An investment company’s Liquidity Risk Management Program (“LRMP”) must be designed to meet the requirements of Rule 22e-4 of the Investment Company Act of 1940 (the “Liquidity Rule”) and the liquidity-related reporting requirements of Rule 30b1-10 and Form N-LIQUID. Adopted in October 2016, the Liquidity Rule requires a Fund to assess, manage, and periodically review its liquidity risk. Due to the complexity of the rule and the need to develop for new technology, the compliance date for these provisions was extended to June 1, 2019, for larger entities (defined as over $1 billion in total net assets), and December 1, 2019, for smaller entities (under $1 billion in total net assets). Regardless of their asset size, Funds should have already implemented the following three components of their LRMP:
- Appointment of a LRMP Administrator(s)
Funds are required to have appointed an individual or group of individuals responsible for the administration of the LRMP (the “LRMP Administrator”). Most Foreside clients have selected a “Liquidity Committee” whose responsibility is to review and assess the liquidity risk of each Fund. Assessing liquidity risk includes discussing liquidity and trading with portfolio managers and traders, performing liquidity assessments of securities in each portfolio, and reporting to the Board, at least annually.
- Liquidity Classifications
Each Committee, using information obtained after reasonable inquiry and taking into account relevant market, trading, and investment-specific considerations, must classify the liquidity of each portfolio investment into one of four classification categories:
- Highly Liquid: an investment that the Fund reasonably expects to convert into cash within three business days or less
- Moderately Liquid: an investment that the Fund expects to convert into cash in more than three calendar days, but less than seven calendar days.
- Less Liquid: an investment that the Fund expects to convert into cash in seven calendar days or less, but where the sale is expected to settle in more than seven calendar days.
- Illiquid: an investment that a Fund expects cannot be sold or disposed of in seven calendar days or less without the sale or disposition significantly changing the investment’s market value.
To assist Liquidity Committees in making these classifications, third-party service providers such as Intercontinental Exchange (ICE) Data Services and Bloomberg Valuation can provide preliminary liquidity classifications based on trade size and market impact parameters provided to the vendor by the Committee specific to each Fund or security type.
- Determination of a Highly Liquid Investment Minimum (“HLIM”)
Funds should have also made a determination whether the Fund primarily holds assets that are highly liquid investments and have adopted a highly liquid investment minimum. This requirement is for a Fund to determine the minimum percentage of its net assets that must be invested in highly liquid investments, defined as cash or investments that are reasonably expected to be converted to cash within three business days without significantly changing the market value of the investment.
Once the Funds have established their LRMP criteria discussed above, they are required to complete on an annual basis the following two reporting and disclosure requirements:
- Annual LRMP Report to the Board
- The Liquidity Rule requires the LRMP Administrator to provide an annual report to the Fund Board on the adequacy of the LRMP and the effectiveness of its implementation, including any material changes to the LRMP; and
- The oversight of the LRMP, its adequacy and the effectiveness of its implementation, including the operation of the highly liquid investment minimum for each Fund (if applicable), and any material changes to the LRMP, including the adoption of or changes made to a Fund’s HLIM.
- Disclosure to shareholders regarding the implementation of the LRMP to be included in a Fund’s next annual or semi-annual report
- The disclosure is included as a separate section, similar to the discussion of board approval of the advisory contracts.
- The disclosure also discusses operational effectiveness of the Fund’s LRMP over the past fiscal or calendar year. The discussion can be tailored to the Fund’s specific liquidity risks identified in the liquidity assessment and give a narrative description of these risks and how they are managed. The discussion may, but is not required to include the classification process, shareholder redemption subscription history, and the HLIM determination in the Fund’s liquidity risk management process.
- The Fund may opt to include specific liquidity risks that it faced over the past year, such as significant redemptions, changes in the overall market liquidity of the investments the Fund holds, and how those risks were managed.
The purpose of the Liquidity Rule was to provide shareholders information regarding how liquidity in their open-end funds is managed, thereby reducing the risk that funds will be unable to meet redemption or other legal obligations. These reforms also were intended to give investors better information to make investment decisions and to give the Securities and Exchange Commission more detailed information to conduct comprehensive monitoring and oversight of an ever-evolving investment company industry.
Foreside continues to work with our clients in the development of their LRMP and related disclosures to boards and shareholders. Contact us to learn more.