On January 10, 2018, the staff of the SEC’s Division of Investment Management issued guidance in the form of frequently asked questions (FAQs) relating to the liquidity risk management (LRM) program requirements of Rule 22e-4 under the Investment Company Act of 1940, as amended (the Liquidity Rule) which was adopted in October 2016. These FAQs address (i) the delegation of LRM program administrative duties to sub-advisers and (ii) the definition of, and applicability of the Liquidity Rule to, “In-Kind ETFs.”
On February 21, 2018, the SEC staff issued additional FAQs to address other items under the Liquidity Rule.8 These new FAQs address (i) liquidity classification by asset class; (ii) consideration of an investment’s reasonably anticipated trading size; (iii) price impact assumptions in liquidity classifications; (iv) classifying investments in pooled investment vehicles; (v) provisional investment classifications and related compliance monitoring; (vi) pre-trade activity and the 15% limitation on illiquid investments; (vii) reporting requirements; and (viii) investment classification considerations for ETFs. The following is a summary of the SEC staff’s guidance.
Asset Class Liquidity Classification
- The Liquidity Rule permits a fund to classify and review portfolio investments according to asset class, provided the fund has a process for separately classifying and reviewing any investment “if the fund or its adviser has information about any market, trading, or investment specific considerations that are reasonably expected to significantly affect the liquidity characteristics of that investment as compared to the fund’s other portfolio holdings within that asset class.” The staff stated that a fund may establish a range of liquidity profiles that different investments within an asset class are reasonably expected to exhibit, as well as criteria for determining when an investment has made a “significant” departure from that range. The staff clarified that every departure from the typical range should not require separate classification and review but that funds should establish criteria for identifying “true significant outliers.”
- A fund that uses asset class classification should establish a “reasonable framework” in its LRM program for identifying significant exceptions, which may involve an automated process. Any such framework or automated process should be tested periodically as part of the fund’s required review of its LRM program.
Reasonably Anticipated Trading Size
- The Liquidity Rule provides that a fund must consider expected trade sizes and market depth in making liquidity classification determinations of its investments. For a fund that uses asset class classification, the staff stated that the Liquidity Rule permits the fund to determine reasonably anticipated trade sizes and market depth for all of its investments belonging to the same asset class as a group. For a fund that has significant variation in the sizes of its positions within an asset class, the staff indicated that the fund should consider whether using percentages of the full position, as opposed to fixed dollar amounts, may offer a more reasonable approach in considering reasonably anticipated trade sizes because using fixed dollar amounts on positions of widely varying size may result in unreasonable trade sizes in some cases.
- The Liquidity Rule does not require a fund, in determining reasonably anticipated trade sizes, to predict future portfolio management decisions that may be made in response to redemption requests or with respect to trades executed for reasons other than meeting redemptions. The staff stated that a fund should estimate the portion of an investment that it reasonably believes could be sold to meet redemptions, noting that a fund would be able to make certain simplifying assumptions in making such estimates (e.g., assuming all portfolio investments would be sold pro rata in response to a redemption). The staff also stated that it would not consider a zero or near-zero reasonably anticipated trading size to be a reasonable assumption.
Price Impact Standard
- In classifying the liquidity of an investment, a fund must consider how quickly the fund may convert the investment to cash (or sell or dispose of it, as applicable) “without . . . significantly changing the market value of the investment.” The staff stated that such price impact assumptions are subjective and may vary by fund, asset class or investment. Accordingly, a fund has flexibility in defining what amounts to a “significant change in market value” in its policies and procedures. In this regard, the staff stated that a fund need not use a fixed amount or a percentage as a price impact assumption and may have differing price impact standards for different investments or asset classes, although a fund may also choose a fixed number if determined reasonably.
