SEC Issues Final Rule On Investment Company Liquidity Risk Management

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SEC Issues Final Rule On Investment Company Liquidity Risk Management

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Schiff Hardin’s Investment Management Group

On October 31, 2016, the Securities and Exchange Commission (SEC) issued its final rule with respect to investment company liquidity risk management programs. The final rule includes a new rule under the Investment Company Act of 1940, as amended (1940 Act), as well as related new and amended rules and forms.[1] In adopting the final rule, the SEC took into account many of the concerns raised in the more than 70 comment letters received on the proposing release[2], particularly with respect to the liquidity classification requirement and the responsibilities of a board. Under the final rule, while the board does have certain duties and responsibilities with respect to certain aspects of a fund’s liquidity program, the SEC pared back much of what had been in the Proposing Release to ensure that the board’s role remains one of oversight and not management. The overarching goal of the liquidity program, as described in the Adopting Release, is to enable a fund to assess and manage its liquidity risk; however, the program is not expected to be able to eliminate all liquidity risk. The general compliance date is December 1, 2018 (smaller complexes have until June 1, 2019), except for the Form N-1A amendments, which have a compliance date of June 1, 2017.

Broad Overview

The liquidity risk management program required under the final rule will need to initially be approved by a fund’s board and the board will also need to approve the person(s) designated to administer the program; however, the board will not be required to approve changes to the program. The program as adopted in the final rule has four main components:

  • Funds must generally classify each portfolio investment[3] into one of four buckets (reduced from the six buckets in the Proposing Release)—the board is not required to approve these classifications.
  • Funds must have a “highly liquid investment minimum” (which is similar to the three-day liquid asset minimum from the Proposing Release)—the board is not required to approve the highly liquid investment minimum, except in certain circumstances discussed below.
  • Funds have a 15 percent limit on purchases of illiquid investments (the definition of illiquid investments subject to this limit has been enhanced from the Proposing Release).
  • Funds will be required to file new Form N-LIQUID confidentially with the SEC within one business day if its illiquid investments exceed 15 percent of net assets or if the fund’s highly liquid investments falls below its minimum for more than a brief period of time.

Program Overview and Scope of Rule 22e-4

Final rule 22e-4 under the 1940 Act (Rule 22e-4) requires each registered open-end management investment company, including open-end exchange-traded funds (ETFs) but not including money market funds, to adopt and implement a written liquidity risk management program designed to assess and manage the fund’s liquidity risk, which will be overseen by the fund’s board (the Program). Closed-end funds are not subject to Rule 22e-4. In addition, unit investment trusts are generally not subject to the Program requirement.

Rule 22e-4 defines “liquidity risk” as the risk that a fund could not meet requests to redeem[4] shares issued by the fund without significant dilution of remaining investors’ interests in the fund. When determining whether a fund’s liquidity risk will cause significant dilution for purposes of this definition, a fund should consider the impact of liquidity risk on the total net assets of the fund and the adverse consequences such dilution will have on all the fund’s remaining shareholders. The SEC states in the Adopting Release its view that “significant” is not meant to reference just a slight net asset value movement but is also not just limited to a fire-sale situation. Each fund’s Program must include the following required elements:

  • Assessment, management, and periodic review of the fund’s liquidity risk and such assessment includes considering whether the fund’s strategy is appropriate for an open-end fund.
  • Classification of the liquidity of each of the fund’s portfolio investments, as well as at least monthly reviews of the fund’s liquidity classifications (certain types of ETFs are exempt from this requirement). Asset-class-based classification, as opposed to security-by-security classification, is permitted in certain circumstances as discussed further below.
  • Determining and periodically reviewing a highly liquid investment minimum (although many ETFs and certain types of funds whose assets “primarily” consist of highly liquid investments are exempt from this requirement).
  • Limiting the fund’s investments in illiquid investments that are assets to no more than 15 percent of the fund’s net assets.
  • For funds that engage in, or reserve the right to engage in, redemptions in kind, the establishment of policies and procedures regarding how they will engage in such redemptions in kind.

