The populist backlash in Chapter 11
From a bankruptcy perspective, the pandemic has unfolded differently than many expected. Prior economic crises have caused sharp upswings in bankruptcy filings. The 2007-2009 crisis was true to form, with business bankruptcy filings doubling during this time, to 60,837 in 2009 from 28,322 in 2007.1 Given that governments almost completely shut down the American economy in 2020, an even greater surge seemed likely. Many observers predicted a massive wave of bankruptcies.2 Bankruptcy scholars and bankruptcy organizations sprang into action, calling for Congress to increase the capacity of the bankruptcy system (primarily by increasing the number of bankruptcy judges) and to assure access to financing for companies that filed for bankruptcy.3
David Skeel
S. Samuel Arsht Professor Corporate Law – University of Pennsylvania Law School
The big surprise of the current pandemic is that the great bankruptcy wave of 2020 never materialized. The number of very large corporate bankruptcies increased,4 but overall business bankruptcies went down rather than up (from 22,780 in 2019 to 21,655 in 2020), and the decrease in consumer bankruptcy filings was even more dramatic (752,160 in 2019, 522,808 in 2020, a 28% drop).5 The most obvious reason for the surprising decline in bankruptcy filings was the enormous amount of stimulus money that buoyed the economy, including well over $1 trillion of business lending capacity in the CARES Act of March 2020 and subsequent boosters of the small business portion of the legislation. In addition, the buoyancy of the stock market provided access to equity capital for firms that might have found themselves in bankruptcy under other circumstances.
Although the pandemic confounded the typical pattern of rising bankruptcies during an economic crisis, in another respect the pandemic has proved true to form: It has provoked a populist backlash. During the 2007-2009 crisis, populist movements emerged on both ends of the political spectrum—the Tea Party on the right and Occupy Wall Street on the left—in each case, protesting bailouts of large financial institutions.
The current crisis has prompted another populist backlash, as can be seen in controversies that have arisen in the Purdue Pharma opioid bankruptcy and in the bankruptcy of USA Gymnastics after revelation of horrendous sexual abuse by former team doctor Larry Nassar. Unlike the Tea Party and Occupy Wall Street, the current outrage is directed at the bankruptcy process itself. There is a growing populist perception that Chapter 11—the bankruptcy provisions used to restructure financially distressed businesses—has become deeply unfair. It benefits insiders—the “haves”—at the expense of outsiders—the “have nots.”
The closest analogy to the current populist backlash comes not from the most recent pre-pandemic crisis but much earlier, during the Great Depression.6 After emerging in the second half of the nineteenth century, the American approach to corporate reorganization (originally known as “equity receivership”) came to be dominated by large Wall Street banks such as J.P. Morgan and large Wall Street law firms such as Cravath, Swaine & Moore. The banks that had underwritten a class of bonds would offer to represent the investors who bought the bonds in negotiations with a financially distressed railroad or other business. In the 1930s, New Deal reformers such as William Douglas—a Yale law professor who became chairman of the Securities & Exchange Commission and later a Supreme Court Justice—concluded that the Wall Street banks and lawyers were profiting (through the fees they charged and by assuming positions of control) at the expense of the investors they purposed to represent. The reformers ripped control from Wall Street by persuading Congress to enact, and President Roosevelt to sign, the Chandler Act of 1938. The Chandler Act prohibited bankers or lawyers that had represented a company before bankruptcy from representing it after the bankruptcy filing, which meant the company’s underwriters could no longer run the reorganization process. Within a few years, Wall Street had disappeared from bankruptcy.
The pandemic has spurred a remarkably similar populist backlash. Even before the pandemic, concerns were growing about current developments in the restructuring of large corporations. Critics complained about companies’ ability to file for bankruptcy almost anywhere they want to (“forum shopping”), insider control of the restructuring process, the payment of bonuses to managers before and during bankruptcy, and the use of bankruptcy in cases like Purdue Pharma to resolve not only the obligations of the company itself but also of individuals or entities like the Sacklers who have not filed for bankruptcy themselves. During the pandemic, discontent with current bankruptcy practice has grown considerably.7 Lawmakers have introduced a spate of bills, each of which has been prompted by populist dissatisfaction with current Chapter 11 practice.
