Open-End Fund Liquidity Risk Management Programs; Swing Pricing; Re-Opening of Comment Period for Investment Company Reporting Modernization Release — SEC — US

1Unless otherwise noted, all references to statutory sections are to the Investment Company Act, and all references to rules under the Investment Company Act will be to Title 17, Part 270 of the Code of Federal Regulations [17 CFR 270]. SECURITIES AND EXCHANGE COMMISSION 17 CFR Parts 210, 270, 274 [Release Nos. 33–9922; IC–31835; File Nos. S7–16–15; S7–08–15] RIN 3235–AL61; 3235–AL42 Open-End Fund Liquidity Risk Management Programs; Swing Pricing; Re-Opening of Comment Period for Investment Company Reporting Modernization Release AGENCY: Securities and Exchange Commission. ACTION: Proposed rule; re-opening of comment period. SUMMARY: The Securities and Exchange Commission is proposing a new rule and amendments to its rules and forms designed to promote effective liquidity risk management throughout the openend fund industry, thereby reducing the risk that funds will be unable to meet redemption obligations and mitigating dilution of the interests of fund shareholders in accordance with section 22(e) and rule 22c–1 under the Investment Company Act. The proposed amendments also seek to enhance disclosure regarding fund liquidity and redemption practices. The Commission is proposing new rule 22e–4, which would require each registered open-end fund, including open-end exchangetraded funds (‘‘ETFs’’) but not including money market funds, to establish a liquidity risk management program. The Commission also is proposing amendments to rule 22c–1 to permit a fund, under certain circumstances, to use ‘‘swing pricing,’’ the process of adjusting the net asset value of a fund’s shares to effectively pass on the costs stemming from shareholder purchase or redemption activity to the shareholders associated with that activity, and amendments to rule 31a–2 to require funds to preserve certain records related to swing pricing. With respect to reporting and disclosure, the Commission is proposing amendments to Form N–1A regarding the disclosure of fund policies concerning the redemption of fund shares, and the use of swing pricing. The Commission also is proposing amendments to proposed Form N–PORT and proposed Form N– CEN that would require disclosure of certain information regarding the liquidity of a fund’s holdings and the fund’s liquidity risk management practices. In connection with these proposed amendments, the Commission is re-opening the comment period for Investment Company Reporting Modernization, Investment Company Act Release No. 31610 (May 20, 2015). DATES: The comment period for the proposed rule published June 12, 2015 (80 FR 33589) is reopened. Comments on this release (Investment Company Act Release No. 31835) and Investment Company Act Release No. 31610 should be received on or before January 13, 2016. ADDRESSES: Comments may be submitted by any of the following methods:
Electronic Comments

Use the Commission’s Internet
comment form (http://www.sec.gov/ rules/proposed.shtml); or
Send an email to rule-comments@
sec.gov. Please include File Number S7– 16–15 or S7–08–15 on the subject line; or
Use the Federal Rulemaking Portal
(http://www.regulations.gov). Follow the instructions for submitting comments. Paper Comments
Send paper comments to Secretary,
Securities and Exchange Commission, 100 F Street NE., Washington, DC 20549–1090. All submissions should refer to File Number S7–16–15 or S7–08–15. The file number should be included on the subject line if email is used. To help the Commission process and review your comments more efficiently, please use only one method. The Commission will post all comments on the Commission’s Internet Web site (http://www.sec.gov/ rules/proposed.shtml). Comments are also available for Web site viewing and printing in the Commission’s Public Reference Room, 100 F Street NE., Washington, DC 20549, on official business days between the hours of 10 a.m. and 3 p.m. All comments received will be posted without change; the Commission does not edit personal identifying information from submissions. You should submit only information that you wish to make available publicly. Studies, memoranda, or other substantive items may be added by the Commission or staff to the comment file during this rulemaking. A notification of the inclusion in the comment file of any such materials will be made available on the Commission’s Web site. To ensure direct electronic receipt of such notifications, sign up through the ‘‘Stay Connected’’ option at www.sec.gov to receive notifications by email. FOR FURTHER INFORMATION CONTACT:
Melissa S. Gainor, Senior Special Counsel; Naseem Nixon, Senior Counsel; Amanda Hollander Wagner, Senior Counsel; Sarah A. Buescher, Branch Chief; or Sarah G. ten Siethoff, Assistant Director, Investment Company Rulemaking Office, at (202) 551–6792, Division of Investment Management, Securities and Exchange Commission, 100 F Street NE., Washington, DC 20549–8549. SUPPLEMENTARY INFORMATION: The Securities and Exchange Commission (the ‘‘Commission’’) is proposing for public comment amendments to rules 22c–1 [17 CFR 270.22c–1] and 31a–2 [17 CFR 270.31a–2], and new rule 22e–4 [17 CFR 270.22e–4], under the Investment Company Act of 1940 [15 U.S.C. 80a–1 et seq.] (‘‘Investment Company Act’’ or ‘‘Act’’); amendments to Form N–1A [referenced in 17 CFR 274.11A] under the Investment Company Act and the Securities Act of 1933 (‘‘Securities Act’’) [15 U.S.C. 77a et seq.]; amendments to
Article 6 [17 CFR 210.6–01 et seq.] of
Regulation S–X [17 CFR 210]; and amendments to proposed Form N–PORT [referenced in 17 CFR 274.150] and proposed Form N–CEN [referenced in 17 CFR 274.101] under the Investment Company Act.1
Table of Contents
I. Introduction
II. Background
A. Open-End Funds
B. The Role of Liquidity in Open-End Funds
1. Introduction
2. Liquidity Management by Open-End
Funds
C. Recent Developments in the Open-End
Fund Industry
1. Fixed Income Funds and Alternative
Funds
2. Evolution of Settlement Periods and
Redemption Practices
D. Current Regulatory Framework
1. Statutory and Regulatory Requirements
2. 15% Guideline
3. Overview of Current Practices
E. Rulemaking Proposal Overview
III. Discussion
A. Program Requirements and Scope of Proposed Rule 22e–4
1. Proposed Program Elements
2. Scope of Proposed Rule 22e–4 and
Related Disclosure and Reporting Requirements
3. Request for Comment
B. Classifying the Liquidity of a Fund’s Portfolio Positions Under Proposed Rule 22e–4
1. Proposed Relative Liquidity
Classification Categories
2. Factors to Consider in Classifying the
Liquidity of a Portfolio Position

2An open-end fund is required by law to redeem its securities on demand from shareholders at a price approximating their proportionate share of the fund’s net asset value at the time of redemption.
Section 22(d) of the Act prohibits a dealer from
selling a redeemable security that is being offered to the public by or through an underwriter other than at a current public offering price described in the fund’s prospectus. Rule 22c–1 under the Act requires open-end funds, their principal underwriters, and dealers in fund shares (and certain others) to sell and redeem fund shares at a price determined at least daily based on the current net asset value next computed after receipt of an order to buy or redeem. Together, these provisions require that fund shareholders be treated equitably when buying and selling their fund shares. While a money market fund is an open-end management investment company, money market funds generally are not subject to the amendments we are proposing (except certain amendments to proposed Form N–CEN) and thus are not included when we refer to ‘‘funds’’ or ‘‘open-end funds’’ in this release except where specified. The term ‘‘mutual fund’’ is not defined in the 1940 Act. 3As of the end of 2014, there were 8,734 openend funds (excluding money market funds, but including ETFs), as compared to 2,960 at the end of 1992. See Investment Company Institute, 2015 Investment Company Fact Book (2015), available at http://www.ici.org/pdf/2015_factbook.pdf (‘‘2015 ICI Fact Book’’), at 177 and 184. 4Revisions of Guidelines to Form N–1A, Investment Company Act Release No. 18612 (Mar. 12, 1992) [57 FR 9828 (Mar. 20, 1992)] (‘‘Guidelines Release’’).
3. Ongoing Review of the Liquidity of a
Fund’s Portfolio Positions
C. Assessing and Managing a Fund’s
Liquidity Risk
1. Assessing a Fund’s Liquidity Risk
2. Periodic Review of a Fund’s Liquidity
Risk
3. Portfolio Liquidity: Minimum
Investments in Three-Day Liquid Assets
4. Portfolio Liquidity: Limitation on Funds’
Investments in 15% Standard Assets
5. Policies and Procedures Regarding
Redemptions in Kind
6. Discussion of Additional Liquidity Risk
Management Tools
7. Cross-Trades
D. Board Approval and Designation of Program Administrative Responsibilities
1. Initial Approval of Liquidity Risk
Management Program
2. Approval of Material Changes to
Liquidity Risk Management Program and Oversight of the Three-Day Liquid Asset Minimum
3. Designation of Administrative
Responsibilities to Fund Investment Adviser or Officers
4. Request for Comment
E. Liquidity Risk Management Program Recordkeeping Requirements F. Swing Pricing
1. Proposed Rule 22c–1(a)(3)
2. Guidance on Operational Considerations
Relating to Swing Pricing
3. Master-Feeder Funds
4. Financial Statement Disclosure
Regarding Swing Pricing
G. Disclosure and Reporting Requirements Regarding Liquidity Risk and Liquidity Risk Management
1. Proposed Amendments to Form N–1A
2. Proposed Amendments to Proposed
Form N–PORT
3. Proposed Amendments to Proposed
Form N–CEN
H. Compliance Dates
1. Liquidity Risk Management Program
2. Swing Pricing
3. Amendments to Form N–1A
4. Amendments to Form N–PORT
5. Amendments to Form N–CEN
6. Request for Comment
IV. Economic Analysis
A. Introduction and Primary Goals of Proposed Regulation B. Economic Baseline
1. Funds’ Current Practices Regarding
Liquidity Risk Management, Swing Pricing, and Liquidity Risk Disclosure
2. Economic Trends Regarding Funds’
Liquidity and Liquidity Risk Management
3. Fund Industry Developments
Highlighting the Importance of Funds’ Liquidity Risk Management
C. Benefits and Costs, and Effects on
Efficiency, Competition, and Capital Formation
1. Proposed Rule 22e–4
2. Swing Pricing
3. Disclosure and Reporting Requirements
Regarding Liquidity Risk and Liquidity Risk Management D. Request for Comment
V. Paperwork Reduction Act Analysis
A. Introduction
B. Rule 22e–4
C. Rule 22c–1
D. Rule 31a–2
E. Form N–PORT
F. Form N–CEN
G. Form N–1A
H. Request for Comments
VI. Initial Regulatory Flexibility Act Analysis
A. Reasons for and Objectives of the Proposed Actions B. Legal Basis
C. Small Entities Subject to the Proposed
Liquidity Regulations
D. Projected Reporting, Recordkeeping, and Other Compliance Requirements
1. Proposed Rule 22e–4
2. Swing Pricing
3. Disclosure and Reporting Requirements
Regarding Liquidity Risk and Liquidity Risk Management E. Duplicative, Overlapping, or Conflicting Federal Rules F. Significant Alternatives G. General Request for Comment
VII. Consideration of Impact on the Economy
VIII. Statutory Authority and Text of
Proposed Amendments
Text of Rules and Forms
I. Introduction
Daily redeemability is a defining feature of open-end management investment companies (‘‘open-end funds’’ or ‘‘funds’’) such as mutual funds.2 As millions of Americans have come to rely on open-end funds as an investment vehicle of choice, the role of fund liquidity management in reducing the risk that a fund will be unable to meet its obligations to redeeming shareholders while also minimizing the impact of those redemptions on the fund (i.e., mitigating investor dilution) is becoming more important than ever. The U.S. fund industry has experienced significant growth in the last 20 years,3 markets have grown more complex, and funds pursue more complex investment strategies, including fixed income and alternative investment strategies that are focused on less liquid asset classes. Yet, it has been over twenty years since we have provided guidance regarding the liquidity of open-end funds other than money market funds.4 We remain committed, as the primary regulator of open-end funds, to designing regulatory programs that respond to the risks associated with the increasingly complex portfolio composition and operations of the asset management industry. Commission staff engaged with large and small fund complexes to better understand funds’ management of liquidity risk. Through these outreach efforts our staff has learned that, while some funds and their managers have developed comprehensive liquidity risk management programs, others have dedicated significantly fewer resources to managing liquidity risk in a formalized way. We believe proposing to address these variations in practices is appropriate and that it is in the interest of funds and fund investors to create a regulatory framework that would reduce the risk that a fund will be unable to meet its redemption obligations and minimize dilution of shareholder interests by promoting stronger and more effective liquidity risk management across open-end funds. We are proposing a set of comprehensive reforms that would provide for: (i) Liquidity risk management standards that address issues arising from modern portfolio construction; (ii) a new pricing method that, if funds choose to use it, could better allocate costs to shareholders entering or exiting the fund; and (iii) fuller disclosure of information regarding the liquidity of fund portfolios and how funds manage liquidity risk and redemption obligations. To accomplish this, first, we are proposing new rule 22e–4 under the Act, which would require funds to establish liquidity risk management programs. Under the proposed rule, the principal components of a liquidity risk management program would include a fund’s classification and monitoring of each portfolio asset’s level of liquidity, as well as designation of a minimum amount of portfolio liquidity, which funds would tailor to their particular

5ETFs registered with the Commission are organized either as open-end management investment companies or unit investment trusts. See section 4(2) of the Act (defining ‘‘unit investment trust’’ as an investment company which (i) is organized under a trust indenture, contract of custodianship or agency, or similar instrument, (ii) does not have a board of directors, and (iii) issues only redeemable securities, each of which represents an undivided interest in a unit of specified securities, but does not include a voting trust). Most ETFs are organized as open-end management investment companies and, except where specified, when we refer to ETFs in this release, we are referring to ETFs that are organized as open-end management investment companies. 6See 2015 ICI Fact Book, supra note 3, at 114. 7See section 2(a)(32) of the Act (defining a ‘‘redeemable security’’ as any security, other than short-term paper, that entitles its holder to receive approximately his proportionate share of the issuer’s current net assets, or the cash equivalent thereof), and section 22(e) of the Act (providing, in
part, that no open-end fund shall suspend the right
of redemption, or postpone the date of payment upon redemption of any redeemable security in accordance with its terms for more than seven days after tender of the security absent specified unusual circumstances). 8See 2015 ICI Fact Book, supra note 3, at 60. 9See Exchange-Traded Funds, Investment Company Act Release No. 28193 (Mar. 11, 2008) [73 FR 14618 (Mar. 18, 2008)] (‘‘ETF Proposing Release’’). 10Authorized participants purchase ETF shares at the ETF’s NAV through the ETF’s underwriter or other service provider. 11See Request for Comment on Exchange-Traded Products, Securities Exchange Act Release No. 75165 (June 12, 2015) [80 FR 34729 (June 17, 2015)] (‘‘2015 ETP Request for Comment’’), at n.19 and accompanying text. 12See id. at n.20 and accompanying text. 13See id. at n.21 and accompanying text. 14For example, if ETF shares begin trading on national securities exchanges at a price below the ETF’s NAV, authorized participants can purchase ETF shares in secondary market transactions and, after accumulating enough shares to comprise a creation unit, redeem them from the ETF in exchange for the more valuable securities in the ETF’s redemption basket. Those purchases create greater market demand for the ETF shares, and thus tend to drive up the market price of the shares to a level closer to NAV. Conversely, and again by way of example, if the market price for ETF shares exceeds the NAV of the ETF itself, an authorized participant can deposit a basket of securities in exchange for the more valuable creation unit of ETF shares, and then sell the individual shares in the market to realize its profit. These sales would increase the supply of ETF shares in the secondary market, and thus tend to drive down the price of the ETF shares to a level closer to the NAV of the ETF share. In each case, the authorized participant (or its market maker customer) may hedge its circumstances after consideration of a set of market-related factors established by the Commission. Second, in order to provide funds with an additional tool to mitigate potential dilution and to manage fund liquidity, we are proposing amendments to rule 22c–1 under the Act to permit funds (except money market funds and ETFs) to use ‘‘swing pricing,’’ a process of adjusting the net asset value of a fund’s shares to pass on to purchasing or redeeming shareholders more of the costs associated with their trading activity. Lastly, in order to give investors, market participants, and Commission staff improved information on fund liquidity and redemption practices, we are proposing amendments to our disclosure requirements and recently proposed data reporting forms. We discuss these proposals as well as why liquidity management is so vital to investors in open-end funds and the developments that have led us to this proposal further below. Taken together, these reforms are designed to provide investors with increased protections regarding how liquidity in their open-end funds is managed,
thereby reducing the risk that funds will be unable to meet redemption obligations and mitigating dilution of the interests of fund shareholders. These reforms are also intended to give investors better information with which to make investment decisions, and to give the Commission better information with which to conduct comprehensive monitoring and oversight of an everevolving fund industry.
II. Background
A. Open-End Funds
Over the past few decades, investors increasingly have come to rely on investments in open-end funds to meet their financial needs and access the capital markets. Individuals invest in these funds for a variety of reasons, from investing for retirement and their children’s college education to providing a source of financial security for emergencies and other lifetime events. Institutions also invest significantly in open-end funds as part of basic or sophisticated trading and hedging strategies or to manage cash flows. There are currently two kinds of open-end funds: Mutual funds and ETFs.5 At the end of 2014, 53.2 million households, or 43.3 percent of all U.S. households owned mutual funds.6 Mutual funds allow investors to pool their investments with those of other investors so that they may together benefit from fund features such as professional investment management, diversification, and liquidity. Fund shareholders share the gains and losses of the fund, and also share its costs. Investors in mutual funds can redeem their shares on each business day and, by law, must receive their pro rata share of the fund’s net assets (or its cash value) within seven calendar days after delivery of a redemption notice.7 ETFs also offer investors an undivided interest in a pool of assets. Since 2003, the number of ETFs traded in U.S. markets has increased by more than 1,200 funds, and the assets held by ETFs have increased from $151 billion at the end of 2003 to $1.9 trillion at the end of 2014.8 ETF shares, similar to stocks, are bought and sold throughout the day by investors on an exchange through a broker-dealer.9 In addition, like mutual funds, ETFs provide redemption rights on a daily basis, but, pursuant to exemptive orders, such redemption rights may only be exercised by certain large market participants—typically broker-dealers— called ‘‘authorized participants.’’ Authorized participants may purchase and redeem ETF shares at the ETF’s net asset value per share (‘‘NAV’’) from the ETF.10 When an authorized participant transacts with an ETF to purchase and sell ETF shares, these share transactions are structured in large blocks called ‘‘creation units.’’ Most ETFs are structured so that an authorized participant will purchase a creation unit with a ‘‘portfolio deposit,’’ which is a basket of assets (and sometimes cash) that generally reflects the composition of the ETF’s portfolio.11 The ETF makes public the contents of the portfolio deposit before the beginning of the trading day.12 After purchasing a creation unit, an authorized participant may hold the ETF shares or sell (or lend) some or all of them to investors in the secondary market. Similarly, for most ETFs, when an authorized participant wishes to redeem ETF shares, it presents a creation unit of ETF shares to the ETF for redemption and receives in return a ‘‘redemption basket,’’ the contents of which are made public by the ETF before the beginning of the trading day. The redemption basket
(which is usually, but not always, the same as the portfolio deposit) typically consists of securities and a small amount of cash.13 In addition, while less common, some ETFs represent to the Commission that they ordinarily intend to conduct all purchase and redemption transactions with authorized participants in cash instead of an in-kind basket of assets, and all ETFs reserve the right to transact with authorized participants in cash. The ability of these authorized participants to purchase and redeem creation units at each day’s NAV enables authorized participants (or market makers that trade through authorized participants) to exercise arbitrage opportunities that are generally expected to have the effect of keeping the market price of ETF shares at or close to the NAV of the ETF.14

exposure to cover the risk from the time the arbitrage opportunity is exercised through the time it can deliver shares or assets to the ETF, at which time it will unwind its hedge. See ETF Proposing Release, supra note 9, at nn.25–30 and accompanying text; see also 2015 ETP Request for Comment, supra note 11, at section I.C.2. 15See Eaton Vance Management, et al., Investment Company Act Release Nos. 31333 (Nov. 6, 2014) (notice) (‘‘ETMF Notice’’) and 31361 (Dec. 2, 2014) (order). For the purposes of the proposed amendments to rule 22c–1, the definition of ‘‘exchange-traded fund’’ shall include ETMFs. 16For example, many retail investors would have difficulty investing in certain foreign and emerging market securities given local requirements for purchasing and holding such securities. In addition, some securities may only be sold in large blocks that retail investors would be unlikely to be able to purchase. Many retail investors also may not have the expertise to construct investment strategies followed by, for example, alternative funds on their own. See also Notice Seeking Comment on Asset Management Products and Activities, Docket No. FSOC–2014–0001 (‘‘FSOC Notice’’); Comment Letter of the Asset Management Group of SIFMA and the Investment Adviser Association on the FSOC Notice (Mar. 25, 2015) (‘‘SIFMA IAA FSOC Notice Comment Letter’’), at 12 (‘‘Pooled funds provide many individual investors exposure to asset classes that they could not reach without investing collectively.’’); Comment Letter of the Investment Company Institute on the FSOC Notice (Mar. 25, 2015) (‘‘ICI FSOC Notice Comment Letter’’), at 11 (‘‘The vast majority of [mutual fund] investors would be unable to replicate such investment exposure by directly holding securities themselves.’’). 17See e.g., Rick Ferri, Index Funds Gain Momentum (Part 1 of 2), FORBES (July 29, 2013), available at http://www.forbes.com/sites/rickferri/ 2013/07/29/index-funds-gain-momentum-part-1-of2/ (discussing the growth of passively managed index funds and ETFs that follow indexes). 18See sections 5(a)(1) and 2(a)(32) of the Act. All other management companies are closed-end (‘‘closed-end funds’’). Closed-end fund shareholders do not have redemption rights and closed-end funds are usually traded on secondary markets, either on exchanges or over the counter, at prices that may be at a premium or a discount to the fund’s NAV. 19Section 22(e) of the Act provides, in part, that no registered investment company shall suspend the right of redemption or postpone the date of payment upon redemption of any redeemable security in accordance with its terms for more than seven days after tender of the security absent specified unusual circumstances. 20See Comment Letter of Fidelity Investments on the FSOC Notice (Mar. 25, 2015) (‘‘Fidelity FSOC Notice Comment Letter’’), at 6 (‘‘mutual funds normally process redemption requests by the next business day’’); see also ICI FSOC Notice Comment Letter, supra note 16, at
17 (‘‘For example, a mutual fund has by law up to seven days to pay proceeds to redeeming investors, although as a matter of practice funds typically pay proceeds within one to two days of a redemption request.’’). 21 17 CFR 240.15c6–1. In a 1995 staff no-action letter, the Division of Investment Management expressed the view that because rule 15c6–1 under the Exchange Act applies to broker-dealers and does not apply directly to funds, the implementation of T+3 pursuant to rule 15c6–1 did not change the standards for determining liquidity, which were based on the requirements of section 22(e) of the Investment Company Act. The Division noted, however, that as a practical matter, many funds have to meet redemption requests within three business days because a broker-dealer is often involved in the redemption process. See Letter from Jack W. Murphy, Associate Director and Chief Counsel, Division of Investment Management, SEC, to Paul Schott Stevens, General Counsel, Investment Company Institute (May 26, 1995), available at http://www.sec.gov/divisions/ investment/noaction/1995/ici052695.pdf, (‘‘May 1995 Staff No-Action Letter’’); see also Fidelity FSOC Notice Comment Letter, supra note 20, at 6 (‘‘As a practical matter, three-day settlement requirements under Exchange Act Rule 15c6–1 . . . effectively take most fund investments to a T+3 settlement timeline.’’). 22See ICI FSOC Notice Comment Letter, supra note 16, at 6–7 (‘‘Daily redeemability is a defining feature of mutual funds. This means that liquidity management is not only a regulatory compliance matter, but also a major element of investment risk management, an intrinsic part of portfolio management, and a constant area of focus for fund managers.’’). 23ETFs have some discretion in determining their basket composition. See, e.g., New York Alaska ETF Management LLC, et al., Investment Company Act Release Nos. 31667 (June 12, 2015) (notice) and 31709 (July 8, 2015) (order). 24ETF Proposing Release, supra note 9 at section III.A.1. But see, e.g., Shelly Antoniewicz, Investment Company Institute, Plenty of Players Provide Liquidity for ETFs (Dec. 2, 2014), available at http://www.ici.org/viewpoints/view_14_ft_etf_ liquidity (‘‘Antoniewicz’’) (stating that most of the trading activity in bond ETF shares is done in the secondary market and not through creations and redemptions with authorized participants). Recently, the Commission has also approved exchange-traded managed funds (‘‘ETMFs’’).15 ETMFs are a hybrid between a traditional mutual fund and an ETF. Like ETFs, ETMFs would have shares listed and traded on a national securities exchange; directly issue and redeem shares in creation units only; impose fees on creation units issued and redeemed to authorized participants to offset the related costs to the ETMFs; and primarily utilize in-kind transfers of portfolio deposits in issuing and redeeming creation units. Like mutual funds, ETMFs would be bought and sold at prices linked to NAV and
would seek to maintain the confidentiality of their current portfolio positions. While no ETMF has been launched yet, the proposed rule and amendments (except the proposed amendments to rule 22c–
1) would also apply to ETMFs to the
same extent as to other open-end funds whose shares are redeemable on a daily basis. Open-end funds are an attractive investment option for many different types of investors because they provide diversification, economies of scale, and professional management. They also facilitate retail investors’ access to certain investment strategies or markets that might be difficult (if not impossible) or time consuming for investors to replicate on their own.16 Additionally, open-end funds have become a popular investment vehicle because they may provide a costefficient way for investors to track a benchmark index or strategy.17 B. The Role of Liquidity in Open-End Funds

Introduction
A hallmark of open-end funds is that they must be able to convert some portion of their portfolio holdings into cash on a frequent basis because they issue redeemable securities,18 and are required by section 22(e) of the Investment Company Act to make payment to shareholders for securities tendered for redemption within seven days of their tender.19 As a practical matter, many investors expect to receive redemption proceeds in less than seven days as some mutual funds disclose in their prospectuses that they will generally pay redemption proceeds on a next-business day basis.20 Furthermore, open-end funds that are redeemed through broker-dealers must meet redemption requests within three business days because broker-dealers are subject to rule 15c6–1 under the Securities Exchange Act of 1934 (the ‘‘Exchange Act’’), which establishes a three-day (T+3) settlement period for security trades effected by a broker or a dealer.21 Given the statutory and regulatory requirements for meeting redemption requests, as well as any disclosure made to investors regarding payment of redemption proceeds, a mutual fund must adequately manage the liquidity of its portfolio so that redemption requests can be satisfied in a timely manner.22 Sufficient liquidity of ETF portfolio positions also is important. ETFs typically make in-kind redemptions of creation units, which can mitigate liquidity concerns for ETFs compared to mutual funds, if the in-kind redemptions are of a representative basket of the ETF’s portfolio assets that do not alter the ETF’s liquidity profile.23 However, transferring illiquid instruments to the redeeming authorized participants could result in a liquidity cost to the authorized participant or any of its clients, which would then be reflected in the bid-ask spread and ultimately impact investors. Moreover, declining liquidity in an ETF’s basket assets could affect the ability of an authorized participant or any of its clients to readily assemble the basket for purchases of creation units and to sell securities received upon redemption of creation units.24 In addition, a significant amount of illiquid securities in an ETF’s portfolio can make arbitrage opportunities more difficult to evaluate because it would be difficult for market makers to price, trade, and hedge their exposure to, the

25See Comment Letter of the Investment Company Institute on Exchange-Traded Funds, File No. S7–07–08 (May 19, 2008) (discussing the impact of the inclusion of illiquid assets in an ETF’s portfolio). See also Comment Letter of The American Stock Exchange LLC on the Concept Release: Actively Managed Exchange-Traded Funds, File No. S7–20–01 (Mar. 5, 2002) (‘‘Ultimately it is in the interest of the sponsor and investment adviser to provide for effective arbitrage opportunities. It is unlikely that an . . . ETF sponsor would be able to convince the critical market participants such as specialists, market makers, arbitragers and other Authorized Participants to support a product that contained illiquid securities to a degree that would affect the liquidity of the ETF, making it difficult to price, trade and hedge, ultimately leading to its failure in the marketplace.’’). 26ETFs exist today only through exemptive orders issued by the Commission providing relief from a number of provisions of the Investment Company Act, including the requirement that they sell and redeem their individual shares at NAV. 27See 2015 ETP Request for Comment, supra note 11, at n.102 and accompanying text (requesting comment on the trading of exchange-traded product securities that invest in less liquid assets and the effective functioning of the arbitrage mechanism in these products). See, e.g., Comment Letter of BlackRock, Inc. on the 2015 ETP Request for Comment (Aug. 11, 2015) (discussing the arbitrage mechanism with respect to less liquid assets); Comment Letter of KCG Holdings, Inc. on the 2015 ETP Request for Comment (Aug. 17, 2015) (‘‘While ETF pricing closely tracks NAV for most ETFs, certain types of ETFs exhibit less close alignment between ETF prices and NAV. . . Price discovery difficulties in the bond market makes it much more difficult and expensive to perform arbitrage in bond ETFs, and this difficultly may be exacerbated during stressed market environments.’’); Comment Letter of State Street Global Advisors on the 2015 ETP Request for Comment (Aug. 17, 2015) (discussing the arbitrage mechanism with respect to fixed-income based ETFs). 28See, e.g., Bradley Hope et al., Stock-Market Tumult Exposes Flaws in Modern Markets, The Wall Street Journal (Aug. 25, 2015), available at http://www.wsj.com/articles/stock-market-tumultexposes-flaws-in-modern-markets-1440547138 (noting that ‘‘[d]ozens of ETFs traded at sharp discounts’’ to NAV during a market sell-off, ‘‘leading to outsize losses for investors who entered sell orders at the depth of the panic’’). We recognize that not all changes in market liquidity can lead to such extreme results. In many cases of day-to-day price volatility and fluctuations in liquidity, market participants will simply demand greater compensation for purchasing less liquid or more volatile assets. However, declining liquidity can become so acute that market makers and investors begin to refrain from conducting transactions. See, e.g.,
Carrie Driebusch et al., The Problem with ETFs, The Wall Street Journal (Sept. 14, 2015) (stating that the ‘‘trading turmoil of Aug. 24 disrupted the arbitrage activity in which traders buy and sell ETFs and their components to take advantage of price discrepancies.’’). 29See, e.g., Matthew Tucker & Stephen Laipply, ‘‘Fixed Income ETFs and the Corporate Bond Liquidity Challenge’’ (2014), available at http:// www.ishares.com/us/literature/brochure/blackrockish-fixed-income-etfs-wp-prd-814.pdf, at 9 (‘‘It should be noted that, although fixed income ETFs have created an incremental source of bond market liquidity for investors, the ETF structure itself remains dependent on the liquidity of the underlying bond market. ETFs serve as efficient risk transfer vehicles because the value at which they trade is reflective of the value of the underlying bonds held within the ETF. If a true and actionable value discrepancy between the ETF and its underlying bond portfolio develops, market participants can trade one versus the other to take advantage of the arbitrage opportunity. This mechanism is premised upon a functioning OTC bond market that can be accessed to buy and sell the underlying securities. Ultimately, if the underlying bond market liquidity becomes impaired then the ETF creation/redemption process would become impaired as well. In such a scenario the ETF would continue to provide price discovery, but would mechanically begin to function more like a closed-end fund (which is unable to grow or shrink in size in order to balance supply and demand). While ETFs provide liquidity enhancement for the bond market, they remain structurally dependent upon the same market.’’). Market stresses have demonstrated how declines in market liquidity may cause an ETF’s shares to trade at a significant premium or discount to the shares of the ETF’s underlying portfolio assets. See, e.g., Eleanor Laise, Risks Lurk for ETF Investors, The Wall Street Journal (Feb. 1, 2010), available at http://www.wsj.com/articles/SB10001424 052748703837004575012772071656484 (‘‘A lack of liquidity also may cause the ETF to trade at a large premium or discount to net asset value. . . . This means an investor buying the fund may overpay for that portfolio, or an investor selling could get less than that basket of securities is worth.’’); Bradley Kay, Has the ETF Arbitrage Mechanism Failed?, Morningstar (Mar. 11, 2009), available at http:// news.morningstar.com/articlenet/
article.aspx?id=283302 (stating that during periods
of market stress, market prices for ETFs may deviate significantly from NAV); ETF Trends, While Athens Exchange is Closed, the Greece ETF Show Goes On (July 6, 2015), available at http:// www.etftrends.com/2015/07/while-athensexchange-is-closed-the-greece-etf-show-goes-on/ (reporting that the Global X FTSE Greece 20 ETF was trading at a significant discount compared to the net asset value of its underlying portfolio assets because of the closure of the Athens Stock Exchange); ETF Trends, China A-Shares ETFs Trading at Steep Discount to NAV (July 9, 2015), available at http://www.etftrends.com/2015/07/ china-a-shares-etfs-trading-at-steep-discount-tonav/ (reporting that U.S.-listed China A-shares ETFs were trading at a steep discount to the underlying market because of the fact that a significant number of companies stopped trading on China’s mainland stock exchanges). 30When an ETF does permit an authorized participant to redeem in cash, it typically requires the authorized participant to pay a fee covering the costs of the liquidity it receives. See BlackRock, Viewpoint, Fund Structures as Systemic Risk Mitigants (Sept. 2014), available at http:// www.blackrock.com/corporate/en-us/literature/ whitepaper/viewpoint-fund-structures-as-systemicrisk-mitigants-september-2014.pdf (‘‘BlackRock Fund Structures Paper’’), at 7. 31However, an ETMF’s transferring illiquid instruments to the redeeming authorized participants would likely affect the premium/ discount over NAV at which ETMF shares trade. See ETMF Notice, supra note 15, at n.17. 32ETMF market makers would assume no intraday market risk in their ETMF share inventory positions because all trading prices are linked to NAV. See id. at paragraphs 13 and 24. 33See supra note 2. ETF.25 The effective functioning of this arbitrage mechanism has been pivotal to the operation of ETFs and to the Commission’s approval of exemptions that allow their operation.26 The liquidity of the ETF’s portfolio positions is a factor that contributes to the effective functioning of the ETF’s arbitrage mechanism and the ETF shares trading at a price that is at or close to the NAV of the ETF.27 If authorized participants are unwilling or unable to trade ETF shares in the primary market, and the majority of trading takes place among investors in the secondary market, the ETF’s shares may trade at a significant premium or a discount to the value of the ETF’s underlying portfolio securities.28 As a result, the ETF’s arbitrage mechanism that keeps the secondary price at or close to NAV would not function effectively. In a period of significant decline in market liquidity, this could cause the ETF, in effect, to function more like a closedend investment company, potentially frustrating the expectations of secondary market investors.29 In addition, all ETFs permit authorized participants to redeem in cash, rather than in kind, and some ETFs ordinarily redeem authorized participants in cash. ETFs that elect to redeem authorized
participants in cash, like mutual funds, would need to ensure that they have adequate portfolio liquidity (in conjunction with any other liquidity sources) to meet shareholder redemptions.30 As noted above, ETMFs have features of both mutual funds and ETFs. As ETMFs would redeem their shares on a daily basis from authorized participants, the ETMF would need to hold sufficiently liquid assets to meet such redemptions to the extent that authorized participants redeem in cash. Like ETFs, however, the ETMF’s ability to make in-kind redemptions could mitigate liquidity concerns.31 Further, as ETMF market makers would not engage in the same arbitrage as ETF market makers,32 the liquidity of an ETMF’s portfolio might have a limited relevance beyond the ETMF’s ability to meet redemptions.
2. Liquidity Management by Open-End
Funds
Portfolio managers consider a variety of factors in addition to liquidity when constructing a fund’s portfolio, including the fund’s investment strategies, economic and market trends, portfolio asset credit quality, and tax considerations. Nevertheless, meeting daily redemption obligations is fundamental for open-end funds, and funds must manage liquidity in order to meet these obligations.33 Several factors influence how liquidity management by open-end funds affects the equitable treatment of investors in a fund, investor incentives, and potentially the orderly operation of the markets when fulfilling redemption obligations.

