SEC Reverses Itself and Votes Against Public Reporting of Liquidity Classifications
In something of a turnaround, the Commission on March 14 voted, 3 to 2, to change a previously adopted liquidity classification requirement. Under the proposed amendments, funds will no longer need to publicly report the classification buckets their securities fall into. Instead, they will simply need to provide a qualitative narrative describing how their liquidity risk management programs are working.
In addition, the proposed amendments will allow funds to classify a security in more than one of the four buckets required by the existing Liquidity Risk Management Rule, which was adopted in October 2016.
"Whether the Commission ultimately determines that the information is to be reported privately or publicly, it is almost unprecedented for a key element of a new rule being walked back so quickly," said Willkie Farr partner and former SEC deputy chief of staff James Burns. "It certainly speaks to the consternation the Liquidity Risk Management Rule has occasioned and suggests a questioning on the part of this new Commission if not a wholesale repudiation of the notion of asset management firms presenting a systemic footprint. Quite a change in outlook in a relatively short period of time."
"The change addresses perhaps the biggest concern raised by the Liquidity Risk Management Rule," said Morgan Lewis partner John McGuire. "The public disclosure of what securities fit in certain liquidity buckets essentially takes subjective information (the
adviser’s determination of how liquid it thinks a particular security is) and portrays it as something that can easily be misunderstood as objective information (that the adviser’s liquidity determination is always correct). That could be dangerously misleading for investors who might mistakenly believe that such subjective determinations are facts. I’m not sure how useful this information will be to the SEC, but for now the Commission has acted to protect investors from this potentially misleading information."
"The Commission is proposing a new requirement that funds disclose information about the operation and effectiveness of their liquidity risk management program in their annual reports to shareholders," the SEC said in its preamble to the proposal. "The Commission in turn is proposing to rescind the current requirement in Form N-PORT under the Investment Company Act of 1940 that funds publicly disclose aggregate liquidity classification information about their portfolios, in light of concerns about the usefulness of that information for investors."
The proposed amendments, which now are open to public comment for 60 days after publication in the Federal Register, are the latest changes softening the blow of the Liquidity Risk Management Rule and related requirements. Other actions taken by the SEC since Jay Clayton became chairman include:
An extension of the Rule’s classification deadline by six months (ACA Insight, 2/26/18); and
Two releases of FAQs designed to help funds and their advisers comply with the Rule’s requirements (ACA Insight, 3/12/18).
Clayton, who said that funds will still be required to report bucket classification data privately to the Commission, cited the public’s lack of access to the SEC’s non-public data as one of the considerations behind the new proposal.
"While the Commission is well-situated to understand fund-to-fund variabilities in the classification process because of our access to the nonpublic data, as well as our ability to follow up with funds, many of the factors leading to those fund to fund variabilities would not be apparent to retail investors or the markets more broadly," he said. "I believe it is the Commission’s responsibility to ensure that the information we are requiring funds to disclose is not only accurate, but placed in a proper context such that it will be of value to investors — e.g., promote investor understanding and, importantly, not lead to investor confusion or, worse, misleading information."
He also suggested that the reporting of "more granular fund-specific quantitative or position level detail would risk, among other things, investor confusion and predatory trading behaviors."
"The proposed amendments described during today’s open meeting seems reasonable," said Ropes & Gray counsel David Tittsworth. "One should remember that they are proposed. The Commission will take comments from all sources and then vote on a final rule, so it is certainly possible that additional changes could be made before a final vote. It also seems clear that a majority of the Commissioners are willing to consider other changes to the amendments after they go into effect and they have an opportunity to evaluate the effectiveness and costs."
"The section of the proposal that is going to get the most discussion is the ‘roll-back’ of the requirement to publicly file your aggregated liquidity profile, in other words, publicly reporting the liquidity classifications," said Shearman & Sterling partner Nathan Greene. "The pros/cons for that disclosure can be debated. But there are also pros/cons to the discussion of liquidity risk in the annual report, the SEC’s suggested alternative. Bottom line, there’s going to be a lively comment period."
The 3-2 vote took place during Clayton’s first open meeting as SEC chairman. Those voting no on the proposal, as might be expected, were the two Democratic commissioners, Kara Stein and Robert Jackson.
"I am not persuaded that we should amend our liquidity Rule and take useful disclosures away from investors," Stein said. She noted that the final Liquidity Risk Management Rule itself was a compromise. "The initial proposed Rule would have required public disclosure of the liquidity classification for each individual investment in the fund. There would have been six classifications or buckets. The final Rule reduced the number of buckets to four and allowed funds to report the aggregate value of investments that fall into each bucket, as a percentage."
"This is akin to disclosing the ingredient list on a food label," she said. The Food and Drug Administration requires such information. "Consumers can use the ingredient information to decide if they want to purchase the food product. After all, the product might contain an allergen or some other ingredient a consumer might not want."
"Liquidity information of a fund", she said, "is no different. It gives investors some indication of the liquidity profile of what’s in the fund. Investors can therefore make a better determination as to whether the fund is appropriate for them to purchase."
Commissioners Michael Piwowar and Hester Peirce, who voted with Clayton in favor of the proposals, had their own criticisms – mainly that the proposal did not go far enough.
"I am disappointed that the Commission is missing a golden opportunity," Piwowar said. When the SEC chose to delay the compliance date for the liquidity Rule’s classification requirements, he said, "we acknowledged that the one-size-fits-all ‘bucketing’ methodology has already turned out to be more costly and complex than anticipated and that the role for service providers is going to be more extensive than we had originally understood. Industry participants have found the prescriptive bucketing approach to be suboptimal for its intended purpose, and funds are finding more effective ways to manage their liquidity risk."
Now, he said, would have been the time for a more "meaningful" retrospective review of the existing Rule. "Unfortunately, a majority of the Commission has decided to pass up the opportunity . . . to the detriment of investors and the investment companies that serve them."