The Staff of the U.S. Securities and Exchange Commission’s (SEC) Division of Investment Management has published a first set of responses to frequently asked questions (FAQs) regarding Rule 22e-4 under the U.S. Investment Company Act of 1940 (1940 Act) (Liquidity Rule).1 The FAQs provide guidance on: (1) the manner in which responsibilities under a fund’s liquidity risk management program may be delegated to third parties, including to a fund’s sub-adviser; and (2) the definition of an “in-kind” exchange-traded fund (In-Kind ETF).
Background of Liquidity Rule
The Liquidity Rule generally requires registered open-end investment companies (other than money market funds) to establish liquidity risk management programs (Liquidity Programs). Liquidity Programs must contain several elements, including:
- The assessment, management and periodic review of a fund’s2 liquidity risk;
- The classification and monthly review of the liquidity of a fund’s portfolio investments; and
- The determination and periodic review of a fund’s highly liquid investment minimum (HLIM) and procedures to address a shortfall.
The Liquidity Rule exempts In-Kind ETFs from the portfolio liquidity classification and the HLIM requirements.3 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.
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). The Program Administrator could be the fund’s investment adviser or sub-adviser, a specific fund officer or a group of officers.
The compliance date for the Liquidity Rule is December 1, 2018 for fund complexes with $1 billion or more in net assets and June 1, 2019 for fund complexes with less than $1 billion in net assets. However, multiple industry participants, including this firm, have requested that the SEC delay the compliance date of the Liquidity Rule.4
Sub-Advised Funds (FAQs Nos. 1 – 8)
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 (in some cases, to resolve differences) among a fund’s Program Administrator, investment adviser and sub-adviser, as well as any other third party responsible for liquidity classifications (e.g., third party model or data provider). This coordination may require substantial effort, particularly if there are differing views as to the liquidity of a particular portfolio investment.
Delegation of Responsibilities (FAQ Nos. 1 and 6)
In the FAQs, the Staff explicitly acknowledged that a fund’s Program Administrator may delegate responsibilities under the fund’s Liquidity Program to third parties, including the fund’s sub-adviser, “subject to appropriate oversight.” The FAQs also note that an entity with delegated responsibilities may sub-delegate some of those responsibilities to other third parties. However, the Staff emphasized that, regardless of whether a fund’s Program Administrator delegates all or a portion of its responsibilities, the fund “at all times retains ultimate responsibility for complying with the rule.” In addition, the Staff noted that a fund “may wish to implement policies and procedures regarding the scope of” any delegation by the Program Administrator, and the Program Administrator “may, in turn, wish to implement policies and procedures to oversee those to whom it has delegated responsibilities.”
The Staff further explained that, if a fund’s Program Administrator delegated responsibility to classify the liquidity of the fund’s portfolio investments to either the fund’s investment adviser or sub-adviser, “that entity’s decisions would control how the fund classifies its investments.” However, if a fund’s Program Administrator delegated responsibility to classify the liquidity of the fund’s portfolio investments to both the fund’s investment adviser and sub-adviser, the Staff noted that a fund’s Liquidity Program “could address how the fund would resolve” any differing views on the liquidity of a particular portfolio investment. The Staff then provided the following “illustrative” examples of how a fund’s Liquidity Program could address these differing views: (1) identify the specific entity whose liquidity classifications control; (2) establish another method to determine which liquidity classification would control (e.g., a factor analysis or hierarchy); or (3) adopt the most conservative (i.e., least liquid) classification.
Differing Responsibilities under Multiple Liquidity Programs; Differing Liquidity Classifications Across Funds (FAQs Nos. 3, 4 and 5)
The Staff recognized that investment advisers and sub-advisers may provide advisory services to funds in multiple fund complexes, and that advisers and sub-advisers may have responsibilities under each fund’s Liquidity Program. The Staff explained that a fund’s Liquidity Program should be “tailored to the fund’s risks and circumstances” and acknowledged that differences in Liquidity Programs may occur.
Importantly, the Staff stated that an adviser or sub-adviser is “under no obligation to reconcile”: (1) the elements of different Liquidity Programs; (2) the underlying methodologies, assumptions or practices of different Liquidity Programs; or (3) the outputs of different Liquidity Programs (including the liquidity classifications of fund investments). However, the Staff noted that, even though an adviser and sub-adviser may have responsibilities under different Liquidity Programs, a fund’s board-approved Liquidity Program would always govern how that adviser or sub-adviser implements its responsibilities for that particular fund. As a result, the Staff acknowledged that funds may “appropriately arrive at different [liquidity] classifications for the same instrument” based on a particular fund’s assumptions as to market and trading conditions and the particular circumstances informing its analysis.