Classifying Investments in Pooled Investment Vehicles
- For investments in other pooled investment vehicles such as mutual funds, ETFs, closed-end funds or private funds, a fund may focus on the liquidity of the pool’s shares or interests rather than “look through” to the pool’s underlying investments. The staff stated that it generally would be appropriate for a fund to look through to the pool’s underlying investments only when the fund has reason to believe that doing so could materially alter its view of the liquidity of the pool’s shares.
Provisional Classification Activity and Related Compliance Monitoring; Timing and Frequency of Classification of Investments
- The staff stated that regular monitoring of compliance with a fund’s designated highly liquid investment minimum (HLIM) (if applicable) and the 15% limit on illiquid investments is essential to compliance with the Liquidity Rule. A fund should monitor changes in the value or size of an existing investment in conjunction with its daily net asset value calculations. However, the staff stated that monitoring for compliance with these limits does not require a fund to reclassify its existing investments on a daily basis because the fund may continue to use the classifications that it last verified and determined as part of its monitoring process (generally the last reported classification on Form N-PORT).
- With respect to classifying newly acquired investments, the Liquidity Rule does not specify a time period within which an investment must be classified, but does require at least monthly review of the classifications of a fund’s investments. The staff stated that it would not object if a fund classifies a newly acquired investment during its next regularly scheduled monthly classification.
- The staff stated that intra-month reassessment of an investment’s classification is required only when a fund becomes aware of changes in relevant market, trading and investment-specific considerations that are “reasonably expected to materially affect” the investment’s current classification. A fund may identify in its policies and procedures events that could trigger an intra-month reassessment under this standard (e.g., a trading halt or delisting of a security, default or bankruptcy of an issuer or a counterparty, significant macroeconomic developments, natural disasters or political upheaval). The staff also stated that if an intramonth reassessment of an investment’s classification is triggered, a fund need review only those investments that the fund reasonably expects to be materially affected by the trigger.
- The staff stated that use of “provisional classifications” (i.e., any liquidity classification other than a monthly classification reported to the SEC on Form N-PORT or a reclassification made pursuant to intra-month compliance monitoring) by a fund is purely voluntary, noting that a fund may conclude that provisional classifications are helpful in assessing and managing liquidity risk.
- If a fund falls below its HLIM or exceeds the 15% limit on illiquid investments based on compliance monitoring or by finalizing a provisional reclassification in accordance with its policies and procedures, the fund would be subject to applicable reporting requirements.
Pre-trade Activity and the 15% Limitation on Illiquid Investments
- The Liquidity Rule does not require classification of an investment prior to acquisition. However, the staff stated that a fund should implement reasonably designed policies and procedures to prevent the acquisition of an illiquid investment that would cause the fund to exceed the 15% limitation on illiquid investments. For example, a fund could preliminarily identify certain asset classes or investments it reasonably believes are likely illiquid based on previous trading experience or an understanding of the general characteristics of the asset class, or through other means. The staff also stated that this preliminary analysis could be performed through an automated process based on a list of such investments or asset classes that the fund reasonably believes are likely to be illiquid, provided that the process is periodically tested as part of the fund’s required review of its LRM program.
- In evaluating the likelihood that an asset class or investment is illiquid, the staff stated that it does not believe it would be reasonable to assume that a fund is selling only a single trading lot when considering the market depth of the asset class or investment. A fund would not need to evaluate the actual size of its holdings in the asset class or engage in a full evaluation of its reasonably anticipated trading size for the asset class; rather, the staff stated that a fund may use any reasonable method to evaluate the market depth of an asset class or investment it identifies as likely being illiquid based on a preliminary evaluation.
- The staff also stated that a fund’s policies and procedures could require additional monitoring in reviewing acquisitions as the fund’s percentage of illiquid investments increases.
Related Reporting Requirements
- The Liquidity Rule, Rule 30b1-10 and Form N-LIQUID require reporting to the fund’s board and the SEC when a fund exceeds the 15% limitation on illiquid investments or falls below its HLIM, if applicable. The staff stated that, in circumstances in which a provisional classification of an investment is made or a reclassification of an investment is made by a third-party service provider or sub-adviser that would result in the fund exceeding the 15% limitation on illiquid investments or falling below its HLIM, the fund may need a reasonable amount of time to determine and verify that a liquidity issue actually exists. The staff stated that this determination and verification process should generally be completed within three business days.
