Liquidity management obligations for investment funds

Introduction

In response to recent market volatility and disruption, operators of retail investment funds and their boards have been reminded of their governance and conduct obligations in light of potential liquidity risks. In addition, the Australian Securities and Investments Commission (ASIC) has requested that responsible entities, as the operators of registered schemes (retail funds), assist the regulator with monitoring the situation by introducing notification measures. We briefly explore these obligations and what they may imply for both existing compliance measures as well as testing of operational and risk management systems.

In recent weeks the Australian and global markets have been impacted by the disruption caused by the current pandemic. This has played out in different contexts in asset management, but from a liquidity management perspective, it has been felt both at the underlying asset level and through trading operations. Certain asset classes and sectors have been more clearly affected such as retail, tourism and airlines. In addition, volatility in bond markets has caused certain unlisted bond funds to adjust their buy-sell spreads in order to cater for the pricing impacts. In the medium term, we may also expect to see investor-led changes to the patterns of applications and redemptions from investment funds as the broader economic effects of the pandemic play through. These factors all have the potential for a significant effect on the liquidity profile of certain investment funds.

ASIC letter

In this context, ASIC published in April a letter to responsible entities which reminded them and their boards of some key statutory obligations:

• The responsible entity and its officers owe duties to the members of the scheme to ensure that they exercise their powers and carry out their duties in the best interests of the scheme members. Other general registered scheme obligations complement this primary duty, including ensuring that scheme property is valued at regular intervals appropriate to the nature of the property – a key obligation at times of liquidity uncertainty.
• The primary scheme-related obligations are complemented by a responsible entity’s ongoing duties as an Australian financial services licensee. These include doing all things necessary to ensure that the financial services covered by the licence are provided efficiently, honestly and fairly, having adequate risk management systems and maintaining adequate financial and other resources.

In its letter to responsible entities, ASIC also emphasised some more specific expectations in terms of scheme liquidity:

• Responsible entities should be actively monitoring the levels of redemptions and applications in relation to their funds.
• The terms on which redemptions are made available should also be actively monitored for each scheme, including ensuring that the terms remain consistent with the underlying liquidity profile of the scheme’s assets. ASIC indicated that any mismatches between the redemption terms and underlying assets should be addressed.
• The liquidity profile of the scheme should be actively assessed, taking both a short term and a long term view in order to ensure future redemption requests can be met. If a scheme becomes non-liquid, ASIC has reminded responsible entities that they should determine whether redemptions need to be suspended in order to protect the interests of all members and to meet the statutory duties.
• Responsible entities should be monitoring the valuation of scheme property and its flow through to unit prices, including ensuring appropriate buy-sell spreads have been calculated and are being applied. In this regard, as mentioned above, we have already seen some movement in spreads as a response to bond pricing.
• ASIC’s expectations under Regulatory Guide 259: Risk management systems of responsible entities (RG 259) also need to be taken into account, particularly with regard to liquidity management, risk management systems and stress testing.
• Disclosure and member communications must be undertaken in a timely manner and consistently with the obligations for registered schemes, such as ensuring that members are treated equally and fairly.

In addition, ASIC has requested responsible entities provide notifications to ASIC in the event that any scheme becomes non-liquid or if a decision is made to suspend redemptions. This notification is separate to the statutory breach reporting obligations and so in that sense can be viewed as supporting ASIC’s monitoring activity in this area. It may also inform actions that ASIC takes in the future to assist responsible entities and members should issues arise.

Finally, ASIC in its letter reminded responsible entities that, should they be in a position where they have to declare a scheme as non-liquid for an extended period of time, it may be relevant to consider applying to ASIC for hardship relief. Subject to an entity satisfying the relevant criteria, ASIC can grant relief to facilitate partial investor access to funds in cases of hardship and also provide rolling withdrawal relief to responsible entities to simplify the procedure for periodic withdrawal offers.

Measures responsible entities can and should adopt

In light of the above, there is a range of measures that responsible entities can and should be adopting to ensure that their operational and regulatory response to these developing market conditions are sufficiently robust to address liquidity issues. Key questions to ask may include:

• Have liquidity management crisis scenarios been updated (where necessary), mapped and stress tested pursuant to RG 259?
• Has a framework been established to account for current scheme financial obligations regarding distributions, redemptions, operational needs and unexpected expenses?
• Have authorisations been obtained and contingency plans been developed for appropriate responses?
• Do changes need to be made to factor in remote working?
• Has there been an assessment of operational resilience and any changes needed to meet recently modified regulatory obligations?

We have already begun to see and advise on proactive steps being taken by a number of responsible entities, including upgrades to third party asset manager monitoring, reviews of board delegation and reporting processes as well as checks on current disclosure and constituent document terms. While it remains to be seen whether there will be a repeat of the unlisted scheme liquidity issues that arose in Australia during the global financial crisis, many of the lessons learned during that period will no doubt be relevant for the current and upcoming challenges faced by investment funds and their operators.