On November 3, 2017, the Investment Company Institute (ICI) issued a letter to the SEC (the Supplemental Letter), supplementing the ICI’s July 20, 2017 letter, requesting that the SEC delay the compliance date of, and ease compliance with, the liquidity risk management program rule (the Liquidity Rule) and its related reporting requirements. The Supplemental Letter provides the results of an ICI member survey as well as findings from vendors’ asset classification (i.e., “bucketing”) of sample portfolios as additional support for the ICI’s request that the SEC “adjust the compliance schedule for the liquidity rule’s asset classification and related requirements as soon as possible, for the amount of time the SEC needs to ease compliance with the rule’s bucketing requirements, including through targeted rule amendments.” At a minimum, the ICI requests that the SEC delay these requirements by at least one year. In this regard, the ICI notes that its recommendations are consistent with the Treasury Department’s recent report, which advised that the SEC “take appropriate action to postpone the currently scheduled December 2018 implementation of Rule 22e-4’s bucketing requirement.”¹

The ICI asserts that the requested compliance adjustments to the Liquidity Rule—which “has no real antecedent in industry practice or regulation, either in the US or globally”—are “justified and reasonable and well within the SEC’s discretion” in view of:

(i) the lack of a statutory deadline for implementation of any aspect or component of the liquidity rule or any of its related reporting requirements; (ii) the limited nature of the requested compliance adjustments and absence of any risk of harm to the public from those adjustments; (iii) the impracticability of complying with the bucketing and related reporting requirements by December 1, 2018 (the relevant compliance date for most funds); and (iv) the public interest in reexamining the requirements in light of their associated compliance burdens and limited utility.

Background

On October 13, 2016, the SEC adopted the Liquidity Rule, which will require registered open-end investment companies (including open-end exchange-traded funds (ETFs) but excluding money market funds) to adopt and implement written liquidity risk management programs reasonably designed to assess and manage the fund’s liquidity risk.

The Liquidity Rule will require that a fund’s liquidity risk management program incorporate elements relating to  (i) assessment, management and review of fund liquidity risk, (ii) liquidity classification of portfolio investments,  (iii) highly liquid investment minimum, (iv) illiquid investments, and (v) redemptions in kind.²

The Liquidity Rule establishes additional board responsibilities, and requires the board to appoint either the fund’s investment adviser or one or more fund officers as being responsible for administering the liquidity risk management program. The Liquidity Rule also establishes additional disclosure and recordkeeping responsibilities. Currently, the Liquidity Rule requires that funds in groups of related investment companies with $1 billion or more in net assets as of the end of the most recent fiscal year comply with the Rule’s requirements by December 1, 2018; funds in groups of related investment companies with less than $1 billion in net assets as of the end of the most recent fiscal year are currently required to comply by June 1, 2019.³

On July 20, 2017, the ICI issued a letter to SEC Chairman Jay Clayton expressing “deep concerns” about the fund industry’s ability to meet the compliance deadlines for the Liquidity Rule. The letter requested 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) adjust the compliance schedule for the Liquidity Rule and related reporting requirements by at least one year, even if the SEC does not pursue the recommended rule amendments; (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.

ICI’s Supplemental Letter

The ICI’s Supplemental Letter explains why the bucketing requirements have “proven to be—by far—the most costly and vexing piece of the rule to implement,” including, among other things, because the rule would require funds to take into account “a number of complex and interrelated fund-, market-, trading-, and investment-specific factors and make judgment calls” and would necessitate “uniform output from these inputs.” The ICI also asserts that “bucketing systems capable of doing these things are far from complete” and “systems likely will require several more months before they are mature enough for meaningful evaluation, testing, and all other necessary product- and firm-specific due diligence.” Given the foregoing complexities and challenges, the Supplemental Letter notes that the ICI has extensively engaged its members on rule implementation and, to this end, surveyed members to have a better understanding of (1) their ability to comply with the Liquidity Rule by the current compliance date; and (2) the associated costs.

The survey results, according to the ICI, “provide a strong foundation for the Commission to determine that a delay is necessary and appropriate,” particularly in view of concerns with “vendor readiness.” In this regard, a large majority of survey respondents (91%) indicated that they are considering utilizing vendors, and “most will seek help with bucketing in particular,” and a majority of respondents (73%) “do not believe vendors’ offerings will be sufficiently mature to make an informed selection until 2018.” The Supplemental Letter suggests that only after vendor products are ready for client evaluation can firms then select a product, onboard the vendor, test the product and present a substantially complete liquidity risk management program to their board for approval—a process which is expected to take several months.

The Supplemental Letter also asserts that delaying the rule’s compliance date would allow for enhancements to processes that would increase the utility of the information to be reported to the SEC. In this connection, the ICI cites its evaluation of sample output from vendors’ current offerings, including the results of a bucketing exercise performed by five vendors as to three sample portfolios. According to the ICI, the results of the exercise demonstrated: (1) uniformity of results for small (i.e., $100 million) portfolios; (2) modest dispersion of results for mid-size (i.e., $1 billion portfolios); and (3) more pronounced dispersion of vendor results and percentages across buckets for large (i.e., $10 billion) portfolios. The foregoing, the ICI asserts, demonstrates the limited utility of bucketing data because, as to larger funds for instance, “it is highly likely that as overall portfolio size or fund position size scales up, liquidity will appear to diminish, even if the fund were to invest primarily or entirely in investments that market participants view as highly liquid.” In fact, the ICI notes, “we can expect to see more dispersion across buckets and vendors as sizes increase” since vendors “will employ differing models and default assumptions with different sensitivities to certain factors.” In sum, by delaying the compliance date, the ICI believes that funds and vendors could evaluate further the responsiveness of vendor models to variations in underlying assumptions and further refine their processes.

_{1. With respect to the liquidity rule, the Treasury Department’s report “reject[ed] any highly prescriptive regulatory approach to liquidity risk management, such as the bucketing requirement” and, instead, “supports the SEC adopting a principles-based approach.”}

_{2. For a more detailed discussion of the Liquidity Rule, please see the Vedder Price White Paper, “SEC Adopts New Rules Mandating Open-End Fund Liquidity Risk Management Programs and Permitting Swing Pricing,” published on October 28, 2016 and available at: http://www.vedderprice.com/SEC-Adopts-NewRules-Mandating-Open-End-Fund-Liquidity-Risk-Management-Programs-and-Permitting-Swing-Pricing-10-28-2016/}

_{4. Note that the reporting requirements added to Form N-PORT by the Liquidity Rule have been delayed by the temporary final rule recently adopted by the SEC concerning compliance with investment company reporting modernization reforms.  See the related summary under “New Rules” above.}