Microsoft Word - 5. Tucker_Print.docx TUCKER_VANDENTOORN_FINAL WILL SWING PRICING SAVE SEDENTARY SHAREHOLDERS? Anne M. Tucker & Holly van den Toorn* This Article explains and explores new Securities Exchange Commission rules authorizing optional swing pricing for mu- tual funds. Swing pricing is an anti-dilution tool intended to protect sedentary investors who enter, and stay, in a fund. Workers setting aside money for retirement are often sedentary investors. Mutual funds are the mainstay vehicle for retire- ment investors, yet as sedentary shareholders they can experi- ence significant asset dilution over their savings lifetime. Swing pricing—a mutual fund pricing mechanism that allo- cates transaction costs to the triggering shareholders—could save sedentary shareholders, collectively, billions of dollars. The mutual fund industry’s operational complexities and competing regulatory obligations may prevent funds from im- mediately utilizing swing pricing once it becomes effective in November 2018. The biggest obstacle is a time conflict reminis- cent of the chicken and egg problem. Under current industry operations, mutual funds will not receive the trading infor- mation necessary to adjust the daily price of the fund (swing the price) until after funds have to finalize the price adjust- ment. Blockchain technology—offering secure, automated, and verified ledgers—may present an operational path forward for the industry. The SEC’s swing pricing approach leaves unanswered how funds will overcome these, and other, hurdles. This Article ex- plores the components of swing pricing, as well as the objec- tions to and perceived benefits of swing pricing, and concludes with two unique perspectives on the SEC rules: one academic * Anne M. Tucker, Associate Professor of Law, Georgia State Univer- sity College of Law. Holly van den Toorn has over eighteen years of mutual fund industry experience and is currently a Legal and Compliance Manager for a publically traded company, its wholly-owned registered investment ad- visors, and affiliated mutual funds. Ms. van den Toorn is a part-time law student and expects to complete her J.D. in May 2019. Tucker_VanDenToorn_Final No. 1:130] WILL SWING PRICING SAVE SEDENTARY SHAREHOLDERS? 131 and one professional. This Article maintains that mutual funds should take on the challenge of implementing swing pricing, and that market incentives will pave the way. I. Introduction ............................................................... 132 II. Mutual Funds, Liquidity, and Dilution: A Primer .... 135 A. Liquidity, Net Asset Value, and Fund Flows ..... 139 B. Defining Dilution ................................................. 144 III. Swing Pricing ............................................................. 148 A. Swing Pricing Overview ...................................... 148 B. International Perspectives on Swing Pricing ..... 149 C. U.S. Swing Pricing Rules .................................... 150 1. Optional .......................................................... 151 2. Swing Threshold............................................. 152 3. Swing Factor .................................................. 155 4. BOD Implementation and Oversight ............. 158 a. Operational Accountability ...................... 158 b. Board Accountability & Fiduciary Duty .. 159 c. Transparency & Shareholder Disclosures 161 IV. Analysis of Swing Pricing Comments & Rule Ramifications ............................................................. 163 A. Benefits ................................................................ 164 B. Swing Pricing Obstacles ...................................... 170 1. Operational Challenges.................................. 171 a. Mutual Fund Data & Market Timing ...... 172 b. No Safe Harbor ......................................... 177 c. Fund Size Matters .................................... 179 d. A Possible Path Forward: Block Chain Technology ................................................ 180 2. Conceptual Challenges ................................... 184 a. Volatility & Arbitrage .............................. 184 b. Imperfect Equalization ............................. 188 c. Compliance Costs & Priority .................... 190 V. Mutual Fund Liquidity: Existing and Considered Tools to Recoup & Reduce Costs ......................................... 191 A. Purchase and Redemption Fees: Overview & Challenges ........................................................... 192 B. In-Kind Redemptions: Overview & Challenges .. 193 C. A Considered Alternative: Dual Pricing ............. 196 TUCKER_VANDENTOORN_FINAL 132 COLUMBIA BUSINESS LAW REVIEW [Vol. 2018 VI. Conclusion .................................................................. 198 An Industry Perspective on Swing Pricing ............... 200 An Academic Perspective on Swing Pricing .............. 203 On This We Can Agree .............................................. 206 Appendix .............................................................................. 208 Federal Legislation .................................................... 208 SEC Rules .................................................................. 208 Other Agency Rules ................................................... 208 I. INTRODUCTION Most of us envision our sunset years involving less work, more leisure, and maybe even a warmer climate. Retirement requires saving today for tomorrow’s time off. The way that most working Americans save for retirement is through mu- tual funds available through an employer-sponsored plan or an individual retirement account. Retirement savings fueled mutual fund growth with combined assets of $18.9 trillion at year-end 2016.1 Retirement investors—meaning any worker of any age setting aside some of their paycheck for retirement savings—are encouraged to set an automated contribution at the time of employment and pick their funds (i.e., allocate their assets). Once set, many retirement investors do not change their initial asset allocation but instead stay in the same fund, earning them the label “sedentary.”2 Consider that 1 INV. CO. INST., 2017 INVESTMENT COMPANY FACT BOOK 10–11 (2017), https://www.icifactbook.org/deployedfiles/FactBook/Site%20Properties/pdf/ 2017/2017_factbook.pdf [perma.cc/8NLB-NJHT] (noting that households make up the largest group of mutual fund investors and that registered in- vestment companies managed twenty-two percent of household financial as- sets, a significantly increased figure over the last several decades due to the change in retirement saving structures). 2 Retirement investors often unwittingly violate financial planning rules, but they do tend to adhere to one rule: they are long-term investors. Rebalancing asset allocations within an account, reviewing plan options for low-fee investments, and updating asset allocations to reflect shifting risk tolerance/profiles consistent with an investor’s retirement age are just a few of the financial planning best practices violated by the ‘set it and forget it’ model. For a discussion of common investor mistakes, see FED. RESEARCH Tucker_VanDenToorn_Final No. 1:130] WILL SWING PRICING SAVE SEDENTARY SHAREHOLDERS? 133 just over 5% of retirement investors changed their investment choices in 2016, meaning that 95% did not.3 There may be a hidden cost to setting investments and for- getting about them. Long-term, sedentary shareholders who stay in a fund may be subsidizing the activity of other inves- tors who are entering or exiting the fund. The subsidy paid by sedentary investors, if incurred, is relatively little—a fraction of transaction costs each day. The fractional costs com- pounded over thirty years and aggregated across the retire- ment system, however, pose significant costs in absolute terms: estimates range from $10–17 billion annually. The U.S. Securities and Exchange Commission’s (“SEC”) swing pricing rules target this slow leak of retirement savings, known as as- set dilution. In October 2016, the SEC adopted the Liquidity Rules.4 As a part of the new rules—to be effective in November 2018— DIV., LIBRARY OF CONG., BEHAVIORAL PATTERNS AND PITFALLS OF U.S. INVES- TORS 7–14 (2010), https://www.sec.gov/investor/locinvestorbehaviorre- port.pdf [perma.cc/U3LQ-RXFD] (discussing investor mistakes). See also Jill E. Fisch & Tess Wilkinson-Ryan, Why Do Retail Investors Make Costly Mistakes? An Experiment on Mutual Fund Choice, 162 U. PA. L. REV. 605, 620–26 (2014) (summarizing literature on investor mistakes). 3 For evidence of investors’ preference to set investment accounts and then forget them, consider 2016 data collected by the Investment Company Institute (the “ICI”) from twenty-nine million employer-based defined con- tribution retirement accounts, which shows that only 5.6% of participations changed the asset allocation of their contributions and 9.4% rebalanced their existing allocations. SARAH HOLDEN & DANIEL SCHRASS, INV. CO. INST., DEFINED CONTRIBUTION PLAN PARTICIPANTS’ ACTIVITIES, 2016, at 5 (2017), https://www.ici.org/pdf/ppr_16_rec_survey_q4.pdf [perma.cc/957U-H54L]. One exception to this observation is target date funds, where investors se- lect the fund based on their target date of retirement. Because the fund re- balances automatically each year and the asset allocation changes as the worker/saver approaches retirement age, investors are encouraged to leave their investment in that fund for the duration of their working/saving life. See, e,g., Investor Bulletin: Target Date Retirement Funds, SEC (May 1, 2010), https://www.sec.gov/investor/alerts/tdf.htm [perma.cc/4X3R-YTQP]. 4 The Securities and Exchange Commission (the “SEC”) adopted the Liquidity Rules to combat liquidity costs, and other structural concerns re- lated to the mutual fund industry. The Liquidity Rules also address open- end funds’ liquidity risk management, derivatives, swing pricing, and pro- pose to codify the fifteen percent illiquid securities guidelines. The rules TUCKER_VANDENTOORN_FINAL 134 COLUMBIA BUSINESS LAW REVIEW [Vol. 2018 the SEC authorized optional partial swing pricing as a liquid- ity tool to allocate transactional and other costs to the share- holders generating the expenses when exiting or entering a fund.5 Allocating expenses to the entering or departing fund shareholders through swing pricing prevents dilution of exist- ing shareholders’ investments. Swing pricing is facially a tech- nical issue, but a scratch to the surface reveals it as a lens into key aspects of mutual fund investment—a practice 54.9 mil- lion U.S. households engage in to the tune of $16.3 trillion.6 This Article provides a technical, but accessible, review of swing pricing focusing on the theory, rules, benefits, chal- lenges, and regulatory alternatives. Part II introduces readers to a key attribute of U.S. open-ended mutual funds—the daily Net Asset Value (“NAV”)—and explains the relationship be- tween NAV and new SEC regulatory priorities of fund liquid- were originally released on September 22, 2015 and were finalized in No- vember 2016 with an effective date of January 1, 2018. Open-End Fund Li- quidity Risk Management Programs; Swing Pricing; Re-Opening of Com- ment Period for Investment Company Reporting Modernization Release, 80 Fed. Reg. 62274, 62283 (proposed Oct. 15, 2015) (to be codified at 17 C.F.R. pts. 210, 270, 274) [hereinafter Swing Pricing First Proposal]. The SEC is- sued final liquidity risk management rules in October 2016. Investment Company Liquidity Risk Management Programs, 81 Fed. Reg. 82142 (Nov. 18, 2016) (to be codified at 17 C.F.R. pts. 270, 274) [hereinafter Final Li- quidity Risk Rules]. The SEC’s Liquidity Management Rule provides a framework for a fund to evaluate and manage its liquidity profile. Id. at 82155. Funds will provide liquidity data to the SEC via Form N-PORT and N-CEN, including details about a fund’s liquidity risk management prac- tices. Id. at 82193–97, 82222–23. The SEC’s stated goal with respect to the liquidity risk management rules is to ensure that funds can meet share- holder redemptions and avoid shareholder investment dilution. Id. at 82148–50, 82262. In order to encourage funds to proactively manage and reduce dilution, the SEC incorporated an additional anti-dilution tool in its release: swing pricing. Id. at 82262. The SEC established swing pricing guidelines in a separate release, which forms the basis of our discussion in this Article. See Investment Company Swing Pricing, 81 Fed. Reg. 82084 (Nov. 18, 2016) (to be codified at 17 C.F.R. pts. 210, 270, 274) [hereinafter Final Rules]. 5 Final Rules, supra note 4, at 82084. 6 INV. CO. INST., supra note 1, at 130; see also Holden, supra note 3, at 2 (describing defined contribution plan asset trends from 2007–2016). Tucker_VanDenToorn_Final No. 1:130] WILL SWING PRICING SAVE SEDENTARY SHAREHOLDERS? 135 ity management and shareholders’ asset dilution. Part III ac- quaints readers with swing pricing, connects the conversation with international initiatives, and provides a detailed exami- nation of the new SEC swing pricing rules for U.S. mutual funds. Drawing from the public comments submitted to the SEC and industry sources, Part IV describes the anticipated benefits of the new rules and catalogues the operational and conceptual challenges impeding swing pricing implementa- tion by mutual funds. Finally, Part V discusses existing tools to manage mutual fund liquidity and prevent shareholders’ asset dilution, and compares these options to swing pricing. Part VI first identifies the views on swing pricing shared by both authors of this Article, then proceeds to explicate each author’s individual perspective, including the benefits and ob- stacles that lie ahead. Here these two voices, previously left to the footnotes, take center stage as this Article discusses the merit and challenges of swing pricing from two fundamentally different perspectives. The first contributes an industry, top- down perspective that is practical and focused on implemen- tation. The second provides a bottom-up perspective that em- phasizes the role of mutual funds in our retirement system and praises the potential for a more level-playing field for exit- constrained retirement investors who should not subsidize more sophisticated investors’ exits. Both authors agree on the relative merits of swing pricing and conclude that the SEC’s reliance on market solutions to resolve the considerable oper- ational challenges is a shrewd but ultimately appropriate reg- ulatory choice. II. MUTUAL FUNDS, LIQUIDITY, AND DILUTION: A PRIMER “Cash is king,” as the old adage goes, applies to mutual fund investments. Liquidity refers to how quickly or easily a fund can convert an asset into cash.7 Liquidity is central to 7 For a discussion of liquidity generally and as applied to mutual funds, see Conrad Ciccotello, The Nature of Mutual Funds, in MUTUAL FUNDS: PORTFOLIO STRUCTURES, ANALYSIS, MANAGEMENT, AND STEWARDSHIP 1, 5–7 (John A. Haslem, ed., 2010). TUCKER_VANDENTOORN_FINAL 136 COLUMBIA BUSINESS LAW REVIEW [Vol. 2018 mutual funds because fund shareholders have a right to re- deem their fund shares in exchange for cash, calculated on the fund’s current NAV.8 Funds calculate their NAV daily. It is the price at which new investors buy into a fund and the price paid to redeeming shareholders when they exit the fund. Daily cash-out or cash-in prices (i.e., the NAV) and quick conversion of mutual fund stock to cash are defining features of open-ended mutual funds.9 Mutual funds are obligated to respond to a shareholder’s redemption and send cash proceeds to the shareholder within seven days of receiving an order to redeem.10 Every shareholder has a right to quickly cash out of a fund, making liquidity management a fundamental part of the portfolio manager’s job.11 NAV is a key component to un- derstanding fund share dilution and exposing the connection between liquidity and dilution—the SEC’s regulatory aim of swing pricing rules. Here this Article takes a brief detour to familiarize readers with the regulatory landscape unique to mutual funds. Expert readers may wish to skip to Part III. Mutual funds sit at the legislative and administrative intersection of SEC authority 8 Pricing of Redeemable Securities for Distribution, Redemption and Repurchase, 17 C.F.R § 270.22c-1 (2017). 9 Inv. Co. Inst., Comment Letter on Open-End Fund Liquidity Manage- ment Programs A-1 (Jan. 13, 2016) [hereinafter Inv. Co. Inst. Comment Let- ter], https://www.sec.gov/comments/s7-16-15/s71615-54.pdf [perma.cc/E7RZ-5LP5]. Closed-end funds are traded in a manner similar to stocks—in an exchange facilitated competitive bidding process that deter- mines the price as opposed to trading at NAV. Thus, a closed-end fund can trade at a premium or a discount to its NAV. For a discussion of closed-end mutual funds, see Closed-End Fund Information, SEC, https://www.sec.gov/fast-answers/answersmfclosehtm.html [perma.cc/5C4N-H47T]. 10 Swing Pricing First Proposal, supra note 4, at 62277 (describing quick cash conversion as a “hallmark” of open-end funds). Citations to the Proposed Rules are provided in this Article when the proposal contains a rich discussion of the concepts motivating the new rules, mutual fund prac- tices, or provisions eliminated or differing from the final rules. 11 Inv. Co. Inst. Comment Letter, supra note 9; see also Ciccotello, su- pra note 7, at 6 (“[A]n open-end fund manager must not only select securi- ties but also manages the portfolio with an eye toward Daily flow into and out of the fund.”). Tucker_VanDenToorn_Final No. 1:130] WILL SWING PRICING SAVE SEDENTARY SHAREHOLDERS? 137 under the Securities Act of 1933, the Exchange Act of 1934, the Investment Advisors Act of 1940, and the Investment Company Act of 1940.12 Maintaining its mandate to protect investors, the SEC released sweeping liquidity management rules and announced “evaluation of . . . investment advisers’ liquidity risk management practices” as an examination pri- ority.13 Changes to the mutual fund industry drove this liquid- ity regulation. According to research by the SEC’s Division of Economic and Risk Analysis (the “DERA”) from 2000–2014, mutual funds’ investments in less liquid asset classes grew significantly, with foreign bond and equity funds growing from 11% to 17.4% of total US mutual fund industry assets, 12 Congress created the SEC to regulate the U.S. securities market with the passage of the Securities Act of 1933 and the Securities Exchange Act of 1934, and designed it “to restore investor confidence” in the markets. Securities Act of 1933, Pub. L. No. 73-22, 48 Stat. 74 (codified as amended at 15 U.S.C. § 77a (2017)); Securities Exchange Act of 1934, Pub. L. No. 73- 291, 48 Stat. 881 (codified as amended at 15 U.S.C. § 78a (2017)). See also What We Do, SEC, https://www.sec.gov/about/whatwedo.shtml [perma.cc/Q3DK-W253]. In 1940, Congress again acted to pass the Invest- ment Company Act and Investment Advisers Act in order to regulate com- panies, including investment companies (commonly called mutual funds) and the investment advisers that manage mutual funds. See Investment Company Act of 1940, Pub. L. No. 76-768, 54 Stat. 789 (codified as amended at 15 U.S.C. § 80a-1 to 80a-64 (2017)); Investment Advisers Act of 1940, Pub. L. No. 76-768, 54 Stat. 847 (codified as amended at 15 U.S.C. § 80b-1 to 80b-21 (2017)). The Sarbanes-Oxley Act of 2002 and the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 are two prime instances of legislation that stemmed from events significantly affecting the ever- changing markets, and from which the SEC drew new regulations and over- sight functions. Sarbanes-Oxley Act of 2002, 15 U.S.C. § 7201 (2002); Dodd- Frank Wall Street Reform and Consumer Protection Act, 12 U.S.C. § 5301 (2010). 13 Press Release, SEC, SEC Announces 2016 Examination Priorities (Jan. 11, 2016), https://www.sec.gov/news/pressrelease/2016-4.html [perma.cc/6QCJ-7UHF]. TUCKER_VANDENTOORN_FINAL 138 COLUMBIA BUSINESS LAW REVIEW [Vol. 2018 as an example.14 In particular, alternative asset class15 mu- tual fund strategies grew from total assets of $365 million in 2005 to $334 billion in 2014—a faster rate than any other as- set class.16 Alternative strategies typically experience more volatility when compared to mutual funds holding traditional asset classes,17 which equates to less liquidity. DERA’s empir- ical results show that when an average equity fund experi- ences an outflow, liquidity decreases.18 Significantly, a fund with fewer assets and less equities may experience a greater liquidity reduction.19 The continued growth in mutual fund assets as a whole demonstrates investor reliance on funds to meet financial sav- ings needs.20 Mutual funds’ importance to savings for individ- ual and systemic financial stability, coupled with increased li- quidity vulnerabilities in new fund types, prompted the SEC to propose a suite of liquidity risk management rules, includ- ing a proposal on swing pricing.21 14 Memorandum from Paul Hanoua et al., Div. of Econ. & Risk Analysis on Liquidity and Flows of U.S. Mutual Funds to Mark Flannery, Dir. & Chief Economist, Div. of Econ. & Risk Analysis 1 (Sept. 2015) [hereinafter SEC Liquidity Whitepaper], https://www.sec.gov/dera/staff-papers/white- papers/liquidity-white-paper-09-2015.pdf [perma.cc/YJ4W-LAJ8]. 15 The SEC eschews a singular definition of alternative mutual funds classifying the group by a primary investment strategy that falls into one of three categories: (1) non-traditional asset classes such as currencies or man- aged futures, (2) non-traditional strategies such as long-short equities, or (3) less liquid investments such as private debt. Final Rules, supra note 4, at 82152 n.95. 16 SEC Liquidity Whitepaper, supra note 14, at 1. 17 Id. at 2. Traditional asset classes include publicly traded stocks and bonds such as U.S. Treasury Notes. 18 Id. 19 Id. 20 Final Rules, supra note 4, at 82119. 21 See Swing Pricing First Proposal, supra note 4, at 62278–81 (estab- lishing a basis for SEC regulation of mutual funds). There is no comparable discussion in the Final Rules, supra note 4. Following the financial crisis in 2008 when money market funds broke the buck, the SEC issued new money market fund regulations in 2010 and 2014 requiring a floating NAV and authorizing new liquidity tools—such as liquidity fees and redemption gates—to money market fund boards in order to curb outflows in a run. Tucker_VanDenToorn_Final No. 1:130] WILL SWING PRICING SAVE SEDENTARY SHAREHOLDERS? 