On October 13, 2016, the SEC approved new Rule 22e-4 under the Investment Company Act of 1940, as amended (the 1940 Act), which will require certain open-end investment companies other than money market funds, to adopt and implement written liquidity risk management programs.¹ In addition, new Rule 30b1-10 will require those funds to confidentially notify the Securities and Exchange Commission (the SEC) when their investment portfolios breach particular liquidity thresholds. Compliance with Rules 22e-4 and 30b1-10 will require significant involvement of management and compliance personnel, as well as mandatory board oversight and dedication of resources, before and following the rules’ compliance date. In addition, a fund with a relatively less liquid or illiquid portfolio may need to modify its investment strategies and potentially reconsider its status as an open-end fund. 

The compliance date for the new rules and reporting requirements is December 1, 2018, for larger entities and June 1, 2019, for smaller entities.² This legal alert provides an overview of these new rules and requirements.

Liquidity Risk Management Program Under Rule 22e-4

Redeemability is a fundamental feature of open-end funds. In order to satisfy redemption requests for cash, open-end funds must maintain sufficient liquid assets (or other sources of liquidity). Open-end funds that inadequately manage liquidity are more likely to violate their legal obligations to process redemption requests in a timely manner³ and/or dilute the interests of their remaining investors. In addition, an open-end fund’s failure to properly manage liquidity may call into question the truthfulness and accuracy of the fund’s disclosures, the reliability of the fund’s valuations, the appropriateness of the fund’s status as an open-end fund, and the effectiveness of the fund’s compliance policies and procedures. Accordingly, the SEC recently adopted Rule 22e-4 to further enhance and regulate the manner in which open-end funds manage liquidity risk. 

Definition of Liquidity Risk and Requirement to Adopt a Liquidity Risk Management Program

Rule 22e-4 requires open-end funds—including mutual funds (except money market funds) and exchange-traded funds (ETFs)⁴—to “adopt and implement a written liquidity risk management program that is reasonably designed to assess and manage [the fund’s] liquidity risk.” The SEC defines “liquidity risk” 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.” A fund dilutes the interests of remaining investors when it sells or otherwise disposes of a security in a manner that negatively impacts the market value of the investment. In the context of redemption requests, a fund dilutes the interests of remaining investors when it disposes of an asset for less than carried value. 

The term “significant” is not defined in the SEC’s definition of liquidity risk. However, it is not intended to reference slight changes to a fund’s net asset value per share (NAV). Nor is it limited to the degree of dilution that may occur when a fund disposes of securities at deep discounts, or “fire sale” prices, to meet redemption requests. Instead, a fund’s liquidity risk management program should focus on the fund’s ability to meet redemptions in a manner that does not harm shareholders. Funds are required to assess and manage liquidity risk, not necessarily eliminate it.

As previously stated, a fund’s liquidity risk management program must be “reasonably designed” to assess and manage the fund’s liquidity risk. Although the Adopting Release emphasizes that a fund’s program should be appropriately tailored to reflect the fund’s particular liquidity risk, all programs generally must incorporate the following elements (unless otherwise provided by Rule 22e-4):

1. Assessment, management, and periodic review of liquidity risk.
2. Classification of portfolio investments and filing of related reports on Form N-PORT.
3. Determination of a “highly liquid investment minimum” and filing of related reports on Forms N-PORT and N-LIQUID.
4. Limit on illiquid investments and filing of related reports on Form N-LIQUID.
5. Establishment of policies and procedures for in-kind redemptions.

Each required element is further discussed below. 

Assessment, Management, and Periodic Review of Liquidity Risk

As part of its liquidity risk management program, a fund must undertake an initial review of its liquidity risk and re-evaluate its liquidity risk no less frequently than annually thereafter. Rule 22e-4 sets forth “liquidity risk factors” that, to the extent applicable, must be considered as part of the initial review.⁵ The liquidity risk factors are not intended to be exhaustive, and a fund must take into account other considerations to the extent necessary to adequately assess and manage the fund’s liquidity risk. For instance, the SEC believes that stress tests could be particularly useful to a fund in evaluating its liquidity risk, although Rule 22e-4 does not specifically require stress tests. 

Liquidity Risk Factor No. 1: Investment strategy and portfolio liquidity

The first liquidity risk factor that a fund must consider is its “investment strategy and liquidity of portfolio investments . . . , including whether the investment 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.” In addition, funds must analyze this liquidity risk factor in light of both “normal” and “reasonably foreseeable stressed” conditions. Neither “normal” nor “reasonably foreseeable stressed” conditions is defined. Stressed conditions will likely entail different scenarios for different types of funds, and the extent to which stressed conditions are reasonably foreseeable will vary depending on the fund’s facts and circumstances. To identify reasonably foreseeable stressed conditions, funds should consider all relevant factors, including historical experience, market sensitivities, changes in interest rates, and stresses unrelated to market risk, such as social, political, and geographic risks. 

