SEC Adopts Rule Requiring Liquidity Risk Management Programs for Funds

Investment Management Update

Date: October 24, 2016

On October 13, 2016, the Securities and Exchange Commission (SEC or Commission) announced a final rule that requires open-end mutual funds (excluding money market funds) and exchange-traded funds (ETFs) to adopt liquidity risk management programs. Under new rule 22e-4 (New Rule) of the Investment Company Act of 1940, as amended (1940 Act), a fund is required to develop a risk management program that is designed to assess and manage the fund’s liquidity risk (the risk that a fund could not meet requests to redeem shares issued by the fund without significant dilution of remaining investors’ interests in the fund). For ETFs, the New Rule incorporates tailored program requirements to reflect the particular liquidity-related risks of ETFs. Additionally, the SEC announced amendments to rule 22c-1 of the 1940 Act that give funds the option to adopt “swing pricing,” a liquidity management tool, whereby transacting shareholders would bear the costs associated with fund transactions made in connection with their purchases or sales of fund shares.

Portfolio Assets Classifications

The New Rule requires a fund (other than an In-Kind ETF, defined below) to classify its portfolio of investments into four liquidity categories. In each case, the determination is based on the fund’s reasonable expectation that a sale of the asset can be effected, in current market conditions, without the sale significantly changing the market value of the investment prior to the sale. The four categories are:

  • Highly liquid investments – cash and any investment reasonably expected to be convertible to cash (meaning the ability to be sold, with the sale settled) in three business days or less.
  • Moderately liquid investments – any investment reasonably expected to be convertible to cash in more than three calendar days but in seven calendar days or less.
  • Less liquid investments – any investment reasonably expected to be sold or disposed of in seven calendar days or less, where the sale or disposition is reasonably expected to settle in more than seven calendar days.
  • Illiquid investments – any investment that may not reasonably be expected to be sold or disposed of in seven calendar days or less.

Classifications of a fund’s portfolio assets will be reported on Form N-PORT.

The New Rule requires a fund to take into account relevant “market, trading, and investment-specific considerations” in classifying its portfolio investments’ liquidity. The fund also must consider the investment’s market depth in classifying the investment (determining the extent to which trading varying portions of a position in a particular portfolio investment, in sizes that the fund would reasonably anticipate trading, is reasonably expected to significantly affect the liquidity characteristics of that investment). For derivatives transactions that a fund has classified as moderately liquid investments, less liquid investments, and illiquid investments, the fund must identify the percentage of its highly liquid investments that is segregated to cover, or pledged to satisfy margin requirements in connection with, derivatives transactions in each of these classification categories and disclose these percentages on its Form N-PORT filings. The fund also must review its portfolio investments’ classifications at least monthly and more frequently if changes in relevant market, trading, and investment-specific considerations are reasonably expected to materially affect one or more of its investments’ classifications. Finally, the fund must take into account certain considerations for highly liquid investments that it has segregated to cover certain derivatives transactions.

Limitation on Funds’ Illiquid Investments

The New Rule reaffirms the SEC’s position that illiquid assets are limited to 15% of a fund’s assets. However, to the extent a fund is not currently taking into account market, trading, and investment-specific considerations or market depth when assessing the illiquidity of its investments, the new regulatory requirements regarding the process for determining that certain investments are illiquid under the New Rule are likely to result in the fund determining that a greater percentage of its holdings are illiquid than under the SEC’s existing guidelines.

Assessment and Periodic Review of Liquidity Risk

A fund is required to assess, manage, and periodically review its liquidity risk based on a minimum set of factors (a fund may take into account additional factors). To the extent any liquidity risk factor specified in the New Rule is not applicable to a particular fund, the fund will not be required to consider it in assessing and managing its liquidity risk. The minimum factors to consider in determining a fund’s liquidity risk are, as applicable:

  • Investment strategy and liquidity of portfolio investments during both normal and reasonably foreseeable stressed conditions, including whether the investment strategy is appropriate for an open-end fund, the extent to which the strategy involves a relatively concentrated portfolio or large positions in particular issuers (which can reduce liquidity), and the use of borrowings for investment purposes and derivatives (including derivatives used for hedging purposes); and
  • Short-term and long-term cash flow projections during both normal and reasonably foreseeable stressed conditions; and
  • Holdings of cash and cash equivalents, as well as borrowing arrangements and other funding sources.
Highly Liquid Investment Minimum