Differing Liquidity Classifications for Multi-Manager Funds (FAQs Nos. 7 and 8)
For funds that employ two or more sub-advisers, where each sub-adviser manages its own distinct “sleeve” (Multi-Manager Funds), the Staff acknowledged that sub-advisers may come to differing judgments as to the liquidity of a particular portfolio investment that is held in each sleeve. Under these circumstances, the Staff stated that “neither the fund, [P]rogram [A]dministrator, nor the adviser nor the sub-advisers with delegated [Liquidity Program] responsibilities would be under any obligation to resolve these differences for compliance purposes (e.g., in connection with monitoring for compliance with the fund’s [HLIM] (if applicable) and the 15% limit on illiquid investments).”5 Accordingly, for purposes of complying with a fund’s HLIM or 15% limit on illiquid investments, a Multi-Manager Fund could potentially have holdings in a particular portfolio investment where a portion of that investment is classified in one liquidity category while another portion of that same investment is classified in a different liquidity category.6
The Staff confirmed that Form N-PORT does not permit a fund to report more than one liquidity classification for a particular portfolio investment. Accordingly, for purposes of reporting on Form N-PORT (rather than compliance purposes), the Staff believes that a fund’s Liquidity Program should have a process for selecting the single liquidity classification for a particular portfolio investment. The Staff provided the following “illustrative” examples of how a fund’s Liquidity Program could address different liquidity classifications for purposes of reporting on Form N-PORT: (1) adopt the liquidity classification of the sub-adviser with the largest investment position; (2) use a weighted average calculation (based on each sub-adviser’s classification and its respective position size) and round to the nearest classification; or (3) use the most conservative (i.e., least liquid) classification.7
Definition of In-Kind ETF (FAQs Nos. 9 – 15)
The Liquidity Rule exempts In-Kind ETFs from the portfolio liquidity classification and the HLIM requirements. The appeal of this exemption is significant because of the substantial costs and operational challenges associated with these 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 FAQs provide useful parameters for determining whether, and under what circumstances, an ETF is (or remains) an In-Kind ETF.
Determining a de minimis Cash Amount (FAQ Nos. 9 and 11)
The Staff confirmed that an ETF may “exclude the amount of cash in redemption proceeds that is proportionate to the ETF’s uninvested portfolio cash for purposes of defining and testing compliance with its de minimis cash amount.” The Staff also stated that “it would be reasonable for an In-Kind ETF to determine that if the percentage of its overall redemption proceeds paid in cash does not exceed 5% (subject to permissible exclusions) ... such use would be de minimis.”
More importantly, however, the Staff believes that an In-Kind ETF could determine that “cash use of more than 5% in redemptions is de minimis.” The Staff stated that an ETF making such a determination should examine the ETF’s particular facts and circumstances, including the ETF’s Liquidity Program and whether cash redemptions in excess of 5% could present “liquidity risks substantially similar to those of mutual funds.” However, the Staff noted that it would be unreasonable for an ETF to consider redemptions in cash in excess of 10% of the ETF’s overall redemption proceeds (subject to permissible exclusions) as a de minimis cash amount.
According to the Liquidity Program Adopting Release, an In-Kind ETF “generally should describe in its [Liquidity Program], to the extent applicable, how the fund analyzes the ability of the ETF to redeem in-kind in all market conditions such that it is unlikely to suddenly fail to continue to qualify for this exception to the classification and [HLIM] requirements, the circumstances in which the In-Kind ETF may use a de minimis amount of cash to meet a redemption, and what amount of cash would qualify as such.”
Timing of Compliance when an ETF Loses its In-Kind Status (FAQ No. 10)
The Staff acknowledged that there are “practical considerations” that would prevent an ETF that loses its status as an In-Kind ETF from coming into immediate compliance with the portfolio liquidity classification and the HLIM requirements. Accordingly, the Staff stated that it “would not recommend enforcement action” so long as an ETF complies with these requirements “as soon as reasonably practicable” after the ETF no longer qualifies as an In-Kind ETF. The Staff further stated that during the applicable reporting period, an ETF must note in Item E.5 of Form N-CEN whether it currently qualifies as an In-Kind ETF.
Impact of a Redemption Transaction Entirely in Cash on an ETF’s In-Kind Status (FAQ No. 12)
In the Liquidity Program Adopting Release, the SEC stated that “an ETF that normally redeems in-kind, but delivers all cash to a single authorized participant [(AP)] that elects to receive cash, would not be an ETF that uses a de minimis amount of cash.” The Staff clarified this statement by stating its belief that “a redemption transaction consisting entirely of cash does not necessarily preclude an ETF from qualifying as an In-Kind ETF so long as such a redemption transaction as a proportion of the ETF’s aggregate redemption transactions does not exceed the de minimis amount of cash defined in the ETF’s policies and procedures, and the AP who receives the cash redemption is not an AP who has elected to receive cash redemptions as a standard practice.”
