SEC Proposes Changes to Investment Company Liquidity Risk Management Liquidity Classification Disclosures

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The U.S. Securities and Exchange Commission (SEC) on March 14, 2018 proposed a rule (Proposed Rule) that would: (i) eliminate or modify certain disclosure requirements of Form N-PORT; and (ii) add a new disclosure requirement to Form N-1A relating to the liquidity risk management rule applicable to open-end investment companies (including exchange-traded funds but excluding money market funds) (funds).1 If the Proposed Rule is adopted, a fund would:

  • No longer be required to disclose its aggregate liquidity classification information on Form N-PORT but, instead, would include a discussion about the operation and effectiveness of the fund’s liquidity risk management program in its annual shareholder report;

  • Be permitted to classify single investments into multiple liquidity classification “buckets” on Form N-PORT under certain specified circumstances; and

  • Disclose its holdings of cash and certain cash equivalents on Form N-PORT.

Replacing Aggregate Liquidity Classifications with New Management Discussion

In its current form, Form N-PORT requires funds to publicly disclose the aggregate percentage of their portfolio holdings that fall into the four liquidity buckets2 set forth in Rule 22e-4 (Liquidity Rule) under the Investment Company Act of 1940.3 The Proposed Rule would eliminate this requirement, and replace it with a new Form N-1A requirement to include a narrative-style discussion in a fund’s annual shareholder report about the “operation and effectiveness” of the fund’s liquidity risk management program during the period covered by the report.4 Although the Proposed Rule does not prescribe specific information to be included in the discussion, the SEC noted in the Proposed Rule release that the new discussion “should provide investors with enough detail to appreciate the manner in which a fund manages its liquidity risk,” and suggests as examples that a fund may “opt to discuss the particular liquidity risks that it faced over the year, such as significant redemptions, changes in the overall market liquidity of the investments the fund holds, or other liquidity risks, and explain how those risks were managed and addressed, and whether those risks affected fund performance.”

The SEC indicated that this proposed change was prompted by comments from industry participants who expressed concern that public reporting of aggregate portfolio liquidity classifications, without any accompanying explanation as to the underlying subjectivity, methodological decisions and assumptions shaping this information, would not provide necessary context for investors. As a result, the SEC stated its belief that investors would not be adequately informed as to how the aggregate classification data related to liquidity risk and the management thereof, and that investors might “inappropriately focus” on a fund’s liquidity risk over other types of investment risks. The SEC noted that the new disclosure is intended to address these concerns by providing investors with “appropriate context” so that they may understand the “nature and relevance” of a fund’s liquidity risk management with respect to their investment.5 The SEC also noted that this new discussion would complement any existing liquidity risk disclosure included as a principal investment risk in a fund’s prospectus.

The Proposed Rule would also make non-public the information that will be reported on Form N-PORT concerning the proportion of a fund’s investments that fall into the highly liquid investment bucket and which have been segregated to cover derivative transactions. The SEC noted that it believes that this information would have limited utility for investors, since investors would no longer have access to a fund’s aggregate liquidity classifications (including a fund’s portfolio aggregate highly liquid investments).

Classifying an Investment under Multiple Liquidity Buckets

The Liquidity Rule requires a fund to classify each of its investments into one of four liquidity buckets, and those classifications are to be reported on Form N-PORT on a monthly basis.6 The Proposed Rule would permit funds to report on Form N-PORT a single investment under multiple liquidity buckets in three circumstances: (i) if a fund has multiple sub-advisers with differing liquidity views; (ii) if portions of the position have differing liquidity features that justify treating the portions separately; or (iii) if the fund chooses to 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).7 If a fund chooses to classify an investment under multiple liquidity buckets, the fund would be required to indicate which of the three circumstances prompted the split classification, and the fund would be permitted to provide additional context (in the explanatory notes section of Form N-PORT) regarding the circumstance that caused the split classification.

The SEC requested comments on other possible circumstances under which funds should be allowed to report multiple classifications. In addition, the SEC noted in the Proposed Rule release that some funds prefer to classify investments based on an assumed sale of the entire holding, and then allocate portions of the holding to more than liquidity bucket. In light of this practice, the SEC requested comments as to whether a fund should be required to use a consistent approach for classifying its holdings (i.e., whether a fund should be required to classify its investments using either a full liquidation analysis or anticipated trading size, but not both).

Disclosing Cash and Certain Cash Equivalents

The Proposed Rule would add a new item to Form N-PORT, requiring a fund to report its cash holdings and certain cash equivalents; these are not currently required to be reported in response to Parts C or D of Form N-PORT.8 The SEC stated that access to this information will enable the SEC to monitor trends in the fund industry regarding the use of cash and cash equivalents, and to “more accurately assess the composition of a fund’s highly liquid investment minimum (‘HLIM’).” The SEC further noted that information about the amount of cash being held by funds provides a glimpse into other areas, such as a fund’s net inflows and outflows.

Comment Period and Compliance Dates

Comments on the Proposed Rule should be received by the SEC by May 18, 2018. The SEC expects that the compliance dates for the Proposed Rule, if adopted, would correspond to the revised compliance dates the SEC adopted for Form N-PORT.9

Footnotes

1) Investment Company Liquidity Disclosure, Release No. IC-33046 (Mar. 14, 2018).

2) The four liquidity classification “buckets” are: highly liquid investments; moderately liquid investments; less liquid investments; and illiquid investments.

3) For further information regarding the Liquidity Rule and related guidance, please refer to the following Dechert OnPoints: SEC Adopts New Rules and Rule Amendments to: (1) Require Liquidity Risk Management Programs for Registered Open-End Investment Companies; (2) Modernize Reporting Requirements for Registered Investment Companies; and (3) Permit Registered Open-End Investment Companies to use “Swing Pricing”; SEC Staff Issues Liquidity Rule Frequently Asked Questions; and SEC Delays Compliance Dates for Certain Liquidity Rule Requirements; SEC Staff Issues Responses to Second Set of Liquidity Rule FAQs.

4) This disclosure would be part of the management discussion of fund performance.

5) Although aggregate liquidity classification information would no longer be made public automatically via Form N-PORT, the SEC noted in the Proposed Rule release that it may periodically publish reports that include “aggregate and anonymized liquidity data.” In addition, the Proposed Rule release indicated that the staff of the SEC’s Divisions of Investment Management and Economic and Risk Analysis (DERA) will make a recommendation to the SEC by June 2020 regarding whether there should be “public dissemination of fund-specific liquidity classification information.”

6) Rule 22e-4(b)(1)(ii); Form N-PORT, Item C.7.a.

7) The information that a fund reports on Form N-PORT regarding the liquidity classification of its individual investments would continue to remain non-public.

8) The SEC noted that certain investments that could qualify as cash equivalents (such as investments in a money market fund) are already required to be reported on the current Form N-PORT. Other cash equivalents (such as accounts receivable) are not considered investments and are not currently required to be disclosed on Form N-PORT.

9) The SEC delayed the initial compliance dates for Form N-PORT by adopting a temporary final rule on December 14, 2017. For further information, please refer to Dechert OnPoint, SEC Announces Delay in Form N-PORT Filing Requirements.

 

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