Rule 22e-4 calls for a tailored program for ETFs, requiring them to consider additional factors as part of their liquidity risk assessment and management that reflect potential liquidity-related concerns that could arise from the structure and operation of ETFs. Rule 22e-4 exempts ETFs that redeem all but a de minimis amount of their shares in kind and disclose their portfolio holdings daily (In-Kind ETFs) from the classification and highly liquid investment minimum requirements.

Rule 22e-4 requires each fund to designate its investment adviser or officer(s) as responsible for administering the day-to-day aspects of the Program (the Program Administrator). The persons designated to be the Program Administrator cannot solely be portfolio managers, as the SEC is concerned that if only portfolio managers run the Program, it might not be administered with sufficient independence to achieve the goal of managing fund liquidity risk. However, as also noted by the SEC in the Adopting Release, portfolio managers can provide valuable input to the liquidity risk management process, and, if a fund determines to have a team or committee administer the Program, portfolio managers could be part of such a team or committee. Some funds may also determine that an investment sub-adviser would be best suited to act as Program Administrator.  

Board Responsibilities for Oversight of the Program: Each fund’s board must approve, but not design, the fund’s Program, as well as the fund’s designation of the Program Administrator. The board does not need to approve material changes to the Program; rather, similar to rule 38a-1, the board will be required to review, no less frequently than annually, a written report prepared by the Program Administrator that describes a review of the Program’s adequacy and effectiveness, including, if applicable, the operation of the highly liquid investment minimum, and any material changes to the Program. The SEC reiterates its view in the Adopting Release that the role of the board is general oversight and that consistent with that obligation, it is expected that directors will exercise their reasonable business judgment in overseeing the Program on behalf of fund investors. Directors may satisfy their obligations with respect to the initial approval of the Program by reviewing summaries of the Program prepared by the Program Administrator, legal counsel, or other persons familiar with the Program. Such summaries should familiarize directors with the key features of the Program and provide them with an understanding of how the Program addresses the required assessment of the fund’s liquidity risk.

Each Program element and the other requirements of Rule 22e-4 are discussed in more detail below.

Program Elements - Assessment, Management, and Review of Liquidity Risk

The SEC clarifies in the Adopting Release that each fund should tailor its particular Program to ensure that it is adequately assessing and managing its liquidity risk based on its strategies and risks; however, it is not expected that a fund would eliminate all adverse impacts of liquidity risk. A fund must consider, if applicable, the specific factors which are outlined in Rule 22e-4 and the fund must also include other features and disclosures with respect to its liquidity risk to the extent that it is necessary to effectively assess and manage that liquidity risk.

In assessing and managing risks, the Program should consider the impact of various factors both under current conditions as well as under reasonably foreseeable stressed conditions.[5]

The specific factors that a fund must consider, if applicable, are:

1.  The fund’s investment strategy and the liquidity of its portfolio investments during both normal and reasonably foreseeable stressed conditions (including whether the fund’s investment strategy is appropriate for an open-end fund[6], the extent to which the strategy involves a relatively concentrated portfolio or large positions in particular issuers, and the use of borrowings for investment purposes and derivatives).

  • The SEC notes in the Adopting Release that in considering the use of derivatives, all derivatives must be considered, including those used solely for hedging. In addition, the SEC notes that apart from the liquidity of the derivatives positions themselves, funds need to assess, manage, and periodically review other potential liquidity demands that may result from the use of derivatives (i.e., variation margin or collateral calls the fund may be required to meet).

2.  The fund’s short-term and long-term cash flow projections during both normal and reasonably foreseeable stressed conditions.

  • The SEC provides guidance in the Adopting Release of certain factors funds may want to consider in evaluating cash flow projections:
    • The size, frequency, and volatility of historical purchases and redemptions of fund shares during normal and reasonably foreseeable stressed periods
    • The fund’s redemption policies
    • The fund’s shareholder ownership concentration
    • The fund’s distribution channels
    • The degree of certainty associated with the fund’s short-term and long-term cash flow projections

3.  The fund’s holdings of cash and cash equivalents[7], as well as borrowing arrangements and other funding sources.

  • In the Adopting Release, the SEC states its belief that a fund should consider the overall benefits and risks of including borrowing arrangements as part of its Program and the Adopting Release contains several questions that should be considered in performing that analysis. The Adopting Release also includes considerations that a fund should make when deciding if interfund lending would be appropriate as part of its Program.

