Illiquid Security Definition

• Page 7 of the InvestX presentation claims that "Illiquid securities are defined as instruments that take longer than a single day to liquidate in the public markets." That definition appears to be too narrow.
• For example, the Marriam-Webster dictionary defines illiquid securities as "an asset or security that cannot be sold quickly due to a shortage of interested buyers or a lack of an established trading market. Illiquid assets cannot be easily converted into cash without potential for losing a significant percentage of their value."
• Similarly, the Financial Dictionary defines illiquid assets as "an asset that is difficult to sell because of its expense, lack of interested buyers, or some other reason." Therefore, the part of InvestX definition that refers to public markets is not completely accurate. As long as there are enough sellers willing to sell an asset and enough buyers willing to buy it, a market technically exists, even if it is not public (for example, the public may not have access to the market, but private, accredited investors might have access).
• Furthermore, the part of the definition that states that illiquid securities are those instruments that take longer than a single day is also to narrow, according to public sources. The Securities and Exchange Commission (SEC) stated in its 1986 rule on The Acquisition and Valuation of Certain Portfolio Instruments by Regitered Investment Companies that "The term "illiquid security" generally includes any security which cannot be disposed of promptly and in the ordinary course of business without taking a reduced price",
• More importantly, the SEC specifically explained that "a security is considered illiquid if a fund cannot receive the amount at which it values the instrument within seven days." This formal definition seems to still be true to this day, as the SEC recently stated that "an illiquid investment is an investment that the fund reasonably expects cannot be sold in current market conditions in seven calendar days without significantly changing the market value of the investment."

The Main Thesis of InvestX — The 15% Limit

• InvestX claims on page 7 of its presentation that "institutions holding 15% of their funds in illiquid securities will need to sell private investments to rebalance their portfolio within 90 days to stay in compliance." This claim is factually inaccurate. A similar claim on the same page states that "funds (mutual, hedge and others) registered under the 1940 Investment Companies Act are allowed a maximum of 15% of their portfolios in illiquid securities by regulation." This is also a misrepresentation of official SEC rules.
• The 15% illiquid investment limit is set forth in SEC's Rule 22e-4. The rule specifically prohibits a fund to purchase additional illiquid investments in the event that more than 15% of its portfolio consists of illiquid investments. It does not state anything about rebalancing a portfolio by selling illiquid investments once the 15% limit is breached.
• In a proposal of Rule 22e-4, the SEC "requested comment as to whether [it] should require a fund to divest its assets in excess of the 15% limit." Some commenters stated that such a requirement "could result in the fund needing to sell the illiquid investments at prices that incorporate a significant discount to the investments’ stated value, or even at fire sale prices, [so, it] could adversely affect shareholders and could potentially negate the liquidity risk management benefits of the illiquid investment limit". Therefore, the SEC decided not to force funds to liquidate illiquid assets. The final rule only states that "a fund will be prohibited from acquiring any illiquid investment if, immediately after the acquisition, its illiquid investments that are assets would exceed 15% of its net assets."
• Additionally, there is no set amount of time in which a fund can exceed a 15% limit. A fund can exceed a 15% limit indefinitely, as long as the fund's board deems it to be in the best interest of the fund and its shareholders. The fund is required to perform a liquidity analysis of its portfolio at least once every 30 days, and if it breaches the 15% limit, it must notify the board and the SEC (via the N-LIQUID form). The fund's management must also present a plan to the board "to bring its illiquid investments back within the limit within a reasonable period of time". However, the board alone can approve the plan. So, even though the management must present a plan to rebalance the portfolio "within a reasonable period of time" to the board every 30 days, the board can determine that the plan is viable and the board alone has the responsibility of determining what a "reasonable period of time" is.
• Actually, because illiquid assets are defined as those assets that are difficult to sell promptly, it can be reasonably assumed that a fund would opt to purchase additional liquid assets to rebalance the portfolio and push it below the 15% limit. Buying additional liquid assets would be easier and less expensive for a fund to do than selling illiquid assets quickly, probably at a discount. However, this point is irrelevant because, as explained above, funds do not have to rebalance their portfolio to stay in compliance. They just need to stop purchasing illiquid assets.
• To conclude, the SEC decided not to require funds to sell their illiquid assets precisely to avoid the situation which InvestX aims to exploit (funds forced to sell assets below the market value). Furthermore, the 90-day limit stated by InvestX does not exist in any regulations, and it is probably arising from the fact that all funds have to publish their portfolios every quarter of a financial year, which roughly equates to every 90 days.

Redemptions and Margin Calls

• Margin calls have indeed compounded the Coronavirus stock market crash and it is a reasonable assumption to make that some investors were forced to ask for redemptions so that they can deposit additional collateral and meet the margin calls. However, because the crash happened so abruptly, in many cases investors were not given the opportunity to deposit additional collateral. Instead, the brokers were forced to liquidate their positions immediately on their behalf.
• Investor redemptions do reduce a fund's assets. However, it cannot be determined with absolute certainty whether those assets are cash, liquid assets, or illiquid assets. Funds have to pay redemption proceeds to a shareholder within seven days of receiving a redemption request, so it is reasonable to assume that funds will sell liquid assets to compensate the shareholders.
• Even though the above two points are valid, InvestX conclusion that they compound the liquidity problem for funds is not. This is because, as explained above, the problem itself does not exist.

