The Securities and Exchange Commission announced charges against Pinnacle Advisors LLC for violations of the Liquidity Rule by a mutual fund it advised and whose liquidity risk management program it administered, as well as charges against four individuals for aiding and abetting Liquidity Rule violations. This is the first time the SEC has brought charges under the Liquidity Rule.

According to the SEC’s complaint, Syracuse, New York-based Pinnacle intentionally misclassified assets belonging to a mutual fund client as “less liquid,” when they should have been classified as “highly illiquid,” per the criteria set out in the rule. The rule requires open-end funds to keep no more than 15% of their net assets in “highly illiquid” assets so they can meet redemption obligations if many investors try to redeem in a short period of time.

The mutual fund is now a liquidating trust and was not named as a defendant in the complaint.

The SEC alleges that the fund kept 21% to 26% of its assets in “highly illiquid” assets from June 2019 to June 2020 but misclassified assets to stay under the 15% maximum.

There are four categories of asset under the rule: highly liquid, moderately liquid, less liquid and highly illiquid. All four are defined in terms of how long the asset would take to settle without significantly impacting the value of the fund. Highly liquid assets are those that could be sold in three days or less; moderately liquid would take three to seven days; less liquid would also sell in three to seven days but take longer than seven days to settle; and highly illiquid assets take longer than seven days to sell.

The Investment Company Act of 1940 requires mutual funds to satisfy redemptions within seven business days, so capping the value of the assets that cannot be sold in that amount of time helps ensure that this obligation is feasible in a time of high stress.

The fund in question held assets in an unnamed medical device company that should have been classified as “highly illiquid,” according to the SEC, because the shares the fund owned were restricted. In order to sell shares in this company, the fund would have to give the company itself 15 days to decide to buy them (right of first refusal), then allow the company three days to present the offer to the remaining shareholders, who then would have 10 days to buy the shares. Only after all of that could the shares be offered on another market. This means the shares in question could have been held hostage for as long as 28 days before the fund could find another market for the shares.

Despite this, Pinnacle continued to classify them as “less liquid,” or assets which could be sold within three to seven days, but which could take longer to settle. The SEC also accuses Pinnacle of ignoring the advice of its counsel, who resigned in June 2019 “over this issue.”

An affiliate of Pinnacle Advisors, Pinnacle Investments, settled separately with the SEC for $476,000, according to an SEC press release. In the settlement, the firm neither admitted nor denied the SEC’s findings that Pinnacle Investments made “false and misleading statements in its Form ADV brochure regarding reviews of advisory client accounts and failing to disclose certain conflicts of interests, adopt and implement related policies and procedures, and deliver to clients required information about advisory personnel.” One individual also settled charges stemming from the same instance.”

In November 2022, the SEC proposed requiring swing pricing for mutual funds. That same proposal, which has not yet been finalized, would also make changes to the liquidity categories at play in this case. The proposal would limit the categories to three instead of four: highly liquid, moderately liquid and illiquid. The illiquid category would apply to assets which cannot be converted to U.S. dollars within seven days. The proposal would also require most open-end funds to keep at least 10% of their net assets in highly liquid assets.