On May 5, 2023, the SEC announced its first enforcement actions under Rule 22e-4 under the Investment Company Act of 1940, the SEC’s liquidity rule, specifically in the form of a lawsuit filed in federal court and a settled administrative proceeding—both of which stem from the same underlying violations of the rule by a registered mutual fund. These actions provide important insight into the SEC’s commitment to enforcing new rules, and also send a broader message about board oversight responsibilities
The SEC’s Allegations
According to the SEC’s complaint filed on May 5, 2023 in the U.S. District Court for the Northern District of New York, between June 1, 2019, which was the compliance date for relevant aspects of the liquidity rule for smaller entities such as the fund in question, and at least June 16, 2020, approximately 21% to more than 26% of the fund’s net assets were invested in shares of a private medical device company. The SEC stated that the shares were not listed on any securities exchange or traded in any over-the-counter market and bore additional sale restrictions imposed by the subscription agreements pursuant to which they were acquired and by the issuing company’s operating agreement. The fund’s shareholder reports and financial statements identified the shares as illiquid and indicated that market quotations were not readily available for the shares both before and after the effective date of the liquidity rule. However, the securities were classified as “less liquid” for purposes of the liquidity rule. The SEC alleged that during this time, the fund’s president (who also served as the fund’s portfolio manager) and its chief compliance officer, chief financial officer, vice president and treasurer, as well as its two independent trustees (by virtue of their service on the valuation and audit committees), were aware of the illiquid nature of the shares.
The SEC alleged that, in the period leading up to the compliance date for the liquidity rule, both the fund’s external auditors and the outside attorney serving as fund counsel expressed concerns about the fund’s concentration in the restricted shares and the impending need to comply with the liquidity rule. Additionally, the complaint indicates that the fund’s investment in the restricted shares had been subject to scrutiny by the staff of the SEC’s Division of Investment Management, who in connection with reviews of the fund’s public disclosure had raised questions about the investment that remained unresolved as of the liquidity rule’s compliance date.
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