Distressed Employees and ESOs

• Employee stock options (ESOs) typically have a post-termination exercise (PTE) period of 90 days. This is the period under which ESOs are treated as incentive stock options by the Internal Revenue Service (IRS). The IRS offers a favorable tax treatment for incentive stock options, but this definition of employee stock options expires after 90 days. Therefore, InvestX's claim that "laid off employees typically have 30 -90 days to exercise their options and pay the tax" is generally true, although the range is heavily skewed towards the 90-day mark.
• However, many startups are reconsidering the 90-day PTE period. This is particularly true of technology companies, which InvestX seems to be targeting. In fact, many technology companies have already extended the PTE period. For example, some companies, like Quora, have a 10-year PTE period. Pinterest and Coinbase have a 7-year PTE period. Many more companies have smaller PTE periods, but those are still measured in years instead of days. In fact, extending the PTE period seems to be a trend among startups, particularly technology companies, and especially those based in Sillicon Valley.

• Disregarding the issue of an unknown PTE period for the target companies, the main problem with InvestX's theory about employee stock options is the assumption that laid off employees will have enough cash at hand to exercise stock options in that period. Since InvestX bases its calculations on the number of jobless claims, it can be reasonably assumed that people filing for unemployment benefits will not have enough funds available to exercise the options. In fact, one of the reasons that companies are considering extending the PTE period is precisely the fact that employees would have more time to amass the necessary cash to exercise the options. Furthermore, employees might not be likely to exercise their options because that essentially means buying equity in a company that just laid off a significant amount of their workforce. Employees, especially laid off employees, are likely to be risk-averse in this case, given the uncertain nature of the company's future and whether it will ever have an IPO (which would supposedly allow them to profit on their company equity).
• The second problem with InvestX's strategy is targeting the people that want to sell these options. Some companies restrict selling the options on a secondary market. Employees of companies that do not restrict this are likely to turn to well-known ESO exercise solutions, like the ESO Fund. The ESO Fund helps employees exercise their ESOs and pay taxes on them. It then buys the securities from those employees to cover the costs and possibly make a profit. This reduces uncertainty for the employees and simplifies the matter of profiting from ESOs for them. It is unclear what InvestX's competitive advantage would be compared to solutions like the ESO Fund.

Reporting Rules and other Considerations for Targeting Illiquid Funds

• Since, as explained above, funds are not required to divest their illiquid assets, the strategy for targeting them may not have much merit. However, some questions about the reporting rules for funds will still be addressed below.
• "Funds are required to assess, manage, and periodically review their liquidity risk." They do so by classifying the investments in its portfolio into four categories, according to the number of days in which the fund can reasonably expect to liquidate the investment. The four categories are "highly liquid investments, moderately liquid investments, less liquid investments, and illiquid investments." Additionally, the fund may classify investments into different asset classes, like stocks, bonds and fixed-income instruments, financial derivatives, cash and cash equivalents, and tangible assets (like real-estate).

• The funds have to review their liquidity risk at least monthly (30 days) and they have to report the information about their liquidity risk management program to the board and the SEC. Reporting to the SEC is done through the N-PORT form. Previously, the funds needed to report their liquidity status to the SEC on a monthly basis. However, the SEC changed that rule in 2019, and now funds are required to maintain the liquidity information for each month internally. They are only required to submit the N-PORT form once every three months, and that form should contain information for the previous three months (or, what is referred to as "three monthly reports").
• As mentioned above, the funds are only required to disclose their portfolios to the public once every quarter. So, "information reported on Form N‑PORT for first and second months of each fund’s fiscal quarter is non-public information." The information for the third month is publicly available information, even though it has a 60-day delay before becoming publicly available — "Information reported on Form N-PORT for the third month of each fund’s fiscal quarter must be filed no later than 60 days after the end of the fiscal quarter and will be made publicly available immediately (with the exception of the items identified in General Instruction F of Form N-PORT). If a fund files early (i.e., prior to the 60-day deadline), the quarter-end information will be made public at the time of filing."
• By making amendments to the N-PORT form, the SEC made additional efforts to protect funds’ sensitive data and to make sure that filings intended to be non-public are not made public.

• The breach of the 15% liquidity limit mentioned above must be reported to the SEC using the form N-LIQUID within one business day of the occurrence.
• N-LIQUID is a confidential form and these reports will never be made public, just like the internal reports to the fund's board.

• Each fund has a discretionary right/obligation to determine a "minimum percentage of its net assets that must be invested in highly liquid investments, defined as cash or investments that are reasonably expected to be converted to cash within three business days."
• The difference between the right and obligation arises from the fact that a fund may well choose to have a highly-liquid investment minimum of 0%. Its only obligation is to decide upon that minimum, and to disclose it to the SEC and the public. The fund, in consultation with the board can change that minimum annually.
• This minimum is there to provide a sense of security to shareholders and potential shareholders. It informs investors that the fund will always have at least some highly liquid investments at hand to meet the demand for redemptions.
• The fund is also required by the SEC to "implement policies and procedures for responding to a highly liquid investment minimum shortfall." However, since this minimum is a discretionary decision of the fund, the only real obligation imposed by the SEC is for the fund to notify its board in the event that this minimum falls under the limit specified by the fund itself.