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This report describes and comments on four practices that have prompted populist backlash. Several other controversial features of current practice that are not considered here are referenced in the footnote below.8
Bankruptcy venue
The first and most longstanding magnet for populist outcry is a company’s choice of where to file its bankruptcy case—known as bankruptcy “venue.” Under the current filing rule a company can file for bankruptcy in any of the following locations: where its headquarters are; its principal assets are; it is domiciled; or an “affiliate” of the company has already filed for bankruptcy.9 Although this sounds like a limited set of options, in practice a company can file its bankruptcy case almost anywhere in the country due to the “affiliate” option. If a Pennsylvania company wished to file for bankruptcy in South Dakota, it could simply create a new, wholly owned entity in South Dakota and have the new entity file for bankruptcy in South Dakota. The Pennsylvania company could then file for bankruptcy in South Dakota since an “affiliate” is in bankruptcy there.
During the decade after the current bankruptcy code was enacted in 1970s, many large corporate debtors filed for bankruptcy in the Southern District of New York. Starting in 1990, Delaware joined New York as another popular filing location for large corporate debtors. The late 1990s saw the first serious challenge to this “forum shopping.” Critics complained that New York and Delaware judges lured companies to their districts by, among other things, allowing bankruptcy lawyers to charge high fees, quickly approving all of the debtor’s initial (“first day order”) requests, and by authorizing rapid sales of the debtors’ assets.10 They also complained that New York and Delaware were too inconvenient for employees and small creditors of companies whose operations were in other states, which it made it impossible for small parties to participate.
Venue reform was never enacted, but it continued to percolate, with support from both Democrats and Republicans. In recent years, several other locations have joined New York and Delaware as popular venues, including Richmond, Virginia and most recently the Southern District of Texas (Houston). The new twist in the controversy is that debtors in several of these locations can pick not just the district where they file but the particular judge.11 The Southern District of Texas has made this easy by committing to assign all large Chapter 11 cases to two judges in the district. In Southern District of New York, a debtor that files its bankruptcy case in White Plains was, until late last year, certain to get Judge Robert Drain, the only Southern District of New York judge sitting in White Plains.12 Purdue Pharma appears to have filed its case there for this reason.
Congress is currently considering legislation sponsored by Senators Cornyn (R-TX) and Warren (D-MA) that would ban venue shopping.13 Under the proposed legislation, large corporate debtors would generally be required to file for bankruptcy in the state where their headquarters or principal assets are.14 The reform would remove domicile—the state where a debtor is incorporated—as a venue option, and the debtor could only file for bankruptcy where an affiliate has filed if the affiliate owns a majority of the debtor’s stock—that is, if the affiliate is the parent corporation.
As often is the case with populist measures, the proposed legislation has beneficial features but also deeply problematic ones. Some of the forum shopping concerns are well taken. Debtors should not be able to pick particular judges within a district and permitting a debtor to file anywhere an affiliate has filed is too easy to manipulate. But removing a debtor’s ability to file in its domicile would be seriously counterproductive. The loser here would be Delaware, where most large corporations are incorporated. Not only is the debtor’s state of domicile an obvious filing location for a large corporation, but substantial empirical evidence suggests that debtors that file for bankruptcy in Delaware file there because of the expertise of Delaware’s bankruptcy judges.15
Third party releases
Another contentious practice is so-called “third party releases.” When a corporation completes a Chapter 11 reorganization, its prebankruptcy obligations are extinguished. The bankruptcy laws only contemplate that the corporate debtor’s obligations will be extinguished, however, not the obligations of other parties such as the directors or officers of the debtor or outside parties that were involved in wrongdoing by the debtor. In many cases, a corporate debtor asks the court to extinguish the obligations of some of these other parties, often in return for a payment by the third parties. In the Purdue Pharma case, the Sacklers agreed to pay roughly $4.5 billion in return for a court order extinguishing their potential liability related to the opioid crisis. When companies owned by private equity funds file for bankruptcy, the private equity sponsor often seeks this protection. Such a release is known as a third-party release.
Courts have struggled with the question of whether third party releases should be permitted. Except with corporate debtors that have asbestos liability, which are subject to a special rule,16 bankruptcy law does not speak to the question of whether third party releases are permissible. There are plausible arguments that they are constitutional and plausible arguments that they are not.17 Some courts allow them, while others do not. As a result, corporate debtors sometimes seek to file their case in a location where third-party releases are permitted.