Explaining its rationale, the Staff noted that where an ETF engages in a redemption transaction consisting entirely of cash “to accommodate an AP’s election to receive cash as a standard practice (emphasis in original),” that ETF may be exposed to liquidity risk (e.g., the risk that the ETF would need to sell investments to make a cash redemption in adverse liquidity situations) and thus would not qualify as an In-Kind ETF. However, the Staff noted that, if such an all-cash redemption transaction is at the discretion of the ETF (and not the election of the AP to receive cash as a standard practice), then “the choice to provide cash or in-kind redemptions would be under the ETF’s control.” Under these circumstances, the Staff believes that the ETF would not be exposed to liquidity risk.
Methods to Test de minimis Cash Use (FAQ No. 13)
The Staff stated that an In-Kind ETF may employ various “reasonable approaches to determine whether its cash use is de minimis,” provided that the approach selected is “consistently applied” and sufficiently described in the ETF’s Liquidity Program. The Staff stated that it would not object if an In-Kind ETF implemented the following approaches: (1) “testing each individual redemption transaction, to ensure that each has no more than a de minimis cash amount;” or (2) “testing its redemption transactions in their totality over some reasonable period of time to ensure that, on average, its aggregate redemption transactions have no more than a de minimis cash amount.” The Staff explained that what constitutes a reasonable period of time may differ based on how frequently a fund engages in redemption transactions. The Staff stated that a reasonable period of time for an ETF frequently engaging in redemptions “might be a day or a week, while a reasonable period of time for a fund with less frequent redemption activity may be up to a month.” However, the Staff stated its belief that testing redemption transactions over a period of time exceeding one month would not be reasonable.
Time Period for Re-Qualifying as an In-Kind ETF (FAQ No. 14)
In response to a question regarding whether an ETF must wait at least two years before it can regain its in-kind status, the Staff stated its view that there is no specific time period that an ETF must wait before concluding that it once again qualifies as an In-Kind ETF. The Staff believes that an ETF should adopt a facts and circumstances analysis to determine whether it re-qualifies as an In-Kind ETF. As part of this analysis, the ETF should “reasonabl[y] determin[e], based on its particular facts and circumstances, that the event that caused it to lose its status as an In-Kind ETF was an extraordinary one-time event that is unlikely to occur again.”8 Further, the Staff noted that an ETF that loses its in-kind status should consider the appropriateness of using the exemption in view of the SEC’s position that an “In-Kind ETF’s written policies and procedures should describe how it analyzes its ability to redeem in-kind in all market conditions such that it is unlikely to suddenly fail to qualify for the exception.”
Factors to Consider in Determining an ETF’s In-Kind Status (FAQ No. 15)
In response to a question regarding the factors an ETF may consider in determining whether it qualifies as an In-Kind ETF, the Staff stated that an ETF’s past redemption practices, although generally relevant in determining the in-kind status of an ETF, are not dispositive. The Staff explained that the determination of an ETF’s in-kind status can include “a forward-looking component.” For example, the Staff stated that an ETF with little or no operating history could determine that it qualifies as an In-Kind ETF based on an evaluation of the ETF’s “policies and procedures and its expected redemption practices.” The Staff added that an ETF that has an operating history could review “material changes to its policies and procedures and redemption practices and their anticipated effects” when deciding whether it qualifies as an In-Kind ETF.
The Liquidity Rule represents significant changes to current liquidity management and reporting requirements. On balance, the FAQs provide generally pragmatic guidance to funds as funds attempt to begin to formalize their proposed Liquidity Programs. Significant operational challenges and interpretive ambiguities nevertheless remain, particularly with respect to the portfolio liquidity classification requirement.
The FAQs provide a pragmatic framework for delegating responsibilities under a fund’s Liquidity Program to third parties, including to the fund’s sub-adviser. The FAQs make clear that the fund’s Liquidity Program should provide clear authority to the Program Administrator to delegate certain responsibilities, as well as any limitations or conditions on the ability to delegate these responsibilities. The FAQs also make clear that a fund’s Liquidity Program (and any ancillary policies and procedures) should include: (1) a process to resolve any disagreements or conflicts among those parties to whom responsibilities have been delegated (to the extent the responsibility is delegated to more than one person); and (2) an 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. It remains that the implementation of any approach chosen by a fund to handle third parties will require the agreement and assistance of the third parties and processes to handle the program among the parties, which may not always be easily accomplished.
For In-Kind ETFs, the FAQs make clear that an ETF’s Liquidity Program (and any ancillary policies and procedures) should address the circumstances under which the ETF would qualify as an In-Kind ETF (e.g., specifying the amount of cash that would qualify as de minimis, specifying the methods and time periods to test de minimis cash use), as well as the circumstances under which an ETF could once again qualify as an In-Kind ETF after losing its status as such (e.g., factors to reasonably determine that the event that caused it to lose its status as an In-Kind ETF was an extraordinary one-time event that is unlikely to occur again).