On May 5, 2023, the Securities and Exchange Commission (the “SEC”) announced its first enforcement action against an investment adviser for violations of Rule 22e-4(b) (the “Liquidity Rule”) of the Investment Company Act of 1940.[i] The complaint charged a New York-based investment advisory firm (the “Advisor”) and several officers and trustees, with allegedly aiding and abetting a mutual fund it advised (the “Fund”) in holding more than 15% of the Fund’s investment portfolio in illiquid assets in violation of the Liquidity Rule.
Overview of the Liquidity Rule
The Liquidity Rule, adopted in 2016, requires mutual funds to establish a written management program to manage liquidity risk.[ii] A risk management program must classify the liquidity of a fund’s portfolio investments as “highly liquid,” “moderately liquid,” “less liquid,” or “illiquid,” depending on the amount of calendar days a fund may be able to sell the asset without a significant change in its market value.[iii]
The Liquidity Rule requires mutual funds to review liquidity classifications on a monthly basis and prohibits funds from investing more than 15% of their net assets in “illiquid” investments in an effort to ensure that investment firms have sufficient liquidity to meet investor requests, particularly during times of market stress.[iv] If a fund exceeds the 15% limit, its administrators must report to the fund’s board of directors with an explanation for the excess and a plan for bringing illiquid investments back to below-limit levels.[v] The fund must also make a filing with the SEC to report the occurrence.[vi]
Summary of the Case
The SEC’s investigation revealed several alleged violations of the Liquidity Rule primarily relating to inadequate management of liquidity risks, failure to maintain required liquidity buffers, and misleading disclosures about the Advisor’s liquidity management practices with respect to the Fund. The Fund held approximately 21% to 26% of its net assets in restricted shares of a medical device company between June 2019 and June 2020, but allegedly failed to comply with applicable reporting requirements. The Fund also failed to bring its position in the shares under the 15% threshold.[vii]
The SEC not only imposed fines on the Advisor, but also pursued individual liability against certain officers and trustees of the Advisory that administered the Fund’s risk management program. The Advisor and its key personnel allegedly aided and abetted the Fund’s violations by classifying the Fund’s largest allegedly illiquid investment as “less liquid” investments, even though the shares were not registered and were subject to transfer restrictions.[viii] In addition, the Advisor classified the shares as “less liquid” investments against the advice of the Fund’s counsel. They also failed to disclose the relevant transfer restrictions to the SEC, allegedly misleading the SEC with respect to the basis for the “less liquid” classification.[ix]
Although the Liquidity Rule permits some flexibility when a fund exceeds the 15% limit, the SEC alleges that the Advisor and the Fund did not take the required steps to remedy its violation of the limit by reporting the situation to its board with a plan to lower the level of the Fund’s illiquid investments.[x]
The charges against the Advisor signal that the SEC is focused on not only technical compliance with the Liquidity Rule, but also how an investment adviser and fund handle illiquid investment circumstances under the Liquidity Rule. The SEC’s focus on the individual officers and trustees of the Advisor and the Fund further demonstrates that the individuals who administer liquidity risk management programs for mutual funds will be subject to higher scrutiny.[xi]
This heightened focus on liquidity classification comes at roughly the same time as a November 2022 proposed amendment to the Liquidity Rule that would require mutual funds to categorize “less liquid” securities as illiquid, further demonstrating that such classifications are a current priority for the SEC.[xii]
Accordingly, investment advisers will need to take greater care with how they categorize portfolio investments within the bounds of the Liquidity Rule to ensure compliance with portfolio limitations on illiquid investments. In gray areas between “illiquid” and “less liquid” investments, erring on the side of caution by classifying investments as “illiquid” may decrease the risk of compliance deficiency.
[i] See, SEC, Press Release, SEC Charges Investment Adviser and Fund Trustees with Liquidity Rule Violations (May 5, 2023), https://www.sec.gov/news/press-release/2023- (90#:~:text=The%20action%20is%20the%20first,requires%20funds%20to%20adopt%20a; SEC v. Pinnacle Advisors, LLC, 5:23-cv-547 (FJS/ATB) (May 5, 2023), https://www.sec.gov/litigation/complaints/2023/comp-pr2023-90.pdf (hereinafter, “Complaint”).
[ix] Complaint at 10, 16.