Using the liquidity risk factors listed above, a fund will also be required to establish a highly liquid investment minimum (or, the minimum amount of the fund’s net assets that the fund invests in highly liquid investments that are assets with positive values). A fund will be able to determine its own highly liquid investment minimum, as well as (within a fairly broad range) the assets it will hold to satisfy its minimum. The New Rule does not specify how a shortfall in a fund’s highly liquid investment minimum is to be addressed, but instead provides general guidance directing a fund’s board of directors to adopt and implement policies and procedures for responding to a shortfall in a fund’s highly liquid investments. These policies and procedures must include reporting to the fund’s board of directors, no later than the board’s next regularly scheduled meeting, regarding any shortfall of the fund’s highly liquid investments compared to its minimum. A fund is required to report to its board within one business day, and submit a non-public report to the Commission, if its highly liquid investment minimum shortfall lasts more than seven consecutive calendar days. The report to the board should also include an explanation of how the fund plans to restore its minimum within a reasonable period of time. A fund must periodically review, no less frequently than annually, the fund’s highly liquid investment minimum. These requirements regarding highly liquid investment minimums are not applicable to In-Kind ETFs (defined below) and funds whose portfolio assets consist primarily of highly liquid investments.

Board Approval and Review

Under the New Rule, the board is responsible for approving the fund’s liquidity risk management program, which provides the framework for evaluating the liquidity of the fund’s investments, and approving the investment adviser personnel, officer, or officers who are responsible for administering the program. In addition, similar to rule 38a?1, the board will be required to review, no less frequently than annually, a written report prepared by the person designated to administer the liquidity risk management program that describes a review of the program’s adequacy and effectiveness, including, if applicable, the operation of the highly liquid investment minimum and any material changes to the program.

A fund’s liquidity risk management program will require initial approval by the fund’s board, including a majority of its independent members. The board may satisfy its obligations by reviewing summaries of a fund’s liquidity risk management program provided by the person designated to administer the program. Material changes to a fund’s liquidity risk management program do not need board approval before being implemented, but must be described in the annual report regarding the program.

A fund’s board of directors is not normally required to specifically approve the fund’s highly liquid investment minimum, although during a time in which a fund’s highly liquid investments are below the fund’s determined minimum level, a fund’s highly liquid investment minimum can be changed only with board approval.

If a fund’s holdings of illiquid investments exceed 15% of its net assets, the fund board must be informed of that fact within one business day of the occurrence, with an explanation of the extent and causes of the occurrence and how the fund plans to bring its illiquid investments down to or below 15% of its net assets within a reasonable period of time.


The SEC adopted certain tailored liquidity risk management program requirements for ETFs. In assessing, managing, and periodically reviewing its liquidity risk, an ETF will be required to consider certain additional factors, as applicable, that take into account its unique operation. Like all funds, each ETF also will be required to limit its investments in illiquid investments to no more than 15% of its net assets and to obtain certain board approvals regarding the program. In-Kind ETFs will not be required to classify their portfolio investments or comply with the highly liquid investment minimum requirement. An In-Kind ETF is an ETF that meets redemptions through in-kind transfers of securities, positions, and assets other than a de minimis amount of cash, and that publishes its portfolio holdings daily.[1]

The liquidity risk management program for an In-Kind ETF should describe how the fund analyzes the ability of the ETF to redeem in-kind in all market conditions such that it is unlikely to suddenly fail to continue to qualify for this exception to the classification and highly liquid investment minimum requirements; the circumstances in which the In-Kind ETF may use a de minimis amount of cash to meet a redemption; and what amount of cash would qualify as such. As part of its policies and procedures, an In-Kind ETF generally should also describe how the ETF will manage and/or approve any portion of a redemption that is paid in cash and document the ETF’s determination that such a cash amount is de minimis.

An ETF intending to rely on the exceptions to the New Rule applicable to In-Kind ETFs must report publicly to the Commission on Form N-CEN its designation as an In-Kind ETF, so that there is clarity on which ETFs meet this definition and are thus subject to the tailored liquidity risk management program.