139 Liquidity management is not a “one size fits all approach,” but a complex task requiring individually tailored tools .22 It is influenced by a broad range of factors, including (1) asset type, the asset’s available market (i.e., buyers and sellers), and settlement period; (2) available portfolio cash and the ability to borrow, such as via a credit facility; and (3) market conditions at the time of the transaction. The following discus- sion provides an overview of liquidity, NAV, fund flows, and dilution, their connection to each other, and the market and regulatory choices that they invoke. A. Liquidity, Net Asset Value, and Fund Flows Trading volume—i.e., the amount of a particular security that is traded over a given period of time—is an essential ele- ment in assessing the liquidity and price of a security.23 The Money Market Funds, 17 C.F.R. § 270.2a-7(c) (2017); see also Press Release, SEC, SEC Adopts Money Market Fund Reform Rules (July 23, 2014), https://www.sec.gov/news/press-release/2014-143 [perma.cc/L46N-R8PZ] (describing the money market rules as addressing “risks of investor runs” while “preserving the benefits of the funds”). 22 Inv. Co. Inst. Comment Letter, supra note 9, at A-3. 23 See Daniel Fricke & Austin Gerig, Liquidity Risk, Speculative Trade, and the Optimal Latency of Financial Markets 3 (SEC, Div. of Econ. & Risk Analysis, Working Paper) (Dec. 1, 2014) https://www.sec.gov/files/dera-wp- liquidity-risk.pdf [perma.cc/JBU7-D5H7] (noting three main factors affect- ing liquidity including price volatility, “the number of public investors who trade the asset,” and correlated asset value). One author of this Article, Holly van den Toorn, has professional experience in the mutual fund industry and conducted interviews with other mutual fund professionals in her research for this Article. The responses received provide a unique perspective on swing pricing and insight into the mutual fund industry. While these professionals agreed to have their responses used for research, they asked to remain anonymous. As such, this Article cites to these interviews as follows: FaceTime Interview with Anonymous (Sept. 3, 2016) (notes on file with author) [hereinafter FaceTime Interview with Anonymous]. Holly van den Toorn also shares her professional experi- ence, observations, and opinions in the footnotes. TUCKER_VANDENTOORN_FINAL 140 COLUMBIA BUSINESS LAW REVIEW [Vol. 2018 higher the trading volume, the more liquid the security is per- ceived to be.24 If a limited market exists for a security, pricing of that security will be highly sensitive to the number of bids (requests to buy) and asks (requests to sell) available for the security.25 The more bids and asks that exist for a particular security, the more liquid that security is perceived to be.26 For example, IBM is a large capitalization company of $141.6 billion and heavily traded stock in January 2018.27 IBM stock traded, on average, 4.3 million shares a day.28 Large capitalization and frequent trading indicate a highly liquid stock. A portfolio manager wanting to buy or sell IBM stock could do so easily with “plenty of room for trading.”29 A portfolio manager interested in trading in IBM would look at the accumulated trades for that date: If the trading volume is significantly lower than average, it may signal reduced liquid- ity and thereby influence the decision to sell (less risky in a tight market) or buy (more risky in a tight market).30 Conversely, WD-40 is a small capitalization stock, with a market capitalization of only $1.78 billion31 and an average daily trading volume of 55,538 shares in January 2018.32 Given its relatively low trading volume, a fund holding WD- 24 “Liquidity, therefore, is affected by market participation, and we should expect liquidity to increase with market size.” Fricke & Gerig, supra note 23, at 1. 25 FaceTime Interview with Anonymous, supra note 23; see also ROB- ERT C. POZEN, THE MUTUAL FUND BUSINESS 215–18 (1998). 26 FaceTime Interview with Anonymous, supra note 23. 27 See International Business Machines Corporation Common Stock & Summary Data, NASDAQ, http://www.nasdaq.com/symbol/ibm (last visited Jan. 26, 2018). 28 Id. (generating a ninety-day average daily volume as of close of busi- ness on Jan. 26, 2018 of 5,258,836 shares). 29 FaceTime Interview with Anonymous, supra note 23. 30 Id. See also POZEN, supra note 25, at 219 (noting the importance of supply and demand in investment research and surveying data such as “money flows and volume trends”). 31 NASDAQ, WD-40 Company Common Stock Quote and Summary Data, http://www.nasdaq.com/symbol/wdfc (last visited Jan. 26, 2018). 32 Id. The ninety-day average daily volume is not provided on the NASDAQ website; therefore the fifty-day average daily volume is provided in this instance. Tucker_VanDenToorn_Final No. 1:130] WILL SWING PRICING SAVE SEDENTARY SHAREHOLDERS? 141 40 stock would experience a significant hit to share price if a portfolio manager tried to sell its entire holding all at once.33 As a consequence, a fund would choose to “work the order” to sell its shares of a low trade volume stock over the course of several days to lessen the depression of the stock’s price.34 The asset type—e.g., stocks or bonds—may influence trad- ing volume, the availability of counterparties, and liquidity. Stock, for example, represents a share of ownership in a com- pany (i.e., equity); the stockholder is entitled to earnings, or dividends.35 Common and preferred stock are the two big buckets of equity, with common stock dominating the ex- changes and serving as the focus of liquidity regulations.36 The stock market is comprised of central exchange where each day investors buy and sell over $5 trillion in assets world- wide.37 Supply and demand for a given stock, influenced in part by company and market-wide news, drive an ever-fluctu- ating, but readily available, current stock price.38 33 FaceTime Interview with Anonymous, supra note 23; see also POZEN, supra note 25, at 217 (“[P]ortfolio managers need to take into account other factors relating to the management of a mutual fund. These include the cash flows resulting from shareholder purchases and redemptions, as well as the liquidity of individual securities and market sectors.”). 34 FaceTime Interview with Anonymous, supra note 23. 35 See GAIL ROLLAND, MARKET PLAYERS: A GUIDE TO THE INSTITUTIONS IN TODAY’S FINANCIAL MARKETS xxi–xxii (2011) (describing stock attributes); see also POZEN, supra note 25, at 211–12 (discussing dividends). 36 ROLLAND, supra note 35, at 34–35 (discussing the initial public offer- ing of shares and the choice to offer common or preferred stock); see also POZEN, supra note 25, at 2225–28 (discussing common and preferred stock). 37 See David Scutt, Here’s How Much Currency Is Traded Every Day, BUSINESS INSIDER (Sept. 2, 2016), http://www.businessinsider.com/heres- how-much-currency-is-traded-every-day-2016-9 [perma.cc/5XU9-859T] (discussing the size of the equities market). The World Bank estimates of global trading value at $77.5 trillion in 2016. Stocks Traded, Total Value, WORLD BANK, http://data.worldbank.org/indicator/CM.MKT.TRAD.CD (last visited Jan. 26, 2018). For a list of major exchanges worldwide, and their visualization by size, see All of the World’s Stock Exchanges by Size, MONEY PROJECT (Feb. 16, 2016), http://money.visualcapitalist.com/all-of-the- worlds-stock-exchanges-by-size/ [https://perma. cc/XLE4-ZFUJ]. 38 See generally, POZEN, supra note 25, at 215–19 (discussing portfolio managers and active management strategies that incorporate corporate news events). TUCKER_VANDENTOORN_FINAL 142 COLUMBIA BUSINESS LAW REVIEW [Vol. 2018 Bonds, on the other hand, are contractual agreements to pay money (i.e., a debt) with a range of features including var- ying qualities, variable or fixed coupons (or interest rates), maturities, and yields.39 Interest rates and credit ratings af- fect bond pricing.40 Bonds primarily trade over the counter (“OTC”),41 through intermediaries, such as broker-dealers, in order to link counterparties.42 Bonds trade at a variable pace, with a particular bond possibly not trading for weeks or even months.43 Because of this, current prices may not be readily available, making it difficult to trade bonds on the stock mar- ket.44 OTC bonds may be traded over the telephone so that traders can capture the most current information about the availability of buyers and the bond features themselves. Assets outside the mainstream classes of stocks and bonds introduce new complexity and obscurity that impact a secu- rity’s perceived liquidity.45 For example, a mortgage-backed security (“MBS”) experiences a limited trading market, as it is a complex, structured investment vehicle with a limited consortium of buyers.46 Pools of individual mortgages are col- lateral for an MBS, which are subject to credit and default 39 Id. at 167–70 (describing the bond market generally and key fea- tures). 40 ROLLAND, supra note 35, at xx (“Credit risk is the risk that the bor- rower will not make the expected payments, such as repaying the debt at maturing or the interest payments promised. Interest rate risk comes about from these interest payments.”). 41 Melissa Woodley, Liquidity in the Over-The-Counter Market for Cor- porate Bonds 1 (Jan. 17, 2008) (unpublished manuscript), https://pa- pers.ssrn.com/sol3/papers.cfm?abstract_id=1084560 [perma.cc/ WKE7- 33TC]. 42 Nathan Foley-Fisher et al., Over-the-Counter Market Liquidity and Securities Lending 7 (June 25, 2017) (unpublished manuscript), https://pa- pers.ssrn.com/sol3/papers.cfm?abstract_id=2869959 [perma.cc/VHX5- T9LC]. 43 FaceTime Interview with Anonymous, supra note 23. 44 Id. 45 POZEN, supra note 25, at 217 (noting that the liquidity of securities is “especially important in thinly traded markets”). 46 See ROLLAND, supra note 35, at 183–84. Tucker_VanDenToorn_Final No. 1:130] WILL SWING PRICING SAVE SEDENTARY SHAREHOLDERS? 143 risks.47 The interest and principal payments of these mort- gages support the MBS, and any mortgage default affects the pooled security.48 As default rates rise in the pooled mort- gages, the MBS is also more likely to default.49 Increased de- fault risk negatively affects an investor’s ability to sell the MBS, and, thus negatively affects the value of the security.50 Limited buyers and depressed pricing may produce a wider bid/ask spread on an MBS when a portfolio manager decides or is forced to sell an MBS position. 51 A wider bid/ask spread indicates that the security is less liquid, and a greater dispar- ity between the expected market price and price actually re- ceived indicates a riskier investment.52 The 2008 financial cri- sis exemplifies a time when homeowners defaulted on mortgage payments, which resulted in a downward spiral for MBS value where few buyers existed and those who did were only willing to pay cents on the dollar. The aggregate of individual security prices in the fund pro- vides the basis for a fund to calculate its daily NAV.53 The prices of portfolio securities rise or fall daily in concert with market influences and securities transactions conducted in the portfolio.54 Consider $10 million of an MBS priced at $100.00 in a fund’s portfolio. The security price ($100.00) represents what 47 Id. 48 Id. 49 Id. 50 See POZEN, supra note 25, at 178–80 (discussing the risks associated with investing in bonds and noting that “[l]iquidity or marketability risk depends on the ease with which an issue can be sold at or near its value”). 51 Swing Pricing First Proposal, supra note 4, at 62299 (defining the bid/ask spread as the “difference between bid and offer prices for a particu- lar asset” and mentioning that the spread has “historically been viewed as a useful measure for assessing the liquidity of assets that trade in the OTC markets”); see also POZEN, supra note 25, at 180 (noting that the primary measure of liquidity is the size of the bid/ask spread: the wider the spread, the greater the risk). 52 POZEN, supra note 25, at 180. 53 See Ciccotello, supra note 7, at 5–6 (discussing NAV calculation com- ponents and challenges). 54 Id. TUCKER_VANDENTOORN_FINAL 144 COLUMBIA BUSINESS LAW REVIEW [Vol. 2018 a portfolio manager expects to receive when she sells the se- curity. If a substantial fund redemption occurs, the fund man- ager must sell assets, including the MBS, to meet the redemp- tion.55 Assume that on the day they are forced to sell, however, the market experiences low trading volume. The broker- dealer to whom they attempt to sell the MBS knows that there is limited demand for it, and thus offers only $99.50. Though the fifty-cent hit—$50,000 in total—may seem insignificant in relation to near-billion dollar funds, it is a big loss on a single trade. With forced selling in an illiquid market, these losses can represent a large portion of a fund’s portfolio and com- pound over time.56 When funds sell steeply discounted assets, such as this MBS, in a distressed market with few buyers, the sale results in illiquidity and substantial dilution to remain- ing shareholder investments by means of a reduced NAV.57 B. Defining Dilution Shareholder dilution is the reduction in a shareholder’s in- vestment holding—reflected as the NAV times the number of fund shares held. When shareholder capital activity—namely, inflows to, or outflows from, the fund—occur a NAV price that does not mitigate the transaction costs of buying or selling the assets in the fund, dilution occurs.58 In other words, dilution occurs when a fund’s NAV declines for existing (sedentary) 55 See POZEN, supra note 25, at 217 (describing redemption demands). 56 Id. See also FaceTime Interview with Anonymous, supra note 23 (in- terviewee commenting that losses compound over time to become significant and terming a loss on ten percent of a fund as “a big knock”); SEC LIQUIDITY WHITEPAPER, supra note 14, at 3. 57 See The Origins of the Financial Crisis, ECONOMIST (Sept. 7, 2013), https://www.economist.com/news/schoolsbrief/21584534-effects-financial- crisis-are-still-being-felt-five-years-article [perma.cc/YG5E-943E? type=im- age] (describing the factors that contributed to the financial crisis, the sys- temic impact of devaluations of CDOs, and the subsequent “fire-sale prices” of such assets); see also ROLLAND, supra note 35, at 183–84. 58 ASS’N OF THE LUX. FUND INDUS., ALFI SWING PRICING SURVEY 4 (Dec. 2015) [hereinafter ALFI 2015 SURVEY], http://www.alfi.lu/sites/alfi.lu/files/ALFI-Swing-Pricing-Survey-2015-FI- NAL.pdf [perma.cc/RT9M-XH54]. Tucker_VanDenToorn_Final No. 1:130] WILL SWING PRICING SAVE SEDENTARY SHAREHOLDERS? 145 shareholders when the fund buys or sells assets to accommo- date shareholder purchases or redemptions.59 The triggering shareholder(s) does not cover the transaction cost; rather, the existing shareholders do so with a reduced NAV. For example, assume that a fund has $100 million in total assets and that its NAV is $10.00. A typical redemption for a large institutional shareholder is $500,000, but a shareholder may become unhappy with the fund’s performance and decide to withdraw its entire investment in the fund—say, $5 mil- lion. In order to process the redemption and send cash pro- ceeds of $5 million to the exiting shareholder, the fund man- ager must sell five percent of the fund’s portfolio assets. At the time of the redemption order, the market is flat—i.e., assets were trading at stable and predictable prices—so the fund would have carried the $10.00 NAV to the next day. Once the transaction is underway, the rapid increase in sales depresses the market price, which, combined with transaction costs, de- creases the fund’s NAV to $9.90 per share.60 Funds are required to process the shareholder redemption at a price based on the next calculated NAV—i.e., on the day that the redemption order was placed.61 And the redeeming shareholder receives the $10.00 NAV for the following rea- sons. Funds typically sell securities on the same day, or the days immediately following a redemption order. 62 Funds book 59 To illustrate, consider a shareholder who redeems 1000 shares on a day when the fund’s NAV is $1000 per share, but the fund incurs significant transaction costs in meeting the shareholder redemption—costs that are not charged to the exiting fund shareholders, but which is a cost borne by the shareholders that stay in the fund. After the redemption closes, the fund’s NAV may decline to $990 per share resulting in a dilution in the value of the sedentary shareholders’ per share interest in the fund from $1000 to $990. See POZEN, supra note 25, at 263–65 (discussing the effect of large trade size on sale process and price); see also supra Section II.A. 60 See POZEN, supra note 25, at 263–65 (discussing the sale process in- volved in executing large trades and their effect on price); see also supra Section II.A. 61 Pricing of Redeemable Securities for Distribution, 17 C.F.R § 270.22c-1 (2017). 62 See Swing Pricing First Proposal, supra note 4, at 62326 (discussing the redemption process). TUCKER_VANDENTOORN_FINAL 146 COLUMBIA BUSINESS LAW REVIEW [Vol. 2018 the security sale price the next business day after the trans- action.63 The triggering shareholder escapes the negative fi- nancial impact caused by its redemption order because the fund has not yet recorded the financial implications of the se- curities transactions.64 The remaining shareholders’ portfolio value drops because of the decreased NAV—i.e., the dilution of their investment. The sedentary shareholders absorb trans- action-cost effects on the fund’s NAV and long-term perfor- mance.65 Fund performance declines by one percent in the above scenario, but only for the shareholders who remain in the fund at the discount NAV of $9.90, and not for the share- holders who exited at the $10.00 NAV. The remaining share- holders’ return on investment is thereby reduced by one per- cent in this limited scenario. Over time, these small negative price impacts equal a significant cumulative drag on perfor- mance over the lifespan of a sedentary shareholders’ invest- ment. One of the SEC’s primary objectives with respect to mutual funds is to minimize the impact of redemptions on the value of fund shares and prevent dilution.66 Portfolio managers also have a vested interest in minimizing dilution as it adversely affects the performance of the fund,67 and thus usually ad- versely affects the portfolio manager’s compensation.68 Port- 63 Id. This means that a fund records the transactions that affected the NAV on the day after the trades were executed (or trading day, noted as T+1). For example, a fund shareholder redeems shares on Monday, causing the fund manager to sell fund assets to meet the shareholder redemption. The sales may not be recorded, and therefore factored into NAV until Tues- day (T+1). 64 See supra Section II.A. 65 Anne M. Tucker, Locked In: The Competitive Disadvantage of Citizen Shareholders, 125 YALE L. REV. FORUM 163, 179 (2015). 66 Inv. Co. Inst. Comment Letter, supra note 9, at 9. 67 Id. at 10. 68 A portfolio manager’s bonus compensation is typically tied to the per- formance of the fund she manages. Disclosures relating to a portfolio man- ager’s compensation can be found in a fund’s Statement of Additional Infor- mation attached to the annual prospectus filing (Form NA-1). See e.g., Virtus Asset Trust, Supplement to Statement of Additional Information, Tucker_VanDenToorn_Final No. 1:130] WILL SWING PRICING SAVE SEDENTARY SHAREHOLDERS? 147 folio managers also, and importantly, owe shareholders a fi- duciary duty.69 A fund with a stable shareholder base and rel- atively low flows and transaction costs is likely to experience little dilution.70 Nonetheless, even a fund that experiences minimal dilution or shareholder activity can suffer a perfor- mance drag over time from paying transaction costs related to shareholder purchases and redemptions. Various jurisdictions, including the United States, have developed solutions for mitigating dilution. For example, since 2002 the United Kingdom’s Financial Services Authority (the “FSA”) has permitted funds to charge dilution levies.71 A fund may charge an entering or exiting shareholder a tax—i.e., a dilution levy—that is paid to the fund rather than to the fund manager.72 Part V discusses other methods such as redemp- tion fees, dual pricing, and redemptions in-kind to allocate transaction costs to triggering shareholders and addressing li- quidity needs. Many international jurisdictions already use swing pricing to combat the dilutive effects of unallocated transaction costs triggered by active shareholders. (July 17, 2017), https://www.virtus.com/assets/files/1bo/8622b_as- settrust_sai.pdf [perma.cc/G4AK-Z8NG] (“Each portfolio manager’s bonus may be structured differently but generally incorporates an evaluation of the Fund’s investment performance as well as other subjective factors.”). 69 Sec. & Exch. Comm'n v. Capital Gains Research Bureau, Inc., 375 U.S. 180, 191 (1963) (“The Investment Advisers Act of 1940 thus reflects a congressional recognition ‘of the delicate fiduciary nature of an investment advisory relationship,’ as well as a congressional intent to eliminate, or at least to expose, all conflicts of interest . . . .”). 70 Id. at 64. 71 Id. at E-7; see also COLUMBIA THREADNEEDLE INVS., Fund Charges and Costs Explained, http://www.columbiathreadneedle.com/fees/fund- charges-and-costs-explained/ [perma.cc/GW92-HH25] (providing an exam- ple of dilution adjustment transaction costs). 72 See Dilution Levy, SOMERSET CAPITAL MGMT., http://som- ersetcm.com/investment-approach/dilution-levy/ [perma.cc/E23A-XXRY] (describing a dilution levy event in June 2014). TUCKER_VANDENTOORN_FINAL 148 COLUMBIA BUSINESS LAW REVIEW [Vol. 2018 III. SWING PRICING A. Swing Pricing Overview Swing pricing is a process by which a mutual fund adjusts its daily NAV in an attempt to impose transaction costs on the shareholders initiating the expense-generating activity.73 A fund incurs transaction costs when a shareholder redeems shares, for example, and, as a result, the fund must sell port- folio securities to raise cash to meet the redemption order. Similarly, a large shareholder purchase into the fund will prompt the fund manager to purchase securities aligned with its investment strategy, again incurring certain transaction costs. Portfolio managers are typically more concerned with large redemptions than purchases, because purchases present less urgency to take action; a fund can maintain a cash posi- tion and wait for an opportune time to purchase securities. Expenses include transaction fees and charges—e.g., com- missions, custody fees, transfer taxes, or repatriation costs74—as well as costs such as market impact and spread costs arising from purchases or redemptions.75 Attributing ex- penses to the triggering, and mobilized, shareholder protects the existing, and sedentary, shareholders from incurring the expense and thereby diluting their shares.76 Simply stated, a fund’s NAV could be adjusted up in the event of a large pur- chase, and adjusted down in the event of a large redemption.77 A mutual fund can shield its investors from market impact by utilizing swing pricing. A mutual fund confronts market impact when it must sell securities at a lower price than it 73 See Swing Pricing First Proposal, supra note 4, at 62276 (defining swing pricing). 