In addition to the fund’s principal investment strategies, various other aspects of a fund’s investment strategies may significantly affect liquidity risk. For example, liquidity risk may be affected by whether the fund is actively or passively managed or whether portfolio managers are unwilling or unable to dispose of certain assets for tax reasons or otherwise. When assessing its investment strategies in accordance with Rule 22e-4, a fund must also consider whether its investment strategies are suitable for the open-end fund structure. To the extent that a fund’s investment strategy involves investing in thinly traded or illiquid securities, investing in securities with extended settlement periods, maintaining a highly concentrated portfolio, holding investments that are particularly difficult to sell in stressed conditions, or otherwise raises a significant degree of liquidity risk, the fund should determine whether its status as an open-end fund is appropriate and should potentially reconsider its continued operation as an open-end fund.

Rule 22e-4 also requires a fund to consider the extent to which its strategy involves a relatively concentrated portfolio or large positions in particular issuers. A relatively less diversified fund may have fewer options when selling investments to meet redemption requests. For a less diversified fund, the markets for its portfolio holdings are more likely to be uniform or correlated, which may compel the fund to dispose of investments in unfavorable markets and at unfavorable prices. In addition, as a portfolio becomes more concentrated, portfolio managers have less flexibility to reposition a fund in defensive markets or to adhere to the adviser’s investment mandate.
 
A fund must also consider the use of borrowings for investment purposes and the use of derivatives, including those used for hedging purposes, when assessing liquidity risk. Funds may borrow through banks or financing transactions such as reverse repurchase agreements and short sales, all of which may affect a fund’s liquidity risk. Borrowings may create liquidity risk because payments to counterparties may reduce the assets that would otherwise be available to meet redemptions requests. In addition, a fund should consider the liquidity of its derivatives positions, as well as any variation margin or collateral calls the fund may be required to meet. 

Liquidity Risk Factor No. 2: Short-term and long-term cash flow projections 

The second liquidity risk factor that a fund must consider is its “short-term and long-term cash flow projections,” and this liquidity risk factor must also be analyzed in light of both normal and reasonably foreseeable stressed conditions. Although not formally included in Rule 22e-4, the Adopting Release provides “guidance” on evaluating a fund’s cash flow projections. Under the guidance, a fund should at least consider, in light of normal and reasonably foreseeable stressed conditions, the following five factors: 

1. The size, frequency, and volatility of historical purchases and redemptions. 
2. The fund’s redemption policies and practices. 
3. The fund’s shareholder ownership concentration. 
4. The fund’s distribution channels. 
5. The degree of certainty associated with the fund’s short-term and long-term cash flow projections. 

The SEC did not formally adopt these five factors as part of Rule 22e-4 in order to avoid a “checklist” approach to liquidity risk management. Funds should also consider any other factors that affect its particular short-term and long-term cash flow projections under normal and reasonably foreseeable stressed conditions. 

Liquidity Risk Factor No. 3: Cash and cash equivalents, borrowing arrangements, and other funding sources

The third liquidity risk factor that a fund must consider is its “holdings of cash and cash equivalents, as well as borrowing arrangements and other funding sources.” The SEC believes that cash and cash equivalents can be a valuable liquidity risk management tool, as they remain highly liquid in nearly all market conditions. The SEC recognizes that borrowing and other funding arrangements may assist a fund in meeting redemption requests. However, the SEC warns that borrowing and funding arrangements may not be beneficial to liquidity risk management if they leverage the fund at the expense of non-redeeming investors. In addition, the benefits of funding arrangements may be mitigated or outweighed by the terms of such arrangements (e.g., if multiple funds may draw from the same credit facility) and the financial health of counterparties. 

Liquidity Risk Factors Nos. 4 and 5: Liquidity risk factors applicable only to ETFs

In addition to the three liquidity risk factors discussed above, an ETF must consider, to the extent applicable, the following two liquidity risk factors:

1. The relationship between the ETF’s portfolio liquidity and the way in which, and the prices and spreads at which, ETF shares trade, including the efficiency of the arbitrage function and the level of active participation by market participants (including authorized participants); and
2. The effect of the composition of baskets on the overall liquidity of the ETF’s portfolio. 

These liquidity risk factors are based on the structure and operation of ETFs. The ETF structure permits only authorized participants to purchase or redeem shares from an ETF in creation and redemption baskets, and only authorized participants transact in ETF shares at NAV. Secondary market participants, on the other hand, purchase and sell ETF shares at their market prices. The combination of the creation and redemption basket process and secondary market trading creates arbitrage opportunities that, if effective, keep the market prices of the ETF’s shares at or close to NAV. If an ETF holds a significant amount of illiquid or thinly traded securities, the arbitrage process may not operate efficiently, in which case secondary market investors may not be buying and selling shares of the ETF at prices that are at or close to the ETF’s NAV. The SEC believes that such situations may cause different investors (authorized participants and secondary market investors) to be treated inequitably, raising concerns under the 1940 Act. Furthermore, when ETFs create or redeem shares in-kind using baskets of securities and other assets, the composition of the baskets can affect the liquidity of the ETFs’ portfolios. When a basket does not reflect a pro rata share of the ETF’s portfolio, the liquidity profile of the ETF may be altered, and harm to the ETF’s liquidity profile may adversely affect the fund’s future ability to meet cash redemptions or mitigate shareholder dilution. 