The Sacklers’ efforts to obtain third party releases has triggered populist ire at their use. The bankruptcy judge approved the releases, although he required the debtor to reduce the scope of the releases. The district court subsequently reversed, concluding that the bankruptcy laws do not authorize third party releases.18 This decision has been appealed to the federal court of appeals.
As with bankruptcy venue, Congress is currently considering a dramatic intervention—legislation that would almost completely ban third party releases.19 Unlike with venue, there is a plausible argument for simply disallowing third party releases, even if they are legally permissible. The argument is that parties who have not themselves filed for bankruptcy should not be entitled to benefits of bankruptcy such as the extinguishing of debts. If the Sacklers or other third parties want this benefit, they need to file for bankruptcy.
The argument that third party releases should be permitted, at least on some occasions, is more pragmatic. Some argue that the treatment of nondebtors such as the Sacklers is so closely related to the debtor’s reorganization that the company’s financial distress cannot be resolved without also addressing potential claims against the nondebtors.20 Defenders of third party releases also contend that everyone, including victims, may be better off when a release is given in return for compensation by the third parties. The Sacklers have argued that if they were not given relief they would defend themselves vigorously outside of bankruptcy and victims would likely receive much less than the $4.5 billion the Sacklers have agreed to pay in the bankruptcy.
Rather than simply banning third party releases, a more nuanced response would be to insist that third parties seeking a release provide more transparency about their assets and ability to contribute.21 In a sense, they would be required to submit to some same rules about disclosure that would apply if they had filed for bankruptcy. Releases might also be limited to third parties that did in fact make a substantial contribution to the payment of victims or other creditors.
The “Texas Two-Step”
A third controversial practice is moving assets from one entity to another—often creating a “good company” with plenty of assets and an asset poor “bad company”—and then subsequently putting one or both of the entities in bankruptcy. Private equity funds often conduct internal reorganizations that are alleged to have this effect after they acquire a company, as in the Chapter 11 cases of the Chicago Tribune and Caesar’s.22 More recently, financially distressed debtors have taken advantage of a Texas law that appears to bless these transactions.23 The most controversial current example is Johnson & Johnson. Johnson & Johnson created a separate entity for its talc line of business, which is subject to numerous lawsuits, and put the separate entity into bankruptcy. This strategy has become known as the “Texas Two-Step.”
These transactions also have spurred populist backlash, both because they seem to involve manipulation by insiders and because the manipulators often are private equity funds, a bête noire of many populists. The proposed legislation to ban third party releases mentioned earlier also would amend bankruptcy law to require dismissal of any case involving a divisional merger that “had the intent or foreseeable effect of … separating material assets from material liabilities … and … assigning all or a substantial portion of those liabilities to the debtor.”24
As with the other issues, courts already have a more nuanced response available to them. When a company transfers assets from a “bad company” to a “good company” within its corporate structure and one or both later end up in bankruptcy, the transfer can be challenged as a “fraudulent conveyance” if the bad company did not receive adequate compensation for the assets it transferred. Fraudulent conveyance challenges were central to the Chicago Tribune and Caesar’s cases.
With a Texas Two-Step transaction, creditors also can challenge the bankruptcy case as having been filed in bad faith. If the transaction is abusive—if the bad company doesn’t have any real assets, for instance—the court can simply throw the case out.
Lender control of bankruptcy outcomes
Another controversial feature of current practice is lenders’ use of their financing agreement and related contracts to dictate the outcome of a Chapter 11 case. When Neiman Marcus filed for bankruptcy, it had signed a financing agreement with lenders to borrow $675 million, together with a so-called Restructuring Support Agreement that locked in a reorganization plan that required Neiman to transfer control to the lenders.25 Once the financing was approved, the case was over—no other outcome was possible.
If the market for providing financing to debtors in bankruptcy were competitive, lenders’ use of lending agreements to control the restructuring process might be less problematic. But the debtors’ current senior lenders have a monopoly, or nearly so, because other lenders fear that their loan will simply subsidize the senior lenders if the senior lenders have priority over the new lenders. Only if the court awards new lenders a “priming lien”—that is, priority over the current senior lenders—will new lenders offer to finance the debtor’s operations in bankruptcy. Bankruptcy courts have the power to provide priming liens if the senior lenders will be “adequately protected,” but they have been reluctant to do so.26
Although the monopoly of debtors’ current lenders has not yet gotten significant attention in policy circles, the issue is even more pervasive in practice. As with the issues discussed earlier, the problem does not require a legislative solution. Bankruptcy courts could facilitate competition by signaling a greater willingness to grant priming liens to new lenders and by declining to enforce contractual provisions that impede competition.27
A breaking point?