In addition to the above factors, ETFs (both In-Kind ETFs and other open-end ETFs, but not UIT ETFs) will need to consider, if applicable, the following two factors:

  • The relationship between the ETF’s portfolio liquidity and the way in which, and the prices and spreads at which, ETF shares trade, including the efficiency of the arbitrage function and the level of active participation by market participants (including authorized participants).
  • The effect of the composition of baskets on the overall liquidity of the ETF’s portfolio.

Periodic Review of the Program: Rule 22e-4 requires that a fund periodically review its liquidity risk, taking into account the same factors that are considered when initially assessing and managing its liquidity risk. Such a review must happen at least annually but a fund may determine that its particular circumstances warrant a more frequent review.

Program Elements - Classifying the Liquidity of a Fund’s Portfolio Investments

Rule 22e-4 also requires funds, except for In-Kind ETFs, to classify the liquidity of each portfolio investment, including derivatives, into one of four buckets. Such classification should be based on the fund’s reasonable expectations under current market conditions (in contrast to the assessing and managing liquidity risk element which also requires a fund to take into account reasonably foreseeable stressed conditions):

  • Highly liquid investments: Cash and any investments reasonably expected to be convertible to cash[8] in current market conditions within three business days or less without the conversion to cash significantly changing[9] the market value[10] of the investment.
  • Moderately liquid investments: Any investments reasonably expected to be convertible to cash in current market conditions in more than three calendar days but in seven calendar days or less without the conversion to cash significantly changing the market value of the investment.
  • Less liquid investments: Any investments reasonably expected to be sold or disposed of[11] in current market conditions in seven calendar days or less without the sale or disposition significantly changing the market value of the investment, but where the sale or disposition is reasonably expected to settle in more than seven calendar days.
  • Illiquid investments: Any investment that may not reasonably be expected to be sold or disposed of in current market conditions in seven calendar days or less without the sale or disposition significantly changing the market value of the investment. With the adoption of Rule 22e-4, the SEC is withdrawing its existing guidance and replacing it with this new regulatory requirement and guidance for determining whether a portfolio investment is illiquid.

In classifying investments, a fund must take into account relevant market, trading, and investment-specific considerations in classifying its portfolio investments’ liquidity. While Rule 22e-4 does not list out factors that a fund should or must consider, the SEC provides guidance in the Adopting Release on certain considerations a fund may want to think through. To the extent applicable, the SEC states that a fund may want to consider the following factors:

  • Existence of an active market for the asset, including whether the asset is listed on an exchange, as well as the number, diversity, and quality of market participants
  • Frequency of trades or quotes for the asset and average daily trading volume of the asset (regardless of whether the asset is a security traded on an exchange)
  • Volatility of trading prices for the asset
  • Bid-ask spreads for the asset
  • Whether the asset has a relatively standardized and simple structure
  • For fixed income securities, maturity and date of issue
  • Restrictions on trading of the asset and limitations on transfer of the asset

A fund must also consider the investment’s market depth in determining its classification. Market depth should be considered in the context of the size of a position that the fund reasonably anticipates trading. To the extent that a fund determines that trading varying portions of a position is reasonably expected to significantly alter the liquidity characteristics of that investment, the fund would need to take this into account in making its classification determination. Therefore, if the fund determined that a downward adjustment in the liquidity classification of a particular position is appropriate in the context of its reasonably expected trading activity, then the new liquidity classification would apply to the fund’s entire position in that investment, not just to the portion of the position that the fund reasonably expects to trade.

Lastly, a fund must take into account certain considerations for highly liquid investments that it has segregated to cover certain derivatives transactions. For a derivative transaction that has been classified as a moderately liquid investment, a less liquid investment, or an illiquid investment, a fund must identify the percentage of its highly liquid investments that it has segregated to cover or pledged to satisfy margin requirements for such transactions. In calculating this percentage, a fund that has segregated or pledged non-highly liquid investments as well as highly liquid investments to cover derivatives transactions must first use the segregated or pledged assets that are highly liquid investments to cover derivatives transactions classified in the three lower liquidity classification buckets.[12] In a change from the Proposing Release, the liquidity classification of segregated assets is not linked to the liquidity of a fund’s derivatives transactions.

