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News January 22, 2018 Issue

SEC Liquidity Risk Management FAQs Flesh Out ETFs, Role of Subadvisers

Funds and advisers with questions about liquidity risk management programs may breathe a bit easier – at least if some of those questions pertained to how in-kind exchange-traded funds work and the role of sub-advisers. The SEC’s Division of Investment Management on January 10 issued FAQs that address at least some of the questions that have arisen in these areas.

The 15 FAQs are divided into two parts: The first eight address subadviser questions, while the final seven provide answers about how various aspects of ETFs need to work under the requirements of Investment Company Act Rule 22e-4, the Liquidity Risk Management Rule, adopted by the Commission in October 2016.

The subadviser FAQs, while provided first, basically "reconfirm what most funds already thought," said ACA Compliance Group director Erik Olsen. They address questions such as whether a liquidity risk management program administrator may delegate responsibilities to a subadviser, whether an administrator can oversee multiple and different liquidity risk management programs, and whether different funds may classify the same investment differently.

The ETF FAQs, on the other hand, are likely to be of more interest to funds and their advisers, if only because they provide more definition to the concept of an in-kind ETF’s de minimis cash redemption transactions. All seven of these FAQs address in-kind ETFs, which are ETFs that meet redemptions through in-kind transfers of securities, positions and assets (rather than through a de minimis amount of cash), and that publish their portfolios daily.

Among the topics addressed by the ETF FAQs is defining the percentage of cash redemptions allowed to fall within a de minimis definition. Up until this set of FAQs, the SEC had not provided an answer, Olsen said. While the Rule states that in-kind ETFs may have a de minimis amount of cash redemptions, it does not define the percentage of redemptions that could safely be considered de minimis.

"Some advisers and funds who were waiting for this guidance may now feel more comfortable proceeding," said Sidley Austin counsel Douglas McCormack. "The FAQs provide some helpful flexibility and are reasonable."

ETF FAQs

Following is a summary of some of the FAQ responses relating to ETFs. Funds, their advisers and subadvisers are urged to read the full FAQs.

  • Is there a de minimis cash amount that the SEC staff would view as reasonable? (FAQ 11). ETFs that redeem more than the de minimis amount of cash are considered by the SEC as potentially having "substantially similar liquidity risks as mutual funds," the agency staff said. As such they are subject to the same requirement as mutual funds, including the Rule’s investment classification and highly-liquid investment minimum – in other words, they would lose the advantage of being considered in-kind ETFs. Defining what constitutes a de minimis amount of cash, however, is a determination that the staff left to each ETF, which means, it acknowledged, that "what is de minimis may differ among ETFs." The staff did provide some insight into its thinking here, however, and indicated that an acceptable de minimis cash redemption percentage would be between 5 percent and 10 percent. "It would be reasonable for an in-kind ETF to determine that if the percentage of its overall redemption proceeds paid in cash does not exceed 5 percent, . . . such use would be de minimis." At the same time, it left the door open for the possibility that some ETFs may determine that more than 5 percent in cash redemptions would also be an acceptable de minimis figure. Overall redemption proceeds of more than 10 percent in cash "would be unreasonable" as a de minimis percentage in terms of qualifying as an ETF, the staff said.
  • Is an ETF that engages in a single redemption transaction consisting entirely of cash necessarily precluded from quantifying as an in-kind ETF under the Rule? (FAQ 12). The key here, again, is whether the amount of cash falls within the de minimis limit. "The staff believes that a redemption transaction consisting entirely of cash does not necessarily preclude an ETF from qualifying as an in-kind ETF so long as such a redemption transaction as a proportion of the ETF’s aggregate redemption transactions does not exceed the de minimis amount of cash defined in the ETF’s policies and procedures. . . ." the staff said.
  • What methods may an in-kind ETF use to test whether its cash use is de minimis? (FAQ 13). The staff pretty much leaves this up to each ETF. "The staff believes that an in-kind ETF may take a variety of reasonable approaches to determine whether its cash use is de minimis, so long as the approach the ETF selects is consistently applied," it said. Again, as with other questions, it provided some suggestions here, stating that "it would not object" if these approaches included: testing each individual redemption transaction to ensure that each has no more than a de minimis cash amount; or testing its redemption transactions in their totality over some reasonable period of time to ensure that, on average, its aggregate redemptive transactions have no more than a de minimis cash amount. Whatever method is used, "the staff believes that the ETF’s policies and procedures should describe the ETF’s approach for testing compliance and the time period used, and they should be applied consistently."

Subadviser FAQs

Following is a summary of some of the FAQ responses relating to subadvisers. Funds, their advisers and subadvisers are urged to read the full FAQs.

  • May the program administrator delegate responsibilities to a subadviser under the fund’s liquidity risk management program, subject to appropriate oversight? (FAQ 1). The agency staff provided an unequivocal "yes" here. The final Rule, it noted, "explains that the term ‘adviser’ as used in the adopting release and the Rule generally refers to any person, including a subadviser, that is an ‘investment adviser’ of the investment company. A fund’s subadviser could thus be designated as program administrator." In addition, the staff said, program administrators may also delegate specific responsibilities to a subadviser.
  • May an adviser (including a subadviser) administer, or have specific designated responsibilities under, multiple liquidity risk management programs that differ from one another? (FAQ 3). The answer here is also in the affirmative. "An adviser (including a subadviser) may have responsibilities under multiple fund liquidity risk management programs that differ from one another (including multiple programs within the same fund complex), and the staff believes that such an adviser is under no obligation to reconcile the elements of those programs; the programs’ underlying methodologies, assumptions or practices; or the program outputs (e.g., liquidity classifications of fund investments)."
  • May different funds classify the same investment differently? (FAQ 5). The staff said that the SEC recognizes that different funds may classify the liquidity of similar investments differently based on the facts and circumstances informing their analysis. "This could result in classifications of the same investment that vary from fund to fund. This flexibility in classification also extends to multiple subadvisers with distinct sleeves (FAQ 7). However, the staff noted in response to FAQ 8, this flexibility does not extend to how a fund reports an investment’s liquidity classification on Form N-PORT. The form "does not permit a fund to report more than one liquidity classification of a single investment," it said. "If . . . a fund classifies the same investment held in multiple sleeves differently for purposes of compliance with the Rule, the staff believes that its policies and procedures should have a process for selecting a single classification for that investment for purposes of Form N-PORT reporting." As with other questions, it offers some possibilities to resolve this challenge: a fund could adopt the classification of the subadviser with the largest position in the investment, calculate a weighted average based on each subadviser’s classification and its respective position size and round to the nearest classification; or use the most conservative, or least liquid, classification.