Complaints about insider control of Chapter 11 were rising even before the recent pandemic. The pressure has steadily increased during the pandemic, due both to the pandemic and to the confluence of highly controversial bankruptcy filings by Purdue Pharma, USA Gymnastics, the Boy Scouts, and others.
The long-term implications of the populist backlash triggered by these developments may depend on how bankruptcy professionals and bankruptcy judges respond to this unrest. If courts address the legitimate concerns raised by bankruptcy populists, the credibility and effectiveness of Chapter 11 may be restored. The Johnson & Johnson and Purdue Sackler cases offer hints of such a trend. With the talc entity of Johnson & Johnson, a bankruptcy judge transferred the case from North Carolina to New Jersey after allegations of forum shopping, and a motion to dismiss the case as having been filed in bad faith is pending. In Purdue Pharma, a district court struck down the controversial Sackler releases.
If these problems continue to fester, the populist backlash may lead to sweeping bankruptcy reform. Such reform is unlikely to be carefully tailored to the problems that prompted it. It could even destroy traditional Chapter 11 practice, much as the Chandler Act of 1938 brought an end to the reorganization framework that presaged current Chapter 11.
Although the pandemic did not overwhelm the bankruptcy system as many expected, it did bring a spate of preexisting conditions to light.28 The lesson for bankruptcy insiders, the “haves” of the bankruptcy process, seems to be “Physician, heal thyself,” before it’s too late.
Credit scoring: Improve or eliminate?
Your credit score plays a major role in your life, impacting your ability to rent an apartment, buy a house, get a credit card, and even how much you pay for auto insurance. These three-digit numbers, graded on a scale that resembles the SAT, have become more accessible to consumers due to recent changes in law, technology, and business. Credit scores are clearly impactful in the lives of Americans, but are they being created accurately, fairly, and with proper regulatory oversight? Is there a better way?
Credit scores are built on credit reports, files kept on most Americans by several large credit reporting bureaus. What are these reports and scores made of? How accurate are they? Who ensures they are fair and accurate?
On December 7, the Center on Regulation and Markets will convene a group of experts to discuss these questions and get to the core of the issue: Are credit scores and credit reports the right method for society to allocate credit? If so, how can they be improved? If not, what should replace them?
Viewers can submit questions for speakers by emailing [email protected] or via Twitter using #CreditScore.
Stability and inclusivity of stablecoins: A conversation with Circle CEO Jeremy Allaire
While cryptocurrency has been around for over a decade, it has only gained mainstream popularity recently. Crypto backers see the technology as the way of the future, but its instability leaves others skeptical. As a less volatile alternative to traditional cryptocurrencies, asset-backed stablecoins have joined the market. But as with all new technology, important questions must be resolved before stablecoins could become a more widely accepted part of our financial system.
In this fireside chat with Circle co-founder, chairman, and CEO Jeremy Allaire, we will discuss the rise of stablecoins, the state of regulation of stablecoins, and the potential for greater inclusion through new financial technology (fintech). The dialogue will cut through much of the hype of cryptocurrency – stablecoins in particular – and dive into the two important and distinct issues surrounding stablecoins: financial stability and inclusion.
This event will be part of the Brookings Center on Regulation and Markets’ Series on Financial Markets and Regulation, which looks at financial institutions and markets broadly and explores how regulatory policy affects consumers, businesses, investors, fintech, financial stability, and economic growth.
Viewers can submit questions for speakers by emailing [email protected] or via Twitter using #Stablecoin.
What is swing pricing?
The problem
In March 2020, at the start of the COVID-19 pandemic in the U.S., investors pulled more than $100 billion out of corporate investment-grade and high-yield bond mutual funds, forcing funds to sell some of their holdings. The spread between corporate bond yields and U.S. Treasuries (a market that had its own dysfunction) widened, transaction costs rose, and issuance of new bonds came to a halt, disrupting the flow of credit to the nation’s corporations. This led the Federal Reserve to intervene by offering, for the first time, to buy corporate bonds and exchange traded corporate bond funds in what proved a successful effort to keep credit to corporations flowing. It was an extraordinary move that underscores the risks these funds pose to financial stability. (For details, see this Federal Reserve note.)