74 Swing Pricing First Proposal, supra note 4, at 62337; see also Final Rules, supra note 4, at 82105 (discussing transaction costs). 75 Swing Pricing First Proposal, supra note 4, at 62337; see also Final Rules, supra note 4, at 82105 (discussing redemptions). 76 Swing Pricing First Proposal, supra note 4, at 62329; see also Final Rules, supra note 4, at 82094 (discussing dilution). 77 Swing Pricing First Proposal, supra note 4, at 62329; see also Final Rules, supra note 4, at 82094 (discussing price adjustments). Tucker_VanDenToorn_Final No. 1:130] WILL SWING PRICING SAVE SEDENTARY SHAREHOLDERS? 149 would have if given more time to sell.78 At times, a fund may be compelled to sell a less liquid security, or a smaller market security where a large sale would depress the price, in order to meet a redemption.79 Shareholder inequity may motivate swing pricing imple- mentation. When costs diminish a fund’s NAV, shareholders who remain in the fund hold a portfolio with fewer reflected assets. Any shareholder who redeems the following day (or later) will do so at a lower redemption price,80 harming exist- ing fund shareholders. Conversely, the diminished NAV ben- efits an entering fund shareholder who is able to purchase more shares at an artificially lower price.81 Swing pricing, if applied in this situation, would cause a downward adjustment to the NAV, externalizing the transaction costs (from the per- spective of the fund and remaining shareholders) and allocat- ing it to the redeeming (exiting) shareholder. Swing pricing smooths NAV fluctuation and price impacts after large share- holder transactions, thereby supporting more consistent fund performance and diminishing the negative impact to, and un- equal treatment of, remaining shareholders.82 B. International Perspectives on Swing Pricing While swing pricing rules are new to U.S. markets, they reflect established mutual fund practice trends in Europe, with asset managers based in in the United Kingdom (the “UK”), Switzerland, and France applying swing pricing.83 78 See discussion supra Section II.A. 79 See discussion supra Section III.A. 80 See discussion supra Section II.B. 81 Such a significant NAV deterioration opens opportunities for arbi- trage, particularly for large institutional shareholders who may have mul- tiple accounts. Utilizing multiple accounts to conduct arbitrage—i.e., the selling out of one account and purchasing in another at an opportune time when the NAV is reduced significantly—permits the shareholder to circum- vent a fund’s short-term trading and market-timing monitoring process. 82 Final Rules, supra note 4, at 82130. 83 CHRISTINE CUSATIS, SWING PRICING 101, at 3 (2016), http://www.nicsa.org/downloads/White%20Papers/SwingPricing101_White Paper_March2016.pdf [perma.cc/W59S-SNMB]; see also FRENCH ASSET TUCKER_VANDENTOORN_FINAL 150 COLUMBIA BUSINESS LAW REVIEW [Vol. 2018 Luxembourg is the largest mutual fund capital in the world outside of the United States, and funds domiciled in Luxem- bourg have used swing pricing for two decades.84 In 2006, the Association of the Luxembourg Fund Industry (“ALFI”) con- vened a working group to study the theory and practice of swing pricing and released a swing pricing survey and guide- lines in 2011, with updates in 2015. 85 The SEC relied on ALFI research and data in creating the U.S. swing pricing proposed rules.86 The remainder of this Article compares and contrasts, where meaningful, the U.S. rules with those in European ju- risdictions. C. U.S. Swing Pricing Rules In October 2016, the SEC finalized and enacted the Liquid- ity Risk Management Program Rules87 and the Swing Pricing Rules,88 originally released September 22, 2015.89 All open- end management investment companies, excluding money market funds and exchange-traded funds (“ETFs”), must com- ply with the broader liquidity rules, and may implement swing pricing practices.90 The swing pricing rules—the focus of this Article—will be effective in November 2018,91 and the liquidity risk management program rules have a compliance MGMT. ASS’N, CODE OF CONDUCT FOR ASSET MANAGERS USING SWING PRICING AND VARIABLE ANTI-DILUTION LEVIES (2016), http://www.afg.asso.fr/wp-con- tent/uploads/2014/06/GuidePro_SwingPricing_actualise_2016_ENG.pdf [perma.cc/JK82-3WU2] (describing swing pricing policies and procedures in France). 84 CUSATIS, supra note 83, at 3. 85 ALFI 2015 SURVEY, supra note 58, at 6. 86 Swing Pricing First Proposal, supra note 4, at 62327; see also Final Rules supra note 4, at 82095 (citing to ALFI for guidance on swing pricing rules). 87 Final Liquidity Risk Rules, supra note 4, at 82142. 88 Final Rules, supra note 4, at 82084. 89 Swing Pricing First Proposal, supra note 4, at 62388. 90 Final Rules, supra note 4, at 82089; Final Liquidity Risk Rules, su- pra note 4, at 82142. 91 Final Rules, supra note 4, at 82084. Because swing pricing rules are optional, the rules have a stated effective date, not an effective compliance date. Tucker_VanDenToorn_Final No. 1:130] WILL SWING PRICING SAVE SEDENTARY SHAREHOLDERS? 151 date of December 1, 2018 for large funds and June 1, 2019 for small funds.92 The rules aim to promote fairness in invest- ments, prevent investor dilution, and discourage early re- demptions in times of heightened illiquidity.93 The following subsections explore the main swing pricing rule components, including the voluntary nature of the rules, the swing thresh- old, and the swing factor. They also examine a fund’s board of directors’ implementation and oversight responsibilities, fidu- ciary duties, as well as reporting and shareholder disclosure requirements. 1. Optional Swing pricing is optional, which creates an opt-in ap- proach.94 A mutual fund may implement swing pricing if the fund’s board of directors adopts swing pricing policies and pro- cedures.95 92 Final Liquidity Risk Rules, supra note 4, at 307. Because the liquid- ity risk management program rules are mandatory and thus the effective date is the same as the compliance date. 93 Final Rules, supra note 4, at 82117–18 (“The primary goals of the swing pricing regulations are to promote investor protection by allowing a fund, if it chooses, to use swing pricing to mitigate potential dilution of non- transacting shareholders’ interests that could occur when the fund incurs costs as a result of other investors’ purchase or redemption activity . . . . Furthermore, because redeeming shareholders do not bear the cost of exist- ing a fund, shareholders might have an incentive for early redemptions in times of liquidity stress because of a first-mover advantage, which could re- sult in further dilution of non-transactions shareholders’ interests. To the extent that such a first-mover advantage triggers the sale of less liquid port- folio investments at discounted or even fire sales prices, correlated invest- ments and funds and other investors holding these and correlated invest- ments will be negatively impacted . . . .”). 94 Id. at 82128 (“But because funds differ notably in terms of their par- ticular circumstances and risks, as well as with respect to the tools funds use to manage risks relating to liquidity and shareholder purchases and redemptions, we decided to adopt a rule that would permit swing pricing as a voluntary tool for funds.”). 95 Final Rules, supra note 4, at 82108. TUCKER_VANDENTOORN_FINAL 152 COLUMBIA BUSINESS LAW REVIEW [Vol. 2018 2. Swing Threshold A mutual fund that opts in to swing pricing must set a threshold at which its swing pricing procedures are triggered and NAV will be adjusted96—a practice known as partial, as opposed to “full,” swing pricing.97 Whether the swing pricing rules should be partial or full was a matter of debate in the rule comments, with the SEC electing a partial approach in the proposed and final rules.98 The swing threshold is a specified percentage of a fund’s NAV, and is triggered when the absolute value of net pur- chases and redemptions exceeds it.99 Trading within the mu- tual fund, as a whole, as opposed to within individual share classes, triggers the threshold.100 Balanced redemptions and purchases will not trigger swing pricing because the regula- tory focus is on net transactions.101 Swing pricing will only ap- ply to significant one-directional trading. The SEC established a process to set the swing threshold rather than prescribing a formula or set percentage for the threshold.102 The threshold, however, must be greater than 96 Final Rules, supra note 4, at 82088. 97 See ALFI 2015 SURVEY, supra note 58, at 4 (“Swing pricing has two distinct forms: First, the ‘full’ swing method, whereby the NAV adjusts up or down every NAV calculation day based on the direction of net capital activity regardless of the size of shareholder dealing; Second, the ‘partial’ swing method that is only invoked when the net capital activity is greater than a pre-determined threshold . . . .”). 98 Invesco, Comment Letter on Liquidity Management 6 (Jan. 13, 2016), https://www.sec.gov/comments/s7-16-15/s71615-75.pdf [perma.cc/ GV2Y-LW7K] (stating that it should be mandatory, partial swing pricing in order to encourage implementation and avoid the equalization critiques raised below). 99 Final Rules, supra note 4, at 82120. 100 Id. at 82099 (“[B]ecause the economic activity causing dilution oc- curs at the fund level, it would not be appropriate to employ swing pricing at the share class level to target such dilution.”). 101 Id. at 82128. Note that the SEC rejected comment suggestions that only net redemptions (as opposed to net subscriptions or redemptions) trig- ger the swing pricing threshold. Id. at 82097–98. 102 Id. at 82095, 82097 (“On balance, we [the SEC] continue to believe that setting a minimum threshold for all funds would not be appropriate, Tucker_VanDenToorn_Final No. 1:130] WILL SWING PRICING SAVE SEDENTARY SHAREHOLDERS? 153 zero.103 Funds using swing pricing must determine their own swing threshold based on fund size, cash and cash equiva- lents, borrowing, and historical purchase and redemption ac- tivities, among other factors.104 The SEC identifies four non-exhaustive “factors” for con- sideration in setting the threshold.105 These factors include fund portfolio contents and history, investment strategy and likely transaction costs, and cash holdings.106 Two factors— investment strategy and cash—overlap with the liquidity risk assessment components required under the suite of new li- quidity regulations.107 First, a fund should evaluate the “size, frequency, and vol- atility of historical net purchases or net redemption of fund shares during normal and stressed periods.”108 For example, consider a smaller fund with a shareholder who controls over fifty percent of the fund. The fund could experience an infre- quent but significant redemption, versus a large fund with a diverse base of shareholder constituents who trade frequently. The swing threshold for each fund would differ based upon in- vestor flow expectations. This factor also indicates that an in- vestment adviser who manages multiple funds in the same fund family may consider a different threshold for each fund.109 and that funds should be provided the flexibility to implement swing pricing at a threshold level that best fits their particular circumstances based on the required factors and the guidance set forth herein.”). 103 Final Rules, supra note 4, at 82097. 104 Final Rules supra note 4, at 82095. 105 Id. See also id. at 82096 (“The rule does not preclude a fund from considering other factors that the fund believes may be relevant.”). 106 Final Rules supra note 4, at 82095. 107 Final Rules, supra note 4, at 82096 (describing the overlap as “not surprising, because evaluating a fund’s liquidity risk may be relevant to de- termining the fund’s swing threshold”). 108 Final Rules, supra note 4, at 82095. 109 For example, if an investment adviser manages a large cap equity fund (highly liquid) with infrequent flows, a small cap equity fund (less liq- uid) with large flows, and an alternative fund (least liquid) with constant flows, the adviser may choose a different threshold for each based on each fund’s unique characteristics. An investment advisor may manage a variety TUCKER_VANDENTOORN_FINAL 154 COLUMBIA BUSINESS LAW REVIEW [Vol. 2018 Second, a mutual fund must consider its “investment strat- egy and the liquidity of the fund’s portfolio assets.” 110 As dis- cussed above,111 the asset type being sold is germane to its liquidity, which in turn affects the daily NAV of the fund. As- set types such as MBS, banks loans, and derivatives will nat- urally be less liquid than large-capitalization stocks and U.S. Treasury securities. If a significant portion of the fund portfo- lio is invested in equities or U.S. Treasuries, the fund’s thresh- old may need to be set higher, as it can better accommodate redemptions while still maintaining liquidity and a stable NAV than if it were heavily invested in bonds and MBS. Transaction costs unique to the asset market are a third, related factor.112 Different assets, as discussed above, have different exposure to market impact costs where liquidity and availability influence price fluctuations, especially in the face of a large transaction. In this way, the SEC requires that fund managers consider market impact costs in setting a threshold. Additionally, different portfolio assets have different commis- sions, expenses, etc.113 Fourth, funds must consider cash holdings and alternative funding sources.114 How much cash or cash equivalent a fund holds in anticipation of liquidity needs may offset the market impact of a less liquid portfolio. Many funds also currently uti- lize a credit facility such as a line of credit or inter-fund lend- of funds such as a small bank loan fund with frequent flows, a large-cap equity fund with minimal flows, a large alternative fund with average flows, and a mid-size U.S. Treasury fund with volatile flows based on market fluc- tuations. Because of the different asset types, sizes, and flows, and therefore the differences in the relative liquidity of each fund, the swing thresholds may be different based on each fund’s ability to meet its redemptions. 110 Final Rules, supra note 4, at 82095 (discussing Rule 22c-1(a)(3) and threshold factors). 111 See supra Section II.A. 112 Final Rules, supra note 4, at 82095. 113 The author has made this observation in her role in the mutual fund industry. See also POZEN, supra note 25, at 516 (discussing mutual fund fees). 114 Final Rules, supra note 4, at 82095. Tucker_VanDenToorn_Final No. 1:130] WILL SWING PRICING SAVE SEDENTARY SHAREHOLDERS? 155 ing, borrowing against it in order to satisfy a shareholder’s re- demption.115 Cash on hand, or the ability to borrow cash, to satisfy shareholder redemptions allows the fund to wait for a better market price with sufficient buyers and potentially curb losses from a forced sale of less liquid securities. Other jurisdictions’ experiences with swing pricing in- formed the SEC’s threshold framework.116 In December 2015, the ALFI—a main organization studying mutual fund swing pricing in the international mutual fund capital of Luxem- bourg—released new information on swing pricing.117 Accord- ing to the ALFI’s 2015 swing pricing survey, the most common swing threshold was one percent or less.118 Roughly half of re- spondents indicated a three percent swing threshold or less, and the remaining half of managers reported a three percent or more threshold.119 In addition, the majority of responding managers indicated that they distinguish thresholds by fund, primarily based on fund-specific characteristics such as in- vestment objective, fund size, or asset class.120 3. Swing Factor The swing factor is an amount, expressed as a percentage of the fund’s NAV, by which a fund adjusts its NAV per share once the swing threshold (discussed above) is met.121 The 115 The author has made this observation in her role in the mutual fund industry. 116 Final Rules, supra note 4, at 82096. 117 ALFI 2015 SURVEY, supra note 58, at 6; ASS’N OF THE LUX. FUND IN- DUS., SWING PRICING GUIDELINES 11 (2015) [hereinafter ALFI 2015 GUIDE- LINES], http://www.alfi.lu/ sites/alfi.lu/files/Swing-Pricing-guidelines-fi- nal.pdf [perma.cc/ URM6-Q5ZJ] (explaining that the ALFI provides additional considerations in setting the swing threshold: (1) setting a threshold too low will increase NAV volatility; (2) setting it too high will void the purpose of protecting from dilution; (3) whether a consistent thresh- old across all funds is appropriate; and (4) correlating high liquidity to a higher threshold and lower liquidity to a low threshold). 118 ALFI 2015 SURVEY, supra note 58, at 11. 119 Id. 120 Id. at 12. 121 Final Rules, supra note 4, at 82103. TUCKER_VANDENTOORN_FINAL 156 COLUMBIA BUSINESS LAW REVIEW [Vol. 2018 swing factor is the discount or tax applied to the NAV to ac- count for any near-term liquidity stress experienced by the fund. A fund’s swing factor must be calculated122 based on ex- pected near-term costs generated by net purchases or redemp- tions incurred on the day that the swing factor is used.123 Near-term costs are estimated costs that are not antici- pated to be incurred by the fund for several days, including spread costs.124 Transaction fees—including mark-ups and downs, brokerage commissions and custody fees, transfer taxes, repatriation costs, and fees for investments in other funds—are additional near-term costs.125 Charges resulting from purchases or sales and borrowing-related costs—such as interest charges or credit draw downs—generated with re- demptions are also near-term costs.126 Swing factors are not intended to be stable, but are de- signed to accommodate fluctuation.127 The swing factor can be determined using a base amount subject to adjustments or calculated based upon a formula or algorithm.128 Each participating fund sets their own swing pricing pro- cedures, subject to the following restrictions. First, any swing factor used must be reasonable in relation to the cost incurred by the fund.129 Second, a mutual fund’s board of directors must establish and disclose an upper swing limit that cannot 122 The designated swing pricing administrator within the fund sets the swing factor, though the upper limit must be approved by the board. Final Rules, supra note 4, at 82104, 82108. See also id. at 82108 (requiring swing pricing funds to designate an officer responsible for administering the policy). 123 Id. at 82104. 124 Id. 125 Final Rules, supra note 4, at 82104–05. See also Swing Pricing First Proposal, supra note 4, at 62336 (also including market impact costs, which were eliminated from consideration in setting the swing factor in the final rule). 126 Final Rules, supra note 4 at 82104–05; Swing Pricing First Pro- posal, supra note 4, at 62336–37. 127 Swing Pricing First Proposal, supra note 4, at 62336. 128 Final Rules, supra note 4, at 82107. 129 Id. at 82106. Tucker_VanDenToorn_Final No. 1:130] WILL SWING PRICING SAVE SEDENTARY SHAREHOLDERS? 157 exceed two percent of assets,130 which avoids high NAV ad- justments and resulting volatility.131 The two-percent cap re- flects common practice in Luxembourg, as well as similar caps on redemption fees under SEC Rule 22c-2 and restrictions on money market funds.132 The swing pricing limits reflect the balance the SEC struck between fund discretion and investor- protection concerns.133 The final swing pricing rules differ from the proposed rules by excluding market impact costs and asset values from the swing factors.134 The SEC cited difficulty in calculating mar- ket impact costs and the limited experience in other swing pricing jurisdictions.135 ALFI’s 2015 swing pricing survey doc- umented that few funds incorporate market impact costs into its swing factor.136 The final rules also excluded the value of assets purchased or sold from the swing factor because it would have required “a level of precision in setting the swing factor . . . that would undercut funds being able to set a swing factor on a periodic basis.”137 Asset value, if left in, would have required managers to evaluate possible future trades—a difficult task in volatile market conditions. Consider for example, that a fund manager 130 Id. at 82106. Funds must disclose the upper limits in Form N-1A and Form N-CEN. Id. at 82107. Under the proposed rules, a fund could choose a ceiling, but was not required to do so. Swing Pricing First Proposal, supra note 4, at 62337–38; Final Rules, supra note 4, at 82108–09 (discuss- ing comments received on swing pricing threshold). 131 See supra note 117. 132 Final Rules, supra note 4, at 82106–07; ALFI 2015 SURVEY, supra note 58, at 4, 11 (in its 2015 survey, ALFI notes that most fund managers set a cap on the swing factor, with two percent, the most common number). 133 Final Rules, supra note 4, at 82109. 134 Final Rules, supra note 4, at 82105. 135 Id. Note that the third swing threshold considers “costs associated with transactions in the markets in which the fund invests” so the rules indirectly incorporate market impact costs. Id. at 82095. 136 ALFI 2015 SURVEY, supra note 58, at 9–10. Other variations in the swing factor in European jurisdictions include a combination of bid/offer spread impacts, excluding transaction taxes, and even excluding explicit transaction costs. Id. 137 Final Rules, supra note 4, at 82105. TUCKER_VANDENTOORN_FINAL 158 COLUMBIA BUSINESS LAW REVIEW [Vol. 2018 may prepare to mitigate liquidity concerns if a threshold is met. She may utilize a credit facility138 with the plan to trade the following day after volatility has decreased. She has an idea of what to sell, but if the following day an off-setting pur- chase is made into the fund, it negates the need for any addi- tional securities transactions. Downward adjustment to the NAV because of the anticipated, but unrealized, transaction would invert the investor protection and anti-dilution princi- ples of the swing pricing rules. 4. BOD Implementation and Oversight The SEC’s swing pricing rules emphasize implementation procedures and ongoing oversight to facilitate accountability, fiduciary duty-triggering actions, and shareholder disclosure. a. Operational Accountability A fund must segregate swing pricing operations from fund portfolio management.139 A fund board must also appoint a swing pricing administrator—a fund officer, investment advi- sor, or committee—responsible for implementing and oversee- ing swing pricing.140 The swing pricing administrator submits 138 A credit facility is a line of credit available to funds from a bank or other financial institution that allows funds to borrow instead of selling shares in an unfavorable market in order to meet large redemptions or ad- dress liquidity concerns with small cap companies. See, e.g., LEE GREMIL- LION, MUTUAL FUND INDUSTRY HANDBOOK: A COMPREHENSIVE GUIDE FOR IN- VESTMENT PROFESSIONALS 115 (2005) (discussing fund lines of credit). 