SEC Replaces Requirement to Disclose Liquidity Buckets With Requirement to Disclose Effectiveness of Liquidity Risk Management Program

Shearman & Sterling LLP

In a split vote on June 28, 2018, the Securities and Exchange Commission adopted a new rule to require certain open-end investment companies to disclose in their annual or semi-annual shareholder reports information about the operation and effectiveness of their liquidity risk management program. The new rule replaces a requirement for funds to disclose a snapshot of the fund’s historic aggregate liquidity classification data on Form N-PORT.

The SEC also amended Form N-PORT to give funds more flexibility in reporting liquidity classifications. The amendments will allow funds to split their portfolio holdings into more than one “bucket” when split reporting more accurately reflects the liquidity of the investment or eases cost burdens. Finally, the SEC amended Form N-PORT to require funds to disclose holdings of cash and cash equivalents that are not reported elsewhere.

Disclosure of Liquidity Information

Rule 22e-4 requires open-end funds (other than money market funds and “in-kind” exchange-traded funds) to classify portfolio investments into one of four “buckets” and report those classifications on Form N-PORT. (Funds were required to report the aggregate percentage of investments in each bucket, although investment-level buckets remained non-public.) In eliminating this reporting requirement, the SEC acknowledged that the quarterly public disclosure of the liquidity information may sometimes mislead investors and lack objectivity. The Form N-PORT disclosure, it said, did not provide investors with necessary context about the liquidity risk, methodologies and assumptions used to conduct liquidity classification. In short, the SEC said that shareholder report and prospectus disclosure of liquidity risks will better serve the purpose of tailoring information necessary for particular liquidity risks and management practices of the specific fund.

In place of the bucket reporting requirement, the SEC now requires funds to briefly discuss the operation and effectiveness of their liquidity risk management program in a new section of the fund’s report to shareholders (annual or semi-annual). The disclosure is intended to complement the existing liquidity risk disclosure in prospectus and the fund’s discussion of the factors that materially affected performance in the MDFP section of the shareholders report. Notably, the SEC refused to exempt highly liquid funds and in-kind ETFs from the requirement to include this new narrative disclosure, noting that while these funds are exempt from certain provisions of rule 22e-4, the requirement to adopt liquidity risk management programs apply to them.

To satisfy this new disclosure requirement, a fund must provide investors with enough details to understand how a fund manages its liquidity risk. A fund may, but is not required to, discuss the role of the classification process, the 15% illiquid investment limit, and the “highly liquid investment minimum” (HLIM) in the fund’s liquidity risk management process. The SEC provided some examples of liquidity risks that funds may want to include in the disclosure, such as significant redemptions, changes in the overall market liquidity of the investments the fund holds and others. Funds may explain how those risks were managed and addressed for the given period and provide context and other necessary supplemental information about its practices for investors.

Amendments to Liquidity Data Reporting Requirements

In responding to concerns from commenters that the requirement to classify entire holdings in a single bucket may not accurately reflect the liquidity of that position, the SEC amended Form N-PORT to allow funds to split on a percentage basis its holding portfolio into more than one bucket provided they indicate a specific reason for a split. The instructions to Form N-PORT allow funds to disclose the percentage of holdings attributable to multiple classifications only when:

  • portions of the position have differing liquidity features that justify treating the portions separately; or
  • a fund has multiple sub-advisers with differing liquidity views; or
  • 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 anticipated trading).

In the first two cases, the fund would classify the holdings using the reasonably anticipate trade size for each portion of the position.

The SEC also clarified that funds electing the splitting approach on Form N-PORT may also apply such splitting more generally in their bucketing under rule 22e-4 because the rule itself does not require positions to be put into a single category.

Disclosure of Cash and Cash Equivalents

The SEC also amended the Form N-PORT to require funds each quarter to disclose holdings of cash and cash equivalents, as defined by GAAP, that were not reported in Parts C and D of the Form. Because cash is a highly liquid investment under rule 22e-4, the amendment will allow the SEC to effectively monitor a fund compliance with its HLIM after elimination of the aggregate liquidity profile disclosure, discussed above. In adopting this requirement, the SEC explained that this information would provide a more complete picture of a fund’s holdings.

Compliance Dates

The SEC provided additional time for compliance with the new shareholder report requirements—it is triggered once a fund had their liquidity risk management programs in effect for a full year. The compliance dates for the Form N-PORT and Form N-1A amendments are provided in the chart below:

FORM N-PORT

Compliance Date

First N-PORT Filing Date

Large Entities

June 1, 2019

July 30, 2019

Small Entities[1]

March 1, 2020

April 30, 2020

FORM N-1A

 

 

Large Entities

Dec. 1, 2019

 

Small Entities

June 1, 2020

 

Our Take

The amendments are designed to provide investors with a broader picture to allow holistic evaluation of the liquidity risks of the fund and effectiveness of the risk management program. It will also add the appropriate context, so that investors could better understand its subjective nature and importance of these risks to their investments.

Commenters largely supported proposed amendments to Form N-PORT, providing the flexibility of splitting funds holdings into more than one bucket. Commenters expect a better accuracy and elimination of reconciliation costs.

Industry comments also generally supported disclosure about cash and cash equivalents. The SEC believes this is necessary to help them monitor HLIM trends.

 

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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