SEC Releases FAQs to Help Fund Complexes Comply with Liquidity Rule– January 19, 2018 by Lori Novak

With the deadline approaching at the end of this year for large fund complexes to implement a Liquidity Rule program, the staff of the SEC’s Division of Investment Management recently issued a series of frequently asked questions to help funds comply.
 
Rule 22e-4, better known as the Liquidity Rule, requires non-money market mutual funds and certain exchange-traded funds (ETFs) to adopt and implement a liquidity risk management program designed to reduce the risk that funds will be unable to meet their redemption obligations and to mitigate dilution of the interests of fund shareholders. The FAQs provided guidance around two main topics: in-kind transfers of securities and other assets (In-kind ETFs) and sub-advised funds.
 
These FAQs are a timely reminder that the compliance dates are fast approaching. Fund complexes with net assets of $1 billion or more as of the end of their most recent fiscal year must implement a Liquidity Rule program by December 1, 2018. Smaller entities have until June 1, 2019 to comply. 

ETFs

The FAQs clarify that an In-Kind ETF, which is exempt from the Liquidity Rule, may exclude from its calculation of de minimis cash the amount of cash in its redemption proceeds that is proportionate to its uninvested portfolio cash. The FAQs also clarify that an In-Kind ETF should define what constitutes a de minimis amount of cash in its policies and procedures, also acknowledging that the de minimis threshold may differ among ETFs. While a bright line test was not provided for determining the de minimis threshold of overall redemption proceeds paid in cash, certain examples ranged between five percent of cash being paid as part of the redemption as reasonable, to 10 percent being deemed unreasonable.  Notably, the 10 percent threshold would not necessarily “be representative of a de minimis amount in the context of other requirements under the federal securities laws.”
 
The FAQs also discussed if a single redemption was transacted entirely in cash, whether that itself would preclude the ETF from qualifying as an In-Kind ETF. The staff indicated that if the redemption was carried out in cash to meet an authorized participant’s election to redeem in cash, the ETF would be exposed to similar risks that the rule was designed to address and would therefore not qualify as an In-Kind ETF. Conversely, if the cash redemption option is at the discretion of the ETF, then the cash redemption would not preclude the ETF from qualifying as an In-Kind ETF. The staff also noted that testing for compliance with the de minimis cash exception, the testing could be performed at either an individual transaction level or in aggregate across all the fund’s redemptions for a period, with the frequency of the testing in aggregate depending on the frequency of the basket activity. For example, a monthly test may not be appropriate for a fund with high-volume activity.
 
Additional guidance was provided that once an ETF loses its status as an In-Kind ETF, it should come into compliance with the Liquidity Rule “as soon as reasonably practicable.” The ETF, however, is not precluded from subsequently requalifying for the In-Kind ETF exception contained in the Liquidity Rule.  However, the board of the ETF must determine that the event that caused it to lose its status as an In-Kind ETF was an extraordinary onetime event. In addition, there is no prescribed period for which the ETF must wait to reassess the exception, e.g., it is not required to wait two years before it can requalify. 

Sub-advised Funds

A fund must designate a board-approved person to act as the Liquidity Rule program administrator. The FAQs clarify that the Liquidity Rule program administrator should have flexibility to delegate to an “appropriate entity” responsibilities ranging from administering the entire Liquidity Rule program to handling discrete functions. There are a number of parties within a fund’s environment that may be designated these responsibilities, including the fund’s sub-adviser. The FAQs recognize that there may be different conclusions reached among varying reporting entities as each entity assesses the liquidity level based on “the facts and circumstances informing their analysis…including the relevant market, trading and investment –specific characteristics” when classifying the investments liquidity. As such, it is expected that the classification of the same investment may vary from fund to fund, even across the same investment company complex. An adviser (including a sub-adviser) may have responsibilities under multiple fund Liquidity Rule programs that differ from one another, including multiple programs within the same fund complex. The staff of the Division of Investment Management believes that, in this case, an adviser has no obligation to reconcile the elements of those programs; the programs’ underlying methodologies, assumptions or practices; or the program outputs, such as liquidity classifications of fund investments.
 
In addition, the FAQs addressed situations where both an investment advisor and a sub-advisor, or multiple subadvisors within the same fund, are involved in determining the liquidity classification and have differing points of view. The staff made it clear that the program should include a process for resolving these differences and that Form N-PORT does not permit the reporting of a single investment in different liquidity classifications. Accordingly, the fund’s policies and procedures should include a process for selecting a single liquidity classification for each investment for reporting purposes. A fund can adopt any “reasonable method for resolving this difference, so long as the fund applies that method consistently.”
 
These FAQs are a timely reminder that the compliance dates are fast approaching. Fund complexes with net assets of $1 billion or more as of the end of their most recent fiscal year must implement a Liquidity Rule program by December 1, 2018. Smaller entities have until June 1, 2019 to comply.
 
Read the full set of FAQs. 
 
Cohen & Company is not rendering legal, accounting or other professional advice. Any action taken based on information in this blog should be taken only after a detailed review of the specific facts and circumstances.