The growth of open-end fixed income funds magnifies the systemic significance of the tension between shareholders’ expectations of daily liquidity and the (often illiquid) holdings of the funds. The average corporate bond is traded about once a month. Shareholders in an open-end bond fund expect (and receive in many cases) to be able to sell their shares much more easily and quickly than if they held bonds directly. When he was governor of the Bank of England, Mark Carney said, “These funds are built on a lie, which is that you can have daily liquidity, and that for assets that fundamentally aren’t liquid.”
In normal times, redemptions are modest and can be met by an offsetting inflow of funds or by selling liquid securities in the portfolio like Treasuries.[1] But big outflows can force a fund to sell holdings of less liquid securities that may require a price concession to attract a buyer. Especially in times of stress, big sales force down bond prices because of the absence of a truly liquid market for the underlying bonds. This, in turn, raises the rates that all corporate borrowers have to pay on newly issued bonds—if they can sell them at all—thus harming the overall economy.
Shareholders in a fund who get out early can redeem at a better price than those who remain, because their redemptions are met before the fire sale forces the fund to mark down the value of its portfolio. This creates a “first-mover advantage,” which can induce a rush to the door that amplifies the price movements that would otherwise occur. (With equity funds, this is less of an issue. Most equities are traded in highly liquid markets where prices quickly reflect order flow. To be sure, there are small stocks that do not trade every day, but most trade every few days, and there is not enough volume in any single small stock to create a problem. The average corporate bond trades once a month; some commercial paper hardly ever trades. So any selling of such fixed-income securities can affect the price substantially.)
A possible solution
More widespread adoption of swing pricing. Swing pricing is widely used in Europe but not in the U.S., although its use was authorized by the SEC in 2018. Basically, it allows the manager of an open-end fund to adjust its net asset value up or down when inflows or outflows of securities exceed some threshold. In this way, a fund can pass along to first movers the cost associated with their trading activity, better protect existing shareholders from dilution, and reduce the threats to financial stability.
This brief draws from the report of the Task Force on Financial Stability, which recommended more widespread use of swing pricing, and a roundtable the Task Force convened with industry, academic, and public sector officials to consider the pros, cons, challenges and costs to doing so.
What is an NAV, and why is that important for open-end funds?
The net asset value (NAV) is the price at which shareholders can purchase or sell their shares in an open-end mutual fund. The Investment Company Act of 1940 requires mutual funds to offer and redeem shares at the next net asset value calculated by the fund after receipt of an order. The NAV is usually calculated by dividing the value of the fund’s assets by the number of its shares. With swing pricing, this calculation of the NAV is adjusted up or down to account for the price impact and transactions costs that will be incurred because of redemptions and new share purchases that will occur after the NAV is calculated. Most U.S. funds calculate their daily NAV using the closing market price of the securities at 4:00 pm Eastern time. Orders from investors that are submitted after 4:00 pm are executed at the next day’s NAV.
Open-end funds can issue an unlimited number of shares. In contrast, a closed-end fund has a set number of shares, the price of which is determined in the market and can diverge from the net asset value of the underlying assets. Exchange-traded funds (ETFs) combine characteristics of open-end and closed-end funds. The price of ETFs fluctuates throughout the day and is determined by the price in the market. The movement in ETF prices is indicative of the kind of swing in an NAV that might be needed in stress, because the ETF price adjusts to attract a willing buyer.
What is dilution and the first-mover advantage in open-end funds?
If shareholders redeem a large quantity of shares in an open-end mutual fund, the fund may be forced to sell not only the highly liquid U.S. Treasuries it holds, but other assets as well. If many funds are doing the same thing at the same time—as they were in March 2020—the price of their underlying assets can fall; this is known as a “fire sale.” The first redeemer or first mover gets out at the initial NAV, which does not reflect the price declines associated with the subsequent fire sale, leaving the remaining investors to bear the costs associated with the portfolio manager having to sell assets to satisfy the first movers. This decline in the value of the fund’s holdings, which are owned by the remaining investors, is known as “dilution.” In a stress situation, therefore, investors have strong incentives to be among the “first movers,” which itself can amplify redemptions and resulting fire sales.
