Friday, October 14, 2016 08.40AM / SEC Chair Mary Jo White
Good morning. This is an open meeting of the Securities and Exchange Commission on October 13, 2016 under the Government in the Sunshine Act.
The Commission will consider recommendations from the staff of the Division of Investment Management to adopt final rules to modernize and enhance liquidity risk management and reporting of information by registered investment companies, including mutual funds and exchange-traded funds (ETFs). These recommendations are part of a series of transformative reforms I publicly outlined in December 2014 to enhance the SEC’s oversight and regulation of the asset management industry. I am very pleased that the staff, ever impressive, continues to advance this initiative expeditiously with the critical final rules before us today.
We will first discuss and vote on the recommendation for enhanced reporting, and then discuss and vote on the recommendations for liquidity risk management programs and swing pricing, on which we will take separate votes.
Modernizing and Enhancing Fund Reporting
The Commission’s oversight and regulation of the asset management industry is central to our mission – millions of investors rely on funds to support their retirement, invest for college, and achieve their other important financial goals. Nearly 55 million households, or 44 percent of all U.S. households, owned shares of more than 17,000 mutual funds at the end of 2015. The Commission, since 1940, has been responsible for regulating the industry that is entrusted with these critical investments. Today, the SEC oversees registered investment companies with combined assets of about $18 trillion and registered investment advisers with over $67 trillion in regulatory assets under their management.
Over the years, the asset management industry has become increasingly complex and has offered a growing range of investment strategies, including those that use derivatives, fixed income securities and other alternative strategies, as well as different fund structures, including ETFs. These changes can provide investors with more ways to meet their financial goals, but they can also increase the potential risks for fund portfolios and operations, as well as potentially for the broader markets.
Enhancing Commission Oversight and Increasing Public Transparency
The series of initiatives announced in December 2014 are designed to better match our regulatory framework with the current operations of today’s industry – an exercise that the Commission has engaged in throughout its history in response to a changing industry. Central to these efforts is gathering the necessary data to understand how the industry operates and the impact it can have on investors and the broader markets. The Commission and staff rely on information that funds report to monitor industry trends, identify risks, inform rulemaking, and assist in examination and enforcement efforts. Investors rely on this same information to assess different funds and to make more informed investment decisions.
Many of our current reporting requirements, however, have not been substantially changed in decades, and so do not fully capture the volume and complexity of information relevant today to the Commission and investors, nor enable the use of up-to-date technology to report and analyze it.
It is therefore essential that that our reporting requirements be modernized without delay. The Commission took an important first step in August, adopting final rules to enhance the reporting and disclosure of information provided by investment advisers, including new required reporting about separately managed accounts and their use of derivatives and borrowing. Today’s recommendation marks an even more significant step by updating and enhancing reporting requirements for most registered investment companies.
As the staff will explain in more detail, the reforms before us today are sweeping and will give the Commission and investors powerful new tools to understand the investment activities of funds. For the first time, funds will be required to report information about their complete portfolio holdings to the Commission monthly. Funds will also report census-type information annually in a new reporting form. The new data – reported in a structured format immediately useful for analysis –will include extensive information about their use of derivatives, basic risk metrics, securities lending activities, liquidity, and pricing of portfolio instruments. This modernized reporting framework will, in short, fundamentally change how the Commission and investors can monitor and assess funds, including their potential risks.
The recommendation before us today adopts many of these data requirements as proposed, but also strengthens the final rules with discrete changes to respond to the many thoughtful comments we received. In particular, the recommendation takes into account concerns that portfolio holdings information could be misused, and takes steps to mitigate these concerns through targeted modifications to requirements as to how and when that information is made public. Our close monitoring of the operation of these measures in practice will be important in determining whether we have struck the optimal balance between the benefit to investors of receiving full portfolio information and the risk to funds of that information being misused, and whether any further modifications to these requirements are appropriate.
Continued Evaluation of Electronic Delivery of Shareholder Reports
While not required for the substantive elements of our modernization effort, last year’s proposal also included a provision to permit funds to provide shareholder reports and portfolio information on fund websites. This proposal, which was designed to improve the overall accessibility of reports and reduce costs borne by funds and investors, incorporated important investor protections designed to preserve the ability of investors who preferred paper reports to continue to receive them.
