As larger mutual fund groups plan for their December 1, 2018 compliance date under the SEC’s Fund Liquidity Rule,[1] what major judgment calls must they be prepared to answer for fund directors?  Here is a non-exhaustive list and the quick reference guide:

Do we need a HLIM?
This is a fund-by-fund decision within each complex.  Unless a fund “primarily” holds investments that are deemed “highly liquid,” or is an “in-kind ETF,” the rule requires the fund to determine a highly liquid investment minimum (HLIM).   “Primarily” is a term of art - - or regulatory negotiation - - which has traditionally meant about 65% for prospectus disclosure purposes but may mean something more like 50+% for liquidity purposes (given that the Rule also imposes a 15% cap on illiquid securities).

Fortunately, historical data on widely traded asset classes, including (at least) most equities and investment grade bonds, may permit many funds to consider themselves primarily highly liquid.  For other asset classes, such as high yield bonds, small cap equities or small bond issues, a more granular analysis of the fund’s likely investment strategy and data for the associated securities may be needed. 

What is an appropriate HLIM for a fund that needs one?
Excellent question.  Next.

More seriously, fund managers are examining historical shareholder redemption demands under normal and foreseeably stressed conditions, as contemplated by the rule, to estimate peak liquidity demands. The concern for both portfolio managers and investors is that holding cash or highly liquid bonds (e.g. US Treasuries) even in amounts in the range of 5-10% may put a drag on performance compared to unregistered products – or more aggressive fund competitors - - which invest in the same asset classes.  In such cases, the rule could actually change the nature of the product.  This issue may benefit from further regulatory guidance.

How should we source liquidity classification data?
Many groups, even some with very substantial internal capabilities, indicate that they are opting to outsource this data to vendors who have responded to this new opportunity.  The use of independent vendors is very similar to the way securities pricing is handled, and makes sense for many of the same reasons.  In particular, the choice of a widely recognized vendor may make the fund’s independent directors, and regulators, more comfortable that the data is free of the appearance of managerial bias. (It also poses the risk that the industry’s reporting will be very standardized.) That being said, the rule does not require the use of third-party providers, and there is no reason that fund groups could not establish protocols assuring the quality and independence of in-house classifications.

For subadvised and multi-manager funds, should the fund’s or the subadviser(s)’ liquidity assessments govern?
The SEC’s pending amendments to the Rule, if adopted, will provide some welcome flexibility to funds with these more complex structures.  Specifically, where the Board chooses to adopt the subadvisers’ view of the investments under their management, and different subadvisers classify the same security differently, the fund would have the flexibility to report that security in different liquidity categories or “buckets” on Form N-PORT.  In addition, the fund may delegate other program responsibilities.[2]  This does not, however, relieve the fund’s overall compliance responsibility, including for example the  15% illiquid securities cap or HLIM, if applicable.  As the SEC staff noted in prior FAQ guidance, “the fund at all times retains ultimate responsibility for complying with the rule.”[3]

Must we move to daily liquidity monitoring?
For two aspects of the rule, monthly review is not going to do the trick:  any breach of the 15% cap on illiquid securities must be reported to the Fund’s board within one business day; and, for HLIM funds, any shortfall of the HLIM in excess of seven days must be reported to the board.    Individual funds that can demonstrate that they never come close to either limit may be able to avoid daily monitoring, but obviously fund groups covering a wide range of asset classes are more likely to need a daily process.

For ETFs, which compliance regime fits best?
The Rule applies to ETFs, but “In-Kind ETFs” were exempted from the investment classification and HLIM portions of the rule.  The idea is that ETFs that may require their institutional counterparties (who are almost invariably large brokerage firms) to accept securities rather than cash in redemptions, do not need to liquidate securities and therefore have little liquidity risk of their own. However, the definition of In-Kind ETF was seen to impose a separate set of regulatory requirements, in particular concerning the requirement that in-kind redemptions may not include more than a de minimus percentage of cash.[4]  The SEC staff subsequently issued guidance that, among other things, gave comfort that a fund board could reasonably consider a cash figure under 5% as de minimus.  Nevertheless, some fund groups that manage both ETFs and open-end mutual funds may find it more efficient to apply their liquidity programs across the board.

Are further changes or guidance likely forthcoming?
Yes, but there has been no indication that major changes are in the offing.

At the very least, the SEC will issue a release adopting or modifying the reporting-related amendments it proposed, somewhat controversially, in March 2018.  In the context of that amendment, many industry commenters have asked the SEC to revise its four-part classification scheme, colloquially known as “buckets.”  A change of buckets would be quite significant, but please note that these suggestions went somewhat beyond the topics on which the SEC requested comment.

History also suggests that the agency continues to approach the Rule with some flexibility around the edges. The agency has already issued two guidance releases, and twice tweaked some compliance deadlines, although not the large-group program compliance date of December 1, 2018.  None of these actions has, however, hinted at a significant change in overall direction.  Perhaps as important, the industry has remained committed to working with the SEC as its primary regulator on this subject.   

[1] Investment Company Liquidity Risk Management Programs, SEC Release 33- 10233; IC- 32315 (October 13, 2016) (adopting rule); 17 CFR 270.22e-4 (“Rule 22e-4”).  Please see the accompanying Summary for key terms, rule requirements and compliance dates.

[2] SEC Release No. IC-33046 (March 14, 2018) (proposing amendments).

[3] Investment Company Liquidity Risk Management Programs Frequently Asked Questions, as revised, January 10 2018.

[4] Id.