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SEC Liquidity Bucketing: Provisional, Verified, and Final


By Nels Ylitalo  |  August 13, 2019

In its FAQ on the Investment Company Liquidity Risk Management Programs rule (the SEC Liquidity Rule also referred to as Rule 22e-4), the SEC has enumerated a taxonomy of liquidity classification (“bucketing”) exercises that carry different reporting consequences. The taxonomy adds welcome breathing room between the liquidity bucketing exercise and the rule’s next-business-day breach reporting obligations by distinguishing between provisional classifications, verified classifications, and final classifications.

The liquidity classification requirements under the SEC Liquidity Rule have been a moving target since the SEC first proposed the rule in September 2015. From one rule-making stage to the next, the proposed liquidity bucketing requirements were replaced piece-by-piece, in a process reminiscent of the ship of Theseus thought experiment, which goes as follows: Suppose the ship once sailed by Theseus is maintained in a museum. Over time, each of the ship’s rotting boards is replaced by a new piece. Once the ship’s original pieces have all been replaced, is it still the same ship?

The analogy between the piecemeal transformation of the liquidity bucketing requirements throughout the rule-making process and the ship of Theseus is not entirely apt because, while the SEC replaced certain of the original pieces of liquidity bucketing, the SEC effectively discarded some original elements and retained others. The liquidity bucketing requirements, as embodied in the final rule, are better likened to an updated keel and structure of the original requirements. In its final form, the liquidity classification process leaves many more elements to the judgment of program administrators than had been allowed originally, including the interpretation of “current market conditions,” “significantly changing the market value of the investment,” and reasonably anticipated trade size.

One of the most significant changes to the liquidity bucketing requirements from the proposal stage to the final rule is required frequency. While the proposed rule contemplated whether review of liquidity classifications should be an “ongoing process,” the final rule only requires funds to classify investments into liquidity buckets “at least monthly in connection with reporting the liquidity classification for each portfolio investment on Form N-PORT.” Under the final rule, intra-month classification is required only if “changes in relevant market, trading, and investment-specific considerations are reasonably expected to materially affect one or more of [a fund’s] investments’ classifications.” Funds are required to have processes in place reasonably designed to identify such changes on an intra-month basis.

While some funds have opted to conduct full portfolio liquidity bucketing as a daily exercise (more aligned with the concept of ongoing review in the proposed rule), many funds intend to undertake liquidity bucketing—and to report the classification data on Form N-PORT—on a monthly basis, in accordance with the final rule. In fact, 59% of fund complexes and 62% of advisers responding on this point to the ACA Liquidity Risk Management Program Rule Survey (August 2018) indicated they will conduct liquidity bucketing on a monthly basis.

While the SEC changed the original “ongoing process” liquidity bucketing standard to an easily administered “at least monthly” standard, the SEC did not make a coordinate change to the breach-reporting obligations. Breach reporting obligations may still arise intra-month.

By way of a quick review, under the SEC Liquidity Rule, funds that do not “primarily” hold highly liquid investments are required to establish a “highly liquid investment minimum” (or HLIM) below which their highly liquid investments must not fall. At the other end of the liquidity spectrum, funds must not permit their illiquid investments to rise above more than 15% of the fund’s net assets.

While the SEC could have required funds to report HLIM or 15% Illiquid Limit breaches only if funds’ monthly full portfolio liquidity bucketing exercise revealed any such breach, the SEC did not do that. Instead, the SEC has required that funds implement processes reasonably designed to identify liquidity shifts on an intra-month basis, which can potentially trigger an investment (re)classification, which can potentially trigger a short-fuse reporting obligation.

HLIM breaches that persist for seven consecutive calendar days or less must be reported to the board at the next regularly scheduled meeting. However, HLIM breaches that persist beyond seven consecutive calendar days must be reported the next business day to the board and to the SEC on Form N-LIQUID (which means, presumably, day nine of the breach, since day eight will be the day of the triggering event). By contrast, all breaches of the 15% Illiquid Limit, no matter how long they persist, must be reported the next business day to the board and the SEC on Form N-LIQUID.

Easing the next-business-day reporting standard to large extent, the SEC’s FAQ contemplates that funds may undertake provisional intra-month classification. As discussed in the FAQ, threshold breaches that are identified via an intra-month provisional classification exercise do not trigger a reporting obligation, whether for breach of an HLIM or 15% Illiquid Limit. Instead, provisionally-identified breaches of the HLIM or 15% Illiquid Limit start a three business day clock (including the day the ostensible triggering event is observed), during which time a fund must verify the provisional intra-month classification. The liquidity classification resulting from the verification process constitutes a “verified classification” of the investment or investments, at which point the standard HLIM and 15% Illiquid Limit reporting obligations do apply. 

The third type of classification exercise—in addition to “provisional” and “verified”—is simply the standard monthly final or official liquidity classifications reported on Form N-PORT. Any breaches of the HLIM or 15% Illiquid Limit identified during the monthly “final” classification process are, of course, subject to standard reporting obligations.

Liquidity committees and program administrators should consider policy and procedure designs that ease compliance with short-fuse reporting obligations, take advantage of the range of options for intra-month monitoring processes and control costs for vendor solutions that are priced based on the frequency with which clients elect to conduct liquidity bucketing.

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Nels Ylitalo

Vice President, Director Product Strategy, Regulatory Solutions

Mr. Nels Ylitalo is Director of Product Strategy for Regulatory Solutions at FactSet. Previously, he worked in signals intelligence in the United States Navy prior to attending law school at Yale where he earned a JD in 2007. Following law school, he was a corporate/M&A attorney representing VC and PE funds as well as corporate clients in M&A transactions. Mr. Ylitalo’s portfolio covers a broad range of financial services regulations with a current focus on buy-side regulatory requirements and challenges, globally.


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