Classification of Portfolio Investments and Filing of Related Reports on Form N-PORT

All funds that are required to adopt and implement liquidity risk management programs (except “In-Kind” ETFs)⁶ must also classify the liquidity of their individual portfolio investments (including derivative transactions) and file related reports with the SEC on Form N-PORT. Although funds are not required to constantly assess and report on the liquidity of their portfolio investments, funds must review the classifications of their portfolio investments and file reports on Form N-PORT at least monthly and as-needed when changes in current market, trading, and investment-specific considerations are reasonably expected to materially affect one or more of the fund’s investment classifications. 

Classification of Portfolio Investments

A fund is required to classify each portfolio investment, including derivative transactions (regardless of whether they are classified as assets or liabilities on the fund’s balance sheet), into one of four liquidity categories:

1. Highly liquid investment: “any cash held by a fund and any investment that the fund reasonably expects to be convertible into cash in current market conditions in three business days or less without the conversion to cash significantly changing the market value of the investment.”⁷
2. Moderately liquid investment: “any investment that the fund reasonably expects to be convertible into cash in current market conditions in more than three calendar days but in seven calendar days or less, without the conversion to cash significantly changing the market value of the investment.”

With respect to the two liquidity categories above, the term “convertible to cash” refers to the fund’s ability to sell an investment, with the sale settled, in the prescribed period of time. If an investment could be viewed as either a highly liquid investment or a moderately liquid investment, because the period to convert the investment to cash depends on the calendar or business day convention used, the asset should be categorized as a highly liquid investment. 

3. Less liquid investment: “any investment that the fund reasonably expects to be able to sell or dispose of in current market conditions in seven calendar days or less without the sale or disposition significantly changing the market value of the investment, . . . but where the sale or disposition is reasonably expected to settle in more than seven calendar days.”⁸
4. Illiquid investment: “any investment that the fund reasonably expects cannot be sold or disposed of in current market conditions in seven calendar days or less without the sale or disposition significantly changing the market value of the investment.”⁹

Each fund must classify its portfolio investments based upon a reasonable inquiry. For each investment, a fund may rely on its reasonable expectations for how a hypothetical disposition of the asset would affect its market value under current market conditions. Funds are not expected to make precise determinations or consider foreseeable market conditions. Indeed, the SEC recognizes that liquidity classifications involve subjective judgments and estimations. 

The term “significant changes,” as used in the four liquidity categories, is not intended to capture small changes in the market value of an investment, but is not limited to changes in market value that are more likely to occur in fire-sale situations. Importantly, the SEC believes that a fund’s classification policies and procedures should specifically address what the fund considers to be a significant change in market value.

When classifying investments, Rule 22e-4 requires funds to take into account “relevant market, trading, and investment-specific considerations.” The SEC did not codify a list of specific factors, as originally proposed, because the SEC concluded that funds should tailor their considerations to their particular facts and circumstances. Nonetheless, the SEC believes that the following nine factors, to the extent applicable, could be “useful and relevant” aspects of the market, trading, and investment-specific considerations that a fund must take into account: 

1. Existence of an active market for the asset, including whether the asset is listed on an exchange, as well as the number, diversity, and quality of market participants.¹⁰ 
2. Frequency of trades or quotes for the asset and average daily trading volume of the asset (regardless of whether the asset is a security traded on an exchange).¹¹
3. Volatility of trading prices for the asset.¹²
4. Bid-ask spreads for the asset.¹³
5. Whether the asset has a relatively standardized and simple structure.¹⁴
6. For fixed income securities, maturity and date of issue.¹⁵  
7. Restrictions on trading of the asset and limitations on transfer of the asset.¹⁶
8. The size of the fund’s position in the asset relative to the asset’s average daily trading volume and, as applicable, the number of units of the asset outstanding.¹⁷
9. Relationship of the asset to another portfolio asset.¹⁸  

As previously indicated, the nine factors set forth above are not meant to be an exhaustive list of considerations that a fund may take into account when evaluating the liquidity of its individual portfolio investments. Moreover, depending on the facts and circumstances, a fund may decide to focus more heavily on certain factors and less on others, which is permissible so long as the fund accounts for all relevant market, trading, and investment-specific considerations.

Rule 22e-4 permits funds to classify and review portfolio investments (including derivative transactions) based on asset class. However, the fund must separately classify and review any investment within an asset class for which the fund or its adviser, after reasonable inquiry, has information about any market, trading, or investment-specific considerations that is reasonably expected to significantly affect the liquidity characteristics of the investment compared to the fund’s other portfolio holdings within that class. Rule 22e-4 does not specify how a fund must identify investments that should be classified separately. Nonetheless, the SEC believes that “reasonably designed” asset-based classification policies and procedures would likely include the sources and types of information to be considered. Those sources and types of information should include not only the nine factors listed above, but also information related to the asset’s particular facts and circumstances.

In addition, a fund’s asset-based classification policies and procedures should incorporate sufficient detail to “meaningfully distinguish between asset classes and sub-classes.” For example, a fund could consider common stock of large-capitalization companies as an acceptable asset category, but using broad asset classes such as “equity,” “fixed income,” and “other” would not be acceptable. A fund’s asset-based classification policies and procedures should also include procedures for updating default asset-class liquidity classifications as relevant market, trading, and investment-specific considerations warrant. 