34A fund can have cash on hand to meet redemptions from cash held in the fund’s portfolio, cash received from investor purchases of fund shares, interest payments and dividends on portfolio securities, or maturing bonds. See, e.g., Fidelity FSOC Notice Comment Letter, supra note 20, at n.17 (‘‘[S]ecurities do not need to be sold every time a redemption order is placed. Sale of fund assets is necessary only when gross redemptions significantly exceed net inflows.’’). 35See, e.g., id., at 21 (‘‘When facing stressed markets and shareholder redemptions, a portfolio manager must decide whether to: (i) maintain current portfolio composition and sell a cross
section of holdings; (ii) meet redemptions with cash
and/or index futures if held, with the result being increased concentrations in non-cash positions; or (iii) reposition a portfolio’s composition by selling a mixture of holdings and cash and/or index futures, thereby realigning holdings in response to shifting market prices and expectations.’’). A fund could also use a line of credit to meet redemptions instead of selling assets, but using a line of credit leverages the fund, and thus many funds only do so infrequently. See infra section III.C.5.a (discussing the extent to which drawing on a credit line to meet redemptions could result in negative impacts on the fund, and providing guidance on borrowing arrangements entered into by funds); see also Fidelity FSOC Notice Comment Letter, supra note 20, at 21 (‘‘Fully substituting cash liquidation for security sales is a very short-term strategy if redemptions are persistent.’’); Comment Letter of Invesco Ltd. on the FSOC Notice (Mar. 25,
2015) (‘‘Invesco FSOC Notice Comment Letter’’), at
10 (stating that Invesco portfolio managers do not automatically sell the most liquid assets when there is a need to raise cash for redemptions or other purposes and that they may seek to rebalance portfolios in falling markets in a manner that cushions the impact of redemptions). But see infra note 371 (noting that other funds rely on lines of credit more frequently). A fund also may reserve the right to redeem its shares in kind instead of in cash. However, there are often logistical issues associated with paying inkind redemptions, which limit the availability of inkind redemptions under many circumstances. See infra section III.C.5.c. 36Some mutual funds disclose that they may temporarily depart from their investment strategies in order to take a ‘‘temporary defensive position’’ to avoid losses in response to adverse market, economic, political or other conditions. See Investment Company Names, Investment Company Act Release No. 24828 (Jan. 17, 2001) [66 FR 8509 (Feb. 1, 2001)] (‘‘Investment Company Names Rule Release’’). 37See, e.g., Matt Wirz, Waddell Fund’s Sales Leave Investors With Riskier Securities, The Wall Street Journal (June 16, 2015), available at http:// www.wsj.com/articles/waddell-funds-sales-leaveinvestors-with-riskier-securities-1434482621 (noting that from July 2014 through June 2015, a high-yield bond fund experienced heavy redemptions that caused its net assets to shrink 33% in this period, and during this same period, the fund’s holdings of bonds rated triple-C or below grew to 47% of assets, from 35% before the redemptions). 38There are practical limitations on a fund’s ability to sell a pro rata slice of its portfolio, such as minimum trade sizes, transfer restrictions, illiquid assets, tax complications from certain sales, and avoidance of odd lot positions. 39Paul Hanouna, Jon Novak, Tim Riley, Christof Stahel, ‘‘Liquidity and Flows of U.S. Mutual Funds,’’ Division of Economic and Risk Analysis White Paper, September 2015, available at http:// wcm.sec.gov/dera/staff-papers/white-papers/ liquidity-white-paper-09-2015.pdf. 40Rule 22c–1(a). See also supra note 2. 41Commission rules do not require that a fund calculate its NAV at a specific time of day. Rule 22c–1 generally requires that the purchase and redemption of a redeemable security be effected at the current NAV next computed after receipt of a purchase or redemption request. See rule 22c–1(a). Current NAV must be computed at least once daily, subject to limited exceptions, Monday through Friday, at the specific time or times set by the board of directors. See rule 22c–1(b)(1). 42Rule 2a–4(a)(2)–(3). 43See Adoption of Rule 2a–4 Defining the Term ‘‘Current Net Asset Value’’ in Reference to Redeemable Securities Issued by a Registered Investment Company, Investment Company Act Release No. 4105 (Dec. 22, 1964) [29 FR 19100 (Dec. 30, 1964)]. First, it is important to consider how a mutual fund (or ETF redeeming shares by using significant amounts of cash) meets
redemptions. When a fund receives redemption requests from shareholders, and the fund does not have cash on hand to meet those redemptions,34 the fund has discretion to determine whether to sell portfolio assets to generate cash to meet the redemptions and which assets will be sold, or to obtain cash by other available means such as bank lines of credit.35 A fund may choose to sell its most liquid assets first. This method of selling is limited to some degree by the investment strategies of the fund, and a fund pursuing this method of meeting redemptions to any significant degree may in the near term need to rebalance its portfolio so that the fund continues to follow its investment strategies.36 A fund that chooses to sell its most liquid assets to meet fund redemptions may minimize the effect of the redemptions on short-term fund performance for redeeming and remaining shareholders, but may leave remaining shareholders in a potentially less liquid and riskier fund until the fund rebalances.37 In contrast to meeting redemptions by selling its most liquid assets first, a fund alternatively could choose to meet redemptions by selling, to the best of its ability, a ‘‘strip’’ of the fund’s portfolio (i.e., a cross-section or representative selection of the fund’s portfolio assets).38 Funds also could choose to meet redemptions by selling a range of assets in between its most liquid, on one end of the spectrum, and a perfect pro rata strip of assets, on the other end of the spectrum. Additionally, funds could choose to opportunistically pare back or eliminate holdings in a particular asset or sector to meet redemptions. As discussed further in section IV.B.2, analysis conducted by staff in the Division of Economic and Risk Analysis (the ‘‘DERA Study’’ 39) suggests that the typical U.S. equity fund appears to sell relatively more liquid assets (as opposed to a strip of the fund’s portfolio) to meet redemptions, and that as a fund’s liquidity decreases, a fund will become even more likely to sell its relatively more liquid assets (rather than a strip of its portfolio) to meet redemptions (thus resulting in decreased liquidity in the fund’s portfolio). Second, the effect of redemptions on shareholders is determined by how and when those redemptions affect the price of the fund’s shares. Under rule 22c–1, all investors who redeem from an openend fund on any particular day must receive the NAV next calculated by the fund after receipt of such redemption request.40 As most funds, with the exception of money market funds, only calculate their NAV once a day, this means that redemption requests received during the day receive the end of day NAV, typically calculated as of 4 p.m. Eastern time.41 When calculating a fund’s NAV, however, rule 2a–4 requires funds to reflect changes in holdings of portfolio securities and changes in the number of outstanding shares resulting from distributions, redemptions, and repurchases no later than the first business day
following the trade date.42 We allow this calculation method to provide funds with additional time and flexibility to incorporate last-minute portfolio transactions into their NAV calculations on the business day following the trade date, rather than the trade date.43 As a practical matter, this calculation method also gives broker-dealers, retirement plan administrators, and other intermediaries additional time to process transactions received by 4 p.m. on the trade date, which then may be reflected in the fund’s NAV on the business day following the trade date. Given that under many circumstances reflecting these changes on the trade date would not materially affect the fund’s price, we have allowed and continue to allow such changes to be reflected no later than the first business day following the trade date. Nevertheless, we recognize that trading activity and other changes in portfolio holdings associated with meeting redemptions may occur over multiple business days following the redemption request. Such activities associated with meeting redemptions may include, for example, selling assets and, if the fund’s most liquid assets are sold to meet redemptions, rebalancing the portfolio to avoid departing from the fund’s investment strategies. If these activities occur (and their associated costs are incurred) in days following redemption requests, the costs of providing liquidity to redeeming investors could be borne at least partially by the remaining investors in the fund, thus potentially diluting the

44See, e.g., Comment Letter of Mutual Fund Directors Forum on the FSOC Notice (Mar. 25, 2015), at 5 (stating that ‘‘there could be severe outlier situations in which sudden and extensive redemptions might impose costs on non-redeeming shareholders, either because of increases in transaction costs associated with selling portfolio securities in stressful circumstances or because portfolio managers are forced to sell securities into falling markets at a price less than what they believe the security’s fundamental value to be.’’). We note that ETFs either conduct redemptions with authorized participants in kind or, if in cash, typically require the authorized participant to pay a fee covering the costs of the liquidity it receives. See supra note 30 and accompanying text. Accordingly, ETFs do not necessarily create the same dilution concerns as mutual funds. 45See Comment Letter of Nuveen Investments on the FSOC Notice (Mar. 25, 2015) (‘‘Nuveen FSOC Notice Comment Letter’’), at 10 (stating that ‘‘to the extent that the prices of portfolio securities do not reflect the most current market conditions, which is more likely to occur with less liquid asset classes in stressed markets, a fund with net redemptions may be paying more to redeeming shareholders than it should (giving such redeemers a ‘first mover advantage’), thereby harming remaining shareholders and the long-term performance of the fund’’ but noting that there is no evidence that shareholders are actually motivated by this advantage); Comment Letter of Occupy the SEC on the FSOC Notice (Mar. 25, 2015) (‘‘Occupy the SEC FSOC Notice Comment Letter’’), at 13 (stating that many funds that hold securities traded over-thecounter cannot observe market prices so they base their NAVs on price estimates and that these ‘‘estimates are surely lagging, particularly in turbulent times’’). 46See, e.g., Jason Greene & Charles Hodges, The Dilution Impact of Daily Fund Flows on Open-end Mutual Funds, 65 J. of Fin. Econ. 131 (2002) (‘‘Greene & Hodges’’) (‘‘Active trading of open-end funds has a meaningful economic impact on the returns of passive, nontrading shareholders, particularly in U.S.-based international funds. The overall sample of domestic equity funds shows no dilution impact, but we find an annualized negative impact of 0.48% in international funds (and nearly 1% for a subsample of funds whose daily flows are particularly large).’’). 47See, e.g., In re Heartland Advisors, Inc., et al., Investment Company Act Release No. 28136 (Jan. 25, 2008) (‘‘Heartland Release’’) (settled enforcement action against advisory firm alleging that certain high-yield bond funds experienced liquidity problems (caused in part by adviser’s unwillingness to sell bond holdings at prices below which the funds had valued them) and, as a result, the funds borrowed heavily against a line of credit to meet fund redemption requests, and investors redeemed fund shares at prices that benefited redeeming shareholders at the
expense of remaining and new investors). 48 Id. 49See, e.g., Qi Chen, Itay Goldstein & Wei Jiang, Payoff Complementarities and Financial Fragility:
Evidence from Mutual Fund Outflows, 97 J. Fin. Econ. 239 (2010), at 240 (‘‘Because mutual funds conduct most of the resulting trades after the day of redemption, most of the costs are not reflected in the NAV paid out to redeeming investors, but rather are borne by the remaining investors. This leads to strategic complementarities—the expectation that other investors will withdraw their money reduces the expected return for staying in the fund and increases the incentive for each individual investor to withdraw as well—and amplifies the damage to the fund.’’); Comment Letter of State Street Corporation on the FSOC Notice (Mar. 25, 2015), at 3 (‘‘Anticipation of other investors’ activity could be a powerful motivator for selling units by a fund holder, particularly if the structure of the fund was such that continuing investors were concerned in some way of being disadvantaged by earlier generations of exiting investors.’’). But see Fidelity FSOC Notice Comment Letter, supra note 20, at 9–10 (stating that there are several limitations in the Chen, Goldstein, & Jiang academic paper, including that its analysis excluded retirement shares, analyzed only equity and not bond funds, and did not examine recent data (it examined data from 1995 to 2005); Nuveen FSOC Notice Comment Letter, supra note 45, at 10 (stating that there is no evidence that shareholders are actually motivated by a first-mover advantage). We also note that any first-mover advantage may be further mitigated in ETFs to the extent that they conduct in-kind redemptions of authorized participants or charge liquidity fees for cash redemptions. See supra note 30 and accompanying text. 50See, e.g., Comment Letter of BlackRock on the FSOC Notice (Mar. 25, 2015) (‘‘BlackRock FSOC Notice Comment Letter’’), at 17 (stating that although incentives to redeem may exist, this does not necessarily imply that investors will in fact redeem en masse in times of market stress, but also noting that a well-structured fund ‘‘should seek to avoid features that could create a ‘first-mover advantage’ in which one investor has an incentive to leave’’ before others); Comment Letter of Association of Institutional Investors on the FSOC Notice (Mar. 25, 2015) (‘‘AII FSOC Notice Comment Letter’’), at 10–11 (‘‘The empirical evidence of historical redemption activity, even during times of market stress, supports the view that either (i) there are not ‘incentives to redeem’ that are sufficient to overcome the asset owner’s asset allocation decision or (ii) that there are disincentives, such as not triggering a taxable event, that outweigh the hypothesized ‘incentives to redeem.’ ’’); Comment Letter of The Capital Group Companies on the FSOC Notice (Mar. 25, 2015), at 8 (‘‘We also do not believe that the mutualization of fund trading costs creates any first mover advantage.’’); ICI FSOC Notice Comment Letter, supra note 16, at 7 (‘‘Investor behavior provides evidence that any mutualized trading costs must not be
sufficiently large to drive investor flows. We consistently observe that investor outflows are modest and investors continue to purchase shares in most funds even during periods of market stress.’’). 51See, e.g., Joshua Coval & Erik Stafford, Asset Fire Sales (and Purchases) in Equity Markets, 86 J. Fin. Econ. 479 (2007) (‘‘Coval & Stafford’’) (‘‘Funds experiencing large outflows tend to decrease existing positions, which creates price pressure in the securities held in common by distressed funds. Similarly, the tendency among funds experiencing large inflows to expand existing positions creates positive price pressure in overlapping holdings. Investors who trade against constrained mutual funds earn significant returns for providing liquidity. In addition, future flow-driven transactions are predictable, creating an incentive to front-run the anticipated forced trades by funds experiencing extreme capital flows.’’); Teodor Dyakov & Marno Verbeek, Front-Running of Mutual Fund Fire-Sales, 37 J. of Bank. and Fin. 4931 (2013) (‘‘Dyakov & Verbeek’’) (‘‘We show that a real-time trading strategy which front-runs the anticipated forced sales by mutual funds experiencing extreme capital outflows generates an alpha of 0.5% per month during the 1990–2010 period . . . Our results suggest that publicly available information of fund flows and holdings exposes mutual funds in distress to predatory trading.’’). See infra notes 805–809 and accompanying text for a discussion of predatory trading concerns. 52See, e.g., Greene & Hodges, supra note 46. 53See, e.g., Fidelity FSOC Notice Comment Letter, supra note 20, at 18 (‘‘Managing liquidity levels to fulfill [a fund adviser’s] fiduciary obligations benefits [redeeming and remaining] shareholders as well as the broader financial markets.’’). interests of non-redeeming shareholders.44 The less liquid the fund’s portfolio holdings, the greater these liquidity costs can become.45 Thus, with respect to redemptions, there can be significant adverse consequences to remaining investors in a fund when it fails to adequately manage liquidity.46 For example, portfolio assets held by a fund can become increasingly illiquid as its more liquid portfolio assets are sold to meet redemptions and thus could have a compounding effect of causing the fund’s entire portfolio to become increasingly illiquid for purposes of meeting future shareholder redemptions, which could adversely affect the fund’s risk profile.47 Furthermore, if a fund finds that it can only sell portfolio assets (or portions of a position in a particular asset) that are less liquid at prices that incorporate a significant discount from fair value, the discounted sale price can materially affect the fund’s NAV.48 These factors in fund redemptions— either individually or in combination— can create incentives in times of liquidity stress in the markets for early redemptions (or a ‘‘first-mover advantage’’).49 If investor redemptions are motivated by this first-mover
advantage,50 they can lead to increasing levels of redemptions, and as the level of outflows from a fund increases, the incentive to redeem also increases.51 Regardless of whether investor redemptions are motivated by a firstmover advantage or other factors, there can be significant adverse consequences to remaining investors in a fund when it fails to adequately manage liquidity.52 This underlines the importance of fund liquidity management for advancing investor protection by reducing the risk that a fund would be unable to meet redemption obligations without materially affecting the fund’s NAV.53 There also is a potential for adverse effects on the markets when open-end funds fail to adequately manage liquidity. For example, if liquid asset levels are insufficient to meet redemptions, funds may sell less-liquid portfolio assets at discounted or even fire sale prices. These sales can produce significant negative price pressure on those assets and correlated assets. Accordingly, redemptions and funds’ liquidity risk management can affect not just the remaining investors in the fund, but any other investors holding these assets. Such liquidity stress on the assets held in the fund may transmit

54See, e.g., Francis A. Longstaff, The Subprime Credit Crisis and Contagion in Financial Markets, 97 J. Fin. Econ. No. 3 436 (2010) (finding that financial contagion during the financial crisis from the subprime asset-backed securities market was propagated to other markets primarily through liquidity and risk-premium channels, rather than through a correlated-information channel); U.S. Presidential Task Force on Market Mechanisms & U.S. Dept. of the Treasury, Report of the Presidential Task Force on Market Mechanisms (Jan. 1988), available at https://archive.org/details/ reportofpresiden01unit (‘‘1987 Market Crash Report’’), at III–16—III–26, IV–1—IV–8 (discussing mutual fund selling behavior during the October 1987 stock market crash, and in particular the selling of three mutual fund companies, whose heavy selling of assets to meet significant redemptions ‘‘accounted for approximately one quarter of all trading on the NYSE for the first 30 minutes that the Exchange was open’’ on October 19, 1987 and that such selling had ‘‘a significant impact on the downward direction of the market’’). 55FSOC Notice, supra note 16. 56Comments submitted in response to the FSOC Notice are available at http://www.regulations.gov/ #!docketDetail;D=FSOC-2014-0001. 57See, e.g., Itay Goldstein, Hao Jiang & David T. Ng, Investor Flows and Fragility in Corporate Bond Funds, unpublished working paper (June 25, 2015), available at http://finance.wharton.upenn.edu/ ∼itayg/Files/bondfunds.pdf (finding that ‘‘corporate bond funds tend to have more concave flowperformance relationships when they have more illiquid assets and when the overall market illiquidity is high’’ and that these results ‘‘point to the possibility of fragility’’). 58 DERA Study, supra note 39, at Table 2. 59 Id. 60These figures were obtained from staff analysis of Morningstar Direct data, and are based on fund categories defined by Morningstar. 61See Transcript, Roundtable on Fixed Income Markets (Apr. 16, 2013), available at https:// www.sec.gov/spotlight/fixed-income-markets/2013- 04-16-fixed-income-markets-transcript.txt (discussing, among other topics, liquidity characteristics and risks in the municipal bond and corporate bond markets); Report on the Municipal Securities Market (July 31, 2012), available at https://www.sec.gov/news/studies/2012/ munireport073112.pdf (discussing, among other topics, the low liquidity, opacity and fragmentation of the municipal securities market). 62See, e.g., Chair Mary Jo White, Speech, Intermediation in the Modern Securities Markets:
Putting Technology and Competition to Work for Investors, (June 20, 2014), available at http:// www.sec.gov/News/Speech/Detail/Speech/ 1370542122012; Commissioner Luis A. Aguilar, Speech, Advocating for Investors Saving for Retirement, (Feb. 5, 2015), available at http:// www.sec.gov/news/speech/advocating-for-investorssaving-for-retirement.html; Commissioner Daniel M. Gallagher, Speech, A Watched Pot Never Boils: the Need for SEC Supervision of Fixed Income Liquidity, Market Structure, and Pension Accounting, (Mar. 10, 2015), available at http:// www.sec.gov/news/speech/031015-spch-cdmg.html and Remarks Regarding the Fixed Income Markets at the Conference on Financial Markets Quality, (Sept. 19, 2012), available at http://www.sec.gov/ News/Speech/Detail/Speech/1365171491192; Commissioner Michael S. Piwowar, Speech, Remarks at the 2014 Municipal Finance Conference presented by The Bond Buyer and Brandeis International Business School, (Aug. 1, 2014), available at http://www.sec.gov/News/Speech/ Detail/Speech/1370542588006; Commissioner Kara M. Stein, Speech, Mutual Funds—The Next 75 Years, (June 15, 2015), available at http:// www.sec.gov/news/speech/mutual-funds-the-next75-years-stein.html; Norm Champ, former Director of the Division of Investment Management, Speech, Remarks to the ICI 2014 Securities Law Developments Conference, (Dec. 10, 2014), available at http://www.sec.gov/News/Speech/ Detail/Speech/1370543675348; IM Guidance Update No. 2014–01, Risk Management in Changing Fixed Income Market Conditions (Jan. 2014), available at http://www.sec.gov/divisions/ investment/guidance/im-guidance-2014-1.pdf (‘‘2014 Fixed Income Guidance Update’’). 63See, e.g., 2014 Fixed Income Guidance Update, supra note 62; Office of Compliance Inspections and Examinations, National Exam Program 2015 Examination Priorities, available at http:// www.sec.gov/about/offices/ocie/nationalexamination-program-priorities-2015.pdf (‘‘National Exam Program 2015 Examination Priorities’’) (‘‘With interest rates expected to rise at some point in the future, we will review whether mutual funds with significant exposure to interest rate increases have implemented compliance policies and procedures and investment and trading controls sufficient to ensure that their funds’ disclosures are not misleading and that their investments and liquidity profiles are consistent with those disclosures.’’); Office of Compliance Inspections and Examinations, National Exam Program 2014 Examination Priorities, available at http://www.sec.gov/about/offices/ocie/nationalexamination-program-priorities-2014.pdf (‘‘The staff will monitor the risks associated with a changing interest rate environment and the impact this may have on bond funds and related disclosures of risks to investors.’’). 64 DERA Study, supra note 39, at pp. 7–8. While there is no clear definition of ‘‘alternative’’ in the mutual fund space, an alternative mutual fund is generally understood to be a fund whose primary
investment strategy falls into one or more of the three following buckets: (i) non-traditional asset classes (for example, currencies or managed futures funds), (ii) non-traditional strategies (such as long/ short equity, event driven), and/or (iii) less liquid assets (such as private debt). Their investment strategies often seek to produce positive riskadjusted returns that are not closely correlated to traditional investments or benchmarks, in contrast to traditional mutual funds that historically have pursued long-only strategies in traditional asset classes. stress to other funds or portions of the market as well.54 In December 2014, the Financial Stability Oversight Council (‘‘FSOC’’) issued a notice seeking public comment on the potential risks to the U.S. financial system that may be posed by asset management products and activities in the areas of liquidity and redemptions among others.55 Although our rulemaking proposal is independent of FSOC, several commenters responding to the FSOC notice discussed issues concerning liquidity and redemptions, and we have considered and cited to the relevant comments throughout the release.56 As the primary regulator of the U.S. securities markets, we are proposing rules today that focus on mitigating the adverse effects that liquidity risk in funds can have on investors and the fair, efficient and orderly operation of the markets. To the extent there are any potential financial stability risks from poor fund liquidity management,57 our proposal may mitigate those risks as well.
C. Recent Developments in the OpenEnd Fund Industry
Recent industry developments have underlined our focus on the importance of liquidity risk management practices in open-end funds. These developments include significant growth in assets of, and shareholder inflows into, open-end funds with fixed income strategies and alternative strategies since 2008 and the evolution of settlement periods and redemption practices utilized by openend funds. While mutual funds holding U.S. equities continue to make up the largest category of funds in terms of fund assets, their share of the total industry assets has declined from 65.2% in 2000 to 44.5% in 2014.58 Assets of foreign bond and foreign equity funds have grown during the same period from 11% to 17.4%,59 and there has been significant growth in fixed income and alternative strategy funds, as discussed below.

Fixed Income Funds and Alternative
Funds
We have observed significant growth in cash flows into, and assets of, fixed income mutual funds and fixed income ETFs. Assets in these funds grew from $1.5 trillion at the end of 2008 to $3.5 trillion at the end of 2014, with net inflows exceeding $1.3 trillion during that period.60 As growth in fixed income fund assets was occurring, we increased our focus on fixed income market structure, holding a roundtable focused on the fixed income markets in 2013 and publishing a report on the municipal securities markets in 2012.61 In addition, both Commissioners and Commission staff have spoken about the need to focus on potential risks relating to the fixed income markets and their underlying liquidity.62 Commission staff also has focused on the nature of liquidity risk management in fixed income funds, including by selecting fixed income funds as an examination priority in 2014 and 2015.63 We also have observed recent growth in alternative mutual funds. Since 2005, the assets of open-end funds with alternative strategies have grown significantly, from approximately $365 million at the end of 2005 to approximately $334 billion at the end of
2014.64 Although the assets of open-end
funds pursuing alternative strategies accounted for a relatively small percentage (approximately 3%) of the mutual fund market as of December 2014, the growth of assets in these funds has been substantial, with asset growth of approximately 58% each year from

65 Id.
66See, e.g., Brian Haskin, Flows to Liquid Alts Drop in December, End 2014 Up 10%, DailyAlts.com, (Feb. 16, 2015), available at http:// dailyalts.com/flows-liquid-alts-drop-december-end2014-10 (‘‘Going into 2014, investors held the view that interest rates would rise and, thus, they looked to reduce interest rate risk and/or increase income with the more flexible non-traditional bond funds. This all came to a halt as interest rates actually declined and flows to the category nearly dried up in the second half. This also impacted market neutral strategies which are often used as a substitute for fixed income portfolios.’’). 67A private fund is an issuer that would be an investment company, as defined in section 3 of the Investment Company Act, but for the exclusion from the definition of ‘‘investment company’’ in
section 3(c)(1) or 3(c)(7) of the Act. Section
202(a)(29) of the Investment Advisers Act of 1940 (the ‘‘Investment Advisers Act’’). 68See Comment Letter of Private Equity Growth Capital Council on the FSOC Notice (Mar. 25, 2015). 69See Comment Letter of Managed Funds Association on the FSOC Notice (Mar. 25, 2015). 70Based on data reported in response to questions 32 and 50 of Form PF. Reports filed on Form PF are submitted by advisers registered with the Commission with at least $150 million in private fund assets under management. For a definition of which funds are treated as ‘‘qualifying hedge funds’’ for purposes of Form PF that must complete these questions, see General Instructions to Form PF, available at http://www.sec.gov/about/forms/ formpf.pdf. 71Based on data reported in response to question 49 of Form PF. 72Norm Champ, former Director of the Division of Investment Management, Speech, Remarks to the Practicing Law Institute, Private Equity Forum, (June 30, 2014), available at http://www.sec.gov/ News/Speech/Detail/Speech/1370542253660. (noting that alternative mutual funds should consider setting criteria for assessing the liquidity of a security and consider including those criteria in written policies and procedures for registered fund compliance programs under rule 38a–1 under the Act); National Exam Program 2015 Examination Priorities, supra note 63 (‘‘We will continue to assess funds offering alternative investments and using alternative investment strategies, with a particular focus on: (i) leverage, liquidity, and valuation policies and practices; (ii) factors relevant to the adequacy of the funds’ internal controls, including staffing, funding, and empowerment of boards, compliance personnel, and back-offices; and (iii) the manner in which such funds are marketed to investors.’’). 73See, e.g., Invesco FSOC Notice Comment Letter, supra note 35, at 14 (noting that it ‘‘was not long ago that equity securities settled on a T+7 basis rather than today’s T+3 standard and initiatives are underway to shorten that time to T+2’’). 74See Securities Transactions Settlement, Exchange Act Release No. 33023 (Oct. 6, 1993) [58 FR 52891 (Oct. 13, 1993)] (‘‘Securities Transactions Settlement Release’’) (adopting rule 15c6–1 under the Exchange Act). 75See May 1995 Staff No-Action Letter, supra note 21 (noting that funds that are sold through brokers or dealers and that hold portfolio securities that do not settle within three business days ‘‘should assess the mix of their portfolio holdings to determine whether, under normal circumstances, they will be able to facilitate compliance with the T+3 standard by brokers and dealers,’’ taking into account the ‘‘percentage of the portfolio that would settle in three days or less, the level of cash reserves, and the availability of lines of credit or interfund lending facilities.’’). 76See PricewaterhouseCoopers LLP (in conjunction with the Depositary Trust Clearing Corporation (‘‘DTCC’’) Industry Steering Committee), Shortening the Settlement Cycle:
The Move to T+2 (2015), available at http:// www.ust2.com/pdfs/ssc.pdf; DTCC, DTCC Recommends Shortening the U.S. Trade Settlement Cycle (Apr. 2014), available at http:// www.dtcc.com/∼/media/Files/Downloads/ WhitePapers/T2-Shortened-Cycle-WP.pdf; see also Recommendation of the Investor Advisory Committee: Shortening the Trade Settlement Cycle in U.S. Financial Markets (Feb. 12, 2015), available at https://www.sec.gov/spotlight/investor-advisorycommittee-2012/settlement-cycle-recommendationfinal.pdf. See also Letter from Mary Jo White, Chair, SEC, to Kenneth E. Bentsen, Jr., President & CEO, Securities Industry and Financial Markets Association, and Paul Schott Stevens, President & CEO, Investment Company Institute (Sept. 16, the end of 2011 to the end of 2014.65 While growth in alternative mutual funds and ETFs has slowed over the past year, a rising interest rate environment could cause inflows to these funds to increase once again, as investors look to reduce their interest rate risk and/or increase income by investing in alternative strategies.66 Unlike alternative mutual funds and ETFs, private funds (such as hedge funds and private equity funds) pursuing similar alternative strategies can invest in portfolio assets that are relatively illiquid without generating the same degree of redemption risk for the fund because investor redemption rights are often limited.67 In addition, investor expectations of private funds’ redemption rights differ from the redemption expectations of typical retail investors in open-end funds. For example, investors in private equity funds typically commit their capital for the life of the fund.68 Hedge funds often contain ‘‘lock-up’’ provisions (in which an investor only can redeem after a specified period of time has elapsed since its initial investment), typically impose limitations on the frequency of redemptions (e.g., allowing redemptions only once a quarter or once a year), and require advance notice periods for redemptions.69 They also are often able to impose gates, suspensions of redemptions, and side pockets to manage liquidity stress. As a result these funds can, and often do, restrict investor redemption rights as the liquidity of the funds’ portfolio assets declines. Data reported on Form PF show that at December 31, 2014, only 16.5% of qualifying hedge funds allowed investors to withdraw any of their investment in seven days or less and for almost 60% of reporting qualifying hedge funds, the liquidity of the fund’s portfolio was greater than the withdrawal rights provided to investors for all time frames reported on the form.70 As of that date, 88% of qualifying hedge funds may suspend investor withdrawals and 62% may impose gates on investor withdrawals.71 In contrast, alternative strategy mutual funds and ETFs have no such ability to tailor investor redemption rights based on the liquidity profile of the funds’ portfolios. Yet some of these funds seek to pursue similar investment strategies as
hedge funds and other private funds, while still being bound by the redemption obligations applicable to open-end funds. Accordingly, our staff has been focused on the liquidity of alternative strategy mutual funds and ETFs, the nature of liquidity and redemption risks faced by investors in these funds given their legal right to be paid the proceeds of any redemption request within seven days.72 The findings in the DERA Study have lent further support to our focus on liquidity risk management practices in this industry segment, as the study found that alternative strategy mutual funds had cash flows that were significantly more volatile than other strategies, indicating that these funds may face higher levels of redemption risk. Volatility in flows places additional importance on liquidity risk management to prevent some of the consequences from a failure to adequately manage liquidity discussed in section II.B.2 above. The proposed rule and rule amendments build off of many of the observations we and our staff have made through efforts examining the growth in funds and ETFs with fixed income strategies and alternative strategies that are discussed below.
2. Evolution of Settlement Periods and
Redemption Practices
Practices relating to securities trade settlement periods and the timing of the payment of redemption proceeds to investors also have evolved considerably over the decades since the Commission last addressed liquidity needs in open-end funds.73 Prior to the adoption of rule 15c6–1 under the Exchange Act in 1993, which established three business days (T+3) as the standard settlement timeframe for broker-dealer trades, there was no federal rule that mandated a specific settlement cycle for securities transactions.74 Before the adoption of rule 15c6–1, trades settled on a T+5 basis based on industry practice, and the decline in the securities trading settlement period from T+5 to T+3 prompted funds that were sold through broker-dealers to satisfy redemption requests within three business days.75 In recent years, market participants have explored the possibility of further reducing this T+3 settlement period.76

2015), available at http://www.sec.gov/divisions/ marketreg/chair-white-letter-to-sifma-ici-t2.pdf; Commissioner Luis A. Aguilar, Public Statement, The Benefits of Shortening the Securities Settlement Cycle, (July 16, 2015), available at http:// www.sec.gov/news/statement/benefits-ofshortening-the-securities-settlement-cycle.html; Commissioner Michael S. Piwowar and Commissioner Kara M. Stein, Public Statement, Statement Regarding Proposals to Shorten the Trade Settlement Cycle, (June 29, 2015), available at http://www.sec.gov/news/statement/statementon-proposals-to-shorten-the-trade-settlementcycle.html. 77 Disclosures by open-end funds are subject to the antifraud provisions of the federal securities laws. Therefore there may be liability under these provisions if a fund fails to meet redemptions within seven days or any shorter time disclosed in the fund’s prospectus or advertising materials. See
section 17(a) of the Securities Act, section 10(b) of
the Exchange Act and rule 10b–5 under the Exchange Act, and section 34(b) of the Exchange Act; see also Fidelity FSOC Notice Comment Letter, supra note 20, at 6 (‘‘mutual funds normally process redemption requests by the next business day’’); Nuveen FSOC Notice Comment Letter, supra note 45, at 9 (noting settlement periods for trades of fund portfolio securities as a relevant factor in assessing liquidity risk, particularly with securities that ‘‘do not trade with enforceable settlement rights and tend to settle over longer settlement periods than the T+1 or T+3 periods over which mutual fund share redemptions themselves settle’’). 78Based on staff analysis of Morningstar Direct Data, net assets of bank loan mutual funds and ETFs grew from $14.6 billion in December 2008 to $123.5 billion in December 2014. 79See, e.g., BlackRock, Viewpoint, Who Owns the Assets? A Closer Look at Bank Loans, High Yield Bonds and Emerging Markets Debt (Sept. 2014) (‘‘BlackRock, Viewpoint, Who Owns the Assets?’’), available at https://www.blackrock.com/corporate/ en-fi/literature/whitepaper/viewpoint-closer-lookselected-asset-classes-sept2014.pdf (‘‘[T]he settlement periods for bank loans are longer than the settlement periods for fixed income securities such as high yield bonds, which typically settle in three days. This delayed settlement period may cause a potential liquidity mismatch for mutual funds offering daily liquidity, requiring fund managers to ensure that a fund has sufficient liquidity over settlement windows to meet potential redemptions.’’); Comment Letter of OppenheimerFunds on the FSOC Notice (Mar. 25,
2015) (‘‘OppenheimerFunds FSOC Notice Comment
Letter’’) at 3–4 (stating that ‘‘loans still take longer to settle than other securities. Median settlement times for buy-side loan sales are 12 days’’ and noting that an ‘‘important tool in managing settlement times is the establishment of a credit line dedicated to bank loan funds.’’). 80See infra note 92 and accompanying text. Under current Commission guidelines, a portfolio security or other asset is considered illiquid if it cannot be sold or disposed of (rather than settled) in the ordinary course of business within seven days at approximately the value at which the fund has valued the investment. 81Mutual funds and ETFs investing in foreign securities can also have such settlement mismatches. See, e.g., Investment Company Institute, Understanding Exchange-Traded Funds:
How ETFs Work, (Sept. 2014), at n.34, available at https://www.ici.org/pdf/per20-05.pdf (noting that internationally focused ETFs generally require authorized participants to post collateral ‘‘because the timing of clearing and settlement in another country may not coincide with the T+3 settlement cycle in the United States’’). There has been significant growth in emerging market funds since the year 2000. See infra note 664 and accompanying text. 82Section 22(e) permits open-end funds to suspend redemptions and postpone payment for redemptions already tendered for any period during which the New York Stock Exchange (‘‘NYSE’’) is closed (other than customary weekend and holiday closings) and in three additional situations if the Commission has made certain determinations. First, a fund may suspend redemptions for any period during which trading on the NYSE is restricted, as determined by the Commission. Second, a fund may suspend redemptions for any period during which an emergency exists, as determined by the Commission, as a result of which it is not reasonably practicable for the fund to: (i) liquidate its portfolio securities, or (ii) fairly determine the value of its net assets. Third, a fund may suspend redemptions for such other periods as the Commission may by order permit for the protection of fund shareholders. See also Letter from Douglas Scheidt, Associate Director and Chief Counsel, Division of Investment Management, SEC, to Craig S. Tyle, General Counsel, Investment Company Institute (Dec. 8, 1999) available at http:// www.sec.gov/divisions/investment/guidance/ tyle120899.htm, at n.2 and accompanying text. The Commission has rarely issued orders permitting the suspension of redemptions for periods of restricted trading or emergency circumstances but has done so on a few occasions. See, e.g., In the Matter of The Reserve Fund, on behalf of two of its series, the Primary Fund and the U.S. Government Fund, Investment Company Act Release No. 28386 (Sept. 22, 2008) [73 FR 55572 (Sept. 25, 2008)]; see also, e.g., In the Matter of Municipal Lease Securities Fund, Inc., Investment Company Act Release No. 17245 (Nov. 29, 1989). Money market funds are able to suspend redemptions in certain limited circumstances. See rule 22e–3 under the Act; see also infra note 155 and accompanying text. 83Periodic Repurchases by Closed-End Management Investment Companies; Redemptions by Open-End Management Investment Companies and Registered Separate Accounts at Periodic Intervals or with Extended Payment, Investment Company Act Release No. 18869 (July 28, 1992) [57 FR 34701 (Aug. 6, 1992)] at nn.16–18 and accompanying text (‘‘Interval Fund Proposing Release’’) (citing Investment Trusts and Investment Companies: Hearings on S. 3580 before a Subcomm. of the Senate Comm. on Banking and Currency, 76th Cong., 3d Sess. 291–92 (1940) (statement of David Schenker, Chief Counsel, SEC Investment Trust Study)). 84See supra notes 41–43 and accompanying text for a
discussion of why this calculation method is permitted under rule 22c–1 and rule 2a–4. We also have observed that some openend funds disclose in their prospectuses that they generally will satisfy redemption requests in even shorter periods of time than T+3, including on a next-business-day basis.77 While standard settlement periods for securities trades in the markets have tended to fall significantly over the last several decades—and investor expectations that redemption proceeds will be paid promptly after redemption requests have risen—settlement periods for other securities held in large amounts by certain funds have not fallen correspondingly. For example, some bank loan funds (an asset class that has grown in recent years) 78 invest substantial amounts of their assets in bank loans and loan participations, which typically have long settlement times compared to other investments.79 Based on our review of fund filings, many funds that invest in these assets do not consider most of their portfolio holdings to be illiquid and generally represent in their disclosures that they comply with the Commission’s current guidelines, which state that an open-end fund should invest no more than 15% of its net assets in ‘‘illiquid’’ assets.80 However, the settlement periods associated with some bank loans and loan participations may extend beyond the period of time the fund would be required to meet shareholder redemptions, creating a potential mismatch between the timing of the receipt of cash upon sale of these assets and the payment of cash for shareholder redemptions.81 Overall, the evolution of the market towards shorter settlement periods—and corresponding investor expectations— combined with open-end funds holding certain securities with longer settlement periods have raised concerns for us about whether fund portfolios are sufficiently liquid to support a fund’s ability to meet its redemption obligations. D. Current Regulatory Framework

