The Securities and Exchange Commission has finalized new rules for mutual funds and certain exchange traded funds that impose new disclosure requirements, board responsibilities, and liquidity risk management programs. The requirements are the latest in a series of regulations aiming to impose bank-like regulation upon non-banks.
“I see this and some of the other proposals they have had, as the SEC trying to stay ahead of the Financial Stability Oversight Council [a multi-regulator body, established by the Dodd-Frank Act, to address systemic risk]. The SEC is the primary financial regulator for the mutual fund industry and, with the FSOC making noises about regulating the asset management industry, this is the Commission getting in front of that and saying, ‘We got this one,’ ” says Jack Murphy, a partner with the law firm Dechert who specializes in mutual funds. “I imagine the conversation between the FSOC and the SEC being something along the lines of, ‘Let us take a stab at this and then you can look at where we end up.’”
As for the industry’s perspective, it “would much rather deal with the SEC regulations than FSOC and banking regulations, if only because the SEC understands the mutual fund industry far better.”
The new reporting requirements, according to Megan Johnson, a financial services partner with Dechert, “are the SEC saying it needs all this information in order to tell the FSOC that it knows what funds hold illiquid securities, what funds have Russian equities, for example, and where pockets of potential problems exist.” The SEC “wants to beat back people who are trying to come onto its turf to regulate funds.”
The new SEC rules apply to open-end funds, those accepting unlimited investment shares that can be issued or redeemed at any time.
“These new rules represent a sweeping change for the industry by requiring strong transparency provisions and enhanced investor protections,” SEC Chair Mary Jo White said. “Funds will more effectively manage liquidity risk and both Commission staff and investors will receive additional and better-quality information about fund holdings.”
Reporting modernization rules will enhance data reporting for mutual funds, ETFs, and other registered investment companies. With these rules, registered funds will be required to file a new monthly portfolio reporting form (Form N-PORT) and a new annual reporting form (Form N-CEN) that will require census-type information. The information will be reported in a structured data format, which will allow both the Commission and the public to better analyze the information. The rules will also require enhanced and standardized disclosures in financial statements and will add new disclosures in fund registration statements relating to a fund’s securities lending activities.
“Funds will more effectively manage liquidity risk and both Commission staff and investors will receive additional and better quality information about fund holdings.”
Mary Jo White, Chairman, SEC
The liquidity risk management rules are designed to promote effective liquidity risk management for mutual funds and ETFs, reducing the risk that funds will not be able to meet shareholder redemptions and mitigating potential dilution of the interests of fund shareholders. The new rules will require mutual funds and ETFs to establish liquidity risk management programs that address multiple elements, including classification of the liquidity of fund portfolio investments and a highly liquid investment minimum. The rules also strengthen the 15 percent limit on illiquid investments and will require enhanced disclosure regarding fund liquidity and redemption practices.
Another rule will permit mutual funds to use swing pricing—the process of adjusting a fund’s net asset value to pass on to purchasing or redeeming shareholder costs associated with their trading activity.
Most funds would be required to begin filing reports on new Forms N-PORT and N-CEN after June 1, 2018, while fund complexes with less than a $1 billion in net assets would be required to begin filing reports on Form N-PORT after June 1, 2019.
“The SEC appears to have been responsive to some of the industry's concerns with the proposed rule,” says Kenneth Burdon, investment management counsel for the law firm Skadden, Arps, Slate, Meagher & Flom. “For example, the liquidity buckets appear more workable and the rule release emphasizes the board's oversight role, in contrast to the more specific and detailed board approval requirements in the proposed rule.”
The original rule required firms to classify each fund holding into one of six “liquidity buckets” based on how effectively and rapidly each asset could be liquidated; the final rule reduces the number of categories to four.
“A significant change from the proposed rule is the revision to the 15 percent limit for illiquid investments,” Burdon says. “Now, for example, to determine whether an investment is illiquid, a fund is required take into account the market depth for trading position sizes the fund would reasonably anticipate trading. The proposed rule stated that a fund would not need to consider the size of its position in the asset for purposes of the 15 percent limitation.”
Regarding a breach of the 15 percent limit, “if that breach is ongoing, the final rule requires the board to make a determination that management's plan to bring the fund back into compliance with the 15 percent limit continues to be in the best interests of the fund,” he explains. “What is interesting is how the requirement to consider a strategy’s appropriateness for an open-end fund could interact with the new manner in which illiquidity is evaluated for purposes of the 15 percent test. The final rule release candidly recognizes this interaction could lead a fund to reconsider its structure or continued operation as an open-end fund.”
LIQUIDITY RISK MANAGEMENT
The following is from a Securities and Exchange Commission fact sheet on liquidity risk management programs.