- The staff stated that the obligation for reporting a violation of the 15% limitation on illiquid investments or the HLIM to the SEC or the fund’s board will be triggered, and the deadline for reporting such a violation will be calculated based upon, when the fund determines and verifies that it is not in compliance with either such standard rather than when the event occurs that gives rise to the fund making such determination and verification. However, the report should indicate that the fund was out of compliance with the relevant standard as of the trade date of the event that led to the fund being cut out of compliance rather than the date when it was determined and verified.
ETFs and Investment Classification
- Under the Liquidity Rule, ETFs that satisfy redemptions through in-kind transfers of securities positions and assets, other than a de minimis amount of cash, and that publish portfolio holdings on a daily basis are “In-Kind ETFs” that are exempt from certain LRM program requirements. (See “In-Kind ETFs” below.) The staff stated that it recognizes that an ETF that does not qualify as an In-Kind ETF but nevertheless redeems shares in-kind to a material extent may have a liquidity profile different from that of a similar ETF that primarily satisfies redemptions in cash. Accordingly, the staff stated that it may be appropriate for such an ETF to reflect these differences in its liquidity classification procedures and in designating its HLIM, if applicable.
- The staff also stated that the guidance in the immediately foregoing bullet point would apply equally to any mutual fund that redeems in-kind to any material extent.
- A board may designate a sub-adviser as the Fund’s LRM program administrator under the Liquidity Rule. The staff additionally stated that a program administrator may delegate specific responsibilities (e.g., providing liquidity classifications for the fund’s investments) to a sub-adviser or other appropriate third party and, further, that entities with delegated responsibilities may sub-delegate to others, provided there is appropriate supervision. The staff noted that the fund retains ultimate responsibility for complying with the Liquidity Rule. Accordingly, the staff recommended that a fund implement policies and procedures governing the scope and conditions of delegating LRM program responsibilities.
- Because the Liquidity Rule requires funds—and not advisers—to adopt LRM programs, an investment adviser (including a sub-adviser) has no independent obligation to adopt and implement its own LRM program.
- Certain investment advisers (or sub-advisers) may provide advisory services to multiple funds in multiple fund complexes that have differing practices, including different LRM programs with unique policies and procedures (including different LRM programs for funds in the same complex). The FAQs clarified that an entity administering multiple LRM programs that differ from one another is under no obligation to reconcile those programs, the programs’ methodologies or the programs’ outputs (e.g., different liquidity classifications of certain investments). Each fund’s board-approved LRM program will control how an adviser or a subadviser carries out any of its responsibilities under Rule 22e-4 to that particular fund.
- Further to the previous bullet point, an investment adviser, sub-adviser or other LRM program administrator, or its delegate, may classify the same investment differently across multiple funds based on the funds’ differing LRM programs. The SEC staff noted that, under the Liquidity Rule, “a fund must take into account ‘relevant market, trading, and investment-specific characteristics’ in classifying its portfolio investments’ liquidity,” and that different funds (even funds within the same complex) are permitted to arrive at different conclusions.
- Pursuant to an LRM program administrator’s ability to delegate, an LRM program administrator may adopt an approach whereby multiple entities (e.g., the investment adviser and a sub-adviser) may have input as to the liquidity classification of particular investments. A fund may consider addressing in its policies and procedures how to treat a circumstance in which the adviser and sub-adviser reach a different conclusion regarding the liquidity classification of a particular investment. The staff noted certain possible solutions, including allowing a specified party’s determination to control, employing a factor analysis or hierarchy, or using the most conservative determination. However, the staff clarified that other methodologies could be used.