These proposed measures received considerable comment — pro, con and in between. The staff continues to consider these comments and will not be presenting a recommendation today for a final rule on this part of the proposal, which will remain outstanding. Among other considerations, the staff is exploring ways to better protect investors who prefer to receive printed shareholder reports in the mail and the processing fees that funds, and ultimately their investors, must pay to broker-dealer intermediaries. In August, the NYSE filed proposed rule amendments that would define as well as limit the processing fees its members could charge under the Commission’s proposed reforms. This is an important development that the staff continues to study.
Any final rule must provide robust protections that serve the interests of all investors and their funds. The issues raised are important ones, and I have directed the staff to vigorously evaluate them and prepare a recommendation for the Commission’s consideration by the end of the year. The balance of the reforms from last year’s reporting modernization proposal is ready to be finalized and should not be held pending the staff’s remaining work. It is vital that we advance our modernization of the reporting framework without delay, and I am very pleased that the staff recommends today that we do so.
Before I ask David Grim, Director of the Division of Investment Management, to discuss the staff recommendation, I would like to thank a number of the Commission staff for applying their deep expertise to this rulemaking. Thank you Dave, Diane Blizzard, Sara Cortes, Michael Pawluk, Daniel Chang, Matthew DeLesDernier, Jay Krawitz, Andrea Ottomanelli Magovern, Naseem Nixon, Matthew Giordano, Kristy Von Ohlen, Tim Dulaney, Tim Husson, Heather Fernandez and Gregg Jaffray.
Thanks also to our economists from the Division of Economic and Risk Analysis – Director Mark Flannery, Christof Stahel, Christopher Vincent, and Matthew Kozora for their excellent work. And great thanks to Annie Small, Meridith Mitchell, Lori Price, Malou Huth, Cathy Ahn, Monica Lilly and Kevin Christy from the Office of the General Counsel. I would also like to express gratitude to my fellow Commissioners and all of our counsels for their engagement and comments on these recommendations.
Enhancing Liquidity Management
Managing the liquidity of an investment portfolio is a core responsibility of “open-end” funds like mutual funds and most ETFs. Such funds are indeed defined by their obligation to redeem their investors’ shares each business day, and careful management of portfolio liquidity is essential for meeting this obligation. Recent trends, including the significant growth of open-end funds investing in potentially less-liquid strategies, have made the effective management of fund liquidity even more important than ever for investors and the broader markets.
Among other negative effects, inadequate liquidity management can threaten investor confidence, dilute investor interests, and – in extreme cases – result in late or suspended redemptions. Last December, for example, an open-end fund suspended redemptions and planned liquidation after experiencing significant redemption requests and a significant decline in its net asset value over a six-month period. That event illustrated how investors can be harmed when a fund holding less liquid assets does not adequately anticipate increased redemptions. Concerns were also raised about the possibility of potentially similar events at other funds.
Liquidity Risk Management Programs
It is imperative that open-end funds manage their liquidity carefully, both to ensure that redemptions can be fulfilled in a timely manner and to minimize the impact of redemptions on remaining investors and the broader marketplace. The recommendation before us today includes all of the essential elements of the proposal, centered on a requirement for funds to establish a liquidity risk management program overseen by the fund’s board of directors.
Funds will be required to classify each portfolio investment’s level of liquidity into one of four categories, based on the number of days in which the fund’s investment would be convertible to cash in current market conditions without the sale significantly changing the market value. A fund also will be required to designate a minimum amount that the fund must invest in highly liquid investments convertible to cash within three business days without significantly changing the investment’s market value. And – critically – a fund will be required to limit the amount of illiquid assets held in the fund to 15 percent or less of the fund’s net assets.
A fund’s board will be required to approve the liquidity risk management program and the designation of the program administrator, and would be required to review an annual report on the program’s adequacy and effectiveness. The recommendation also includes requirements for funds to report more information to the Commission about their liquidity position, as well as provide enhanced disclosure to investors regarding the liquidity of fund portfolios and how funds manage liquidity risk.
