Starting in November 2018, U.S. public, open-ended mutual funds will have the option to adjust the daily pricing of the fund—the net asset value or NAV—to account for and recoup large transaction costs. Currently, the fund, and therefore its remaining shareholders, absorb those costs generated by existing shareholders. This quiet, technical change in the regulation—swing pricing—is a part of the SEC’s sweeping mutual fund Liquidity Management Rules, adopted in 2016.
Swing pricing is an anti-dilution tool protecting shareholders staying in a fund—the sedentary shareholders—by guarding their investment from transaction cost erosion, which by 2014 estimates total $10-17 billion annually. This amount is relatively small in the mutual fund universe, but large in absolute terms. The cost of this erosion is particularly concerning, because it is likely disproportionately affecting retirement investors who enter funds through defined contribution plans, face exit constraints[1], and are sedentary.
Our article, Will Swing Pricing Save Sedentary Shareholders?,[2] recently published in the Columbia Business Law Review, combines an academic and industry review of the rules, foundational mechanics of swing pricing, implementation hurdles, and possible solutions. We marry our distinct experiences in our discussion of liquidity drivers, tracking the rule’s evolution from proposal to final form, including rulemaking comments, and exploring alternative structural approaches. We also compare the swing pricing rules to existing tools for mitigating transaction costs in Europe, where swing pricing is already in effect, and to existing U.S. tools such as in-kind transactions. We conclude with an opinion offered from our two divergent perspectives. We highlight a few key takeaways from our article below.
Challenges to Swing Pricing
Current mutual fund industry operations and nuances prevent swing pricing implementation. Consider that in the U.S., while the trading cut-off time of 4:00p.m. EST is strictly enforced, intermediaries and retirement account administrators are permitted to aggregate trades and send the trade information to the fund after 4:00p.m. By the time the fund must publish its NAV at 6:00p.m., it may not have received all the information necessary to determine whether the swing threshold has been met and to adjust the NAV.
Despite significant advances, consistent industry technology and processes addressing trade consolidation and transmissions are lacking. European jurisdictions, where mutual funds swing the NAV, provide a path forward, but it is one that would require substantial adjustment to current U.S. practices, causing disruption. These operational hurdles also highlight how the influx of retirement plan investors stresses the mutual fund transaction infrastructure, precipitating the need for an update.
Safe Harbor for “Blind Swinging”
Because funds often receive trade information necessary to trigger swing pricing after the NAV is cut, a fund must decide how to adjust its NAV with incomplete information. In other words, a fund may engage in “blind swinging.” As an example, a fund could have relatively neutral flow estimates reported throughout the day, and, after a fund determines no adjustment is needed when it calculates its final NAV, receive notice of substantial purchases or redemptions. This technically incorrect calculation of the swing threshold and swing factor could trigger a fund’s NAV error policy and cause a fund to correct any material NAV error by reimbursing any shareholders who are materially economically harmed by the technical error.
European jurisdictions mitigate blind swinging concerns with a safe harbor that guards against a miscalculation of the swing threshold if it is based on reasonable estimates. The new SEC rules for U.S. funds lack a safe harbor for blind swinging funds but offer shelter to funds that produce reasonable fund flow estimates after reasonable inquiry following SEC-prescribed procedures. This subtle difference in the regulatory structure exposes funds, and their lawyers, to the real or imagined threats of lawsuits and enforcement actions for blind swinging. Even subtle psychological barriers can impede implementation.
Blockchain as a Solution
Noting these operational challenges, and how the industry raised these issues in its rulemaking comments, we propose blockchain as a possible solution to some of the more difficult operational issues. Blockchain technology is capable of facilitating a large, virtual, secure, and nearly automatic public ledger. The U.S. mutual fund industry has yet to fully realize the potential of this nascent technology. Blockchain represents the exciting possibility that mutual funds could record peer-to-peer transactions in real time, reducing the need for operational intermediaries. In the process, fund flow information could be delivered instantaneously and accurately, eliminating a substantial objection to the feasibility of swing pricing.
Additionally, blockchain is notable for its immutability. That is, it is designed to identify and block fraudulent transactions via decentralization and verification. Blockchain allows for multiple parties to access and contribute to a ledger, and each party must authenticate its identity with a digital signature. Adopting blockchain technologies could facilitate the collection, transmission, and receipt of complete and accurate fund flow information by the fund’s 4:00p.m. cut-off time. A fund could then more easily and accurately assess whether the swing threshold has been met and how to adjust the NAV accordingly—all the while still publishing the NAV by the 6:00p.m. EST deadline.
Sparking a Discussion Among Directors
Our article is designed to provide a roadmap to swing pricing implementation and the issues while spurring discussion among fund boards of directors and retirement policy thought leaders. We encourage directors to become educated about the benefits of swing pricing and lead an industry dialogue. Swing pricing’s clear benefit as an anti-dilution tool to sedentary shareholders should motivate directors and fund managements alike to consider a path to implementation, regardless of operational challenges. Similarly, funds that service large pools of retirement investors and work with retirement plans should see mission alignment between their strategies and swing pricing—helping retirement investors protect and grow their nest eggs. In our article, we note that the SEC opened the door to swing pricing but did not pave the operational path forward, thus leaving fund directors in the driver’s seat. In fact, with directors leading the conversation, the industry might well find its way to enhancing industry technology and processes that will benefit shareholders and funds in the longer term through the implementation of swing pricing and modernized transactions.
ENDNOTES
[1] Anne M. Tucker, Locked In: The Competitive Disadvantage of Citizen Shareholders, 125 Yale L. Rev. Forum 163, 179 (2015).
[2] Anne M. Tucker & Holly van den Toorn, Will Swing Pricing Save Sedentary Shareholders, 1 Col. Bus. L. Rev. 130 (2018).
This post comes to us from Professor Anne M. Tucker at Georgia State University College of Law, and Holly van den Toorn, a student at the law school and a legal and compliance manager for a publicly traded company, its wholly-owned registered investment advisers, and affiliated mutual funds. The post is based on their recent article, “Will Swing Pricing Save Sedentary Shareholders?,” available here.