139 Final Rules, supra note 4, at 82108, 82110. The SEC clarified seg- regation requirements in the final rules and specifically excluded portfolio managers in order to discourage potential incentives to set swing factors to manipulate short-term performance, benchmark setting, and peer compar- isons. Id. at 82110–11. 140 Id. at 82108, 82110. See also Pricing of Redeemable Securities for Distribution, Redemption and Repurchase, 17 C.F.R. § 270.22c-1 (2017) (de- scribing redeemable securities). A fund’s valuation committee would be a natural fit to house swing pricing functions as they relate to the primary function of the valuation committee. For a discussion of mutual fund boards of directors, see GREMILLION, supra note 138, at 40–42 (discussing mutual fund board functions and committees). Tucker_VanDenToorn_Final No. 1:130] WILL SWING PRICING SAVE SEDENTARY SHAREHOLDERS? 159 a written report to the fund’s board. 141 The report must re- view the adequacy of the fund’s swing pricing policies and pro- cedures, implementation effectiveness, success in mitigating dilution, materials changes since the last report, and the fund’s compliance with swing threshold and factor require- ments under the SEC rules.142 The swing pricing administra- tor also must comply with record keeping requirements under SEC Rule 31a-2(a)(2) for computing and evidencing the daily NAV.143 When the swing threshold is met, the administrator must document the unswung NAV, data for the swing factor calcu- lation, the actual level of redemptions or purchases exceeding the threshold, the swing factor applied, and any back-testing data to verify the swing calculation.144 b. Board Accountability & Fiduciary Duty A fund’s board of directors must establish swing pricing policies and procedures—importantly the swing threshold, swing factor, and swing procedures—approved by a majority of the fund’s independent directors.145 Additionally the board reviews the swing pricing reports and implementation process at least annually.146 The SEC likens the board’s role with 141 The swing pricing report is another reason to consider locating swing pricing functions within the valuation committee because the re- port—similar to the new compliance and new LMP reports—would likely entail back testing and other types of verification, which are analyses al- ready performed by the fund’s valuation committee. For a discussion of the types of post-trade compliance monitoring that may be a part of a fund’s valuation committee work, see GREMILLION, supra note 138, at 121–23 (de- scribing post trade compliance procedures). 142 Final Rules, supra note 4, at 82108–09. See also Liquidity Risk Management Programs, 17 C.F.R. § 270.22e-4 (2017). 143 Final Rules supra note 4, at 82111. 144 Id. at 82125. 145 Id. at 82108–09. 146 Id. at 82109, 82111. See also Compliance Procedures and Practices of Certain Investment Companies, 17 C.F.R. § 270.38a-1 (2017) (requiring that a board receive reports on policies and procedures reasonably intended to prevent the violation of federal securities law, including Rule 22c-1). TUCKER_VANDENTOORN_FINAL 160 COLUMBIA BUSINESS LAW REVIEW [Vol. 2018 swing pricing to its significant responsibility regarding valu- ation and pricing related matters under the Investment Advi- sors Act.147 The SEC attempts to strike the right balance between board oversight and the role of management in daily opera- tions with the swing pricing rules.148 The required fund board actions under the rules trigger fiduciary duties and actions must be taken in the best interest of fund shareholders. Fidu- ciary duty liability follows board action and, at least symboli- cally, transaction-price monitoring.149 In discharging its du- ties, the board may rely upon officer reports and data provided by management, including the swing pricing administra- tor.150 147 Final Rules, supra note 4, at 82108. See also Investment Advisors Act, 15 U.S.C. § 80a-2 (2017) (“‘Value’, with respect to assets of registered investment companies . . . means . . . with respect to other securities and assets owned at the end of the last preceding fiscal quarter, fair value at the end of such quarter, as determined in good faith by the board of directors.”). SEC regulations regarding securities valuation include 17 C.F.R. §§ 2a-4, 2a-7(c)(1)(i), 2a-7(g)(1)(i)(A)–(C), and 18f-3d. 148 Final Rules, supra note 4, at 82108. Some commentators requested that the fund advisor, with better daily operational knowledge, oversee and administer swing pricing. 149 Id. at 82109. See also Interpretive Matters Concerning Independent Directors of Investment Companies, Investment Company Act Release No. 24083, 64 FR 59877, 59877–79 (Nov. 3, 1999) (discussing the independence of mutual fund directors). For a discussion of the perceived conflict of inter- est between mutual fund boards of directors and the investor advisors, es- pecially as related to fee structures and oversight functions, see, e.g., R. GLENN HUBBARD ET AL., THE MUTUAL FUND INDUSTRY: COMPETITION AND IN- VESTOR WELFARE 20–24 (2010); cf. Donald C. Langevoort, Private Litigation to Enforce Fiduciary Duties in Mutual Funds: Derivative Suits, Disinter- ested Directors and the Ideology of Investor Sovereignty, 83 WASH. U. L.Q. 1017, 1040 (2005) (“One can have relatively moderate expectations for the performance of disinterested directors and still believe that the strategy adds some value, and there is a body of evidence to support this.”). 150 Final Rules, supra note 4, at 82110. See also Letter of Michael Did- iuk, Div. of Inv. Mgmt., SEC, to Dorothy Berry, Chair, Indep. Dirs. Council and Jameson Baxter, Chair, Mutual Fund Dirs. Forum (Nov. 2, 2010), https://www.sec.gov/divisions/investment/noaction/2010/idc- mfdf110210.pdf [perma.cc/73AY-D8DW] (urging mutual fund board reli- ance on summary quarterly reports). Tucker_VanDenToorn_Final No. 1:130] WILL SWING PRICING SAVE SEDENTARY SHAREHOLDERS? 161 A participating fund’s board of directors is responsible for overseeing policies to identify and correct errors in swing pric- ing estimates and application.151 The swing pricing adminis- trator, overseen by a fund’s board of directors, is responsible for ensuring the reasonableness and accuracy of any swing pricing system.152 c. Transparency & Shareholder Disclosures In the final rules and in response to extensive comments, the SEC revised the reporting components of price deviations on participating funds’ financial statements. Utilizing Form N-1A, the annual registration form for investment compa- nies,153 participating funds must report swing pricing compo- nents in a fund’s financial highlights, notes to the financial statement, statement of assets and liabilities, and statement of changes in net assets.154 The financial highlights section of Form N-1A is the focus of the required disclosures. Funds’ financial statement notes will include disclosures that a fund has adopted swing pricing, the methods to determine whether the swing threshold is met, whether swing pricing was utilized in the reporting period, and if so, what effects it had on a fund’s reported NAV.155 Funds must explain swing pricing to provide investors with 151 Final Rules, supra note 4, at 82111–12. Policies may include the swing pricing estimate components and the use of back testing of estimated fund flows to verify the accuracy and reliability of a fund’s estimation tech- niques. Id. at 82114–15. 152 Id. at 82115 (noting that it is not a fund’s auditor’s responsibility to ensure reasonableness and accuracy because auditors do not have the req- uisite “expertise”). 153 Form N-1A. See also 17 C.F.R. § 270.8b-5 et seq. (2005). 154 Final Rules, supra note 4, at 82111–13. Participating funds are also encouraged to discuss swing pricing, as applicable, in the existing prospec- tus and statement of additional information sections. See id. at 82116 n.366. 155 Id. at 82114. See SEC Form N-1A., Item 6(d). The required disclo- sures are similar to what funds report when using securities lending pro- grams or lines of credit. Questions remain about whether auditors and coun- sel must, or should, provide opinions about the appropriateness of the actions taken. TUCKER_VANDENTOORN_FINAL 162 COLUMBIA BUSINESS LAW REVIEW [Vol. 2018 the general information needed to understand it.156 Partici- pating funds must report the upper swing limit. The SEC characterized the reported upper limit as a “critical” disclo- sure assisting investors in comprehending investment risks associated with particular funds.157 It also creates transpar- ency regarding potential price adjustments. Importantly, and to prevent gaming and unfair trading, participating funds are not required to disclose the swing threshold or swing factor in the prospectus.158 Participating funds must make additional disclosures in a variety of formats and subject to different valuation stand- ards. For example, participating funds can report the swung NAV as a separate line item in addition to the GAAP (the U.S. Generally Accepted Accounting Principles) NAV.159 Partici- pating funds will report the GAAP NAV, rather than a swung NAV, on the statement of assets and liabilities160 and in com- municating shareholders’ total financial return.161 Participat- ing funds will report the swung NAV on the statement of changes in net assets to reflect the number of shares and the dollar amounts received and paid for shares for shares sold or redeemed.162 The technical specificity of the additional disclo- sure rules reveal the operational complexity and fundamental change to mutual fund operations required by swing pricing. 156 Id. at 82116. See also SEC Form N-1A, Item 6 (instructing funds on required share purchase and sale disclosures). 157 Final Rules, supra note 4, at 82106. See also Amended Part C of Form N-CEN (outlining disclosure of the swing factor upper limit). 158 Final Rules, supra note 4, at 82116. 159 Id. at 82113. 160 The final rules did not implement an amendment to Regulation S- X rule 6-04.19 to require funds to disclose the swung NAV, as originally proposed. Id. at 82112. The GAAP NAV should incorporate the effects of swing pricing through the accounting period. Id. 161 Id. at 82113–14 (citing to the incorporation of swung NAV pricing effects in the total return using GAAP NAV). 162 Id. at 82113. See also 17 CFR 210.6-09.4(b) (establishing the current regulations on mutual fund share price reporting). Tucker_VanDenToorn_Final No. 1:130] WILL SWING PRICING SAVE SEDENTARY SHAREHOLDERS? 163 IV. ANALYSIS OF SWING PRICING COMMENTS & RULE RAMIFICATIONS The mutual fund industry actively participated in the no- tice and comment period of the proposed rules and influenced the final rules. The SEC extended the liquidity rule comment period to January 13, 2016, during which time it received 89 comments, 48 of which addressed swing pricing. Roughly half (48.8%) generally supported swing pricing, and half did not. The submitted comments varied in length, relevance, and technicality.163 The comments provided a technical back- ground to the proposed rules, and informed the analysis of the benefits and detriments of the rules in the following subsec- tions. The swing pricing comments grouped around the following issues: general liquidity benefits, cost spreading and dilution, the role of board oversight, transparency/disclosure issues to shareholders, implementation expenses, operational concerns regarding the timing and price calculations in the U.S. mutual fund market, and the lack of a safe harbor for pricing errors. 163 See, e.g., John Wahh, Comment Letter on Swing Pricing (Oct. 1, 2015), https://www.sec.gov/comments/s7-16-15/s71615-2.htm [perma.cc/ 83BQ-8YHS] (totaling 1 page in length); cf. Inv. Co. Inst. Comment Letter, supra note 9 (totaling 117 pages in length). TUCKER_VANDENTOORN_FINAL 164 COLUMBIA BUSINESS LAW REVIEW [Vol. 2018 FIGURE 1: SWING PRICING COMMENTS BY CATEGORY A. Benefits Swing pricing promises three main benefits to individual investors, the mutual fund industry, and the investment land- scape. First, swing pricing may benefit individual investors by mitigating dilution of invested assets caused by other inves- tors’ transactions costs. Second, swing pricing offers benefits to mutual funds through higher reported investment returns and a larger asset pool if funds can successfully siphon out transaction costs from its valuations. Third, swing pricing re- moves disincentives for long-term investment positions (the default of so many American retirement investors), counters first-mover advantages in a liquidity crisis, and levels the playing field between active and sedentary investors. In Part VI, this Article evaluates the relative weight of these benefits from the authors’ academic and industry perspectives. Swing pricing counteracts the dilutive nature of mutual fund shareholder purchases and redemptions where the transaction cost of the activity may not be fully paid by the initiating shareholders.164 Without swing pricing, long-term 164 Inv. Co. Inst. Comment Letter, supra note 9, at 56. Expenses 6 Intermed. 13 Safe Harbor 14 Timing 20 BOD 21 Disclos. 23 Flex. 28 0 5 10 15 20 25 30 Comment Category Swing Pricing Comments Expenses Intermed. Safe Harbor Timing BOD Disclos. Flex. Tucker_VanDenToorn_Final No. 1:130] WILL SWING PRICING SAVE SEDENTARY SHAREHOLDERS? 165 mutual fund shareholders who were, and remain, investors in the fund may finance and subsidize transaction costs associ- ated with mutual fund shareholder exit or new investment.165 SEC comments generally supported the dilution-mitigating effects of swing pricing.166 Shifting transaction costs to trig- gering shareholders and away from the existing shareholders facilitates equitable pricing and returns among all sharehold- ers. Swing pricing removes the unintended preferential pric- ing that funds may inadvertently give to active, over seden- tary, investors. Experts debate the superiority of certain investment strat- egies and approaches, but there is evidence and agreement on the eroding effects of fees on investment returns.167 The indi- vidual transaction costs shifted from triggering, active mutual fund shareholders to sedentary, long-term mutual fund share- holders is small compared to mutual fund assets as a whole, and even the assets of individual investors. The collective transaction costs, especially when applied to sedentary share- holders investing in a single fund over an extended period, is significant in absolute terms.168 A 2013 study estimated that 165 ALFI 2015 SURVEY, supra note 58, at 6. 166 See Charted Fin. Analyst Inst., Comments Letter on Swing Pricing, (Jan. 12, 2016), https://www.sec.gov/comments/s7-16-15/s71615-34.pdf [perma.cc/ Q874-6BKW] (“We generally support giving funds the option to use swing pricing as a way to mitigate the dilution of share value for fund shareowners as a result of transaction costs related to purchases and re- demptions.”). 167 See e.g., Investor Bulletin: Mutual Fund Fees and Expenses, SEC (May 12, 2014), https://www.sec.gov/files/ib_mutualfundfees.pdf [perma.cc/P3GK-CB6C] (“The more you pay in fees and expenses, the less money you will have in your investment portfolios, and These fees and ex- penses really add up over time. Given the compounding effect of fund fees and expenses and their impact on your investment returns, you may want to use a mutual fund cost calculation to compute how the costs of different mutual funds would add up over time.”). 168 High mutual fund fees can consume up to thirty percent of an in- vestor’s return on a thirty-year investment, and liquidity fees contribute to the erosion of investor returns. Liquidity fees are relatively low in compar- ison with fees charged by mutual funds, but in absolute terms, liquidity transaction costs extract real costs from sedentary investors. See e.g., Su- sanna Kim, 401(k) Fees May Cut 30% from Retirement Balance, ABC NEWS TUCKER_VANDENTOORN_FINAL 166 COLUMBIA BUSINESS LAW REVIEW [Vol. 2018 sedentary mutual fund investors absorbed trading and liquid- ity costs of $10–17 billon.169 Additional studies estimated the trading costs reduced annual returns “of actively managed U.S., international and global equity mutual funds by an av- erage of 26 basis points on an equal-weighted basis and 20 basis points asset-weighted over the 2007 to 2013 period.”170 Mutual fund investors entering through a retirement savings plan—such as a 401(k)—are among the investors likely to bear the residual transaction costs if unmitigated by swing pricing.171 In addition to preventing an undue advantage to active mutual fund shareholders, swing pricing may positively affect mutual fund shareholder returns and correlated fund man- ager compensation.172 The 2015 ALFI survey demonstrated (May 30, 2012), http://www.demos.org/news/401k-fees-may-cut-30-retire- ment-balance [perma.cc/3QUP-XLGN] (reporting that average 401(k) fees can consume thirty percent of retirement savings); see also Tucker, supra note 65, at 181. 169 Miles Livingston & David Rakowski, Mutual Fund Liquidity and Conflicts of Interest, 23 J. APPLIED FIN. 95, 97–103 (2013); see also Tucker, supra note 65, at 179. 2016 SEC comments from the same sources estimated the dilution costs at $20 billion annually. Seymour Sacks, Sacks Equaliza- tion Model, Inc., Comment Letter on Swing Pricing (Nov. 20, 2015), https://www.sec.gov/comments/s7-16-15/s71615-19.pdf [perma.cc/9A6L- CJ2Q] (estimating “that this trading activity fees and including market im- pact costs, are costing existing shareholders an estimated total of $20 billion a year”). 170 Eaton Vance Inv. Advisors, Comment Letter on Swing Pricing (June 13, 2016) https://www.sec.gov/comments/s7-16-15/s71615-151.pdf [perma.cc/RCX3-MYL]; see also Swaffield, Comment Letter on Swing Pric- ing 8–9 (Jan. 13, 2016). 171 Retirement investors entering through plans such as 401(k) have limited exit options because they “are likely to be low-dollar (due to contri- bution limits); long-term (due to tax penalties on preretirement-age with- drawals); and unsophisticated in account allocation strategies and manage- ment.” Tucker supra note 65, at 164. See also id. at 168–69 (discussing why retirement investors are comparatively “locked in” or sedentary compared with retail investors). 172 Cf. Eaton Vance Comment Letter, supra note 170 (disclaiming the net benefits of swing pricing). “[T]he aggregate returns of fund sharehold- ers, before expenses, are exactly the same whether or not a fund uses swing pricing. It’s a zero sum game: the observed improvement in fund returns Tucker_VanDenToorn_Final No. 1:130] WILL SWING PRICING SAVE SEDENTARY SHAREHOLDERS? 167 swing pricing’s positive effect on mutual fund returns.173 By shielding the fund, and therefore the investors, from liquidity transaction costs, the fund retains a larger asset pool, which in turn increases NAV, or the trading value of the fund.174 If, for example, a fund reallocates $1 million in liquidity transac- tion costs to the triggering/active shareholders, then the fund’s assets under management reflect the retained $1 mil- lion, the NAV reflects the higher asset pool, and manager’s performance incentives are calculated based on the higher as- set pool. The SEC posits that swing pricing could “indirectly foster capital formation by bolstering investor confidence.”175 The theory is that if potential investors, particularly long- term investors, understand the anti-dilution protections of swing pricing, they will be more likely to invest in mutual funds offering swing pricing.176 Swing pricing’s positive ef- fects may be the carrot that the mutual fund industry needs in order to undertake the operational and organizational changes necessary to implement swing pricing. Recall that swing pricing is optional, meaning that funds will only partic- ipate if it makes economic sense to do so. that comes with swing pricing is sourced from, and equally offset by, the net transaction costs paid by buyers and sellers of fund shares each day that swing pricing is in effect. After expenses, swing pricing actually reduces ag- gregate shareholder returns by the amount of fund expenses incurred to implement the fund’s swing pricing program.” Id. 173 ALFI 2015 SURVEY, supra note 58, at 6. 174 Id. 175 Swing Pricing First Proposal, supra note 4, at 62369. See also Final Rules supra note 4, at 82126. The authors question this logic and ask which investors they are referring to. Individual retirement investors are unlikely to understand swing pricing or seek it out, which leaves sophisticated in- vestors to do so. Many retirement investors invest through employer-spon- sored plans where investment professionals select and monitor the plan’s menu of investment options. The persistence of high-fee funds and potential conflicts of interest through revenue sharing are common criticisms of the effectiveness of the professional investment services provided to 401K in- vestors. See e.g., Ian Ayres & Quinn Curtis, Beyond Diversification: The Per- vasive Problem of Excessive Fees and “Dominated Funds” in 401(k) Plans, 124 YALE L.J. 1476, 1487–91 (2015). 176 Final Rules, supra note 4, at 82126. TUCKER_VANDENTOORN_FINAL 168 COLUMBIA BUSINESS LAW REVIEW [Vol. 2018 Swing pricing may also deter short-term trading and pos- sible market-timing or arbitrage.177 Imposing liquidity trans- action costs on triggering shareholders increases the price at which one can earn a short-term sale profit, and therefore in- creases the risks of short-term trading. The 2015 ALFI Guide- lines note that a shareholder’s investment will likely need to increase by at least double the value of the swing factor in or- der to recoup costs and realize a gain.178 Swing pricing deter- rence would work on top of existing anti-market-timing tools that funds independently possess, permitting restrictions on market-timing shareholders.179 Mutual funds’ use of existing market-timing tools180 mitigates deterrence benefits gained from swing pricing rules. 