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Division of Investment Management Staff Issues Liquidity Risk Management Program FAQs

On January 10, 2018, the staff of the SEC’s Division of Investment Management issued guidance in the form of frequently asked questions (FAQs) relating to the liquidity risk management (LRM) program requirements of  Rule 22e-4, which was adopted in October 2016. The FAQs generally address two categories of questions: (i) the delegation of LRM program administrative duties to sub-advisers and (ii) the definition and applicability of Rule 22e-4 to “In-Kind ETFs.” The following is a summary of the issues addressed in the FAQs.

Sub-Advised Funds

• The staff clarified that a board may designate a sub-adviser as LRM program administrator under Rule 22e-4. The staff additionally stated that a program administrator may delegate specific responsibilities (e.g., providing liquidity classifications for the fund’s investments) to a sub-adviser or other appropriate third party and, further, that entities with delegated responsibilities may subdelegate to others, provided there is appropriate supervision. The staff noted that the fund retains ultimate responsibility for complying with Rule 22e-4. Accordingly, the staff recommended that a fund implement policies and procedures governing the scope and conditions of delegating LRM program responsibilities.

• Because Rule 22e-4 requires funds—and not advisers—to adopt LRM programs, an investment adviser (including a sub-adviser) has no independent obligation to adopt and implement its own LRM program.

• The staff recognized that certain investment advisers (or sub-advisers) may provide advisory services to multiple funds in multiple fund complexes that have differing practices, including different LRM programs with unique policies and procedures (including different LRM programs for funds in the same complex). The FAQs clarified that an entity administering multiple LRM programs that differ from one another is under no obligation to reconcile those programs, the programs’ methodologies or the programs’ outputs (e.g., different liquidity classifications of certain investments). The staff further clarified that each fund’s board-approved LRM program will control how an adviser or sub-adviser carries out any of its responsibilities under Rule 22e-4 to that particular fund.

• Further to the previous bullet point, an investment adviser, sub-adviser or other LRM program administrator, or its delegate, may classify the same investment differently across multiple funds based on the funds’ differing LRM programs. The staff noted that, under Rule 22e-4, “a fund must take into account ‘relevant market, trading, and investment-specific characteristics’ in classifying its portfolio investments’ liquidity,” and that different funds (even funds within the same complex) are permitted to arrive at different conclusions.

• Pursuant to an LRM program administrator’s ability to delegate, an LRM program administrator may adopt an approach whereby multiple entities (e.g., the investment adviser and a sub-adviser) may have input as to the liquidity classification of particular investments. In such instances, the staff believes a fund may consider addressing in its LRM policies and procedures how to treat a circumstance in which the adviser and sub-adviser reach a different conclusion regarding the liquidity classification of a particular investment. The staff noted certain possible solutions, including allowing a specified party’s determination to control, employing a factor analysis or hierarchy or using the most conservative determination. However, the staff clarified that other methodologies could be used.

• The staff clarified that in a multi-manager fund in which the various sub-advisers of distinct sleeves are responsible for designating the liquidity classification of portfolio investments, each sub-adviser is permitted to classify the same investment differently even within the same fund, and that none of the fund, the LRM program administrator or the adviser or sub-adviser has any obligation to reconcile these differences for compliance purposes (e.g., monitoring compliance with the fund’s highly liquid investment minimum, if applicable, or the 15% limit on illiquid investments).

• The staff noted that, notwithstanding the foregoing bullet point, Form N-PORT does not permit a fund to report more than one liquidity classification for a single investment. Accordingly, an LRM program’s policies and procedures should include a methodology for selecting a single liquidity classification for Form N-PORT reporting purposes in circumstances in which different sub-advisers classify the same investment differently for compliance purposes. For illustrative purposes only, the staff noted that a fund may choose to report the classification of the sub-adviser with the largest position in the asset, calculate a weighted average and round to the nearest liquidity classification or report the most conservative (i.e., the lowest) liquidity classification. The staff encouraged a fund with diverging liquidity classifications to report these policies and procedures in the explanatory notes section of Form N-PORT.

In-Kind ETFs

Under Rule 22e-4, ETFs that satisfy redemptions through in-kind transfers of securities positions and assets, other than a de minimis amount of cash, and that publish portfolio holdings on a daily basis are “In-Kind ETFs” that are exempt from certain LRM program requirements. The FAQs address the following considerations with respect to InKind ETFs under the Rule:

• For purposes of determining an ETF’s status as an In-Kind ETF, Rule 22e-4 permits each ETF to determine what constitutes a de minimis amount of cash in its policies and procedures; the Rule does not establish a precise methodology. Rather, an ETF may take “a variety of reasonable approaches,” provided the approach is applied consistently. The staff stated that it would not object to an approach that includes testing each individual redemption transaction or testing redemption transactions in the aggregate over a reasonable period of time to ensure that the cash amounts used are de minimis. For determining what is a “reasonable period of time,” the staff suggested a day or a week for an ETF with frequent redemption basket activity or a month for an ETF with less frequent redemption basket activity. However, the staff stated that in no event would a period in excess of one month be deemed reasonable.

• Although de minimis amounts may differ depending on the facts and circumstances of each ETF, the staff believes that it would be reasonable to determine that overall redemption proceeds paid in cash not exceeding 5% would be de minimis, but that it would be unreasonable to determine that redemption proceeds paid in cash exceeding 10% (subject to permissible exclusions, e.g., the amount of uninvested cash in the ETF’s investment portfolio) are de minimis. An ETF should evaluate its particular facts and circumstances to determine whether an amount of cash in excess of 5% (subject to permissible exclusions) is de minimis, including whether such cash redemptions would give rise to liquidity risks substantially similar to those applicable to mutual funds.

• The staff clarified that an ETF may exclude the cash portion of redemption proceeds that is proportionate to the uninvested cash in the ETF’s investment portfolio for purposes of defining and testing compliance with the de minimis standard.

• Noting the practical considerations that would prevent an ETF that loses its status as an In-Kind ETF from coming into immediate compliance with the provisions of Rule 22e-4 from which In-Kind ETFs are exempt, the staff stated that it would not recommend enforcement against an ETF that loses its In-Kind ETF designation so long as the ETF comes into compliance with the Rule “as soon as reasonably practicable” after the In-Kind ETF designation is lost.

• A new ETF with little or no operating history may use a forward-looking analysis of its policies and procedures and expected redemption practices to determine that it is an In-Kind ETF. The staff stated, more generally, that backwards-looking redemption history is not by itself dispositive, and that an ETF with an operating history may consider making material changes to its policies and procedures and redemption practices to qualify as an In-Kind ETF.

The SEC expects to update the FAQs from time to time to include responses to additional questions.

The FAQs are available at: https://www.sec.gov/investment/investment-company-liquidity-risk-managementprograms-faq

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