As part of the classification process, Rule 22e-4 requires funds to consider market depth. Under Rule 22e-4, a fund must categorize the liquidity of its entire position in an investment; a fund cannot classify the liquidity of particular portions of its position. For example, a fund cannot determine that 50% of its position in an investment is moderately liquid, and that the other 50% of its position is less liquid. Nonetheless, the fund must consider the liquidity of particular portions of its entire position when classifying the liquidity of its investment. Specifically, under Rule 22e-4, a fund must consider whether trading varying portions of a position in a particular portfolio investment or asset class, in sizes that the fund would reasonably anticipate trading, is reasonably expected to significantly affect the liquidity characteristics of that investment. If so, the fund must take that information into account when classifying the liquidity of the fund’s entire position in the investment. 

Rule 22e-4 does not provide any derivatives-specific factors that a fund would have to evaluate when classifying a derivative transaction’s liquidity. The SEC believes that the liquidity of derivative transactions depend on particular facts and circumstances, including market demand, the liquidity of underlying reference assets, and whether the transactions are centrally cleared. Nevertheless, the SEC believes that a fund should consider the nine factors set forth above, to the extent applicable, and any other relevant market, trading, and investment-specific considerations. Also, for derivative transactions that a fund classifies as liabilities on its balance sheet, a fund should interpret the definitions of “highly liquid investment,” “moderately liquid investment,” and “less liquid investment” to refer to the time period in which the fund reasonably expects to be able to exit the transactions, rather than the time period in which the fund can convert the position to cash or dispose of the investment. 

Related Reports on Form N-PORT 

A fund that is required to classify its individual portfolio investments must also file reports with the SEC on Form N-PORT. The report must be made at least monthly, and as-needed when changes in current market, trading, and investment-specific considerations are reasonably expected to materially affect one or more of the investment classifications. As part of Form N-PORT, a fund must report the liquidity classifications for its individual portfolio holdings (or position-level liquidity classifications), which will be reported in a structured data format and will not be disclosed to the public. Also, a fund must report the aggregate percentages of its portfolio that fall into each of the four liquidity categories. This information will be disclosed to the public only for the third month of each fiscal quarter, and will include a 60-day delay. 

For the derivative transactions classified as “moderately liquid investment,” “less liquid investment,” or “illiquid investment,” the Fund must also identify on Form N-PORT the percentage of highly liquid investments that are segregated to cover, or pledged to satisfy margin requirements in connection with, the derivative transactions in each such liquidity category. For purposes of calculating these percentages, a fund that has segregated or pledged highly liquid investments and non-highly liquid investments to cover derivative transactions should first use segregated or pledged assets that are highly liquid investments to cover non-highly liquid derivative transactions, unless the fund has specifically identified segregated non-highly liquid investments as covering such derivatives transactions. This information will also be disclosed to the public only for the third month of each fiscal quarter, and will include a 60-day delay.

Determination of a “Highly Liquid Investment Minimum” and Filing of Related Reports on Forms N-PORT and N-LIQUID

Highly Liquid Investment Minimum 

Except for funds that primarily invest in “highly liquid investments,”¹⁹ Rule 22e-4 requires each fund to establish a “highly liquid investment minimum.” A fund’s highly liquid investment minimum is the minimum percentage of the fund’s net assets to be invested in highly liquid investments.²⁰ Although the SEC is requiring funds to establish a floor for highly liquid investments, the SEC emphasizes that it is not requiring or suggesting that a fund should only, or primarily, use highly liquid investments to satisfy redemption requests. In addition, Rule 22e-4 does not prohibit a fund from acquiring assets other than highly liquid investments, even when a fund’s portfolio falls below the highly liquid investment minimum (if acquiring non-highly liquid assets is consistent with the fund’s “shortfall” policies and procedures discussed below). 

Funds are required to periodically review, no less frequently than annually, their highly liquid investment minimums. However, a fund should review its highly liquid investment minimum more frequently than annually if circumstances warrant, and a fund should review its highly liquid investment minimum at any time the fund encounters “extremely stressed market conditions” that could increase its liquidity risk to “unusual levels.” For purposes of determining its highly liquid investment minimum, a fund must consider the liquidity risk factors that are required to be considered during the assessment of the fund’s liquidity risk. The fund should also take into account other considerations to the extent they were necessary to adequately assess the fund’s liquidity risk.²¹ The fund should consider both normal and reasonably foreseeable stressed conditions, although the fund must consider stressed conditions only to the extent they are reasonably foreseeable during the period until the next review of the highly liquid investment minimum. Board approval of the highly liquid investment minimum is not required; however, while a shortfall is ongoing, a fund’s highly liquid investment minimum cannot be changed without board approval (including approval by a majority of the independent directors).