Statutory and Regulatory
Requirements
Section 22(e) of the Act provides that
no open-end fund shall suspend the right of redemption or postpone the date of payment of redemption proceeds for more than seven days after tender of the security absent specified unusual circumstances.82 This statutory requirement was enacted ‘‘in response to abusive practices of early open-end companies that claimed that their securities were redeemable, but then instituted barriers to redemption’’ to prevent net redemptions or to prevent shareholders from switching to other funds.83 As previously discussed, in addition to the seven-day redemption requirement in section 22(e), rule 15c6– 1 under the Exchange Act also impacts the timing of open-end fund redemptions because the rule requires broker-dealers to settle securities transactions, including transactions in open-end fund shares, within three business days after the trade date. Furthermore, rule 22c–1 under the Act, the ‘‘forward pricing’’ rule, requires funds, their principal underwriters, and dealers to sell and redeem fund shares at a price based on the current NAV next computed after receipt of an order to purchase or redeem fund shares, even though fund assets may be sold in subsequent days in order to meet redemption obligations.84 Thus, there

85Under rule 2a–7, money market funds must maintain sufficient liquidity to meet reasonably foreseeable redemptions, generally must invest at least 10% of their portfolios in assets that can provide daily liquidity and at least 30% of their portfolios in assets that can provide weekly liquidity, and may not acquire any illiquid security if, immediately after the acquisition, the money market fund would have invested more than 5% of its total assets in illiquid securities. Rule 2a–7. Additionally, the Commission recently adopted amendments to rule 2a–7 that, among other things:
(i) give boards of directors of money market funds discretion to impose a liquidity fee or temporarily suspend the right of redemption if a fund’s weekly liquidity level falls below the required regulatory threshold; and (ii) require all non-government money market funds to impose a liquidity fee if the fund’s weekly liquidity level falls below a designated threshold of 10%, unless the fund’s board determines that imposing such a fee is not in the best interests of the fund. Money Market Fund Reform; Amendments to Form PF, Investment Company Act Release No. 31166 (July 23, 2014) [79 FR 47736 (Aug. 14, 2014)] (‘‘2014 Money Market Fund Reform Adopting Release’’). 86Statement Regarding ‘‘Restricted Securities,’’ Investment Company Act Release No. 5847 (Oct. 21,
1969) [35 FR 19989 (Dec. 31, 1970)] (‘‘Restricted
Securities Release’’) (‘‘Because open-end companies hold themselves out at all times as being prepared to meet redemptions within seven days, it is essential that such companies maintain a portfolio of investments that enable them to fulfill that obligation. This requires a high degree of liquidity in the assets of open-end companies because the extent of redemption demands or other exigencies are not always predictable.’’); Resale of Restricted Securities; Changes to Method of Determining Holding Period of Restricted Securities Under Rules 144 and 145, Investment Company Act Release No. 17452 (Apr. 23, 1990) [55 FR 17933 (Apr. 30, 1990)] (‘‘Rule 144A Release’’) (adopting rule 144A under the Securities Act). 87 Guidelines Release, supra note 4, at section I (‘‘[A] mutual fund must compute its net asset value each business day and give purchase and redemption orders the price next computed after receipt of an order. Moreover, most mutual funds allow shareholders easily to exchange their fund shares for shares of another mutual fund managed by the same investment adviser, in transactions which generally can include only nominal costs. Shareholders thus easily may move their money among equity, income, and money market funds as they choose, increasing the need for liquidity of mutual fund assets.’’); see also Restricted Securities Release, supra note 86 (discussing valuation difficulties that may be associated with restricted securities). 88 Guidelines Release, supra note 4. 89Rule 144A Release, supra note 86, at n.61. 90 In the rule 38a–1 adopting release, the Commission stated that funds should adopt policies and procedures regarding the pricing of portfolio securities and fund shares. See Compliance Programs of Investment Companies and Investment Advisers, Investment Company Act Release No. 26299 (Dec. 17, 2003) [68 FR 74714 (Dec. 24, 2003)] (‘‘Rule 38a–1 Adopting Release’’) (‘‘These pricing requirements are critical to ensuring fund shares are purchased and redeemed at fair prices and that shareholder interests are not diluted.’’). The Commission also identifies ‘‘portfolio management processes’’ as an issue that should be covered in the compliance policies and procedures of a fund or its adviser and indicates that each fund should tailor its policies and procedures to address the fund’s particular compliance risks. See id., at n.82 (noting that the chief compliance officer’s annual report should discuss the fund’s particular compliance risks and any changes that were made to the policies and procedures to address newly identified risks). 91See supra note 81 and accompanying text. 92 Guidelines Release, supra note 4, at section III. (‘‘If an open-end company holds a material percentage of its assets in securities or other assets for which there is no established market, there may be a question concerning the ability of the fund to make payment within seven days of the date its shares are tendered for redemption. The usual limit on aggregate
holdings by an open-end investment company of illiquid assets is 15% of its net assets. An illiquid asset is any asset which may not be sold or disposed of in the ordinary course of business within seven days at approximately the value at which the mutual fund has valued the investment.’’). The Guidelines Release modified prior Commission guidance that set a 10% limit on illiquid assets for open-end funds. See Restricted Securities Release, supra note 86. While the wording of the Guidelines Release limits holdings of illiquid assets above 15% of a fund’s net assets, the Guidelines Release cites a prior Commission statement regarding the ‘‘prudent limit on mutual fund holdings of illiquid securities’’ that limits a fund from acquiring any illiquid asset if, immediately after such acquisition, the fund’s holdings of illiquid assets would exceed a certain percentage of the fund’s net assets. See Guidelines Release, supra note 4, at n.8 (citing Restricted Securities Release, supra note 86). The latter interpretation (that is, the interpretation that the 15% standard is a limit on the acquisition of illiquid assets, not a limit on the holdings of illiquid assets) is consistent with approaches that Congress and the Commission have historically taken in other parts of the Investment Company Act and the rules thereunder. See infra note 348. 93 Guidelines Release, supra note 4; see also ETF Proposing Release, supra note 9; Valuation of Debt Instruments and Computation of Current Price Per Share by Certain Open-End Investment Companies (Money Market Funds), Investment Company Act Release No. 13380 (July 11, 1983) [48 FR 32555 (July 18, 1983)]; Rule 144A Release, supra note 86. 94See Restricted Securities Release, supra note
86. Securities offered pursuant to rule 144A under
the Securities Act may be considered liquid depending on certain factors. See Rule 144A Release, supra note 86. The Commission stated that ‘‘determination of the liquidity of Rule 144A securities in the portfolio of an investment company issuing redeemable securities is a question of fact for the board of directors to determine, based upon the trading markets for the specific security’’ and noted that the board should consider the unregistered nature of a rule 144A security as one of the factors it evaluates in determining its liquidity. Id. The Division of Investment Management has also stated that an open-end fund’s board of directors may determine that an issue of commercial paper in reliance on are a number of statutory and regulatory provisions that must be considered in assessing a fund’s ability to meet redemptions and mitigate potential dilution of shareholders’ interests. With the exception of money market funds subject to rule 2a–7 under the Act, the Commission has not promulgated rules requiring open-end funds to invest in a minimum level of liquid assets.85 The Commission historically has taken the position that open-end funds should maintain a high degree of portfolio liquidity to ensure that their portfolio securities and other assets can be sold and the proceeds used to satisfy redemptions in a timely manner in order to comply with section 22(e).86 The Commission also has stated that open-end funds have a ‘‘general responsibility to maintain a level of portfolio liquidity that is appropriate under the circumstances,’’ and to engage in ongoing portfolio liquidity monitoring to determine whether an adequate level of portfolio liquidity is being maintained in light of the fund’s redemption obligations.87 As noted in this guidance, a fund experiencing net outflows due to shifts in market sentiment may wish to consider reducing its illiquid asset holdings to maintain adequate liquidity.88 Similarly, a fund may need to determine whether it is appropriate to take certain actions when it has determined that a previously liquid holding has become illiquid due to changed circumstances.89 Open-end funds also are required by rule 38a–1 under the Act to adopt and implement written policies and procedures reasonably designed to prevent violations of the federal securities laws. A fund’s compliance policies and procedures should be appropriately tailored to reflect each fund’s particular compliance risks.90 An open-end fund holding a significant portion of its assets in securities with long settlement periods or with infrequent trading, for instance, may be subject to relatively greater liquidity risks than other open-end funds, and should appropriately tailor its policies and procedures to comply with its redemption obligations.91
2. 15% Guideline
In addition to the Commission’s historical statements regarding the importance of adequate liquidity in open-end fund portfolios pursuant to
section 22(e) of the Act, long-standing
Commission guidelines generally limit an open-end fund’s aggregate holdings of ‘‘illiquid assets’’ to 15% of the fund’s net assets (the ‘‘15% guideline’’).92 Under the 15% guideline, a portfolio security or other asset is considered illiquid if it cannot be sold or disposed of in the ordinary course of business within seven days at approximately the value at which the fund has valued the investment.93 The 15% guideline has generally caused funds to limit their exposures to particular types of securities that cannot be sold within seven days and that the Commission and staff have indicated may be illiquid, depending on the facts and circumstances, such as private equity securities, securities purchased in an initial public offering, and certain other privately placed or other restricted securities 94 as well as certain

section 4(a)(2) of the Securities Act is liquid, even
if it may not be resold under rule 144A in certain circumstances. Merrill Lynch Money Markets Inc., SEC Staff No-Action Letter (Jan. 14, 1994). 95See Interval Fund Proposing Release, supra note 83. 96See Rule 144A Release, supra note 86. 97 Id. 98There are varying degrees of formality in the adoption and implementation of these procedures. 99See 2014 Fixed Income Guidance Update, supra note 62 (noting that fund advisers ‘‘generally assess overall fund liquidity and funds’ ability to meet potential redemptions over a number of periods’’ and discussing certain steps that fund advisers may consider taking given potential fixed income market volatility); see also infra note 151 and accompanying text. 100Press coverage has detailed steps some funds and their advisers have taken to manage liquidity in light of changing market conditions as well. See, e.g., Jessica Toonkel, Fund Boards, Management Go on High Alert Around Bond Liquidity, Reuters (Nov. 24, 2014), available at http://www.reuters.com/
article/2014/11/24/us-funds-bondholders-alertidUSKCN0J80AD20141124 (reporting that
investment advisers ‘‘have been testing their funds against various market scenarios, building cushions of cash, shorter-duration bonds and other liquid securities, and regularly discussing risks with their boards’’); Katy Burne, Bond Funds Loan Up on Cash, The Wall Street Journal (Nov. 30, 2014), available at http://www.wsj.com/articles/bondfunds-load-up-on-cash-1417394534 (discussing cash buffers and use of certain derivatives to manage liquidity concerns); Cordell Eddings, Bond Liquidity Risk in $3.5 Trillion Funds Defused by Cash, Bloomberg (Aug. 18, 2014), available at http://www.bloomberg.com/news/articles/2014-08- 17/bond-liquidity-risk-in-3-5-trillion-funds-defusedby-cash-pile (discussing cash holdings in U.S. fixed income funds that are at historically significant levels). 101See, e.g., Nuveen FSOC Notice Comment Letter, supra note 45, at 12 (‘‘We stress test a fund’s ability to meet redemptions over a one-month period in a badly stressed market by hypothetically assuming a large increase in net redemptions, cash outflows for derivatives cash collateral and cash outlay requirements imposed by various leverage structures, and comparing the level of cash needed to meet that hypothetical scenario against the amount of cash the fund could reasonably expect to raise from various sources (including selling assets in a hypothetically stressed market or drawing on a credit facility) in that same time frame.’’); ICI FSOC Notice Comment Letter, supra note 16, at 24 (stating that some asset managers conduct forms of stress testing to determine the impact of certain changes on portfolio liquidity). 102See, e.g., BlackRock FSOC Notice Comment Letter, at 6 (stating that among several overarching principles that provide the foundation for a prudent market liquidity risk management framework for collective investment vehicles is having ‘‘a risk management function that is independent from portfolio management, with direct reporting lines to senior leadership and a regular role in communication with the asset manager’s board of directors’’). instruments or transactions not maturing in seven days or less, including term repurchase agreements.95 The Commission has not established a set of required factors that must be considered when assessing the liquidity of these or other types of securities, but rather has provided ‘‘examples of factors that would be reasonable for a board of directors to take into account with respect to a rule 144A security (but which would not necessarily be determinative).’’ 96 These factors include: the frequency of trades and quotations for the security; the number of dealers willing to purchase or sell the security and the number of other potential purchasers; dealer undertakings to make a market in the security; and the nature of the security and the nature of the marketplace in which it trades, including the time needed to dispose of the security, the method of soliciting offers, and the mechanics of transfer.97
3. Overview of Current Practices
Over the last two years, Commission staff has had the occasion to observe through a variety of different events the current liquidity risk management practices at a cross-section of different fund complexes with varied investment strategies. The staff has observed that liquidity risk management techniques may vary across funds, including funds within the same fund complex, in light of unique fund characteristics, including, for example, the nature of a fund’s investment objectives or strategies, the composition of the fund’s investor base, and historical fund flows. These observations collectively have shown the staff that, even with various unique characteristics, many open-end funds and fund complexes have implemented procedures for assessing, classifying, and managing the liquidity of their portfolio assets.98 Specifically, some of the funds observed by the staff assess their ability to sell particular assets within various time periods (typically focusing on one-, three-, and/or seven-day periods).99 In conducting this analysis, these funds may take into account relevant market, trading, and other factors, and monitor whether their initial liquidity determination should be changed based on changed market conditions. This process helps open-end funds determine their ability to meet redemption requests in various market conditions within the disclosed period for payment of redemption proceeds. Funds observed by the staff that have implemented procedures for assessing and classifying the liquidity of their portfolio assets also often have developed controls to manage fund portfolio liquidity risk and the risk of changing levels of shareholder redemptions, such as holding certain amounts of the fund’s portfolio in highly liquid assets, setting minimum cash reserves, and establishing committed back-up lines of credit or interfund lending facilities.100 A few of the funds observed by staff conduct stress testing relating to the availability of liquid assets to cover possible levels of redemptions.101 Some of these funds’ advisers also have periodic discussions with their boards of directors about how the fund approaches liquidity risk management and what emerging risks they are observing relating to liquidity risk. We have observed that some of the funds with the more thorough liquidity risk management practices have appeared to be able to better meet periods of higher than typical redemptions without significantly altering the risk profile of the fund or materially affecting the fund’s performance, and thus with less dilutive impacts. Conversely, the Commission is concerned that some funds employ liquidity risk management practices that are substantially less rigorous. Some funds observed by the staff do not take different market conditions into account when evaluating portfolio asset liquidity, and do not conduct any ongoing liquidity monitoring. Some funds do not incorporate any independent oversight of fund liquidity risk management outside of
the portfolio management process.102 Staff has observed that some of these funds, when faced with higher than normal redemptions, experienced particularly poor performance compared with their benchmark and some even experienced an adverse change in the fund’s risk profile, each of which can increase the risk of investor dilution. Finally, the Commission learned through staff outreach that many funds treat their risk management process for assessing the liquidity profile of portfolio assets, and the incorporation of market and trading information, as entirely separate from their assessment of assets under the 15% guideline. The former process is typically conducted on an ongoing basis through the fund’s risk management function, through the fund’s portfolio management function, or through the fund’s trading function (or a combination of the foregoing), while assessment of assets under the 15% guideline is more typically conducted upon purchase of an asset through the fund’s compliance or ‘‘backoffice’’ functions, with little indication that information generated from the risk management or trading functions informs the compliance determinations. This functional divide may be a byproduct of the limitations of the 15% guideline as a stand-alone method for comprehensive liquidity risk management, a situation that our

103See infra section III.C.4 for a discussion of the limitations of the 15% guideline. 104Such other initiatives include modernizing investment company reporting and disclosure, addressing the risks of derivatives use, and requiring large investment companies and investment advisers to engage in annual stress tests as required by section 165(i) of the Dodd-Frank Wall Street Reform and Consumer Protection Act (‘‘Dodd-Frank Act’’). See Chair Mary Jo White, Speech, Remarks to the New York Times DealBook Opportunities for Tomorrow Conference (Dec. 11, 2014), available at http://www.sec.gov/News/ Speech/Detail/Speech/1370543677722; Investment Company Reporting Modernization, Investment Company Act Release No. 31610 (May 20, 2015) [80 FR 33590 (June 12, 2015)] (‘‘Investment Company Reporting Modernization Release’’). 105Proposed rule 22e–4(a)(8) defines ‘‘Three-Day Liquid Asset’’ to mean ‘‘any cash held by a fund and any position of a fund in an asset (or portion of the fund’s position in an asset) that the fund believes is convertible into cash within three business days at a price that does not materially affect the value of that asset immediately prior to sale. In determining whether a position or portion of a position in an asset is a three-day liquid asset, a fund must take into account the factors set forth in paragraph (b)(2)(ii) of this section, to the extent applicable.’’ Proposed rule 22e–4(a)(9) defines ‘‘Three-Day Liquid Asset Minimum’’ to mean ‘‘the percentage of the fund’s net assets to be invested in three-day liquid assets,’’ in accordance with rule 22e–4(b)(2)(iv)(A) and (C). 106See, e.g., Comment Letter of Markit on the FSOC Notice (Mar. 25, 2015), at 2 (‘‘we believe that liquidity and redemption risk contained in asset management products can be mitigated by providing risk managers or investors of pooled investment vehicles better information about the liquidity risk associated with pool investments so that they can price it more accurately. This could be done through, among other things, disclosures of the ‘prudent valuation’ (accounting for pricing uncertainty) of the fund’s investments and the implementation of appropriate liquidity risk management policies and procedures’’). 107See infra section IV.C.3. proposed framework is meant to address.103 Overall, our staff outreach has increased our understanding of some of the valuable liquidity risk management practices employed by some firms as a matter of prudent risk management. This outreach also has shown us the great diversity in liquidity risk management practices that raises concerns regarding various funds’ ability to meet their redemption obligations and minimize the effects of dilution under certain conditions. Collectively, these observations have informed our understanding of the need for an enhanced minimum baseline requirement for fund management of liquidity risk. E. Rulemaking Proposal Overview Against this background, today we are proposing a multi-layered set of
reforms designed to promote effective liquidity risk management throughout the openend fund industry and thereby reduce the risk that funds will not be able to meet redemption obligations and mitigate potential dilution of the interests of fund shareholders in accordance with section 22(e) of, and rule 22c–1 under, the Investment Company Act. The proposed amendments also seek to enhance disclosure regarding fund liquidity and redemption practices. In addition, these proposed reforms are intended to address the liquidity-related developments in the open-end fund industry discussed above and are a part of a broader set of initiatives to address the impact of open-end fund investment activities on investors and the financial markets, and the risks associated with the increasingly complex portfolio composition and operations of the asset management industry.104 First, we are proposing new rule 22e– 4, which would require each registered open-end fund, including open-end ETFs but not including money market funds, to establish a liquidity risk management program. The proposed rule would require a fund’s liquidity risk management program to incorporate certain specified elements. One primary element of this program is a new requirement for funds to classify and monitor the liquidity of portfolio assets, reflecting that liquidity may be viewed as falling on a spectrum rather than a binary conclusion that an asset is either ‘‘liquid’’ or ‘‘illiquid.’’ Another principal feature is a new requirement that funds establish a minimum amount of their assets that would be held in cash and assets that the fund believes are convertible to cash within three business days at a price that does not materially affect the value of that asset immediately prior to the sale.105 This proposed requirement is aimed at decreasing the likelihood that funds would be unable to meet their redemption obligations and promote effective liquidity risk management industry-wide. We also anticipate that the proposed program requirement would result in investor protection benefits, as improved liquidity risk management could decrease the chance that a fund could meet its redemption obligations only with material effects on the fund’s NAV or changes to the fund’s risk profile. Even with improved liquidity risk management, circumstances could arise in which shareholder purchase and redemption activity could dilute the value of existing shareholders’ interests in the fund. For this reason, we are also proposing amendments to rule 22c–1 under the Act to permit a fund (except a money market fund or ETF) to use ‘‘swing pricing,’’ the process of adjusting a fund’s NAV to effectively pass on to purchasing or redeeming shareholders more of the costs stemming from their trading activity. Swing pricing could protect existing shareholders from dilution associated with such purchase and redemption activity and could be another tool to manage liquidity risks. Pooled investment vehicles in certain
foreign jurisdictions currently use various forms of swing pricing to mitigate shareholder dilution associated with other shareholders’ capital activity, and we believe swing pricing could be an effective tool to assist U.S. registered funds in mitigating potential shareholder dilution. Finally, we are proposing disclosureand reporting-related amendments to provide greater transparency with respect to funds’ liquidity risks and risk management. Specifically, we are proposing amendments to Form N–1A to require disclosure regarding swing pricing, if applicable, and to improve disclosure regarding how funds meet redemptions of fund shares. We also are proposing amendments to proposed Form N–PORT and proposed Form N– CEN to provide detailed information, both to the Commission and the public, regarding a fund’s liquidity-related holdings data and liquidity risk management practices. We note that while these disclosure- and reportingrelated amendments are primarily applicable to mutual funds that are not money market funds, as well as ETFs, certain of the proposed amendments are applicable to money market funds as well. We anticipate that these proposed requirements will facilitate the Commission’s risk monitoring efforts by providing greater transparency regarding the liquidity characteristics of fund portfolio holdings, as well as to monitor and assess compliance with rule 22e–4 if adopted. While proposed Form N–PORT and proposed Form N– CEN are primarily designed to assist the Commission, we believe that the proposed requirements also would increase investor understanding of particular funds’ liquidity-related risks and redemption policies, which in turn would assist investors in making investment choices that better match their risk tolerances.106 We note that many investors, particularly institutional investors, as well as academic researchers, financial analysts, and economic research firms, could use the information regarding a fund’s liquidity-related holdings data and liquidity risk management practices reported on Form N–PORT to evaluate fund portfolios.107 Finally, we are

108Under proposed rule 22e–4(a)(5), ‘‘fund’’ means ‘‘an open-end management investment company that is registered or required to register under section 8 of the Act (15 U.S.C. 80a–8) and includes a separate series of such an investment company, but does not include a registered openend management investment company that is regulated as a money market fund under § 270.2a– 7.’’ 109 In addition to the seven-day redemption requirement in section 22(e), rule 15c6–1 under the Exchange Act also impacts the timing of open-end fund redemptions because the rule requires brokerdealers to settle securities transactions, including transactions in open-end fund shares, within three business days after the trade date. See supra note 21 and accompanying text. Furthermore, funds’ redemption obligations are also governed by any disclosure to shareholders that a fund has made about the time within which it will meet redemption requests, as disclosures by open-end funds are subject to the antifraud provisions of the federal securities laws. See supra note 77 and accompanying text. 110See infra section IV.C.1. 111Proposed rule 22e–4(b)(1). 112Proposed rule 22e–4(a)(7). This definition is similar to the definition of ‘‘liquidity risk’’ that the Commission has used in other contexts, modified as appropriate to apply to the specific liquidity needs of investment companies. See Financial Responsibility Rules for Broker-Dealers, Exchange Act Release No. 70072 (July 30, 2013) [78 FR 51823 (Aug. 21, 2013)], at n.291 (‘‘Generally, funding liquidity risk is the risk that a firm will not be able to meet cash demands as they become due and asset liquidity risk is the risk that an asset will not be able to be sold quickly at its market value.’’). This proposed definition contemplates that a fund consider both expected requests to redeem, as well as requests to redeem that may not be expected, but are reasonably foreseeable. See infra
section III.C.
113Proposed rule 22e–4(b)(1), (2).
114See proposed rule 22e–4(a)(5).
115See infra section III.C.1.
116Proposed rule 22e–4(b)(3).
117Proposed Items 11(c)(7)–(8) of Form N–1A. 118Proposed Items B.7, C.7, and C.13 of proposed Form N–PORT; proposed Item 44 of proposed Form N–CEN. proposing to require that ETFs report on proposed Form N–CEN information regarding any requirement to post collateral by authorized participants that are purchasing or redeeming shares. Such collateral requirements could affect authorized participants’ capacity and willingness to serve as authorized participants for ETFs, and, in turn, the effective functioning of the ETF’s arbitrage mechanism and the ETF shares trading at a market price that approximates the NAV of the ETF.
III. Discussion
A. Program Requirements and Scope of Proposed Rule 22e–4 Today we are proposing new rule 22e–4 under the Investment Company Act, which would require that each registered open-end management investment company, including openend ETFs but not including money market funds,108 establish a written liquidity risk management program. We expect that the proposed rule 22e–4 program requirements would reduce the risk that funds will be unable to timely meet their redemption obligations under
section 22(e) of the Investment
Company Act and other statutory and regulatory provisions,109 mitigate potential investor dilution, and provide for more effective liquidity risk management among funds. We believe that this, in turn, would result in significant investor protection benefits and enhance the fair and orderly operation of the markets.110

Proposed Program Elements
Proposed rule 22e–4 would require each fund to adopt and implement a written liquidity risk management program that is designed to assess and manage the fund’s liquidity risk.111 Under the proposed rule, liquidity risk would be defined as the risk that a fund could not meet requests to redeem shares issued by the fund that are expected under normal conditions, or are reasonably foreseeable under stressed conditions, without materially affecting the fund’s net asset value.112 Proposed rule 22e–4 specifies that a fund’s liquidity risk management program shall include the following required program elements: (i) classification, and ongoing review of the classification, of the liquidity of each of the fund’s positions in a portfolio asset (or portions of a position in a particular asset); (ii) assessment and periodic review of the fund’s liquidity risk; and (iii) management of the fund’s liquidity risk, including the investment of a set minimum portion of net assets in assets that the fund believes are convertible to cash within three business days at a price that does not materially affect the value of that asset immediately prior to sale.113 Proposed rule 22e–4 incorporates specific requirements for each of these program elements, and these requirements are discussed in detail below. A fund may, as it determines appropriate, expand its liquidity risk management procedures and related disclosure concerning liquidity risk beyond the required program elements, and should consider doing so whenever it would be necessary to ensure effective liquidity management. A fund would be required to set and invest a prescribed minimum portion of net assets in assets that are cash or that the fund believes are convertible to cash within three business days at a price that does not materially affect the value of that asset immediately prior to the sale, and also would be required to classify the liquidity of the fund’s portfolio positions. In other respects, the proposed program requirements are more principles-based and would permit each fund to tailor its liquidity risk management program to the fund’s particular risks and circumstances. The requirements of proposed rule 22e–4, including the liquidity risk assessment requirements, are applicable to all open-end funds, which term is defined to include each separate series of a registered open-end investment company.114 Therefore, each series of a fund would be responsible for developing a liquidity risk management program tailored to its own liquidity risk in order to comply with the proposed rule. We anticipate that liquidity risk could differ—sometimes significantly—among the series of an investment company, based on variations in each of the proposed liquidity risk assessment factors required to be considered. Under these circumstances, it would be appropriate for each series’ liquidity risk management program to incorporate risk assessment and risk management elements that are distinct from other series’
programs. However, to the extent that the series of an investment company are substantially similar in terms of cash flow patterns, investment strategy, portfolio liquidity, and the other factors a fund would be required to consider in assessing its liquidity risk,115 it may be appropriate for each series to adopt the same or a similar liquidity risk management program. Proposed rule 22e–4 includes board oversight provisions related to the liquidity risk management program requirement. Specifically, a fund’s board would be required to approve the fund’s liquidity risk management program, any material changes to the program, and the fund’s designation of the fund’s investment adviser or officers as responsible for administering the fund’s liquidity risk management program (which cannot be solely portfolio managers of the fund).116 A fund also would be required to disclose certain information about its liquidity risk and risk management in its registration statement,117 as well as on proposed Forms N–CEN and N– PORT.118
Scope of Proposed Rule 22e–4 and
Related Disclosure and Reporting Requirements Proposed rule 22e–4, as well as the related disclosure and reporting requirements, would apply to all registered open-end funds (including

119See supra notes 18–22 and accompanying text (discussing funds’ redemption obligations under
section 22(e) of the Investment Company Act
(requiring funds to make payment to shareholders for securities tendered for redemption within seven days of their tender), as well as circumstances in which funds must satisfy redemption requests within a period shorter than seven days (because they are sold through broker dealers, which are subject to rule 15c6–1 under the Exchange Act (establishing a three-business day (T+3) settlement period for security trades effected by a broker or a dealer), and/or because they have disclosed to investors that they will meet redemption requests within a period shorter than seven days). 120See infra section III.C.1. 121Proposed rule 22e–4(b)(2)(iii)–(iv). 122See infra section III.C.1. 123For example, certain foreign securities (equities as well as fixed income securities) may entail very long settlement times and trading limitations. See infra note 197. Also, certain equity securities, such as microcap equity securities, trade relatively infrequently, which in turn could diminish their liquidity. See Securities and Exchange Commission, Office of Investor Education and Advocacy, ‘‘Microcap Stock: A Guide for Investors’’, available at http://www.sec.gov/investor/pubs/ microcapstock.htm. 124For example, during the ‘‘Flash Crash’’ of October 15, 2014, one of the most volatile trading days since 2008, yield decreases on 10-year Treasuries resulted in certain fixed income market participants turning off automatic pricing on electronic trading platforms on account of fears that the market was moving too quickly for automatic prices to keep up with the market. This, in turn, slowed the pace of trading in U.S. Treasuries, temporarily decreasing their liquidity. See, e.g., Joint Staff Report: The U.S. Treasury Market on October 15, 2014 (July 13, 2015), available at http:// www.treasury.gov/press-center/press-releases/ Documents/Joint_Staff_Report_Treasury_10-15- 2015.pdf (‘‘Flash Crash Staff Report’’) (report of staff findings from the U.S. Department of the Treasury, the Board of Governors of the Federal Reserve System, the Federal Reserve Bank of New York, the U.S. Securities and Exchange Commission, and the U.S. Commodity Futures Trading Commission discussing in depth, among other things, the strains in liquidity conditions during the events of October 15). 125See infra note 627 and accompanying text. 126See infra note 727 and accompanying text. 127See supra notes 23–30 and accompanying text. 128See supra notes 25–29 and accompanying text. The Commission’s 2015 Request for Comment on Exchange-Traded Products requests comment on the effectiveness and efficiency of the arbitrage mechanism for exchange-traded products (including ETFs) whose portfolio securities are relatively less liquid. See 2015 ETP Request for Comment, supra note 11, at Question #15. 129See supra note 30 and accompanying text. Based on the same consideration, we propose to include ETMFs within the scope of rule 22e–4. See supra note 31 and accompanying text. 130See supra note 24 and accompanying
text. 131See infra note 144 and accompanying paragraph. We note that the vast majority of ETFs are organized as open-end funds. See ETF Proposing Release, supra note 9. 132See sections 22(e), 2(a)(32) (defining ‘‘redeemable security’’) and 5(a)(1)–(2) (defining ‘‘open-end company’’ and ‘‘closed-end company’’) of the Act. 133See Guidelines Release, supra note 4; see also Repurchase Offers by Closed-End Management Investment Companies, Investment Company Act Release No. 19399 (Apr. 7, 1993) [58 FR 19330 (Apr. 14, 1993)] (‘‘Repurchase Offers Release’’), at n.7 and accompanying text. open-end ETFs) other than money market funds. The liquidity risk management program required under proposed rule 22e–4 would reduce the risk that funds would be unable to meet shareholder redemptions in light of their statutory and regulatory requirements for meeting redemption requests, as well as any disclosure made to investors regarding payment of redemption proceeds, without materially affecting the fund’s NAV.119 Although we recognize that various fund characteristics, such as a fund’s investment strategy, ownership concentration, redemption policies, and other similar factors, could make a fund relatively more prone to liquidity risk,120 we believe that all registered open-end funds (other than money market funds), not only those whose investment strategies create greater liquidity risk, should fall within the scope of proposed rule 22e–4. While we are not proposing different liquidity risk management program requirements for different types of funds, the proposed rule is designed to result in robust liquidity risk management programs whose scope, and related costs and burdens, are adequately tailored to manage the liquidity risk faced by a particular fund. The proposed rule requires each fund to assess its liquidity risk periodically, after consideration of certain enumerated factors, and to adopt policies and procedures for managing its liquidity risk based on this assessment.121 For example, a fund whose ownership is relatively concentrated, and that has an investment strategy requiring it to hold a significant portion of unlisted securities that do not trade frequently, would likely establish a different liquidity risk management program than a fund whose portfolio assets consist mostly of exchange-traded securities with a very high average daily trading volume.122 We are not proposing to exclude any particular subset of open-end management investment companies other than money market funds from the scope of proposed rule 22e–4, because even funds with investment strategies that historically have entailed relatively little liquidity risk could experience liquidity stresses in certain environments. For example, although most equity securities are generally understood to be more liquid than fixed income securities, investments in certain types of equities involve some degree of liquidity risk.123 Also, unexpected market events could cause the liquidity of assets
that typically are more liquid to decrease.124 Furthermore, different types of funds within the same broad investment strategy may demonstrate different levels of liquidity (and thus, presumably, different levels of liquidity risk).125 We are also not proposing to provide different liquidity requirements for relatively small funds because, as discussed in the Economic Analysis section below, smaller funds tend to demonstrate relatively high flow volatility (and thus possibly greater liquidity risk).126 Like traditional open-end funds, the Commission believes that open-end ETFs could experience liquidity risk, and thus proposes to include open-end ETFs within the scope of rule 22e–4.127 As discussed above, the liquidity of an ETF’s portfolio securities is a factor that contributes to the effective functioning of the ETF’s arbitrage mechanism and the ETF shares trading at a price that is at or close to the NAV of the ETF.128 In addition, ETFs that permit authorized participants to redeem in cash, rather than in kind, and ETFs that typically redeem in cash, like traditional mutual funds, would need to ensure that they have sufficient portfolio liquidity (in conjunction with any other liquidity sources) to meet shareholder redemptions in cash.129 And especially in times of declining market liquidity, the liquidity of an ETF may be limited by the liquidity of the market for the ETF’s underlying securities.130 As discussed below, we believe that the liquidity-related concerns relevant to ETFs structured as unit investment trusts (‘‘UITs’’) are different from those relevant to open-end ETFs, and thus we are proposing not to include ETFs structured as UITs within the scope of proposed rule 22e–4.131 The scope of proposed rule 22e–4 does not include closed-end investment companies (‘‘closed-end funds’’). Closed-end funds do not issue redeemable securities and are not subject to section 22(e) of the Investment Company Act.132 Closed-end funds’ liquidity needs are consequently different from those of open-end funds. This has been acknowledged previously by the Commission; for example, the 15% guideline is applicable only to open-end funds and not closed-end funds.133 Closed-end funds that elect to repurchase their shares at periodic intervals under Investment Company Act rule 23c–3 (‘‘closed-end interval funds’’) are subject to certain liquidity standards in order to ensure that they can complete repurchase offers, and must adopt written procedures reasonably designed to ensure that their portfolio assets are sufficiently liquid to

