Shearman And Sterling

Investment Funds, Digital Stock

Mar 26, 2018

The SEC’s Liquidity Rule: Where Do We Stand?

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In October 2016, a unanimous Securities and Exchange Commission adopted a package of rules for Investment Company Liquidity Risk Management Programs (collectively, the “Liquidity Rule”) and set a deadline for implementation (in most cases) of December 2018. The fund industry greeted the Liquidity Rule, and especially the so-called “bucketing” element that assigns a liquidity rating to every portfolio investment, as a significant new operational hurdle. A series of easing steps taken by the agency since January 2018, which include implementation pushbacks to next year, were therefore met with surprise and relief. But the rulemaking also brought division within the Commission into clear view: advocates for the status quo—including Commissioner Kara Stein, who issued a strongly worded dissent to the new proposal—worry that underlying risks remain unchanged, while Commissioner Hester Peirce suggested in a speech that she was open to scrapping mandated buckets altogether.

As a recap, much happened in just eight weeks:

  • January 10 - The SEC staff issues a package of Frequently Asked Question (FAQ) responses in January that were viewed as broadly sensible clarifications that would ease day-to-day compliance with some elements of the Liquidity Rule. Notably, those responses were encouraging for funds considering bucketing broad groups of securities together (so-called “asset class classification”) in lieu of security-by-security analysis and clarified that in many cases monthly classifications could be maintained without being automatically revisited on a more frequent basis. In other words, the FAQ responses reinforced flexibility already built into the Liquidity Rule.
  • February 21 - The SEC authorizes postponement of the compliance dates for certain provisions of the Liquidity Rule. On the same day, the SEC staff added another set of responses to the FAQ file, which again generally provide for more day-to-day compliance flexibility.
  • March 14 - The SEC proposes amendments suggesting that public posting of a fund’s aggregate liquidity scores will not be required and instead could be replaced with a requirement to discuss the fund’s liquidity management efforts in fund reports.

And as a reminder of where we started from, the Liquidity Rule, as adopted in 2016, included the following key requirements:

  • Open-end funds (other than money market funds) and certain exchange-traded funds (“ETFs”) will establish and maintain liquidity risk management programs, based in each case on fund-by-fund liquidity risk assessment. The program will be overseen by a designated liquidity risk management administrator and will provide for at least annual reporting to the fund board. The board also must make certain findings, notably approval of the initial program and the administrator.
  • These funds will make quarterly “bucketing” reports to the SEC on new Form N-PORT.
  • These funds will comply with a 15% limit on illiquid securities (substantially similar to a longstanding requirement with the same limit but a somewhat different definition of illiquidity).
  • Many funds will establish and maintain a highly liquid investment minimum (the “HLIM”).
  • Certain breach reports relating to the 15% test and the HLIM will be filed with the SEC and made to fund boards.

New Compliance Dates

The SEC postponed compliance for certain provisions of the Liquidity Rule by six months. The extended compliance dates relate to the classification requirements, HLIM, board approval, board reporting, and recordkeeping of the liquidity risk management program and the reporting requirements tied to the classification and HLIM requirements. Larger funds[1] have until June 1, 2019 (revised from December 1, 2018) to meet the asset classification requirements. Smaller funds[2] have until December 1, 2019 (revised from June 1, 2019).

However, the SEC did not postpone other provisions of the Liquidity Rule, and registered funds are still required to adopt a liquidity risk management program and limit illiquid investments to 15 percent of their portfolio holdings by December 1, 2018, for larger funds and June 1, 2019, for smaller funds. The new compliance dates also do not relate to fund considerations relating to swing pricing, which go into effect in November 2018.

As a quick reference table:

Delayed to June 1, 2019 (for larger funds)

Not Delayed (December 1, 2018 compliance date for larger funds)

Classification requirement (commonly known as “bucketing”)

Written Liquidity Risk Management Program

HLIM (determinations and periodic reviews)

Board approval of designated Liquidity Risk Program Administrator

Board approval of Liquidity Risk Management Program and related annual review requirements

Compliance with the 15% limit on illiquid investments

Form N-PORT disclosures relating to fund classification and HLIM

Redemption in-kind procedures

Form N-LIQUID disclosures regarding breach of HLIM (Part D)

Form N-LIQUID (Parts A through C)

Recordkeeping requirements related to the delayed elements (but not recordkeeping requirements related to liquidity risk management, 15% illiquidity or board designation of the program administrator elements)