Rule 22e-4 would require mutual funds and other open-end management investment companies, including ETFs, to establish liquidity risk management programs. The rule would exclude money market funds from all requirements of this rule and ETFs that qualify as “in-kind ETFs” from certain requirements. The liquidity risk management program would be required to include multiple elements, including:
Assessment, management, and periodic review of a fund’s liquidity risk
Classification of the liquidity of fund portfolio investments
Determination of a highly liquid investment minimum
Limitation on illiquid investments
Assessment, Management, and Periodic Review of a Fund’s Liquidity Risk: Funds would be required to assess, manage, and periodically review their liquidity risk, based on specified factors. Liquidity risk would be defined as the risk that a fund could not meet requests to redeem shares issued by the fund without significant dilution of remaining investors’ interests in the fund.
Classification of the Liquidity of Fund Portfolio Investments: Each fund would be required to classify each of the investments in its portfolio. The classification would be based on the number of days in which the fund reasonably expects the investment would be convertible to cash in current market conditions without significantly changing the market value of the investment, and the determination would have to take into account the market depth of the investment. Funds would be required to classify each investment into one of four liquidity categories: highly liquid investments, moderately liquid investments, less liquid investments, and illiquid investments. Additionally, funds would be permitted to classify investments by asset class, unless market, trading, or investment-specific considerations with respect to a particular investment are expected to significantly affect the liquidity characteristics of that investment as compared to the fund’s other portfolio holdings within that asset class.
Determination of a Highly Liquid Investment Minimum: A fund would be required to determine a minimum percentage of its net assets that must be invested in highly liquid investments, defined as cash or investments that are reasonably expected to be converted to cash within three business days without significantly changing the market value of the investment. The fund also would be required to implement policies and procedures for responding to a highly liquid investment minimum shortfall, which must include board reporting in the event of a shortfall.
Limitation on Illiquid Investments: A fund would not be permitted to purchase additional illiquid investments if more than 15 percent of its net assets are illiquid assets. An illiquid investment is an investment that the fund reasonably expects cannot be sold in current market conditions in seven calendar days without significantly changing the market value of the investment. The determination would have to follow the same process as the other liquidity classifications, and funds would have to review their illiquid investments at least monthly.
If a fund breaches the 15 percent limit, the occurrence must be reported to the board, along with an explanation of how the fund plans to bring its illiquid investments back within the limit within a reasonable period of time, and if it is not resolved within 30 days, the board must assess whether the plan presented to it is in the best interest of the fund and its shareholders.
Board Oversight: A fund’s board, including a majority of the fund’s independent directors, would be required to approve the fund’s liquidity risk management program and the designation of the fund’s adviser or officer to administer the program. The fund’s board also would be required to review, at least annually, a written report on the adequacy of the program and the effectiveness of its implementation.
Source: Securities and Exchange Commission
Dechert’s Murphy agrees that the final rule was scaled back based on industry feedback to the proposal. The reduction in the number of “liquidity buckets” means they are now “set up a lot closer to the way fund groups look at liquidity now.” Funds can now focus on asset classes, rather than on an investment-by-investment basis, and they have more flexibility.
Reporting requirements, although more manageable in the final rule, still raise concerns.
It is not that the public disclosure of information is increasing, because it is still on a quarterly basis with 60-day lag, Johnson says. One concern raised in the rulemaking process, however, is that given the quantity and different kinds of data that will be filed in structured data format, “competitors, institutional investors, and third parties will have an easier time analyzing some of it.”
The SEC was not ultimately persuaded by concerns that proprietary fund strategies could be reverse engineered from the data, although it did agree to allow a measure of non-public reporting for information that might be considered confusing, stale, and even harmful to investors because it is outdated.
Johnson understands the value the SEC sees in this reporting.
“In response to the Russian embargo a couple of years ago, the staff had to individually go out to people they thought might have significant holdings in Russia and wanted to get more information from them so they could report to Treasury and figure out how potential sanctions were going to affect funds,” she says. “With the kind of reporting that is going to come with this modernization proposal, they would already have much of that data and not have to have done so much manual inquiry.”
“Funds understand why the SEC wants this data,” she adds. “But it is a huge amount of information they are going to have to be providing every month and it is going to be a challenge to get it all set up.”
Board oversight is stressed in the new rule, especially in keeping strategies clear of the 15 percent ceiling on illiquid assets.
“It is important for the board to really listen to how the adviser views the liquidity for each fund within the complex,” says Brenden Carroll, an associate in the Dechert’s financial services group. “There are many boards that already do this now, and this mandates what they are already doing to some extent. Some of it will be more formal and better documented, but many boards already ask about whether a strategy is appropriate for an open-end fund and whether there is potential danger for any liquidity mismatches. The first step is to really understand how the adviser plans to administer this program and what they see as potentially affecting any given fund.”
The SEC took this step, he says, to bring some of the less robust programs up to where other programs already are.
One area where the SEC took no action is with a proposal to allow funds to distribute shareholder materials electronically, rather than traditional, expensive mailings that many suspect most investors all but ignore. Among those who lobbied against the rule: paper and envelope companies.
A split board, at best, means the proposal will be resubmitted on another day. “Fund complexes would be thrilled to have that on the agenda, because it could potentially offset some of the costs that are going to be inherent in all of the reporting information,” Johnson says.