In determining whether a fund is meeting its highly liquid investment minimum, the fund will look only to its investments that are “assets” of the fund. The reference to investments that are “assets” is intended 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.²²

Shortfall Policies and Procedures Requirement

Rule 22e-4 also requires each fund to adopt policies and procedures for responding to “shortfalls,” or when the fund falls below its highly liquid investment minimum. The policies and procedures must require that a shortfall be reported to the fund’s board no later than the next regularly scheduled meeting and include a brief explanation of the causes for the shortfall, the extent of the shortfall, and any actions taken in response to the shortfall. In addition, the policies and procedures must require a report to the board within one business day if the shortfall lasts more than seven consecutive calendar days, and the report must include an explanation of how the fund plans to remediate the shortfall within a reasonable period of time. Fund management generally should take into account the fund’s liquidity risk, as well as facts and circumstances leading to the shortfall, in determining a reasonable time for remediating the shortfall.

Otherwise, the shortfall policies and procedures may be flexible and may take into account a fund’s particular facts and circumstances. The SEC noted that a fund’s policies and procedures could specify: (1) actions that a fund may take in response to a shortfall under different conditions; (2) market and fund circumstances that could impact a fund’s response to a particular shortfall; (3) how the fund would assess the length of time needed to remediate a shortfall; and (4) the persons who will typically determine how to respond to a shortfall. The SEC also noted that, if a fund regularly experiences shortfalls, the fund should consider whether the fund’s risk management policies and procedures should be modified. 

Related Reports on Form N-PORT

Funds are required to report to the SEC their highly liquid investment minimums as part of their Form N-PORT filings. In addition, if a fund’s highly liquid investment minimum changed during the reporting period, prior minimums established during the reporting period must also be reported. Funds will also be required to report the number of days during the reporting period that they experienced shortfalls. All reported information on Form N-PORT related to a fund’s highly liquid investment minimum will be made public only for the third month of each fiscal quarter, and will include a 60-day delay.

Related Reports on Form N-LIQUID

If a fund experiences a shortfall for more than seven consecutive calendar days, then the fund is required to notify the SEC on Form N-LIQUID within one business day. Form N-LIQUID filings will be confidential.

Limit on Illiquid Investments and Related Reports on Form N-LIQUID

Limit on Illiquid Investments

Rule 22e-4 codifies (and replaces) the SEC’s long-standing guidance restricting a fund’s ability to invest in illiquid investments. Specifically, under Rule 22e-4, a fund is prohibited from acquiring any illiquid investment if, immediately after the acquisition, the fund would have invested more than 15% of its net assets in illiquid investments (based on the same definition of illiquid investment used in the classification process discussed above). It should be noted that compliance with Rule 22e-4 in this context may require a fund to assess the liquidity of an investment before purchase or acquisition.

A fund is not required to divest itself of assets if more than 15% of a fund’s net assets are invested in, or become invested in, illiquid investments. However, funds are required to take action if their holdings breach the 15% limit. In such circumstances, the person(s) designated to administer the liquidity risk management program must report the breach to the board within one business day, and the report must include an explanation of how the fund plans to bring the fund’s illiquid investments to a level at or below 15% of net assets within a reasonable period of time. In addition, if a breach lasts for 30 consecutive calendar days, then the fund’s board (including a majority of the independent directors), must assess whether the fund’s plan for remediating the breach continues to be in the best interests of the fund. The SEC also expects that a fund’s annual report to the board on the adequacy and effectiveness of the fund’s liquidity risk management program would report on any breaches during the year, whether a breach is ongoing, and how the fund plans to bring the fund’s illiquid investments to a level at or below 15% of net assets within a reasonable period of time. 

Related Reports on Form N-LIQUID

Pursuant to new Rule 30b1-10, if more than 15% of a fund’s net assets are or become illiquid investments, the fund is required to notify the SEC on new Form N-LIQUID within one business day. The form requires a fund to provide information about: (1) the date(s) of the breach; (2) the current percentage of the fund’s net assets that are invested in illiquid investments; and (3) the illiquid investments themselves. In addition, a fund is required to report on Form N-LIQUID within one business day of when the fund is no longer in breach of the 15% limit. Form N-LIQUID filings will be confidential.

Establishment of Policies and Procedures for In-Kind Redemptions 

Under Rule 22e-4, funds that engage in in-kind redemptions or reserve the right to redeem in-kind must adopt and implement written policies and procedures for in-kind redemptions as part of their liquidity risk management programs. The policies and procedures should generally address the circumstances under which the fund would consider redeeming in-kind as well as the process for redeeming in-kind. The SEC expects that a fund’s policies and procedures would contemplate a variety of issues and circumstances. Such issues and circumstances may include:

• The particular circumstances in which a fund may choose to employ in-kind redemptions (e.g., at all times, under stressed conditions, under certain conditions).
• Whether a fund would use in-kind redemptions only for requests over a certain size.
• The ability of shareholders, or certain types of shareholders (e.g., retail versus institutional), to receive redemption proceeds in-kind.
• Whether omnibus accounts present any unique issues.
• Potential operational issues, including notice to shareholders that may be subject to in-kind redemptions and processes for transferring securities.
• If and how the fund would use less liquid or illiquid securities to satisfy in-kind redemptions. 

