Investment Management Update
October 2016
SEC Adopts Rule Requiring Liquidity Risk Management Programs for Funds
On October 13, 2016, the Securities and Exchange
Commission (SEC or Commission) announced a final rule
that requires open-end mutual funds (excluding money
market funds) and exchange-traded funds (ETFs) to adopt
liquidity risk management programs. Under new rule 22e-4
(New Rule) of the Investment Company Act of 1940, as
amended (1940 Act), a fund is required to develop a risk
management program that is designed to assess and
manage the fund’s liquidity risk (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). For ETFs, the New Rule incorporates tailored
program requirements to reflect the particular liquidityrelated risks of ETFs. Additionally, the SEC announced
amendments to rule 22c-1 of the 1940 Act that give funds
the option to adopt “swing pricing,” a liquidity management
tool, whereby transacting shareholders would bear the
costs associated with fund transactions made in connection
with their purchases or sales of fund shares.
Portfolio Assets Classifications
The New Rule requires a fund (other than an In-Kind ETF,
defined below) to classify its portfolio of investments into
four liquidity categories. In each case, the determination is
based on the fund’s reasonable expectation that a sale of
the asset can be effected, in current market conditions,
without the sale significantly changing the market value of
the investment prior to the sale. The four categories are:
•
Highly liquid investments – cash and any investment
reasonably expected to be convertible to cash
ATLANTA
CINCINNATI
CLEVELAND
COLUMBUS
•
•
•
(meaning the ability to be sold, with the sale settled) in
three business days or less.
Moderately liquid investments – any investment
reasonably expected to be convertible to cash in more
than three calendar days but in seven calendar days or
less.
Less liquid investments – any investment reasonably
expected to be sold or disposed of in seven calendar
days or less, where the sale or disposition is reasonably
expected to settle in more than seven calendar days.
Illiquid investments – any investment that may not
reasonably be expected to be sold or disposed of in
seven calendar days or less.
Classifications of a fund’s portfolio assets will be reported
on Form N-PORT.
The New Rule requires a fund to take into account relevant
“market, trading, and investment-specific considerations” in
classifying its portfolio investments’ liquidity. The fund also
must consider the investment’s market depth in classifying
the investment (determining the extent to which trading
varying portions of a position in a particular portfolio
investment, in sizes that the fund would reasonably
anticipate trading, is reasonably expected to significantly
affect the liquidity characteristics of that investment). For
derivatives transactions that a fund has classified as
moderately liquid investments, less liquid investments, and
illiquid investments, the fund must identify the percentage
of its highly liquid investments that is segregated to cover,
or pledged to satisfy margin requirements in connection
with, derivatives transactions in each of these classification
categories and disclose these percentages on its Form NPORT filings. The fund also must review its portfolio
DAYTON
NEW YORK
WASHINGTON, D.C.
ATTORNEY ADVERTISING
Investment Management Update
October 2016
Highly Liquid Investment Minimum
investments’ classifications at least monthly and more
frequently if changes in relevant market, trading, and
investment-specific considerations are reasonably expected
to materially affect one or more of its investments’
classifications. Finally, the fund must take into account
certain considerations for highly liquid investments that it
has segregated to cover certain derivatives transactions.
Using the liquidity risk factors listed above, a fund will also
be required to establish a highly liquid investment minimum
(or, the minimum amount of the fund’s net assets that the
fund invests in highly liquid investments that are assets with
positive values). A fund will be able to determine its own
highly liquid investment minimum, as well as (within a fairly
broad range) the assets it will hold to satisfy its minimum.
The New Rule does not specify how a shortfall in a fund’s
highly liquid investment minimum is to be addressed, but
instead provides general guidance directing a fund’s board
of directors to adopt and implement policies and
procedures for responding to a shortfall in a fund’s highly
liquid investments. These policies and procedures must
include reporting to the fund’s board of directors, no later
than the board’s next regularly scheduled meeting,
regarding any shortfall of the fund’s highly liquid
investments compared to its minimum. A fund is required
to report to its board within one business day, and submit a
non-public report to the Commission, if its highly liquid
investment minimum shortfall lasts more than seven
consecutive calendar days. The report to the board should
also include an explanation of how the fund plans to restore
its minimum within a reasonable period of time. A fund
must periodically review, no less frequently than annually,
the fund’s highly liquid investment minimum. These
requirements regarding highly liquid investment minimums
are not applicable to In-Kind ETFs (defined below) and funds
whose portfolio assets consist primarily of highly liquid
investments.
Limitation on Funds’ Illiquid Investments
The New Rule reaffirms the SEC’s position that illiquid
assets are limited to 15% of a fund’s assets. However, to the
extent a fund is not currently taking into account market,
trading, and investment-specific considerations or market
depth when assessing the illiquidity of its investments, the
new regulatory requirements regarding the process for
determining that certain investments are illiquid under the
New Rule are likely to result in the fund determining that a
greater percentage of its holdings are illiquid than under
the SEC’s existing guidelines.
