Under the new Investment Company Act of 1940’s Rule 22e-4 that was adopted in October 2016, open-end funds (excluding money market funds) are required to establish liquidity risk management programs and provide additional liquidity-related disclosures in various SEC filings. Using a principles-based approach that takes into account certain market, trading and investment-specific considerations, funds will be required to classify their assets into one of four liquidity categories. Subject to board approval, funds will be required to designate the investment advisor, officer or officers who will be responsible for administering the program.
The adopting release dictates that a portfolio manager cannot be the lone administrator of the program, as the SEC believes this could create potential conflicts of interest in managing a fund’s liquidity risk. Where applicable, subadvisors could be designated as the administrator of the program. However, while they may be well positioned to perform asset classification duties, they generally would not have the transparency into a fund’s shareholder base to perform consideration of reasonably foreseeable redemption activity. Depending on whether a fund has one or multiple subadvisors, additional challenges may present themselves when building systems and processes for timely and effective monitoring of a fund’s overall liquidity. Firms that have begun planning for implementation of the rule have identified that a committee with representation from portfolio management, risk, compliance and legal seems to be the trending best practice — not so dissimilar from the composition of a board’s valuation committee. Each of these groups would certainly provide valuable data and varying perspectives in administering the program, and the resulting diversification should sufficiently mitigate the potential conflict of interest concerns noted by the SEC.
Although the rule does not require the use of third-party vendors, firms are expecting their third-party vendors to provide valuable input to supplement the liquidity analysis of a fund’s investments. Keeping in mind that the use of third-parties does not limit a fund’s responsibility for overall management of the program, funds should consider to what extent they will rely on data provided by third-parties and clearly define that within their programs. In order to rely on the data provided by third-party vendors, the person or committee responsible for administering the program should perform due diligence over the methodologies and data inputs provided, including understanding whether or not there is a Service Organization Controls Report (SOC 1) or equivalent report available. As suggested within the adopting release, the SEC intentionally decreased the classification framework from six to four categories in an attempt to address concerns from commenters that “the proposed six-category classification framework would place undue reliance on data vendors and analysts, and that such reliance could produce potential systemic risk issues.”
Ultimately, there is no one-size-fits-all approach with respect to monitoring your liquidity risk management program, but understanding the complexity of a portfolio and its shareholder base will be beneficial in determining who will administer the program, how frequently a fund should be monitoring liquidity and to what extent firms will need to hire additional support.
Cohen & Company is not rendering legal, accounting or other professional advice. Any action taken based on information in this blog should be taken only after a detailed review of the specific facts and circumstances.
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