Friday, February 23, 2018

SEC extends compliance date for open-end fund liquidity classification

By Anne Sherry, J.D.

The SEC added six months to the deadline by which open-end funds must comply with classification-related elements of the liquidity risk management program rule. The new compliance dates are June 1, 2019, for larger fund groups, and December 1, 2019, for smaller fund groups. The other requirements of the liquidity rule will hew to the original schedule of December 1, 2018, and June 1, 2019, for larger and smaller groups, respectively. Staff in the Division of Investment Management also issued an additional set of FAQs to address questions that have arisen with respect to liquidity classification (Release No. IC-33010, February 22, 2018).

Liquidity risk management. In October 2016, the Commission approved Rule 22e-4 to require open-end management investment companies to adopt LRM programs that include classifications of the liquidity of portfolio assets and to conduct periodic evaluations of liquidity risk. The final rule provides four liquidity time-frame categories and requires reporting of the percentage of each classification on a quarterly basis. The changes require enhanced disclosure regarding fund liquidity and redemption practices, and funds must periodically review whether assets have become illiquid over time. The rule excludes money market funds from all requirements and ETFs that qualify as "in-kind ETFs" from certain requirements.

FAQs. Investment Management’s work on the FAQs adds 19 questions to the 15 that were issued last month. The new guidance addresses asset class liquidity classification; reasonably anticipated trading size; price impact standard; classifying investments in pooled investment vehicles; professional investment classification and compliance monitoring; timing and frequency of classification; pre-trade activity and the 15 percent illiquid investment limit; related reporting requirements; and ETF investment classification.

For example, the staff recognized that highly sensitive exception methodologies for funds using an asset class method of investment classification may result in too many false positives, undermining the balance the Commission sought in permitting class-based classification. Funds should include in their policies and procedures a reasonable framework for identifying exceptions, which may rely on automated processes. The fund need not justify every classification on a CUSIP-by-CUSIP basis, and potential exceptions are not necessarily required to be reclassified.

In determining reasonably anticipated trading sizes for portfolio investments and asset classes, a fund need not predict which specific portfolio positions it will sell or consider actual trades executed for reasons other than meeting redemptions, nor does it need to predict its future portfolio management decisions relating to meeting redemptions. As to the price impact standard, funds retain the flexibility to establish the meaning of what constitutes a “significant change in market value” in their policies and procedures. This includes the flexibility to use a fixed number or use different standards for different investments or asset classes.

The rule does not specify when a fund must make the initial classification of a newly acquired investment, but requires at least monthly reviews of classification status. Investment Management staff would not object if a fund waits until its next regularly scheduled monthly classification to classify a newly acquired investment or consider an investment for reclassification. Moreover, funds are required under the rule to conduct intra-month reviews of an investment’s liquidity classification when a fund becomes aware of changes in relevant market, trading and investment-specific considerations that are reasonably expected to materially affect an existing classification of that particular investment. The staff does not see this as a de facto ongoing review requirement and would not object if a fund complied by identifying in its policies and procedures events that it reasonably expects would materially affect an investment’s classification.

A fund is not required to classify an investment or conduct related compliance monitoring before acquiring that investment. For purposes of the 15 percent illiquid investment limit, a reasonable method of compliance with respect to acquisitions would be to preliminarily identify asset classes or investments the fund reasonably believes are likely to be illiquid. The staff believes funds could automate such a preliminary evaluation of asset classes or investments, and they could base that evaluation on the general characteristics of the investments the fund purchases. While it would not be reasonable to assume a fund is only selling a single trading lot, the fund could use any reasonable method to evaluate the market depth of the asset classes or investments it preliminarily identifies as likely being illiquid.

This is Release No. IC-33010.