Using data on daily fund flows, Falato, Goldstein, and Hortacsu find that between February and March 2020, the average bond fund experienced outflows of about 10% of net asset value, far larger than the 2.2% experienced during the peak of the 2013 taper tantrum. They find that fund illiquidity and vulnerability to fire-sale spillovers were the primary drivers of these outflows, and that the “more fragile funds benefitted relatively more from the announcement effect of the Fed facilities.”
How does swing pricing address this issue?
Swing pricing is a mechanism to apportion the costs of redemption and purchase requests on the shareholders whose orders caused the trades. It is designed so that remaining shareholders don’t bear all the costs (including dilution) caused by first movers. In effect, those attempting to take advantage of limited fund liquidity are charged for their redemptions by adjusting the price they receive to reflect the liquidity of the market for the fund’s assets. With swing pricing, the incentive to be a first mover is diminished, and with it the risk that existing shareholders will be diluted and the risk that large redemptions will drive prices down sharply with spillover effects on the market and the economy. To be fair both to those who sell and those who remain, a swing price must reflect a fair valuation and approximate the costs imposed by first movers; it cannot be set simply to impose an enormous penalty on redeeming shareholders.
Under full swing pricing, the NAV is adjusted daily for the likely costs of redemptions, regardless of the amount of shareholder activity. Under partial swing pricing, the adjustment is triggered only when net redemptions exceed some pre-determined threshold—a recognition that small transactions do not pose much of a problem.
How does swing pricing work in Europe?
Many global open-end mutual funds are based in Luxembourg (because it has a favorable regulatory climate), and many of those routinely use swing pricing.
Not all funds follow the same procedures, but here’s an illustrative example. All orders that will be redeemed at a given day’s NAV must be received by noon CET on the day of the trade. In that case, any orders received after noon will be processed at the next day’s NAV. The NAV itself is not set until 4 pm CET each day. This gives the fund four hours to assess its order imbalance and determine the gap between buy and sell orders. Most buy and sell orders can be “crossed,” so that rather than buying and selling new securities, the redeeming and purchasing customers can have ownership transferred without incurring any transactions costs or putting pressure on prices. If there is a net imbalance (say, many more requests to redeem than to purchase), then to meet the net demands, some securities will need to be sold. If there is a large imbalance, then the NAV is adjusted (or “swung”) to reflect the impact of the sales.
The swing threshold is the amount of net subscriptions or redemptions that trigger the adjustment to the NAV. The fund then estimates how much prices for the assets being sold are likely to move to meet the subscription or redemption requests it has received; other factors taken into account include transaction costs and the bid-ask spread. The fund then uses those estimates to adjust the NAV by some percentage, generally no more than 2% or 3%. The adjustment is known as the swing factor.
Swing thresholds and swing factors vary depending on the market for the fund’s underlying securities. Swing factors tend to be larger in funds that invest in more thinly traded securities.
Fund managers set the rules and size of the adjustment and disclose their procedures, but precise details are not always disclosed so as to avoid investors exploiting them unfairly. A bond fund prospectus might, for instance, set a maximum swing factor of 3%, but give the fund discretion up to that level.[2] (For an example, see paragraph 17.3 of the prospectus for BlackRock’s Luxembourg-based global funds. )
Here is a stylized example of partial swing pricing from Allianz. It shows the threshold (the volume of orders) that trigger swing pricing in normal markets and in times of distressed markets, and the size of the swing under various scenarios (0.5% or 1.0%).
A survey by the Bank of England and the Financial Conduct Authority of 272 U.K. mutual funds found that 83% (202 funds) have the option to use swing pricing in place. Most funds using partial swing pricing had a trigger of net flows of 2% or less of total NAV. During COVID, however, several funds used their discretion and reduced their swing threshold or moved to full swing pricing. Swing pricing is advantageous to investors not only because it mutes dilution, but because the fund needs to hold fewer lower-yielding highly liquid assets to meet redemptions.
Researchers at the Bank for International Settlements compared the track record of Luxembourg-based funds (which generally use swing pricing) to similar U.S.-based funds (which do not use swing pricing). They found that the Luxembourg-based funds hold less cash than their U.S. counterparts. They also found that during the 2013 taper tantrum, the Luxembourg funds had higher returns than their U.S. counterparts (in part because there was less dilution and in part because they hold less cash), though there was more daily volatility in the Luxembourg funds.
In addition to the Luxembourg-based funds, funds based in the U.K., Ireland, France, Netherlands, and recently Germany use swing pricing.
