A Small Entity Compliance Guide[1]

Introduction

On October 13, 2016, the U.S. Securities and Exchange Commission (“SEC”) adopted new rules and a new form, as well as amendments to a rule and forms designed to promote effective liquidity risk management for open-end management investment companies (“funds”). The amendments will enhance disclosure regarding fund liquidity and redemption practices and would enhance funds’ management of their liquidity risks, which would strengthen our securities markets and better protect investors.

On February 22, 2018 the SEC adopted an interim final rule that revised the compliance date for the provisions of rule 22e-4 related to the classification of funds’ portfolio investments, highly liquid investment minimum, board approval of the liquidity risk management program, Part D of Form N-LIQUID, and the liquidity-related amendments to Form N-PORT by six-months. The interim final rule also provided guidance to assist funds that will not be engaging in full portfolio classification before the revised compliance date and “in-kind” ETFs, which are not required to engage in full portfolio classification, in identifying illiquid investments and thus applying the 15% illiquid investment limit. The new compliance date for these provisions is June 1, 2019, for larger entities (revised from December 1, 2018) and December 1, 2019, for smaller entities (revised from June 1, 2019).

On June 28, 2018, the SEC adopted a final rule that requires funds to disclose information about their liquidity risk management program in their reports to shareholders. In addition, the SEC amended Form N-PORT to enhance the liquidity information reported to the Commission.

On February 27, 2019, the SEC adopted an interim final rule that modified the submission deadlines for funds filing non-public monthly reports on Form N-PORT. The interim final rule requires funds to maintain the information required by Form N-PORT, including their liquidity classification information, in their records on a monthly basis. The interim final rule requires funds to file all three monthly reports with the Commission no later than 60 days after the end of each fiscal quarter. The interim final rule also amends Form N-LIQUID to provide for a voluntary explanatory notes section.

Highlights

A fundamental feature of open-end funds is that they allow investors to redeem their shares daily. Funds need to maintain sufficiently liquid assets in order to meet shareholder redemptions while also minimizing the impact of those redemptions on the fund’s remaining shareholders.

Liquidity Risk Management Programs

Rule 22e-4 requires funds, including ETFs, to establish liquidity risk management programs. The rule excludes money market funds from all requirements of the rule and ETFs that qualify as “in-kind ETFs” from certain requirements. The liquidity risk management program is required to include multiple elements, including:

• Assessment, management, and periodic review of a fund’s liquidity risk;
• Classification of the liquidity of fund portfolio investments;
• Determination of a highly liquid investment minimum;
• Limitation on illiquid investments; and
• Board oversight.

Assessment, Management, and Periodic Review of a Fund’s Liquidity Risk

Funds are required to assess, manage, and periodically review their liquidity risk, based on specified factors. Liquidity risk is defined as the risk that a fund could not meet requests to redeem shares issued by the fund without significant dilution of remaining investors’ interests in the fund.

Classification of the Liquidity of Fund Portfolio Investments

Each fund is required to classify each of the investments in its portfolio on at least a monthly basis. The classification is based on the number of days in which the fund reasonably expects the investment would be convertible to cash (or sold or disposed of) in current market conditions without significantly changing the market value of the investment, and the determination has to take into account the market depth of the investment. Funds are required to classify each investment into one of four liquidity categories: highly liquid investments, moderately liquid investments, less liquid investments, and illiquid investments. Additionally, funds are permitted to classify investments by asset class, unless market, trading, or investment-specific considerations with respect to a particular investment are expected to significantly affect the liquidity characteristics of that investment as compared to the fund’s other portfolio holdings within that asset class.

Funds that meet the definition of “in-kind ETF” under the rule are not subject to this requirement.

Determination of a Highly Liquid Investment Minimum

A fund is required to determine a minimum percentage of its net assets that must be invested in highly liquid investments, defined as cash or investments that are reasonably expected to be converted to cash within three business days without significantly changing the market value of the investment. The fund is also required to implement policies and procedures for responding to a highly liquid investment minimum shortfall, which must include board reporting in the event of a shortfall.

Funds that primarily hold assets that are highly liquid investments and funds that meet the definition of “in-kind ETF” under the rule are not subject to this requirement.

