November 9, 2023 - The SEC has expressed concern about the ability of open-end funds to meet investor redemption requests without material dilution. This concern led to the SEC’s proposed Open-End Fund Liquidity Risk Management and Swing Pricing rulemaking last November. As you may recall, in addition to the swing pricing/hard close component, the SEC proposed amendments to the 2016 Liquidity Risk Management Rules. In particular, the SEC proposes to eliminate the “Less Liquid Investments” liquidity classification on which open-end loan funds (and others) rely. If the proposed amendments are adopted, loan assets would likely be classified as “Illiquid Investments” – of which an open-end fund can hold only 15%. Without modification to the proposed amendments, this would force open-end loan funds to either liquidate or convert to a closed-end or interval fund format. Therefore, the LSTA has been actively engaged with members and the SEC to demonstrate that open-end loan funds have sufficient liquidity means to meet any redemption request without material dilution. This engagement includes the submission of our February comment letter (summarized here), meetings with SEC staff and Commissioners, and most recently, the submission of a second comment letter describing contractual expedited settlement arrangements (ESAs) – the product of months of work by the LSTA and its interested members.
In this letter, the LSTA reiterated its offer of a highly liquid investment minimum (HLIM) equal to 10% of a fund’s assets to allow for the retention of the “Less Liquid Investments” classification. The 10% HLIM is in addition to the existing liquidity tools available to advisers effectively mitigate liquidity risk (e.g., committed lines of credit and active cash management) and a new tool further enhancing the toolbox – ESAs. The LSTA’s ESA is a standardized arrangement that would permit open-end loan funds to settle sales of loans within three business days after the trade date where an ESA exists between the fund and the buyer. This is accomplished by settling an expedited trade as a participation if settling by assignment has not been possible by T+3. Today, open-end loan funds do not typically have contractual arrangements in place; funds will request expedited settlement at the time of trade and the buyer will agree on a best-efforts basis. The ESA turns a best-efforts arrangement into a contractual one. The LSTA’s ESA includes an ESA Agreement and a Master Participation Agreement which must be executed between an adviser on behalf of its open-end loan funds and the dealer. The ESA Agreement sets forth the parameters of the arrangement: when expedited settlement can be requested, which loan trades can be expedited, the conditions that need to be met before an ESA is available, and representations from the manager on behalf of itself and the funds eligible to use the ESA. The Master Participation Agreement allows for the swift execution of a participation by being pre-negotiated and pre-executed where only a schedule covering the relevant trade(s) need be executed at time of settlement.
It is the LSTA’s sincere hope that the SEC agrees with the LSTA’s position that it is appropriate to retain the “Less Liquid Investments” classification for the reasons outlined above. Drafts of the Expedited Settlement Agreement, the Master Participation Agreement for Expedited Settlement Template, and proposed modification to the LSTA’s Par Confirm to support ESAs will soon be circulated to the Trade Practices and Forms Committee.
For more information, please contact Tess Virmani.