Asset-Class-Based Classification: A fund may classify portfolio investments based on asset class rather than by individual positions as long as the fund or its adviser, after reasonable inquiry, does not have any information about any market, trading, or investment-specific considerations that are reasonably expected to significantly affect the liquidity characteristics of an investment that would suggest a different classification for that investment. The Adopting Release notes that a fund’s asset-class-based classification procedures should incorporate sufficient detail to meaningfully distinguish between asset classes and sub-classes.[13] While Rule 22e-4 does not specify exactly what needs to be considered in determining if a particular investment should be classified separately from the rest of its asset class, the SEC states in the Adopting Release that reasonably designed policies and procedures would likely include the sources of inputs that inform its exception process as well as particular variables that could affect the fund’s classification of certain investments. The SEC also states that there are some asset classes, such as complex structured securities, that have such a wide range of liquidity characteristics that each holding would need to be classified individually.

Use of Third Party Data for Classification Determinations: The SEC notes in the Adopting Release that it understands that some third-party service providers currently provide data and analysis assessing the liquidity of portfolio investments and that many may assess certain market, trading, or investment-specific considerations in doing so. While the SEC states that a fund could appropriately use this type of data to inform or supplement its own consideration of the liquidity of its portfolio investments, it is not required to do so. Additionally, the SEC recommends that if such data is used, then a fund should consider having the Program Administrator review the quality of such data and the methodologies used to determine if it is accurately assessing the liquidity of those portfolio investments.

Review of Classification Determinations: A fund must review its classifications at least monthly and more frequently if changes in relevant market, trading, or investment-specific considerations are reasonably expected to materially affect one or more of its investments’ classifications. As noted in the Adopting Release, relevant market-wide developments could include changes in interest rates or other macroeconomic events, market-wide volatility, market-wide flow changes, dealer inventory or capacity changes, and extraordinary events such as natural disasters or political upheaval and asset class and investment-specific developments that a fund may wish to consider include, among others, regulatory changes affecting certain asset classes and corporate events (such as bankruptcy, default, pending restructuring, or delisting, as well as reputational events).

Program Elements—Highly Liquid Investment Minimum

Rule 22e-4 requires that a fund determine the minimum amount of the fund’s net assets that the fund invests in highly liquid investments that are assets[14] (the Highly Liquid Investment Minimum). In determining what its Highly Liquid Investment Minimum should be, a fund must consider, as applicable, all the factors it considers in assessing its liquidity risk during both normal and stressed conditions that are reasonably foreseeable during the period until the next review of the Highly Liquid Investment Minimum.

Rule 22e-4 also requires that a fund have policies and procedures for responding to a shortfall in its Highly Liquid Investment Minimum. Such policies and procedures must include reporting to the fund’s board, no later than the next regularly scheduled meeting, on any shortfall of the fund’s Highly Liquid Investment Minimum, along with a brief explanation of the causes of such shortfall, the extent of the shortfall, and any actions taken in response. If such a shortfall lasts for more than seven consecutive calendar days, then a fund must report to its board within one business day and submit a confidential report to the SEC, including an explanation of how the fund plans to restore its minimum within a reasonable amount of time. The Adopting Release notes that Rule 22e-4 allows for flexibility in a fund’s shortfall policies and procedures.

As mentioned above, funds that primarily hold assets that are highly liquid investments do not need to have a Highly Liquid Investment Minimum. The SEC notes in the Adopting Release that a fund whose assets consist primarily of highly liquid investments should include in its Program how it determines that it primarily holds assets that are highly liquid investments, including, for example, how it defines “primarily.” The SEC also notes in the Adopting Release that its view is that if a fund were to hold less than 50 percent of its assets in highly liquid investments, then it would be unlikely to qualify as holding primarily assets that are highly liquid investments. In determining whether a fund is comprised primarily of highly liquid investments, a fund must exclude any highly liquid investments that are segregated to cover derivatives transactions that are classified other than highly liquid investments or are pledged to satisfy margin requirements. If such a fund modifies its investment strategy or otherwise no longer primarily holds assets that are highly liquid investments, then it would need to approve a Highly Liquid Investment Minimum.

