The Securities and Exchange Commission (the “SEC”) voted recently to adopt new Rule 22e-4 under the Investment Company Act of 1940, as amended (the “1940 Act”), (the “Rule”)1 that will require registered open-end management investment companies, including mutual funds and exchange-traded funds (“ETFs”)2 (each a “fund”) (but excluding money market funds), to adopt and implement written liquidity risk management programs designed to assess and manage liquidity risk.3
December 1, 2018 for larger entities; funds that, together with other investment companies in the same “group of related investment companies” (i.e., fund complex), have net assets of at least $1 billion as of the end of the most recent fiscal year.
June 1, 2019 for smaller entities; funds that, together with the other investment companies in the same fund complex, have net assets of less than $1 billion as of the end of the most recent fiscal year.
Elements of Liquidity Risk Management Programs
While each fund that is subject to the Rule will be required to comply with certain requirements, the fund may tailor its liquidity risk management program as appropriate based on the fund’s particular risks and circumstances. Subject to certain exceptions, each fund’s program must include policies and procedures reasonably designed to incorporate the following requirements:
- Assessment of Liquidity Risk. The fund must assess, manage and periodically (but at least annually) review its liquidity risk based on a consideration of, as applicable, (i) its investment strategy and the liquidity of its investments during normal and reasonably foreseeable stressed conditions, including whether the strategy is appropriate for an open-end fund, 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; (ii) its short-term and long-term cash flow projections during normal and reasonably foreseeable stressed conditions; and (iii) its holdings of cash and cash equivalents, borrowing arrangements and other funding sources. ETFs must also assess, manage and review factors relating to how the shares are being traded and basket composition.
- Classification of Portfolio Assets. The fund must classify each of its portfolio investments, including derivative transactions, as (i) a “highly liquid investment” (i.e., reasonably expected to be convertible into cash in current market conditions in three business days or less without significantly changing the investment’s market value); (ii) a “moderately liquid investment” (i.e., reasonably expected to be convertible into cash in current market conditions in more than three, but no more than seven, calendar days without significantly changing the investment’s market value); (iii) a “less liquid investment” (i.e., reasonably expected to be able to be sold or disposed of in current market conditions in seven calendar days or less without such sale or disposition significantly changing the investment’s market value, but where the sale or disposition is reasonably expected to settle in more than seven calendar days); or (iv) an “illiquid investment” (i.e., reasonably expected not to be able to be sold or disposed of in seven calendar days or less without the sale or disposition significantly changing the investment’s market value). In classifying each portfolio investment, the fund must use information obtained after reasonable inquiry and take into account relevant market, trading and investment-specific factors. The classifications must be reviewed and included, on a monthly basis, on new Form N-PORT (adopted concurrently in a separate release). Additional requirements apply with respect to derivatives transactions that a fund has not classified as “highly liquid.” Under the Rule, the fund may classify and review its investments according to their asset class, but the fund must separately classify and review any investment within an asset class if the fund or its adviser has information regarding market or other factors that are reasonably expected to significantly affect the investment’s liquidity characteristics relative to other fund holdings within that class. “In-Kind ETFs”4 will not be required to comply with these requirements.
- Highly Liquid Investment Minimum. Unless it primarily holds assets that are highly liquid investments, the fund must establish a minimum percentage of its net assets that will be invested in highly liquid investments. In establishing this minimum, the fund should consider the same factors used to classify its portfolio assets (e.g., investment strategy, cash flow projections, cash holdings, etc.). The fund must periodically (but at least annually) review the highly liquid investment minimum. The program must include policies and procedures for responding to a shortfall in the fund’s highly liquid investments below the applicable highly liquid investment minimum. Such policies and procedures must require the individual responsible for administering the program (the “Program Administrator”) to report to the fund’s board of directors no later than its next regularly scheduled meeting with a brief explanation of the cause of the shortfall, the extent of the shortfall, and any actions taken in response. Additionally, the policies and procedures must require the Program Administrator, if a shortfall lasts more than seven consecutive calendar days, to report to the board within one business day thereafter with an explanation as to how the fund intends to restore the minimum within a reasonable period of time.5 In-Kind ETFs will not be required to comply with these requirements.
- Limitation on Illiquid Investments. The program must contain policies and procedures that prohibit the fund from acquiring any illiquid investment if, immediately following the acquisition, the fund would have invested more than 15% of its net assets in illiquid investments with positive values (i.e., “assets”).6 The policies and procedures must require the Program Administrator to report to the fund’s board of directors within one business day when the fund holds more than 15% of its net assets in illiquid investments that are assets.7 In the report to the board, the Program Administrator must explain (i) the extent and causes of the occurrence and (ii) how the fund plans to bring its illiquid investments that are assets to or below 15% of its net assets within a reasonable period of time.Redemptions In-Kind. Any fund that engages in, or reserves the right to engage in, redemptions in-kind must establish policies and procedures regarding how and when it will engage in such redemptions.
Board Approval and Oversight of the Program and Related Matters
Each fund’s board of directors, including a majority of the independent directors, must (i) initially approve the liquidity risk management program; (ii) approve the designation of the Program Administrator; and (iii) review at least annually a written report prepared by the Program Administrator that addresses the program’s operation, adequacy and effectiveness.8 Fund boards also must assess whether any plan presented by the Program Administrator in the event that the fund exceeds the 15% limit discussed above continues to be in the best interest of the fund if, 30 days after the occurrence (and at each consecutive 30-day period thereafter), the amount of the fund’s illiquid investments that are assets still exceeds the limit. As noted above, fund boards will also be responsible for considering matters relating to changes to the highly liquid investment minimum in the event of a shortfall.
In connection with the adoption of the Rule, the SEC amended Form N-1A to require additional prospectus disclosures concerning fund redemption procedures. Each fund will be required to disclose the number of days following receipt of shareholder redemption requests in which the fund typically expects to pay redemption proceeds. If the number of days differs by method of payment, the fund must disclose, for each method, the number of days in which it expects to pay redeeming shareholders. Additionally, the fund must disclose the methods (e.g., cash or in-kind) it typically uses to meet redemption requests and whether it uses these methods regularly or only in stressed market conditions.
1 Investment Company Liquidity Risk Management Programs, Investment Co. Act Release No. 32315 (October 13, 2016).
2 The Rule only applies to ETFs structured as open-end funds. For purposes of this memorandum, the term “ETF” refers to open-end ETFs only, unless otherwise indicated.
3 Liquidity risk is defined as the risk that the fund could not meet requests to redeem shares issued by the fund without significant dilution of remaining investors’ interests in the fund.
4 An “In-Kind ETF” is defined as an ETF that meets redemptions through in-kind transfers of securities, positions, and assets other than a de minimis amount of cash and that publishes its portfolio holdings daily.
5 Additionally, the fund must file new Form N-LIQUID within one business day if a shortfall lasts more than seven consecutive calendar days.
6 The Rule refers to illiquid investments that are “assets” to clarify that the limit on illiquid investments only applies to investments with positive values. See Liquidity Risk Adopting Release at 230 n. 744.
7 The fund also must file new Form N-LIQUID with the SEC within one business day if (i) more than 15% of the fund’s net assets are, or become, illiquid investments that are assets or (ii) it determines that its holdings in illiquid investments that are assets have changed to be less than or equal to 15% of its net assets.
8 Each fund must maintain copies of certain materials furnished to the fund’s board of directors in connection with the program and a written copy of its liquidity risk management program and the related policies and procedures.