The SEC also believes that effective policies and procedures would likely address how the fund selects securities to redeem in-kind, including whether the fund plans to redeem securities in-kind as a pro rata ratio of the fund’s portfolio holdings. For a fund that redeems in-kind pro rata, the SEC believes that a fund’s policies and procedures might address how the fund plans in-kind redemptions of odd or small lots. For a fund that does not redeem in-kind pro rata, the SEC believes that, to be effective, the policies and procedures would address how securities are selected and distributed in a manner that is fair to redeeming investors and remaining investors (e.g., avoiding cherry-picking of undesirable securities, shareholder favoritism, harmful tax consequences, and improper valuation).

Board Oversight and Designation of Program Administrative Responsibilities

Rule 22e-4 imposes a number of specific duties and obligations on a fund’s board of directors,²³ including the following:

• To initially approve the fund’s written liquidity risk management program.
• To approve the investment adviser, officer, or officers who are responsible for administering the program.
• To review, no less than annually, a written report prepared by the person(s) designated to administer the program that includes a review of the program’s adequacy and effectiveness and any material changes thereto. 
• To receive (and potentially act upon) reports on highly liquid investment minimum shortfalls.
• To approve any change to the fund’s highly liquid investment minimum while the fund is experiencing a highly liquid investment minimum shortfall.
• To receive (and potentially act upon) reports on breaches of the 15% illiquid investment limit (including, in certain situations, assessing whether the fund’s plan for remediating the breach continues to be in the best interests of the fund).

Initial Approval of the Liquidity Risk Management Program

A fund will be required to obtain initial approval of its written liquidity risk management program from the fund’s board of directors (including a majority of the independent directors). Rule 22e-4 does not require the board to approve the program thereafter, and the fund is not required to obtain board approval for changes to the program, including material changes thereto. However, the fund’s board will be required to review a written report from the program administrator(s), to be provided to the board no less frequently than annually, that addresses the operation, adequacy, and effectiveness of the program. 

Of course, it is expected that a fund’s directors will exercise their reasonable business judgment in overseeing the fund’s liquidity risk management program. With respect to the initial approval of the program, directors may satisfy their obligations by reviewing summaries of the program prepared by the program administrator(s), legal counsel, or other persons familiar with the program. The summaries should familiarize directors with the salient features of the program and provide them with an understanding of how the program addresses the fund’s liquidity risk.

Designation of Administrative Responsibility

As noted above, the fund’s board of directors (including a majority of the independent directors) must approve the designation of the fund’s investment adviser (including any sub-adviser), officer, or officers who will be responsible for administering the fund’s liquidity risk management program. This approach is intended to properly task the person(s) who are in a position to manage the fund’s liquidity risks with responsibility for administering the program. 

Under Rule 22e-4, a fund’s portfolio managers cannot be solely responsible for administering the liquidity risk management program. The Adopting Release expresses concern that if only portfolio managers administer the program, the program might not be administered with sufficient independence to effectively manage liquidity risk. A fund generally should consider the influence that portfolio managers may have on the administration of the program and seek to designate persons who provide an independent check on potential conflicts of interest. Although the fund’s portfolio managers cannot be solely responsible for administering the program, the program administrator(s) may consult with the fund’s portfolio managers, traders, risk managers, and others as necessary or appropriate in administering the program. Portfolio managers may also be a part of any committee or group designated to administer the program. 

Oversight of the Highly Liquid Investment Minimum 

Under the final rule, boards generally will not be required to approve the highly liquid investment minimum or changes thereto. However, if a fund is experiencing a shortfall, the fund’s board of directors (including a majority of the independent directors) must approve any change to the fund’s highly liquid investment minimum. The final rule also requires the board to receive a report at its next regularly scheduled meeting whenever the fund experiences a shortfall. In addition, if the fund experiences a shortfall for more than seven consecutive calendar days, the program administrator(s) must report the shortfall to the board within one business day thereafter, and the report must include an explanation of how the fund plans to remediate the shortfall within a reasonable period of time. 

Oversight of the Illiquid Investment Limit 

A fund board must be informed within one business day if the fund’s holdings of illiquid investments exceed 15% of the fund’s net assets. As part of the report, the board must be provided with an explanation of the extent and causes of the occurrence and how the fund plans to bring its net assets to a level at or below the 15% illiquid investment limit within a reasonable period of time. In addition, if a breach lasts for 30 consecutive calendar days, then the fund’s board (including a majority of the independent directors), must assess whether the fund’s plan for remediating the breach continues to be in the best interests of the fund.

Recordkeeping Requirements

Each fund (and In-Kind ETF) will be required to maintain complete records regarding its liquidity risk management program, and these records will of course all be available to the SEC staff. In particular, funds must maintain at least the following:

• A written copy of the policies and procedures adopted as part of its liquidity risk management program for at least five years in an easily accessible place (this would include any shortfall policies and procedures regarding the highly liquid investment minimum). 
• Copies of any materials provided to its board in connection with the board’s initial approval of the fund’s liquidity risk management program and approval of the designated program administrator(s). 
• Copies of the annual (or more frequent) written reports provided to the board on the adequacy of the fund’s liquidity risk management program, including the fund’s highly liquid investment minimum, and the effectiveness of its implementation for at least five years after the end of the fiscal year in which the documents were provided to the board, the first two years in an easily accessible place. 
• Records of any materials provided to the board related to the fund dropping below its highly liquid investment minimum. 
• A written record of how its highly liquid investment minimum, and any adjustments thereto, were determined, including the fund’s assessment and periodic review of its liquidity risk for a period of not less than five years, the first two years in an easily accessible place, following the determination of, and each change to, the fund’s highly liquid investment minimum.