Changes to Form N-CEN (report on lines of credit and interfund lending)

 

Proposed Amendments

The amendments propose to

  • Eliminate public disclosure of the aggregate liquidity profile (bucketing) on Form N-PORT.
  • Require funds instead to “briefly discuss the operation and effectiveness of the Fund’s liquidity risk management program during the most recently completed fiscal year” in their annual reports to shareholders (funds generally still would have the option to disclose any classification information they choose).
  • Permit funds to “split” classification of an investment across buckets in certain defined circumstances when reporting investment-specific bucketing information on Form N-PORT (Form N-PORT currently contemplates that a fund will place each investment in a single liquidity bucket).[3]
  • Require funds to report their holdings of cash and cash equivalents on Form N-PORT to assist the SEC in monitoring trends in their use.

In the release, the SEC indicated that the staff has engaged extensively with industry participants regarding the complexities of the Liquidity Rule and especially around concerns that public disclosures of liquidity classifications—which can vary firm-by-firm and even fund-by-fund—will be confusing. The alternative of discussion of the liquidity risk management program in the annual report was described as a more flexible, principles-based approach and appropriate to the goal of informing shareholders of a fund’s liquidity profile.

If adopted, the SEC expects to provide a tiered set of compliance dates based on asset size aligned with the compliance dates previously adopted for Form N-PORT.

The FAQs

On January 21, 2018, the SEC staff released a series of FAQs related to the Liquidity Rule. These FAQs discuss the staff’s views on sub-advised funds, ETFs that redeem shares through in-kind transfers of securities, and asset class liquidity classifications, among other things.

Then on February 21, 2018, the SEC staff issued an additional set of FAQs related to the Liquidity Rule, generally focusing on questions that arose with respect to the liquidity classification process.

Our Take

The industry, broadly, is cheered by the prospect of an SEC willing to reopen and ratchet back a rule before it goes into effect. Some observers, however, are concerned that an unwelcome precedent may be set—that late-stage changes can just as easily upset implementation planning as they can ease it (as an example in this case, vendor contracts may have been negotiated on the basis of the original Liquidity Rule’s terms) and also that too much change calls into question the SEC’s “steady hand.”

As to the specifics of the latest proposal, the task of presenting a brief annual overview of the operation and effectiveness of the liquidity risk management program in shareholder reports will not necessarily be an easy one. There can be subjectivity and the prospect of confusion there too.

Finally, keep in mind that funds subject to the Liquidity Rule still must have a written liquidity risk management program in place by December 1, 2018, although more onerous components  (liquidity classification and the HLIM) can be implemented by the later June compliance date.

Don’t take the foot too far off the gas.

Footnotes

[1] Funds that, together with other investment companies in the same group of related investment companies, have net assets of $1 billion or more as of the end of the most recent fiscal year of the fund.

[2] Funds that, together with other investment companies in the same group of related investment companies, have net assets of less than $1 billion as of the end of its most recent fiscal year.

[3] Funds would be permitted to classify the same investment in different buckets only under three circumstances: “(1) if a fund has multiple sub-advisers with differing liquidity views; (2) if portions of the position have differing liquidity features that justify treating the portions separately; or (3) if the fund chooses to [also] classify the position through evaluation of how long it would take to liquidate the entire position (rather than basing it on the sizes it would reasonably anticipate trading). In (1) and (2), a fund would classify using the reasonably anticipated trade size for each portion of the position.”

As the SEC noted, under the proposed Instructions to Item C.7 of Form N-PORT, a fund taking the proportionality approach would split the entire holding among the four classification categories. “For example, a fund holding $100 million in Asset A could determine that it would be able to convert to cash $30 million of it in 1-3 days, but could only convert the remaining $70 million to cash in 3-7 days. This fund could choose to split the liquidity classification of the holding on Form N-PORT and report an allocation of 30% of Asset A in the Highly Liquid category and 70% of Asset A in the Moderately Liquid category. Such a fund would not use sizes that it reasonably anticipates trading when engaging in this analysis, but instead would assume liquidation of the whole position.”

Funds that choose not to take advantage of this proportional splitting approach may continue to use the approach laid out in the final rule of bucketing an entire position based on the liquidity of the sizes the fund would reasonably anticipate trading.

Authors and Contributors

Paul Schreiber

Of Counsel

Investment Funds

+1 212 848 8920

+1 212 848 8920

New York

Thomas Majewski

Counsel

Investment Funds

+1 212 848 7182

+1 212 848 7182

New York