These measures will fundamentally reform our oversight and regulation of liquidity management by open-end funds, and they have been strengthened by focused changes drawn from the comment process. First, the recommendation is now better tailored to the liquidity risks faced by different kinds of funds, with an improved classification scheme for the liquidity of fund investments and a more targeted approach to ETFs. Second, the controls around the accumulation of illiquid positions have been tightened, with increased oversight when a fund dips below its highly liquid investment minimum or exceeds the limit on illiquid investments. These refinements and others will ensure that the rule supports better liquidity management across the full range of open-end funds while minimizing operational burdens.
The recommendation also includes amendments to our existing rules to permit open-end funds – except money market funds and ETFs – to use “swing pricing.” Swing pricing is designed to provide funds with an additional, optional tool to mitigate potential dilution and to better manage fund liquidity.
The price that a purchasing or redeeming fund investor receives typically does not take into account the transaction and other costs that may arise when the fund invests proceeds from purchasing investors or sells assets to meet redemptions. These costs, while they often are typically minimal, currently may be borne by the remaining investors in the fund, thus potentially diluting their interest, and can become greater for funds with less liquid portfolio holdings. Investors also may have an incentive to redeem quickly during times of liquidity stress in the markets to avoid further losses, which could lead to increasing outflows and further dilution of remaining fund investors’ interests.
Enabling funds to use swing pricing provides another tool to mitigate shareholder dilution, along with existing options like redemption fees and in-kind redemptions. Under the recommendation, a fund that chooses to use swing pricing will adjust its net asset value (NAV) per share by an amount known as the “swing factor” in response to the costs associated with the shareholder purchase and redemption activity.
While it is used in other jurisdictions, swing pricing will be new for American funds. As with any new tool, we must take pains to ensure that the appropriate parameters and controls are in place to help direct its use and avoid unintended consequences for investors or the markets. The recommendation for the final rule incorporates a series of modifications to enhance the rule in this regard, including more defined roles for the board and fund managers, more limited discretion in setting the swing factor, and the disclosure of an upper limit on the fund’s swing factor that does not exceed two percent. In addition, a delayed effective date (two years after publication in the Federal Register) will give the market time to implement necessary operational changes before this new pricing method becomes available.
These steps do not obviate the need for our close attention to how swing pricing is ultimately used by market participants. While this tool clearly is intended to and can work to benefit investors and strengthen funds, its novelty and effects will require continued close scrutiny. Accordingly, I have directed the staff to both continuously monitor market practices associated with funds’ use of swing pricing to mitigate dilution and to present a review of this work to the Commission two years after the rule becomes effective.
Making sure we have strong oversight and the right regulatory tools for the modern asset management industry is a high priority for the agency. During my tenure, we began with fundamental reforms to money market funds, which will be fully implemented tomorrow. In addition to the rules we finalize today and those we finalized in August, the Commission has proposed reforms to limit the amount of leverage that funds are permitted to obtain through the use of derivatives and require investment adviser business continuity and transition planning. Staff is hard at work developing recommendations for the final rules in these areas, and is also considering ways to implement annual stress testing by large investment advisers and large funds. I expect the Commission to consider the final rules on derivatives in the near term, with action to follow on the others as soon as possible.
Before I ask David Grim, the Director of the Division of Investment Management, to provide additional details on the recommendation, I would like to recognize the exceptional work of the staff. Thank you Dave, Diane Blizzard, Doug Scheidt, Sarah ten Siethoff, Thoreau Bartmann, Melissa Gainor, Kathleen Joaquin, Zeena Abdul-Rahman, John Foley, Andrea Ottomanelli Magovern, Naseem Nixon, Amanda Hollander Wagner, Ryan Moore, and Matthew Giordano from the Division of Investment Management.
In the Office of the General Counsel, I want to thank Annie Small, Meridith Mitchell, Lori Price, Malou Huth, Robert Bagnall, Mykaila DeLesDernier, Monica Lilly, Michael Conley, John Avery and Daniel Matro.
Throughout this process, SEC staff from the Division of Economic and Risk Analysis provided economic analyses that were essential in formulating these reforms. Specific thanks also to Mark Flannery, Christof Stahel, James Mcloughlin, John Cook and Tristan Chiappetti.
Finally, I would like to express my gratitude to my fellow Commissioners and their counsels for their engagement and comments on this rulemaking.