Investment Company Act | Liquidity | Mutual Funds

SEC Requires Mutual Funds to Adopt Liquidity Risk Management Programs

The SEC adopted new mutual fund liquidity Rule 22e-4 (the “Rule”) under the Investment Company Act of 1940 on October 13, 2016, in a decision that has been considered by many to be the most significant fund-related regulation since the Rule 38a-1 compliance program rule’s adoption in 2003. At the heart of the Rule is a requirement for open-end investment companies (except money market funds) to establish Liquidity Risk Management Programs.  “Liquidity risk” is defined in the Rule as “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.”

Given the Rule’s large scope of requirements, analysis and potential operational impacts, affected fund managers are encouraged to plan ahead of each compliance date described below.  The 459-page adopting release in particular contains helpful details that go beyond the scope of this article.  Larger entities, namely those in fund families with assets of $1 billion or more, will be required to comply by December 1, 2018.

Under the Rule, Liquidity Risk Management Programs must include written policies and procedures that address the following components:

  • Assess, manage and periodically review the fund’s liquidity risk
  • Classify fund assets into one of four liquidity risk categories or buckets
  • Establish a minimum portfolio concentration of highly liquid investments
  • Limit illiquid investments to no more than 15% of the fund’s net assets
  • Adopt in-kind redemption procedures, if applicable
  • Require oversight of the program by the fund’s board

What Funds are Subject to Rule 22e-4?

  • Open-end management investment companies
  • Open-end exchange-traded funds (ETFs)
  • Exclusions:
    • Money market funds under Rule 2a-7 of the Investment Company Act of 1940
    • Closed end funds
    • ETFs that redeem all but a de minimis amount of their shares in kind and disclose their portfolio holdings daily (in kind ETFs)
    • Unit investment trusts (UITs) are excluded from the Rule’s Liquidity Risk Management Program requirements but are required to perform a limited liquidity review under the Rule.

Note: For funds organized as part of multi-series vehicles, each series will need a Liquidity Risk Management Program tailored to its own liquidity risk.

Required Elements – Liquidity Risk Management Program

Similar in structure to Rule 38a-1, the Rule requires funds to implement written policies and procedures to address each of the required liquidity risk management program components.  It also requires the fund’s board to designate and approve an administrator (the “Administrator”) for the program, which can be the fund’s investment adviser, sub-adviser(s) or one or more fund officers.  The Rule does not allow portfolio managers to be solely responsible for administering the program.  The Administrator of the Liquidity Risk Management Program must then prepare a written report to the board at least annually, addressing the adequacy of the program, including the highly liquid investment minimum (described in more details below), and the effectiveness of its implementation.  The Administrator must also report to the board within one business day whenever the fund falls below its highly liquid investment minimum for more than seven consecutive calendar days.  The SEC must also be informed on the new Form N-LIQUID within one business day of a seven-day shortfall.  If the shortfall occurs for only a brief period of time, the Administrator must report the occurrence to the board at its next regularly scheduled meeting.

Assessing, Monitoring and Reviewing Risk

The SEC stated that the liquidity risk assessment requirement generally provides a broad, principles-based framework for a fund’s liquidity risk management program and that fund managers must consider factors including, but not limited to:

  • investment strategy and the liquidity of investments during normal and reasonably foreseeably stressed conditions (i.e., whether the strategy is appropriate for an open-end fund, to what extent the strategy involves a relatively concentrated portfolio or large positions, and the use of any borrowings for investment purposes and derivatives)
  • short- and long-term cash flow projections during both normal and reasonably foreseeably stressed conditions
  • holdings of cash and cash equivalents, as well as borrowing arrangements and other funding sources.

Fund managers are required to assess, manage, and periodically review liquidity risk at least annually, and more frequently if the nature of the investments or circumstances warrant it.

Detailed requirements related to each of the above, along with additional considerations for ETFs, are included in the Adopting Release.


