In a letter to U.S. Securities and Exchange Commission (SEC) Chairman Jay Clayton, the Investment Company Institute (ICI) formally requested a delay and re-examination of certain elements of Rule 22e-4 under the Investment Company Act of 1940 (Liquidity Rule) and the fund reporting modernization rules (Modernization Rule).1 Specifically, the ICI’s letter requested that the SEC:
Delay the compliance deadline for the liquidity classification (or “bucketing”) requirement under the Liquidity Rule and related requirements as soon as possible. This delay would provide the SEC with sufficient time to re-examine these requirements and propose and finalize targeted amendments to the Liquidity Rule that would permit funds to formulate their own policies and procedures to classify the liquidity of their portfolio investments;
Delay the compliance deadline for the liquidity classification requirement and related requirements by at least one year, even if the SEC determines not to propose targeted amendments to the Liquidity Rule;
Modify the frequency of the Form N-PORT reporting requirement from monthly to quarterly, until the SEC sufficiently addresses the industry’s concerns on data security; and
Delay the compliance deadlines for the Form N-PORT and Form N-CEN reporting requirements for at least six months, even if the SEC determines not to modify the frequency of the Form N-PORT reporting requirement.
The ICI’s letter did not specify the manner in which the SEC should implement its requests. However, any substantive changes to the Liquidity and Modernization Rules would likely require SEC approval after public notification of the proposed changes and opportunity to provide comment, consistent with the Administrative Procedure Act.
The ICI’s Liquidity Rule Recommendations
While the ICI generally indicated its support for most of the requirements under the Liquidity Rule, it requested that the SEC delay the compliance deadline for the liquidity classification (or “bucketing”) requirement and related requirements as soon as possible. Under the liquidity classification requirement, non-money market mutual funds (except “in-kind ETFs”) will be required to classify the liquidity of their portfolio investments (including derivatives transactions) into one of four uniform liquidity categories, based on the number of days within which the fund determines that it reasonably expects an investment to be convertible to cash (or, for the “less-liquid” and “illiquid” categories, sold or disposed of), without significantly changing the market value of the investment. According to the ICI, this requirement “has proven to be – by far – the most costly and vexing piece of the rule to implement.” The ICI indicated that a delay, accompanied by a request for additional comments, would provide the SEC with sufficient time to re-examine this requirement, as well as to propose and finalize targeted amendments to the Liquidity Rule that would permit funds to formulate their own policies and procedures to classify the liquidity of their portfolio investments.
The ICI emphasized that, in addition to being costly and difficult to implement, the classification of portfolio investments into uniform liquidity categories may be misleading since the classifications would be subjective and forward-looking, with potentially adverse market effects (such as encouraging herding behavior).2 Moreover, the ICI noted that a uniform classification requirement is not an essential feature of liquidity risk management and oversight. The ICI recommended that, rather than using a “days to cash” formula, each fund be allowed to formulate its own policies and procedures for classifying the liquidity of its portfolio investments. According to the ICI, this approach would reduce costs and operational difficulties while allowing funds to focus on comprehensive liquidity risk assessment, management and review.
However, even if the SEC determines not to propose targeted amendments to the Liquidity Rule as discussed above, the ICI requested a delay to the compliance deadline for the liquidity classification requirement and related requirements by at least one year.3 According to the ICI, this delay would: (1) provide third-party service providers with additional time to develop systems and products that may be relied upon by fund complexes in classifying the liquidity of portfolio investments; and (2) provide fund complexes with additional time to educate and seek approval from their boards on proposed liquidity risk management programs.
The ICI’s Modernization Rule Recommendations
New Form N-PORT will require certain registered investment companies4 to electronically file portfolio-wide and position-level information on a monthly basis with the SEC, in a structured extensible markup language (XML) format, no later than 30 days after each month’s end. Position-level liquidity classification information will be reported on a non-public basis to the SEC. However, Form N-PORT will require public reporting of aggregate percentages of a fund’s portfolio investments in each liquidity category. This aggregate information will be reported monthly on Form N-PORT, but it will be disclosed to the public only for the third month of each fiscal quarter, with a 60-day delay.
The ICI requested that the SEC modify the frequency of the Form N-PORT reporting requirement from monthly to quarterly until the SEC sufficiently addresses the industry’s concerns on data security, including by implementing the recommendations of a third-party expert. The ICI suggested that the SEC could, however, continue to collect other data on Form N-PORT on a monthly basis. The ICI noted that the information that will be reported on Form N-PORT is “valuable and sensitive” and requires adequate protection from the SEC, and that any breach of the SEC’s data security would cause “irreparable harm.”5 The ICI cited reports by the SEC’s inspector general and by the Government Accountability Office, which noted current weaknesses in the SEC’s information security program.6 In addition to addressing the weaknesses cited by these reports, the ICI recommended that the SEC “implement aggressive measures to protect Form N-PORT data, including independent third-party testing and verification of its information security programs, prior to requiring firms to commence monthly filing of portfolio holdings.”
However, even if the SEC determines not to modify the frequency of the Form N-PORT reporting requirement as discussed above, the ICI requested a delay to the compliance deadlines for the Form N-PORT and Form N-CEN reporting requirements for at least six months. As with the liquidity classification requirement, the ICI cited the operational challenges of obtaining, compiling and reporting the vast amount of new data that will be required to be reported on Form N-PORT and Form N-CEN. According to the ICI, a six-month delay would allow fund complexes to, among other things: (1) develop new technologies to compile the data required to be reported on Form N-PORT and assess the sources of this data; and (2) coordinate with third-party service providers that may be used in this process. For the first six months following compliance, the ICI also recommended that the SEC maintain as non-public all data reported on Form N-PORT.
The Liquidity and Modernization Rules impose significant new compliance, reporting and other requirements on fund complexes, all of which present a number of unique challenges. As fund complexes progress on developing their liquidity risk management programs and reporting systems, it has become apparent that certain amendments may be appropriate, and that more time may be necessary to implement new programs and systems, which the ICI’s letter underscores. Any delay to the compliance deadlines for the Liquidity and Modernization Rules, and any targeted amendment to the Liquidity Rule that would permit a fund to formulate its own policies and procedures to classify the liquidity of its portfolio investments, would therefore be a welcome development. Although the outcome of the ICI’s requests is uncertain, these requests reflect the substantial questions and burdens that the implementation of the rules present and that the SEC will likely be compelled to address before the final compliance dates.