Review of Highly Liquid Investment Minimum: Rule 22e-4 requires that a fund review its Highly Liquid Investment Minimum no less frequently than annually. A discussion of the Highly Liquid Investment Minimum must be included in the written annual report to the board on the adequacy and effectiveness of a fund’s Program.

Board Responsibilities and Oversight of Highly Liquid Investment Minimum: While a fund’s board is not required to specifically approve a fund’s Highly Liquid Investment Minimum, if the fund wants to make a change in its Highly Liquid Investment Minimum during a time when it has a shortfall, then the board must approve that change. In addition, the board must receive the required reports discussed above if the fund were to have a shortfall in its Highly Liquid Investment Minimum.

Program Elements—Limitation of a Fund’s Illiquid Investments

Rule 22e-4 prohibits a fund from acquiring any illiquid investment if, immediately after the acquisition, such fund would have invested more than 15 percent of its net assets in illiquid investments that are assets. The Adopting Release states that the SEC’s definition refers to assets to clarify it is only holdings with positive values that should be considered in the calculation and that illiquid investments with negative values should not be netted against illiquid investments with positive values when calculating compliance with the 15 percent limit.

Board Oversight of Illiquid Investments: A fund must notify its board, and confidentially the SEC, within one business day if its illiquid investments that are assets exceed 15 percent of its net assets. In addition, the Program Administrator must explain in a report to the board the extent and causes of the occurrence, and how the fund plans to bring its illiquid investments that are assets to or below 15 percent of its net assets within a reasonable amount of time. If the amount of the fund’s illiquid investments that are assets is still above 15 percent of its net assets 30 days from the occurrence (and at each consecutive 30 day period thereafter), then the board, including a majority of its independent directors, must assess whether the plan presented to it continues to be in the best interests of the fund. In addition, if a fund exceeds the 15 percent limit on illiquid investments at any time during the year, then the written report to the board regarding the adequacy and effectiveness of the Program would discuss the breach and, if the fund is still breaching the limit at the time of the report, the plan to bring the illiquid investments that are assets to or below 15 percent of the fund’s net assets within a reasonable amount of time.

Policies and Procedures Regarding Redemptions in Kind

If a fund engages in or reserves the right to engage in redemptions in kind, then Rule 22e-4 requires such fund to adopt and implement written policies and procedures regarding in-kind redemptions as part of its Program. These policies and procedures should address the process for redeeming in kind as well as the circumstances in which a fund would consider redeeming in kind. The Adopting Release notes that the policies and procedures could state that a fund would use in-kind redemptions at all times or only under stressed conditions. The policies and procedures should also state if such redemptions in kind would apply to all shareholders or only to shareholders requesting redemptions over a certain size. A fund should also consider the ability of its shareholders to receive redemptions in kind and its policies and procedures may include different procedures depending on the shareholder type (i.e., retail investors would get cash redemptions but institutional shareholders would be given redemptions in kind) and should also consider any operational difficulties that may be encountered. Additionally, the policies and procedures should lay out how the fund would determine which securities would be used for a redemption in kind (i.e., a pro rata share of all portfolio holdings or a non-pro rata distribution) and how it would deal with in-kind redemptions of illiquid or restricted securities. The SEC notes in the Adopting Release that if redemption in kind is not done pro rata, then the fund’s policies and procedures need to address how securities would be selected and distributed in a way that is fair and does not disadvantage either the redeeming shareholder or the shareholders remaining in the fund.

Cross Trades

The SEC in the Adopting Release also provides guidance on factors that funds may want to consider adding to their Rule 17a-7 policies and procedures with respect to cross-trades of less liquid investments.

New Disclosure and Reporting Requirements

Form N-1A: Additional disclosure will be required on Form N-1A with respect to a fund’s redemption policies and procedures. This new disclosure will apply to all open-end funds, including all ETFs and money market funds. Funds will now be required to disclose in the prospectus the number of days following receipt of shareholder redemption requests in which the fund typically expects to pay redemption proceeds to redeeming shareholders and the methods the fund typically uses to meet redemptions, including whether those methods are used regularly or only in stressed market conditions. In a change from the Proposing Release, funds will not be required to file credit agreements as exhibits to their registration statements.