134Specifically, rule 23c–3 requires that: (i) A specified percentage of the investment company’s portfolio consists of assets that can be sold or disposed of in the ordinary course of business, at approximately the price at which the investment company has valued the investment, within the period within which the investment company pays repurchase proceeds; and (ii) the investment company’s board of directors adopts written procedures reasonably designed, taking into account current market conditions and the company’s investment objectives, to ensure that the company’s portfolio assets are sufficiently liquid so that the company can comply with its fundamental policy on repurchases. See rule 23c–3(b)(10)(i), (iii). Based on staff analysis, there were 26 closed-end interval funds, representing approximately $5.7 billion in assets, in 2014. 135See Interval Fund Proposing Release, supra note 83, at text following n.35 (‘‘Closed-end companies are not subject to a liquidity standard.’’). 136Securities and Exchange Commission, Office of Investor Education and Advocacy, Unit Investment Trusts (UITs), available at http:// www.sec.gov/answers/uit.htm (‘‘UIT Answers’’). 137UITs typically consist of a number of consecutive series, with each series representing units in a specific, separate portfolio of securities. Unlike traditional open-end investment companies, UITs have no corporate management structure, and their portfolios are not managed. 138With respect to UITs that are not ETFs, and that do not serve as separate account vehicles that are used to fund variable annuity and variable life insurance products, sponsors have historically maintained a secondary market in UIT units, rather than having the series liquidate portfolio securities to meet redemptions, because a large number of redemptions could necessitate premature termination of the series. See Form N–7 for Registration of Unit Investment Trusts under the Securities Act of 1933 and the Investment Company Act of 1940, Investment Company Act Release No. 15612 (Mar. 9, 1987) [52 FR 8268 (Mar. 17, 1987)] (‘‘Form N–7 Re-Proposing Release’’), at text following n.1; see also UIT Answers, supra note 136. At present, however, the majority of UIT assets are attributable to separate account vehicles that are used to fund variable annuity and variable life insurance products, and the sponsors of these UITs do not typically maintain a secondary market in UIT units. See infra note 139 and accompanying text. 139Based on data as of December 2014. 140 Jeffrey K. Dellinger, The Handbook of Variable Income Annuities 448–450 (2006). 141See UIT Answers, supra note 136. 142See id. Because of this lack of management, some UIT trust documents provide that its administrator must redeem a pro rata share of the trust’s holdings when an investor redeems from a UIT, subject to practical constraints such as securities with transfer restrictions. 143See infra section III.D. 144Based on information from Morningstar as of
July 22, 2015, the following ETFs are structured as UITs, and each ETF tracks the index in its name unless otherwise noted: SPDR Dow Jones Industrial Average ETF Trust, SPDR S&P 500 ETF Trust, SPDR S&P Midcap 400 ETF Trust, Invesco Powershares QQQ Trust Series 1 (which tracks the NASDAQ 100 Index), and the Invesco BLDRS Index Funds Trust (which has ETFs tracking the BNY Mellon Asia 50 ADR Index, the BNY Mellon Developed Markets 100 ADR Index, the BNY Mellon Emerging Markets 50 ADR Index, and the BNY Mellon Europe Select ADR Index). 145See infra notes 722–725 and accompanying text. 146Rule 2a–7(d)(4). 147Rule 2a–7(d)(4)(i). 148See supra section II.D.2. 149Rule 2a–7(d)(4)(ii). comply with their fundamental policies on repurchases.134 However, other closed-end funds are subject to no explicit liquidity requirements under the 1940 Act.135 Because closed-end funds, with the exception of closed-end interval funds, are not subject to specific statutory or regulatory liquidity requirements, we are not proposing to include closed-end funds within the scope of rule 22e–4. Although closedend interval funds do have to comply with certain liquidity standards and therefore must manage their liquidity risk, we believe that the written liquidity procedures they are required to adopt under rule 23c–3(b)(10)(iii) are adequate given these funds’ more limited liquidity needs. Also, because closed-end interval funds do not permit shareholders to redeem their shares each day, they may be better able to structure their portfolios to anticipate their liquidity needs than open-end funds. For these reasons, we are not including these funds within the proposed scope of rule 22e–4. UITs, including ETFs structured as UITs, also would not be covered within the scope of proposed rule 22e–4. A UIT issues redeemable securities, like a traditional open-end fund, which represent undivided interests in an essentially fixed portfolio of securities.136 As units of a UIT series137 are redeemable, UITs are subject to the requirements of section 22(e).138 We are not proposing to include UITs within the scope of the proposed rule for a number of reasons. First, we understand based on staff analysis that approximately 75% of the assets held in UITs currently serve as separate account vehicles that are used to fund variable annuity and variable life insurance products.139 These UITs essentially function as pass-through vehicles, investing principally in securities of one or more open-end investment companies, which as discussed above would be subject to the scope of proposed rule 22e–4.140 Thus, we believe that the liquidity risk of these UITs would be even more limited if proposed rule 22e–4 were adopted, because their underlying holdings are funds that would be required to adopt their own liquidity risk management programs under the proposed rule. Second, UITs are not actively managed, and their portfolios are not actively traded. A UIT buys a relatively fixed portfolio of securities,
and generally holds them with little change for the life of the UIT.141 A UIT does not have a board of directors, corporate officers, or an investment adviser to render advice during the life of the trust.142 Accordingly, the provisions of proposed rule 22e–4, which require a fund’s board to approve and oversee a liquidity risk management program and the fund’s adviser or officers to administer the program, are thus inapposite to the management structure of a UIT.143 Finally, we also are not including UIT ETFs within the scope of proposed rule 22e–4 because UIT ETFs generally track established and widely recognized indices.144 Moreover, they fully replicate their underlying indices including with respect to their basket assets. Therefore, we do not view a liquidity risk management program as necessary or beneficial for UIT ETFs. We also propose to exclude from the scope of rule 22e–4 all money market funds subject to the requirements of rule 2a–7 under the Investment Company Act. Money market funds are subject to extensive requirements concerning the liquidity of their portfolio assets. As described below, these requirements are more stringent than the liquidity-related requirements applicable to funds that are not money market funds (and that would be applicable to funds that are not money market funds under proposed rule 22e–4), on account of the historical redemption patterns of money market fund investors and the assets held by money market funds.145 Rule 2a–7 includes a general portfolio liquidity standard, which requires that each money market fund hold securities that are sufficiently liquid to meet reasonably foreseeable shareholder redemptions in light of its obligations under section 22(e) of the Act and any commitments the fund has made to shareholders.146 Money market funds are also subject to a specific limitation on the acquisition of illiquid securities. Namely, a money market fund cannot acquire illiquid securities if, immediately after the acquisition, the fund would have invested more than 5% of its total assets in illiquid securities.147 This limit on illiquid asset holdings is more stringent than the corollary 15% guideline for open-end funds that are not money market funds, which as discussed above, limits a fund’s aggregate holdings of illiquid assets to 15% of the fund’s net assets.148 In addition to the 5% limit on money market funds’ illiquid asset holdings, all taxable money market funds must invest at least 10% of their total assets in ‘‘daily liquid assets,’’ 149 and all money

150Rule 2a–7(d)(4)(iii).
151On the compliance date for the disclosurerelated money market fund reforms adopted in 2014 (Apr. 14, 2016), money market funds will be required to disclose each day the percentage of their total assets invested in daily liquid assets and weekly liquid assets on their Web sites. See rule 2a– 7(h)(10)(ii) (a money market fund must maintain a
schedule, chart, graph, or other depiction on its
Web site showing historical information about its investments in daily liquid assets and weekly liquid assets for the previous six months, and must update this historical information each business day, as of the end of the preceding business day). As of the compliance date, they also will be required to report information about the liquidity of their portfolio securities on Form N–MFP. See Form N– MFP Items C.21, C.22, and C.23. 152See infra section III.G.2; proposed Item C.7 of proposed Form N–PORT (requiring a fund to disclose whether a portfolio investment is a 15% Standard Asset); Form N–MFP Item 44 (requiring a money market fund to disclose whether each portfolio security is an illiquid security). 153See infra notes 722–725 and accompanying text for a discussion of why we are not proposing a liquidity fee regime similar to that for money market funds for other types of open-end management investment companies. 154See rule 2a–7(c)(2); see also 2014 Money Market Fund Reform Adopting Release, supra note 85, at section III.A. The compliance date for the amendments to rule 2a–7 related to liquidity fees and gates is October 14, 2016. 155See rule 22e–3(a) (permitting a money market fund to permanently suspend redemptions and liquidate if the fund’s level of weekly liquid assets falls below 10% of its total assets or, in the case of a fund that is a government money market fund or a retail money market fund, the fund’s board determines that the deviation between the fund’s amortized cost price per share and its market-based NAV may result in material dilution or other unfair results to investors or existing shareholders); see also 2014 Money Market Fund Reform Adopting Release, supra note 85, at section III.A.4 (discussing amendments to rule 22e–3 adopted as part of the 2014 money market fund reforms); Division of Investment Management, 2014 Money Market Fund Reform Frequently Asked Questions (Aug. 4, 2015), available at http://www.sec.gov/divisions/ investment/guidance/2014-money-market-fundreform-frequently-asked-questions.shtml. market funds must invest at least 30% of their total assets in ‘‘weekly liquid assets.’’ 150 There is no current or proposed corollary requirement for open-end funds that are not money market funds to invest certain portions of their assets in daily liquid assets or weekly liquid assets. Money market funds are also subject to liquidity-related disclosure and reporting requirements.151 These disclosure and reporting requirements do not currently extend to funds that are not money market funds, although under the proposed amendments to Form N–PORT, funds that are not money market funds would be required to report information about each portfolio asset’s liquidity classification under rule 22e–4 and whether it is a 15% standard asset.152 Money market funds also have certain tools at their disposal to manage heavy redemptions that are not available to other open-end funds.153 A money market fund is permitted to impose a
liquidity fee on redemptions or temporarily suspend redemptions if its weekly liquid assets fall below 30% of its total assets and the fund’s board determines that imposing a fee or gate is in the fund’s best interests; if a fund’s weekly liquid asset falls below 10% of total assets, the fund is required to impose a liquidity fee on redemptions unless the fund’s board determines that imposing such a fee would not be in the fund’s best interests.154 Additionally, rule 22e–3 permits a money market fund to suspend redemptions and postpone payment of redemption proceeds in an orderly liquidation of the fund if, subject to other requirements, the fund’s board makes certain findings.155 Because money market funds are required to maintain a liquidity risk management program, we propose that these funds be excluded from the scope of rule 22e–4.
3. Request for Comment
While we request detailed comment on each of the specific elements of proposed rule 22e–4 below, here we request comment on the general program requirement of the proposed rule, as well as the extent to which the proposed program requirement would promote effective liquidity risk management.

As proposed, rule 22e–4 would
require that a fund’s liquidity risk management program include certain general elements. Do commenters believe that the general elements of the program would enhance a fund’s ability to assess and manage its liquidity risk? Are there any elements that should be excluded from the program requirement, or are there any additional elements that should be included in the program requirement? Should any of the proposed elements be modified? Do commenters believe that the program would enhance funds’ management of liquidity risk better than they already do in practice? Do commenters believe that the program would materially strengthen a fund’s ability to meet its redemption obligations and would materially reduce potential dilution? Should the rule focus not just on the liquidity of the fund’s assets but also more specifically and prominently on its liabilities, such as derivatives obligations, that may affect the liquidity of the fund?
Should the Commission be more
prescriptive in requiring a fund to adopt certain specific policies and procedures for classifying and monitoring the liquidity of portfolio assets, assessing and periodically reviewing liquidity risk, and/or managing the fund’s liquidity risk, beyond the proposed requirements of rule 22e–4? If so, what other procedures should the Commission require? Are there operational challenges associated with any of the other procedures the Commission could require? To what extent do funds currently have policies and procedures resembling the proposed program requirements? Have funds’ current policies and procedures proven effective at managing liquidity risk, and how have they evolved in recent years? Are these policies and procedures primarily overseen by a fund’s chief compliance officer, chief risk officer (if any), or someone else? We also request comment on the scope of proposed rule 22e–4.
Do commenters agree that all openend funds, including open-end ETFs but
excluding money market funds, should be subject to the program requirement of the proposed rule? If not, why not? Do commenters agree that the proposed program requirement gives enough flexibility for a fund to adopt a program whose scope, and related costs and benefits, are adequately tailored for that fund to manage its actual and potential liquidity risk?
Should certain funds or types of
funds be excluded from the proposed program requirement, or subject to a different or less stringent requirement, because their investment strategies, ownership concentrations, redemption policies, or some other factor makes them less prone to liquidity risk? If so, which funds or types of funds, and why? Should smaller funds and smaller fund complexes be excluded from the proposed program requirement, or subject to a different or less stringent requirement? Why or why not? How should we distinguish between funds that should be subject to liquidity risk management program requirements and those that should not? Conversely, are there particular types of funds (or investment strategies) that are subject to heightened liquidity risk and should be subject to more prescriptive or stringent requirements under a liquidity risk management program or otherwise? If so, what types of funds should be considered to have higher liquidity risk and why? Can these types of funds be easily categorized or defined? What enhanced liquidity risk management program requirements should be considered for such funds and why? Are there any types of funds (or investment strategies) with such limited liquidity that we should consider limiting their ability to be structured as open-end funds?

156See, e.g., Comment Letter of Charles Schwab & Co., Inc. on the 2015 ETP Request for Comment (Aug. 17, 2015) (‘‘At a minimum, we believe it is important that ETF managers have the ability to construct non-pro rata baskets, subject to compliance and board oversight to help identify and address instances where the use of such baskets may conflict with the interests of the ETF and its shareholders.’’). 157See supra section II.D. 158See 2014 Fixed Income Guidance Update, supra note 62; see also BlackRock FSOC Notice Comment Letter, supra note 50, at 6 (stating that among several overarching principles that provide the foundation for a prudent market liquidity risk management framework for collective investment vehicles is ‘‘[m]easuring or estimating (a) levels of liquid assets with recognition of tiers of liquidity, (b) liquidation time frames’’); Invesco FSOC Notice Comment letter, supra note 35, at 11 (stating that their liquidity analysis includes classifying certain portfolio holdings in liquidity buckets across a liquidity spectrum, utilizing certain quantitative metrics and qualitative factors). 159See, e.g., ICI FSOC Notice Comment Letter, supra note 16, at 23 (‘‘While the SEC’s 85 percent liquidity test requires binary determinations for each portfolio holding . . ., for broader liquidity management purposes fund managers think of portfolio holdings as falling along a liquidity continuum.’’).

Do commenters agree that open-end
ETFs and ETMFs should be included? If not, why not? Do commenters believe that ETFs and/or ETMFs incur additional liquidity risk if they permit redeeming authorized participants to receive cash, rather than an in-kind basket of securities, in exchange for redeemed shares?
Should any of the requirements of
the proposed rule be modified for ETFs or ETMFs on account of the relief from
section 22(e) some of these funds
receive under their exemptive orders? Should any of the requirements apply differently when an ETF or an ETMF is organized as a class of an open-end fund or as a feeder fund in a master-feeder structure where other classes or feeder funds operate as traditional mutual funds? Exemptive orders for ETF relief include provisions that govern the composition of portfolio deposits and redemption baskets. In general, portfolio deposits and redemption baskets must represent pro rata slices of the ETF’s portfolio and must be the same for all purchasers and redeemers that transact with the ETF on the same day. In recent years, ETF sponsors have requested increased flexibility in determining the composition of portfolio deposits and redemption baskets.156
We request comments on whether
such flexibility would result in favorable or unfavorable changes in how ETFs manage the liquidity of their holdings. For example, would ETFs benefit from reduced cash drag? Would the flexibility enable or encourage ETFs to reduce the overall liquidity of their portfolios or to hold a greater amount of relatively illiquid assets? Does the existing 15% guideline adequately address any concerns regarding liquidity that could result from greater basket flexibility? Would the requirements we are proposing adequately address any concerns regarding liquidity that could result from greater basket flexibility? If not, could other requirements adequately address any concerns? We request comment on the types of investment products that the Commission proposes not to include, or to specifically exclude, from the scope of proposed rule 22e–4.
Do commenters agree that closedend funds, including closed-end
interval funds, should not be included within the scope of the proposed rule? Should we make any changes to the liquidity requirements for closed-end interval funds?
Do commenters agree that UITs
should not be included within the proposed rule’s scope? Is there any subset of UITs that should be considered for inclusion, if only for some aspects of the rule? Is there a significant risk that UITs (or a certain subset of UITs) may not be able to meet redemption requests? With respect to UITs that are not ETFs, and that do not serve as separate account vehicles that are used to fund variable annuity and variable life insurance products, is it reasonable to expect that UIT sponsors would maintain a secondary market in UIT units to the same extent and in the same manner as they have historically?
Alternatively, should we require
UITs to meet certain minimum liquidity requirements at the time of deposit of the securities, such as requiring a UIT to maintain a prescribed minimum portion of its net assets in assets that it believes are convertible to cash within three business days at a price that does not materially affect the value of that asset immediately prior to the sale? Why or why not? What specific requirements of proposed rule 22e–4 should be modified for UITs to account for the facts that UITs are not actively managed, UITs’ portfolios are not actively traded, and UITs do not have a board of directors, corporate officers, or an investment adviser to render advice during the life of the trust?
Is it appropriate that we include
ETFs organized as open-end funds but not ETFs organized as UITs within the rule? Should we exclude from the scope of the rule ETFs organized as open-end funds that, similar to UIT ETFs, fully track established and widely recognized indices? Why or why not? Do commenters believe that ETFs organized as open-end funds would reorganize as UITs in response to the rule? Why or why not?
Do commenters agree that we
should specifically exclude money market funds from the scope of proposed rule 22e–4? Is there any subset of money market funds that should be considered for inclusion, if only for some aspects of the rule? B. Classifying the Liquidity of a Fund’s Portfolio Positions Under Proposed Rule 22e–4 We have not updated the liquidity guidelines applicable to funds and fund portfolio assets in over two decades, and we believe that developments in the fund industry as well as staff observations of funds’ current liquidity risk management practices warrant proposing requirements for classifying the liquidity of funds’ portfolio positions.157 We are aware based on staff experience that many fund managers engage in analysis of the liquidity of portfolio assets, beyond considering whether the fund’s portfolio construction is consistent with the 15% guideline, and we believe that all openend funds and their shareholders would benefit from a comprehensive review of the liquidity of funds’ portfolio positions. Staff outreach has shown that funds today employ notably different procedures for assessing and classifying the liquidity of their portfolio assets.158 Some funds have implemented procedures that analyze multiple aspects relating to an asset’s liquidity, including relevant market, trading, and asset-specific factors, and monitor whether their initial liquidity determinations should be amended based on changed conditions. While the 15% guideline requires a binary determination of whether an asset is liquid or illiquid, funds with relatively comprehensive liquidity classification procedures tend to view the liquidity of their portfolio assets in terms of a moreliquid to less-liquid spectrum.159 This ‘‘spectrum’’-based approach to liquidity can enhance a fund’s ability to construct a portfolio whose liquidity profile is calibrated to reflect the fund’s specific liquidity needs. The staff has observed, however, that other funds, including some with relatively less liquid strategies, use liquidity classification practices that are substantially less thorough, do not take relevant factors into account when evaluating portfolio assets’ liquidity and do not incorporate ongoing liquidity monitoring. To the extent that these practices result in a fund holding assets that are insufficiently liquid to meet redemptions without materially

160Proposed rule 22e–4(b)(2)(i).
161 Id.; see also infra section III.B.1.a. 162See proposed rule 22e–4(b)(2)(ii); see also infra sections III.B.1.a, III.B.2. 163See infra section III.C.4. 164See generally infra section III.C (discussing the proposed requirements associated with assessing and managing a fund’s liquidity risk); see also infra
section III.C.1 (discussing the factors a fund would
be required to consider in assessing its liquidity risk, that is, the risk that a fund could not meet requests to redeem shares issued by the fund that are expected under normal conditions, or are reasonably foreseeable under stressed conditions, without materially affecting the fund’s net asset value). 165See supra notes 94–97 and accompanying text. 166The Commission has, however, discussed factors that would be reasonable for a board of directors to take into account in assessing the liquidity of a rule 144A security (but which would not necessarily be determinative). See supra notes 96–97 and accompanying text. 167 In section III.C.4 below, we discuss the interplay between the 15% guideline as proposed to be codified and the proposed requirement for a fund to invest a set minimum portion of its net assets in three-day liquid assets. 168As discussed in detail below, proposed rule 22e–4 would require a fund to assess and manage its liquidity risk, and these risk assessment and risk management requirements would be based in part on the proposed liquidity classification requirement set forth in proposed rule 22e–4(b)(2)(i) and described in this section. See infra sections III.C.1, III.C.3. We are also proposing to require that a fund disclose information regarding the liquidity classification of each of the fund’s portfolio positions, as determined pursuant to proposed rule 22e–4(b)(2)(i). See infra section III.G.2. 169See proposed rule 22e–4(a)(3) (defining ‘‘convertible to cash’’ as ‘‘the ability to be sold, with the sale settled’’). 170See infra section III.D.3 (discussing designation of administrative responsibilities for the liquidity risk management program to the fund’s adviser or officers). 171These factors are discussed in detail below. See infra section III.B.2. affecting the fund’s NAV (assuming that the fund must sell portfolio assets to meet redemptions), we believe these practices could adversely affect fund investors—either by decreasing the price that redeeming shareholders will receive for their shares and the price of the shares held by non-redeeming investors, or if the fund sells its most liquid assets to meet redemptions, by potentially increasing the liquidity risk of the fund shares held by nonredeeming shareholders. Due to the foregoing concerns, we are proposing new requirements for classifying and monitoring the liquidity of funds’ portfolio positions. Under proposed rule 22e–4, a fund would be required to classify the liquidity of each of the fund’s positions in a portfolio asset (or portions of a position in a particular asset) and review the liquidity classification of each of the fund’s portfolio positions on an ongoing basis.160 In classifying and reviewing the liquidity of portfolio positions, proposed rule 22e–4 would require a fund to consider the number of days within which a fund’s position in a portfolio asset (or portions of a position in a particular asset) would be convertible to cash at a price that does
not materially affect the value of that asset immediately prior to sale.161 The proposed rule would require a fund to consider certain specified factors in classifying the liquidity of its portfolio positions.162 The proposed liquidity categorization process would be in addition to the existing 15% guideline (which would be retained, as discussed below 163) and would require a fund to assess the liquidity of its portfolio positions individually, as well as the liquidity profile of the fund as a whole. A fund would be able to use this assessment, in turn, to establish procedures for managing its liquidity risk and to determine whether the liquidity of its portfolio reflects its liquidity needs for meeting shareholder redemptions, thus reducing potential dilution of nonredeeming shareholders.164 As described above, we understand that, in practice, funds apply the 15% guideline to limit the funds’ exposures to particular types of securities that generally cannot be sold or sold quickly.165 Although the 15% guideline involves determining whether an asset can be sold or disposed of within seven days at approximately its stated value, it does not involve a fund considering whether it can actually receive the proceeds of any sale within seven days. The 15% guideline also does not involve a fund taking into account any market or other factors in considering an asset’s liquidity,166 or assessing whether the fund’s position size in a particular asset affects the liquidity of that asset. In contrast, the proposed liquidity categorization approach incorporates each of these aspects, which, as discussed further below, we believe are critical to comprehensively assessing the liquidity of a fund’s position in a particular portfolio asset.167 We thus have come to consider the 15% guideline alone to be insufficient to limit a fund’s liquidity risk given the fund’s obligations to meet shareholder redemptions. We believe the principal benefit of the 15% guideline is to limit the ability of certain highly illiquid strategies, such as private equity, to operate in an open-end fund form.

Proposed Relative Liquidity
Classification Categories a. Proposed Classification Requirement Proposed rule 22e–4(b)(2)(i) would require a fund to classify each of the fund’s positions in a portfolio asset (or portions of a position in a particular asset) based on the relative liquidity of the position.168 For purposes of proposed rule 22e–4, a fund would assess the relative liquidity of each portfolio position based on the number of days within which it is determined, using information obtained after reasonable inquiry, that the fund’s position in an asset (or a portion of that asset) would be convertible to cash 169 at a price that does not materially affect the value of that asset immediately prior to sale. That is, the person who classifies the liquidity of each portfolio position 170 must determine—using information obtained after reasonable inquiry—the time period in which the fund would be able to sell the position, at a price that does not materially affect the value of that asset immediately prior to sale, and settle the sale (i.e., receive cash for the sale of the asset). With respect to this determination, the term ‘‘immediately prior to sale’’ is meant to reflect that the fund must determine whether the sales price the fund would receive for the asset is reasonably expected to move the price of the asset in the market, independent of other market forces affecting the asset’s value. The term ‘‘immediately prior to sale’’ is not meant to require a fund to anticipate and determine in advance the precise current market price or fair value of an asset at the moment before the fund would sell the asset. As discussed in more detail below, a fund would be required to consider certain specified market-based, trading, and asset specific factors in determining how long a particular portfolio position would take to convert to cash.171 In making this assessment, a fund could determine that different portions of a position in a particular asset could be converted to cash within different times. If a fund were to conclude, based on the liquidity classification factors required to be considered, that it would take the fund longer to convert its entire position in an asset to cash than it would to convert only a portion of that position to cash, it could determine, for example, that 50% of the position could be converted to cash within 1 day, but the remainder of the position could take up to 3 days to convert to cash. Staff outreach has shown that some funds currently consider the liquidity character of their portfolio holdings— particularly relatively large holdings—to be tiered in this manner, with a certain percentage of the holding deemed to be more liquid than the remainder of the holding. Proposed rule 22e–4 would thus specify that a fund would be

172See proposed rule 22e–4(b)(2)(i) (emphasis added). 173See infra text following note 194 (discussing potential overlaps between the 2–3 business day and 4–7 calendar day liquidity classification categories). 174See proposed Item C.13 of proposed Form N– PORT; see also infra section III.G.2. 175See infra section III.G.2. 176See proposed rule 22e–4(a)(8); proposed rule 22e–4(b)(2)(iv)(A)–(C); see also infra section III.C.3. 177See Investment Company Institute, Valuation and Liquidity Issues for Mutual Funds (Feb. 1997) (‘‘ICI Valuation and Liquidity Issues White Paper’’), at 42. 178See proposed rule 22e–4(b)(2)(ii); see also infra section III.B.2. 179See infra section III.B.2.i. required to adopt policies and procedures for classifying the liquidity of each of the fund’s positions in a portfolio asset, or portions of the fund’s position in a particular asset.172 In this release, any reference to a fund classifying the liquidity of its position in a particular portfolio asset should be read to also include circumstances in which the fund would classify the liquidity of portions of a position in a particular asset. Based on its determination of the number of days within which the fund could convert its position in an asset to cash under this standard, the fund would be required to classify each of its positions in a portfolio asset into one of six liquidity categories:
Æ Convertible to cash within 1 business day. Æ Convertible to cash within 2–3 business days. Æ Convertible to cash within 4–7 calendar days.173 Æ Convertible to cash within 8–15 calendar days. Æ Convertible to cash within 16–30 calendar days. Æ Convertible to cash in more than 30 calendar days. As discussed below, we anticipate that the proposed liquidity categorization approach would permit a fund to take a more nuanced approach to portfolio construction and liquidity risk management than an approach under which a fund would simply designate portfolio assets as liquid or illiquid. The proposed approach also would provide the framework for detailed reporting and disclosure about the liquidity of funds’ portfolio assets in a structured data format, as the six liquidity categories described above would be incorporated into the fund’s portfolio holdings reporting on proposed Form N–PORT.174 In particular, the structured data format would increase the ability of Commission staff, investors, and other potential users to aggregate and analyze the data in a much less labor-intensive manner. This data, in turn, would assist Commission staff in monitoring risks and trends with respect to funds’ portfolio liquidity (for example, observing whether portfolio liquidity increases or decreases in response to market events), and would also permit investors to better evaluate the liquidity profile of funds’ portfolios and better assess the potential for returns and risks of a particular fund.175 In addition, the proposed categorization requirement also would provide the foundation for the requirement for a fund to invest a prescribed minimum percentage of its net assets in ‘‘three-day liquid assets’’ (that is, any cash held by a fund and any position in an asset, or portion thereof, that the fund believes is convertible to cash within three business days at a price that does not materially affect the value of that asset immediately prior to sale).176 The proposed approach would require a fund to assess the liquidity of its entire position in a portfolio asset, or each portion of that position, as opposed to the liquidity of the normal trading lot for that asset. It has been argued that because a fund will not likely need to sell its entire position in a particular asset under normal market circumstances, liquidity determinations should be based on the sale of a single trading lot for that asset, except in unusual circumstances.177 We agree that the fact that a fund may not be able to convert its entire position in an asset to cash at a price that does not materially affect the value of that asset immediately prior to sale should not, by itself, be dispositive of a portfolio asset’s liquidity. Nevertheless, assessing liquidity only on the basis of the ability to sell and receive cash for a single trading lot of a portfolio asset ignores the fact that a fund needing to sell certain assets in order to meet redemptions would almost certainly need to sell greater than
one trading lot of a particular asset. In addition, a fund may need to dispose of an entire position because of deteriorating credit quality or other portfolio management factors. Similarly, an index fund may need to sell an entire position in an asset if that asset falls out of the tracked index. The liquidity of the entire position size thus is relevant to the liquidity of the overall portfolio, a fund’s ability to meet its stated investment strategy, and a fund’s portfolio management. The proposed categorization approach also is meant to promote more consistent liquidity classification practices within the fund industry. Proposed rule 22e–4 would require a fund to consider certain specified factors, to the extent applicable, with respect to each position in an asset (or similar asset(s), if data concerning a particular portfolio asset is not available to the fund). The proposed rule would specify that this consideration must include certain specified market, trading, and asset-specific factors (each discussed in more detail below), as applicable.178 We believe that codifying these factors would contribute to more consistency in the quality and breadth of funds’ analyses of their portfolio positions’ liquidity, while recognizing that funds’ portfolios, and the particular assets included within a portfolio, are diverse and that not every factor will be relevant to each liquidity determination. We recognize, and anticipate, that different funds could classify the liquidity of identical portfolio positions differently, depending on their analysis of the factors required to be considered under the proposed rule. There could be multiple appropriate reasons for this, including different information available to funds at different times, and fund-specific reasons for classifying the liquidity of a position in a particular way that are not equally applicable to another fund (for example, in the context of an asset used for hedging or risk mitigation purposes 179). Proposed rule 22e–4 does not specify that certain asset classes fall within particular liquidity categories, because we believe that individual funds would be more effective in assessing and reviewing their portfolio positions’ liquidity based on an evaluation of market and asset-specific factors, than the Commission would be in determining asset classes’ liquidity based on a categorical approach. While we recognize that permitting each fund to determine its own portfolio positions’ liquidity would likely result in less consistency in funds’ portfolio position liquidity classifications than specifying by rule which asset classes fall into certain liquidity categories, we believe that the proposed approach is preferable to an approach that involves Commission-imposed liquidity classifications of certain asset classes. We are concerned that an approach involving Commission-imposed liquidity classifications would likely result in certain assets’ liquidity being overestimated and others’
liquidity being underestimated, since we believe that a portfolio position’s liquidity character depends on a range of interrelated factors (as discussed

180See infra section III.B.2.
181See, e.g., Flash Crash Staff Report, supra note 124 (noting that, while ‘‘[t]he U.S. Treasury market is the deepest and most liquid government securities market in the world,’’ liquidity conditions in the market for U.S. Treasury securities became ‘‘significantly strained’’ during the October 2015 ‘‘Flash Crash’’). 182See infra section III.G.2. 183See infra note 205 and accompanying paragraph. 184See infra section III.G.2.a. 185See supra note 118 and accompanying text; see also infra notes 563–565 and accompanying text. 186See infra sections III.G.2.a; IV.C.3.b. 187We note that Question 32 on Form PF requests information regarding the percentage of the reporting fund’s portfolio capable of being liquidated within certain time frames. See supra note 70 for additional information about Form PF. However, the time frames associated with the liquidity categories in proposed rule 22e–4 are different from those incorporated in Form PF Question 32 on account of the different redemption obligations of registered funds versus private funds, as well as, relatedly, the different liquidity profile of registered funds’ portfolio assets (generally) versus private funds’ portfolio assets. 188With respect to the one-day and two-to-threeday liquidity categories, we are proposing to incorporate a convertible-to-cash time period that is based on business days instead of calendar days, in order to minimize unnecessary re-classifications of portfolio positions that could affect data analyses of a fund’s Form N–PORT data reporting regarding these positions. If these two liquidity categories were based on calendar days instead of business days, a portfolio position reported on a Friday might be considered to be convertible to cash within three calendar days (because markets would not be open over the weekend), but the same portfolio position reported on a different weekday would be considered to be convertible to cash within one or two calendar days. This could cause a fund to have to re-classify portfolio positions based on the reporting date, and this reclassification could skew analyses that the Commission staff or other parties conduct using Form N–PORT data. Because the required classification is the most granular in shortest-term liquidity categories, we believe such reporting consistency is particularly important. However, after the one-day and two-to-three-day liquidity categories, we are proposing to switch to a calendar day framework both to tie to the seven calendar day requirement for meeting redemptions under section 22(e) of the Act and because the longer the timeframe is to convert the asset to cash, the more we recognize the timeframe is likely to be a less precise estimate and thus the additional precision from the business day categorization is less likely to be material to the classification. below).180 Also, we are concerned that Commission-imposed liquidity classifications would be overly rigid and would be difficult to adjust quickly to
reflect changing market conditions.181 Thus, we believe that this approach would be more likely to provide an inaccurate reflection of an asset’s liquidity than the proposed classification approach. Although we are not proposing an approach that presumes that certain asset classes fall within particular liquidity categories, we note that if a fund is an outlier with respect to its liquidity classifications, Commission staff would be able to identify such outlier classifications based on the fund’s position-level liquidity disclosure on Form N–PORT and determine whether further inquiry is appropriate.182 If Commission staff does determine to examine a fund’s liquidity classifications based on the fund’s Form N–PORT disclosure, it would be able to examine whether the fund considered the required factors in classifying the liquidity of its portfolio positions. Thus, while the actual liquidity classifications assigned to funds’ portfolio positions could vary from fund to fund, the proposed approach provides a regulatory framework that should promote consistency in funds’ liquidity classification practices. The proposed approach to liquidity classification reflects our understanding that many funds evaluate assets’ liquidity across a liquidity spectrum, as opposed to making a binary determination of whether an asset is liquid or illiquid. As discussed above, Commission staff outreach to funds has shown us that it is common for funds to treat portfolio assets as relatively liquid or illiquid compared to other portfolio assets, and some funds ‘‘score’’ the liquidity of their portfolio holdings based on a variety of factors, including the period of time it takes to convert the holdings to cash, similar to those that we are proposing. We also understand that some third-party service providers currently provide data and analyses assessing the relative liquidity of a fund’s portfolio assets.183 A nuanced liquidity classification approach has practical benefits in terms of managing liquidity to meet anticipated redemptions. Because we understand based on staff outreach that many funds today consider very few, if any, of their portfolio assets to be holdings limited by the 15% guideline, we believe that the proposed spectrumbased approach to liquidity classification acknowledges the liquidity variation in funds’ portfolio positions better than the current framework, in which a fund could consider its entire portfolio (or a significant portion of the portfolio) to be simply ‘‘liquid.’’ We believe that this approach would permit a fund to better plan how it would meet redemptions occurring in a day, a week, or some other period, by categorizing asset positions in terms of the respective times in which they could be converted to cash and constructing the fund’s portfolio in order to manage its expected and reasonably foreseeable redemptions during these periods. The proposed liquidity classification approach also would enhance a fund’s ability to adjust its
portfolio composition in anticipation of, or in reaction to, adverse events, or to comply with its investment strategy or mandate. The proposed approach would provide the framework for reporting and disclosure about the liquidity of funds’ portfolio assets that would permit our staff to better monitor liquidity trends and funds’ liquidity risk profiles, and also would help investors and other market participants assess funds’ relative liquidity. As discussed below, we are proposing amendments to proposed Form N–PORT that would require a fund to indicate the liquidity classification of each of a fund’s portfolio positions.184 Funds are not currently required to disclose information about the liquidity of their portfolio assets, although Item C.7 of Form N–PORT, as proposed earlier this year, would require that each fund report whether each particular portfolio security is an ‘‘illiquid asset’’ and defines illiquid assets in terms of current Commission guidelines.185 Requiring a fund to classify the liquidity of each portfolio position also would facilitate fulsome reporting of a fund’s liquidity profile on Form N–PORT. As discussed below, we believe that the proposed N–PORT reporting requirements would permit enhanced Commission monitoring and oversight of the fund industry and would result in investor protection benefits, because we believe the proposed requirements would permit investors (particularly institutional investors), as well as academic researchers, financial analysts, and economic research firms, to use the liquidity-related data reported on Form N–PORT to evaluate fund portfolios and related risks.186 The time frames associated with the proposed liquidity categories reflect our understanding of some of the relevant periods that some funds currently consider in assessing the liquidity of a fund’s portfolio assets.187 There are many ways in which identifying portfolio positions that are convertible to cash in one business day or two-tothree business days could enhance a fund’s ability to calibrate its liquidity profile in order to manage its expected and reasonably foreseeable redemptions during these periods.188 For example, if a fund discloses that it will generally pay redemption proceeds within one business day after receiving a shareholder’s redemption request (although it may delay payment for seven calendar days, as permitted by
section 22(e) of the Investment

