The US Securities and Exchange Commission’s (SEC) proposed rules regarding 1940 Act reporting modernization, released May 2015, were another shot across the bow for the US asset management industry. This new proposal is the first of a five-part initiative that SEC Chair Mary Jo White announced in December 2014, aimed at proactively addressing perceived risks in the asset management industry, including portfolio composition and operational risks and concerns related to derivatives, portfolio liquidity, and leverage exposure.
The SEC Seeks to Modernize Data Collection Practices
The overarching goal of the proposal is to allow the SEC to receive more useful data in a more modern, usable format—“structured data”—so the agency can better analyze funds’ compliance and risk exposures. The proposed reporting modernization rules are tightly linked to another set of SEC-proposed rules on liquidity risk management, as well as a December 2015 SEC proposal governing the use of derivatives holdings.
Form N-Port replaces Form N-Q
The reporting modernization proposal would require funds to file a new form, known as Form N-PORT, monthly. Form N-PORT would replace quarterly Form N-Q and capture information such as portfolio holdings and prices, leverage statistics, and counterparty risk metrics. Every third filing of Form N-PORT—the last in each quarter—will be released to the public sixty days after it is filed.
Form N-CEN replaces Form N-SAR
Under the modernization proposal, another form, Form N-CEN, would be introduced, replacing current Form N-SAR. Form N-CEN would be filed once a year, at fiscal year-end, and would include information traditionally filed on Form N-SAR—details about fund service providers and certain financial data—as well as new information, including enhanced reporting with regard to exchange-traded funds and securities lending activities. Additionally, Regulation S-X, which governs how financial statements are prepared, would be modified to standardize the way derivatives holdings are reported.
The modernization proposal complements two additional proposals, released in September 2015 and December 2015, respectively. The first centers on liquidity risk management, while the second serves to limit funds’ derivatives holdings. Though all three proposals are still in the comment stage (comment letters are due in January 2016 for both the modernization and liquidity proposals, and March 2016 for the derivatives proposal), it is worth noting that the liquidity risk proposal relies on data that would only be collected under the terms of the new reporting requirements, notably through Form N-PORT. By using information gathered on Form N-PORT, the SEC would have a better understanding of funds’ risk exposures, and how funds may react during times of market stress. Risk metrics related to derivatives would also provide the SEC with a way to monitor compliance with the new derivatives rules.
Adjusting to a New Reporting Normal
Though the industry appreciates the need for certain aspects of the proposed rule, taking it all in is daunting. The most difficult part of compliance will be the development of appropriate technology, processes, and procedures.
One of the key challenges for managers will be identifying the correct sources of information, and discovering how to extract it each month. Managers should begin working now to locate gaps in fund data, and work with providers to facilitate ready and accurate access.
The increased data reporting called for by the new rules is also accompanied by several concessions, notably the electronic distribution of financial statements. Under the terms of the proposal, instead of mailing quarterly statements to shareholders, managers would be allowed to mail a notice directing shareholders to a website to find the information.
Funds are Cautiously Supportive
Judging from comments received by the SEC on this proposal so far, the investment community understands, and generally supports, the agency’s need to modernize its data gathering capabilities. Certainly some of its forms, and the systems those forms rely on, have become outdated in the 21st century.
The Investment Company Institute, for example, commented to the SEC in its letter submitted in August: “Broadly speaking, we support the proposals, notwithstanding the extraordinary effort, cost, and burdens involved in implementing them.”
At the same time, however, the Institute expressed concerns over issues of data privacy, as well as potentially sensitive fund-holding and strategy information that, for proprietary and competitive reasons, should not be disseminated.
As industry players and regulators continue to scrutinize and debate the new reporting modernization, liquidity, and derivatives proposals, the financial services community awaits new proposals on transitioning client assets and the use of appropriate stress tests.
Certainly, it has been a long time since 1940 Act funds have had to deal with such significant changes, but the impact and breadth of the new reporting modernization proposal, and its kin, is staggering. These are broad, sweeping regulatory developments that will require significant investment of time, energy, and money.
This article was originally published in the 2016 Regulatory Field Guide. The guide features insights from a number of our experts on key regulatory developments that will have the greatest impact for asset managers in the year ahead – and beyond. Visit bbh.com/regulatoryfieldguide to explore the guide.