177 Id. 178 Id. 179 Market-Timing Rule, 17 C.F.R § 270.22c-2. The SEC began to re- quire disclosure in a fund’s prospectus regarding the risks of frequent pur- chases and redemptions of fund shares, including the risk of dilution and the increased trading and administrative costs. As a result of these risks, the SEC also required a fund to disclose its policies and procedures designed to deter frequent trading, including the specific restrictions such as the number of “round trips” (in and out = 1 round trip), minimum holding peri- ods, redemption fees, or other restrictions a fund may have on purchases and redemptions. Funds may also impose restrictions on individual share- holders who may be deemed to be disruptive shareholders based on their transaction history and the circumstances surrounding the transactions. Disclosure Regarding Market Timing, 69 Fed. Reg. 22300 (Apr. 23, 2004) (codified at 17 C.F.R. pts. 239, 274) [hereinafter Market Timing Disclosure Rule]. 180 Each fund is required to disclose whether the fund’s board of direc- tors has adopted a frequent trading policy and procedures; or, if not, the specific basis for the board’s determination that it does not need such policy and procedures. The vast majority of fund boards have adopted a frequent trading policy and procedure, which it can define as it sees fit. Funds must disclose any restrictions or limitations it may impose on shareholders deemed to be “frequent traders.” For example, a fund may choose a policy that prohibits a shareholder from purchasing a fund within thirty days after the shareholder sells the fund. Funds must also disclose any fees imposed to shareholders deemed to be frequent traders. Market Timing Disclosure Rule, supra note 179, at 22302. Tucker_VanDenToorn_Final No. 1:130] WILL SWING PRICING SAVE SEDENTARY SHAREHOLDERS? 169 In times of liquidity stress, mutual fund shareholders may perceive a first-mover advantage181 in racing to redeem their mutual fund shares at a declining, but not bottom, price.182 Redemptions motivated by concerns about a tanking fund price can generate significant outflows, exacerbating the price declines and creating a mutual fund run. A fund experiencing large outflows “may be exposed to predatory trading activity in the securities it holds.”183 Shareholders remaining in the fund suffer the consequences of these actions—namely a “ma- terial dilution” of the fund’s’ assets.184 Existing redemption fees may stem first-mover advantage concerns, and swing pricing would add additional deterrence.185 The SEC de- scribed the intended disincentive as: [I]f non-transacting shareholders understood that re- deeming shareholders—especially shareholders seek- ing to redeem large holdings—would bear the esti- mated costs of their redemption activity, it would reduce shareholders’ incentive to redeem large hold- ings quickly because there would be less risk that non- transacting shareholders would bear the costs of other shareholders’ redemption activity.186 The absence of a minimum swing pricing threshold under the rules further discourages a first-mover advantage.187 181 The first mover advantage identifies the incentive to sell before the transaction costs of a large redemption are incurred. A shareholder not per- sonally interested in selling shares may decide to do so if they perceive that other, especially large, shareholders will redeem their shares. The incentive to be the first, if shared among a large group of shareholders, can create a run on a fund, which accelerates the negative pricing pressures that funds may experience when they need to meet large redemption orders. See Final Rules, supra note 4, at 82091. 182 Id. at 82086. 183 Id. 184 Id. 185 Id. at 82091. Cf. Eaton Vance Comment Letter, supra note 170, at 9 (arguing that an undisclosed swing factor and threshold cannot meaning- fully influence shareholder behavior). 186 Final Rules, supra note 4, at 82091. 187 Id. at 82091, 82096–97. “Swing pricing provides funds with an ad- ditional tool to pass estimated near-term costs stemming from shareholder TUCKER_VANDENTOORN_FINAL 170 COLUMBIA BUSINESS LAW REVIEW [Vol. 2018 An equalization rationale or level mutual fund playing field may be a silent or unacknowledged force behind the swing pricing rules.188 Mutual funds currently enjoy popular and policy prominence in retirement savings. Mutual funds are a key design component of individual investors’ financial stability and in American retirement policy. Perceived, and documented, inequities in the system are undesirable, partic- ularly those without a market solution that extract costs from long-term retirement investors. Mutual fund inattention to disparities may create a public relations crisis, if not a regu- latory one, in the future—the kind that leads to severe inter- vention or more restrictive regulation, in addition to public backlash. The optional swing pricing rules may be an oppor- tunity for mutual funds to address these inequities on mostly their own terms and timetable without more onerous SEC in- tervention. While not explicitly stated in any of the comments or the SEC’s preamble to the swing pricing rules, the equali- zation and public opinion rationales may be driving forces be- hind the rules. B. Swing Pricing Obstacles Challenges litter the path to achieving the promised bene- fits of swing pricing described above, and they are catalogued in this Subsection. These challenges may be thought of as op- erational and conceptual in origin. The operational challenges purchase or redemption activity on to the shareholders associated with that activity, and could therefore lessen dilution of non-transacting shareholders and limit any possible redemptions motivated by a potential first-mover ad- vantage.” Id. at 82121. 188 Consider, for example, the text accompanying the swing pricing rules: In order to effectively mitigate possible dilution arising in connection with shareholder purchase and redemption ac- tivity, a fund’s swing threshold should generally reflect the estimated point at which net purchases or net redemptions would trigger the fund’s investment adviser to trade portfo- lio assets in the near term, to a degree or of a type that may generate material liquidity or transaction costs for the fund. Id. at 82096. Tucker_VanDenToorn_Final No. 1:130] WILL SWING PRICING SAVE SEDENTARY SHAREHOLDERS? 171 relate to fund data, the mechanics of the mutual fund market, and funds’ risk in cost estimates without a safe harbor. Con- ceptually, swing pricing rules raise concerns about price vola- tility, imperfect equalization among mutual fund sharehold- ers, and compliance costs and priority. Conceptual criticisms would persist even after a mutual fund industry operations adjustment to implement swing pricing. Part VI evaluates the relative impediments posed by these challenges from both ac- ademic and industry perspectives. 1. Operational Challenges BlackRock and Vanguard, two of the largest U.S. mutual funds, expressed support for swing pricing as an option to mit- igate shareholder dilution while simultaneously cautioning that the U.S. mutual fund industry does not have the pricing and data capabilities to successfully implement it.189 A seem- ingly insurmountable time conflict exists for mutual funds un- der current procedures. Funds receive the information needed to trigger swing pricing late in the day, but must report either a standard or swung NAV early in the day. This time conflict creates a scenario where funds may end up electing to swing the fund with incomplete information—aptly called blind swinging—and must do so without a liability shield. The mu- tual fund industry is understandably nervous about these cru- cial operational questions because any change to operating procedures will affect mutual funds and the intermediaries that service them. In short, operational changes are necessary 189 BlackRock and Vanguard, large institutional players in the mutual fund industry, express support for swing pricing as well as concerns regard- ing the current operational viability of swing pricing in the United States, stating that the SEC should delay the rule or assist in facilitating industry change that would be necessary to implement swing pricing. See Barbara Novick & Benjamin Archibald, BlackRock, Comment Letter on Swing Pric- ing, at 7 (Jan. 13, 2016), https://www.sec.gov/comments/s7-16-15/s71615- 36.pdf [perma.cc/X2KY-HWH7]; see also Mortimer J. Buckley, Vanguard, Comment Letter on Swing Pricing, at 16–17 (Jan. 6, 2016), https://www.sec.gov/comments/s7-16-15/s71615-29.pdf. [perma.cc/BV6X- FEW7]. TUCKER_VANDENTOORN_FINAL 172 COLUMBIA BUSINESS LAW REVIEW [Vol. 2018 to implement swing pricing, and those changes will be time- consuming, costly, and difficult. a. Mutual Fund Data & Market Timing The timing of U.S. mutual fund operations creates a “blind” swing pricing implementation where funds must declare the trading threshold met without complete trading information. Twenty SEC comments discussed these data timing chal- lenges, approximately forty-two percent of the comments re- ceived.190 Several industry commentators decried the existing operational feasibility in the mutual fund industry, and its re- liance on intermediaries, to support swing pricing.191 Consider first that U.S. mutual funds strike the daily NAV shortly after the trading deadline of 4:00 pm (eastern stand- ard time zone), the time by which most funds receive their purchase and redemption orders.192 Funds would swing the daily NAV price, if appropriate, by adjusting it per the swing factor for liquidity costs due to trading volumes. Broker-deal- ers and other intermediaries like retirement accounts, how- ever, are permitted to transmit orders to funds after the 4:00 pm deadline and after the NAV price is struck.193 The 4:00 pm trading deadline applies to intermediaries, who may receive a 190 See e.g., Inv. Co. Inst. Comment Letter, supra note 9, at 21 (discuss- ing the operational challenges of the “arbitrary time intervals” in the pro- posed rules); see also supra Figure 1. For a complete list of comments on the Proposed Rule: Open-End Fund Liquidity Risk Management Programs; Swing Pricing; Re-Opening of Comment Period for Investment Company Reporting Modernization Release, visit https://www.sec.gov/comments/s7- 16-15/s71615.shtml [perma.cc/AYQ5-JNGA]. 191 See, e.g., Marc R. Bryant, Fidelity Mgmt. & Research Co., Comment Letter on Swing Pricing, at 11 (Jan. 13, 2016), https://www.sec.gov/com- ments/s7-16-15/s71615-45.pdf [perma.cc/Z8LJ-SK33] (cautioning that “the existing operational systems supporting the mutual fund industry will not support effective swing pricing”). 192 Id. at 11–12. See also Timothy W. Cameron & Lindsey Weber Keljo, Sec. Indus. and Fin. Mkts. Ass’n, Comment Letter on Swing Pricing (Jan. 13, 2016), https://www.sec.gov/comments/s7-16-15/s71615-65.pdf [perma.cc/ UB97-PPY9] (setting out in detail the timing of receipt of fund flow infor- mation to U.S. mutual funds). 193 Vanguard Comment Letter, supra note 189, at 17 n.47. Tucker_VanDenToorn_Final No. 1:130] WILL SWING PRICING SAVE SEDENTARY SHAREHOLDERS? 173 purchase or sale order from individual investors through the close of trading. Intermediaries need time to aggregate and transmit the buy and sell orders to the respective funds, which happens after the 4:00 pm trading deadline, and processing occurs throughout the night.194 Mutual funds strike the NAV between 6:00–8:00 pm, and often without complete purchase order information.195 While broker-dealer intermediaries may accept orders until 4:00 pm, these intermediaries do not transmit the orders to the fund company until after 4:00 pm. In the U.S., a significant percentage of shareholder transactions through intermediaries are not transmit- ted to the fund company until after the fund’s NAV is calculated. The primary mechanism for these interme- diaries to submit trades is through the National Secu- rities Clearing Corporation, which allows intermedi- aries to transmit the amount of shares until 8:30 pm for orders that met the proper order cutoff of 4:00 pm.196 The Securities Industry and Financial Markets Associa- tion (“SIFMA”) reports that an estimated eighty percent of shareholders do not invest directly with a fund, but rather through a financial intermediary such as a retirement plan.197 Most funds, SIMA cautioned, will not “have sufficient infor- mation about fund flows at the time the NAV is struck to de- termine whether the swing threshold has been breached and thus the NAV should be adjusted.”198 Certain intermediaries, such as retirement plans and insurance companies, may re- quire the NAV before processing fund trading thus further ex- 194 Id. See also INV. CO. INST., EVALUATING SWING PRICING: OPERA- TIONAL CONSIDERATIONS 6 (2016), https://www.ici.org/pdf/ppr_16_evaluat- ing_swing_pricing.pdf [perma.cc/SY32-JW29] [hereinafter INV. CO. INST. CONSIDERATIONS]. 195 Vanguard Comment Letter, supra note 189, at 17 n.47. See also INV. CO. INST. CONSIDERATIONS, supra note 194, at 6. 196 Fidelity Comment Letter, supra note 191, at 12. 197 Sec. Indus. and Fin. Mkts. Ass’n, supra note 192, at 15–16. 198 Id. at 3. TUCKER_VANDENTOORN_FINAL 174 COLUMBIA BUSINESS LAW REVIEW [Vol. 2018 tending the time for funds to receive complete trading infor- mation and complicating the information loop needed to im- plement swing pricing accurately.199 Under swing pricing rules, a fund must evaluate net share- holder activity to determine if the swing threshold has been met before the NAV is struck.200 The most crucial component of the swing pricing framework is whether the swing thresh- old has been met or not. Estimating a swing threshold for pur- poses of adjusting—or swinging—the NAV shortly after the 4:00 pm deadline, and without complete trading information, creates an operational impediment and forces “blind” swing- ing by participating funds.201 One industry commentator sum- marized the “conflicting requirements”: Established workflows provide for the broker-dealers, bank trust departments, retirement recordkeepers and other intermediaries that process the vast major- ity of mutual fund purchases and redemptions to use the current transaction price as an input in their daily processing. Among other considerations, intermediar- ies require receipt of the current transaction price to translate the value of customer orders expressed in share amounts or as percentages of holdings into dol- lar amounts. So long as fund transaction processors and distribution intermediaries require a fund’s price as an input into their processes for determining the value of daily net fund flows, the swing pricing re- quirement that a reliable estimate of daily net flows is available at the time the daily transaction price is es- tablished cannot be fulfilled.202 199 Final Rules, supra note 4, at 82100–01. 200 Inv. Co. Inst. Comment Letter, supra note 9, at 55–56, 59–60. 201 Dechert LLP, Comment Letter on Swing Pricing, at 20 (Jan. 13, 2016), https://www.sec.gov/comments/s7-16-15/s71615-70.pdf [perma.cc/ 2M5T-367H] (“Given that the successful implementation of swing pricing depends heavily on a fund’s receipt of timely and reasonably accurate cash flow estimates, to the extent that current trade processing systems and practices limit the ability of funds to receive intraday order flow infor- mation, it will be very difficult to develop a workable swing pricing re- gime.”). 202 Eaton Vance Comment Letter, supra note 170, at 5. Tucker_VanDenToorn_Final No. 1:130] WILL SWING PRICING SAVE SEDENTARY SHAREHOLDERS? 175 The rules force a seemingly impossible set of operations by on participating funds.203 First, it requires the nearly instan- taneous processing and collection of all trading activity from a variety of sources, including intermediaries. Second, it re- quires an instantaneous and simultaneous assessment of trading activity to determine if the threshold is met. The rules require a third immediate and simultaneous action: assessing the trading costs and setting the swing factor. Between 4:00 pm and 6:00 pm, participating funds must complete trading, garner it from a variety of sources, evaluate trading volumes and costs, and issue an adjusted NAV.204 Layered service pro- viders within the mutual fund industry serve as consolidation clearing houses for other mutual fund platforms. These inter- mediaries rely upon the technology of those other service pro- viders (i.e., broker-dealers and retirement platforms) to incor- porate the trading data for the day from the underlying intermediaries in order to generate a consolidated purchase and redemption order.205 Transactions within retirement ac- counts must also be verified for compliance with retirement savings rules, adding an additional transactional layer and delay between trading close, transmission, and incorporation into the fund’s NAV.206 203 Sec. Indus. and Fin. Mkts. Ass’n, supra note 197, at 15–16 (setting out in detail the timing of receipt of fund flow information to U.S. mutual funds). 204 Contrast the U.S. operations with those of European jurisdictions, where mutual funds receive complete trade information by noon each day. European funds have up to seven hours to assess shareholder trade infor- mation as well as portfolio trading needs and related costs. Inv. Co. Inst. Comment Letter, supra note 9, at D-1 to D-3. The current NAV calculation process, however, requires subjective judgments and estimates such as val- uations for standardized market pricing. See Final Rules, supra note 4, at 82093 (“We note that current NAV calculation processes already include subjective judgments and estimates, including, for example, fair-value de- terminations for assets that lack readily available market quotations.”). 205 Inv. Co. Inst. Considerations, supra note 194, at 6–7. 206 Id. See also Interview with Holly van den Toorn, Legal and Compli- ance Manager, in Atlanta, Ga. (2017). Holly van den Toorn also noted addi- tional operational challenges regarding fund flow estimation such as whether dividend reinvestments, automatic investment plans, or manda- tory minimum withdrawals should be included in the transactions to which TUCKER_VANDENTOORN_FINAL 176 COLUMBIA BUSINESS LAW REVIEW [Vol. 2018 FIGURE 2: RELATIONSHIPS BETWEEN INTERMEDIARIES, RE- TIREMENT INVESTORS, AND MUTUAL FUNDS At step 1, intermediaries collect trades. At step 2, interme- diaries collate trades.207 At step 3, intermediaries transmit the swing factor must be applied. As a practical matter, the operational dif- ficulty of achieving the exclusion of such transactions from an adjusted NAV may not even be possible at this time. 207 Each intermediary collects trades from underlying shareholders and sends them through “omnibus accounts” (as one big group trade) to the fund’s transfer agent. These trades are collected by intermediaries through- out the day up until the 4:00 p.m. cut-off time mandated by the SEC. It could still take the intermediary until 6:00 p.m. or later, or even overnight, to deliver the trade files to the fund’s’ transfer agent. B roker-D ealers (ex: M errill Lynch) W ire H ouses (ex: Pershing) Third-Party A dm in- istrators (TPA s) & R etirem ent Plan R ecord K eepers R etirem ent A ccounts Fund’s Transfer A gent Interm ediary O m nibus A ccount M utual Fund Step #2: Interm ediaries collate trades Step #3: Interm ediaries transm it trades to m utual fund Step #4: T he m utual fund m anages inflow s (purchases) and redem ptions (asset sales) Step #1: Interm ediaries collect trades Tucker_VanDenToorn_Final No. 1:130] WILL SWING PRICING SAVE SEDENTARY SHAREHOLDERS? 177 trades to mutual fund.208 Finally, at step 4, the mutual fund manages inflows (asset purchases) and redemptions (asset sales).209 b. No Safe Harbor Unlike in European jurisdictions,210 the U.S. swing pricing rules do not create a safe harbor to protect a fund’s miscalcu- lation of the swing threshold based upon reasonable esti- mates.211 Mutual fund insiders, including one author, are con- cerned that the operational impossibility will breed a situation ripe for mutual fund shareholder lawsuits and en- forcement actions.212 David Blass, the General Counsel of the Investment Company Institute (the “ICI”), summarized the concern as “[s]wing pricing would introduce a new potential source of pricing error” because a fund may well be using es- timated flow information, and if materially inaccurate, cause the fund to materially misstate its NAV.213 Incorrect estima- tions of the swing factor may trigger a fund’s price or NAV 208 Direct Shareholders are shareholders whose accounts are directly on the fund’s transfer agent system and don’t go through an intermediary. 209 The transfer agent processes all trades and tells the fund how much cash it needs to make available for redemptions, or how much it has to in- vest. Shareholder trades can be T+1 or T+3, so funds may have advanced notice of large trades. The information is sent to the fund’s accounting agent who sends a “cash sheet” or “super sheet” to the portfolio manager/team who will then adjust the portfolio as needed. 210 The ALFI Swing Pricing Guidelines provide: “If acting in good faith, the fund is swung based on a flow estimate which is subsequently found to be inaccurate, this in itself would not normally be considered an error if the fund’s standard and appropriate policies and procedures have been fol- lowed.” ALFI 2015 GUIDELINES, supra note 58, at 30. 211 Final Rules, supra note 4, at 82100 n.189. See also Swing Pricing First Proposal, supra note 4, at 62340. 212 Dechert, supra note 201, at 24 (“[T]he Commission could expressly provide that the relevant parties, including the fund, the swing pricing ad- ministrator and the fund board, would not be exposed to liability for NAV errors of this type if there were adequate guardrails in place and reasonable measures were taken to implement swing pricing.”). 213 Inv. Co. Inst. Comment Letter, supra note 9, at 62. TUCKER_VANDENTOORN_FINAL 178 COLUMBIA BUSINESS LAW REVIEW [Vol. 2018 correction policies.214 Funds’ NAV correction policies typically provide for a fund to correct a material NAV error and require a fund’s investment advisor to reimburse shareholders suffer- ing “material economic loss due to the errors.”215 NAV mis- statements would require reprocessing all shareholders af- fected by the inaccurate NAV; a significant burden would thereby be placed on funds and their service providers.216 Rather than create a safe harbor, the rules rely on a rea- sonable estimate of fund flows after a reasonable inquiry.217 The swing pricing policies and procedures required under the rules should outline flow estimate procedures.218 What consti- tutes a reasonable estimate will vary depending on the fund and the trading circumstances.219 For example, a fund with consistent redemption levels and a large, direct shareholder base (as opposed to retirement plan investors) may be “better positioned to make a high confidence estimate of flows with less effort, than a fund that is primarily distributed through intermediaries, who has experienced volatile purchases and redemptions and has a mix of distribution partners and insti- tutional and retail shareholders.”220 The SEC also encouraged 214 Id. 215 Id. at 61–62. 