While investor fairness has been the primary driver of swing pricing in Europe, market participants say it can affect investor behavior in ways that may contribute to financial stability. If an investor has a very large order to place in a European-based fund, the investor may spread out the purchase or sale over several days or otherwise break up the order to avoid imposing costs on the mutual fund that will be passed along in an adjusted swing price.
What are the impediments to implementing swing pricing in the U.S.?
The institutional structure of the market and operational issues are the main impediments to embracing swing pricing in the U.S.
Although the NAV is usually set at 4:00 pm Eastern time every trading day, many U.S. funds don’t know the size of their net inflows and outflows until late in the day or even the next morning. Many funds receive order flows from intermediaries that stand between an investor and the fund, such as 401k plan administrators, broker-dealers, and financial advisers. Some intermediaries have agreements that allow them to receive requests until 4:00 pm Eastern but not convey the order to the fund until that evening or even the next morning, but then upon passing them on still have the order serviced at that 4:00 pm NAV. In other words, the fund managers determine the NAV before they know how large the flow of orders is. Such agreements would need to be renegotiated and the software systems used by the intermediaries would need to be overhauled if new redemption rules were to be put in place. The intermediaries would also need to rework their client agreements.
Industry participants noted the following additional considerations:
Setting a cutoff at 12:00 noon New York time for investors to place mutual fund orders at today’s NAV would be 9:00 am in California and 6:00 am in Hawaii. But global funds based in Luxembourg deal with even more time zones and have navigated this problem.
Retirement fund record keepers and insurance companies require actual NAVs to process trades, e.g. an investor who wants to sell $1 million worth of shares need to know an NAV to translate the $1 million into an actual number of shares. European funds often price such trades at yesterday’s NAV.
Smaller fund management companies may not have the resources to implement swing prices.
In any event, changing all this would be costly and would require a mandate from the Securities and Exchange Commission and coordination with other regulators, including the Department of Labor (which has oversight over retirement plans) and FINRA, among others. No single fund or group of funds will make this shift unless everyone else is doing so as well.
If a shift were mandated, the same rules would need to be applied to other types of savings vehicles that are economically similar to mutual funds, such as bank collective investment trusts.
When it authorized swing pricing in the U.S. in 2018, the SEC said, “We…appreciate the extent of operational changes that will be necessary for many funds to conduct swing pricing and that these changes may still be costly to implement, but we were not persuaded by commenters who argued that these changes are insurmountable, and indeed one stated that despite these challenges ‘the long-term benefits of enabling swing pricing for U.S. open-end mutual funds outweigh the one-time costs related to implementation for industry participants.’”
What are the alternatives to full-scale swing pricing?
One alternative would be for funds to consult and gather information from intermediaries and vendors a few hours before 4:00 pm, and then allow (or mandate) the fund managers to estimate a full-day’s flows and apply a swing factor if indicated. This would accomplish some, perhaps even much, of the benefits of swing pricing without the cost of reorganizing the whole network of vendors, intermediaries, and fund managers. It probably would require a safe harbor to protect intermediaries, vendors, and funds from liability if the estimates proved inaccurate.
The SEC anticipated such a possibility in its 2018 rule: “We acknowledge that full information about shareholder flows is not likely to be available to funds by the time such funds need to make the decision as to whether the swing threshold has been crossed, but we do not believe that complete information is necessary to make a reasonable high confidence estimate. Instead, a fund may determine its shareholder flows have crossed the swing threshold based on receipt of sufficient information about the fund shareholders’ daily purchase and redemption transaction activity to allow the fund to reasonably estimate, with high confidence, whether it has crossed the swing threshold.”
Other ways that have been discussed to mitigate the impact of transaction costs to a mutual fund’s portfolio generated by subscriptions and redemptions, as well as to reduce the risks to financial stability, are:
An anti-dilution levy or redemption fee—a surcharge on investors subscribing or redeeming shares to offset the effect of those orders.
Dual pricing, i.e. one price for buying shares and another for redeeming.
Notice periods of perhaps a few days before an order can be executed.
Redemption in kind, e.g. giving the shareholder bonds, not cash (not practical for funds with retail investors).
Restricted redemption rights so investors can redeem up to a certain dollar amount on any one day.
Redemption gates that allow a fund to limit withdrawals (although the experience with these for money market funds indicates that such gates tend to exacerbate the rush for the exits).
A regulatory mandate to align redemption policies (including a requirement of advance notice) with the liquidity of the underlying securities.
