The Liquidity Rule Finally Takes Shape!
In May, we discussed eight things that you needed to know about the liquidity rule.
At that time, we noted that part of the rule was due to take effect in December 2018 for large fund families or June 2019 for smaller fund families. The parts that were delayed until 2019 included the liquidity classifications (i.e., the buckets) and the highly liquid minimum requirement. More importantly, our third point was that the SEC would have more changes to the liquidity rule in 2018.
At that time, the SEC was considering changes to the requirement that an investment company publicly disclose its aggregate liquidity information (i.e., its liquidity profile) in its annual shareholder report on Form N-CSR instead of Form N-PORT, and the disclosure would be narrative, as opposed to quantitative. We expected the SEC to follow through with these changes, and now it has.
On June 28, 2018, the SEC adopted amendments to Rule 22e-4 (the Liquidity Risk Management Program rule). As Commissioner Piwowar noted in this public comment on the changes, the intent of Rule 22e-4 was, in part, to provide investors with information on a fund’s liquidity profile. The SEC stated in its press release that “[m]amagement of liquidity risk is important to funds’ ability to meet their statutory obligation—and their investors’ expectations—regarding redeemability of their shares.” While the SEC believed that such information would help investors make better decisions, Commissioner Piwowar disagreed and argued that the quantitative disclosure envisioned by the SEC was neither helpful to investors nor informative. Commissioner Piwowar based his position on the fact that Form N-PORT would not allow a fund to offer context around its liquidity risk, methodologies, assumptions, or market conditions.
Commissioners Jackson and Stein both dissented from the SEC’s decision to adopt the amendments. Commissioner Stein noted that the original rule would have provided investors with four liquidity reports per year in Form N-PORT and in a manner that made comparison across funds easier for investors. She questions why the SEC does not require funds to give investors a consistent and straightforward liquidity profile that would give them some sign of the liquidity of a fund’s portfolio. Commissioner Stein worries that under the new requirements, which we highlight below, funds can use their discretion to shape their liquidity disclosure, to the determinate of investors.
Ultimately, the amendments were a compromise between the Commissioners Jackson and Stein who wanted to keep Rule 22e-4 as is and Commissioners Pierce and Piwowar who tried to rescind the liquidity classification requirements, as recommended by the Treasury Department in its report: A Financial System that Creates Economic Opportunities—Asset Management and Insurance. As Chairman Clayton noted in his public statement: “While liquidity in today’s market conditions may be well understood…[m]arket conditions, and as a result liquidity, can change rapidly and unexpectedly. Accordingly, projecting liquidity is, in many ways, a portfolio-specific exercise that relies on subjectivity, and managing liquidity is a continuous exercise.” He then explains that liquidity determinations are often based on quantitative data, but not, specifically, liquidity buckets. And with that, Chairman Clayton called for the SEC to collect over the next year data on liquidity disclosure and evaluate it before mandating disclosure requirements.
Funds must now include liquidity disclosure in shareholder reports under Form N-CSR, not Form N-PORT
Under the amendments, open-end investment companies (including ETFs) must discuss a fund’s liquidity profile and risk in its Management Discussion of Fund Performance letter (the “MDFP Letter”). The MDFP letter is required in annual reports but is optional for semi-annual reports. Per the changes, a fund can now choose which report to include its liquidity disclosure, the semi-annual or the annual. Additionally, the SEC has added a new section to Form N-1A that requires a fund to evaluate the operations and effectiveness of its liquidity risk management program; this new section will be included in the annual report to shareholders. Because of this new requirement, the liquidity disclosure is eliminated from Form N-PORT. By using the shareholder report as the conduit for the liquidity disclosure, the SEC has once again relied on the prospectus and shareholder report as the foundation for plain English disclosure.
Funds will have more flexibility to report their liquidity profile
Rather than providing aggregated quantitative data on a fund’s liquidity in Form N-PORT, as proposed in the initial iteration of the rule, funds will now use narrative disclosure to highlight their liquidity profile. Under the amendments, a fund must provide its investors with details on how its manager handles liquidity risk, but the MDFP Letter does not need to disclose the classification process used by the manager. In the MDFP Letter, a fund’s management must discuss any material liquidity events that affected the fund’s performance during the reporting period. The discussion must contain the following elements.
A description of the liquidity event and its surrounding circumstances such as market conditions.
How the event affected performance.
What management did in response to the event.
But funds will need to perform some assessment on the effectiveness of their liquidity program
Also included in the shareholder report is a requirement that a fund assesses the overall operation and effectiveness of its liquidity risk management program. This requirement is expressly moved from the MDFP Letter to a section of the shareholder report that will follow the discussion of board approval of advisory contracts. As previously required by the liquidity rule, the board must annually review a fund’s liquidity program, and this disclosure requirement in the shareholder report will summarize the factors considered by the board and its conclusions. The program’s administrator must submit a report to the board similar to the Rule 38a-1 report or the 15(c) responses that the board receives when it evaluates the fund's compliance program and advisory contract, respectively. The period covered by the assessment may be an annual period that does not coincide with the fund’s most recently completed fiscal year end.