216 Id. at 62. 217 Final Rules, supra note 4, at 82099 (discussing price and swing threshold estimates). Cf. Invesco, supra note 98, at 6 (urging the SEC to create a “safe harbor for good faith decisions and actions that shield funds from potential liability”). 218 Final Rules, supra note 4, at 82100 (“Such policies and procedures could describe the process by which the fund obtains shareholder flow infor- mation—including flows obtained from intermediaries—as well as the amount and kind of transaction data that the fund believes necessary to obtain before making its estimate of total net flows in order to determine whether the swing threshold has been exceeded, and applying swing pricing that day.”). 219 Id. at 82100 (“We recognize that funds may take different ap- proaches in determining whether they have sufficient flow data to make a reasonable high confidence estimate, and that the completeness of data— such as the percentage of actual versus estimated net flow data—as well as the nature and types of estimates used may vary based on the particular circumstances of the fund.”). 220 Id. Tucker_VanDenToorn_Final No. 1:130] WILL SWING PRICING SAVE SEDENTARY SHAREHOLDERS? 179 funds, consistent with European practices, to regularly back- test fund flow-estimating procedures with actual data to con- firm and refine the estimating procedures.221 c. Fund Size Matters Large-fund-complex advantages and restricted fund op- tions are two possible side effects of the intermediary/mutual fund-timing problem. Under the first—large fund complex ad- vantages—the concern is that larger funds can exert more pressure to get their orders processed first by their distribu- tion partners thus improving their information and reducing operational friction.222 This is the mutual fund “Wal-Mart” ad- vantage where the largest provider garners the most supply chain support and priority, reinforcing its superiority over smaller offerings. The second concern reflects a practical real- ity that intermediaries may choose to protect themselves from the timing pressures exacerbated by swing pricing and ex- clude participating funds from the platform.223 There are thousands of mutual funds, and the idea is that if intermedi- aries find compliance to be a hassle, they will opt for funds without swing pricing. The diversity of the mutual fund industry—there were over 9500 mutual funds in the United States in 2016224—en- sures that there will be early adopters in the market to utilize 221 Id. 222 Id. at 82101–02. See generally Inv. Co. Inst. Considerations, supra note 194, at 5–7. 223 Final Rules, supra note 4, at 82101 (“In addition, funds also ex- pressed concerns that intermediaries may choose not to offer funds that choose to implement swing pricing, due to the increased processing and technology burdens that swing pricing would impose on intermediaries, a consideration that funds will evaluate as they determine whether to adopt swing pricing.”). 224 Number of Mutual Funds in the United States from 1997 to 2016, STATISTA, https://www.statista.com/statistics/255590/number-of-mutual- fund-companies-in-the-united-states/ [perma.cc/7UGG-AZE4]. See also Dis- tribution of Investment Fund Assets in the United States in 2016, by Type, STATISTA, https://www.statista.com/statistics/255606/asset-allocation-mu- tual-funds-usa/) [perma.cc/2KER-EPPM] (displaying that of these funds, as- TUCKER_VANDENTOORN_FINAL 180 COLUMBIA BUSINESS LAW REVIEW [Vol. 2018 swing pricing with distribution models and an investor base better able to accommodate the information challenges of swing pricing.225 These early adopters, including larger fund complexes, may drive industry changes through the market, rather than through an SEC mandate. Additionally, the ex- tended implementation time for the optional rules further al- low early adopters to drive market changes necessary for broader participation.226 d. A Possible Path Forward: Block Chain Technology Blockchain227 is one implementation strategy for swing pricing in the U.S. mutual fund industry. Simply described, blockchain technology facilitates a large, virtual, secure, dis- tributed, and nearly automatic public ledger.228 Blockchain sets were distributed roughly 42% in domestic equity funds, 14% in inter- national equity funds, 22% in bond funds, 14% in money market funds, and 8% in hybrid funds like ETFs and alternative funds). 225 Final Rules, supra note 4, at 82101–02. The SEC also said it: [U]nderstand[s] that certain funds with investors that pri- marily transact directly with the fund’s principal under- writer or transfer agent, or that are primarily distributed through affiliates or broker-dealers (that could potentially provide timely flow data), and/or do not have a substantial number of investors transacting in retirement plans or in- surance products could more easily obtain sufficient net flow information. In addition, larger fund complexes with the ability to more easily get net flow information from their in- termediaries, including those that have established large trade notification processes, may have the leverage to nego- tiate operational solutions and the resources to implement swing pricing sooner for certain funds, which may result in inefficient one-off solutions rather than coordinated indus- try-wide operational solutions that may reduce costs for in- vestors overall. Id. 226 See id. at 82101–03. 227 See generally SHAWN S. AMUIAL ET AL., THE BLOCKCHAIN: A GUIDE FOR LEGAL AND BUSINESS PROFESSIONALS (2016). 228 See Wulf A. Kaal, Blockchain Innovation for Private Investment Funds 5–7 (Univ. of St. Thomas, Minn. Legal Studies, Research Paper Tucker_VanDenToorn_Final No. 1:130] WILL SWING PRICING SAVE SEDENTARY SHAREHOLDERS? 181 can deliver both speed and accuracy. Blockchain technology records peer-to-peer transactions in real time reducing (if not eliminating) the role of intermediaries.229 It also reduces the need for operational intermediaries—a significant obstacle to swing pricing implementation discussed above—and speeds up fund flow information.230 Another key feature of blockchain technology is its immu- tability; it is designed to eliminate fraudulent transactions through decentralization and verification.231 Multiple parties can access and contribute to a blockchain ledger, and parties must provide digital signatures to authenticate their iden- tity.232 To simply illustrate, each transaction creates a new block in the chain, and as transactions continue, the chain grows from 1 to 2, to 5, to 10, and so on. If multiple parties have access to the verified chain, a single party cannot alter No.17-21, 2017), https://papers.ssrn.com/sol3/papers.cfm?abstract_id= 2998033 [perma.cc/442Y-GFSJ] (describing key attributes of blockchain technology). 229 Id. at 5. 230 See AMUIAL ET AL., supra note 227 (arguing that blockchain “incen- tivizes direct peer-to-peer transactions, including compensation, between the creator and consumer, eliminating the need for intermediation. Inter- mediaries . . . are replaced by code, connectivity, crowd, and collaboration. Blockchain . . . creates a platform for trust through truth and transparency for parties through its immutability and use of cryptography.”). See also Kaal, supra note 228, at 5 (stating that transaction costs will be reduced by the elimination of intermediaries). 231 Rik Kirkland, How Blockchains Could Change the World: Interview with Don Tapscott, MCKINSEY & CO. HIGH TECH (May 2016), https://www.mckinsey.com/industries/high-tech/our-insights/how-block- chains-could-change-the-world [perma.cc/533A-ZM2B]. 232 Kaal, supra note 228, at 8 (arguing that cryptographic technology enhances the security of the blockchain by embedding information from all prior transactions through algorithm-generated unique hash values before adding the next transaction, or block. . . .). See also id. at 8. (“That hash value ensures the authenticity of each transaction before it is added to the block. The smallest change to the blockchain, even a single digit/value, re- sults in a different hash value. A different hash value makes any form of manipulation immediately detectable.”). TUCKER_VANDENTOORN_FINAL 182 COLUMBIA BUSINESS LAW REVIEW [Vol. 2018 the established chain across all of the copies, making it “prac- tically impossible to reverse, alter, or erase information in the blockchain.”233 Leveraging blockchain technologies in mutual fund trans- actions would facilitate a fund closing its fund flow by the cur- rent 4:00 pm deadline with a verified and secure ledger in place.234 A fund could reliably calculate its NAV by 6:00 pm EST, with swing adjustments, if needed. This breakthrough technology seems particularly hopeful for an industry that still relies on paper and faxed orders to some extent.235 The current process of transaction settlement can take as long as a week because intermediaries guarantee assets and institu- tional pass records, and individually verify them.236 Block- chain promises settlement of transactions “within seconds, se- curely and verifiably.”237 The capital markets and investment management indus- tries are currently working on advancements in blockchain, with the hope that future fund distribution can be made auto- matic and instantaneous. Nasdaq Inc., for example, is collab- orating with Nordic financial services group SEB to test a small-scale mutual fund trading platform based on blockchain technology.238 Calastone, a technology company, said in June 2017 that it had successfully transacted mutual fund trades in a test environment and believes that blockchain could rev- 233 Id. at 7. 234 See e.g., Marco Iansiti & Karim R. Lakhani, The Truth About Block- chain, HARV. BUS. REV., Jan.–Feb. 2017, at 118, https://hbr.org/2017/01/the- truth-about-blockchain [perma.cc/V8EA-U4SG]. 235 Attracta Mooney, Blockchain Successfully Tested in Sale of Mutual Funds, FIN. TIMES (June 11, 2017), https://www.ft.com/content/5927fa2c- 4c73-11e7-919a-1e14ce4af89b. 236 Iansiti & Lakhani, supra note 234, at 6. 237 Id. 238 Anna Irrera, Nasdaq, SEB to Test Blockchain for Mutual Funds, REUTERS (Sept. 27, 2017), https://www.reuters.com/article/us-nasdaq-block- chain/nasdaq-seb-to-test-blockchain-for-mutual-funds-idUSKCN1C20LQ [perma.cc/4UUV-Q3EY]. Tucker_VanDenToorn_Final No. 1:130] WILL SWING PRICING SAVE SEDENTARY SHAREHOLDERS? 183 olutionize the mutual fund industry with significant efficien- cies.239 Additionally, on August 1, 2017, new Delaware legis- lation authorized Delaware corporations—a jurisdictional home of a majority of Fortune 500 companies—to use block- chain technology for stock ledgers and other corporate rec- ords.240 Early adopters of blockchain-based stock ledgers and records include private companies in Delaware,241 and a broad range of private investment firms.242 Widespread blockchain adoption in issuing companies and funds is not yet realized. Adoption obstacles include data pri- vacy for public blockchains,243 the novelty of the field,244 re- sistance due to pressure on fee structure and the elimination of intermediary roles,245 and untested regulatory compliance. Additionally, within the mutual fund industry, a crucial step will be for large firms to convince major industry participants to use the same platform.246 Analysis of technology adoption and infiltration performed by two Harvard Business School professors, Marco Iansiti and Karim R. Lakhani, however, 239 Mooney, supra note 235, at 1. 240 81 Del. Laws Ch. 86 (2017). See also Jeff John Roberts, Companies Can Put Shareholders on a Blockchain Starting Today, FORTUNE (Aug. 1, 2017), http://fortune.com/2017/08/01/blockchain-shareholders-law/ [https:// perma.cc/E9RH-YMUE]. 241 Sara Merken, Delaware Blockchain Move Drawing in Private Com- panies, Law Firms, BLOOMBERG BNA (Aug. 11, 2017), https://www.bna.com/delaware-blockchain-move-n73014463104/ [https:// perma.cc/A33Y-M59Z] (citing to two dozen private firms interested in block- chain stock ledgers). 242 Kaal supra note 228, at 19, 28 (listing 120 private investment firms utilizing blockchain and specific applications). 243 Alison Berke, How Safe Are Blockchains? It Depends, HARV. BUS. REV. (March 7, 2017), https://hbr.org/2017/03/how-safe-are-blockchains-it- depends [perma.cc/G57H-C37G] (describing public and private blockchain technology and noting that the financial industry relies upon private block- chains). 244 Kirkland, supra note 231 (“The biggest problems [with blockchain] have to do with governance. Any controversy . . . is going to revolve around these governance issues. This new community is in its infancy . . .[,] the whole world of blockchain and digital currencies is the Wild West.”). 245 Kaal, supra note 228, at 23–25. 246 Mooney, supra note 235, at 2. TUCKER_VANDENTOORN_FINAL 184 COLUMBIA BUSINESS LAW REVIEW [Vol. 2018 suggests that early and strong areas of blockchain growth will occur in localized applications within a small network of fi- nancial firms.247 They predict early and important adoption of private blockchains in the financial industry, including the firms listed above and among others, which will drive further applications and adoptions.248 While not fully realized, the authors of this Article are ex- cited about the potential for blockchain technology to address the operational hurdles to swing pricing—as well as to deliver transaction cost savings through automation, accuracy, and intermediary elimination. 2. Conceptual Challenges This Article distinguishes conceptual challenges from op- erational challenges because the conceptual criticisms persist even if the mutual fund industry implemented the operational changes addressed above. Price volatility and arbitrage, im- perfect equalization among mutual fund shareholders, and rising compliance costs with competing compliance priorities are all conceptual challenges to swing pricing. a. Volatility & Arbitrage Swing pricing may be a source of, not a solution to, volatil- ity, at least in the short term.249 A mutual fund opting into swing pricing is likely to experience greater price volatility (variations) when the NAV swings than when it does not.250 247 Iansiti & Lakhani, supra note 234, at 8. 248 Id. 249 Final Rules, supra note 4, at 82092. (“[A] few [commentators] op- posed swing pricing outright, arguing that it may have negative effects on certain shareholders and may add to fund performance volatility.”). 250 Id. at 82093 (“Swing pricing could increase the volatility of a fund’s NAV in the short-term because NAV adjustments would occur when the fund’s net purchases or net redemptions pass the fund’s swing threshold. Thus, the fund’s day-to-day NAV would show greater fluctuation than would be the case in the absence of swing pricing.”). See also Dechert Com- ment Letter, supra note 201, at 24 (pointing out that price volatility may originate from “(i) the application of an incorrect swing factor to a fund’s Tucker_VanDenToorn_Final No. 1:130] WILL SWING PRICING SAVE SEDENTARY SHAREHOLDERS? 185 Increased price variations might correlate with higher short- term tracking errors where the fund’s return on the swung NAV deviates from a fund’s benchmark return.251 One mutual fund industry commentator cautioned: Swing pricing will distort the comparative perfor- mance records of different funds to reward those that apply swing pricing most aggressively. The difficult- to-quantify and variable nature of the underlying fund costs that the Swing Pricing Proposal seeks to miti- gate and the forced reliance on estimates of daily net flows mean that fund transaction prices adjusted to reflect swing pricing will be subject to errors and sec- ond-guessing, exposing funds utilizing swing pricing to transaction reprocessing costs and potential regula- tory sanctions and litigation.252 These concerns are short-sighted however, because while daily variation may increase, the price would reflect actual transaction costs making the returns more accurate. Addition- ally, as more funds implement swing pricing, the benchmarks will reflect the liquidity costs, and over time, produce both more accurate and consistent returns.253 NAV; (ii) adjusting the fund’s NAV in the wrong direction; and (iii) the fail- ure to adjust the fund’s NAV when the swing threshold has been reached”). 251 Final Rules, supra note 4, at 82093 (“[V]olatility might increase short-term tracking error (i.e., the difference in return based on the swung NAV compared to the fund’s benchmark) during the daily period of NAV adjustment, and could make a fund’s short-term performance deviate from the fund’s benchmark to a greater degree than if swing pricing had not been used, especially if the NAV is swung on the first or last day of a performance measurement period.”). 252 Eaton Vance Comment Letter, supra note 170, at 4. 253 Final Rules, supra note 4, at 82093 (“[S]wing pricing may also result in reduced tracking error over time, as benchmarks typically do not take into account transaction costs associated with responding to daily transac- tions, and if swing pricing recoups such costs, it may result in a fund that implements swing pricing better matching its benchmark on a long-term basis.”). TUCKER_VANDENTOORN_FINAL 186 COLUMBIA BUSINESS LAW REVIEW [Vol. 2018 The ICI, representing 9352 mutual funds,254 expressed concern that disclosures of swing pricing process and fund flow data would create new arbitrage opportunities by disclos- ing heretofore “material non-public information.”255 The Eu- ropean jurisdictions’ experience with swing pricing confirms these suspicions. Historically, European funds were reticent to disclose swing pricing information.256 Many European funds do not disclose the swing threshold—something not re- quired under the U.S. rules—but roughly half of funds re- sponding to a 2015 survey disclose swing pricing information upon client request.257 New swing pricing procedures may contribute to short- term price volatility by deterring advance notice of large trades. Large shareholders or institutional investors often provide funds advance notice of a large purchase or redemp- tion order, as a courtesy.258 Discouraging advance notice aug- ments a funds’ likelihood of “blind” NAV calculations. Funds foster strong relationships and communication with interme- diaries and as a result are able to request advance notice of large shareholder transactions.259 Intermediaries may pro- vide a few days’ to even a few weeks’ notice of large transac- tions, such as when the fund is being added or removed from 254 INV. CO. INST., 2015 ANNUAL REPORT TO MEMBERS 2 (2015), https://www.ici.org/pdf/15_ici_annual.pdf [perma.cc/Z8WM-SLK8]. The as- sociation that would later become the ICI was formed in 1940 in conjunction with the sweeping federal financial reform ushered in by the 1940 Invest- ment Company Act. See also INV. CO. INST, ICI’s Mission, https://www.ici.org/about_ici/mission [perma.cc/BLD5-NPXF] (discussing ICI history further). 255 Inv. Co. Inst. Comment Letter, supra note 9, at 56. Holly van den Toorn notes her conversations with traders discussing the arbitrage possi- bilities that exist if a trader thinks that a fund’s price will be swung. 256 ALFI 2015 SURVEY, supra note 58, at 12. 257 Id. 258 Inv. Co. Inst. Comment Letter, supra note 9, at 56. See also Final Rules, supra note 4, at 82102 n.206 (discussing the advance notice of large trades negotiated by large fund complexes with their intermediaries as a way to avoid in-kind redemptions). 259 Inv. Co. Inst. Comment Letter, supra note 9, at A-11. Tucker_VanDenToorn_Final No. 1:130] WILL SWING PRICING SAVE SEDENTARY SHAREHOLDERS? 187 an investment model, 401(k) plan options, or the intermedi- ary’s platform of funds available to its customers.260 Funds are required to disclose swing pricing practices in the prospec- tus, thus cueing investors in to how their large transactions maybe be affected by a swung NAV.261 Wanting to avoid this effect, large institutional shareholders may alter its courtesy disclosure practice to circumvent a fund from triggering swing pricing on anticipated trading volume, when a day’s trading volume is high, but not yet over the swing threshold. As an example, a large institutional shareholder advises a fund that it intends to redeem $10 million from the fund two weeks in advance of the trade. Such a redemption would trig- ger the fund’s swing threshold. Notice allows the fund’s port- folio managers and traders to assess carefully the potential transaction and market impact costs in the days leading up to the redemption. On the day that a shareholder places a $10 million redemption order, the fund adjusts the NAV to impose a fair representation of costs to the redeeming institutional shareholder, protecting the remaining shareholders from di- lution. Under current mutual fund operations timing, a fund may swing the NAV without complete trading information. In such a scenario, advance notice to the fund may make it more likely that a fund will deem the swing threshold met and ad- just the NAV. An institutional shareholder looking to game the system and avoid the allocation of transaction costs may choose not to provide advance notice.262 260 Id. 261 Final Rules supra note 4, at 82107 (stating disclosure require- ments). 262 An intermediary may feel compelled to consider its clients’ “best in- terests” and may avoid presenting the fund with enough information and time to calculate properly the swing factor in hopes that the fund cannot accurately estimate transaction and market impact costs in its favor. Holly van den Toorn noted the general confusion and concern regarding the extent of the new fiduciary duty standards and whether the new standard would impose a theoretical obligation on an intermediary to avoid triggering the NAV. See also Retirement Conflict of Interest Final Rule, EMP. BENEFIT SEC. ADMIN., https://www.dol.gov/agencies/ebsa/laws-and-regulations/rules-and- regulations/completed-rulemaking/1210-AB32-2 [perma.cc/P5DJ-VRSE] (providing information on the Dept. of Labor’s Fiduciary Duty Rule, with an TUCKER_VANDENTOORN_FINAL 188 COLUMBIA BUSINESS LAW REVIEW [Vol. 2018 In a paradoxical situation, participating funds may receive less advance notice of large trades and thus incur more mar- ket impact costs in meeting large, and unpredictable, redemp- tion demands. Additionally, participating funds may be forced—in the absence of advance notice—to account for transaction costs in an “imprecise” manner.263 Lack of proper notice and operational challenges to receiving accurate flow of information increase the likelihood that a fund will under- or over-estimate the swing factor and adjust the NAV improp- erly, exposing remaining shareholders to dilution—at least at the beginning. There is an important counter-argument that bears noting here. If swing pricing ultimately improves fund performance by removing the performance drag of dilution from reported returns, larger reported investment returns should incentivize advance notice to funds in the long-run. b. Imperfect Equalization The swing pricing rules treat all active shareholders the same—meaning that regardless of the shareholder’s order size, a fund applies the same swung NAV price.264 A share- holder redeeming or purchasing a relatively small number of mutual fund shares is paid (or pay) the same swung NAV as a shareholder with a large order. The inequity complaint arises because the active but small order shareholder is likely subsidizing some of the transaction costs generated by the ac- tive and large order shareholder.265 Consider, for example, the retirement investor who is required, per IRS regulations, to make annual minimum distributions beginning at the age of effective date of January 1, 2018; however, there is uncertainty about im- plementation due to a February 3, 2017 Executive Order signed by Presi- dent Donald Trump ordering the DOL to reexamine the rule). See Exec. Or- der No. 13,772, 82 F.R. 9965 (2017). 