November 8, 2022 - As previously discussed, last week the SEC proposed an Open End Fund Liquidity Risk Management Programs and Swing Pricing Rule, which largely amends the existing 2016 Rule. Many associations are focused on the swing pricing element, among others, which are detailed in this Dechert NewsFlash. However, for the loan market, the liquidity risk management component – and, in particular, the elimination of Category Three “less liquid investments” and the shifting of these investments into Category Four “illiquid investments” – may be most immediately challenging aspect. We highlight several issues below and will discuss in more detail in coming weeks.
In its 2016 Liquidity Risk Management Rule, the SEC was primarily focused on ensuring that open end funds could meet redemptions in periods of market stress. To do so, it split investments into four categories based on their ability to be converted to cash without significantly changing their market value: 1) Highly liquid investments (convertible to cash in three business days); 2) moderately liquid investments (convertible to cash in 4-7 calendar days); 3) less liquid investments (which typically could be sold in seven calendar days, but would take longer to settle); and 4) illiquid investments (which could not be sold within seven calendar days). Importantly, Open End Funds are not permitted to have more than 15% of total assets in illiquid investments.
As the LSTA discussed in its 2016 comment letter, open end loan mutual funds (“LMFs”) have a number of tools to address redemptions in periods of market stress, including expedited settlement arrangements, liquidity lines and holding cash or other securities. At the time, the SEC accepted these arguments and loans held by LMFs generally have been in Category Three (less liquid Investments) since then.
The SEC now is pushing back on that category and these arguments. First, on p. 34, it proposes “to remove the less liquid investment category and to treat these investments as illiquid…For example, many bank loans take longer than seven days to settle. The proposed amendment is designed to reduce the mismatch between the receipt of cash upon the sale of assets with longer settlement periods and the payment of shareholder redemptions. This would better position funds to meet redemptions, including in times of stress.”
While much effort has gone into shortening settlement times, the SEC notes on p. 60-61 that “[b]ank loans are not standardized and have individualized legal documentation. This provides flexibility of terms for bank loans, but also increases the time for a fund to settle a bank loan trade and receive proceeds from the sale, thus increasing the risk of the fund not being able to meet shareholder redemptions.” And while SEC acknowledged that loan settlement times have shortened in periods of stress, it added that “in future stress events these attempts to shorten settlement times may fail since loans are not standardized, have individualized legal documentation, and rely on manual processes for settlement.”
Another point in the 2016 arguments was that LMFs had failsafe mechanisms in the form of liquidity lines of credit, meant to bridge the period between sale and settlement (if needed). The SEC previously took comfort in these lines. Now, though, it questioned whether they would always be available, noting on p. 62 that “funds with significant extended settlement investments have used borrowing through lines of credit to meet redemptions, but lines of credit may not be available to all funds and borrowing imposes costs that can dilute the value of the fund for remaining investors.”
In addition to these two very significant changes, the SEC proposes several other changes, including mandating the “Highly Liquid Investment Minimum” (HLIM) at 10% and deducting fund liabilities from the HLIM.
Bottom line: If loans were shifted into the illiquid investments category – which is limited to 15% of Open End Fund investments – then LMFs might no longer be able to use the Open End format. The LSTA continues to analyze the rule and will be meeting with its LMF Working Group to craft a response.