189See Securities Transactions Settlement Release, supra note 74. In 2004, the Commission issued a concept release seeking input on, among other things, the benefits and costs associated with implementing a settlement cycle for most brokerdealer transactions that is shorter than three days. Concept Release: Securities Transactions Settlement, Investment Company Act Release No. 26384 (Mar. 11, 2004) [69 FR 12922 (Mar. 18, 2004)] (‘‘Securities Transactions Settlement Concept Release’’). Several comments from asset managers received in response to the FSOC Notice noted that, as a practical matter, the three-business-day settlement requirements of rule 15c6–1 effectively take most fund investments to a T+3 settlement timeline. See, e.g., SIFMA IAA FSOC Notice Comment Letter, supra note 16, at n.34; Fidelity FSOC Notice Comment Letter, supra note 20, at n.20. 190See supra note 76 and accompanying text. 191See proposed rule 22e–4(a)(6). 192See infra notes 333–334 and accompanying text (discussing common reasons why a fund could be required to meet redemption requests within three business days, or within some shorter period). 193See proposed rule 22e–4(b)(2)(i)(C)–(F). 194See supra text accompanying and following note 37 (discussing the fact that a fund that sells its most liquid assets to meet redemptions minimizes the effect of the redemptions on shortterm fund performance for redeeming and remaining investors, but may leave remaining investors in a potentially less liquid and riskier fund until the fund rebalances). 195See infra section III.G.2 (discussing proposed Form N–PORT reporting requirements). 196See proposed note to proposed rule 22e– 4(b)(2)(i); see also supra note 188. 197See, e.g., Comment Letter of the Global Foreign Exchange Division to the European Commission and the European Securities and Markets Authority re: Consistent Regulatory Treatment for Incidental Foreign Exchange (FX) Transactions Related to Foreign Securities Settlement—‘‘FX Security Conversions’’ (Mar. 25, 2014), available at http://www.gfma.org/Initiatives/ Foreign-Exchange-(FX)/GFMA-Submits-Commentsto-the-EC-and-the-ESMA-on-Consistent-RegulatoryTreatment-for-Incidental-Foreign-ExchangeTransactions/ (‘‘Typically, the settlement cycle for most non-EUR denominated securities is trade date plus three days (‘T+3’). Accordingly, the bank custodian or broker-dealer would enter into a FX transaction on a T+3 basis as well. In some securities markets, for example in South Africa, the settlement cycle can take up to seven days (T+7).’’). 198See, e.g., James Vickery & Joshua Wright, TBA Trading and Liquidity in the Agency MBS Market, 19 FRBNY Econ. Policy Review 1 (May 2013), available at http://www.newyorkfed.org/research/ epr/2013/1212vick.pdf (noting that over ninety percent of agency mortgage-backed securities trading occurs in the to-be-announced (‘‘TBA’’) forward market, and that the trade date of a TBA trade will usually precede settlement by between two and sixty
days). Company Act), it would be required to identify portfolio assets that, if needed, could be converted to cash within one day. Many funds that do not pay redemption proceeds within a day of receiving a redemption request nevertheless may pay redemption proceeds within a time period shorter than the seven days required by section 22(e). For example, because rule 15c6– 1 under the Exchange Act, which became effective in 1995, established three business days as the standard settlement period for securities trades effected by a broker-dealer, this rule effectively requires most funds to pay redemption proceeds within three business days after receiving a redemption request, because a broker or dealer will be involved in the redemption process.189 Market participants also are exploring further reducing this settlement period from T+3 to T+2, and possibly eventually to T+1.190 Likewise, even funds that do not disclose that they will pay redemption proceeds within periods shorter than seven days may find it useful to identify portfolio positions that may be converted to cash quickly (i.e., within three business days or shorter) in order to meet unexpected or unusually high redemption requests, or to rebalance or otherwise adjust a portfolio’s composition quickly. Along with identifying positions that may be converted to cash within either one business day or two-to-three business days, we believe that identifying each ‘‘less liquid asset’’— that is, any position in an asset (or portion of a position in a particular asset) that is not a three-day liquid asset 191—would enhance a fund’s ability to determine the portion of the fund’s portfolio that the fund may not be able to rely on selling to meet redemption requests within the threeday period required by rule 15c6–1 under the Exchange Act, or within some shorter period.192 Among less liquid assets, some may be convertible to cash in just over three business days, others may not be convertible to cash for a year or more, and still others may fall in between these two extremes. To reflect this, we are proposing four categories of less liquid assets: Positions convertible to cash within four-to-seven calendar days, eight-to-fifteen calendar days, sixteen-to-thirty calendar days, and over-thirty calendar days.193 Determining whether a portfolio position is convertible to cash within four-to-seven calendar days would enhance a fund’s ability to identify those positions that are not immediately or very quickly convertible to cash (i.e., those positions convertible to cash within one, two, or three business days), but that nevertheless could be converted to cash in a time frame that would permit funds to pay redeeming shareholders within the seven-day period established by section 22(e). For example, for a fund that typically sells its most liquid assets to meet redemptions, the four-to-seven day liquidity category could assist the fund in constructing a second layer of portfolio liquidity to meet
redemptions using liquidity within the fund even after it has sold or disposed of its most liquid assets.194 We anticipate that funds could determine that a variety of securities within different asset classes could be converted to cash within fourto-seven calendar days, depending on facts and circumstances. We understand that circumstances could arise in which the settlement period for a particular portfolio position could be viewed either as two-to-three business days or four-to-seven calendar days. For example, if a sale were to occur on a Thursday and be settled on a Monday, the settlement period could be viewed either as two business days or four calendar days. Because this could cause ambiguity for reporting purposes,195 in situations in which the settlement period could be viewed either as two-to-three business days or four-to-seven calendar days, a fund should classify the portfolio position based on the shorter settlement period (i.e., two-to-three business days, not four-to-seven calendar days).196 We believe that the eight-to-fifteen calendar day and sixteen-to-thirty calendar day categories of less liquid assets would distinguish a position that is convertible to cash in close to seven calendar days (i.e., close to the required redemption period established by
section 22(e)) from one that takes
significantly longer (i.e., close to a month) to convert to cash. For example, if a fund were to enter into a period of extended redemptions that it anticipates would last for multiple days, it could begin trying to liquidate eight-to-fifteen day assets in order to plan to meet redemptions that would occur more than a week in the future. The overthirty calendar day category is meant to identify those portfolio positions that are the least liquid, including those that may have very extended settlement periods. Assets with settlement periods longer than three business days would be considered less liquid assets. Assets also should be classified under the rule based on typical expected settlement periods for transactions in that asset in the particular jurisdiction, and not based on the prospect of gaining expedited settlement of the purchase or sale upon request. Transactions in certain types of securities have historically entailed lengthy settlement periods. For example, transactions in certain foreign securities,197 agency mortgage-backed securities (other than secondary market trades),198 and U.S.

199See, e.g., BlackRock, Viewpoint, Who Owns the Assets, supra note 79; Michael Mackenzie & Tracy Alloway, Lengthy US loan settlements prompt liquidity fears, Fin. Times (May 1, 2014) available at http://www.ft.com/intl/cms/s/0/ 32181cb6-d096-11e3-9a81-00144feabdc0.html; OppenheimerFunds FSOC Notice Comment Letter, supra note 79, at 3–4 (stating that ‘‘loans still take longer to settle than other securities. Median settlement times for buy-side loan sales are 12 days’’ and noting that an ‘‘important tool in managing settlement times is the establishment of a credit line dedicated to bank loan funds.’’). bank loan participations 199 typically require settlement periods of more than three business days. An asset having a shorter settlement period could also be considered to be a less liquid asset, however, if a fund were to determine, based on the factors required to be assessed under the proposed rule, that it could not sell its position in the asset and settle the sale (at a price that does not materially affect the value of that asset immediately prior to sale) within three business days. b. Request for Comment We request comment on the proposed requirements for classifying the relative liquidity of a fund’s portfolio positions.

What procedures or practices do
funds currently use to assess and classify the liquidity of portfolio assets? Have these procedures proven effective in the past? If not, under what circumstances were they ineffective, and why? Have funds modified their procedures for assessing and classifying liquidity in recent years to account for changes in market structure and the advent of new types of market participants? If so, how? Who at the fund and/or the adviser is tasked with assessing the liquidity of the funds’ portfolio assets? Are any third-party service providers used in assessing portfolio assets’ liquidity, and if so, how are such service providers used and what are the costs associated with their services? Would the proposed requirements require funds to make systems modifications and what costs would be associated with any potential system modifications? What would the associated costs and other burdens be for funds to assess and classify the liquidity of portfolio assets?
Do commenters agree that it would
be useful for a fund to consider portfolio positions’ liquidity in terms of a spectrum instead of a binary determination that an asset is liquid or illiquid, and do funds currently consider the relative liquidity of portfolio assets by classifying assets (either explicitly or informally) into multiple liquidity categories? If so, what categories are used, and why? Alternatively, should we define the term ‘‘illiquid assets?’’ Why or why not? If so, how should we define it?
Do funds currently consider the
period in which a fund’s position in an asset can be converted into cash (that is, sold, with the sale settled) in assessing and classifying the liquidity of portfolio assets? Do commenters agree that it would be useful for a fund to assess the liquidity of its entire position in a portfolio asset, or portions of a position in a particular asset, as opposed to the liquidity of a single trading lot of a portfolio asset held by the fund? Do funds currently consider the ability to sell varying portions of a fund’s position in a portfolio asset (fractions of the position, as well as the entire position) in assessing that asset’s liquidity?
What assumptions, estimations, and
judgments would funds need to make in order to determine liquidity classifications, and how would these assumptions, estimations, and judgments affect the comparability of reporting across funds? Are there concerns, such as proprietary or liability concerns, associated with reporting liquidity classifications based on such assumptions, estimations, and judgments?
The proposed rule would require a
fund to determine, using information obtained after reasonable inquiry, the number of days within which a fund’s position in a portfolio asset (or portion of a position in a particular asset) would be convertible to cash at a price that does not materially affect the value of that asset immediately prior to sale. Do commenters believe that the terms ‘‘information obtained using reasonably inquiry,’’ ‘‘at a price that does not materially affect the value of that asset,’’ and ‘‘immediately prior to sale’’ are sufficiently clear? If not, how could they be made clearer?
Do the proposed liquidity categories
reflect the manner in which funds currently assess and categorize the liquidity of their portfolio holdings as
part of their portfolio and risk
management? Should we increase or decrease the number of liquidity categories to which a fund might assign a portfolio position? For example, should we combine the last three liquidity categories (convertible to cash within 8–15, 16–30, or in more than 30 calendar days) into one liquidity classification category (e.g., ‘‘convertible to cash in more than 7 calendar days’’)? Why or why not? Should we add one or more liquidity categories outside of the more than 30 calendar day time period (e.g., ‘‘convertible to cash in more than 90 calendar days’’)? Why or why not? Should we revise the time periods associated with any of the proposed liquidity categories? Alternatively, should we permit a fund to classify the liquidity of its portfolio securities based not on conversion-to-cash time periods specified by the Commission, but instead based on conversion-to-cash time periods that the fund determines to be appropriate (taking into account the fund’s redemption obligations)? Would such an approach diminish comparability in funds’ reporting of their liquidity assessment on proposed Form N–PORT, discussed below?
Regarding the proposed liquidity
categories that would be associated with less liquid assets, is there any reason why an asset with a settlement period longer than three business days should not be deemed to be a less liquid asset? What types of funds would be largely composed of assets that would be considered less liquid assets under proposed rule 22e–4?
To what extent do commenters
anticipate that assets in the eight-tofifteen calendar days, sixteen-to-thirty calendar days, and over-thirty calendar days classification categories under the proposed rule overlap with assets that funds currently consider to be limited by the 15% guideline?
Are the proposed liquidity
categories appropriate for ETFs and ETMFs? Should ETFs and ETMFs that transact primarily in kind be permitted to have different liquidity categories? If so, what categories and why?
Should smaller funds or funds
pursuing particular types of investment strategies be permitted to have different liquidity categories? If so, how should we define those subsets of funds?
Should we use business days or
calendar days for all the liquidity classification categories, rather than using business days in the shorter categories, but calendar days for the longer categories? If we used calendar days for all the categories, how could we avoid changes in asset classification based on whether the asset was held near a weekend? In addition, if we used calendar days, how could we obtain information on which assets could be converted to cash within the three business day requirement in rule 15c6– 1? If we used business days for all categories, how could we obtain information on which assets could be converted to cash within the seven calendar day (as opposed to business day) requirement for payment of redemption proceeds under section 22(e) of the Act?

Factors To Consider in Classifying the
Liquidity of a Portfolio Position Staff outreach to the fund industry has highlighted certain common factors

200See supra note 96 and accompanying text. 201See supra paragraphs accompanying note 178 and following note 183. 202See, e.g., ICI FSOC Notice Comment Letter, supra note 16, at 23 (‘‘Specific information that may contribute further to the manager’s view of an asset’s liquidity may include: (i) assessments of bidask spreads, volumes, depth of secondary market for the asset, information from pricing vendors, and other data; (ii) deliberations among portfolio managers and traders regarding valuation and liquidity; (iii) analysis of the capital structure and credit quality of the asset/holding; (iv) the ‘‘newness’’ of a bond issue (newer issues tend to be more liquid); and (v) liquidity data provided by third parties. Some fund managers assign ‘‘liquidity scores’’ to particular holdings based on these types of factors.’’). 203See proposed rule 22e–4(b)(2)(ii). 204See infra section III.B.3.a. 205These third-party vendors may, for example, create liquidity scores for a fund’s portfolio assets based on factors such as duration, rating, bid-ask spreads, and instrument maturity, and provide models that reflect how an asset’s liquidity may be affected by different market conditions. 206See, e.g., Basel Committee on Banking Supervision, Basel III: The Liquidity Coverage Ratio and Liquidity Risk Monitoring Tools (Jan. 2013), at
part 1, section II.A.1, available at http://
www.bis.org/publ/bcbs238.pdf; see also Nuveen Continued that some funds use in evaluating portfolio assets’ liquidity. Specifically, the most comprehensive liquidity analyses take into account relevant market-based, trading, and asset-specific factors in assessing a fund’s ability to convert a position in a portfolio asset (or portions of a position in a particular asset) to cash at approximately its stated value during current market conditions. The Commission has previously provided examples of factors that would be reasonable for a board of directors to consider in assessing the liquidity of a rule 144A security,200 and outreach has shown that certain funds reference these factors when considering the liquidity of all portfolio assets (not just rule 144A securities). Other funds, however, classify the liquidity of their portfolio assets using substantially less thorough practices (e.g., assuming, without individualized analysis, that certain asset classes are always liquid or always illiquid). As discussed above, we believe that a nuanced classification approach may have practical benefits in improving how funds manage liquidity to meet anticipated redemptions.201 Proposed rule 22e–4(b)(2)(ii) would require a fund to take the following factors into account, to the extent applicable, when classifying the liquidity of each portfolio position in a particular asset:

Existence of an active market for the
asset, including whether the asset is listed on an exchange, as well as the number, diversity, and quality of market participants;
Frequency of trades or quotes for
the asset and average daily trading volume of the asset (regardless of whether the asset is a security traded on an exchange);
Volatility of trading prices for the
asset;
Bid-ask spreads for the asset;
Whether the asset has a relatively
standardized and simple structure;
For fixed income securities,
maturity and date of issue;
Restrictions on trading of the asset
and limitations on transfer of the asset;
The size of the fund’s position in
the asset relative to the asset’s average daily trading volume and, as applicable, the number of units of the asset outstanding; and
Relationship of the asset to another
portfolio asset.
These factors are based on those certain investment advisers consider when systematically evaluating the liquidity of portfolio assets.202 We are proposing to require that all funds take into account these factors, as applicable, to encourage effective liquidity assessment across the fund industry. This list is not meant to be exhaustive. We recognize that the specific factors appropriate for consideration could vary depending on the issuer and the particular asset, and therefore an evaluation of a particular portfolio position’s liquidity could focus more heavily on certain factors and less on others. In evaluating the liquidity of its portfolio positions, a fund could also take into account other pertinent factors in addition to those set forth in proposed rule 22e–4(b)(2)(ii). However, a fund would be required to consider, as applicable, the proposed rule 22e– 4(b)(2)(ii) factors as a minimum set of considerations to be used in classifying the liquidity of each portfolio position. If a fund lacks pertinent information about a portfolio asset, the fund would be required to consider the proposed rule 22e–4(b)(2)(ii) factors as applied to similar assets (for purposes of this release, ‘‘comparable assets’’).203 For example, if a fund has never before invested in a particular asset— particularly, an asset that does not trade frequently and for which market data is not generally available or is of low quality—the fund could estimate the time it would take to convert the asset to cash if better market data were available for comparable assets (for example, as applicable, assets that are similar in terms of duration, credit quality, bid-ask spread, and/or maturity). Under these circumstances, a fund would be required to evaluate all applicable 22e–4(b)(2)(ii) factors with respect to the comparable assets. If data concerning a portfolio asset (as opposed to the comparable assets) were to become available to a fund, we would expect that a fund would assess, as part of its ongoing review of the liquidity classifications assigned to each portfolio position, whether the liquidity classification given to the portfolio asset is appropriate in light of newly available data.204 We understand that some third-party service providers currently provide data and analyses assessing the relative liquidity of a fund’s portfolio assets,205 and we believe that a fund could also appropriately use this type of data to inform or supplement its consideration of the proposed liquidity classification factors. However, before doing so, a fund should consider having the person(s) at the fund or investment adviser tasked with administering the fund’s liquidity risk management program review the quality of the data received from third parties, as well as the particular methodologies used and metrics analyzed by third parties, to determine whether this data would effectively inform or supplement the fund’s consideration of the proposed liquidity classification factors. This review
could include an assessment of whether modifications to an ‘‘off-the– shelf’’ product are necessary to accurately reflect the liquidity characteristics of the fund’s portfolio holdings. In the following sections, we discuss each of the proposed liquidity classification factors and provide guidance on specific issues associated with each of these factors that a fund may wish to consider in evaluating the liquidity of its portfolio positions. a. Existence of Active Market, Including Whether the Asset Is Listed on an Exchange, and the Number, Diversity, and Quality of Market Participants Under proposed rule 22e– 4(b)(2)(ii)(A), a fund would be required to consider, to the extent applicable, the existence of an active market for the asset, including whether the asset is listed on an exchange, as well as the number, diversity, and quality of market participants. The manner in which a fund may sell a particular portfolio asset, including whether an asset is listed on an exchange, can affect that asset’s liquidity. While in general, being listed on a developed and recognized exchange increases an asset’s liquidity,206 the fact that an asset is

FSOC Notice Comment Letter, supra note 45, at 9 (‘‘While securities that trade on exchanges. . . or in deep principal/over-the–counter (‘‘OTC’’) markets (e.g., U.S. Treasuries) are generally liquid even in stressed markets, other securities that trade on an OTC basis. . . have faced increasing liquidity challenges in normal markets and can be subject to insufficient quality bids in times of stress as market makers pull back their capital. This can make it not only more difficult to sell these securities, but also to accurately value those assets that are retained.’’). 207See rule 15c3–1(c)(2)(vi)(A)(1) under the Exchange Act (describing securities haircuts for securities issued or guaranteed as to principal or interest by the United States or any agency thereof); see also Liquidity Coverage Ratio: Liquidity Risk Measurement Standards (Sept. 9, 2014) [79 FR 61440 (Oct. 10, 2014)] (‘‘Liquidity Coverage Ratio Release’’) (in liquidity coverage ratio rule adopted by the Office of the Comptroller of the Currency, Board of Governors of the Federal Reserve System, and the Federal Deposit Insurance Corporation, ‘‘Level 1 Liquid Assets’’ are described as securities issued or unconditionally guaranteed as to timely payment of principal and interest by the U.S. Department of the Treasury, and liquid and readilymarketable securities issued or unconditionally guaranteed as to the timely payment of principal and interest by any other U.S. government agency (provided that its obligations are fully and explicitly guaranteed by the full faith and credit of the U.S. government)). But see Flash Crash Staff Report, supra note 124 (noting that, while ‘‘[t]he U.S. Treasury market is the deepest and most liquid government securities market in the world,’’ liquidity conditions in the market for U.S. Treasury securities became ‘‘significantly strained’’ during the October 2015 ‘‘Flash Crash’’). 208See, e.g., Terrence Hendershott & Ananth Madhavan, Click or Call? Auction versus Search in the Over-the-Counter Market (Mar. 19, 2012), available at http://people.stern.nyu.edu/jhasbrou/ SternMicroMtg/SternMicroMtg2012/Accepted/ ClickOrCall13.pdf. 209See, e.g., Abdourahmane Sarr & Tonny Lybek, Measuring Liquidity in Financial Markets, IMF Working Paper (Dec. 2002), available at http:// www.imf.org/external/pubs/ft/wp/2002/ wp02232.pdf (‘‘Liquid markets tend to exhibit five characteristics: (i) tightness (ii) immediacy, (iii) depth, (iv) breadth, and (v) resiliency.’’). 210See, e.g., Sunil Wahal, Entry, Exit, Market Makers, and the Bid-Ask Spread, 10 Rev. of Fin. Stud. 871 (1997), available at http:// www.acsu.buffalo.edu/∼keechung/MGF743/ Readings/H1.pdf (‘‘Large–scale entry (exit) is associated with substantial declines (increases) in quoted end-of-day inside spreads, even after controlling for the effects of changes in volume and volatility. The spread changes are larger in magnitude for issues with few market makers; however, even for issues with a large number of market
makers, substantial changes in quoted spreads take place.’’). 211See, e.g., Amir Rubin, Ownership Level, Ownership Concentration, and Liquidity, 10 J. Fin. Markets 219 (Aug. 2007), available at http:// www.sfu.ca/∼arubin/JFM_2006074.pdf (‘‘We examine the link between the liquidity of a firm’s stock and its ownership structure, specifically, how much of the firm’s stock is owned by insiders and institutions, and how concentrated is their ownership. We find that the liquidity-ownership relation is mostly driven by institutional ownership rather than insider ownership. Importantly, liquidity is positively related to total institutional holdings but negatively related to institutional block holdings.’’). 212See Erik Banks, Liquidity Risk: Managing Funding and Asset Risk (2nd ed. 2013), at 169. 213See id. at 168; see also MarketWatch, Fitch:
Bond Trade Frequency Strongly Linked to Issue Size (Jan. 29, 2015), available at http:// www.marketwatch.com/story/fitch-bond-trade– frequency-strongly-linked-to-issue-size-2015-01-29 (discussing Fitch Ratings study findings showing that smaller investment-grade corporate bond issues, under $500 million, trade materially less frequently than larger issue bonds); Fidelity FSOC Notice Comment Letter, supra note 20, at 21 (‘‘Liquidity management is linked to portfolio managers’ attention to market risks indicated by . . . shrinking transaction volumes which exacerbate the impact cost for additional trading’’). We note that double–counting of trades is a potential issue to consider when assessing average trading volume. Double–counting occurs because of differences between dealer and auction markets. In a dealer market, trades are ‘‘double–counted’’ because the dealer buys from person A and then sells to person B. In an auction market, person A and B trade directly. See, e.g., Anne M. Anderson exchange-traded does not necessarily mean that a fund would be able to convert that asset to cash within a relatively short period. For example, a small-cap equity stock might be listed on an exchange but trade quite infrequently, which would tend to decrease its relative liquidity. Conversely, certain securities that are traditionally traded in over-the-counter (‘‘OTC’’) markets, such as corporate bonds, could be considered more liquid if, for instance, they are frequently traded and there are generally a substantial number of bids to purchase the security. As an extreme example, short-term securities issued (or guaranteed as to principal and interest) by the U.S. government do not trade on exchanges, but are typically considered to be quite liquid.207 The means of trading a portfolio asset can affect its liquidity regardless of whether the asset is a security traded on an exchange. For example, whether an asset is traded in a bilateral transaction with a single dealer, or through an electronic auction mechanism whereby a trader can simultaneously contact multiple counterparties, can have different effects on that asset’s liquidity.208 The choice of trading mechanism may have different liquidity effects depending on the asset being traded and other market conditions, and therefore it is difficult to make general statements regarding the correlation between a particular trading mechanism and the liquidity of the asset being traded. However, a fund should consider past experience in using different trading mechanisms to sell a particular asset (or similar assets), when assessing the liquidity of a portfolio position in that asset. In addition, there are multiple considerations that a fund could assess in evaluating the diversity and quality of market participants for a particular asset. A fund may wish to consider the number of market makers on both the buying and selling sides of transactions. A fund also may consider the quality of market participants who
purchase and sell units of a particular portfolio asset, and may wish to assess, in particular:
The market participant’s capitalization; the reliability of the market participant’s trading platform(s); and the market participant’s experience and reputation transacting in various types of assets. We believe that the diversity and quality of market participants are meaningful in assessing a portfolio position’s liquidity because the most liquid assets tend to have active sale or repurchase markets at all times with diverse market participants.209 The presence of multiple market makers may be a sign that a market is liquid.210 Diversity of market participants, on both the buying and selling sides of transactions, is also an important factor for a fund to consider because it tends to reduce market concentration and may facilitate a market remaining liquid during periods of stress.211 b. Frequency of Trades or Quotes and Average Daily Trading Volume Proposed rule 22e–4(b)(2)(ii)(B) would require a fund to consider the frequency of trades and quotes for a particular asset in evaluating the liquidity of a portfolio position in that asset, as well as the asset’s average daily trading volume, regardless of whether the asset is a security traded on an exchange. In general, the greater the frequency of trades for an asset (and, relatedly, the greater the frequency of bid and ask quotes for that asset), the more liquid that asset is. However, this is not a perfect or complete measure, and trade size also should be considered in assessing the relationship between trade frequency and liquidity. For example, 100 trades at $100 might or might not signify greater liquidity than 50 trades at $200, although they are likely to suggest better liquidity than one trade at $10,000.212 In evaluating the frequency of trades (and bid and ask quotes) for an asset, a fund should generally consider, among other relevant factors, the number of dealers quoting prices for that asset, the number of other potential purchasers and sellers, and dealer undertakings to make a market in the asset. High average trading volume also tends to be correlated with greater liquidity. In general, the greater the average daily trading volume for a particular portfolio asset, the deeper the market, and the more likely it is that a fund would be able to convert its position to cash at a price that does not materially affect the value of that asset immediately prior to sale.213 A fund

& Edward A. Dyl, Trading Volume: NASDAQ and the NYSE, 63 Fin. Analysts J. 79 (May/June 2007), available at http://www.cfapubs.org/doi/abs/ 10.2469/faj.v63.n3.4693. 214See, e.g., Jennifer Huang & Jiang Wang, Liquidity and Market Crashes, 22 Rev. of Fin. Stud. 2607 (2009), available at http:// rfs.oxfordjournals.org/content/22/7/2607.full (discussing how there can be high selling pressure (and high volume) along with low liquidity and how this can create market crashes); Mark Carlson, A Brief History of the 1987 Stock Market Crash with a Discussion of the Federal Reserve Response, Federal Reserve Board Working Paper 2007–13 (Nov. 2006), available at http:// www.federalreserve.gov/pubs/feds/2007/200713/ 200713pap.pdf (discussing how the 1987 stock market crash had both high volume and low liquidity). 215See, e.g., Shantaram P. Hegde & John B. McDermott, The Liquidity Effects of Revisions to the S&P 500 Index: An Empirical Analysis, 6 J. Fin. Markets 413 (2003) (‘‘Using a recent sample of S&P 500 additions, we find a sustained increase in the liquidity of the added stocks.’’). 216See, e.g., Stock Index Liquidity Screen patent application (Owner: Frank Russell Company) (Mar. 19, 2009), available at http://appft.uspto.gov/ netacgi/nph-Parser?Sect1=PTO2&Sect2=HITOFF &p=1&u=%2Fnetahtml%2FPTO%2Fsearch-bool .html&r=1&f=G&l=50&co1=AND&d=PG01&s1=%22 stock+index+liquidity+screen%22&OS=‘‘stock +index+liquidity+screen’’&RS=‘‘stock+index +liquidity+screen’’ (describing various methods that index providers use to identify securities with inadequate liquidity and exclude them from indices). 217See, e.g., Tarun Chordia, Asani Sarkar & Avanidhar Subrahmanyam, An Empirical Analysis of Stock and Bond Market Liquidity, Federal Reserve Bank of New York Staff Reports, no. 164 (Mar. 2003), available at http://www.newyork fed.org/research/staff_reports/sr164.pdf (finding that unexpected liquidity and volatility shocks are positively and significantly correlated across stock and bond markets). 218See, e.g., Prachi Deuskar, Extrapolative Expectation: Implications for Volatility and Liquidity (Aug. 2007), available at https://business. illinois.edu/pdeuskar/Deuskar_Extrapolative_ Liquidity_Volatility.pdf (‘‘Illiquidity amplifies supply shocks, increasing realized volatility of prices, which feeds into subsequent volatility forecasts.’’); see also Fidelity FSOC Notice Comment Letter, supra note 20, at 21 (‘‘Liquidity management is linked to portfolio managers’ attention to market risks indicated by . . . increasing market- and security-specific volatility.’’). 219 In May 2013, Ben Bernanke, then Chairman of the Federal Reserve Board, announced that the Federal Reserve may start scaling back its asset purchase program—in which the Federal Reserve purchased approximately $85 billion worth of bonds and mortgage-backed securities each month—sooner than investors expected. This caused interests rates on fixed income products to spike, and bond prices to fall dramatically. This
market dislocation came to be known as the ‘‘taper tantrum.’’ See Condon & Kearns, Fed Worried About Triggering Another ‘Taper Tantrum,’ BloombergBusiness (Oct. 8, 2014), available at http://www.bloomberg.com/news/articles/2014–10– 08/fed-worried-about-triggering-another-taper-t antrum-. 220See, e.g., Michael J. Fleming, Measuring Treasury Market Liquidity, Federal Reserve Bank of New York Policy Review (Sept. 2003), available at http://www.newyorkfed.org/research/epr/03v09n3/ 0309flem.pdf (providing a literature review of studies analyzing bid-ask spreads in relation to Treasury market liquidity); see also Fidelity FSOC Notice Comment Letter, supra note 20, at 21 (‘‘Liquidity management is linked to portfolio managers’ attention to market risks indicated by. . .heightened market impact costs (as indicated by widening bid/ask spreads)’’). 221See MarketAxess, The MarketAxess Bid-Ask Spread Index (BASI)TM: A More Informed Picture of Market Liquidity in the U.S. Corporate Bond Market (2013), available at http://www.marketaxess.com/ pdfs/research/marketaxess-bid-ask-spread-indexBASI.pdf (discussing methodology for developing an index that tracks bid-ask spreads of U.S. corporate bonds). 222See, e.g., BlackRock Investment Institute, Got Liquidity? (Sept. 2012), available at http:// www.blackrock.com/investing/literature/ whitepaper/got-liquidity-us-version.pdf, at p.7; see also Oppenheimer, Diminished Liquidity in the Corporate Bond Market: Implications for Fixed Income Investors (Mar. 16, 2015), available at https://www.opco.com/redirect/bond-liquidityreport-3–15.aspx, at p.1. 223See, e.g., Michael A. Goldstein & Kenneth A. Kavajecz, Eighths, Sixteenths, and Market Depth:
Changes in Tick Size and Liquidity Provision on the NYSE, 56 J. Fin. Econ. 125 (2000), available at http://www.acsu.buffalo.edu/∼keechung/MGF743/ Readings/G5.pdf (‘‘Using limit order data provided by the NYSE, we investigate the impact of reducing the minimum tick size on the liquidity of the market. While both spreads and depths (quoted and on the limit order book) declined after the NYSE’s change from eighths to sixteenths, depth declined throughout the entire limit order book as well. The combined effect of smaller spreads and reduced cumulative limit order book depth has made liquidity demanders trading small orders better off; however, traders who submitted larger orders in lower volume stocks did not benefit, especially if those stocks were low priced.’’); Hendrik Bessembinder, Tick Size, Spreads, and Liquidity:
An Analysis of Nasdaq Securities Trading Near Ten Dollars, 9 J. of Fin. Intermediation 213 (July 2000), available at http://www.acsu.buffalo.edu/∼ keechung/MGF743/Readings/G4.pdf (‘‘There is no evidence of a reduction in liquidity with the smaller tick size. The largest spread reductions occur for stocks whose market makers avoid oddeighth quotes. This finding provides support for Continued may wish to particularly consider the number of days a particular asset has shown zero trading volume during the prior month, year, or other relevant period, as this could indicate particularly limited liquidity. High trading volume is not always indicative of available liquidity for a particular asset, however. For example, high trading volumes might be associated with high selling pressure on the asset and trades at that time may have a high price impact.214 Assets that are components of widely followed market indices tend to have relatively high trading volume, and therefore relatively high liquidity compared to other assets. If a security is included in such an index, market participants are likely to invest in the security in order to replicate the index. This, in turn, will increase demand and trading volume for the security, therefore increasing the security’s liquidity compared to securities not in such an index.215 Additionally, index components are selected, with a goal of promoting replicability of the index, based on multiple factors including liquidity screens, which in turn may be based on an asset’s trading volume.216 A security’s inclusion in a widely followed market index therefore suggests relatively high trading volume, and thus a greater level of liquidity relative to similar securities that were not chosen to be part of such an index (e.g., a high-yield corporate bond included in a widely followed market index would likely be more liquid than an otherwise similar high-yield corporate bond that is not a component of such an index).
c. Volatility of Trading Prices
Under proposed rule 22e–
4(b)(2)(ii)(C), a fund would be required to consider the volatility of trading prices for a particular portfolio asset when evaluating the liquidity of a position in that asset. In general, there is an inverse relationship between liquidity and volatility,217 as lack of liquidity in a particular asset tends to amplify price volatility for that asset.218 Additionally, Commission staff understands that certain funds and fund groups have historically experienced liquidity disruptions during periods of extreme market volatility, such as the June 2013 ‘‘taper tantrum.’’219 For these reasons, we believe that trading price volatility is potentially a valuable metric to consider in determining an asset’s liquidity. d. Bid-Ask Spreads Bid-ask spreads—the difference between bid and offer prices for a particular asset—have historically been viewed as a useful measure for assessing the liquidity of assets that trade in the OTC markets.220 A fund would thus be required, under proposed rule 22e– 4(b)(2)(ii)(D), to consider a portfolio asset’s bid-ask spreads in evaluating the liquidity of a position in that asset. The bid-ask spread of a particular fixed income asset is related to the riskiness of that asset, as well as the length of time that a broker-dealer believes it will have to hold the asset before selling it.221 In general, high bid-ask spreads for a particular asset correlate with a lack of liquidity in that asset. For example, when liquidity was significantly constricted during the 2007–2009 financial crisis, bid-ask spreads on U.S. investment grade bonds were notably elevated.222 However, bid-ask spreads alone do not necessarily provide a comprehensive understanding of an asset’s liquidity. For instance, bid-ask spreads are often constrained by the increments in which prices are quoted.223