263 Inv. Co. Inst. Comment Letter, supra note 9, at 57. 264 Final Rules, supra note 4, at 82094 (“[A]s the proposed swing pricing rules would apply a single adjusted NAV per share to all shareholder orders, regardless of order size.”). 265 Id. at 82094 (“[S]wing pricing could thus penalize certain investors disproportionately or give other investors inappropriate ‘‘windfalls.’’). Tucker_VanDenToorn_Final No. 1:130] WILL SWING PRICING SAVE SEDENTARY SHAREHOLDERS? 189 70 ½.266 For example, if a fund adjusted its NAV by five basis points to reflect transaction liquidity costs generated by unu- sually large trading that day, a shareholder redeeming 10 shares is paid five basis points less per share than a share- holder redeeming 10,000 shares, and who is also the likely source of the high liquidity transaction costs.267 Regulatory design requires a tradeoff between accuracy and administra- bility that is evident in the swing pricing rules. There is in- deed the potential for some imperfect cost allocation between active shareholders under the rules, but it is a more accurate allocation than between active and sedentary, or long-term, shareholders. Additionally, swing pricing administrator re- ports, mutual fund director oversight, published swing pricing policies and procedures, a consistent (and undisclosed) swing threshold, and an upper limit (two percent) of swing pricing all further safeguard fair application of the rules.268 Another inequity criticism highlights potential impact dif- ferences on large versus small funds. In times of liquidity stress or crisis, some mutual fund industry representatives cautioned that investors will be more likely to redeem from funds without swing pricing, which are more likely to be smaller funds, thus concentrating run risks within smaller funds.269 They worry that swing pricing will “create incentives for investors to redeem from the funds least likely to be able to handle the stress from large amounts of redemptions. This result is both anti-competitive and—to the extent that the SEC is concerned about redemptions leading to ‘fire sales’— counterproductive.”270 266 Qualified Pension, Profit-sharing, and Stock Bonus Plans, 26 C.F.R. § 1.401(a)(9)(C) (2017). 267 Coal. of Mutual Fund Inv’rs, Comment Letter on Swing Pricing (Jan. 18, 2016), at 8, https://www.sec.gov/comments/s7-16-15/s71615-85.pdf [perma.cc/A3BX-QLTC] (describing how the symmetry of the SEC rules dis- advantage certain shareholders under swing pricing). 268 See e.g., Final Rules, supra note 4, at 82094 (describing safeguards of fairness). 269 Dechert Comment Letter, supra note 201, at 22. 270 Id. TUCKER_VANDENTOORN_FINAL 190 COLUMBIA BUSINESS LAW REVIEW [Vol. 2018 c. Compliance Costs & Priority Participating swing pricing funds face significant imple- mentation costs. The SEC estimated swing pricing implemen- tation costs at $1.3 million to $2.25 million per fund com- plex.271 These optional implementation costs are on top of mutual fund compliance with other new regulations passed as part of a liquidity management package. The additional li- quidity rules require liquidity risk management programs, a liquidity classification of each portfolio investment, redemp- tion in-kind policies and procedures,272 and modernizing shareholder reporting forms.273 Additionally the mutual fund industry must also comply with the Department of Labor’s (“DOL”) new definition of who is a fiduciary—a seismic policy and operational shift for the industry.274 271 Swing Pricing Proposed Rules, supra note 4, at 62367–68. The SEC’s cost estimates do not account for industry retooling to provide earlier trade and fund flow information from intermediaries to funds. See e.g., Eaton Vance Comment Letter, supra note 170, at 5. 272 Final Liquidity Risk Rules, supra note 4, at 82142. Most funds would be required to comply with the liquidity risk management program requirements by December 1, 2018, and smaller funds by June 1, 2019. Id. at 82228. 273 SEC Report Modernization Rule, 17 C.F.R. § 200, 210, 232, 239, 240, 249, 270, 274 (2017). 274 DOL Fiduciary Rule, 29 C.F.R. § 2510.3-21(j) (2017). The new rules and subsequent uncertainty has consumed significant resources in the mu- tual fund industry. Holly van den Toorn notes the significant amount of time mutual fund complexes spent in advance of the rule compliance date working with intermediaries, many of which had different approaches to solving for the DOL Fiduciary Rule. Amidst the post-election uncertainty, some complexes launched a specific share class to accommodate intermedi- aries’ compliance, but are not currently offering the special share class until the Rule’s future becomes clear. She also reports that the overall mutual fund industry would prefer to see a fiduciary standard produced in conjunc- tion with their primary regulator, the SEC, to avoid future conflicts. Anne Tucker, the author with primary academic experience, acknowledges the operational and market consolidation changes are likely to follow imple- mentation of the fiduciary duty rule. From her perspective, the painful ele- ments of these changes should never have been permitted in the first place. Self-interestedly promoting high-fee, low-return products—or even medio- cre products—to unsophisticated clients exploits information asymmetries Tucker_VanDenToorn_Final No. 1:130] WILL SWING PRICING SAVE SEDENTARY SHAREHOLDERS? 191 Smaller mutual fund complexes that may have exhausted time and money resources on the mandatory rules are less likely to implement swing pricing because of the additional and optional regulatory compliance and cost burdens that come with the practice. In this way, the rules preference larger fund complexes with greater resources and operational efficiencies in implementing new systems.275 V. MUTUAL FUND LIQUIDITY: EXISTING AND CONSIDERED TOOLS TO RECOUP & REDUCE COSTS Alternatives to swing pricing include redemption fees, in- kind redemptions, and dual pricing. As the mutual fund mar- ket grew, SEC regulations authorized various anti-dilution and other tools to promote mutual fund liquidity. U.S. mutual funds can impose redemption fees and in-kind redemptions as anti-dilution tools. A third tool—dual pricing—which is not authorized for U.S. mutual funds, is also introduced below. Each of these alternatives provides an important regulatory juxtaposition to swing pricing and contextualizes the discus- sion undertaken in this Article. Neither author is convinced that the existing alternatives provide a workable option for and trust misplaced on the veneer of professionalism in the form of nice suits and glossy product brochures. High-fee, low-performance investment options create market inefficiencies, erode individual investors’ retirement accounts, and contribute to a national savings shortfall. For a similar view, see Benjamin P. Edwards, A Rules Change from Trump Means More Money for Wall Street, WASH. POST (Feb. 3, 2017), https://www.washing- tonpost.com/opinions/a-rules-change-from-trump-means-more-money-for- wall-street/2017/02/03/b6c78d3a-ea55-11e6-bf6f-301b6b443624_story.html [perma.cc/GTF6-B4GE]. 275 Dechert Comment Letter, supra note 201, at 20 (“For example, smaller fund complexes are less likely than larger fund complexes to have adequate resources or internal processes in place to be able to support the use of swing pricing. In addition, as the timeliness and accuracy of intraday flow information to a fund depends on the intermediaries through which the fund distributes its shares, certain funds may benefit more than others to the extent they use intermediaries that have developed systems to address the operational concerns associated with swing pricing or have large num- bers of direct shareholders.”). TUCKER_VANDENTOORN_FINAL 192 COLUMBIA BUSINESS LAW REVIEW [Vol. 2018 funds to effectively manage liquidity and mitigate dilution for a wide-ranging set of assets or circumstances. Funds cannot use the available tools, over the long term and on a regular basis, without encountering reputational, operational, and other risks. A. Purchase and Redemption Fees: Overview & Challenges Since 2005, mutual funds can impose a redemption fee, no greater than two percent of the redemption amount, in certain situations.276 A fund retains the redemption fee in order to recoup costs related to the shareholder redemption.277 Purchase and redemption fees present alternative anti-di- lution and cost-shifting devices for mutual funds. The fees, perceived as “simpler” for investors to understand, face inves- tors’ unfavorable perceptions and operational challenges.278 Mutual funds currently impose redemption fees in limited sce- narios such as to “combat ‘market timing’ as part of ‘frequent trading policies.’”279 Further, disclosure and use of a purchase or redemption fee by a fund often discourages shareholder in- vestment.280 Mutual fund industry representatives perceive redemption fees as an impediment to both marketing efforts and having intermediaries offer the fund on its investment 276 Swing Pricing Proposed Rule, supra note 4, at 62327. 277 See SEC, Mutual Fund Redemption Fees, Investment Company Act Release No. 26782, 70 FR 13328. 13341 (Mar. 18, 2005). The redemption fee may be no more than two percent of the value of the shares redeemed. 17 C.F.R. § 270.22c–2(a)(1)(i). Rule 22c–2 requires that each fund’s board of directors (including a majority of independent directors) either (i) approve a redemption fee that in its judgment is necessary or appropriate to recoup costs the fund may incur as a result of redemptions, or to otherwise elimi- nate or reduce dilution of the fund’s outstanding securities, or (ii) determine that imposition of a redemption fee is not necessary or appropriate. Id. 278 Swing Pricing First Proposal, supra note 4, at 62370. See also Final Rules, supra note 4, at 82126 (distinguishing redemption fees and alterna- tives from swing pricing). Purchase and redemption fees might also avoid fees that would avoid the NAV volatility and tracking error that they predict will occur with swing pricing. 279 BlackRock Comment Letter, supra note 189, at 4. 280 Id. Tucker_VanDenToorn_Final No. 1:130] WILL SWING PRICING SAVE SEDENTARY SHAREHOLDERS? 193 menu to clients.281 The existence of the tool, but lack of de- ployment to combat liquidity and dilution concerns, mitigates its viability as a robust alternative to swing pricing. One author challenges the SEC’s claim that swing pricing would be simpler to implement over redemption fees because swing pricing can be implemented through changes to the fund’s policies and procedures, whereas redemption fees re- quire changes to the intermediaries’ systems.282 Not calcu- lated into the SEC’s position is the important role intermedi- aries play in making swing pricing possible.283 If intermediaries agree to significant changes in trading cut-off times, they will necessarily be required to implement such changes within their systems, as well as undertake the ardu- ous and unpleasant task of communicating the significant changes to their clients who purchase funds through their platforms. B. In-Kind Redemptions: Overview & Challenges Many funds reserve the right to utilize in-kind redemp- tions to facilitate the need for liquidity as a result of a signifi- cant redemption or other extraordinary circumstances.284 A fund may send a pro-rata portion of its own portfolio securities to a redeeming shareholder instead of cash proceeds in a time of extraordinary circumstances as a way to mitigate liquidity costs to remaining shareholders.285 The fund must not favor 281 Holly van den Toorn observed in her role in the mutual fund indus- try that redemption fees are viewed unfavorably by intermediaries and shareholders. 282 See Swing Pricing First Proposal, supra note 4, at 627–29 (discuss- ing implementation barriers). 283 See infra Section IV.B.1.a. 284 Final Rules, supra note 4, at 82087 (discussing in-kind redemp- tions). 285 Definitions; Applicability; Rulemaking Considerations, 15 U.S.C. § 80a-2 (“‘Redeemable security’ means any security, other than short-term paper, under the terms of which the holder, upon its presentation to the issuer or to a person designated by the issuer, is entitled . . . to receive ap- proximately his proportionate share of the issuer’s current net assets, or the cash equivalent thereof.”). TUCKER_VANDENTOORN_FINAL 194 COLUMBIA BUSINESS LAW REVIEW [Vol. 2018 one shareholder over another by sending U.S. Treasuries, which are perceived as stable and safe investments, while it sends riskier investments to another shareholder.286 A fund must send a pro-rata portion of its redeemable portfolio secu- rities to eligible investors when it does so.287 While it is un- common to process in-kind redemptions,288 it can be done when a fund and its remaining shareholders would be harmed significantly if it sold securities at steep discounts because of market volatility or stress. Alternatively, funds can use redemptions in-kind as a method of tax management. If a fund holds securities that have significantly appreciated since purchase, selling the se- curity would cause the fund to incur a realized capital gain.289 Annually, realized capitals gains distributions are made to fund shareholders after being off-set by any capital losses the fund realized during the year.290 Capital gains distributions are taxable income to shareholders, and particularly in a tax- advantaged fund, routine capital gains distributions would be problematic for the fund as well as for shareholders.291 286 Holly van den Toorn raises the cherry-picking scenarios as a possi- bility and notes the importance of policies and procedures to protect the pro rata portion of each security. 287 See Kenneth C. Fang, SEC No-Action Letter, 2005 WL 3601654 (Dec. 21, 2005) (GE Institutional Funds requests, and the SEC provides, no- action relief where GE proposes in-kind procedures including pro-rata dis- tribution). This no-action letter is guidance for other mutual funds imple- menting similar in-kind transaction procedures. 288 The use of in-kind redemption is considered uncommon, but in truth, there is little transparency into the process. It is difficult to track this tool’s usage because in-kind redemptions are typically processed through the NSCC with all other trading, also making it difficult to process due to high volumes of regular market trades processing at the same time. Thus, it is difficult to estimate the depth of this particular market practice. 289 Karen Domato, ‘Redemptions in Kind’ Become Effective for Tax Management, WALL ST. J. (Mar. 10, 1999), http://www.wsj.com/arti- cles/SB921028092685519084. 290 Id. 291 Id. Tucker_VanDenToorn_Final No. 1:130] WILL SWING PRICING SAVE SEDENTARY SHAREHOLDERS? 195 No tax event occurs to either party when a fund distributes portfolio securities to a shareholder.292 This is vitally im- portant to funds and shareholders who redeem large portions of a fund. In times of market duress, however, these potential tax benefits are eroded by the fact that the portfolio securities are trading at deeply discounted prices and funds are more likely to capture a capital loss than a gain. Large investors may think twice before making large re- demptions, or a run on a fund, if they can expect to receive securities in-kind rather than cash. In-kind redemption may encourage fund stability by discouraging exit. Redemptions in-kind can dampen the “first mover advantage” and reduce the likelihood that multiple large shareholders would all want to exit a fund in times of market stress—i.e., when the fund NAV is low. Redemptions in-kind are commonplace for Exchange Traded Funds (“ETFs”), but not for mutual funds because of logistical challenges, shareholders’ unwillingness to accept other stock in lieu of cash at the point of exiting the fund, and other issues.293 Mutual funds typically utilize in-kind redemp- tions as a “last resort or emergency measure,” and a fund’s management personnel would be under strained capacity to deal with significant redemptions, possible runs on the fund, and other stressful situations.294 Reliance on in-kind redemptions poses reputational risks for a mutual fund, where the investment benefits from the easy diversification and conversion to cash for investors. His- torically, hedge funds have been more frequent users of this redemption distribution method, but it is typically a “sign of catastrophic liquidity problems” and associated with more locked-in capital.295 In addition to the liquidity challenge for 292 Id. 293 Swing Pricing First Proposal, supra note 4, at 62319–20. See also Final Rules, supra note 4, at 82087 (discussing in-kind redemptions). 294 Swing Pricing First Proposal, supra note 4, at 62320. 295 Domato, supra note 289. See also, e.g., Managed Funds, Comment Letter on Swing Pricing (Jan. 13, 2016), at 2–3, https://www.sec.gov/com- ments/s7-16-15/s71615-83.pdf [perma.cc/6E37-5A8U] (citing to existing li- quidity management tools for private hedge funds such as redemption TUCKER_VANDENTOORN_FINAL 196 COLUMBIA BUSINESS LAW REVIEW [Vol. 2018 mutual fund shareholders receiving in-kind redemptions, an- other disadvantage is that they could receive “odd lots” of se- curities. 296 Odd lots, an atypical amount of stock under the standard 100-share unit,297 may be difficult to sell at the price at which the entire lot was carried by the fund.298 This is par- ticularly the case in the fixed income market, where minimum delivery sizes exist, and odd lots of bonds are traded at re- duced prices because of the difficulty in subsequently selling the small lots of bonds to another investor.299 A shareholder may refuse to take the in-kind securities for this reason.300 C. A Considered Alternative: Dual Pricing U.S. mutual funds cannot engage in dual pricing, some- times referred to as ask/bid dual pricing, although it is avail- able in European jurisdictions.301 Dual pricing allocates inves- tor expenses and protects against dilution. Unlike in-kind redemptions and redemption fees, the SEC has considered but never authorized dual pricing.302 A dual-priced fund is one rights, lock up periods, advance notice requirements of redemptions, early redemption fees, side pockets, gates, and in-kind redemptions.). 296 Holly van den Toorn made this observation in her role in the mutual fund industry. 297 POZEN, supra note 25, at 266. 298 Holly van den Toorn made this observation in her role in the mutual fund industry. 299 Holly van den Toorn made this observation in her role in the mutual fund industry. 300 See e.g., Swing Pricing First Proposal, supra note 4, at 62319 (dis- cussing in-kind redemptions). Holly van den Toorn experienced a situation in which a shareholder essentially refused to take an in-kind redemption due to the operational complexities. Smaller funds may face negotiation dis- advantages in “forcing” the redemption and end up stuck between a rock and regulatory hard place. Ultimately, the fund with which she worked abandoned the in-kind redemption strategy, sold assets, and recorded the tax impact. 301 Dual pricing is applied predominantly to UCITs and AIFs in other jurisdictions. Holly van den Toorn made this observation in her role in the mutual fund industry. 302 In its rule proposal release, the SEC considered permitting dual pricing instead of swing pricing. Swing Pricing First Proposal, supra note 4, Tucker_VanDenToorn_Final No. 1:130] WILL SWING PRICING SAVE SEDENTARY SHAREHOLDERS? 197 that “calculates one price for subscribers, derived from under- lying security offer prices and another price for redeemers, de- rived from underlying security bid prices and in each case, po- tentially the related market costs.”303 Dual pricing conveys transaction costs to the transacting shareholders by publishing a “bid” NAV at which the fund is purchased and an “ask” NAV at which the fund is sold on a business day.304 A “crossing” method matches purchases and sales while portfolio securities are traded and related costs are then borne by the purchasing and selling shareholders via the NAV.305 Thus, two NAVs are published—a bid NAV for pur- chasing shareholders and an ask NAV for redeeming share- holders—spreading the transactional costs to shareholders who precipitate the need for trading portfolio securities. UCITS and alternative investments funds (“AIFs”) sold in markets outside of the United States primarily utilize dual pricing.306 The SEC considered but rejected dual pricing in fa- vor of swing pricing, citing concerns about operational chal- lenges to implement the system as well as investor compre- hension and comfort.307 While dual pricing may effectively externalize transactions costs, U.S. mutual funds have no current authority, or opera- tional capacity, to engage in dual pricing. The different mu- tual fund market timing—when the trading day closes and the time funds have to process orders while striking the NAV— between the U.S. and European markets complicates swing pricing, as discussed above, and complicates dual pricing as well. 308 The criticisms of blind swinging apply with equal at 62329. Note that ALFI does not specify whether it refers to a dual priced mutual fund, UCIT, or AIF. 303 ALFI 2015 SURVEY, supra note 58, at 7. 304 Id. at 9. 305 Id. 306 BLACKROCK, VIEWPOINT: FUND STRUCTURES AS SYSTEMIC RISK MITI- GANTS 6 (2014). 307 The SEC “believe[d] [swing pricing] would be simpler to implement and for investors to understand.” Swing Pricing First Proposal, supra note 4, at 62329. 