SEC Liquidity Management – Rule 22e-4

At the end of 2015, 54.9 million households (44.1 percent of all U.S. households) owned mutual funds. Part of the attraction of funds is that investors are able to redeem their shares on each business day and, by law, receive approximately their pro rata share of the fund’s net assets (or its cash value) within seven calendar days after receipt of a redemption request.

For several decades the SEC (Securities and Exchange Commission) imposed a guideline to maintain a liquidity standard that generally limited a fund to no more that 15% of the net assets in holdings considered “illiquid assets”. The purpose was to ensure that there was sufficient cash to meet the demands of redemptions and therefore comply with the intrinsic understanding that shares can be redeemed at any time. However, based on several changes in the industry, the SEC sought to modernize the Investment Company Act of 1940 (’40 Act’) to address perceived systemic risk in this area.

It was observed that there were a growing number of mutual funds in the fixed income space. Between 2005 and 2015 this sector grew from 7% to 20%. This growth, along with increased investments in illiquid assets, was a concern for funds’ ability to satisfy a large number of redemptions during times of market stress. In addition, there was a concern relating to an unpredictable pattern of redemptions associated with the proliferation of new fund types, such as alternative funds, emerging market funds and high-yield bond funds.

The proposed regulations, Rule 22e-4, were voted on and adopted by the SEC in October 2016 and will come into effect in December 2018.

Overview
Each registered U.S. mutual fund must adopt and implement a written liquidity risk management program that is reasonably designed to assess and manage its liquidity risk. This risk is related to a mutual fund’s ability to pay shareholders who redeem shares within seven days and without significant dilution to remaining investors. This excludes Money Market Funds, Closed End Funds and certain UITs.

According to the regulations the assessment and review must pay consideration to the following factors:

  • How portfolio investments behave in both normal and reasonably foreseeable stressed conditions
  • Short-term and long-term cash flow projections during both normal and reasonable foreseeable stressed conditions
  • Holdings of cash and cash equivalents, as well as borrowing arrangements and of sources of funding
  • Strategies that involve relatively concentrated portfolios or large positions in a particular issuer

The management of the program begins with the introduction of a new 4-tier classification scheme for portfolio holdings:

1. Highly Liquid
Cash or convertible to cash within 3 business days or less without significantly changing market value.

2. Moderately Liquid
Convertible to cash in more than 3 calendar days but less than or equal to 7 calendar days, without significantly changing market value. Note: regulations state that if an investment could be viewed as either highly liquid or moderately liquid because the period to convert to cash depends on calendar or business day convention it should be classified as highly liquid. This would indicate we could rely on business days for testing since it will always yield the lower number of days.

3. Less Liquid
Sell or dispose of in 7 calendar days or less without significantly changing market price, but where sale or disposition is expected to settle in greater than 7 calendar days.

4. Illiquid
Cannot be sold or disposed of in 7 calendar days or less without significantly changing the market value.

The fund must assign classifications to all investments and this must be reviewed at least monthly. The frequency of the review may be increased for any or all investments if conditions exist that may materially affect the classifications. When assessing an investment’s classification the fund should take into account the relevant market, trading and investment specific considerations.

Alternative method for liquidity classification: The Release Notice 33-10233 states on page 91 “The fund may classify portfolio investments based on asset class, so long as the fund or its adviser, after reasonable inquiry, does not have 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”.

To monitor the liquidity risk of the fund there are two primary quantitative restrictions based on these classifications:

Maximum 15% of net assets in Illiquid Investments

  • The requirement is applicable at all times
  • Board must be informed within one business day of the fund exceeding 15% in illiquid investments along with an explanation of how the fund plans to reduce the level to below 15%

Highly Liquid Investment Minimum

  • The regulations do not directly state when this restriction is applicable, however it would be consistent and conservative to assume this is in force at all times
  • Any fund that does not ‘primarily’ hold highly liquid investments must determine a ‘highly liquid investment minimum’ [Footnote 725: In our view, if a fund held less than 50% of its assets in highly liquid investments it would be unlikely to qualify as “primarily” holding assets that are highly liquid investments]
  • This minimum cannot be changed during a period when the fund is below the minimum
  • Failures must be reported to the board no later than the next regularly scheduled meeting and if the failure lasts more than seven consecutive calendar days the board must be notified within one business day and submit a private report with the SEC
  • This requirement exempts “In-Kind ETFs”

Regulatory Reporting
To assist with the SEC’s risk and compliance monitoring and to provide greater transparency a number of reporting requirements are specified by the new regulation:

Form N-PORT (new form)

  • Monthly, privately report the position- level liquidity classifications and the level of Highly Liquid Investments
  • As of the fiscal quarter end, publicly report the aggregate levels of each of the four liquidity classifications
  • For derivatives classified as Moderately Liquid, Less Liquid or Illiquid the fund must disclose the percentage of Highly Liquid investments segregated as ‘coverage’ or to satisfy margin requirements

Form N-LIQUID (new form)

  • Privately report within one business day when the fund exceeds the 15% limit in Illiquid investments
  • Privately report when a fund which has previously exceeded the 15% limit and filed with the SEC no longer exceeds the 15% limit
  • Privately report within one business day when the fund is below its Highly Liquid Investment minimum for more the 7 consecutive calendar days

Form N-CEN (new form)

  • Report on the fund’s use of credit lines, interfund lending and borrowing
  • Report if the fund is an “In-Kind Exchange-Traded Fund”

Form N-1A (amendments)

  • Disclose procedures for redeeming shares including the number of days the fund typically expects to pay redemption proceeds
  • Disclose how the fund expects to meet redemption requests during stressed and non-stressed market conditions

Compliance dates

December 1, 2018 – larger entities (AUM $1B and above)
June 1, 2019 – smaller entities

Last updated 16th October 2017

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