May 11, 2023
On May 5, 2023, the SEC announced its first-ever enforcement of the Liquidity Rule by charging Pinnacle Advisors LLC, an investment adviser, with “aiding and abetting Liquidity Rule violations” regarding one of its mutual funds. The SEC also brought related charges against three trustees and two officers of the fund.
The Liquidity Rule “prohibits mutual funds from investing greater than 15% of their net assets in illiquid investments,” according to the SEC’s press release. The rule additionally mandates that funds adopt a liquidity risk management program and requires any fund exceeding the 15% threshold to take timely remedial steps.
The SEC alleged that the fund advised by Pinnacle Advisors LLC held between 21%-26% of its net assets in illiquid investments. Furthermore, the SEC claimed that the investment advisor and its officers knowingly misclassified its largest illiquid investment as “less liquid,” did not propose steps to regain compliance with the Liquidity Rule and misled the SEC regarding the rationale for this classification. Finally, the SEC’s complaint also targeted the fund’s Liquidity Risk Management Program, along with the fund’s two independent trustees, for failing to properly oversee the fund’s liquidity despite knowing that those shares were, in fact, illiquid.
One trustee consented to a cease-and-desist order, a civil penalty of $20,000, and a 6-month suspension from associating with any investment adviser, registered investment company, or certain other industry participants. The SEC has also charged an affiliate of Pinnacle Advisors, LLC with false and misleading statements in its ADV brochure, failure to disclose conflicts of interests, failure to adopt and implement policies and procedures addressing them, and failure to deliver information about its advisory personnel to clients. The affiliated firm consented to the order (which included a civil penalty totaling roughly $476,000) but did not admit or deny the SEC’s claims.
This is a straightforward case of individuals failing to manage a fund’s liquidity risk, and thus a perfect case for the new rule’s first enforcement and the SEC’s rule proposal on this issue. These individuals failed to meet the basic requirements of the rule. There was no need to show specific harm to a shareholder. The enforcement rests on failures to remedy liquidity issues and misrepresenting illiquid assets as “less liquid.” On November 2, 2022, new liquidity requirements were proposed that would do away with the “less liquid” category, that includes investments that take longer than seven days to settle, as illiquid. There is no question the SEC is paying attention to the current rule. What this enforcement may mean for the future of the proposed requirements remains to be seen.
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