Assessment and Periodic Review of Liquidity Risk
A fund is required to assess, manage, and periodically
review its liquidity risk based on a minimum set of factors (a
fund may take into account additional factors). To the
extent any liquidity risk factor specified in the New Rule is
not applicable to a particular fund, the fund will not be
required to consider it in assessing and managing its
liquidity risk. The minimum factors to consider in
determining a fund’s liquidity risk are, as applicable:
•
•
•
Investment strategy and liquidity of portfolio
investments during both normal and reasonably
foreseeable stressed conditions, 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 (which can reduce liquidity), and the
use of borrowings for investment purposes and
derivatives (including derivatives used for hedging
purposes); and
Short-term and long-term cash flow projections during
both normal and reasonably foreseeable stressed
conditions; and
Holdings of cash and cash equivalents, as well as
borrowing arrangements and other funding sources.
Board Approval and Review
Under the New Rule, the board is responsible for approving
the fund’s liquidity risk management program, which
provides the framework for evaluating the liquidity of the
fund’s investments, and approving the investment adviser
personnel, officer, or officers who are responsible for
administering the program. In addition, similar to rule
38a-1, the board will be required to review, no less
frequently than annually, a written report prepared by the
person designated to administer the liquidity risk
management program that describes a review of the
program’s adequacy and effectiveness, including, if
2
Investment Management Update
October 2016
applicable, the operation of the highly liquid investment
minimum and any material changes to the program.
minimis amount of cash, and that publishes its portfolio
holdings daily.*
A fund’s liquidity risk management program will require
initial approval by the fund’s board, including a majority of
its independent members. The board may satisfy its
obligations by reviewing summaries of a fund’s liquidity risk
management program provided by the person designated
to administer the program. Material changes to a fund’s
liquidity risk management program do not need board
approval before being implemented, but must be described
in the annual report regarding the program.
The liquidity risk management program for an In-Kind ETF
should describe how the fund analyzes the ability of the ETF
to redeem in-kind in all market conditions such that it is
unlikely to suddenly fail to continue to qualify for this
exception to the classification and highly liquid investment
minimum requirements; the circumstances in which the InKind ETF may use a de minimis amount of cash to meet a
redemption; and what amount of cash would qualify as
such. As part of its policies and procedures, an In-Kind ETF
generally should also describe how the ETF will manage
and/or approve any portion of a redemption that is paid in
cash and document the ETF’s determination that such a
cash amount is de minimis.
A fund’s board of directors is not normally required to
specifically approve the fund’s highly liquid investment
minimum, although during a time in which a fund’s highly
liquid investments are below the fund’s determined
minimum level, a fund’s highly liquid investment minimum
can be changed only with board approval.
An ETF intending to rely on the exceptions to the New Rule
applicable to In-Kind ETFs must report publicly to the
Commission on Form N-CEN its designation as an In-Kind
ETF, so that there is clarity on which ETFs meet this
definition and are thus subject to the tailored liquidity risk
management program.
If a fund’s holdings of illiquid investments exceed 15% of its
net assets, the fund board must be informed of that fact
within one business day of the occurrence, with an
explanation of the extent and causes of the occurrence and
how the fund plans to bring its illiquid investments down to
or below 15% of its net assets within a reasonable period of
time.
Disclosure and Reporting Requirements
The New Rule finalizes, substantially as proposed, changes
to Form N-1A for all open-end funds, including money
market funds and ETFs. Item 11 of Form N-1A is amended
ETFs
The SEC adopted certain tailored liquidity risk management
program requirements for ETFs. In assessing, managing, and
periodically reviewing its liquidity risk, an ETF will be
required to consider certain additional factors, as
applicable, that take into account its unique operation. Like
all funds, each ETF also will be required to limit its
investments in illiquid investments to no more than 15% of
its net assets and to obtain certain board approvals
regarding the program. In-Kind ETFs will not be required to
classify their portfolio investments or comply with the
highly liquid investment minimum requirement. An In-Kind
ETF is an ETF that meets redemptions through in-kind
transfers of securities, positions, and assets other than a de
* An ETF that typically redeems in-kind may use cash to: (i)
make up any difference between the net asset value (NAV)
attributable to a creation unit and the aggregate market
value of the creation basket exchanged for the creation unit
(a “balancing amount”); (ii) correspond to uninvested cash
in the fund’s portfolio (which, to the extent that this
amount of cash equals the fund’s cash position in the
portfolio, would be an “in-kind” redemption); or (iii)
substitute for a portfolio position or asset that is not eligible
to be transferred in kind (e.g., a derivative instrument that,
pursuant to contract, is not transferrable). However, if an
In-Kind ETF were to use more than a de minimis amount of
cash (as determined in accordance with its written policies
and procedures) to meet redemptions (for any of the
reasons discussed above or otherwise), it would not qualify
as an In-Kind ETF and would need to comply with the
liquidity risk management program requirements applicable
to other ETFs.
