Liquidity Rule Reminders in Light of Recent Market Turmoil

As financial markets react to daily, dramatic news headlines concerning the coronavirus pandemic, an oil market price war, extraordinary government responses and the economic and financial fallout, funds and their liquidity program administrators may want to keep in mind a few key points under the Securities and Exchange Commission’s Liquidity Risk Management Rule:¹

• Liquidity Classifications and Reclassifications.  The Liquidity Risk Management Rule’s classification provisions require liquidity classification at least monthly and more frequently if changes in relevant market, trading and investment-specific considerations are reasonably expected to materially affect fund investment classifications.²  Under the Liquidity Risk Management Rule, each liquidity classification category (highly liquid, moderately liquid, less liquid and illiquid) is defined with respect to the time it is reasonably expected to take to convert the investment to cash (or sell or dispose of the investment) in current market conditions without significantly changing the market value of the investment.³
  
  • The SEC has provided guidance on factors that funds may take into account in evaluating portfolio investment liquidity.  These include, among others, (i) volatility of trading prices, (ii) bid-ask spreads, (iii) frequency of trades or quotes and average daily trading volume, and (iv) the existence of an active market for an asset class or investment.⁴ 
    
  • The SEC has also stated that funds should consider having their liquidity program administrator review the quality of data received from third-party liquidity classification vendors, as well as the particular methodologies used and metrics analyzed by those vendors.⁵ 
    
• 15% Limit on Illiquid Investments; Highly Liquid Investment Minimum.  Funds and their liquidity program administrators may want to consider whether compliance considerations related to the Liquidity Risk Management Rule’s 15% limit on illiquid investments⁶ and highly liquid investment minimum provisions⁷ may result from liquidity reclassifications or from changes in market value of fund portfolio holdings.
  
  • When a fund holds more than 15% of its net assets in illiquid investments that are assets,⁸ a non-public filing with the SEC on Form N-LIQUID is required within 1 business day, as is a report to the fund’s board of directors concerning the occurrence.⁹  The fund must make an additional non-public filing with the SEC on Form N-LIQUID within 1 business day of bringing its holdings of illiquid investments that are assets to or below 15% of net assets.¹⁰
    
  • Similarly, if a fund’s holdings of highly liquid investments that are assets¹¹ falls below the fund’s highly liquid investment minimum for more than 7 consecutive calendar days, a non-public filing with the SEC on Form N-LIQUID is required within 1 business day, as is a report to the fund’s board of directors concerning the occurrence.¹²
    
  • With respect to those funds that operate as “primarily highly liquid funds” and rely on the related exemption from the Liquidity Risk Management Rule’s highly liquid investment minimum provisions,¹³ the SEC has indicated that there are certain circumstances under which the SEC would not view continued reliance on such exemption as appropriate.¹⁴
    

Funds and their liquidity program administrators may want to review these points as they continue to monitor compliance with the Liquidity Risk Management Rule.

Footnotes

1) See Rule 22e-4 under the Investment Company Act of 1940.  The Liquidity Risk Management Rule is applicable to open-end management investment companies registered or required to register under the Investment Company Act, except for such companies regulated as money market funds under Rule 2a-7 under the Investment Company Act.

2) See Rule 22e-4(b)(1)(ii). The staff of the SEC’s Division of Investment Management has provided guidance permitting funds to comply with the Liquidity Risk Management Rule’s intra-month review requirement “by identifying in its policies and procedures events that it reasonably expects would materially affect an investment’s classification” and “would not object if reasonable policies and procedures limits such events to those that are objectively determinable.”  See Investment Company Liquidity Risk Management Programs Frequently Asked Questions (Apr. 10, 2019) at Question 28.

3) See Rule 22e-4(a)(6), (8), (10) and (12).

4) See Investment Company Liquidity Risk Management Programs, SEC Rel. No. IC-32315 (Oct. 13, 2016) (Liquidity Rule Adopting Release). 

5) See Liquidity Rule Adopting Release (“Also, we generally believe that a fund should consider having the person(s) at the fund or investment adviser designated to administer the fund’s liquidity risk management program review the quality of any data received from third parties, as well as the particular methodologies used and metrics analyzed by third parties, to determine whether this data would effectively inform or supplement the fund’s consideration of its portfolio holdings’ liquidity characteristics.”).

6) See Rule 22e-4(b)(1)(iv).

7) See Rule 22e-4(b)(1)(iii).

8) See Liquidity Rule Adopting Release at n.744 (“Rule 22e-4(b)(1)(iv) refers to investments that are ‘assets’ to make clear that the 15% limit on illiquid investments applies to investments with positive values. Illiquid investments that have negative values should not be netted against illiquid investments that have positive values when calculating compliance with the 15% limit. Thus, only illiquid investments that have positive values (i.e., ‘assets’) should be used in the numerator.”).

9) See Form N-LIQUID, Part B; Rule 22e-4(b)(1)(iv)(A).  If a fund continues to hold more than 15% of its net assets in illiquid investments that are assets 30 days from the occurrence (and at each consecutive 30 day period thereafter), the fund’s board, including a majority of its independent directors, must assess whether the liquidity program administrator’s plan for bringing the fund’s holdings of illiquid investments that are assets to or below 15% of net assets continues to be in the best interest of the fund.

10) See Form N-LIQUID, Part C.  

11) See Liquidity Rule Adopting Release at n.633 (“Rule 22e-4(a)(7) refers to highly liquid investments that are ‘assets’ to make clear that when evaluating whether a fund is meeting its highly liquid investment minimum, the fund should look to its investments with positive values. Highly liquid investments that have negative values should not be netted against highly liquid investments that have positive values when calculating whether the fund is meeting its highly liquid investment minimum. Thus, only highly liquid investments that have positive values (i.e., ‘assets’) should be used in the numerator.”).

12) See Form N-LIQUID, Part D; Rule 22e-4(b)(1)(iii)(A)(3).  Any shortfall of the fund’s highly liquid investment minimum, regardless of duration, must be reported to the fund’s board no later than its next regularly scheduled meeting.  Form N-PORT also calls for non-public disclosure relating to highly liquid investment minimum shortfalls.  See Form N-PORT General Instruction F. and Item B.7.b.

13) See Rule 22e-4(b)(1)(iii)(A).

14) See, e.g., Liquidity Rule Adopting Release (“If a fund were to modify its investment strategy or encounter strategy ‘drift’ such that it no longer primarily held assets that were highly liquid investments, it would be required to adopt and review a highly liquid investment minimum, as well as adopt and implement policies and procedures for responding to a shortfall of the fund’s assets that are highly liquid investments below its minimum. We therefore believe that if a fund’s investment strategy is such that it cannot generally be predicted whether the fund would primarily hold assets that are highly liquid investments (for example, if the strategy were to entail a significant amount of volatility in terms of the fund’s portfolio liquidity), it would be difficult for the fund’s management to conclude that the fund should appropriately be excluded from the highly liquid investment minimum requirement.”).