- In a multi-manager fund in which the various sub-advisers of distinct sleeves are responsible for designating the liquidity classifications of portfolio investments, each sub-adviser is permitted to classify the same investment differently even within the same fund; none of the fund, the LRM program administrator or the adviser or sub-adviser has any obligation to reconcile these differences for compliance purposes (e.g., monitoring compliance with the fund’s HLIM, if applicable, or the 15% limit on illiquid investments).
- The staff noted that, notwithstanding the foregoing bullet point, Form N-PORT does not permit a fund to report more than one liquidity classification for a single investment.9 Accordingly, an LRM program’s policies and procedures should include a methodology for selecting a single liquidity classification for Form N-PORT reporting purposes in circumstances in which different sub-advisers classify the same investment differently for compliance purposes. For illustrative purposes only, the staff noted that a fund may choose to report the classification of the sub-adviser with the largest position in the asset, calculate a weighted average and round to the nearest liquidity classification or report the most conservative (i.e., the lowest) liquidity classification. The staff encouraged a fund with diverging liquidity classifications to report these policies and procedures in the explanatory notes section of Form N-PORT.
Under the Liquidity Rule, ETFs that satisfy redemptions through in-kind transfers of securities positions and assets, other than a de minimis amount of cash, and that publish portfolio holdings on a daily basis are “In-Kind ETFs” that are exempt from certain LRM program requirements. The FAQs address the following considerations with respect to In-Kind ETFs under the Rule:
- For purposes of determining an ETF’s status as an In-Kind ETF, the Liquidity Rule permits each ETF to determine what constitutes a de minimis amount of cash in its policies and procedures; the Rule does not establish a precise methodology. Rather, an ETF may take “a variety of reasonable approaches,” provided the approach is applied consistently. The staff stated that it would not object to an approach that includes testing each individual redemption transaction or testing redemption transactions in the aggregate over a reasonable period of time to ensure that the cash amounts used are de minimis. For determining what is a “reasonable period of time,” the staff suggested a day or a week for an ETF with frequent redemption basket activity or a month for an ETF with less-frequent redemption basket activity. However, the staff stated that in no event would a period in excess of one month be deemed reasonable.
- Although de minimis amounts may differ depending on the facts and circumstances of each ETF, the staff believes that it would be reasonable to determine that overall redemption proceeds paid in cash not exceeding 5% would be de minimis, but that it would be unreasonable to determine that redemption proceeds paid in cash exceeding 10% (subject to permissible exclusions, e.g., the amount of uninvested cash in the ETF’s investment portfolio) are de minimis. An ETF should evaluate its particular facts and circumstances to determine whether an amount of cash in excess of 5% (subject to permissible exclusions) is de minimis, including whether such cash redemptions would give rise to liquidity risks substantially similar to those applicable to mutual funds.
- The SEC staff clarified that an ETF may exclude the cash portion of redemption proceeds that is proportionate to the uninvested cash in the ETF’s investment portfolio for purposes of defining and testing compliance with the de minimis standard.
- Noting the practical considerations that would prevent an ETF that loses its status as an In-Kind ETF from coming into immediate compliance with the provisions of the Liquidity Rule from which In-Kind ETFs are exempt, the staff stated that it would not recommend enforcement against an ETF that loses its In-Kind ETF designation so long as the ETF comes into compliance with the Rule “as soon as reasonably practicable” after the In-Kind ETF designation is lost.
- A new ETF with little or no operating history may use a forward-looking analysis of its policies and procedures and expected redemption practices to determine that it is an In-Kind ETF. The staff stated, more generally, that backwards-looking redemption history is not by itself dispositive, and that an ETF with an operating history may consider making material changes to its policies and procedures and its redemption practices to qualify as an In-Kind ETF.
The SEC staff expects to further update the FAQs from time to time to include responses to additional questions.
The FAQs are available at: https://www.sec.gov/investment/investment-company-liquidity-risk-managementprograms-faq