models implying that changes in the tick size can affect equilibrium spreads on a dealer market and indicates that the relation between tick size and market quality is more complex than the imposition of a constraint on minimum spread widths.’’). 224See BlackRock, Viewpoint, Corporate Bond Market Structure: The Time for Reform Is Now (Sept. 2014), at p.7, available at http:// www.blackrock.com/corporate/en-ae/literature/ whitepaper/viewpoint-corporate-bond-marketstructure-september-2014.pdf. 225See, e.g., Yee Cheng Loon & Zhaodong (Ken) Zhong, The impact of central clearing on counterparty risk, liquidity, and trading: Evidence from the credit default swap market, 112 J. of Fin. Econ. 91 (Apr. 2014), available at http:// papers.ssrn.com/sol3/papers.cfm?abstract_id=2176 561 (analyzing the impact of central clearing on credit default swaps and finding that cleared reference entities experience an improvement in both liquidity and trading activity relative to noncleared entities); Joshua Slive, Jonathan Witmer & Elizabeth Woodman, Liquidity and Central Clearing: Evidence from the CDS Market, Bank of Canada Working Paper 2012–38 (Dec. 2012), available at http://www.bankofcanada.ca/wpcontent/uploads/2012/12/wp2012-38.pdf (analyzing ‘‘the relationship between liquidity and central clearing using information on credit default swap clearing at ICE Trust and ICE Clear Europe,’’ and finding that ‘‘the introduction of central clearing is associated with a slight increase in the liquidity of a contract’’ (but noting that the effects of central clearing on liquidity must be viewed in light of the fact that the central counterparty chooses the most liquid contracts for central clearing, consistent with liquidity characteristics being important in determining the safety and efficiency of clearing)). But see Manmohan Singh, Collateral, Netting and Systemic Risk in the OTC Derivatives Market, IMF Working Paper 10/99 (Apr. 1, 2010), available at https://www.imf.org/external/pubs/cat/longres.cfm ?sk=23741.0 (arguing that large increases in collateral posted for the centrally cleared trades negatively affect market liquidity given that most large banks will be reluctant to offload their positions to central counterparties). 226See, e.g., Sugato Chakravarty & Asani Sarkar, Liquidity in U.S. Fixed Income Markets: A Comparison of the Bid-Ask Spread in Corporate, Government and Municipal Bond Markets, Federal Reserve Board of New York Staff Report No. 73 (Mar. 1999), available at http://papers.ssrn.com/ sol3/papers.cfm?abstract_id=163139. 227The on-the–run phenomenon refers to the fact that, in fixed income markets, securities with nearly identical cash flows trade at different yields and with different liquidity. In particular, most recently issued (i.e., on-the–run) government bonds of a certain maturity are generally more liquid than previously issued (i.e., off-the–run or old) bonds maturing on similar dates. See, e.g., Paolo Pasquariello & Clara Vega, The
on-the-run liquidity phenomenon, 92 J. of Fin. Econ. 1 (Apr. 2009), available at http://webuser.bus.umich.edu/ ppasquar/onofftherun.pdf (analyzing the liquidity differentials of on-the-run and off-the-run U.S. Treasury bonds and finding, among other things, that on-the-run and off-the-run liquidity differentials are economically and statistically significant—showing that on-the-run bonds tend to be more liquid than their off-the-run counterparts— even after controlling for certain intrinsic characteristics of the bonds); Michael Barclay, Terrence Hendershott & Kenneth Kotz, Automation versus Intermediation: Evidence from Treasuries Going Off the Run, 61 J. FIN. 2395 (Oct. 2006), available at http://faculty.haas.berkeley.edu/ hender/on-off.pdf (discussing how ‘‘when Treasury securities go ‘off the run’ their trading volume drops by more than 90%’’). 228See supra section III.B.2.b. 229See Rule 144A Release, supra note 86. As discussed below, the Commission has stated that an investment company’s board of directors may delegate day-to-day responsibility for such determinations to the investment company’s investment adviser, provided that the board retains sufficient oversight. See infra section III.D.3; see also Rule 144A Release at n.61. 230See Rule 144A Release, supra note 86, at text following n.62. 231 ‘‘The frequency of trades and quotes for the security’’ is consistent with proposed rule 22e– 4(b)(2)(ii)(B). ‘‘The number of dealers willing to purchase or sell the security and the number of other potential purchasers’’ and ‘‘dealer undertakings to make a market in the security,’’ are reflected in proposed rule 22e–4(b)(2)(ii)(A). ‘‘The nature of the security and the nature of the marketplace trades’’ is a very general factor, and we believe that many of the proposed rule 22e– 4(b)(2)(ii) factors (in particular, those reflected in proposed rule 22e–4(b)(2)(ii)(A), (B), (C), (D), (E), (F), (G), and (H)) indicate the nature of the security and the nature of marketplace trades. e. Standardization and Simplicity of Structure Proposed rule 22e–4(b)(2)(ii)(E) would require a fund to consider whether a portfolio asset has a relatively standardized and simple structure in evaluating the liquidity of a position in that asset. Assets that trade OTC with terms set at issuance such as sizes, maturities, coupons, and payment dates tend to be relatively more liquid compared to similarly situated assets without standardized terms. The issue of standardization is particularly significant with respect to the corporate bond market, since corporate issuers commonly have large numbers of bonds outstanding, and trading can be fragmented among that universe of bonds. For example, while each of the top ten largest issuers in the United States had one common equity security outstanding as of April 2014, these issuers collectively had more than 9,000 bonds outstanding.224 Conversely, some types of OTC-traded securities exhibit a relatively high level of standardization,
such as government and agency bonds, futures contracts, and certain swap contracts. Central clearing of certain OTC-traded securities, which generally requires the terms of these securities to be highly standardized, has been associated with an increase in these assets’ liquidity, as measured by factors such as the bid-ask spreads for these assets and the number of dealers providing quotes for these assets.225 While standardization of a particular security contract alone is not indicative of that security’s liquidity, standardization can increase liquidity by simplifying the ability to quote and trade securities, enhancing operational efficiency to execute and settle trades, and improving secondary market transparency. f. Maturity and Date of Issue With respect to fixed income assets, proposed rule 22e–4(b)(2)(ii)(F) would require a fund to consider the maturity of a particular asset, as well as when the asset was issued, in assessing the liquidity of the fund’s position in that asset. In general, a fixed income asset trades most frequently in the time directly following issuance, and its trading volume decreases in the asset’s remaining time to maturity.226 Thus ‘‘on-the–run’’ securities (that is, bonds or notes of a particular maturity that were most recently issued) tend to trade significantly more frequently than their ‘‘off-the–run’’ counterparts (that is, bonds or notes issued before the most recently issued bond or note of a particular maturity).227 Because high trading volume generally suggests relatively higher liquidity,228 a fixed income asset’s date of issuance and maturity (which in turn are generally correlated with the trading volume of a fixed income asset) together are important liquidity indicators. We understand, based on staff outreach and industry knowledge, that remaining time to maturity is a key factor that fixed income funds commonly consider in assessing the liquidity of their portfolio positions. g. Restrictions on Trading and Limitations on Transfer Proposed rule 22e–4(b)(2)(ii)(G) would require a fund to consider any restrictions on trading a particular asset, and limitations on transfers of that asset, in evaluating the liquidity of a portfolio position in that asset. We previously stated that the liquidity of rule 144A securities is ‘‘a question of fact for the board of directors [of the fund] to determine based upon the trading markets for the specific security.’’229 We also stated that a fund’s board may find it reasonable to consider certain factors when evaluating the liquidity of a rule 144A security, including: (i) the frequency of trades and quotes for the security; (ii) the number of dealers willing to purchase or sell the security and the number of other potential purchasers; (iii) dealer undertakings to make a market in the security; and (iv) the nature of the security and the nature of the marketplace trades (e.g., the time needed to dispose of the security, the method of soliciting offers, and the
mechanics of transfer).230 These guidance factors are consistent with certain of the proposed rule 22e– 4(b)(2)(ii) factors,231 and a fund is required to consider the proposed rule

232See, e.g., HSBC, Emerging Markets FX:
Regulatory understanding a priority, HSBC’s Emerging Markets Currency Guide 2012 (Dec. 2011), available at http://www.hsbcnet.com/gbm/ attachments/rise–of-the–rmb/currency-guide– 2012.pdf?WT.ac=CIBM_gbm_pro_rmbrise_pbx01_ On; see also Liquidity Coverage Ratio Release, supra note 207, at section II.B.3.iv (discouraging banking entities from holding a disproportionate amount of their eligible highly qualified liquid assets in locations outside the United States where unforeseen impediments may prevent timely repatriation of such assets during a liquidity crisis). 233See, e.g., Stephen H. Bier, Julien Bourgeois & Joseph McClain, Mutual Funds and Loan Investments, The Investment Lawyer (Mar. 2015), at 2, available at http://www.dechert.com/files/ Uploads/Documents/FSG/Mutual%20 Funds%20and%20Loan%20Investments%20- %20The%20Investment%20Lawyer.pdf (‘‘[M]any loans and assignment trades remain bespoke transactions that require consents from borrowers or key syndicate members, and loan documents are still negotiated written documents that require human review. As a result. . .the mechanics of loan trades and certain trade settlement times cause funds to carefully monitor liquidity considerations surrounding loan investments . . . . [In making such determinations, funds] typically consider factors common to general liquidity determinations, as well as factors specific to the loan markets, which can include: (i) the legal limitations on the transferability or sale of a loan including the requirement to obtain consents from borrowers or syndicate agents and members prior to assignment; (ii) the existence of a trading market for the loans and the estimated depth of the market; (iii) the frequency of trades or quotes for the loan; (iv) the estimated length of the settlement period; and (v) the borrower’s health.’’). 234See proposed rule 22e–4(b)(2)(i); supra paragraph accompanying note 177. 235See proposed rule 22e–4(b)(2)(ii)(H). 236Proposed rule 22e–4(b)(2)(ii)(H). 237See, e.g., DERA Study, supra note 39, at p. 27; cf. also Amy K. Edwards, Lawrence E. Harris & Michael S. Piwowar, Corporate Bond Market Transaction Costs and Transparency, 62 J. Fin. 1421, 1444 (June 2007) (‘‘Large issues have significantly lower transaction costs than do small issues.’’). 238See supra section III.B.2.b. 239See, e.g., Marshall E. Blume & Donald B. Keim, Institutional Investors and Stock Market Liquidity:
Trends and Relationships (Aug. 21, 2012), available at http://papers.ssrn.com/sol3/papers.cfm?abstract_ id=2147757 (examining the relation between illiquidity and two measures of institutional stock ownership—the percentage of a stock owned by institutions and the number of institutions that own the stock—and finding that the number of institutions that own and trade a stock is more important than the percentage of institutional ownership in explaining the cross-sectional variability of illiquidity (‘‘an increase in the number of institutional holders of a stock decreases the average number of shares of the stock held by individual institutions and, thereby, reduces the potential size of a trade and its accompanying liquidity-induced impact’’)). 240Proposed rule 22e–4(b)(2)(ii)(H). 241Securities Trading Practices of Registered Investment Companies, Investment Company Act Release No. 10666 (Apr. 18, 1979) [44 FR 25128 (Apr. 27, 1979)] (‘‘Release 10666’’). 242See generally Use of Derivatives by Investment Companies Under the Investment Company Act of 1940, Investment Company Act Release No. 29776 (Aug. 31, 2011) [76 FR 55237 (Sept. 7, 2011)] (‘‘Investment Company Derivatives Use Concept Release’’) (providing background information on the application of section 18 to derivatives and certain other transactions). 22e–4(b)(2)(ii) factors in evaluating the liquidity of a 144A security. Regardless of whether a portfolio asset is a restricted security, it may nevertheless be subject to other limitations on transfer. For example, for securities that are traded in certain foreign markets, government approval may be required for the repatriation of investment income, capital, or the proceeds of sales of securities by foreign investors.232 Portfolio assets furthermore may be subject to certain contractual limitations on transfer.233 Securities subject to transfer limitations in general are less liquid than securities without such limitations. h. Size of Position in an Asset Relative to the Asset’s Average Daily Trading Volume and, as Applicable, Number of Units of the Asset Outstanding Under proposed rule 22e–4, a fund’s liquidity analysis regarding a particular portfolio asset would be required to take into consideration the ability to sell and receive cash for the entire position (or, as applicable, portions of a position in a particular asset), not only its ability to convert a single trading lot of that asset to cash.234 Because the size of a fund’s portfolio position in a particular asset is a key element in determining a fund’s ability to convert the entire position (or portions of a position in a particular asset) to cash, the proposed rule would require a fund assessing the liquidity of a portfolio asset to consider the size of the fund’s position in that asset.235 Staff outreach has shown that many funds currently consider this factor in evaluating the liquidity of their portfolio positions. A fund would be required to consider the size of its
position in a particular portfolio asset relative to the asset’s average daily trading volume and, as applicable, the number of units of the asset outstanding.236 Smallcapitalization securities are generally less liquid than large-capitalization securities237 and, as discussed above, securities with lower trading volume are generally less liquid than securities whose trading volume is higher.238 The size of a fund’s position in a particular portfolio asset could augment the effects of these two liquidity factors. For example, if a fund holds a significant position in a small-capitalization security, this could indicate that its position is relatively illiquid.239 Likewise, holding a large position in a thinly traded security diminishes the possibility that a fund would be able to convert a significant portion of that position to cash in order to meet redemptions. In considering the number of units of an asset that are currently outstanding, a fund may wish to take into account the extent to which units of an asset may be technically outstanding, but cannot be purchased by a member of the public (e.g., shares of a company that the company has repurchased from the public, but not cancelled because the company plans to later reissue the shares, for example to cover employee stock grants). Because units of an asset that cannot be purchased by a member of the public are not able to be actively traded, this consideration could be relevant to a fund’s assessment of how the size of a portfolio position relative to the number of outstanding units may affect that position’s liquidity. When a fund is evaluating the size of its position in a particular asset as a factor in assessing that position’s liquidity, it would be required to consider the extent to which the timing of disposing of the position could create any market value impact.240 Selling a large position in a particular asset into the market over a short time period could entail a negative price impact on the asset, which in turn could cause losses to the fund and its shareholders. Therefore, this consideration is relevant to determining the period in which a fund would be able to convert a particular portfolio position (or portion thereof) to cash, without affecting the value of that asset by virtue of the transaction.
i. Relationship of Asset to Another
Portfolio Asset
Under proposed rule 22e–4(b)(2)(ii)(I), a fund would be required to consider, in assessing the liquidity of a position in a particular portfolio asset, whether the fund invests in the asset because it is connected with an investment in another portfolio asset. This may arise in connection with a derivatives transaction, or if the fund uses an asset for hedging or risk mitigation purposes. When funds enter into certain transactions that implicate section 18 of the Investment Company Act, they generally will maintain in a segregated account certain liquid assets in order to ‘‘cover’’ the fund’s obligation under the transactions. We applied this framework to certain financing transactions in Investment Company Act Release No. 10666 (‘‘Release 10666’’), issued in 1979,241 and also understand that funds today apply this framework to certain derivatives, based on the guidance we provided in Release 10666 and on noaction letters issued by our staff.242 We explained in Release 10666 that ‘‘[a] segregated account freezes certain assets of the investment company and renders

243See also Dear Chief Financial Officer Letter from Lawrence A. Friend, Chief Accountant, Division of Investment Management (Nov. 7, 1997) (staff letter taking the position that a fund could segregate assets by designating such assets on its books, rather than establishing a segregated account at its custodian). 244See Release 10666, supra note 241. 245See infra section III.B.3.a. such assets unavailable for sale or other disposition.’’243 We also stated in Release 10666 that only liquid assets should be placed in a segregated account. Thus, although we expect that assets used by a fund to cover derivatives and other transactions would be liquid when considered in isolation, when evaluating their liquidity for purposes of the proposed rule, the fund would have to consider that they are being used to cover other transactions and, consistent with our position in Release 10666, are ‘‘frozen’’ and ‘‘unavailable for sale or other disposition.’’ Because these assets are only available for sale to meet redemptions once the related derivatives position is disposed of or unwound, a fund should classify the liquidity of these segregated assets using the liquidity of the derivative instruments they are covering. Release 10666 notes that segregated assets may be ‘‘replaced by other appropriate nonsegregated assets of equal value,’’ and when they are so replaced, formerly segregated assets would no longer be considered unavailable for sale or other disposition.244 When a formerly segregated asset is no longer segregated, a fund generally should assess, as part of its ongoing review of the liquidity classifications assigned to each portfolio position, whether the liquidity classification given to the portfolio asset when it was segregated continues to be appropriate.245 A fund may purchase an asset in connection with its holding of another asset for other reasons, such as hedging. For example, a fund might purchase a debt security denominated in a foreign currency and attempt to hedge the currency risks associated with the debt security by entering into a currency future. When evaluating the liquidity of the currency future, the fund should consider the way the currency future is being used in the fund’s portfolio. In situations where a fund purchases a more liquid asset in connection with a less liquid asset, and it plans to transact in the more liquid asset only in connection with the less liquid asset, then the liquidity of the two assets is linked by the fund and, in this case, the fund should consider the liquidity classification of the foreign debt security when determining the liquidity of the currency future. j. Request for Comment We request comment on the proposed factors that a fund would be required to consider, as applicable, in classifying the liquidity of each portfolio position in a particular asset.

What factors do funds currently use
to assess and classify the liquidity of portfolio assets, and do the proposed factors reflect factors that funds already consider when evaluating portfolio assets’ liquidity? Do commenters agree that requiring a fund to consider certain factors would encourage effective liquidity assessment across the fund industry? Would considering certain factors improve funds’ ability to meet their redemption obligations and to reduce potential dilution of nonredeeming shareholders? Would classification generally enhance funds’ liquidity risk management, including funds’ ability to meet their redemption obligations and to reduce potential dilution of non-redeeming shareholders?
Should any of the proposed factors
not be required to be considered by a fund in making liquidity determinations? Should any of the proposed factors be modified? Are there any additional factors, besides the proposed factors, that a fund should be required to consider in evaluating the liquidity of a portfolio position in a particular asset? Should the proposed rule text be modified to explicitly exempt certain types of funds from considering certain factors? Or are there additional factors, besides the proposed factors, that should be required to be considered by certain types of funds? Should funds be required to consider correlations between asset classes more generally, outside the derivatives and hedging contexts? Should certain factors be given more weight than others? Should proposed rule 22e–4 explicitly require a fund to classify the liquidity of a position (or portions of a position in a particular asset) used to cover a derivative position using the same liquidity classification category as it assigned to the derivative? Should the Commission provide additional guidance regarding the circumstances in which a fund should consider the liquidity of a particular portfolio asset in relation to the liquidity of another asset? What types of operational challenges would arise in connection with considering the liquidity of a particular portfolio asset in relation to the liquidity of another asset?
Instead of codifying the factors as
part of proposed rule 22e–4, should the
Commission solely provide guidance as to what would be appropriate for a fund to consider in assessing its portfolio assets’ liquidity? Why or why not? Would the failure to codify the factors diminish how consistently they are applied across the industry?
Would a more principles-based
approach, in lieu of codified factors or guidance, be more appropriate? For example, would it be less costly to implement and allow more flexible use of factors that might be more pertinent in analyzing the liquidity of a particular asset? Or would a more principles-based approach not materially advance portfolio asset liquidity assessments beyond those conducted today under the 15% guidelines, and thus be subject to similar limitations as discussed above as a stand-alone method for liquidity assessment?
To the extent that a fund lacks
pertinent information about a particular portfolio asset, should the fund be required to consider the proposed rule 22e–4(b)(2)(ii) factors with respect to appropriate comparable assets? What characteristics of the portfolio asset and the comparable asset would a fund generally compare in determining the weight to ascribe to the comparable asset’s liquidity in evaluating the portfolio asset’s liquidity?
Should ETFs and ETMFs be
governed by the same, a subset of, or different factors? If so, which factors and why? We seek comment on the Commission’s guidance regarding each of the proposed factors.
Besides the guidance, are there any
other specific issues associated with any of the proposed factors that a fund may wish to consider in evaluating the liquidity of a portfolio position in a particular asset?
Do commenters generally agree
with the guidance that we have proposed regarding the ways that each of the proposed factors could indicate relative liquidity or illiquidity of a portfolio asset? Should we add a note to rule 22e–4 indicating that the release includes additional guidance regarding the proposed factors?

Ongoing Review of the Liquidity of a
Fund’s Portfolio Positions a. Proposed Ongoing Review Requirement Proposed rule 22e–4(b)(2)(i) would require a fund to review the liquidity classification of each of the fund’s portfolio positions on an ongoing basis. As appropriate, a fund could determine to revise its liquidity classification of a portfolio position based on this ongoing

246 Guidelines Release, supra note 4, at section II. 247See ICI Valuation and Liquidity Issues White Paper, supra note 177, at 45. 248See Guidelines Release, supra note 4, at
section II. (stating, with respect to the Commission’s
expectation that a fund would monitor its portfolio liquidity, ‘‘For example, an equity fund that begins to experience a net outflow of assets because investors increasingly shift their moneys from equity to income funds should consider reducing its holdings of illiquid securities in an orderly fashion in order to maintain liquidity.’’). 249See, e.g., Heartland Release, supra note 47. 250See also, e.g., ICI FSOC Notice Comment Letter, supra note 16, at 23–25 (‘‘A mutual fund manager’s liquidity management practices typically will include active monitoring of the liquidity profile of individual portfolio holdings.’’). 251See proposed rule 22e–4(b)(2)(i)–(ii). 252See infra section III.C.3 (discussion of threeday liquid asset minimum requirement). 253We note that at a minimum, a fund would review its liquidity classification at least monthly in order to accurately report this information on proposed Form N–PORT. 254See, e.g., 2014 Fixed Income Guidance Update, supra note 62. review requirement. The Commission has previously stated that it ‘‘expects funds to monitor portfolio liquidity on an ongoing basis to determine whether, in light of current circumstances, an adequate level of liquidity is being maintained.’’246 Some have interpreted this statement to mean that the Commission does not intend for a fund to reassess the liquidity status of individual securities on an ongoing basis, but instead to monitor whether a fund portfolio’s overall liquidity profile is appropriate in light of its redemption obligations under section 22(e).247 We agree that a fund should monitor the liquidity of its portfolio holistically, in light of shareholder flows, to determine the fund’s capacity to meet its redemption obligations.248 However, decreased liquidity of individual portfolio components can directly affect the ability of a fund to meet its redemption obligations, or to meet obligations in a manner that does not dilute the interests of non-redeeming shareholders.249 We thus believe that requiring a fund to review position-level liquidity classifications made under proposed rule 22e–4 on an ongoing basis would reduce the risk that the fund will be unable to meet its redemption obligations and reduce potential dilution of shareholders’ interests. As discussed above, Commission staff understands, based on outreach to the fund industry and information provided by industry participants, that different funds employ varying approaches to monitoring the liquidity of individual assets and positions. We understand that some funds may not normally review the liquidity of individual portfolio assets on a continuing basis after they are acquired. On the other hand, our staff learned through outreach efforts across the fund industry that certain funds periodically reassess the liquidity of each portfolio security based on market-wide developments, as well as events affecting particular securities or asset classes.250 Pursuant to the proposed ongoing review requirement,
each fund would be required to consider the rule 22e– 4(b)(2)(ii) factors, as applicable, in reviewing its portfolio positions’ liquidity on an ongoing basis.251 However, beyond this, rule 22e–4 does not include prescribed review procedures, nor does it incorporate specific developments that a fund must monitor. A fund may wish to determine the frequency of its ongoing review of portfolio positions’ liquidity classifications based in part on the liquidity of its portfolio holdings, as well as the timing of its portfolio acquisitions and turnover, in order to evaluate whether its portfolio acquisitions are in compliance with the three-day liquid asset minimum requirement.252 For example, a fund whose portfolio assets’ liquidity could depend significantly on current market conditions should generally review the liquidity classifications of its portfolio assets relatively often (up to daily, or even hourly, depending on facts and circumstances). On the other end of the spectrum, it may be appropriate for a fund whose portfolio holdings’ liquidity tends to be more stable (for example, a large-cap equity fund) to consider reviewing the liquidity classifications of its portfolio assets less frequently.253 In adopting ongoing review policies and procedures, a fund generally should include policies and procedures for identifying market-wide developments, as well as security- and asset-classspecific developments, that could demonstrate a need to change the liquidity classification of a portfolio position. For instance, relevant marketwide developments could include changes in interest rates or other macroeconomic events, market-wide volatility, market-wide flow changes, dealer inventory or capacity changes, and extraordinary events such as natural disasters or political upheaval.254 Security- and asset-class specific developments that a fund may wish to consider include corporate events (such as bankruptcy, default, or delisting, as well as reputational events) and regulatory changes affecting certain asset classes. Any of these developments could cause changes, for example, in the frequency of trades or quotes for a particular asset, as well as changes to that asset’s trading volume, price volatility, and bid-ask spreads. b. Request for Comment We request comment on the proposed ongoing review requirement.

How do funds currently monitor the
liquidity of portfolio assets, and how frequently do they do so? To what extent do funds anticipate that the ongoing review procedures that would be required under proposed rule 22e–4 would replicate the procedures funds currently use to monitor whether portfolio assets are limited by the 15% guideline? Are current processes largely automated? Do funds believe that systems could be used to automate the monitoring that would be required under proposed rule 22e–4? What tradeoffs or risks does automated monitoring pose vis-a`-vis manual monitoring, and how do firms currently manage those risks? Are there circumstances in which automated monitoring is inappropriate, and, if so, why?
Is the ongoing review requirement,
as proposed, sufficiently clear? Are there certain approaches to ongoing review that we should require and/or on which we should provide guidance? Should we specify a minimum time period for funds to review their liquidity classifications under proposed rule 22e–4? Should we require that a fund monitor for certain specified developments or events, and/or expand our guidance on the market-wide and security- and asset-class-specific developments that a fund could consider?
C. Assessing and Managing a Fund’s
Liquidity Risk
We believe that assessing and managing liquidity risk in a comprehensive manner is critical to a fund’s ability to honor redemption requests within the seven-day period required under section 22(e) of the Investment Company Act, as well as within any shorter time period disclosed in the fund’s prospectus or advertising materials or required for purposes of rule 15c6–1. Proposed rule 22e–4(a)(7) would define liquidity risk as the risk that the fund could not meet requests to redeem shares issued by the fund that are expected under normal conditions, or are reasonably foreseeable under stressed conditions, without materially affecting the fund’s net asset value. This proposed definition contemplates that a fund consider both expected requests to redeem (e.g., shareholder flows relating to seasonality or shareholder tax considerations), as well as requests to redeem that may not be expected, but are reasonably

255See, e.g., infra section IV.C.1.e (discussing why we do not believe that a general stress testing requirement would be an adequate substitute for the proposed three-day liquid asset requirement). 256See infra section III.C.1; see also Nuveen FSOC Notice Comment Letter, supra note 45, at 10– 11 (stating that mutual funds that could have liquidity challenges in difficult markets include those that invest not only in less liquid asset classes, but also those with larger investor concentrations, with fund flows particularly sensitive to changes in the returns of the markets in which they invest, that hold a large amount of a single issuance or a high percentage of its average daily trading volume, with meaningful use of effective leverage, and that invest in assets that do not have contractual settlement periods and tend to settle over longer periods than ordinary securities). 257See supra text following note 100; see also supra note 104 (discussing Commission initiative to require large investment companies and investment advisers to engage in annual stress tests as required by section 165(i) of the Dodd-Frank Act); BlackRock FSOC Notice Comment Letter, supra note 50, at 6 (stating that among several overarching principles that provide the foundation for a prudent market liquidity risk management framework for collective investment vehicles is estimating ‘‘potential fund redemptions based on (a) historical behavior under normal as well as under adverse market conditions, and (b) monitoring investor profiles and related redemption behaviors to help identify potential liquidity needs, recognizing the differences between institutional and retail investors, large and small investors, categories of assets (e.g., retirement versus non-retirement assets), and the platforms on which funds are sold (e.g., self-directed versus through an intermediary’’); AII FSOC Notice Comment Letter, supra note 50, at 15 (‘‘investment advisers to mutual funds continually review a broad series of metrics to evaluate the current adequacy of the fund’s liquidity position. These include historic data regarding redemption request levels, stressing the historic redemption levels, assessing levels of liquidity of categories of assets held by the fund based on industry standards, assessing current and expected market conditions of the types of asset held by the fund and then assessing liquidity in those various market conditions.’’). 258But see Mikhail Simutin, Cash Holdings and Mutual Fund Performance, 18 Rev. of Fin. 1425 (2013) (‘‘Simutin’’) (‘‘Cash holdings of equity mutual funds impose a drag on fund performance but also allow managers to make quick investments in attractive stocks and satisfy outflows without costly fire sales. This article shows that actively managed equity funds with high abnormal cash— that is, with cash holdings in excess of the level predicted by fund attributes—outperform their low abnormal cash peers by over 2% per year.’’). 259Proposed rule
22e–4(b)(2)(iv)(A)–(B). 260Proposed rule 22e–4(b)(2)(iv)(C). 261Proposed rule 22e–4(b)(2)(iv)(D). In addition, proposed rule 22e–4(b)(2)(iv)(E) would require a fund to establish policies and procedures regarding redemptions in kind, to the extent that the fund engages in or reserves the right to engage in redemptions in kind. foreseeable under stressed conditions (e.g., shareholder outflows related to stressed market conditions or increased volatility, or outflows that are reasonable to expect in light of a reputational event affecting the fund or the departure of a fund’s portfolio manager).255 A fund’s liquidity risk depends on a variety of factors, including, among others, its cash flows, investment strategy, portfolio liquidity, use of borrowings and derivatives, cash (and cash equivalents) on hand, and borrowing arrangements.256 Staff outreach has shown that funds consider these types of factors in assessing their liquidity risk, and some funds conduct stress tests (incorporating these factors) to analyze various redemption scenarios to determine whether the fund has sufficient liquid assets to cover different levels of redemptions.257 Likewise, we understand that a fund may employ many different policies and procedures for managing its liquidity risk, including adjusting portfolio composition to withstand potential liquidity stresses, maintaining bank lines of credit or other borrowing arrangements, requesting notification from large shareholders about possible upcoming redemptions, and other similar risk management techniques. In addition, some fund complexes have established a dedicated risk management function, with independent risk oversight. Other funds, however, employ substantially less comprehensive liquidity risk assessment and management practices and procedures. These funds, for example, may have little coordination between the compliance personnel who monitor the fund’s adherence to the 15% guideline, and the portfolio and risk management personnel who assess the liquidity profile of portfolio assets. Staff outreach has shown that it is fairly common for a fund not to have adopted a specific liquidity risk management program, but instead to rely primarily on the portfolio management process to consider liquidity risk when making portfolio management decisions. While a fund’s portfolio management function has access to a great deal of information relevant to the liquidity of the fund’s portfolio assets, and thus pertinent to the fund’s liquidity risk, portfolio managers may have competing interests that could potentially impede effective liquidity risk management. For example, depending on the circumstances, a fund’s portfolio manager could be reluctant to invest a portion of the fund’s assets in highly liquid assets, which may be appropriate for liquidity risk management purposes, but that the manager believes could cause a fund’s performance to lag compared to similar funds or the fund’s benchmark.258 In sum, our staff has
found that the comprehensiveness as well as the independence of funds’ liquidity risk management vary significantly. Because we are concerned with funds’ ability to meet their redemption obligations and to mitigate shareholder dilution associated with redemptions, we are proposing new requirements for assessing and managing funds’ liquidity risk. Proposed rule 22e–4(b)(2)(iii) would require a fund to assess and periodically review its liquidity risk, taking into account certain factors. Proposed rule 22e–4(b)(2)(iv) would require a fund to manage its liquidity risk based on this assessment, including: (i) Requiring the fund to determine (and periodically review) a minimum percentage of the fund’s net assets that must be invested in three-day liquid assets (the fund’s ‘‘three-day liquid asset minimum’’); 259 (ii) prohibiting a fund from acquiring any less liquid asset if the fund would have invested less than its three-day liquid asset minimum in three-day liquid assets; 260 and (iii) prohibiting a fund from acquiring any 15% standard asset if the fund would have invested more than 15% of its net assets in 15% standard assets.261 We are proposing these new requirements with the goal of providing funds with the flexibility to adopt policies and procedures that would be most appropriate to assess and manage their liquidity risk, while at the same time reducing the risk that funds will be unable to meet redemption obligations, minimizing dilution, and elevating the overall quality of liquidity risk assessment and management across the fund industry. Given that a fund’s liquidity risk arises from the interaction of multiple discrete and overlapping factors, we believe that the most effective liquidity risk management programs would be multi-faceted and customized to reflect the sources of the fund’s liquidity risk. The requirements that we are proposing are therefore intended to be largely principles-based and would permit a fund to tailor its risk assessment and management procedures to respond to the fund’s particular risks and circumstances. On the other hand, we also believe that requiring each fund to consider, as a baseline, a standard set of factors for assessing liquidity risk, requiring each fund to keep a minimum portion of net assets in cash and assets that the fund believes are convertible to cash within three business days without materially affecting the value of the asset (which minimum each fund would determine based on standard factors), and limiting a fund’s holdings of 15% standard assets would create an overall framework that we believe would assist the development of effective and thorough liquidity risk assessment and management across the fund industry, thereby strengthening the ability of funds to meet redemption obligations

262To the extent that liquidity risk differs among each series of an investment company, each series would be required to adopt a liquidity risk management program whose liquidity risk assessment and management elements are distinct from other series’ programs. See supra paragraph accompanying notes 114–115. 263See infra sections III.C.3–III.C.5. 264See supra notes 101, 257 and accompanying text. 265See Guidelines Release, supra note 4 (noting that funds should consider cash flows into specific investment strategies in determining whether the fund is maintaining an adequate level of liquidity). 266See supra notes 101, 257 and accompanying text. 267See, e.g., Invesco FSOC Notice Comment Letter, supra note 35, at 11(‘‘Cash inflows from sources such as gross subscriptions (including reinvested dividends on fund shares), dividend and interest payments on portfolio securities and maturities of debt securities held in portfolios do help manage fund level liquidity and are taken into account by portfolio managers as part of their liquidity management.’’); ICI FSOC Notice Comment Letter, supra note 16, at 18 (‘‘Managing liquidity as part of overall portfolio management is a dynamic process requiring fund managers to make daily adjustments to accommodate cash inflows and outflows. . . Portfolio managers and traders typically receive data on cash flows at least daily and thus have a strong sense of whether additional actions (including the sale of portfolio holdings) would be needed to meet redemption requests or otherwise adjust a fund’s liquidity profile.’’). 268Proposed rule 22e–4(a)(7). 269See, e.g., Gordon J. Alexander, Gjergi Cici & Scott Gibson, Does Motivation Matter When Assessing Trade Performance? An Analysis of Mutual Funds, 20 Rev. of Fin. Stud. 125 (Jan. 2007) (noting that unexpected investor flows may force managers to rebalance their portfolios to control liquidity, and that these liquidity-related trades should underperform trades motivated by valuation beliefs). 270See, e.g., supra note 54 and accompanying paragraph; Coval & Stafford, supra note 51 (noting that fire sales can be anticipated based on past flows and returns); Peter Fortune, Mutual Funds, Part I:
Reshaping the American Financial System, New England Econ. Rev. (July/Aug. 1997), at 66–67, (‘‘Fortune’’), available at http://www.bostonfed.org/ economic/neer/neer1997/neer497d.htm (positing that funds with insufficient liquidity to meet redemption requests following a significant decline in stock prices will need to sell securities in a declining market, making the funds more sensitive to price fluctuations); 1987 Market Crash Report, supra note 54, at III–16—III–26, IV–1—IV–8 (discussing mutual fund selling behavior during the October 1987 stock market crash, and in particular the selling of three mutual fund companies, whose heavy selling of assets to meet significant redemptions ‘‘accounted for approximately one quarter of all trading on the NYSE for the first 30 Continued and mitigating dilution of the interests of fund shareholders.

