IM Director's Recent Remarks on Standards of Conduct & Liquidity Risk Management
by Peter Michael Allen
Recently, Dalia Blass, Director of the SEC’s Division of Investment Management (IM) commented about the standards of conduct for investment professionals and liquidity risk management for open-end funds, including mutual funds and exchange-traded funds (ETFs). Given that the SEC recently submitted for public comment proposed rules for standards of conduct for investment professionals, Director Blass’ comments give a concise roadmap of the proposed rules.
For instance, Director Blass concisely pointed out the standards of conduct for broker-dealers (BDs) and investment advisers (IAs), which include proposals for a new disclosure form called a “Relationship Summary,” a form that BDs would be required to show investors. The form is intended to illustrate the key differences between BDs and IAs and requirements under Regulation Best Interest (Reg. BI), which creates a duty for BDs to act in the best interest of retail clients. Director Blass’ speech also discusses the proposed amendments to the liquidity risk management program rule for mutual funds and ETFs, which include a six-month extension of the compliance date for liquidity classification, quarterly disclosure of an aggregate “liquidity profile,” and how the aggregated liquidity buckets may be replaced with a disclosure in the annual shareholder report. You can find more information about the liquidity rule at our early post, “8 Things You Need to Know about the Liquidity Rule.”
1. Standards of Conduct for BDs & IAs
The proposed rules have three parts to 1) give clarity to retail investors about investment professionals, 2) enhance the standard of conduct for BDs, and 3) clarify the standards of conduct for IAs. Director Blass stressed that the SEC wants investors to be “able to understand what type of investment professional they are dealing with, how they differ, and why it matters.” Under the proposed rules, each firm must be direct and clear about its status as a registered IA, a registered BD, or both when communicating with prospective investors and clients. Also, the proposed rules restrict standalone BDs and their representatives from using the terms “adviser” and “advisor.”
“Relationship Summary” – to show investors the critical differences between BDs and IAs.
Firms would need to provide investors with a new disclosure called a “Relationship Summary” to help investors know whether they are talking to a BD, an IA, or both, and why that matters. Director Blass remarked that the “Relationship Summary would serve as a valuable tool for investors” and it would “highlight key differences” between BDs and IAs, which include 1) the principal types of services provided, 2) the legal standards that apply to BDs and IAs, 3) the fees clients pay, and 4) certain conflicts of interest that may exist.
Reg. BI creates a duty for BDs to act in the best interest of retail clients
The proposed rules include Reg. BI, which would create a duty, under the Securities Exchange Act of 1934, for a BD to act in the best interest of its retail clients and not put the BD’s interest ahead of its clients’ interests. Reg. BI incorporates, but goes beyond, the existing suitability standards for BDs because it covers disclosure, standards of care, and conflict obligations. Reg. BI does share similarities to IA’s fiduciary duty such as the requirement to act in the best interest of the retail client. The primary difference is that the duties under Reg. BI are tied to each recommendation a BD makes, in contrast to an IA’s fiduciary duty that applies to the ongoing relationship with a client. Both Reg. BI and IA’s fiduciary duty do not explicitly prohibit conflicts of interest; rather, both regulations prohibit by implication the most egregious conflicts of interest and require disclosure to the client on other conflicts. (For an IA, a conflict of interest may be so egregious that the conflict is a breach of the IA's fiduciary duty. Likewise, for a BD, a conflict of interest that is so egregious that it prevents the BD from being able to act in the best interest of its client would violate Reg. BI.)
2. Liquidity Risk Management for Open-End Funds
Director Blass also mentioned that the SEC recently completed important work on the rule for liquidity risk management for open-end funds, including mutual funds and ETFs. Director Blass remarked that investors in mutual funds and ETFs “expect to be able to exit these funds promptly, and the 1940 Act requires redemption requests to be fulfilled within seven days,” and as a result, “managing the liquidity of the fund’s portfolio is a fundamental aspect of the adviser’s responsibilities.”
In 2016, the SEC adopted a rule to promote liquidity risk management practices among open-end funds, including mutual funds and ETFs. The rule required all open-end funds to adopt liquidity risk management programs, updated guidance regarding the 15% limitation on illiquid investments, and introduced a new requirement for each fund to classify the liquidity of each investment into one of four “liquidity buckets.” Also, the rule strengthened liquidity risk reporting to the SEC, including requiring funds to report the “liquidity buckets" confidentially .”
A six-month extension of the compliance date for liquidity classification
The SEC extended by six months the compliance date for the liquidity classification and related elements to give funds and service providers enough time to develop and test classification systems and seek board approval of their programs. Other provisions of the rule will go into effect as initially scheduled including the requirements to adopt a liquidity risk management program and the limit on illiquid investments up to 15 percent of the fund’s portfolio.
SEC proposes funds publicly disclose an aggregate “liquidity profile” every quarter
The SEC has proposed changes to the rules related to the public reporting requirement. In addition to the confidential reporting, funds would be required to disclose to the public an aggregate fund “liquidity profile” in Form N-PORT, which means that funds would need to disclose the total percentage of their portfolio investments that fall into each of the four buckets for every quarter.
Director Blass stated that liquidity classification is a “process that will rely on a wide variety of data, assumptions, algorithms, and methodologies,” and thus, “the information aggregated at this level may not be what it appears, particularly when placed alongside the information from another fund.” In other words, the quantitative disclosure initially approved by the SEC may not be as helpful to investors or the SEC as the commission intended. Thus, in March 2018, the SEC issued a proposal to modify the public reporting.
Aggregated liquidity buckets may be replaced with some disclosure in the annual shareholder report
The proposed changes would require funds to discuss their liquidity risk management programs in their annual shareholder reports. These proposed changes would replace the requirement for funds to disclose to the public the aggregated liquidity buckets.