Limitation on Illiquid Investments

A fund is not permitted to purchase additional illiquid investments if more than 15 percent of its net assets are illiquid investments that are assets. An illiquid investment is an investment that the fund reasonably expects cannot be sold in current market conditions in seven calendar days without significantly changing the market value of the investment. The determination has to follow the same process as the other liquidity classifications, including at least monthly review of the illiquid investments. If a fund breaches the 15 percent limit, the occurrence must be reported to the board, along with an explanation of how the fund plans to bring its illiquid investments back within the limit within a reasonable period of time, and if the amount of the fund’s illiquid investments that are assets is still above 15% of its net assets 30 days from the occurrence (and at each consecutive 30 day period thereafter), the board must assess whether the plan presented to it is in the best interest of the fund and its shareholders.

Board Oversight

A fund’s board, including a majority of the fund’s independent directors, is required to approve the fund’s liquidity risk management program and the designation of the fund’s adviser or officer(s) to administer the program. The fund’s board also is required to review, at least annually, a written report on the adequacy of the program and the effectiveness of its implementation.

Form N-LIQUID

The new form generally requires a fund to confidentially notify the SEC when the fund’s level of illiquid investments that are assets exceeds 15 percent of its net assets or when its highly liquid investments fall below its minimum for more than a brief period of time.

Additional Disclosure and Reporting Requirements

Form N-1A

Amendments to the registration form used by open-end funds (Form N-1A) require funds to describe their procedures for redeeming fund shares, the number of days in which the fund typically expects to pay redemption proceeds, and the methods for meeting redemption requests. The amendments also require funds to disclose information about the operation and effectiveness of their liquidity risk management program in their reports to shareholders.

Form N-PORT

Amendments to the portfolio holdings reporting form (Form N-PORT) require a fund to maintain in its records position-level liquidity classification information and information regarding a fund’s highly liquid investment minimum on a monthly basis, as well as its holdings of cash and cash equivalents.

Form N-CEN

Amendments to the annual census reporting form (Form N-CEN) require funds to disclose information regarding the use of lines of credit and interfund borrowing and lending, and require an ETF to report if it is an in-kind ETF under the rule.

Compliance Dates

• Rule 22e-4 and Form N-LIQUID. For the provisions of rule 22e-4 related to the classification of funds’ portfolio investments, highly liquid investment minimum, board approval of the liquidity risk management program, and Part D of Form N-LIQUID, the compliance date for larger entities—namely, 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 of the fund—is June 1, 2019,[2] and for smaller entities is six months later, December 1, 2019. The compliance date for all other elements of rule 22e-4 and Form N-LIQUID for larger entities is December 1, 2018 and for smaller entities is six months later, June 1, 2019.
• Form N-PORT. For the amendments to Form N-PORT, the compliance date for larger entities is June 1, 2019. The compliance date for smaller entities is March 1, 2020. This results in larger funds, for example, filing their first reports with additional liquidity-related information on Form N-PORT reflecting data as of June 30, 2019, no later than July 30, 2019.
• Form N-CEN. For the amendments to Form N-CEN, the compliance date for larger entities is December 1, 2018. The compliance date for smaller entities is six months later, June 1, 2019.
• Form N-1A. For the amendments to Form N-1A regarding fund redemptions, the compliance date was June 1, 2017. For the amendments to N-1A regarding the operation and effectiveness of fund liquidity risk management programs, the compliance date for larger entities is December 1, 2019 and for smaller entities is June 1, 2020.

Other Resources

The adopting release for the investment company liquidity risk management program rules can be found on the SEC’s website at https://www.sec.gov/rules/final/2016/33-10233.pdf. An interim final rule release concerning the compliance dates for certain elements of rule 22e-4 and related reporting requirements can be found on the SEC’s website at https://www.sec.gov/rules/interim/2018/ic-33010.pdf. The proposing release for the rules can be found on the SEC’s website at https://www.sec.gov/rules/proposed/2015/33-9922.pdf. The adopting release for the investment company liquidity risk disclosure amendments can be found on the SEC’s website at https://www.sec.gov/rules/final/2018/ic-33142.pdf. The proposing release for the amendments can be found on the SEC’s website at https://www.sec.gov/rules/proposed/2018/ic-33046.pdf.

Contacting the SEC

The SEC’s Division of Investment Management is happy to assist small entities with questions regarding the liquidity risk management rules.

Questions may be directed to the Division of Investment Management’s Office of Chief Counsel by e-mail at IMOCC@sec.gov or by telephone at (202) 551-6825.