Fund managers must classify each investment into one of four liquidity buckets: (1) Highly liquid, which can be converted to cash (via settled trade) within three business days, (2) moderately liquid, which can be can be converted to cash within four to seven calendar days, (3) less liquid, which can be sold or disposed of in less than seven calendar days but settlement is expected to take more than seven calendar days, and (4) illiquid, which may not reasonably expected to be disposed of in seven calendar days or less.

The Rule requires that investment classifications be reviewed at least monthly and more frequently as needed based on market conditions or other developments.  The SEC stated that the review should test whether these developments would “materially affect” one or more of a fund’s classifications.

Highly Liquid Minimum Concentration

Under the Rule, funds are required to set a minimum portfolio weight in highly liquid investments.  The SEC stated that highly liquid securities are those that the manager expects to be convertible to cash within three business days without significantly changing the market value of the investments. Funds may operate below the set minimum, provided the breach is reported promptly to the SEC on new Form N-LIQUID and to the fund’s board whenever the fund falls below the set minimum for more than 7 consecutive calendar days.  If the shortfall occurs for only a brief period of time, the adviser should report the occurrence to the board at its next regularly scheduled meeting. Fund managers must review the highly liquid investment minimum at least annually, but may do so more frequently and/or on an ad hoc basis.

15% Limit on Illiquid Securities

Funds may not acquire an investment, if as a result, illiquid investments would comprise more than 15% of the fund’s net assets.  The SEC further stated that managers are not required to divest any investments if the amount of illiquid securities exceeds 15% due to passive movement.

New Board Responsibilities

  • Approve the initial Liquidity Risk Management Program and the designated program administrator.
  • Review the Administrator’s written annual report of the adequacy and effectiveness of its Liquidity Risk Management Program.
  • Review reports from the Administrator when the fund: falls below its highly liquid minimum investment and/or exceeds the 15% limit on illiquid investments.

New Reporting Requirements for Funds

  • Form N-CEN (Annual “Census” Reporting) must be filed no later than 75 days after fiscal year end and includes information regarding the use of lines of credit, interfund borrowing and lending and the use of swing pricing. Compliance is required from June 1, 2018 forward. Form N-CEN replaces Form N-SAR, which will be rescinded as of June 1, 2018.
  • Form N-PORT must be prepared within 30 days after month end and reports the liquidity classification assigned to each of the fund’s positions and the fund’s highly liquid investment minimum. On December 8, 2017, the SEC issued a temporary rule that provided a nine-month delay to the dates by which funds must file new Form N-PORT on the EDGAR system.  For larger entities (over $1 billion), the compliance deadline of June 1, 2018 remains the same, but the initial filing on EDGAR has been delayed until April 30, 2019.  These larger entities are expected to maintain the data for the delay period.  For smaller entities, compliance and EDGAR filings on N-PORT will be due by April 30, 2020.  Form N-PORT will eventually replace Form N-Q.
  • Form N-LIQUID must be filed within one business day if the fund’s concentration of highly liquid investments drops below its minimum for more than seven consecutive calendar days or if illiquid positions exceed 15% of the fund’s net assets. Form N-LIQUID is a confidential filing and will not be made public.
  • Beginning June 1, 2017, Form N-1A will require a fund to disclose new details related to the settlement of redemptions and the number of days within which redemption proceeds will be paid to shareholders.

Also included in the Rule:

  • Policies and procedures related to the use of in-kind redemptions are now required of applicable funds.
  • The SEC offered new guidance on cross-trades for funds, which the agency believes can be a “useful liquidity risk management tool” while also having “significant potential for abuse.”

Compliance Dates for Rule 22e-4

  • December 1, 2018: Larger funds, that together with other funds in the same “group of related investment companies” have net assets greater than $1 billion as of the end of the most recent fiscal year)
  • June 1, 2019: Fund companies with less than $1 billion in assets.
  • June 1, 2017: Amendments to Form N-1A, regardless of the size of the fund company.

New Regulatory Guidance: