Adopted by the U.S. Securities and Exchange Commission (SEC) in 2016, Rule 22e-4 under the Investment Company Act of 1940 (Liquidity Rule) has presented the fund industry with thorny interpretive questions and compliance challenges. Recently, the SEC and the SEC’s Division of Investment Management (Staff) addressed some of these questions and challenges through new rulemaking and guidance. On January 10 and February 21, 2018, the Staff issued responses to frequently asked questions (FAQs) regarding the Liquidity Rule. Also on February 21, 2018, the SEC delayed the compliance deadline for certain elements of the Liquidity Rule. Most recently, on March 14, 2018, the SEC issued a proposed rule that would modify certain liquidity-related disclosure requirements, including eliminating the requirement that funds publicly disclose aggregate liquidity classification information on a quarterly basis. The following provides a summary of these actions and discusses their impact on affected fund industry participants.
Background on the Liquidity Rule
The Liquidity Rule generally requires mutual funds (other than money market funds) and exchange‑traded funds (ETFs) to establish liquidity risk management programs (Liquidity Programs). Liquidity Programs must contain several components, including:
- The assessment, management and periodic review of a fund’s liquidity risk;
- The classification and monthly review of the liquidity of a fund’s portfolio investments;
- The determination and periodic review of a fund’s highly liquid investment minimum (HLIM) and procedures to address a shortfall; and
- Compliance with the 15% limit on illiquid investments and related reporting requirements.
A fund’s board of directors/trustees must approve the designation of the person, or a group of persons, responsible for administering the fund’s Liquidity Program (Program Administrator).
For a comprehensive discussion regarding the Liquidity Rule’s requirements, please refer to Dechert OnPoint, SEC Adopts New Rules and Rule Amendments to Require Registered Open-End Investment Companies to Establish Liquidity Risk Management Programs and Permit Them to use “Swing Pricing”.
The Liquidity Rule poses a number of unique challenges for funds that employ one or more sub-advisers. For example, the requirement to classify a fund’s portfolio investments into one of four liquidity categories may require coordination or resolution of differences among a fund’s Program Administrator, investment adviser and sub-adviser, as well as any other third parties responsible for liquidity classifications. This coordination may require substantial effort, particularly if there are differing views as to the liquidity of a particular portfolio investment. The January FAQs, however, provide a flexible framework for delegating responsibilities under a fund’s Liquidity Program to third parties, including to the fund’s sub-adviser(s). The FAQs explain that a fund’s Liquidity Program and any ancillary policies and procedures should include: (1) an appropriate oversight component to adequately supervise the parties to whom responsibilities have been delegated and to reasonably ensure that they are carrying out their responsibilities in a manner consistent with the fund’s Liquidity Program; and (2) a process to resolve any conflicts among those parties to whom responsibilities have been delegated to the extent the responsibility is delegated to more than one person.
The Liquidity Rule exempts “In-Kind ETFs” from the portfolio liquidity classification and the HLIM requirements. To qualify as an In-Kind ETF, an ETF must (1) meet redemptions through in‑kind transfers of securities, positions and assets other than a de minimis amount of cash and (2) publish its portfolio holdings daily. The appeal of this exemption is significant because of the substantial costs and operational challenges otherwise associated with Liquidity Rule requirements. However, fund sponsors have been grappling with a number of interpretive ambiguities associated with the definition of an In-Kind ETF – particularly the amount of cash that would qualify as de minimis. The January FAQs provide useful guidance regarding the circumstances under which an ETF would qualify as, or would remain, an In-Kind ETF, including specific parameters for determining the amount of cash that would qualify as “de minimis.”
Liquidity Classification Process
The February FAQs address interpretive and logistical questions that have arisen in connection with the Liquidity Rule’s liquidity classification requirements, and, in general, promote a more flexible, streamlined approach. For example, the FAQs state that funds that intend to classify the liquidity of investments according to asset class should establish in their policies and procedures a “reasonable framework for identifying exceptions,” which may include automated processes, and thus need not make shadow classifications on an investment-by-investment basis. The Staff also recognized that overly sensitive exception processes might result in a number of false positives that could “limit the utility of this asset classification method in identifying true significant outliers” (i.e., deviations that could have a significant effect on liquidity characteristics). The February FAQs also discuss the timing and frequency of liquidity classifications. Notably, the Staff dispelled the notion that the Liquidity Rule creates a de facto requirement to review liquidity classifications on a continuous basis, noting that a fund may limit intra-month classifications to the occurrence of “objectively determinable” events, such as a trading halt, default, or significant macro-economic development, among others. The February FAQs cover other compliance- and reporting-related questions.
For a more detailed discussion of the January FAQs, please refer to Dechert OnPoint, SEC Staff Issues Liquidity Rule Frequently Asked Questions. For a more detailed discussion of the February FAQs, as well as the SEC’s interim rule delaying certain of the Liquidity Rule’s compliance deadlines (discussed below), please refer to Dechert OnPoint, SEC Delays Compliance Dates for Certain Liquidity Rule Requirements; SEC Staff Issues Responses to Second Set of Liquidity Rule FAQs.
Extended Compliance Dates
Concurrent with the Staff’s publication of the February FAQs, the SEC adopted an interim final rule extending by six months the compliance dates for certain of the Liquidity Rule’s requirements, including those relating to the classification of investments, the adoption of an HLIM, and board approval of the Liquidity Program (except with respect to the designation of a Program Administrator), as well as related reporting requirements. The SEC had received many requests from industry participants to allow funds additional time to develop appropriate compliance programs to address the Liquidity Rule’s requirements. The SEC adopting release also provides guidance as to how funds should comply with the new 15% limit on illiquid investments, which is not being delayed, during the interim period prior to the Liquidity Rule’s final compliance date.
Changes to Disclosure Requirements
The SEC has also proposed revising certain liquidity-related disclosure requirements. Specifically, the changes, if approved, would eliminate the requirement for funds to publicly report on Form N‑PORT aggregate liquidity classification data on a quarterly basis, and instead require new narrative disclosure in the fund’s annual shareholder report about the operation and effectiveness of the fund’s Liquidity Program over the past fiscal year. The new requirement is intended to address concerns that aggregate classification data could be confusing or misleading to investors. The SEC has also proposed revisions to Form N-PORT, which would, if approved, permit funds to ascribe multiple liquidity classifications to a single portfolio holding under three specific circumstances: (1) different liquidity-related features justify treating the holding as two or more separate investments (e.g., the fund holds a put option on a portion, but not all, of the investment); (2) the fund is managed by two or more sub-advisers, and the sub-advisers assign different liquidity classifications to the same investment held in multiple “sleeves” of the fund; and (3) the fund classifies its holdings proportionally across liquidity categories based on an assumed sale of the entire position. The revisions would also require funds to report holdings of cash and cash equivalents.
While challenges remain, recent guidance and rulemaking by the SEC and its Staff should come as welcome relief to the fund industry. The Staff’s responses to the FAQs generally contemplate a flexible framework to address the numerous compliance and operational challenges presented by the Liquidity Rule. The SEC’s proposal to rescind the requirement that funds publicly disclose aggregate liquidity classification information provides further indication that the SEC understands that classifying an investment’s liquidity is a highly subjective process. Collectively, these measures provide fund complexes with more flexibility to tailor liquidity risk management practices to their unique structures and risk tolerances.