We do not doubt that all fund managers will decide that their program is operating effectively, but the SEC hopes that managers will offer thoughtful commentary on market conditions and other factors that are affecting the liquidity of the fund’s portfolio. The SEC’s release contemplates that a full explanation of liquidity risk would include the following elements.
A discussion of the manager's assumptions and factors that it considers when evaluating liquidity risk.
A summary of the method used by the manager to check such risk.
Highlights of any events or thresholds that the manager would use to make changes to the portfolio.
Additionally, if a fund changes its liquidity risk management program, we would expect that managers would discuss the reasons for the changes in this section. And of course, illustrations and charts are always helpful when providing such information.
Managers should view this disclosure as a compliment to the liquidity risk disclosure that is included in the fund’s prospectus (either as a principal investment risk or a non-principal investment risk). The SEC notes in its release factors that when a fund is evaluating its liquidity program, it should consider factors such as portfolio concentration, holdings of cash and cash equivalents, significant redemptions, changes in the overall market liquidity of the fund’s investments, and other factors that are specific to the fund’s liquidity risk. Management should discuss how it handled these factors, which may include empirical data metrics that it uses to monitor a fund’s liquidity, such as bid-ask spreads, portfolio turnover, or shareholder concentration.
Funds can split a holding across multiple liquidity classification categories in three specific circumstances
Under the initial rule, a fund had to classify each portfolio holding into one of four defined liquidity categories and report these classifications on Form N-PORT. In the release for the amendments, the SEC stated that “the requirement to classify each entire position into a single classification category poses difficulties for certain holdings and may not accurately reflect the liquidity of that holding, or be reflective of the liquidity risk management practices of the fund.” Under the amended rule, a fund can split a holding across multiple buckets if one of three situations exist.
Differences in Liquidity Characteristics
If the positions comprising the holding have different liquidity features, which justifies separating the parts, then a fund may do so. The SEC cites as an example a holding that includes some positions with an embedded put option. Since the entire holding does not have this option, the liquidity of its components may differ; the SEC cited as another example an equity holding that has some portion that was purchased through a private placement and, therefore, is partially restricted from resale.
Differences in Sub-Adviser Classifications
A fund can also split a holding across multiple categories if it has multiple sub-advisers that take independent liquidity views. (Note that the amendments make inapplicable the staff FAQ 8 on the liquidity rule if the adviser chooses to split the holding across multiple categories. FAQ 8 guided funds on how to reconcile classifications from sub-advisers. If the adviser decides to aggregate the holding into a single classification, then it can still rely on FAQ 8.)
A fund can split the holding across multiple categories if it is tracking how long it would take to liquidate the entire position and the expectation is that the liquidation would reduce the position in parts based on different timelines. For example, the SEC notes that a fund may be able to liquidate 30% of its holding in 1-3 days, making that part highly liquid, but the rest of the holding would take 4-7 days, making that portion moderately liquid.
The first two options use the reasonably anticipated trade size while the last option uses the reasonably expected liquidation period. Each circumstance allows a fund to split its holding into multiple classifications if doing so would give the SEC and investors information that is at least as helpful as the liquidity information initially sought by the SEC. For now, it is up to fund families to decide if the infomraiton provided is more helpful to the SEC and investors.
Funds must now report their cash and cash equivalents in Form N-PORT
In addition to amending Form N-PORT to allow for split categorization, the SEC now requires that funds report their holdings in cash and cash equivalents. This information will be published monthly on Form N-PORT and disclosed publicly on a quarterly basis. Since cash and its equivalents are treated as highly liquid investments, these holdings will allow the SEC to better watch the fund’s highly liquid investment minimum. This data will also give the SEC some insight into the fund’s net cash flows.
The industry didn’t get everything it wanted from the amendments
Most notably, even highly liquid funds and ETFs must provide liquidity disclosure in their shareholder reports.
But the industry did get more time to comply with the liquidity rule
Under the amendments, the changes to Form N-PORT take effect on June 1, 2019, for large fund families and March 1, 2020, for small fund families. For the changes to Form N-1A (the shareholdre report changes), the effective dates are December 1, 2019, for large fund families and June 1, 2020, for small fund families. These dates are illustrated in the table below, which was provided by the SEC in its release.
And more changes are likely to come
While the amendments updated many of the requirements of the liquidity rule, it also left open the possibility for future changes to the rule. As Chairman Clayton stated in his public comments, “[t]he adopting release commits the staff to undertake an evaluation of the operation of the rule, and the classification in particular, after the Commission has gained a year’s worth of experience with the actual data being produced.” The concept of evaluating a recently release rule is a very entrepreneurial approach that will almost certainly result in future changes to the rule. While many may see this entrepreneurial approach as a method for future limitations on the rule, managers need to provide thoughtful commentary in their MDFP Letter, lest the SEC decide that it’s looser approach has not produced acceptable results.