3
Investment Management Update
October 2016
to require a fund to describe its redemption procedures
including, in particular, the number of days in which a fund
expects to pay redemption proceeds following a request,
the methods typically used to meet redemption requests
(e.g., check, wire, ACH), and whether the methods used are
dependent upon market conditions (i.e., whether they are
used “typically” or only in stressed market conditions). If
the method used differs based on market conditions, then
the disclosure must describe the market conditions under
which each method is used. So, too, if the typical number of
days to meet a redemption request differs based on the
method used, a fund must disclose the number of days, or
an estimate showing a range of days, for each possible
method. It is important to note that the focus of this
disclosure is the estimated time it takes a fund to pay
redemption proceeds and not the number of days it may
take for a shareholder to receive such proceeds. To the
extent a fund reserves the right to redeem shares in kind,
Form N-1A has been further amended to require that a fund
disclose this and describe its procedures for processing
redemptions in kind.
Additionally, the New Rule imposes further reporting
requirements on funds:
•
•
Swing Pricing
On October 13, 2016 the SEC also announced a final rule
permitting open-end funds, other than money market funds
and ETFs, to engage in “swing pricing” (Swing Rule). Swing
pricing involves adjusting a fund’s net asset value (NAV) per
share upward for purchasing shareholders and downward
for redeeming shareholders. The difference between the
swing price and the fund’s NAV per share would be used to
mitigate the dilution of existing shareholders resulting from
the transaction-related costs incurred by a fund from
investing additional proceeds received from share purchase
orders or selling portfolio assets to meet redemptions. If
using swing pricing, a fund would adjust its NAV per share
by a specified “swing factor” once the level of net purchases
into or net redemptions from the fund exceeds a certain
threshold. Board approval of swing pricing policies and
procedures and disclosure in the fund’s registration
statement of the upper limit for the swing factor are
required. The Swing Rule requires boards to review periodic
written reports, no less frequently than annually, reviewing
the effectiveness of these swing pricing procedures. If a
fund adopts swing pricing, the fund needs to provide
disclosure to shareholders, including a description of swing
pricing, the upper limit the fund has set on the swing factor,
whether the fund engaged in swing pricing during a given
reporting period, the general effects of using swing pricing
on the fund’s NAV, and the circumstances under which
swing pricing would be used.
The SEC did not adopt further changes to Form N-1A,
proposed by commenters, that would have required
additional disclosure about the details of a fund’s liquidity
management program. The adopting release, however,
noted that there is nothing in Form N-1A prohibiting a
registrant from providing such disclosure to the extent it is
“relevant to understanding disclosures under existing
reporting requirements.”
The New Rule also requires that a fund report to the SEC
when certain significant events related to the fund’s
liquidity occur. This information will be reported on new
Form N-LIQUID, and will be non-public. A fund is required to
report on Form N-LIQUID when:
•
•
•
Funds must report the total percentage of their net
assets representing each of the portfolio asset
categories and other information regarding positionlevel liquidity on a confidential basis on Form N-PORT;
and
Funds must disclose information regarding their use of
lines of credit and inter-fund borrowing and lending on
Form N-CEN.
More than 15% of its net assets are deemed to be
illiquid investments; or
More than 15% of its net investments are deemed
illiquid investments, but subsequently, have changed
such that the fund’s total illiquid investments are now
less than 15%; or
It falls below its highly liquid investment minimum for
more than seven consecutive calendar days.
Compliance Dates
The compliance dates for the liquidity risk management
program requirement and the additional liquidity-related
reporting requirements of Form N-PORT and Form N-CEN
4
Investment Management Update
October 2016
are December 1, 2018 for larger entities (fund families with
assets of $1 billion or more) and June 1, 2019 for smaller
entities (fund families with less than $1 billion in net
assets). The compliance date for the changes for Form N-1A
is June 1, 2017.
The swing pricing rules become effective, and funds may
begin using swing pricing, on October 13, 2018. The delayed
effective date, as stated in the final rule release, is intended
to allow for the creation of industry-wide operational
solutions which may more effectively facilitate the adoption
of swing pricing.
FOR MORE INFORMATION
For more information, please contact:
Tanya L. Goins
404.541.2954
[email protected]
Emily M. Little
614.469.3264
[email protected]
Donald S. Mendelsohn
513.352.6546
[email protected]
Andrew J. Davalla
614.469.3353
[email protected]
***
This advisory bulletin may be reproduced, in whole or in
part, with the prior permission of Thompson Hine LLP and
acknowledgment of its source and copyright. This
publication is intended to inform clients about legal matters
of current interest. It is not intended as legal advice.
Readers should not act upon the information contained in it
without professional counsel.
This document may be considered attorney advertising in
some jurisdictions.
© 2016 THOMPSON HINE LLP. ALL RIGHTS RESERVED.
5