On May 5, 2023, the U.S. Securities & Exchange Commission filed its first enforcement complaint under Rule 22e-4 of the Investment Company Act of 1940, 17 C.F.R. § 270.22e-4 (the Liquidity Rule). The complaint was brought against a mutual fund’s investment adviser, two fund officers, and its two independent trustees for willfully aiding and abetting the fund’s violations of the Liquidity Rule. Simultaneously with the filing of the complaint, the SEC announced a related administrative settlement with the fund’s interested trustee, also for willfully aiding and abetting the fund’s violations. Although the complaint’s filing and the related administrative settlement demonstrate that the SEC is prepared to bring enforcement actions for violations of the Liquidity Rule, the underlying allegations suggest that the SEC’s focus, at least initially, is on situations involving intentional and, seemingly, egregious misconduct.
The Liquidity Rule divides the assets held by open-end funds and ETFs into four categories—“highly liquid,” “moderately liquid,” “less liquid,” and “illiquid”—and prohibits funds from holding more than 15% of their net assets in illiquid investments. If a fund’s illiquid assets exceed 15%, then the administrator of the fund’s liquidity risk management program must report the occurrence to the fund board and the fund must report the occurrence to the SEC on Form N-RN. The purpose of the Liquidity Rule is to “promote effective liquidity risk management throughout the open-end investment company industry, thereby reducing the risk that funds will be unable to meet their redemption obligations and mitigating dilution of the interests of fund shareholders.” Although the compliance date for some aspects of the Liquidity Rule was delayed to December 1, 2019, all funds were required to determine by June 1, 2019, which of their investments were illiquid and report whether they exceeded 15% of the fund’s net assets.
Both the complaint and the administrative settlement allege that, from the beginning of the compliance period on June 1, 2019, through at least June 16, 2020, the fund held more than 15% of its net assets in an illiquid investment in a privately-held medical device company. As is typical for securities purchased in a private placement, the subscription agreement, which was signed by the fund’s then-portfolio manager, disclosed a host of transfer restrictions, including that the shares were not registered under the Securities Act of 1933 (the Securities Act) and could not be resold or transferred unless they were subsequently registered under the Securities Act or an exemption from such registration was available. Both the complaint and the administrative settlement allege that the fund improperly classified the investment as “less liquid” and failed to report on Form N-RN that more than 15% of net assets were illiquid.
The complaint further alleges that, during that period, the defendants knew or recklessly disregarded the reporting requirements of the Liquidity Rule and that the fund’s investment in the privately-held company was misclassified because (1) prior to the compliance date, the fund had disclosed in its shareholder reports and financial statements that the investment was illiquid, (2) the fund’s auditors expressed concern to the defendants about the illiquidity of the investment, (3) the fund’s counsel repeatedly advised the defendants of the reporting requirements of the Liquidity Rule and her opinion that the investment was illiquid, and (4) the fund had previously represented to the SEC staff that the investment was illiquid.
The complaint further alleges that, after the start of the compliance period, and against the advice of counsel, the fund represented to the SEC staff that the administrator of the fund’s liquidity risk management program (which also was the fund’s investment adviser) had concluded that the investment was “less liquid,” rather than illiquid, based on recent sales of the privately-held company’s shares, investor interest at the investment adviser’s affiliated broker-dealer, and positive news that the privately-held company was closing on a sale of certain assets to a third party. Each of these representations was allegedly false and misleading. Fund counsel resigned shortly after these representations were made to the SEC staff.
The complaint alleges that the fund did not report that the investment was illiquid on Form N-RN until June 16, 2020, and only after the fund retained new counsel who advised the defendants that the investment was illiquid and needed to be reported as such, and after the fund’s auditors resigned in part due to concerns regarding the fund’s classification of illiquid securities. The complaint alleges that the independent trustees were aware of the liquidity issues and the concerns raised by the fund’s counsel and auditors but failed to exercise reasonable oversight of the fund’s liquidity risk management program and the program administrator. Shortly after filing Form N-RN, the fund disposed of its liquid assets, made a distribution to its shareholders, placed its illiquid assets in a liquidating trust, and de-registered with the SEC.
The complaint seeks unspecified monetary penalties and injunctive relief against the defendants. The related administrative settlement enjoins the interested trustee from committing or causing violations of the Liquidity Rule; prohibits him from serving on or associating with any investment adviser, broker, dealer, or registered investment company for six months; and requires him to pay a $20,000 penalty.
By filing the complaint and entering into the related administrative settlement, the SEC has demonstrated its commitment to enforcing the Liquidity Rule, but the egregiousness of the alleged misconduct—which includes multiple misrepresentations to the SEC staff and the resignations of the fund’s counsel and auditors—sheds less light on how aggressively the SEC may pursue more inadvertent or subjective violations of the Liquidity Rule. Whether the SEC will bring enforcement actions in connection with good faith disagreements over the classification of potentially illiquid assets remains to be seen.