8 Things You Need to Know About the Liquidity Rule
1. Its name.
Most people simply refer to the rule as the “liquidity rule”, but its technical name is Rule 22e-4: Investment Company Liquidity Risk Management Programs. If the rule survives in any meaningful form, we should start a contest on whether the industry keeps calling it the liquidity rule or refers to it as Rule 22e-4. Think of Rule 38a-1 under the Investment Company Act. Some people may refer to it as the “compliance rule”, but most simply call it Rule 38a-1.
2. It’s effective this year…sort of.
If you are a large fund family (net assets of at least $1 billion), then most of the rules’ requirements begin on December 1, 2018. The exceptions for large fund families are the requirements related to the liquidity classifications (a.k.a., the “buckets”) and the highly liquid minimum (HLIM) requirement; those parts of the rule do not take effect until June 1, 2019. For small fund families, most of the rule takes effect on June 1, 2019, except for the bucket and HLIM requirements, which start on December 1, 2019.
3. The SEC will likely have more changes to the rule in 2018.
The calendar above will probably be obsolete within the next few months. The SEC is already considering more changes to the rule, including rescinding the requirements that investment companies publicly disclose their aggregate liquidity information in Form N-PORT. The disclosure of the fund’s liquidity profile will likely be moved from Form N-PORT to a fund’s annual shareholder report on Form N-CSR, and the disclosure will be narrative, as opposed to quantitative. But know that the SEC will push forward with the liquidity rule, especially given the recent blowup of the LJM Preservation and Growth Fund and other reports about decreased market liquidity.
4. Better tech is needed.
The SEC’s delay of certain components to the rule highlights the industry’s lack of tech readiness. The Interim Rule that delayed the bucket and HLIM components cited a lack of readily available market data for certain asset classes (i.e., insufficient pricing and risk data) and the need for upgraded systems at fund service providers. Many fund families are going to rely on their fund administrator/fund accountant to provide the necessary portfolio data, and these service providers need to update their systems to accommodate these expectations. For now, providers need more time to either develop proprietary systems or onboard vendor systems. In either case, the procedures may be ready, but the systems are still under development, and the procedures will need to reflect the capability of these systems before the administrator can design effective processes.
5. Funds must appoint a liquidity program administrator and adopt a written Liquidity Risk Management Program (LRMP) by the initial effective date, but board approval is delayed until the entire rule takes effect.
Large fund families have about seven months to appoint an LRMP administrator (December 1, 2018) and adopt the program, but board approval isn’t required until June 1, 2019. Small fund families have until June 1, 2019, to adopt an administrator and a program, but board approval isn’t required until December 1, 2019.
Tip: Given that liquidity is a necessary component of portfolio management, we recommend that the program administrator be a qualified person at a Fund’s adviser. If the Fund is a multi-manager fund (i.e., it is managed by one or more subadvisers), the adviser could delegate responsibility to the subadviser(s) for that Fund.
Tip: Large fund families should identify and appoint an administrator no later than August 31, 2018. The administrator may need up to 60 days to prepare the program, which the board will need to approve before December 1, 2018. Our recommendation is to appoint the administrator at a regular board meeting that occurs before August 31, 2018, and then have the administrator present the program to the board at a meeting that occurs before December 1, 2018. Regular quarterly reporting should start with the fiscal quarter ending December 31, 2018, or later.
Tip: Small fund families should identify and appoint an administrator no later than February 28, 2019. The administrator may need up to 60 days to prepare the program, which the board will need to approve before June 1, 2019. Our recommendation is to appoint the administrator at a regular board meeting that occurs before February 28, 2019, and then have the administrator present the program to the board at a meeting that occurs before June 1, 2019. Regular quarterly reporting should start with the fiscal quarter ending June 30, 2019, or later.
Tip: The contract with the program administrator should state that the Funds have the ultimate responsibility for complying with Rule 22e-4.
6. Funds must adopt a 15% limit on illiquid investments by the initial effective date.
Most funds already state this limit in their registration statement (usually in the Statement of Additional Information). Each fund family should check its compliance policies and registration statement disclosure to ensure the limit is included in both places. If the limit is not expressly stated in your compliance policies, then you should amend them by the applicable effective date. For the disclosure, you need to either incorporate it into your next annual update to the registration statement (if that amendment is filed before the effective date) or supplement the registration statement before the effective date.
Tip: If you need to file a supplement, consider doing it around the time of a semi-annual or annual shareholder report to save on mailing costs. And don’t forget to get board approval of the amended disclosure.
7. Funds should incorporate the annual review of the LRMP into their Rule 38a-1 review.
Each year, the chief compliance officer (CCO) for a fund must review the fund’s compliance program. Beginning in 2019 for large fund families and 2020 for small fund families, the CCO should add the review of the LRMP to his or her report.
Tip: Once the other components of Rule 22e-4 take effect, the administrator should revise the program and have the board approve it. Going forward, the administrator and Fund CCO should work closely to review the plan as part of the Fund’s annual Rule 38a-1 review. The administrator should discuss any proposed interim changes with the Fund CCO before presenting such changes to the board.
8. Funds need to review their redemption in-kind (RIK) policies.
Many funds have policies that cover RIKs with affiliated entities under Rule 17a-7 , but those policies don’t necessarily cover unaffiliated transactions. Under Rule 22e-4, funds need to update their policies to state how and when they will engage in RIKs. Once adopted, a summary of these policies should be included in the fund’s registration statement.
If you have questions on Rule 22e-4, please contact Bo Howell at FinTech Law.
 Investors' New Headache: It's Getting Harder to Buy or Sell When they Want, WSJ Article (Apr. 22, 2018).