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From Securities Regulation Daily, January 11, 2018

IM division issues FAQs on investment company liquidity risk management programs

By Amy Leisinger, J.D.

The SEC’s Division of Investment Management has released guidance on the SEC's new fund liquidity risk management (LRM) rule for certain types of funds. Specifically, the guidance responds to questions on the program requirements regarding administration and investment classification by sub-advised funds and the de minimis cash redemption exception for in-kind exchange-traded funds.

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.

Sub-advised funds. In the guidance, the division noted that a program administrator could delegate specific responsibilities to a sub-adviser under the fund’s LRM program, including providing liquidity classifications for the fund’s investments, but that the fund itself will retain ultimate responsibility for compliance with Rule 22e-4. According to the guidance, an adviser or sub-adviser does not have an independent obligation to adopt and implement an LRM program, but the entity may have responsibilities under multiple fund LRM programs that differ from one another without reconciling varying elements of the separate programs.

In addition, the guidance notes that different funds (even those within the same fund complex) may classify the liquidity of similar investments differently based on unique facts and circumstances and appropriately arrive at different classifications for the same instrument. Similarly, multiple sub-advisers may have differing views regarding the appropriate liquidity category for investments and manage separate "sleeves" of a fund autonomously, which could appropriately result in the application of different classifications guided by differing assumptions and methodologies. If such classification differences were to arise, the guidance explains, there is no obligation to resolve the differences in monitoring for compliance with the fund’s highly liquid investment minimum (if applicable) and the 15-percent limit on illiquid investments. However, a fund must reconcile such classification differences for purposes of reporting on Form N-PORT and may use any reasonable method to do so, so long as the fund applies the method consistently, according to the guidance.

ETFs. To qualify for the "in-kind ETF" exception, an ETF may not use more than a de minimis amount of cash to meet redemptions, and, according to the guidance, to the extent the amount of cash in a redemption equals the fund’s cash position in the portfolio, the redemption is "in-kind" and is not considered "cash" subject to the de minimis amount. As such, the guidance notes that an ETF may exclude cash in redemption proceeds that is proportionate to the ETF’s uninvested portfolio cash for testing compliance with its de minimis amount.

Defining what constitutes a de minimis amount of cash is a determination left to each ETF, but the guidance notes that it would be reasonable for an in-kind ETF to determine that, if the percentage of its overall redemption proceeds paid in cash does not exceed five percent, the use would be de minimis. Cash use of more than five percent could qualify as de minimis under certain facts and circumstances, the guidance continues, but overall redemption proceeds paid in cash exceeding 10 percent would be unreasonable. A redemption transaction consisting entirely of cash does not necessarily preclude an ETF from qualifying as an in-kind ETF so long as such a redemption transaction as a proportion of the ETF’s aggregate redemption transactions does not exceed the de minimis amount of cash, the guidance states. According to the guidance, a reasonable approach to determining whether cash use is de minimis may include: (1) testing each individual redemption transaction; or (2) testing redemption transactions in their totality over a reasonable period of time to ensure that, on average, aggregate transactions involve no more than a de minimis cash amount.

The guidance also notes that a fund that has lost its status as an in-kind ETF could potentially avail itself of the exception again if it reasonably determines that the event causing the loss was an extraordinary event unlikely to occur again. An ETF’s backward-looking redemption history is relevant in determining qualification as an in-kind ETF, but the analysis may also have a forward-looking component with regard to expected redemption practices in the case of a new ETF, the guidance concludes.

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