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News February 1, 2016 Issue

Fund Managers Challenge SEC Liquidity Risk Management Proposal

Fund managers, like a number of industry associations, are sounding the alarm in regard to elements of the SECís proposal to manage liquidity risk.

Wells Fargo Asset Management, State Street Global Advisors, J.P. Morgan Asset Management and other advisers sent comment letters to the agency following its September 2015 proposal. Like the Investment Company Institute and other associations (ACA Insight, 1/25/16), many were supportive of the SECís overall goal of regulating liquidity risk, but took issue with some of its specific proposals as too prescriptive and, in some cases, possibly injurious to investors.

"We share general industry concerns that some†aspects of the proposal may be overly prescriptive, and could benefit from a more flexible approach," said State Street in its January 13 comment letter.

"We applaud the goals of the Commissionís proposal and support those aspects of the proposal that are reasonably designed to achieve demonstrable benefits for shareholders," said Wells Fargo in its January 13 comment letter. But the firms said that the new regulation "should be tailored to common levels of liquidity risk and that the demonstrable benefits of such regulation should outweigh the additional costs and complexity created by it."

Willkie Farr partner and former SEC Division of Investment Management director Barry Barbash said that his "general impression" of the comments sent in "is that the industry has accepted the premise of the†liquidity rule, but is very concerned about its mechanics, which appear likely to be difficult and costly to†implement, and not really workable from a practical point of view."

"Itís really hard to see where the SEC is going to be on this after the comments are taken into account," he said. "Iím not sure that the Commission or the Commission staff expected the comments to be as negative as they are. The industry reaction is fairly uniform and consistent."

Morgan Lewis partner John McGuire said he found the SECís proposal "flawed at many levels" and that "there is not any demonstrated need" for it. "I agree with most of the commenters that the proposal is too rigid and prescriptive, and will result in additional cost that will ultimately be borne by investors. A principles based
approach would be better."

The proposal

The SECís proposed funds each create a liquidity risk management program, from which money market funds would be excluded, a concept that many commenters were accepting of. That program, along with other parts of the proposed rule reforms, would mandate:

Classification of fund portfolio assets into six buckets, based on the amount of time an asset would need to be converted to cash without a market impact;

  • Assessment, periodic review and management of each fundís liquidity risk;
  • Establishment of a three-day liquid asset minimum for each fund;
  • Board approval and review of each fundís liquidity risk management program; and
  • New disclosure and reporting requirements.

"Fund boards can expect a new agenda item covering a fairly dense set of materials," said Perkins Coie partner Jesse Kanach. "The boards would be asked to approve the liquidity risk management program as a whole, with particular attention to deciding on the proper three-day liquid asset minimum going forward. Boards would also be presented with interim material changes, information about monthly reports to the SEC and quarterly public disclosures, an annual report on the program covering various elements, and an annual re-approval of the overall program."

Classification and reserve

The proposed classification system and three-day liquid asset minimum appear to raise many of the same concerns from asset managers that they did from associations. Hereís what asset managers had to say:

  • Classification system. "The excessively granular design of the proposed six-category classification and related reporting proposal is fundamentally at odds with the imprecise nature of liquidity judgments and estimates," wrote Wells Fargo. Doing so "would require funds to perform an undertaking that does not comport with the uncertainties and† imprecision inherent in the liquidity assessment process and the impacts of ever-shifting market conditions." Liquidity, the firm noted, is "not a constant in any market." State Street, like a number of other commenters, suggested that a principles-based† approach, similar to Rule 38a-1 under the Investment Company Act, which covers compliance programs, along with appropriate Commission guidance, "will best serve funds, their shareholders and the investment public, and meet the Commissionís goals."
  • Liquid asset minimum. J.P. Morgan, in its January 13 comments, expressed concern that "the proposed three-day liquid asset minimum Ö is not sufficiently dynamic to respond to changing market conditions, and does not offer sufficient flexibility to manage funds efficiently," and also raised a concern that the classifications are based on the number of days it would take to liquidate. Wells Fargo suggested that, rather than manage to a "hard" investment policy minimum, "funds should employ a three day liquid asset target," with the target level "based on an†ongoing assessment of the fundís total liquidity risk profile."

Disclosure concerns

Other sections of the proposal, particularly the disclosure requirements, also drew critical comments. The disclosure proposals would require, among other things, that firms provide the liquidity classifications they use, as well as the three-day liquid asset minimum adopted, on a form proposed in May 2015, Form N-PORT.

"We do not believe the public disclosure of security level liquidity information is in the best interests of the public because it will be inconsistent across funds and managers, which will cause confusion," wrote Pacific Investment Management Company in its January 13 comment letter. "Further, as portfolio liquidity is fluid and dynamic, the information will be stale when disclosed and therefore will not provide investors with any meaningful interpretation."

"A sufficiently objective market convention to measure liquidity has not yet been developed," wrote Wellington Management Company in its January 13 letter. "Disclosures that suggest that one does would be misleading." The firm suggested that the SEC require funds to provide a "qualitative discussion of liquidity risks" in fund offering documents.

Charles Schwab, in its January 13 comments, suggested that while the SEC should continue to make Form N-Q, which details portfolio holdings, available to the public, it should keep Form N-PORT, or at least key elements of the form, confidential. "We believe that the investing public would be overwhelmed by the sheer volume of information reported on Form N-PORT. With more than 17,000 open-end funds and exchange-traded funds reporting this information on a monthly†basis, and each reporting the liquidity of anywhere from dozens to more than a thousand individual portfolio†assets, the amount of information will be overwhelming to investors."

Individual firm concerns

Some asset managers raised concerns about issues that were not raised in many of the letters from others, or took positions that were not totally in agreement with those expressed in other comment letters. These included:

  • Exchange-traded funds. "We believe that there is a critical need to exclude most ETFs from certain†aspects of the proposal," wrote State Street, which noted in its letter that it created the U.S.-listed ETF in 1993. "ETFs that transact almost exclusively in-kind with authorized participants have virtually no cash liquidity obligation. We believe that the imposition of liquidity requirements designed for funds with daily cash redemption requirements will negatively impact ETF investors." Classifying liquidity risk as proposed by the SEC "would be a largely meaningless exercise" since there is no cash to distribute, and "would serve only to absorb time and resources which the ETFís manager could better expend elsewhere." For this reason, a three-day liquid asset minimum would also be "problematic" for ETFs, as it would be†"irrelevant," the firm said. McGuire suggested that the Commission "failed to grasp that, for ETFs that create and redeem in-kind, there is a totally different type of liquidity concern than the concern that mutual funds have, and the concerns addressed by this proposal."
  • Swing pricing. J.P. Morgan, which uses swing pricing with many of its European funds, came out in favor of the practice, seemingly with more enthusiasm than other commenters. The firm said it "applauds the Commissionís willingness to permit swing pricing for open-end funds. Ö We believe that, by reducing dilution of the fund as a result of transaction costs, swing pricing is likely to benefit our long-term shareholders." J.P. Morgan expressed concern about several "operational obstacles" to implementation of swing pricing at this time and offered several comments and recommendations to address them. "Nonetheless," the firm said, "we believe that if the SEC permits the use of swing pricing, the industry will work with its partners in the fund distribution chain to find solutions to the operational concerns."