308 See discussion supra Section III.B. TUCKER_VANDENTOORN_FINAL 198 COLUMBIA BUSINESS LAW REVIEW [Vol. 2018 force to dual pricing.309 The SEC, aware of the dual pricing alternative, rejected it in favor of swing pricing as a simpler and easier-to-understand option. 310 In addition, ALFI notes that dilution can still occur in a dual priced fund if the bid/of- fer NAVs are not a full reflection of the underlying costs of the investment or divestment.311 VI. CONCLUSION This Article concludes by noting both authors’ shared ob- servations and bringing to bear their individual experiences and professional expertise to analyze the value and viability of the swing pricing rule and its components. First, both authors acknowledge that the swing pricing rules signal a significant departure in mutual fund regulation. The limited application (and use) of the existing liquidity and dilution tools outlined in Part V demonstrate the low industry and regulatory priority previously placed on liquidity and di- lution management. Swing pricing, on the other hand, is a tool that with operational changes could be used consistently by many U.S. mutual funds. Second, and most notably, swing pricing authorizes funds to alter the NAV—the single most definitive feature of open-ended funds in the United States. This is a technical, but radical, change to mutual fund regula- tion. Market data and operational timing conflicts are the big- gest barriers to successful swing pricing implementation. How can funds estimate the swing threshold trigger and subse- quent NAV adjustment by the swing factor before they receive complete trading data? Significant industry practices, espe- cially with regard to intermediaries servicing retirement ac- counts, will need procedural adjustments, possibly along with 309 A fund would publish its NAV before it could fully assess the impact of shareholder purchases and redemptions and apply adjustments to calcu- late the separate bid and ask NAVs. 310 Swing Pricing First Proposal, supra note 4, at 62329; see also Final Rules, supra note 4, at 82087 (citing to in-kind redemption comments). 311 ALFI 2015 SURVEY, supra note 58, at 8. Tucker_VanDenToorn_Final No. 1:130] WILL SWING PRICING SAVE SEDENTARY SHAREHOLDERS? 199 the financial incentives, to do so. Complete and reliable mar- ket data are prerequisites to implementing swing pricing with any degree of confidence, accuracy or efficiency, especially in light of the absence of a safe harbor for participating funds. Blockchain technology offering automated, verified, and se- cure ledger maintenance is one promising avenue.312 The voluntary nature of the swing pricing rules compounds the necessity of systemic industry change. The SEC provided the opportunity to swing the NAV, but not the path. It seems clear to both authors that the SEC is using the voluntary as- pect of the rules to allow the first adopters to pave the way. First adopters are likely to be large firms with European funds in their complex and experience with the practice, who also have in-house transfer agents with proprietary systems, budgets, and the teams needed to undertake the expensive proposition. For example, large market players are the early experimenters in blockchain stock ledgers.313 Large firms pre- sumably have greater clout and more leverage with interme- diaries than smaller firms do. This Article refers to this as the Wal-Mart effect, and it seems apt. Intermediaries must be willing to make significant changes to trade cut-off times and operational systems if any early adopter can effectively swing the NAV. Leaving the implementation path up to the mutual fund industry links regulatory success to financial incentives. The industry can solve the operational challenges, but only if it is lucrative to do so. Financial incentives may be found in blockchain technology advances that reduce, if not eliminate, the need for operational staff and inter-institutional verifica- tion of stock ledgers. Cost savings are inherent in collapsing the mutual funds and retirement financial services system. Which parties benefit from the savings—funds, investors, plan servicers, etc.—remains to be seen. Relevant for all mutual funds, the SEC telegraphed its con- cerns regarding liquidity management and dilution preven- tion as regulatory priorities with the new rules. With the 312 See supra notes 227–248 and accompanying text for a discussion of blockchain. 313 See e.g., Irrera, supra note 238 (discussing Nasdaq blockchain tech- nology for mutual funds). TUCKER_VANDENTOORN_FINAL 200 COLUMBIA BUSINESS LAW REVIEW [Vol. 2018 swing pricing rules, the SEC sends a clear message that funds and fund boards should be considering how to address poten- tial dilution to shareholders’ investments. Funds should take the SEC’s message as a prompt to assess their current anti- dilution tools, practices, and related policies and procedures to determine whether they are sufficient in light of not only historical flows and potential emergency situations, but also the SEC’s current concerns regarding fund liquidity. An Industry Perspective on Swing Pricing My primary perspective is that of an active industry par- ticipant, responding to regulatory pronouncements and change.314 The Liquidity Management Program Rules—of which swing pricing is a component—impose new require- ments for funds to digest and implement. The mutual fund industry also faces the much-anticipated, now-delayed DOL Fiduciary Rule. January 2018 is the designated compliance date, however an executive order by President Trump and a subsequent appeal by the Department of Labor have ushered in uncertainty and confusion around the fiduciary duty rule.315 While federal law is being figured out, Nevada passed 314 This Subsection was written by Holly van den Toorn, who has over eighteen years of mutual fund industry experience and is currently a Legal and Compliance Manager for a publically traded company, its wholly-owned registered investment advisors, and affiliated mutual funds. 315 Memorandum on the Fiduciary Duty Rule, 2017 DAILY COMP. PRES. DOC. 95 (Feb. 3, 2017), https://www.whitehouse.gov/the-press-of- fice/2017/02/03/presidential-memorandum-fiduciary-duty-rule [perma.cc/ DL2X-68YH]. The Department of Labor’s (“DOL”) Fiduciary Rule’s compli- ance date was reset to January 1, 2018, but President Trump signed an Ex- ecutive Memorandum compelling the DOL to review the Fiduciary Rule “to determine whether it may adversely affect the ability of Americans to gain access to retirement information and financial advice.” Id. The DOL subse- quently filed a brief in a lawsuit, stating it had proposed to the Office of Management and Budget (“OMB”) to delay the compliance date to July 1, 2019. Brief for Respondents at 1, Thrivent Fin. for Lutherans v. Acosta, 2017 WL 5135552 (D. Minn. Aug. 9, 2017) (No. 16-03289). The DOL offi- cially began the eighteen-month delay in the November 29, 2017 Federal Register publication. 18-Month Extension of Transition Period and Delay of Applicability Dates; Best Interest Contract Exemption (PTE 2016-01); Class Tucker_VanDenToorn_Final No. 1:130] WILL SWING PRICING SAVE SEDENTARY SHAREHOLDERS? 201 its own version of a bill introducing a new fiduciary stand- ard.316 With several significant rules imposing new compliance obligations over the next two years,317 fund complexes and ad- visors must do more with less. Many in the industry are not feeling confident about meeting these obligations in the near- term. Legal and compliance teams are already stretched thin implementing report modernization, liquidity risk manage- ment programs, new liquidity policies and procedures, in ad- dition to addressing the industry disruptions resulting from DOL’s new definition of who is a fiduciary. And this is before tackling swing pricing. In response to these regulatory changes, the industry ex- pects significant consolidation among money managers through time-consuming mergers and acquisitions.318 The mutual fund industry initially balked at the idea that any fund could be prepared to opt into swing pricing—a procedural undertaking of epic proportions. And that’s before we begin to comprehend the operational complexities and ponder the fea- sibility of swing pricing. Perhaps the industry is not at odds with the requirements of swing pricing, but the landscape for the requirements. As discussed above, significant changes to the structure of intermediaries receiving and forwarding trades to funds is needed in order to implement swing pricing. Two factors may Exemption for Principal Transactions in Certain Assets Between Invest- ment Advice Fiduciaries and Employee Benefit Plans and IRAs (PTE 2016- 02); Prohibited Transaction Exemption 84-24 for Certain Transactions In- volving Insurance Agents and Brokers, Pension Consultants, Insurance Companies, and Investment Company Principal Underwriters (PTE 84-24), 82 Fed. Reg. 56545 (Nov. 29, 2017) (to be codified at 29 C.F.R. pt. 2550). 316 See Nev. Rev. Stat. § 628A.010 (2017). 317 See discussion supra note 4. In fact, the ICI recently submitted a request to the new SEC Commissioner to consider delaying the compliance date by an additional year. Memorandum from ICI to ICI Members (July 20, 2017) (on file with the authors). 318 Grace Jennings-Edquist, Complicated Fee, Sales Environment Cre- ates Pent-up M&A Demand, IGNITES (Apr. 27, 2017), http://ig- nites.com/c/1622033/189203/complicated_sales_environment_creates_pent _demand. TUCKER_VANDENTOORN_FINAL 202 COLUMBIA BUSINESS LAW REVIEW [Vol. 2018 increase swing pricing adoptions, particularly among fund managers who do not currently utilize swing pricing in Euro- pean jurisdictions. First, increased flexibility in setting the swing threshold—such as is the practice in Europe—may al- low for customized threshold calculations taking into account additional NAV elements such as market impact, bid-ask spread and excluding transaction taxes. Second, the SEC should issue additional guidance before November 2018 for participating funds on the threshold calculations, preferred operational procedures, and safe harbors. If industry operations can adjust to accommodate the tim- ing and information needs of swing pricing, it may enjoy fu- ture success in the United States. Two related incentives should give mutual funds sufficient reason to implement swing pricing: purported enhancements to a fund’s reported performance and mitigated asset dilution from unallocated transaction costs. But the optional proposal is an expensive way to tackle dilution at a time when demands on industry resources are significant. Once the compliance dust settles enough for investment advisers to have a clear view of the regulatory horizon, indus- try attention will turn to this optional opportunity. Portfolio managers like the idea of swing pricing for its performance enhancing properties, and legal and compliance departments like swing pricing for its shareholder protections despite the complexities of setting the factor and threshold. Transfer agents and back office administrators, however, see a looming headache with compliance, and possible elimination with au- tomating technologies. Blockchain could be in important tool for funds, and could not only reform some antiquated operational systems, but also provide an operational solution to enable funds’ implementa- tion of swing pricing with a measure of confidence in its accu- racy. While transfer agents as we know them could dissolve, opportunities exist for transfer agents to build the path for blockchain becoming an industry-wide standard for pro- cessing shareholder transactions. Mutual funds could see re- duced expenses with smaller back-office staffing needed as a Tucker_VanDenToorn_Final No. 1:130] WILL SWING PRICING SAVE SEDENTARY SHAREHOLDERS? 203 result of full implementation of blockchain, and begin to re- turn value to shareholders with swing pricing as well. While this is a time of great upheaval, it also presents as opportunity for the mutual fund industry and its shareholders. Certainly, the SEC expects funds to bulk up anti-dilution toolboxes. Each shareholder bears the burden of liquidity management under the current reality. Alternatives exist to manage liquidity and dilution, but they are weak or impracti- cal to be used on a consistent, on-going basis. Large firms, in- cluding those that service mutual funds, will be the early adopters of swing pricing. Undoubtedly, a united industry front will smooth the way, as long as funds work with service providers and intermediaries. Swing pricing will be an opportunity for early adopters. Participating funds will see an uptick in fund performance. Fund inflows (new investors) follow positive performance. More importantly, sedentary shareholders will be protected from long-term dilution, which will build shareholder trust and confidence in funds that choose to adopt the practice. The SEC has offered a tool that could serve as a conciliatory olive branch to beleaguered shareholders, many of whom are retire- ment investors hit hard during the recent financial crisis. An Academic Perspective on Swing Pricing My prior research engages with retirement investors,319 making my perspective “bottom up” looking at individuals populating the plans and the consequences of dilution. A brief primer on how retirement investors enter the markets is in order.320 Compensation (i.e., employer matching funds), tax incentives to invest, tax penalties to withdraw, and structural 319 See e.g., Tucker, supra note 65 (describing locked in retirement in- vestors); Anne M. Tucker, The Outside Investor: Citizen Shareholders & Corporate Alienation, 11 U. ST. THOMAS L.J. 99 (2014) (describing the legal rights and restrictions on retirement investors in the traditional corporate governance framework); Anne M. Tucker, Retirement Revolution: Unmiti- gated Risks in the Defined Contribution Society, 51 HOUSTON L. REV. 153 (2013) (describing the legal changes to the retirement experiment). 320 This Subsection was written by Anne M. Tucker, Associate Profes- sor of Law, Georgia State University College of Law. TUCKER_VANDENTOORN_FINAL 204 COLUMBIA BUSINESS LAW REVIEW [Vol. 2018 incentives such as automatic enrollment strongly influence the “choice” to invest.321 Retirement investors entering the mutual fund market through defined contribution plans and individual retirement accounts fueled rapid growth of the in- dustry.322 The mutual fund industry now manages $16.3 tril- lion assets and manages retirement investments for 54.9 mil- lion U.S. households.323 Once invested, retirement investors face exit obstacles that make their investments sticky. In other words, they are more likely to be sedentary, staying in a fund for a long time, and recent ICI retirement investor re- search demonstrates this.324 The shifted focus in retirement planning away from pen- sions to self-directed defined contributions plans (i.e., 401Ks) has been described as the great experiment. In the United States, retiring employees are no longer guaranteed an in- come325 in retirement, but instead are guaranteed access to the assets that they saved and now manage. Robert Merton described the U.S. retirement experiment in the following col- orful terms: [I]t’s a real stretch to ask people to acquire sufficient financial expertise to manage all the investment steps needed to get to their pension goals. That’s a challenge even for professionals. You’d no more require employ- ees to make those kinds of decisions than an au- tomaker would dump a pile of car parts and a tech- nical manual in the buyer’s driveway with a note that 321 See Tucker, supra note 65, at 168–69. 322 INV. CO. INST., supra note 1, at 130; see also Holden, supra note 3, at 2 (describing defined contribution plan asset trends from 2007–2016). 323 ICI FACTBOOK, supra note 1, at 10; see also Holden, supra note 3, at 2. 324 See Holden, supra note 3 and accompanying text. 325 Pensions were never universal and the headline-making failure of steel companies and pensions in the 1970s contributed to the shift to indi- vidual savings vehicles. Retirement Revolution, supra note 319, at 163–167. Tucker_VanDenToorn_Final No. 1:130] WILL SWING PRICING SAVE SEDENTARY SHAREHOLDERS? 205 says, ‘Here’s what you need to put the car together. If it doesn’t work, that’s your problem.’326 In this experiment, to extend the analogy, there are many uncontrolled variables such as how much people save, how well they invest it, and how long they live that make retire- ment policy and market regulation complex and indefinite. Transaction cost dilution, however, is a controllable variable. The U.S. retirement experiment needs every available tool in its arsenal to promote individual and systemic financial sta- bility. The SEC’s swing pricing rules present a path for funds to control at least this one variable. As my co-author ably describes, the SEC’s path is partial, incomplete, and fraught with operational challenges that are significant, scary, and will require individuals within the mu- tual fund industry to spend tedious hours solving. No one wants to do this, and no one wants to ask their colleagues to do this. European funds’ robust experience with swing pricing should be a salve to U.S. mutual fund industry concerns. Eu- ropean market timing differences aside, it is evidence of a workable and profitable system. Some U.S. funds have opera- tions in Europe and therefore have experience with these is- sues. The voluntary nature of the SEC rules and the costs asso- ciated with operational changes to accommodate swing pric- ing practices means that large firms will be the swing pricing pioneers. Large firms will lead the way, and enhanced fund performance (returns without an offset for large transaction costs) should lure in others. The SEC’s voluntary approach ap- pears calculated to leverage the best of market influences— money incentives and competition—to make the necessary 326 Robert C. Merton, The Crisis in Retirement Planning, HARV. BUS. REV., July–Aug. 2014, https://hbr.org/2014/07/the-crisis-in-retirement-plan- ning [perma.cc/6GZS-WCLQ]. Robert Merton’s bio describes him as a recip- ient of the 1997 Alfred Nobel Memorial Prize in Economic Sciences and a School of Management Distinguished Professor of Finance at MIT Sloan School of Management. He is also the resident scientist at Dimensional Fund Advisors, a Texas-based global asset management firm, and Univer- sity Professor Emeritus at Harvard University. TUCKER_VANDENTOORN_FINAL 206 COLUMBIA BUSINESS LAW REVIEW [Vol. 2018 structural changes to timing and reporting practices to facili- tate swing pricing. Another word about operations before concluding with a focus on retirement investors: Structural impediments to swing pricing such as incomplete information, trading trans- actions bleeding into the evening hours, and the role of inter- mediaries reflect an industry that has outgrown its original procedural capacity and intent. Swing pricing has not caused the procedural impediments highlighted in this Article; rather the new practice merely highlights these existing ailments. Swing pricing illustrates the ad hoc and piecemeal develop- ment of industry practices and procedures needed to accom- modate rapid growth and fundamental changes to the inves- tor landscape from individual investors to retirement investors through qualified plans. Operational changes to ac- commodate swing pricing may better reflect the size and in- vestor makeup of the mutual fund industry. Perhaps the re- sulting procedural changes will be an improvement for mutual funds resulting in practices better tailored to serve the current reality of who invests in mutual funds and how they enter the markets. Private blockchains between transacting institu- tions offer a promising solution for the timing and liability hurdles we carefully explored above. Perhaps even more ex- citing for those with an eye out for retirement investors is the potential cost savings from operational reduction in mutual fund transactions promised by blockchain technology. Finally, a last word about retirement investors. Retire- ment policy, tax incentives, and defined contribution plan at- tributes funnel retirement investors to mutual funds and make it difficult for them to leave. A market design that di- lutes sedentary shareholder assets due to unallocated trans- action costs generated by large trades (and presumably large shareholders) erodes that trust, jeopardizes individual finan- cial stability, and, to be unacademic, is unfair. On This We Can Agree The SEC’s swing pricing rules present a half solution to shareholder dilution and create more implementation prob- lems than the rules solve. Funds must volunteer to assume Tucker_VanDenToorn_Final No. 1:130] WILL SWING PRICING SAVE SEDENTARY SHAREHOLDERS? 207 the regulatory and operational challenges presented by the rules. Perhaps this is by design. A partial administrative ap- proach requires a market-led solution born of mutual fund in- dustry and intermediary participation and buy in. For an in- dustry symbolized by a bull327 and which has brought financial innovation and savings capacity to the masses, swing pricing obstacles are not insurmountable. Mutual funds have powerful incentives—financial gain and competition with other funds—to confront the challenges ahead. With the advent of blockchain technology, mutual funds now have pow- erful tools to overcome operational challenges and modernize transactions practices, regardless of whether funds imple- ment swing pricing. 327 For a discussion of the Wall Street bull, or charging bull, see CHARG- ING BULL, http://chargingbull.com/chargingbull.html [perma.cc/G8LL- P7BM]. TUCKER_VANDENTOORN_FINAL 208 COLUMBIA BUSINESS LAW REVIEW [Vol. 2018 APPENDIX Federal Legislation & Agency Rules Referenced in Article Federal Legislation The 1933 Securities Act, 15 U.S.C.A. § 77a The 1934 Securities Exchange Act, 15 U.S.C.A. § 78a The Investment Company Act of 1940, 15 U.S.C.A. § 80a-51 See § 80a-2 for a definition of “value” of securities See § 80a-16 for discussion of board of directors’ election & duties The Investment Advisers Act of 1940, 15 U.S.C.A. § 80b-20 SEC Rules Mutual Fund Governance, 17 C.F.R. § 270.0-1 Net Asset Value Calculations, 17 C.F.R. § 270.2a-4, 2a-7, 18f-3d Money Market Funds, 17 C.F.R. § 270.2a-7 Pricing and Redeeming Shares Board of Directors written procedures Reporting Obligations, 17 C.F.R. § 270.8b-5 Rule 22 Pricing regulations, 17 C.F.R. § 270.22c Market timing, 17 C.F.R. § 270.22c-2 Swing pricing, 17 C.F.R. § 270.22c-1 Liquidity Risk Management Programs, 17 C.F.R. § 270.22e–4 Compliance Procedures & Fund Board of Directors, 17 C.F.R. § 270.38a-1 Other Agency Rules IRS Required Distributions 26 § C.F.R. 1.401(a)(9)-1 DOL Fiduciary Duty, 29 § C.F.R. 2510.3-1 OLE_LINK6 OLE_LINK5 OLE_LINK4 OLE_LINK3 OLE_LINK9 OLE_LINK10