In a letter to SEC Chairman Jay Clayton dated July 20, 2017 (the Letter), Paul Schott Stevens, President and CEO of the Investment Company Institute (ICI), expressed “deep concerns” about the fund industry’s ability to meet the compliance deadlines for the liquidity risk management program and fund reporting modernization rules adopted by the SEC in October 2016.  The Letter states that efforts by the ICI’s member firms to implement these new rules have “reinforced our belief that the Commission needs to re-examine the asset classification element of [new Rule 22e-4 (the Liquidity Rule)] and the required frequency of portfolio holdings reporting.”  

The Letter requests that the SEC take the following actions: (1) adjust the compliance schedule for the Liquidity Rule’s asset classification and related requirements as soon as possible, allowing the SEC time to make “targeted rule amendments”; (2) adopt amendments to the Liquidity Rule allowing funds to formulate their own policies and procedures for how to classify the liquidity of investments; (3) even if the SEC does not pursue the recommended rule amendments, adjust the compliance schedule for the Liquidity Rule and related reporting requirements by at least one year; (4) require quarterly, instead of monthly, reporting of portfolio holdings on Form N-PORT until the SEC addresses information security concerns adequately; and (5) even if the SEC retains the monthly reporting requirement for portfolio holdings, delay the compliance dates for Form N-PORT and Form N-CEN for at least six months.

Certain of these recommendations are described in greater detail below:

•Asset Classification Concerns:  Echoing concerns raised in its comment letter to the SEC when the Liquidity Rule was first proposed, the ICI notes that liquidity classifications–or “bucketing”–risked creating more correlated portfolios and trades across funds because funds would gravitate toward investments perceived as “more liquid.”  The Letter states that such “herding” could “increase dislocations and volatility in financial markets by contributing to cliff events in liquidity.”  The Letter acknowledges the SEC’s desire for uniformity and consistency in liquidity classification and the “surface appeal of such uniformity,” but warns that “the more a regulator insists upon uniformity and consistency in this area, the greater the likelihood of correlation, herding, and cliff events.”  The ICI also expresses the view that there is “substantial risk” that the SEC and other regulators may overemphasize and be misled by such “limited, subjective and forward-looking information,” and that the public may be misled by or fail to fully understand the inherent limitations of the information.  Thus, the ICI maintains that the Liquidity Rule should be amended to allow each fund to craft its own policies and procedures for classifying the liquidity of its investments.  In this connection, the ICI notes that approaching asset classification on an individualized level “would respect the diversity of practices that have emerged in the industry and their validity; focus funds’ attention on comprehensive liquidity risk assessment, management and review; and greatly reduce the cost and complexity of implementing and administering the [Liquidity Rule].”  

•Quarterly Reporting on Form N-PORT:  The Letter notes the valuable and sensitive portfolio holding information funds will be required to report monthly on Form N-PORT and expresses the ICI’s concern with the SEC’s ability to protect such information.  To this end, the Letter highlights recent reports by the SEC’s inspector general and the Government Accountability Office that raise concerns over the SEC’s ability at present to maintain the security of such data.  The ICI contends that the SEC should delay the reporting of monthly portfolio holdings information until these data security concerns have been adequately addressed.  In addition to thoroughly addressing these weaknesses, the ICI recommends that the SEC implement “aggressive” measures to protect data, including independent third-party testing and verification of its information security programs, and that such measures should be taken prior to requiring firms to commence monthly reporting of portfolio holdings.

•Adjust Compliance Schedule for Form N-PORT and Form N-CEN:  The  Letter states that funds are currently not able to easily access, compile and report the “vast amount of new data” to be reported on Forms N-PORT and N-CEN. The ICI asserts that funds will have to create new systems to gather the data and transform it into the form required.  The ICI further states that funds will have to test their systems to ensure accuracy and reliability.  The ICI believes that “most” fund complexes will engage third parties to assist with such reporting, that these third parties have not yet fully developed their products for funds to evaluate and that it may be several months before such products are fully developed.  Thus, the ICI suggests that the SEC delay the compliance dates for Forms N-PORT and N-CEN at least six months to give funds time to, among other things, develop new technologies, assess data sources, review and implement third-party vendor systems or build or enhance their own systems, test their systems to ensure quality and design processes and controls to ensure accuracy.