enable it to administer and carry out the purposes of this chapter and prevent evasions thereof.” 12 U.S.C. §1844(b). But §5 only permits the Board to police within the boundaries of the Act; it does not permit the Board to expand its jurisdiction beyond the boundaries established by Congress….Its rulemaking power is limited to adopting regulations to carry into effect the will of Congress as expressed in the statute.”).
18 Fin. Planning Ass'n v. SEC, 482 F.3d 481 (D.C. Cir., 2007) (regarding the SEC's general rulemaking authority under Investment Advisers Act Section 211(a)), paraphrasing Bd. Of Governors v. Dimension Fin. Corp., 474 U.S. 361, 374 (1986).
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