Form N-PORT: Monthly a fund will report the liquidity classification assigned to each of its portfolio holdings as well as the fund’s highly liquid investment minimum to the SEC on a confidential basis. Funds will disclose publicly (as of the end of each fiscal quarter with a 60 day delay) the aggregated percentage of their portfolio representing each of the four classification buckets as well as the percentage of their highly liquid investments that are segregated to cover, or pledged to satisfy margin requirements in connection with the fund’s derivatives transactions.

Form N-LIQUID: As part of its final rule, the SEC adopted new Form N-LIQUID, which a fund will use to notify the SEC confidentially when more than 15 percent of its net assets are illiquid investments that are assets or if it has a shortfall of its Highly Liquid Investment Minimum for a period exceeding seven calendar days. In addition, a fund will report on Form N-LIQUID if it previously exceeded 15 percent of its net assets in illiquid investments that are assets and the fund has now determined that its illiquid investments that are assets is at or below 15 percent of its net assets.

Form N-CEN: New disclosures will be required on Form N-CEN with respect to a fund’s use of committed and uncommitted lines of credit and interfund borrowing and lending. This new disclosure will apply to all open-end funds, including all ETFs and money market funds. Additionally, ETFs must disclose whether they qualify as an In-Kind ETF.

Compliance Dates

The compliance date for the amendments to Form N-1A is June 1, 2017. All other requirements, including the Program, have a compliance date of December 1, 2018, for larger entities (funds that together with other investment companies in the same group of related investment companies have net assets of $1 billion or more as of the end of the most recent fiscal year) and June 1, 2019, for smaller entities (funds that together with other investment companies in the same group of related investment companies have net assets of less than $1 billion as of the end of the most recent fiscal year).


[1] Release No. IC-32315: Investment Company Liquidity Risk Management Programs (the Adopting Release).

[2] Release No. IC-31835: Open-End Fund Liquidity Risk Management Programs; Swing Pricing; Re-Opening of Comment Period for Investment Company Reporting Modernization Release (the Proposing Release)

[3] As described further below, as an alternative some funds may classify portfolio positions by asset class, rather than by individual position.

[4] The SEC changed the definition from the Proposing Release to eliminate references to redemption requests that are expected under normal conditions or reasonably foreseeable under stressed conditions.

[5] The Adopting Release notes that the time frame for determining what is a “reasonably foreseeable stressed condition” may be generally the time until the next periodic review of the Program.

[6] In the Adopting Release, the SEC specifically points out that funds with significant holdings of securities with extended settlement periods (i.e., bank loan funds) may face challenges operating as open-end funds and should take these holdings into account when determining if the fund is appropriate as an open-end fund.

[7] Current U.S. Generally Accepted Accounting Principles define cash equivalents as short-term, highly liquid investments that are readily convertible to known amounts of cash and that are so near their maturity that they present insignificant risk of changes in value because of changes in interest rates.

[8] With respect to the liquidity classification definitions, “convertible to cash” means the ability to be sold, with the sale settled.

[9] The SEC states in the Adopting Release that a fund’s classification policies and procedures should address what it would consider to be a significant change in market value.

[10] With respect to the liquidity classification definitions, “market value” includes the value of investments that are fair valued.

[11] This differs from the “convertible to cash” requirement for classifying an investment in the highly liquid or moderately liquid buckets.

[12] However, if a fund has specifically identified individual assets that are not highly liquid investments as being segregated to cover such derivatives transactions, then the fund may match those specific segregated assets to specific derivatives transactions and need not assume that segregated highly liquid investments cover those derivatives.

[13] For example, a fund may wish to distinguish how it classifies equity securities based on market capitalization, and whether the security is common stock or preferred stock. With respect to fixed income securities, a fund may wish to distinguish how it classifies based on factors such as issuer type, the market(s) in which the issuer is based, seniority, age, and credit quality. The SEC notes it would not be appropriate to have broad based categories such as equities, fixed income, etc.

[14] When evaluating if a fund meets its Highly Liquid Investment Minimum, it should look only to investments with positive values.