The Staff of the SEC's Division of Investment Management (the "Staff") updated the Investment Company Liquidity Risk Management program's frequently asked questions (FAQs) to respond to new questions that the Staff has received regarding the liquidity rules under Investment Company Act Rule 22e-4 (Rule 22e-4). Rule 22e-4 requires each registered, open-end management investment company, including open-end exchange-traded funds (ETFs), to establish a liquidity risk management program. Rule 22e-4 also requires principal underwriters and depositors of unit investment trusts (UITs) to engage in a limited liquidity review. The Staff expects to update the FAQs from time to time to answer additional questions. The most recent FAQs can be found here.
Below is a summary of new Questions 16–34 in the FAQs and certain answers provided by the Staff.
Asset Class Liquidity Classification (FAQs 16-18)
Questions 16-18 address the requirement of a fund to classify the liquidity of the portfolio investments under Rule 22e-4. In that regard, funds can classify the liquidity of their investments according to asset classes, but funds must separately classify and review any investment within an asset class that they reasonably expect to depart significantly from the range of liquidity characteristics present within such investment's asset class. The Staff believes that only investments that have a significant effect on such liquidity characteristics should trigger separate review and classification. A fund that relies on this asset classification method should include in its policies and procedures a reasonable framework for identifying exceptions to asset class classification. Also, the Staff has indicated there is no presumption that a fund identifying a potential exception must necessarily reclassify such investments.
Reasonably Anticipated Trading Size (FAQs 19-21)
With respect to Questions 19-21, the Staff provides guidance with respect to Rule 22e-4(b)(1)(ii)(B), which applies to classifications of portfolio investments or asset classes. The Staff believes that a fund is permitted to use an aggregated analysis for those investments that a fund classifies by asset class. In applying the related market depth analysis, the Staff believes that funds could arrive at reasonably anticipated trading sizes for its aggregated investments. However, according to the Staff, a fund need not predict which specific portfolio positions it will sell in advance or consider actual trades executed for reasons other than meeting redemptions. Ultimately, Rule 22e-4 requires that a fund make assumptions about the sizes that fund would anticipate trading in a reasonable manner, but does not specify a particular method of doing so.
Price Impact Standard (FAQ 22)
With respect to Question 22, when classifying an investment, a fund is required to consider how quickly it could convert that investment into cash without significantly changing its market value. The Staff believes that a fund has the flexibility to determine what constitutes a significant change in market value and may use differing standards for different investments and/or asset classes.
Classifying Investments in Pooled Investment Vehicles (FAQ 23)
Question 23 pertains to liquidity classification of an investment in another pooled investment vehicle, such as a mutual fund or ETF ("Pools"). A fund that invests in Pools can focus on the liquidity of the Pools' shares or interests when classifying those investments. For Pools that trade on exchanges (e.g., shares of ETFs), a fund should evaluate its liquidity in a manner similar to how it would evaluate the liquidity of other exchange-traded investments (e.g., common stock) and "look through" to the underlying assets only when the fund has reason to believe that doing so could materially alter its liquidity assessment. For Pools that offer redeemable securities or withdrawal rights, a fund generally would focus on the Pools' redemptions rights and "look through" to the Pools' underlying investments only when the fund has a reason to believe that the Pools may not be able to honor such redemption or withdrawal rights.
Provisional Investment Classifications Activity and Related Compliance Monitoring (FAQs 24-26)
With respect to Questions 24-26, under Rule 22e-4(b)(1)(iv), a fund cannot acquire any illiquid investment if, immediately after the acquisition, the fund would have invested more than 15% of its net assets in illiquid investments that are assets. The Staff believes that a fund should regularly monitor and conduct reviews to ensure compliance with its 15% limitation on illiquid investments. The staff believes that use of a provisional classification (other than its required monthly classification) is voluntary and not required; however, a provisional classification may assist a fund in assessing and managing liquidity risk. If a fund verifies and determines that it has fallen below the highly liquid investment minimum or exceeded the 15% limitation, then the fund would be subject to applicable reporting requirements.
Timing and Frequency of Classification (FAQs 27-29)
With respect to Questions 27-29, under Rule 22e-4(b)(1)(ii), a fund is required to conduct at least a monthly review of the classification status of its portfolio investments. A fund is only required to conduct an intra-month reevaluation of an investment's liquidity classification when a fund becomes aware of changes in the relevant market, that is, trading and investment-specific considerations that are reasonably expected to materially affect an existing classification of that particular investment. For changes triggering an intra-month classification review, the Staff believes that a fund is required to review and determine to reclassify only those investments that the fund reasonably expects to be materially affected by the change in question.
* * * * * * * * * *
In this update, the SEC also addressed questions related to the following topics: (i) Pre-trade Activity and the 15% Limitation on Illiquid Investments (FAQs 30-31), (ii) Related Reporting Requirements (FAQs 32-33), and (iii) ETFs and Investment Classification (FAQ 34).