Other Regulations Adopted and Guidance Offered Under the Adopting Release

Cross Trades under Rule 17a-7. In the Adopting Release, the SEC acknowledged that cross trades between affiliated funds under Rule 17a-7 may be a useful tool for managing liquidity risk. Cross-trading can benefit funds and their shareholders by allowing funds that are mutually interested in a securities transaction to mutually conduct the transaction without incurring additional transaction costs or generating market impacts. The SEC warned that cross-trades have significant potential for abuse. The SEC stated that funds should carefully consider whether cross trades involving less liquid assets satisfy the requirements of Rule 17a-7, as well as an adviser’s duty of loyalty and duty to seek best execution. Advisers should also carefully consider whether a cross trade involving a less liquid asset is in the best interests of each fund or other client participating in the transaction. The SEC also noted that a fund’s Rule 38a-1 policies and procedures should contemplate how a fund ensures that cross trades involving less liquid assets comply with Rule 17a-7. 

Amendments to Form N-1A. The SEC also adopted amendments to Form N-1A that will require a fund to further describe its procedures for redeeming fund shares, including the number of days in which the fund typically expects to pay redemption proceeds. If the number of days differs by method of payment, the fund is required to disclose the typical number of days or estimated range of days that the fund expects it will take to pay redemption proceeds for each method. Form N-1A will also require a fund to further disclose the methods the fund typically uses to meet redemption requests, including whether the methods are used under normal and stressed market conditions. Funds will not be required to file their credit agreements as exhibits to their registration statements, as originally proposed. 

Changes to Form N-CEN. The SEC adopted changes to new Form N-CEN, which will require funds to disclose information regarding the use of credit lines, interfund lending, and interfund borrowing. Funds may also disclose under new Form N-CEN whether they are “In-Kind ETFs,” as defined under Rule 22e-4. In-Kind ETFs are not required to classify the liquidity of their portfolio investments or file related reports on Form N-PORT.

                                              
¹Investment Company Liquidity Risk Management Programs, Release Nos. 33-10233, IC-32315 (Oct. 13, 2016) (the “Adopting Release”), available at www.sec.gov/rules/final/2016/33-10233.pdf. At the same time that it adopted the liquidity risk management program requirements, the SEC adopted two related sets of rule and reporting form amendments: (1) a “swing pricing” rule that will permit, but not require, funds to use swing pricing (the process of adjusting a fund’s net asset value to pass on to purchasing or redeeming shareholders the costs associated with their trading activity); and (2) amendments to existing rules and forms that would enhance transparency and modernize reporting requirements for mutual funds, ETFs, and other registered investment companies. These other regulatory developments are beyond the scope of this Legal Alert.
  
² Larger entities are funds, together with other investment companies in the same “group of related investment companies,” that have net assets of $1 billion or more as of the end of the most recent fiscal year. Smaller entities are in fund groups that have net assets below $1 billion. 
  
³ An open-end fund is statutorily required to pay redemption proceeds within seven days of receiving a redemption request. See Section 22(e) of the 1940 Act. In practice, however, settlement periods are generally shorter than seven days, typically three days or less, as a result of broker-dealer settlement requirements (see Rule 15c6-1 under the Securities Exchange Act of 1934, as amended), investor expectations, industry standards, and technological advances. In addition, many fund prospectuses state that investors can ordinarily expect to receive redemption proceeds in less than seven days.

⁴ With respect to unit investment trusts (UITs), Rule 22e-4 requires the principal underwriter or depositor of a UIT to determine, on or before the date of the initial deposit of portfolio securities, that the portion of the illiquid investments that the UIT holds or will hold at the date of deposit are assets consistent with the redeemable nature of its interests. In addition, the principal underwriter or depositor must maintain a record of that determination for the life of the UIT and for five years thereafter. UITs are not otherwise subject to the requirements of Rule 22e-4 or Rule 30b1-10. Nonetheless, principal underwriters and depositors of UITs should consider the requirements of Rule 22e-4 and the SEC’s guidance in the Adopting Release when making the initial determination.

⁵ The SEC recognizes that some of the proposed factors may not be applicable in assessing and managing the liquidity risk of certain funds or types of funds, and to the extent any liquidity risk factor specified in rule 22e-4 is not applicable to a particular fund, the fund will not be required to consider it in assessing and managing its liquidity risk (hence the words “as applicable” are included in the rule’s instruction to consider the specified factors). For example, the Adopting Release explains that a fund will not be required to consider the use of borrowings for investment purposes and derivatives, as specified in the rule, if that fund does not borrow or use derivatives.

⁶ “In-Kind” ETFs are ETFs that redeem shares through in-kind transfers of securities, positions, and assets other than a de minimis amount of cash and that publish their portfolio holdings daily.

⁷ It should be noted that this is the only liquidity category that refers to business days rather than calendar days.
  