Assessing a Fund’s Liquidity Risk
Proposed rule 22e–4 envisions a twopronged liquidity risk assessment and risk management process, whereby a fund would be required to assess its liquidity risk, based on certain specified factors, and then develop a liquidity risk management program tailored to the fund’s liquidity risk.262 Here we discuss the liquidity risk assessment portion of this process. The requirements we are proposing for the fund’s management of the risks identified by this assessment are discussed in a later section of the release.263 Proposed rule 22e–4(b)(2)(iii) would require each fund to assess the fund’s liquidity risk, considering certain specified factors that are discussed in more detail below. We compiled these factors based, in part, on staff outreach to funds and third-party service providers who assess liquidity risk on behalf of funds. To the extent that funds currently conduct liquidity stress tests, we understand that these stress tests commonly incorporate many of the proposed factors (or functionally similar factors).264 The proposed liquidity risk factors also incorporate considerations that we believe have historically contributed to liquidity risk in open-end funds.265 The proposed rule would require each fund to take the following factors into account, as applicable, in assessing the fund’s liquidity risk:
Æ Short-term and long-term cash flow projections, taking into account the following considerations:
D Size, frequency, and volatility of historical purchases and redemptions of fund shares during normal and stressed periods; D The fund’s redemption policies; D The fund’s shareholder ownership concentration; D The fund’s distribution channels; and D The degree of certainty associated with the fund’s short-term and longterm cash flow projections Æ The fund’s investment strategy and liquidity of portfolio assets; Æ Use of borrowings and derivatives for investment purposes; and Æ Holdings of cash and cash equivalents, as well as borrowing arrangements and other funding sources. This list is not meant to be exhaustive. In assessing its liquidity risk, a fund may take into account considerations in addition to the factors set forth in proposed rule 22e– 4(b)(2)(iii). For example, if a fund elects to conduct stress testing 266 to determine whether it has sufficient liquid assets to cover different levels of redemptions, a fund should consider incorporating the results of this stress testing into its liquidity risk assessment. However, a fund would be required to consider, as applicable, the proposed rule 22e– 4(b)(2)(iii) factors as a minimum set of considerations to be used in assessing its liquidity risk. For this reason, a fund that elects to conduct stress tests may wish to review the factors and parameters it uses to construct scenario analyses concerning the adequacy of the fund’s portfolio liquidity, and update these factors and parameters to reflect the proposed liquidity risk assessment factors. We believe that stress tests that incorporate the proposed factors, though not required, could be particularly useful to a fund in assessing its liquidity risk. We recognize that some of the proposed factors may not be applicable in assessing the liquidity risk of certain funds or types of funds. For example, we recognize that certain considerations that the proposed rule would require a fund to consider in assessing its cash flow projections (e.g., shareholder ownership concentration, and the fund’s distribution channels) would generally be more applicable to mutual funds than to ETFs. To the extent that a proposed factor is not applicable to a particular fund, the fund would not be required to consider that factor in assessing its liquidity risk. Below we provide guidance on specific issues associated with each of the proposed liquidity risk assessment factors. We also request comment below with respect to each of the proposed factors, as well as guidance regarding each factor. a. Cash Flow Projections A fund’s cash flow (the amount of cash flowing either into or out of the fund) is important in determining whether the fund will have sufficient cash to satisfy redemption requests.267 Cash flow projections thus directly affect a fund’s liquidity risk.268 As discussed below, we believe that several factors influence the extent to which a fund’s cash flow profile could indicate or contribute to the fund’s liquidity risk. Proposed rule
22e–4(b)(2)(iii)(A) thus would require a fund to consider these factors when evaluating its liquidity risk. In general, we believe that the better a fund’s portfolio and risk managers are able to predict the fund’s net flows, the better they will be able to measure and manage the fund’s liquidity risk.269 Predictability about whether periods of market stress or declines in fund performance generally lead to increased redemptions of fund shares is particularly significant, as careful liquidity risk management during these periods could prevent the need to sell less-liquid portfolio assets under unfavorable circumstances, which in turn could create significant negative price pressure on the assets and, to the extent the fund continues to hold a portion of those assets, decrease the value of the assets still held by the fund at least temporarily.270

minutes that the Exchange was open’’ on October 19, 1987 and that such selling had ‘‘a significant impact on the downward direction of the market’’). 271Proposed rule 22e–4(b)(2)(iii)(A)(1). 272See, e.g., Thomas M. Idzorek, James X. Xiong & Roger G. Ibbotson, The Liquidity Style of Mutual Funds, 68 Fin. Analysts J. 38 (2012), at n.4, available at http://corporate.morningstar.com/us/ documents/MethodologyDocuments/ ResearchPapers/LiquidityStyleOfMutualFunds.pdf (noting that funds with less volatile fund flows can afford to hold more illiquid stocks because they can accommodate redemptions with the liquid portion of their portfolios). 273See, e.g., supra note 270. 274See, e.g., Mark J Kamstra, et al., Seasonal Asset Allocation: Evidence from Mutual Fund Flows (Dec. 2013), available at http://www.bus.umich.edu/ ConferenceFiles/2014-Mitsui-Finance-Symposium/ files/Kramer_Seasonal_Asset_Allocation.pdf (‘‘[W]e find that aggregate investor flow data reveals a preference for U.S. money market and government bond mutual funds in the autumn, and equity funds in the spring, controlling for the influence of seasonality in past performance, advertising, liquidity needs, and capital gains overhang on fund flow. This movement of large amounts of money between fund categories is correlated with a proxy for variation in risk aversion across the seasons, consistent with households’ revealed preferences for safer investments in the fall, and riskier investments in the spring.’’); Hyung-Suk Choi, Seasonality in Mutual Fund Flows, 31 J. of Applied Bus. Research 715 (Mar./Apr. 2015), available at http://www.cluteinstitute.com/ojs/index.php/JABR/
article/viewFile/9162/9156 (‘‘January is the month
when equity funds experience the largest net cash flows and December is the month with the smallest cash flows.’’). 275See, e.g., Woodrow T. Johnson & James M. Poterba, Taxes and Mutual Fund Inflows around Distribution Dates, NBER Working Paper 13884 (Mar. 2006, rev’d Mar. 2008), available at http:// economics.mit.edu/files/2512 (‘‘Johnson & Poterba’’) (finding a ‘‘modest’’ decline in inflows into mutual funds by taxable investors prior to a capital gains distribution date); Brad M. Barger & Terrance Odean, Are Individual Investors Tax Savvy? Evidence from Retail and Discount Brokerage Accounts, 88 J. of Pub. Econ. 419 (Jan. 2004), available at http://faculty.haas.berkeley.edu/ odean/papers%20current%20versions/ areindividualinvestorstaxsavvy_2003.pdf (observing tax losses being related at greater rates than gains only in the month of December). 276See, e.g., Murat Aydogdu & Jay W. Wellman, The Effects of Advertising on Mutual Fund Flows:
Results from a New Database, Financial Management (Fall 2011), available at http:// onlinelibrary.wiley.com/doi/10.1111/j.1755- 053X.2011.01161.x/epdf (finding significant differences in the effectiveness of mutual fund advertising to attract inflows (e.g., smaller funds received significant inflows due to advertising, while ‘‘flagship’’ funds did not attract inflows as a result of their advertisements)). 277See, e.g., Diane Del Guercio & Paula A. Tkac, Star Power: The Effect of Morningstar Ratings on Mutual Fund Flow, 43 J. of Fin. and Quantitative Analysis 907 (Dec. 2008), available at http:// www.jstor.org/stable/27647379?seq=1#page_scan_ tab_contents (finding that certain changes in performance ratings (rather than changes in the underlying fund performance) have a substantial influence on retail investors inflows into and outflows from mutual funds). 278See, e.g., 2015 ICI Fact Book, supra note 3, at 13 (‘‘Investment managers, including mutual funds and pension funds, use ETFs to manage liquidity— helping them manage their investor flows and remain fully invested in the market. Asset managers also use ETFs as part of their investment strategies, including as a hedge against their exposure to equity markets.’’); see also Izhak Ben-David, Francesco A. Franzoni & Rabih Moussawi, Do ETFs Increase Volatility?, NBER Working Paper No. 20071, at 12, available at http://www.nber.org/ papers/w20071.pdf (‘‘Theoretical support for this conjecture comes from Amihud and Mendelson (1986) and Constantinides (1986), who propose that investors with shorter holding periods self-select into assets with lower trading costs. Atkins and Dyl (1997) find support for this conjecture by showing that securities with lower bid-ask spread have higher trading volume. These theories and empirical evidence suggest that, due to the low trading costs of ETFs, a new clientele of highfrequency investors can materialize around the newly created securities. This clientele would not trade the less-liquid underlying assets if ETFs were not present.’’). 279See infra notes 726 and 727. 280Proposed rule 22e–4(b)(2)(iii)(A)(2). 281See Item 6(b) of Form N–1A (requiring a fund to briefly identify the procedures for redeeming shares); proposed amendments to Item 11 of Form N–1A (requiring funds to disclose the number of days in which a fund will pay redemption proceeds to redeeming shareholders, and explain if the number of days differs by distribution channel); infra section III.G.1.a (discussing proposed amendments to Item 11 of Form N–1A). A fund would be required to consider the size, frequency, and volatility of historical purchases and redemptions of fund shares, during both normal and stressed periods, when considering its cash flow projections.271 A fund whose inflows generally correspond to its outflows in terms of timing, size, frequency, and response to market events will likely be able to use cash received from purchases to pay redeeming shareholders, which decreases the
fund’s liquidity risk. Funds whose net flows are relatively less volatile in terms of size and frequency will likely entail less liquidity risk than similar funds with more volatile net flows, because funds with less flow volatility can better plan how to meet fund redemptions and thus will be less likely to need to sell portfolio assets in a manner that creates a market impact in order to pay redeeming shareholders.272 A fund should generally review historical purchases and redemptions of fund shares across a variety of market conditions in order to determine how the fund’s flows may differ during stressed and normal periods (keeping in mind that historical experience may not necessarily be indicative of future outcomes, depending on changes in market conditions and the fund’s particular circumstances). In particular, if outflows are greater, more frequent, or more volatile during stressed periods, this could exacerbate the fund’s liquidity risk.273 A fund may find it instructive to understand when its highest, lowest, most frequent, and most volatile purchases and redemptions occurred within various time horizons, such as the past one, five, ten, and twenty years (as applicable, considering the fund’s operating history). In addition to considering its own historical flow data, a fund, particularly a fund without a substantial operating history, may wish to consider purchase and redemption activity in funds with similar investment strategies. Consideration of similar funds’ purchases and redemptions could show whether the fund’s historical flows are typical or aberrant compared to those seen in similar funds and assist new funds in predicting flow patterns. A fund may wish to evaluate whether the size, frequency, and volatility of its shareholder flows follow any discernable pattern. For example, patterns in shareholder flows have been observed relating to seasonality,274 shareholder tax considerations,275 fund advertising,276 and changes in fund performance ratings provided by thirdparty rating agencies.277 A fund’s investment strategy also could contribute to its shareholder flows: for instance, we understand that certain investors tend to trade in and out of ETFs with index-based strategies frequently because they invest in these ETFs for hedging and/or short-term trading purposes.278 Furthermore, a fund may wish to take into account its assets in assessing historical flow data, since smaller funds may experience greater flow volatility.279 While historical redemption patterns are an important factor in assessing cash flows, a fund should be cognizant of the limitations of using past flow history to assess future cash flow needs. Therefore, a fund would be required to take into account other factors when considering cash flow projections, including its redemption policies.280 Specifically, we believe a fund should generally consider the disclosures in its prospectus or advertising materials regarding the time period in which it will pay
redemption proceeds (or endeavor to pay redemption proceeds),281 and whether its redemption policies vary based on the distribution channels the fund employs. A fund whose policies require it to pay redeeming shareholders on a next-day basis could find itself with fewer options for managing high levels of redemptions than a fund that is bound only by the redemption timing requirements of rule 15c6–1. To illustrate, when a fund that pays redemption proceeds within one day receives a large redemption request and a fund that pays redemption proceeds within three business days pursuant to the timing requirements of rule 15c6–1

282See supra note 270.
283Proposed rule 22e–4(b)(2)(iii)(A)(3). 284We note that a relatively concentrated fund shareholder base may make it easier for funds to communicate with those shareholders about their anticipated future redemptions, and thus plan liquidity demands. However, those shareholders are under no legal obligation to forewarn the fund of their redemptions and so, particularly in times of stress, may not do so. 285Proposed rule 22e–4(b)(2)(iii)(A)(4). 286See, e.g., Board of the IOSCO, Principles of Liquidity Risk Management for Collective Investment Schemes (Mar. 2013), at 5, available at http://www.iosco.org/library/pubdocs/pdf/ IOSCOPD405.pdf (‘‘The responsible entity should consider liquidity aspects related to its proposed distribution channels.’’). 287See supra notes 283–284 and accompanying text. 288A 529 plan is a tax-advantaged plan designed to encourage saving for future college costs that is sponsored by a state, state agency, or educational institution and is authorized by section 529 of the Internal Revenue Code. 289See Johnson & Poterba, supra note 275; see also supra note 274 and accompanying text (discussing seasonality in mutual fund flows). 290Proposed rule 22e–4(b)(2)(iii)(A)(5). 291We understand, based on staff outreach, that advance notification procedures are a relatively common liquidity risk management tool that funds currently employ. See also Invesco FSOC Notice Comment Letter, supra note 35, at 11 (noting that Invesco has advance notification arrangements regarding anticipated redemptions above certain levels in place with certain distribution partners). 292Proposed rule 22e–4(b)(2)(iii)(B). receives a redemption request of the same size, the first fund must satisfy the full request within one day, whereas the second fund has more time to space out the sale of portfolio assets in order to satisfy the redemption request. Even though the shareholder flows of the first and second fund are identical, the redemption policies of the first fund magnify its liquidity risks by requiring that the fund pay redemptions quickly.282 An ETF that typically pays redemption proceeds in kind should generally also consider that it has reserved the right to transact with authorized participants in cash, the circumstances in which it anticipates that it would pay redemption proceeds in cash, and how these policies impact its cash flow projections. A mutual fund also would be required to consider its shareholder ownership concentration as a factor affecting its cash flow projections.283 If a mutual fund’s shares are concentrated in a relatively small group of shareholders, one shareholder’s redemptions of fund shares could result in considerable cash outflows from the fund.284 This in turn could increase the mutual fund’s liquidity risk if the fund does not have procedures in place to manage large redemptions, particularly if the fund were to encounter unexpected redemptions from a large shareholder. For these reasons, we believe a mutual fund should
consider the extent to which its shareholder concentration affects its liquidity risk, particularly taking into account other factors that could magnify shareholder concentration-related liquidity risk (e.g., if a fund has an investment strategy that attracts shareholders who trade based on short-term price movements, shareholders could be more likely to redeem precipitously, and resulting unexpected redemptions by a shareholder with a large ownership stake could cause significant liquidity stresses to the fund). There are multiple ways that a mutual fund’s distribution channels could affect its cash flows (including the predictability of the fund’s cash flows), and the proposed rule would require a mutual fund to consider this factor in evaluating its cash flows and related liquidity risk.285 First, a mutual fund’s redemption practices could depend on its distribution channels. For example, mutual funds that are sold through broker-dealers will have to meet redemption requests within three business days, because rule 15c6–1 under the Exchange Act establishes a T+3 settlement period for securities trades effected by a broker or dealer. Second, to the extent that mutual fund shares are held through omnibus accounts, it could be difficult for a mutual fund to be fully aware of the composition of the underlying investor base,286 including investor characteristics that could affect the mutual fund’s short-term and long-term flows (e.g., whether ownership in the mutual fund is relatively concentrated,287 and whether the mutual fund’s underlying investors share any common investment goals affecting redemption frequency and timing). Finally, a mutual fund’s distribution channels could affect its cash flow predictions insofar as certain distribution channels are generally correlated with particular purchase and redemption patterns. For instance, investors in mutual funds distributed through a retirement plan channel or other planned savings channel (e.g., funds underlying a 529 plan) 288 may be more likely to be long-term investors who do not trade based on short-term price movements, and their purchase and redemption patterns thus may be relatively predictable compared to those of other investors. Investors in mutual funds distributed through certain channels also may have similar purchase and redemption characteristics relating to their financial and tax-related needs. For example, taxable investors who are considering purchasing mutual fund shares around capital gains distribution dates have an incentive to delay their purchases until after the distribution, but non-taxable shareholders (such as those who invest through IRAs and other tax-deferred accounts) face no such incentive for delaying purchases.289 Finally, a fund would be required to consider the degree of certainty surrounding its short-term and longterm cash flow projections.290 A fund could consider the length of its operating history (including the fund’s experience during points of
market instability, illiquidity, or volatility), any observed purchase and redemption patterns, and the applicable other factors set forth in proposed rule 22e– 4(b)(2)(iii)(A) in determining the level of certainty the fund has regarding its cash flows. A fund may find it instructive to employ ranges in considering cash flow projections and their relationship to liquidity risk. For instance, a fund that could reasonably project that its cash flows will fall within a relatively narrow range could more precisely assess its liquidity risk than a fund that could reasonably project a broader range of projected cash flows. If a fund has implemented policies to encourage certain shareholders (e.g., large shareholders, or certain types of shareholders such as institutional shareholders) to provide advance notification of their intent to redeem a significant number of shares of the fund, this could increase the degree of certainty surrounding its cash flow projections.291 b. Investment Strategy and Liquidity of Portfolio Assets Under proposed rule 22e–4, a fund’s procedures for assessing its liquidity risk must take into account the effects that the fund’s investment strategy and the liquidity of its portfolio assets could have on the fund’s liquidity risk.292 A fund’s investment strategy could increase or decrease the fund’s liquidity risk in various ways. For example, whether a fund is actively or passively managed could have ramifications on the fund’s liquidity. On one hand, a fund with a passive investment strategy could have less liquidity risk relative to an actively managed fund that invests in a similar portfolio, to the extent that the portfolio of the passively managed fund is built around a widely followed market index (securities that are

293See supra paragraph accompanying notes 215– 216. 294See, e.g., Antti Petajisto, The Index Premium and Its Hidden Cost for Index Funds, 18 J. of Empirical Fin. 271, 288 (2011), available at http://citeseerx.ist.psu.edu/viewdoc/down load?doi=10.1.1.372.3301&rep=rep1&type=pdf (‘‘The annual index turnover cost from 1990 to 2005 is about 21–28 bp for the S&P 500 and 38–77 bp for the Russell 2000. This is the cost of mechanically tracking the index rather than holding an essentially similar index-neutral portfolio.’’). 295See also Jonathan Wheatley & Joel Lewin, Emerging Market ETFs: Solving the Liquidity Problem or Storing it Up?, Financial Times (Apr. 20, 2015), available at http://www.ft.com/cms/s/0/ 43c52f1e-e75e-11e4-a01c-00144feab7de.html (discussing ETFs built around emerging market corporate bond indexes). 296See section 5(b)(1) of the Investment Company Act. 297 26 U.S.C. 851. To qualify as a regulated investment company, a fund must meet several diversification requirements at the close of each fiscal quarter of the taxable year. See id. 298See Items 4(a), 9 of Form N–1A. 299See, e.g., Karl Habermeier & Andrei Kirilenko, Securities Transaction Taxes and Financial Markets, IMF Working Paper (May 2001), available at http://www.imf.org/external/pubs/ft/wp/2001/ wp0151.pdf (discussing, among other things, the effects of transaction taxes on liquidity). 300See, e.g., Scott J. Donaldson & Francis M. Kinniry Jr., Tax-Efficient Equity Investing: Solutions for Maximizing After-Tax Returns, Vanguard Investment Counseling & Research (2008), available at https://personal.vanguard.com/pdf/flgtei.pdf. 301See infra note 627 and accompanying text. 302Proposed rule 22e–4(b)(2)(iii)(C). Although the use of borrowings and derivatives is a distinct factor under proposed rule 22e–4(b)(2)(iii), a fund should also consider the potential impact of borrowings and derivatives in its assessment of other factors set forth in proposed rule 22e–4(b)(2)(iii), such as the fund’s cash flow projections and its investment strategy and liquidity of portfolio assets. 303See infra note 321. 304See supra section III.B.2.i. 305See Release 10666, supra note 241. components of such an index are generally more liquid than securities that are not).293 An index-tracking fund also may be more likely to sell a ‘‘strip’’ of the portfolio (i.e., a cross-section or representative selection of the fund’s portfolio assets) to meet net redemptions, which minimizes the outcome that the fund would sell its most liquid assets first, in order to continue to closely track the applicable benchmark. On the other hand, indexbased strategies could exhibit increased liquidity risk during periods when an index is being reconstituted, if the index reconstitution results in multiple funds simultaneously attempting to get into or out of the same portfolio position.294 Index-based strategies also could experience increased liquidity risk when the assets in the index become less liquid due to market
events, because the fund’s manager will have less discretion to move the fund’s strategy away from the index’s assets. In addition, index-based strategies that track less-liquid market indices may exhibit more liquidity risk than passively managed funds built around widely-followed market indices.295 The extent to which a fund’s portfolio is diversified (or, relatedly, a fund’s concentration in certain types of portfolio assets) could have ramifications on the fund’s potential liquidity risk as well. A fund’s status as a diversified investment company under the Investment Company Act,296 its status as a regulated investment company under Subchapter M of the Internal Revenue Code,297 and its principal investment strategies as disclosed in its prospectus all could affect the fund’s liquidity risk.298 For example, a fund constrained by various diversification requirements that needs to sell portfolio securities in order to meet redemption requests could be limited by its diversification obligations in determining which portfolio securities it will sell. Such a fund might need to unwind certain portfolio positions under unfavorable circumstances. A fund whose investment strategy requires it to invest a certain percentage of its assets in a particular asset class, industry segment, or securities associated with a particular geographic region could encounter similar limitations, if selling certain portfolio securities would cause the fund to not be in compliance with its investment strategies. On the other hand, a fund with a relatively morediversified portfolio needing to sell portfolio assets to build liquidity would possibly be able to select assets for sale based on whether the markets for those assets are favorable. A relatively lessdiversified fund may have fewer options (i.e., because the markets for its portfolio assets are uniform or correlated) and could thus be compelled to transact in unfavorable markets. Such fund also may need to trade larger dollar amounts of each asset, which may increase the price impact of the trades. In addition to diversification or concentration issues, a fund’s portfolio management decisions that are meant, in part, to decrease an undesirable tax impact on the fund could affect the fund’s liquidity risk. For example, a fund whose portfolio includes foreign securities might manage its portfolio to avoid securities transaction taxes imposed by other jurisdictions.299 Similarly, a fund could be managed using an active tax loss harvesting strategy to opportunistically realize losses that may be used to offset future gains.300 The sale of certain portfolio assets to meet liquidity needs might adversely affect these, and comparable, management practices. Consequently, a fund whose tax management strategy makes its portfolio managers unwilling to sell certain portfolio assets in order to meet redemptions could face increased liquidity risk compared to a similarly situated fund, because it could have fewer desirable
options to generate cash to pay redemptions (and thus could have increased risk that it would need to sell portfolio assets under unfavorable circumstances in order to meet redemptions) than another, similar fund. While we believe consideration of a fund’s investment strategy is an important factor in assessing a fund’s liquidity risk, we caution that different types of funds within the same broad investment strategy may demonstrate different levels of liquidity (and thus, presumably, different levels of liquidity risk).301 The liquidity of a fund’s portfolio assets directly affects the amount of liquidity risk associated with the fund. A fund should consider the portions of the fund’s net assets that are invested in each of the six liquidity categories set forth in proposed rule 22e–4(b)(2)(i). All else being equal, funds with relatively greater portions of their assets invested in less liquid assets would tend to have greater liquidity risk than funds holding relatively fewer less liquid assets.
c. Use of Borrowings and Derivatives for
Investment Purposes
Proposed rule 22e–4 would require a fund to take into account the potential effects of the use of borrowings and derivatives for investment purposes (for example, to enhance returns) on its liquidity risk.302 Funds may borrow from a bank under section 18 of the Investment Company Act. In addition to the asset coverage limitations imposed by section 18,303 any such borrowing would be subject to the terms agreed between a fund and the bank, including terms relating to the maturity date of the borrowing and any circumstances under which the borrowing may be required to be repaid. In addition, as noted above, funds that borrow for investment purposes, for example through financing transactions such as reverse repurchase agreements and short sales, generally do so in reliance on the guidance we provided in Release 10666, under which funds cover their obligations under such transactions by segregating certain liquid assets.304 Segregated assets are considered to be unavailable for sale or disposition, including for redemptions, unless replaced by other appropriate non-segregated assets of equal value.305 This means that a fund that receives significant redemption requests may

306See generally Investment Company Derivatives Use Concept Release, supra note 242, at 13–17. 307See supra section III.B.2.i. 308 Investment Company Derivatives Use Concept Release, supra note 242, at n.46 and accompanying text. 309See In re OppenheimerFunds, Inc., et al., Investment Company Act Release No. 30099 (June 6, 2012) (‘‘OppenheimerFunds Release’’) (settled action) (alleging the adviser made misleading statements regarding two fixed income mutual funds that suffered significant losses during the 2008 financial crisis primarily due to their use of total return swaps to obtain exposure to commercial mortgage-backed securities and noting that the funds ‘‘had to raise cash for anticipated [total return swap] contract payments by selling depressed bonds into an increasingly illiquid market.’’). 310Proposed rule 22e–4(b)(2)(iii)(D). 311FASB Accounting Standards Codification paragraph 305–10–20l. 312See 2014 Money Market Fund Reform Adopting Release, supra note 85, at sections III.A.7 and III.B.6 (clarifying that the reforms to the regulation of money market funds adopted by the Commission in 2014 should not preclude an investment in a money market fund from being classified as a cash equivalent under U.S. GAAP under normal circumstances); Form PF: Glossary of Terms (defining ‘‘cash and cash equivalents’’). 313However, a substantial investment in cash and cash equivalents could decrease a fund’s total return and/or cause a fund to diverge from its investment strategy, and thus a fund may wish to calibrate its holdings of these instruments to manage the fund’s liquidity risk while taking these concerns into consideration. But see Simutin, supra note 258 (observing that actively managed equity funds with cash holdings in excess of the level predicted by fund attributes outperform their low abnormal cash peers by over 2% per year). 314See supra note 35 (noting that most funds do not frequently draw on their lines of credit). 315See, e.g., Miles Weiss, BlackRock Leads Funds Raising Credit Lines Amid Review, Bloomberg (Jan. 21, 2015), available at http://www.bloomberg.com/ news/articles/2015-01-21/blackrock-leads-fundsraising-credit-lines-amid-review (discussing an uptick in demand by funds for bank lines of credit); see also Fortune, supra note 270, at 64 (noting that lines of credit with banks were rarely available to funds prior to the mid-1980s); infra section III.C.5.a (Commission guidance on use of borrowing arrangements and other funding sources as a liquidity risk management control). 316A committed line of credit represents a bank’s obligation, in exchange for a fee, to make a loan to a fund subject to specified conditions. A bank can also provide an uncommitted or standby line of credit, in which the bank indicates a willingness, but no obligation, to lend to a fund. See Fortune, supra note 270, at 47. need to unwind a portion of its financing transactions in order make more liquid assets available for sale to fulfill such requests.
Furthermore, if a fund seeks to unwind its financing transactions in a declining market, it may need to dispose of a greater amount of its more liquid holdings in order to repay its borrowings, thereby reducing the amount of liquid assets it has available to meet redemptions. Consequently, a fund’s assessment of its liquidity risk should include an evaluation of the nature and extent of its borrowings and the potential impact of borrowings on the fund’s overall liquidity profile. The use of derivatives, such as futures, forwards, swaps and written options, may also affect a fund’s liquidity risk. Funds use derivatives for a wide range of purposes, including hedging or risk mitigation, but also to obtain leverage or investment exposures.306 As noted above, funds that use derivatives under which they have an obligation to pay typically do so in reliance on the guidance we provided in Release 10666 and in related noaction letters issued by our staff, and therefore segregate liquid assets in respect of their obligations under derivatives transactions.307 Derivatives may therefore raise concerns that are similar to those discussed above in the context of borrowings. Funds also may be required to dispose of assets in order to post required margins with respect to their short sale transactions. In addition, some derivatives transactions— particularly those that are complex or entered into OTC—may be less liquid, have longer settlement periods, or be more difficult to price than other types of investments, which potentially increases the amount of time required to unwind such transactions. Even highly liquid derivatives may present liquidity risk for some funds. For example, some funds use derivatives for cash and liquidity management purposes. A large-cap equity fund with a temporary cash position may purchase equity index futures that have lower transaction costs, shorter settlement periods and greater liquidity than a direct investment in equity securities, in order to obtain a degree of exposure to largecap equities. While ‘‘equitizing’’ its temporary cash position in this manner may mitigate the potential performance lag associated with a cash holding, it also exposes the fund to market risk.308 Accordingly, a fund’s assessment of liquidity risk should take into account the manner and extent of its derivatives use and the structure and terms of its derivatives transactions. In addition to the liquidity of the derivatives positions themselves, assessing liquidity risk generally may include an evaluation of the potential liquidity demands that may be imposed on the fund in connection with its use of derivatives, including any variation margin or collateral calls the fund may be required to meet.309 To the extent the fund is required to make payments to a derivatives counterparty, those assets would not be available to meet shareholder redemptions. d. Holdings of Cash and Cash Equivalents, as Well as Borrowing Arrangements and Other Funding Sources
Proposed rule 22e–4 would require a fund to consider its cash and cash equivalent holdings, as well as its borrowing arrangements and other funding sources, in assessing its liquidity risk.310 Current U.S. generally accepted accounting principles define cash equivalents as short-term, highly liquid investments that are readily convertible to known amounts of cash and that are so near their maturity that they present insignificant risk of changes in value because of changes in interest rates.311 Examples of items commonly considered to be cash equivalents include certain Treasury bills, agency securities, bank deposits, commercial paper, and shares of money market funds.312 Cash and cash equivalents are extremely liquid (in that they either are cash, or could be easily and nearly immediately converted to known amounts of cash without a loss in value), and significant holdings of these instruments generally decrease a fund’s liquidity risk because the fund could use them to meet redemption requests without materially affecting the fund’s NAV.313 Entering into borrowing arrangements and agreements with other potential funding sources also could affect a fund’s liquidity risk, as they could assist the fund in paying redeeming shareholders without the need to sell portfolio securities under circumstances that could impair the fund’s NAV.314 For example, in the past several decades, it has become increasingly common for fixed income funds to establish lines of credit with commercial banks.315 When considering the extent to which a bank credit facility could affect a fund’s liquidity risk, we believe a fund may find it instructive to evaluate the terms of the credit facility (e.g., associated fees, the borrowing rate, and the time frame for repaying borrowed funds), the amount of the credit facility, whether the credit facility is committed or uncommitted,316 and the financial health of the institution(s) providing the facility (especially to the extent that the fund also holds bonds or other securities issued by such institution(s), as a decrease in these securities’ liquidity—caused, for example, by increased volatility of their trading prices—could contribute to an increased need to borrow from the institution). If a credit facility is shared among multiple funds within a fund family, a fund may wish to consider that the ability of that facility to mitigate the

317See Heartland Release, supra note 47. 318See infra note 320 and accompanying and following text. 319See supra section III.C.1.c (discussing circumstances in which a fund’s use of leverage and derivatives could increase the fund’s liquidity risk). 320See Investment Company Act sections 17(a) (prohibiting first- and second-tier affiliates of a fund from borrowing money or other property from, or selling or buying securities or other property to or from the fund, or any company that the fund controls; 17(b) (permitting the Commission to grant an exemptive order permitting transactions that would otherwise be prohibited under section 17(a) if certain conditions of fairness are met); see also Investment Company Act section 17(d) (making it unlawful for first- and second-tier affiliates of a fund, the fund’s principal underwriters, and affiliated persons of the fund’s principal underwriters, acting as principal, to effect any transaction in which the fund or a company controlled by the fund is a joint or a joint and several participant in contravention of Commission rules); rule 17d–1(a) under the Investment Company Act (prohibiting first- and second-tier affiliates of a fund, the fund’s principal underwriters, and affiliated persons of the fund’s principal underwriters, acting as principal, from participating in or effecting any transaction in connection with any joint enterprise or other joint arrangement or profit-sharing plan in which any such fund or company controlled by a fund is a participant unless an application regarding such enterprise, arrangement or plan has been filed with the Commission and has been granted). 321See Investment Company Act section 18(f) (prohibiting an open-end fund from issuing any senior security, except that a fund may borrow from any bank so long as immediately after the borrowing there is asset coverage of at least 300% for all borrowings of the fund). 322See, e.g., Release 10666 supra note 241. In Release 10666, the Commission considered the application of section 18’s restrictions on the issuance of senior securities to reverse repurchase agreements (among other types of agreements). The Commission concluded that such agreements may involve the issuance of senior securities subject to the prohibitions and asset coverage requirements of
section 18. The Commission further stated that,
although reverse repurchase agreements (among other types of agreements) are functionally equivalent to senior securities, these and similar arrangements nonetheless could be used by funds in a manner that would not warrant application of the section 18 restrictions. The Commission noted that in circumstances involving similar economic effects, such as short sales of securities by funds, Commission staff had determined that the issue of
section 18 compliance would not be raised if funds
‘‘cover’’ senior securities by maintaining ‘‘segregated accounts.’’ The Commission also discussed the specific attributes of segregated accounts, board obligations, and other related matters in Release 10666. liquidity risk of one fund within the family hinges in part on the degree of liquidity risk associated with the other funds sharing the facility. A fund also may wish to consider any negative impact on the fund resulting from borrowing funds for liquidity risk management purposes, as opposed to managing liquidity through the fund’s portfolio construction. For example, borrowing funds to pay redeeming shareholders (for example, to avoid making sales of assets into distressed markets) could be beneficial to redeeming shareholders but could ultimately disadvantage non-redeeming shareholders who would effectively bear the costs of borrowing.317 In assessing the effects of the fund’s borrowing arrangements on the fund’s liquidity risk, a fund may find it useful to assess the purposes for which the fund has historically borrowed funds to pay redemption proceeds. Finally, if a fund holds bonds or other securities issued by a bank, the fund may wish to consider whether entering into a borrowing arrangement with the same bank that issued such securities increases correlated exposure to the bank. A fund also could engage in interfund lending within a family of funds if the fund has obtained exemptive relief from the Commission permitting the arrangement.318 When considering the extent to which an interfund lending arrangement could affect a fund’s liquidity risk, we believe a fund may find it instructive to evaluate the terms of the arrangement (e.g., the lending rate and the time frame for repaying borrowed funds), as well as any conditions required under exemptive relief, including limitations on the circumstances in which interfund lending may be used. For example, it is common for exemptive orders to permit interfund lending in circumstances in which there is a timing mismatch between when a fund is required to pay redeeming shareholders and when any asset sales that the fund has executed in order to pay redemptions will settle (e.g., a fund may be required to pay redeeming shareholders within three business days, but the portfolio transactions the fund has executed in order to pay these shareholders may not settle for seven days). A fund can reasonably predict that it will repay borrowed money relatively quickly and reliably under these circumstances. Therefore this type of borrowing would tend to be very low risk, and thus entail less liquidity risk,319 than borrowing money to pay redemptions without already having secured a price at which the assets used to cover the borrowing will be sold. Finally, a fund could generate liquidity through repurchase transactions, whereby the fund could agree to sell securities to another party at a specified price with a commitment to buy the securities back at a later date for another specified price. A
repurchase agreement is structurally similar to a short-term loan, and thus a fund could use repurchase agreements to temporarily borrow cash to repay redeeming shareholders. A fund may find it instructive to consider how factors such as market conditions, supply and demand factors, whether the repurchase agreement is on a bilateral or tri-party basis, and counterparty credit risk could affect the ability of repurchase transactions to mitigate liquidity risk. A fund’s borrowing and other funding arrangements are subject to restrictions on affiliated transactions and leverage under the Investment Company Act and rules under the Act. For example, funds must obtain exemptive relief from the Commission before executing transactions that implicate section 17 of the Investment Company Act, which restricts transactions between an ‘‘affiliated person of a registered investment company or an affiliated person of such affiliated person’’ and that investment company.320 Thus, as noted above, a fund must obtain exemptive relief before executing interfund lending arrangements. Additionally, funds’ borrowing arrangements must be conducted in compliance with section 18 of the Investment Company Act, which limits a fund’s ability to issue or sell ‘‘senior securities.’’ For instance, section 18(f) of the Investment Company Act limits funds to bank borrowing with 300% asset coverage.321 The Commission and its staff have also taken the position that reverse repurchase agreements may involve the issuance of a senior security subject to the requirements of section 18 and, under certain circumstances, a fund could need to ‘‘cover’’ the senior security by maintaining ‘‘segregated accounts.’’ 322 These statutory and regulatory restrictions could constrain a fund’s ability to use borrowing and other funding sources to meet redemption requests, and these limitations should be considered in assessing a fund’s liquidity risk. e. Request for Comment We request comment on the proposed liquidity risk assessment requirement.