Disclosure and Reporting Requirements

The New Rule finalizes, substantially as proposed, changes to Form N-1A for all open-end funds, including money market funds and ETFs. Item 11 of Form N-1A is amended to require a fund to describe its redemption procedures including, in particular, the number of days in which a fund expects to pay redemption proceeds following a request, the methods typically used to meet redemption requests (e.g., check, wire, ACH), and whether the methods used are dependent upon market conditions (i.e., whether they are used “typically” or only in stressed market conditions). If the method used differs based on market conditions, then the disclosure must describe the market conditions under which each method is used. So, too, if the typical number of days to meet a redemption request differs based on the method used, a fund must disclose the number of days, or an estimate showing a range of days, for each possible method. It is important to note that the focus of this disclosure is the estimated time it takes a fund to pay redemption proceeds and not the number of days it may take for a shareholder to receive such proceeds. To the extent a fund reserves the right to redeem shares in kind, Form N-1A has been further amended to require that a fund disclose this and describe its procedures for processing redemptions in kind.

The SEC did not adopt further changes to Form N-1A, proposed by commenters, that would have required additional disclosure about the details of a fund’s liquidity management program. The adopting release, however, noted that there is nothing in Form N-1A prohibiting a registrant from providing such disclosure to the extent it is “relevant to understanding disclosures under existing reporting requirements.”

The New Rule also requires that a fund report to the SEC when certain significant events related to the fund’s liquidity occur. This information will be reported on new Form N-LIQUID, and will be non-public. A fund is required to report on Form N-LIQUID when:

  • More than 15% of its net assets are deemed to be illiquid investments; or
  • More than 15% of its net investments are deemed illiquid investments, but subsequently, have changed such that the fund’s total illiquid investments are now less than 15%; or
  • It falls below its highly liquid investment minimum for more than seven consecutive calendar days.

Additionally, the New Rule imposes further reporting requirements on funds:

  • Funds must report the total percentage of their net assets representing each of the portfolio asset categories and other information regarding position-level liquidity on a confidential basis on Form N-PORT; and
  • Funds must disclose information regarding their use of lines of credit and inter-fund borrowing and lending on Form N-CEN.
Swing Pricing

On October 13, 2016 the SEC also announced a final rule permitting open-end funds, other than money market funds and ETFs, to engage in “swing pricing” (Swing Rule). Swing pricing involves adjusting a fund’s net asset value (NAV) per share upward for purchasing shareholders and downward for redeeming shareholders. The difference between the swing price and the fund’s NAV per share would be used to mitigate the dilution of existing shareholders resulting from the transaction-related costs incurred by a fund from investing additional proceeds received from share purchase orders or selling portfolio assets to meet redemptions. If using swing pricing, a fund would adjust its NAV per share by a specified “swing factor” once the level of net purchases into or net redemptions from the fund exceeds a certain threshold. Board approval of swing pricing policies and procedures and disclosure in the fund’s registration statement of the upper limit for the swing factor are required. The Swing Rule requires boards to review periodic written reports, no less frequently than annually, reviewing the effectiveness of these swing pricing procedures. If a fund adopts swing pricing, the fund needs to provide disclosure to shareholders, including a description of swing pricing, the upper limit the fund has set on the swing factor, whether the fund engaged in swing pricing during a given reporting period, the general effects of using swing pricing on the fund’s NAV, and the circumstances under which swing pricing would be used.

Compliance Dates

The compliance dates for the liquidity risk management program requirement and the additional liquidity-related reporting requirements of Form N-PORT and Form N-CEN are December 1, 2018 for larger entities (fund families with assets of $1 billion or more) and June 1, 2019 for smaller entities (fund families with less than $1 billion in net assets). The compliance date for the changes for Form N-1A is June 1, 2017.

The swing pricing rules become effective, and funds may begin using swing pricing, on October 13, 2018. The delayed effective date, as stated in the final rule release, is intended to allow for the creation of industry-wide operational solutions which may more effectively facilitate the adoption of swing pricing.


For more information, please contact:

Tanya L. Goins

Emily M. Little

Donald S. Mendelsohn

Andrew J. Davalla


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[1] An ETF that typically redeems in-kind may use cash to: (i) make up any difference between the net asset value (NAV) attributable to a creation unit and the aggregate market value of the creation basket exchanged for the creation unit (a “balancing amount”); (ii) correspond to uninvested cash in the fund’s portfolio (which, to the extent that this amount of cash equals the fund’s cash position in the portfolio, would be an “in-kind” redemption); or (iii) substitute for a portfolio position or asset that is not eligible to be transferred in kind (e.g., a derivative instrument that, pursuant to contract, is not transferrable). However, if an In-Kind ETF were to use more than a de minimis amount of cash (as determined in accordance with its written policies and procedures) to meet redemptions (for any of the reasons discussed above or otherwise), it would not qualify as an In-Kind ETF and would need to comply with the liquidity risk management program requirements applicable to other ETFs.