⁸ Because such less liquid investments are those that may be sold, but not settled, within seven days, a fund generally could use such investments to meet redemption requests only if the fund obtained an additional source of financing to bridge the period until the sales would settle, or if the fund used its cash holdings to meet the redemptions while simultaneously selling the less liquid investment and then replenishing its cash holdings upon settlement. 

⁹ Unlike the moderately liquid investment and less liquid investment categories, the illiquid investment category is based on the time period to sell or dispose of the investment without consideration of the time to settle. With respect to this category, the SEC warns funds against determining that an investment is liquid, rather than illiquid, primarily based on structural characteristics (such as transfer restrictions and transfer halts). Instead, Rule 22e-4 requires funds to primarily consider market, trading, and other relevant information that could result in an investment being appropriately categorized as illiquid.
  
¹⁰ The SEC recognizes that assets traded on an exchange are often relatively liquid, although the SEC also recognizes that assets traded through other mechanisms (e.g., over the counter (OTC)) may also be liquid, depending on the facts and circumstances. With respect to exchange-traded assets, the SEC warns that they are not necessarily convertible into cash within a short period (e.g., small-cap equity stocks may be thinly traded). For each exchange-traded asset, the SEC also encourages funds to take into account the number of market makers on both the buying and selling sides, as well as the quality of market participants (e.g., diversity, capitalization, reliability, experience, reputation). In addition, the SEC reminded funds that although ETF shares may be more readily tradable than less liquid portfolio investments, funds that invest in ETF shares are exposed to the liquidity risks of the ETFs in which they invest. Funds that invest in ETF shares are encouraged to consider the liquidity of the ETFs’ underlying securities when categorizing the liquidity of ETF shares. 
  
¹¹ The SEC believes that a high frequency of trades or quotes, or high average trading volume, for a particular asset tends to indicate that the asset is highly liquid. The SEC recognizes that such assets may actually be trading under unfavorable market conditions, which may negatively affect market values, and that a lower frequency of trades or quotes, or a lower trading volume (e.g., fixed income securities), does not necessarily indicate that an asset is relatively less liquid. 
  
¹² The SEC generally believes that an inverse relationship exists between liquidity and volatility, as the price of a less liquid asset tends to be more volatile. As such, funds should consider volatility when considering an asset’s liquidity category, including how past periods of volatility have affected liquidity. 
  
¹³ Bid-ask spread refers to the difference between bid and offer prices for a particular investment. The SEC believes that high bid-ask spreads for a particular asset correlate with a lack of liquidity, because broker-dealers may be factoring the length of time that they anticipate having to hold an investment prior to sale. The SEC acknowledges that other factors may drive bid-ask spreads up, including the volume and scale of a transaction.

¹⁴ The SEC believes that a more standardized and simply-structured asset tends to be, but is not necessarily, more liquid. For example, assets that are traded OTC and centrally cleared are generally highly standardized. Standardization may increase liquidity by simplifying the ability to quote and trade, enhancing operational efficiencies to execute and settle trades, and improving market transparency. 
  
¹⁵ The SEC believes that, in general, a fixed income asset trades most frequently at the time of issuance, and that its trading volume decreases as it approaches maturity. As such, the SEC generally believes that the most recently issued fixed income securities of a particular maturity (“on-the-run” securities) tend to be more liquid than previously issued fixed income securities of the same maturity (“off-the-run” securities). 
  
¹⁶ The SEC believes that securities subject to trading/transfer restrictions or limitations tend to be relatively less liquid. For example, trades for foreign securities may be subject to government approval, and certain assets may be subject to contractual limitations. 
  
¹⁷ This factor is primarily focused on whether the size of a fund’s entire position (or portion of its position) in an asset affects the fund’s ability to convert the asset to cash in light of the asset’s trading volume. For example, a fund holding a large position in a security that is thinly traded may not be able to convert a significant portion of that position to cash in order to meet redemptions. In considering the number of units of an asset that are currently outstanding, a fund may wish to take into account the extent to which units of an asset may be technically outstanding, but cannot be purchased by a member of the public. 
  
¹⁸ This factor is primarily focused on the relationship between a fund’s derivative transactions and other portfolio holdings, particularly how and the extent to which a fund segregates assets to cover obligations associated with derivative transactions. Assets used to cover derivatives transactions are considered “frozen” or “unavailable for sale or other disposition,” and therefore not available to meet redemption requests.

¹⁹ The SEC expects that any fund that intends to rely on this exception would specify in its policies and procedures how it defines “primarily.” If a fund that primarily invests in highly liquid investments modifies its investment strategy or drifts from its investment strategy such that it no longer primarily invests in highly liquid investments, it would be required to comply with these requirements of Rule 22e-4. 
 
²⁰ A fund must exclude from its calculations the percentage of the fund’s assets that are highly liquid investments but segregated to cover derivate transactions that the fund has classified as non-highly liquid investments. 
  
²¹ It should also be noted that the SEC will not permit a fund to consider lines of credit toward the highly liquid investment minimum, or use lines of credit to reduce the fund’s highly liquid investment minimum.

²² This same approach to “assets” also applies to the 15% illiquid investment limit, discussed below.

²³ Generally, board approvals required by the rule also require approval by a majority of the independent directors.