Does the rising popularity of Exchange Traded Funds change any of these considerations?
ETFs require that buyers and sellers agree on a price that reflects market conditions. So during periods of stress, ETF prices move considerably. In a sense, they have an element of swing pricing built into them. Some investors may prefer ETFs because they know that it will be possible to sell on short notice.
ETFs have their own issues regarding the infrastructure that is needed to support them. To make sure the fund price reflects the value of the securities that the fund is supposed to track, ETFs rely on firms that serve as “authorized participants” (APs) to step in to buy or sell the fund to keep the price of the ETF close to the underlying securities. The APs make profits by arbitraging differences in the prices in the underlying securities and the ETFs. If the APs step back from trading, say, because they are exposed to more risk than they are comfortable with, the ETF prices can become disconnected from the prices of the securities that they are supposed to mimic.
This risk can mean that the ETF prices can also fail to reflect only fundamental risks associated with the securities. Nonetheless, ETFs are not subject to the first mover advantage and seemed to handle March 2020 better than the open-end funds.
Can swing pricing help improve the stability of money market mutual funds?
Money market funds are a special kind of open-end fund that can hold only short-dated securities such as U.S. Treasury bills, commercial paper, and certificates of deposit. By limiting the securities to those deemed relatively safe and liquid, it is expected that the price of the fund will be stable as the securities have no price risk if held to maturity. Problems can—and do—still arise for money market funds if they sell the securities they hold before maturity; in that case, there is price risk. Prime money market mutual funds invest in short-term private-sector securities such as commercial paper and certificates of deposit. Default rates on these securities are low, but they trade infrequently so they are subject to the same kind of illiquidity problems as open-end bond and loan funds.
Prime money market mutual funds suffered a run in March 2020, leading commercial paper markets to freeze up and prompting the Federal Reserve to intervene to keep credit flowing to businesses.
Investors in prime money market funds generally are using these funds as substitutes for bank accounts. They expect to withdraw, possibly large amounts in some circumstances, and at multiple times during the day. As a result, these funds often set an NAV multiple times throughout the day. Some in the industry say that feature of these funds means the information demands of setting a swing would be daunting and incompatible with how investors use them. Still, in a June 2021 consultation report, the Financial Stability Board included swing pricing among several possible policy responses to the problems posed by money market mutual funds.
[1] Heavy selling of Treasuries during the opening months of the COVID-19 pandemic created problems in that market as well. See Chapter 3 of the report of the Task Force on Financial Stability and the Group of Thirty report, “U.S. Treasury Markets: Steps Toward Increased Liquidity.”
[2] When the SEC authorized swing pricing in the U.S. in 2018, it set a 2% ceiling on the swing factor.
Anil Kashyap is a member of the Financial Policy Committee of the Bank of England and a consultant to the Federal Reserve Bank of Chicago and the European Central Bank. He did not receive financial supportfrom any firm or person with a relevant financial or political interest in this piece.
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Overdraft fees are big money for small banks
Once upon a time, if you tried swiping your debit card to buy something and your bank account was empty what happened was simple: Nothing. The register denied your payment. This happened all the time, particularly to Americans living paycheck-to-paycheck.
Then banks figured out that they could cover the overdraft for their customers with little risk and charge quite a lot for the service. It is hard for people to keep track of just how much is in their bank account, particularly since deposits including direct deposits can take days to post to the account.
Overdraft fees can be high, often $35, sometimes charged for each swipe of your debit card when you are out of money. This fee has become big money for banks, generating more than $31 billion in revenues in 2020. It has also become a major cost for tens of millions of families: One out of eleven Americans spends $350 or more a year in overdraft fees. Overdraft is one of many reasons why it is expensive to be poor in America.
Overdrafts are bigger business for some banks than others. JPMorgan Chase collected the most of any bank, more than $2 billion in 2019, which works out to more than $35 in overdraft fees per account. Sen. Elizabeth Warren (D-Mass.) called JPMorgan Chase CEO Jamie Dimon “star of the overdraft show” at a recent Senate hearing. Even when compared to other big banks, JPMorgan Chase earns a lot more in overdraft; Citibank, by contrast, averaged just over $5 per account.
But stopping the analysis with the largest banks misses an important reality: A handful of smaller banks are the true overdraft giants.
Read the rest of this article in Politico, published on June 24, 2021.