Do commenters believe that the
definition of ‘‘liquidity risk’’ in proposed rule 22e–4 is appropriate? Within the proposed definition, are the terms ‘‘reasonably foreseeable’’ and ‘‘without materially affecting the fund’s NAV’’ clear? If not, how could the definition of ‘‘liquidity risk,’’ and terms within the proposed definition, be made more appropriate and/or clear?
How do funds currently assess their
liquidity risk? Who at the fund and/or the adviser is tasked with assessing the fund’s liquidity risk? Who should be tasked with assessing the fund’s liquidity risk? Should the proposed rule specify the officers or functional areas

323See proposed rule 22e–4(b)(2)(i). 324See, e.g., supra paragraph accompanying notes 251–254. 325Under proposed rule 22e–4(b)(2)(iv)(C), a fund would be prohibited from acquiring any less liquid asset if, immediately after the acquisition, the fund would have invested less than its three-day liquid asset minimum in three-day liquid assets. 326We propose to define three-day liquid asset as any cash held by a fund and any position of a fund in an asset (or portion of the fund’s position in an asset) that the fund believes is convertible into cash within three business days at a price that does not materially affect the value of that asset immediately prior to sale. See proposed rule 22e–4(a)(8). 327See proposed rule 22e–4(b)(2)(iv)(A). 328See Investment Company Names Rule Release, supra note 36, at n.36 (‘‘Whether a particular transaction is considered borrowing for investment purposes would depend on all facts and circumstances.’’). 329See supra section III.C.1. 330See proposed rule 22e–4(b)(3)(i). that should be tasked with assessing a fund’s liquidity risk? We also request comment on each of the proposed factors that each fund would be required to consider in assessing its liquidity risk.

What factors do funds currently use
to assess their liquidity risk, and do the proposed factors reflect factors that funds (and/or the adviser, as applicable) already consider when evaluating liquidity risk? Should any of the proposed factors not be required to be considered by a fund in assessing its liquidity risk? Should any of the proposed factors be modified? Are there any additional factors, besides the proposed factors, that a fund should be required to consider in assessing liquidity risk? Should any of the proposed factors be given additional weight and, if so, under what circumstances?
Instead of codifying the proposed
factors as part of proposed rule 22e–4, should we provide guidance on factors that might be appropriate for a fund to consider in assessing its liquidity risk? We seek comment on the Commission’s guidance discussed above regarding each of the proposed factors.
Besides the guidance, are there any
other specific issues associated with any of the proposed factors that a fund may wish to consider in assessing the fund’s liquidity risk? Do commenters generally agree with the guidance that the Commission has proposed regarding the ways in which each of the proposed factors could contribute to a fund’s liquidity risk? Should the staff provide additional guidance about the factors? Should we add a note to rule 22e–4 indicating that the release includes additional guidance regarding the proposed factors?
Are there any factors or procedures
that would be of particular use to a fund without a substantial operating history in assessing liquidity risk? Would a new fund look to purchase and redemption activity in similar funds to predict its flow patterns?

Periodic Review of a Fund’s Liquidity
Risk a. Proposed Liquidity Risk Review Requirement Proposed rule 22e–4(b)(2)(iii) would require a fund to periodically review the fund’s liquidity risk, taking into account each of the factors of proposed rule 22e– 4(b)(2)(iii)(A)–(D) (discussed above in sections III.C.1.a–III.C.1.d). We believe that the periodic review of a fund’s liquidity risk is necessary to determine whether, in light of current circumstances, an adequate level of liquidity is being maintained. Like the proposed requirement to monitor the liquidity of portfolio assets,323 the proposed liquidity risk review requirement would permit each fund to develop and adopt effective and individualized procedures to review the fund’s liquidity risk, tailored as appropriate to reflect the fund’s particular facts and circumstances. A fund would be required to consider each of the proposed rule 22e–4(b)(2)(iii)(A)– (D) factors in reviewing its liquidity risk. However, beyond this, rule 22e–4 does not include prescribed review procedures, nor does it specify the required risk review period or incorporate specific developments that a fund should consider as part of its review. A fund might generally consider whether its periodic review procedures should include procedures for evaluating regulatory, market-wide, and fund-specific developments affecting each of the proposed rule 22e– 4(b)(2)(iii) risk factors. Because a fund’s liquidity risk is directly related to the liquidity of the fund’s portfolio assets (as reflected by proposed rule 22e– 4(b)(2)(iii)(B), which requires consideration of the liquidity of a fund’s portfolio assets as an element of the fund’s liquidity risk assessment), a fund may wish to adopt liquidity risk review procedures that reference the fund’s procedures for monitoring portfolio assets’ liquidity. For example, a fund’s liquidity risk review procedures could specify that certain circumstances giving rise to a revision of a portfolio asset’s liquidity classification 324 could necessitate a review of the fund’s liquidity risk. b. Request for Comment We request comment on the proposed liquidity risk review requirement.

How do funds currently review
liquidity risk? How often do funds currently review this risk? To what extent do funds anticipate that the periodic review procedures that would be required under proposed rule 22e–4 would replicate procedures funds currently use to periodically evaluate liquidity risks facing the fund?
Are there certain review procedures
that the Commission should require and/or on which the Commission should provide guidance? Should the Commission specify how frequently a fund must review its liquidity risk? Should funds review liquidity risk at least as frequently as they conduct ongoing liquidity reviews? Should the Commission expand its guidance on regulatory, market-wide, and fundspecific developments that a fund’s review procedures should cover?

Portfolio Liquidity: Minimum
Investments in Three-Day Liquid Assets a. Proposed Three-Day Liquid Asset Minimum Requirement Proposed rule 22e–4(b)(2)(iv)(A) would require each fund to determine the fund’s ‘‘three-day liquid asset minimum’’ as part of its liquidity risk management program.325 As proposed, the fund’s three-day liquid asset minimum would be defined as the percentage of the fund’s net assets to be invested in three-day liquid assets.326 In determining its three-day liquid asset minimum, a fund would be required to consider the factors a fund would be required to consider in assessing its liquidity risk under proposed rule 22e– 4(b)(2)(iii).327 These factors include an assessment of short-term and long-term cash flow projections, taking into account certain specified considerations discussed further below; the investment strategy and liquidity of the fund’s portfolio assets; the use of borrowings and derivatives for investment purposes (for example, to enhance returns),328 and holdings of cash and cash equivalents, as well as borrowing arrangements and other funding sources. These factors are based, in part, on staff outreach to funds and thirdparty service providers that assess liquidity risk on behalf of funds, and they also incorporate considerations that we believe have historically contributed to liquidity risk in open-end funds.329 A fund’s board would be required to approve the fund’s three-day liquid asset minimum (including any changes to the fund’s three-day liquid asset minimum),330 and a fund would be required to maintain a written record of how the fund’s three-day liquid asset minimum was determined (including an

331See proposed rule 22e–4(c)(3) (each fund must maintain a written record of how the three-day liquid asset minimum, and any adjustments thereto, were determined, including assessment of the factors specified in proposed rule 22e– 4(b)(2)(iii)(A)–(D), for a period of not less than five years (the first two years in an easily accessible place) following the determination of and each change to the three-day liquid asset minimum). 332See supra section II.D.1. 333See, e.g., Fidelity FSOC Notice Comment Letter, supra note 20, at 6 (‘‘As a practical matter, three-day settlement requirements under Exchange Act Rule 15c6–1 . . . effectively take most fund investments to a T+3 settlement timeline.’’). 334See id. at 6 (‘‘mutual funds normally process redemption requests by the next business day’’); see also ICI FSOC Notice Comment Letter, supra note 16, at 17 (‘‘For example, a mutual fund has by law up to seven days to pay proceeds to redeeming investors, although as a matter of practice funds typically pay proceeds within one to two days of a redemption request.’’). 335See supra section III.C.1.a. 336See proposed rule 22e-4(b)(2)(iii)(A). 337See supra text following note 100; see also supra note 104 (discussing Commission initiative to require large investment companies and investment advisers to engage in annual stress tests as required by section 165(i) of the Dodd-Frank Act). assessment of each of the factors proposed rule 22e–4 would require a fund to assess in making this determination).331 We are proposing the requirement for each fund to determine a three-day liquid asset minimum to increase the likelihood that the fund will hold adequate liquid assets to meet redemption requests without materially affecting the fund’s NAV. Although the Commission has stated that open-end funds have a general responsibility to maintain an appropriate level of portfolio liquidity, no requirements under the federal securities laws or Commission rules specifically oblige open-end funds (with the exception of money market funds) to maintain a minimum level of portfolio liquidity.332 We believe that codifying a three-day liquid asset minimum requirement would result in a portfolio liquidity standard that fosters consistency in funds’ consideration of the factors relevant to their liquidity risk management, while simultaneously permitting flexibility in implementation, which we believe is appropriate in light of the significant diversity of holdings and strategies within the fund industry. We believe setting the minimum amount of liquid assets in the fund based on three-day liquid assets is appropriate for a number of reasons. Most funds sell at least some of their shares through broker-dealers, and thus, as a practical matter, are required as a result of rule 15c6–1 under the Exchange Act to meet redemptions within three business days.333 While some mutual funds disclose in their prospectuses that they will generally pay redemption proceeds on a nextbusiness day basis
and many others do so as a matter of practice,334 we are not proposing that funds maintain a minimum amount of assets that may be converted to cash within one day, given the impact such a minimum could have on investment strategies. Staff outreach has shown that, for the funds that typically do target a minimum amount of liquidity in the fund, they typically target either cash and cash equivalents or assets similar to our definition of three-day liquid assets. Accordingly, targeting such a minimum appears to be a common practice for those funds that do establish a target. Consistent with the time period referenced in section 22(e) of the Act, we considered requiring that a fund determine a minimum amount of liquid assets based on assets convertible to cash within seven calendar days at a price that does not materially affect the value of that asset immediately prior to sale (‘‘seven-day liquid assets’’). Determining a minimum amount of seven-day liquid assets would require that a fund have a certain amount of liquidity to meet redemptions within the seven-day period required under the Act. However, we were concerned that requiring a minimum amount of sevenday liquid assets would not as well match regulatory requirements and disclosures that require most funds to meet redemption requests in shorter time periods and market practices and investor expectations that effectively require all funds to meet redemption requests in shorter time periods. We thus believe that a three-day liquid asset minimum more effectively advances our goals of reducing the risk that funds will be unable to meet redemptions and mitigating dilution. We anticipate that the proposed requirement for a fund to consider certain factors, including the factors required in assessing the fund’s liquidity risk, in determining its threeday liquid asset minimum would promote investor protection by reducing the risk funds will be unable to meet their redemption obligations, mitigating dilution, and elevating the overall quality of liquidity risk management across the fund industry. The consideration of certain factors also would require every fund to consider multiple aspects of its history, policies, strategy, and operations that could give rise to liquidity risk. When determining its three-day liquid asset minimum, a fund must consider short-term and long-term cash flow projections, taking into account the following factors, which we discussed previously in connection with the assessment of a fund’s liquidity risk: 335

the size, frequency, and volatility of
historical purchases and redemptions of fund shares during normal and stressed periods;
the fund’s redemption policies;
the fund’s shareholder ownership
concentration;
the fund’s distribution channels;
and
the degree of certainty associated
with the fund’s short-term and longterm cash flow projections.336 We believe consideration of cash flow projections is pivotal to setting an appropriate three-day liquid asset minimum. The primary goal of a minimum level of liquidity is to ensure that each fund is able to meet redemptions and to do so with minimal dilution of shareholders’ interests. Doing so requires that the fund’s adviser, to the best of its ability, understands potential levels of net redemptions and the causes and timing of those redemptions. To adequately make such projections, we believe a fund must consider the sub-factors described above. For example, it would be important to understand not just the magnitude of redemptions the fund tends to receive, but also how frequent redemptions of various sizes are and how volatile the fund’s flows are. It also may be important to understand how the fund’s redemption activity compares to funds with similar investment strategies, for example, to understand whether the fund may have unique liquidity risks (or lack liquidity risks) that may make past redemption experiences less predictive of future redemption risk. It would be essential that the fund formulate its cash flow projections after considering the factors in both normal and stressed periods— minimum liquidity would not likely advance the Commission’s goal of reducing the risk that funds will be unable to meet redemptions and mitigating dilution if funds can only meet redemptions in stressed conditions through sales of portfolio assets that create dilution and significantly increase the fund’s liquidity risk. In addition, a fund, though not required to do so, may wish to consider employing some form of stress testing 337 or consider specific historical redemption scenarios in determining its three-day liquid asset minimum. In formulating the fund’s cash flow projections, a fund also must consider the fund’s redemption policies, shareholder ownership concentration, and distribution channels. These are

338 DERA Study, supra note 39, at Table 6. 339See, e.g., OppenheimerFunds Release, supra note 309. 340See supra note 331. 341See proposed rule 22e–4(b)(iv)(A). important structural features of a fund that can materially affect the risk of significant redemptions—and thus may cause a fund to set a higher three-day liquid asset minimum than one based on its redemption history alone. For example, a fund with a concentrated shareholder base has a high risk that only one or two shareholders deciding to redeem can cause the fund to sell a significant amount of assets, which depending on the liquidity of the fund’s portfolio and how it meets those redemptions, can dilute remaining shareholders. Similarly, a fund whose redemption policy is to satisfy all redemptions on a next business day basis (T+1) or that is sold through distribution channels that historically attract investors with more volatile and/ or unpredictable flows also should consider setting a higher three-day liquid asset minimum than a fund that—all else equal—does not face these risks. Finally, in setting a three-day liquid asset minimum it is critical that a fund consider the degree of certainty associated with the fund’s short-term and long-term cash flow projections. Projections may only be as good as the extent and quality of information that informs them. For example, if a fund does not have great visibility into its shareholder base (e.g., because the fund’s shares are principally sold through intermediaries that do not provide shareholder transparency) or if a fund is uncertain about changing market conditions which are likely to materially affect the fund’s level of net redemptions, it may make projections but be quite uncertain about those projections. In these circumstances, we would expect a fund to set its three-day liquid asset minimum to reflect this uncertainty, for example, by providing a cushion or multiple of its cash flow projections in the event realized net redemptions are significantly higher. A fund should have a three-day liquid asset minimum that will allow it to meet its net redemption projections. In setting its three-day liquid asset minimum, a fund also must consider its investment strategy and the liquidity of portfolio assets. A finding of the DERA Study is that certain investment strategies typically have greater volatility of flows than other investment strategies. For example, the DERA Study indicates that the mean standard deviation of monthly net flows for alternative funds is 13.6% and for emerging market debt funds is 9.4%, but is only 2.7% for municipal bond funds and 4.9% for U.S. corporate bond funds.338 Accordingly, all else equal, we generally would expect that an emerging market debt fund would have a higher three-day liquid asset minimum than a municipal bond fund. Similarly, the less liquid a fund’s overall portfolio assets are, the more a fund may want to establish a higher three-day liquid asset minimum to avoid dilution when meeting
investor redemptions. A fund also must consider its use of borrowings and derivatives in setting its three-day liquid asset minimum. A leveraged fund has an increased risk that it will be unable to meet redemptions and an increased risk of investor dilution compared to an equivalent fund with no leverage. For example, a fund with leverage through bank borrowings may have to meet margin calls if a security the fund provided to the bank to secure the loan declines in value. Such margin calls can render highly liquid portfolio assets unavailable to meet investor redemptions, which can increase dilution and the risk the fund will be unable to meet redemptions. Similarly, a fund that has significant fixed obligations to derivatives counterparties (for example, from a total return swap or writing credit default swaps) must pay out on these obligations when due, even if it means selling the fund’s more liquid, high quality assets to raise cash.339 A fund with a leveraged strategy thus, all else equal, should have a higher three-day liquid asset minimum than a fund that does not. Finally, a fund must consider its holdings of cash and cash equivalents, as well as borrowing arrangements and other funding sources when determining its three-day liquid asset minimum. Unencumbered cash and cash equivalents are assets that the fund can typically readily deploy, in normal and stressed conditions, to meet redemptions. A fund can have cash on hand to meet redemptions from cash held in the fund’s portfolio, cash received from investor purchases of fund shares, interest payments and dividends on portfolio securities, or maturing bonds. Our staff observed that several fund complexes targeted a minimum amount of cash or cash equivalent holdings in the fund because they assumed such holdings would allow the fund to meet redemptions in a stressed period without realizing significant discounts to fair value when the asset was sold. Accordingly, higher cash and cash equivalent holdings may make a fund more comfortable that it can meet redemptions under stressed conditions with a lower three-day asset minimum than an equivalent fund whose three-day asset minimum was comprised primarily of non-cash equivalent assets. A fund also should consider whether it has a line of credit or other funding sources available to it to meet redemptions. As discussed further below, while we believe that liquidity risk management is best conducted primarily through portfolio construction, we recognize a line of credit can facilitate a fund’s ability to meet unexpected redemptions. Because each fund would be required to maintain a written record of how its three-day liquid asset minimum was determined, including an assessment of each of the factors discussed above,340 our examination staff would be able to ascertain that funds are indeed considering the required factors. We expect that a board approving a fund’s three-day liquid asset minimum would consider how the specified factors inform
that minimum, and thus we believe that the proposed rule would cause fund boards to consider a comprehensive set of issues surrounding the fund’s liquidity risk and risk management. Moreover, we believe that the board approval requirement associated with the threeday liquid asset minimum determination would add independent oversight over funds’ liquidity risk management. Although a fund would be permitted to determine its three-day liquid asset minimum under the analysis required by the proposed rule, we generally believe that it would be extremely difficult to conclude, based on the factors it would be required to consider, that a zero three-day liquid asset minimum would be appropriate. Under the proposed rule, a fund’s three-day liquid asset minimum would be a control to manage the fund’s liquidity risk, and as discussed above the fund’s three-day liquid asset minimum would be required to be determined based on the consideration of certain specified factors.341 We believe that it would be extremely difficult to conclude, based on factors such as the fund’s cash flow projections and redemption policies, that zero holdings of three-day liquid assets would allow the fund to manage its liquidity risk (in conjunction with any other liquidity risk management policies and procedures the fund adopts as part of its liquidity risk management program). By way of example, consider a bank loan fund with a ten-year track record. The fund has a history of volatile cash

342See, e.g., BlackRock FSOC Notice Comment Letter, supra note 50, at 6 (statement that among several overarching principles that provide the foundation for a prudent market liquidity risk management framework for collective investment vehicles is ‘‘[r]equiring that individual funds have sufficient sources of market liquidity to meet anticipated redemptions under a range of scenarios, including changes in market risk factors (e.g., interest rates) that may impact the value of portfolio securities and/or collateral and various levels of potential fund redemptions. This could be achieved by setting out principles for managing liquidity and redemption risk that should include maintaining sufficient levels of liquid assets, such as cash and liquid bonds as well as dedicated and shared loan facilities. The principles-based approach should provide appropriate flexibility to tailor practices to particular asset structures and fund redemption terms.’’). 343See infra section III.D.1–2 (discussing board approval of the fund’s three-day liquid asset minimum and any changes thereto), section III.G.2.c (discussing disclosure of a fund’s three-day liquid asset minimum on proposed Form N–PORT). 344A fund’s three-day liquid asset minimum would apply at the series level, not at the class level. flows that it projects will continue, with periods of market stress and reduced performance leading to increased net redemptions, and its largest net redemption during a one-week period was five percent of the fund’s net assets. The fund does not have a concentrated shareholder base and is sold through several broker-dealers. The fund has 98 percent of its net assets invested in bank loans and loan participations that do not settle within three business days, one percent of its net assets invested in corporate bonds (which under this example we are assuming qualify as three-day liquid assets) and one percent of its net assets in cash and cash equivalents. The fund does not borrow or use derivatives for investment purposes, but does have a committed credit line in place with a bank. It would appear that such a fund, after assessing the factors required to be considered, would have a difficult time concluding that its existing three-day liquid asset holdings would be an adequate minimum given the liquidity risks inherent in the fund’s portfolio and its redemption history. We considered establishing a floor for the three-day liquid asset minimum. For example, we considered requiring that a fund set its three-day liquid asset minimum after consideration of the factors described above, but in no event could the minimum be below a certain specified percentage of the fund’s net assets or a certain multiple of its average or worst net redemptions. A uniform percentage three-day liquid asset minimum floor could be difficult, however, given the diverse range of funds to which it would apply and the range of net redemptions within different types of funds indicated by the DERA Study.
If set relatively high, a uniform percentage floor risks requiring excessive liquidity in some funds given their portfolio characteristics, investor base, and flow projections, which may unnecessarily constrain the fund’s returns and investment in certain assets frustrating investors’ goals in choosing to invest in the fund. If set relatively low, it may encourage some funds to set low levels of three-day liquid asset minimums that would not effectively manage liquidity risk or mitigate dilution. A floor also could be set based on a fund’s historical redemptions. However, such a floor would not be forward-looking—a fund should be setting its minimum liquidity based in large part on projections of expected future redemptions. Such an approach risks a fund setting its minimum liquidity too low, for example during a period of rapid inflows that are likely to soon reverse. Conversely, continuing with the same example, it risks setting minimum liquidity too high after those flows have in fact reversed. Accordingly, we preliminarily believe our proposed approach appropriately balances these considerations by requiring that a rigorous set of factors be considered and documented, and the three-day liquid asset minimum approved by the fund’s board, but otherwise allow the minimum to be tailored to the nature of the fund and its cash flow projections. It should allow funds with different investment strategies, and whose cash flow and liquidity needs vary notably from one fund to the next, to manage their individual levels of liquidity risk in a way that best serves their investors.342 We recognize that funds’ three-day liquid asset minimums would likely vary from one fund to the next (even within the same strategy), depending on the factors that each fund would be required to consider. But we believe that consideration and documentation of the required factors, board oversight, and public disclosure of the fund’s three-day liquid asset minimum should constrain funds from setting an inappropriately low minimum in light of the fund’s liquidity needs and risks.343 We also note that assets eligible for inclusion in each fund’s three-day liquid asset minimum holdings could include a broad variety of securities, as well as cash and cash equivalents. While one fund may conclude that it is appropriate to hold a significant portion of its three-day liquid assets in cash and cash equivalents, another could decide it is appropriate to hold equity, debt, derivatives or asset-backed securities as the majority of its three-day liquid asset minimum holdings. We believe that the proposed three-day liquid asset minimum requirement would allow funds to continue to meet a wide variety of investors’ investment needs by obliging funds to maintain appropriate liquidity in their portfolios, while permitting funds to remain substantially invested in portfolio assets that conform to their investment strategies. The proposed three-day liquid asset minimum requirement reflects
liquidity management strategies that we understand from staff outreach that some—but not all—funds use. Based on staff outreach, we understand that funds of different sizes, with varying investment strategies, manage their liquidity by maintaining specified portions of their portfolios in more liquid assets. Some funds invest a certain percentage of their assets in cash and cash equivalents; others invest in other types of more liquid portfolio securities corresponding with their investment strategies. To the extent that a fund already maintains a specified portion of its portfolio in more liquid assets, we anticipate that the proposed three-day liquid asset minimum requirement would formalize this risk management strategy, and augment it by requiring the fund to consider certain factors in determining the portion of assets that the fund will maintain in three-day liquid assets. More importantly, it would require the many funds that do not consider maintaining a minimum amount of liquidity, despite their obligations to meet redemptions within a certain time period, to do so. b. Limiting Acquisition of Less Liquid Assets in Contravention of a Fund’s Three-Day Liquid Asset Minimum Under proposed rule 22e– 4(b)(2)(iv)(C), a fund would not be permitted to acquire any less liquid asset if, immediately after the acquisition, the fund would have invested less than its three-day liquid asset minimum in three-day liquid assets.344 This provision of proposed rule 22e–4 would thus limit the acquisition of less liquid assets if such acquisition would result in the fund holding a smaller percentage of its net assets in three-day liquid assets than the percentage representing its three-day liquid asset minimum. The provision would not, however, require a fund to constantly have invested a certain portion of its net assets in three-day liquid assets. For example, if a fund’s investments in three-day liquid assets were to temporarily drop below the fund’s three-day liquid asset minimum,

345A fund’s investments in three-day liquid assets could drop below the fund’s three-day liquid asset minimum for a variety of reasons. For instance, the fund could sell its most liquid assets in order to obtain cash to meet redemption requests, thereby reducing its holdings of three-day liquid assets. Or, if the market value of a fund’s three-day liquid assets falls relative to the market value of the fund’s less liquid assets, the percentage of a fund’s assets invested in three-day liquid assets could decrease. A fund’s three-day liquid assets also could become less liquid if market conditions deteriorate. 346See supra text preceding and following note 332. 347See infra notes 690–698 and accompanying text. 348This proposed acquisition test (in contrast to a maintenance test) reflects approaches that Congress and the Commission have historically taken in other parts of the Investment Company Act and the rules thereunder. See, e.g., Investment Company Act section 5(c) (a registered diversified company that at the time of its qualification meets the diversification requirements specified in Investment Company Act section 5(b)(1) shall not lose its status as a diversified company because of any subsequent discrepancy between the value of its various investments and the requirements of
section 5(b)(1), so long as any such discrepancy
existing immediately after its acquisition of any security or other property is neither wholly nor partly the result of such acquisition); rule 2a–7(d)(3) (portfolio diversification requirements of rule 2a–7 are determined at the time of portfolio securities’ acquisition); rule 2a–7(d)(4)(i) (limit on a money market fund’s acquisition of illiquid securities if, immediately after the acquisition, the money market fund would have invested more than 5% of its total assets in illiquid securities); rule 2a– 7(d)(4)(ii)–(iii) (minimum daily liquidity requirement and minimum weekly liquidity requirement of rule 2a–7 are determined at the time of portfolio securities’ acquisition). 349Proposed rule 22e–4(b)(2)(iv)(B). 350See infra paragraph following note 352. 351See infra section III.D (discussing the board’s role in approving and overseeing a fund’s liquidity risk management program); see also proposed rule 22e–4(b)(3)(i) and (ii). We note that a fund may hold more three-day liquid assets than required by the three-day liquid asset minimum. Thus, a fund may determine it is appropriate to increase its minimum holdings in three-day liquid assets without waiting for the next board meeting (or calling a special meeting) to formally approve an increase in the minimum. 352See supra note 331. 353See supra note 323 and accompanying text. proposed rule 22e–4(b)(2)(iv)(C) would require the fund to acquire only threeday liquid assets until its investments in three-day liquid assets reach the fund’s three-day liquid asset minimum, but the proposed rule would not require the fund to divest less liquid assets and reinvest the proceeds in three-day liquid assets.345 While we believe that fund shareholders’ interests are generally best served when the percentage of a fund’s assets invested in three-day liquid assets is at (or above) the fund’s three-day liquid asset minimum,346 we believe that requiring a fund to maintain this percentage at all times could adversely affect shareholders and could potentially negate the liquidity risk management benefits of the proposed three-day liquid asset minimum requirement. For instance, if a fund were forced to sell less liquid assets at an inopportune time in order to reinvest the proceeds in three-day liquid assets, the fund might need to sell the less liquid assets at prices that incorporate a significant discount to the assets’ stated value, or even at fire sale prices. These forced sales could produce significant negative price pressure on those assets and decrease the value of the assets still held by the fund, thereby decreasing the value of fund shares held by remaining investors, and possibly creating a firstmover advantage that harms investors who choose not to redeem their shares as quickly as others.347 Also, if a fund needed to rebalance its portfolio frequently to maintain a specified percentage of the fund’s net assets invested in three-day liquid assets, this could produce unnecessary transaction costs adversely
affecting the fund’s NAV, and could cause a fund to sell portfolio assets when it is not advantageous to do so (e.g., when an asset’s price is low, or when sales of an asset would have an undesirable tax impact). For these reasons, we are proposing a requirement that limits the acquisition of less liquid assets when such acquisition would result in a fund investing less than its three-day liquid asset minimum in three-day liquid assets, but we are not proposing to require that funds always maintain a certain portion of their portfolio assets in three-day liquid assets.348
c. Periodic Review of a Fund’s ThreeDay Liquid Asset Minimum
Under proposed rule 22e–
4(b)(2)(iv)(B), each fund would be required to periodically review the adequacy of the fund’s three-day liquid asset minimum, and in conducting such review would be required to take into account the factors a fund would be required to consider in determining its three-day liquid asset minimum. We believe the factors used to determine a fund’s three-day liquid asset minimum also provide an appropriate framework for reviewing the adequacy of a fund’s three-day liquid asset minimum because, as discussed below, changes in the assessment of the factors could provide a basis for adjusting the threeday liquid asset minimum. A fund would be required to complete this review no less frequently than semiannually,349 but could establish a more frequent periodic review period, and in addition could review the three-day liquid asset minimum even more frequently on an ad-hoc basis as conditions demand.350 As discussed below, the fund’s investment adviser or officers administering the fund’s liquidity risk management program would be required to submit written reports to the fund’s board concerning the adequacy of the fund’s liquidity risk management program, including the fund’s three-day liquid asset minimum, and the effectiveness of its implementation. Board approval would be required for any changes to the fund’s three-day liquid asset minimum.351 Each fund would be required to maintain a copy of the written reports provided to the board, as well as a written record of the fund’s assessment of the factors set forth in rule 22e–4(b)(2)(iii)(A) through (D) and the determination of the three-day liquid asset minimum, and any reviews and adjustments to the fund’s three-day liquid asset minimum.352 Because we anticipate that a fund would rely significantly on its three-day liquid assets in meeting fund redemptions, we view the three-day liquid asset minimum determination as a cornerstone of a fund’s liquidity risk management, and we believe it is important for a fund to periodically reassess whether its three-day liquid asset minimum effectively assists the fund in managing its liquidity risk. We envision the determination of a fund’s three-day liquid asset minimum as a dynamic process, incorporating new or updated information into the fund’s assessment of factors, reflecting shareholder-related, fund-managementoriented, or market changes that could affect the fund’s ability to meet redemptions. A fund’s three-day liquid asset minimum could become outdated for multiple reasons. For example, a fund’s shareholder ownership concentration could change or market events could reveal that shareholder redemption patterns are different than anticipated under certain circumstances. Additionally, market events or national regulatory, monetary, and fiscal policies could affect the liquidity of a fund’s portfolio assets. Any of these events, or similar events influencing a fund’s cash flows, portfolio liquidity, or the other liquidity risk factors included in proposed rule
22e–4(b)(2)(iii), could alter the level of three-day liquid assets that a fund would determine appropriate to manage its liquidity risk. Like the proposed requirements to perform an ongoing review of the liquidity of portfolio assets and to review periodically the fund’s liquidity risk,353 the proposed three-day liquid

asset minimum review requirement would permit each fund to develop and adopt its own procedures for conducting this review, taking into account the fund’s particular facts and circumstances. While each fund would be required to consider each of the proposed rule 22e–4(b)(2)(iii)(A)–(D) factors in periodically reviewing its three-day liquid asset minimum, rule 22e–4 would not otherwise include prescribed review procedures or incorporate specific developments that a fund should consider as part of its review. We believe that in developing comprehensive periodic review procedures, a fund should generally consider including procedures for evaluating regulatory, market-wide, and fund-specific developments affecting the fund’s liquidity risk. A fund also may wish to adopt procedures specifying any circumstances that would prompt ad-hoc review of the fund’s three-day liquid asset minimum in addition to the periodic review required by the proposed rule (as well as the process for conducting any adhoc reviews). d. Request for Comment We request comment on all aspects of the proposed three-day liquid asset minimum requirement.

Do commenters agree that the
proposed three-day liquid asset minimum requirement would improve a fund’s ability to meet redemption requests without materially affecting the fund’s NAV? Are we correct that not all funds today target holding a minimum amount of more liquid assets?
Do commenters agree that the
proposed requirement would promote investor protection by enhancing funds’ ability to meet their redemption obligations, mitigating dilution, and elevating the overall quality (comprehensiveness as well as independence) of liquidity risk management across the industry? Would the proposed requirement assist fund boards in overseeing funds’ ability to meet redemption obligations?
Should we define the three-day
liquid asset minimum as proposed?
Should we define three-day liquid assets as proposed? If not, why not? Are there other definitions that would be better? If so, what are they? Should we preclude certain assets or types of assets from being considered three-day liquid assets? If so, which assets or asset types and why? For example, should we prohibit funds from classifying as threeday liquid assets any assets that are subject, directly or indirectly, to a guarantee, put, wrap, swap, or other liquidity enhancement from a third party? Alternatively, should we require specific disclosure regarding such assets? If so, what should be included in the disclosure? Should we require that the fund more stringently or frequently monitor the liquidity of three-day liquid assets?
Would an alternate liquid asset
holdings requirement (e.g., a seven-day liquid asset minimum requirement, a one-day liquid asset minimum requirement, or a buffer of cash and cash equivalents or a combination of the above) better accomplish these goals, and if so, what should that alternate requirement be and why? Should funds that disclose that they will meet redemptions (or are otherwise required to meet redemptions) within less than three business days be required to have liquid asset minimum requirements that correspond to those shorter redemption windows (given that there may be liability under the antifraud provisions of the federal securities laws if a fund fails to meet redemptions within any shorter time disclosed in the fund’s prospectus or advertising materials)? Conversely, should funds that disclose that under normal circumstances they expect to meet redemptions within a period that is longer than three business days (e.g., within the seven days permitted under section 22(e)) be permitted to have liquid asset minimum requirements that correspond to those longer redemption windows? Which funds (and holding how much assets) are not subject to rule 15c6–1 under the Exchange Act? Would different minimum liquidity requirements for different open-end funds be confusing to investors?
Instead of permitting each fund to
determine the portion of liquid asset holdings that would most effectively enable it to manage its own liquidity risk, should the Commission instead mandate a standard level of required minimum liquid asset holdings acrossthe-board, or different levels depending on different investment strategies (or some other fund characteristic)? If so, at what level (e.g., 1%, 5%, 10%), and what considerations would form the basis for the recommended level?
Should the Commission set a floor
below which a fund could not set its three-day liquid asset minimum? Should it do so only for funds that hold above a certain percentage of net assets in less liquid assets? If so, what percentage of less liquid assets should trigger the mandated floor on the threeday liquid asset minimum? What should the floor on the three-day liquid asset minimum be for such funds?
In addition to specifying that a fund
must determine its three-day liquid asset minimum, should the Commission also require a fund to limit its investment in a subset of less liquid assets held by a fund (e.g., assets that can only be converted to cash in over 7 days, over 15 days, over 30 days, or over 90 days at a price that does not materially affect the value of that asset immediately prior to sale)? If so, what should this limit be? Should it be a set percentage of fund assets established by the Commission (e.g., 5%, 10%, 20%, 30%), or should a fund be required to set its own limit, using the factors it would be required to consider in determining its three-day liquid asset minimum (or some other set of factors)? Should this limit apply to all funds, or only a subset of funds (e.g., only funds with certain investment strategies, or whose three-day liquid asset minimums are below a certain threshold)? Would such a requirement be an effective substitute for the limit on 15% standard assets discussed below?
Should we exclude certain funds
from the proposed requirement to determine a three-day liquid asset minimum? For example, should a fund that only invests in three-day liquid assets be required to determine a threeday liquid asset minimum?
Instead of a requirement that limits
the acquisition of less liquid assets when such acquisition would result in a fund investing less than its required minimum in three-day liquid assets, would a requirement mandating that a fund always maintain a specified portion of its assets in three-day liquid assets better facilitate funds’ liquidity risk management and promote investor protection? Should a fund be required to hold some minimum portion of assets in holdings that are likely to be liquid in stressed market environments? If so, what type of assets, at what level, and what considerations would form the basis for the recommended level?
As noted above, the three-day
liquid asset minimum would be tested each time the fund acquires new assets, and a fund would be permitted to fall below its three-day liquid asset minimum if it does so due to redemptions or market events. Once a fund falls below its three-day liquid asset minimum, any acquisition of new assets must be of three-day liquid assets until the fund is at or above its threeday liquid asset minimum. Should we limit the time period (e.g., to 30 days, 60 days, or 90 days) in which a fund can be below its three-day liquid asset minimum so that a fund cannot persistently be below this level of liquidity? Would such an approach better promote investor protection? Would there be operational challenges

354A fund’s investments in 15% standard assets could rise above 15% of the fund’s net assets for a variety of reasons. For instance, the fund could sell its most liquid assets in order to obtain cash to meet redemption requests, thereby increasing its holdings of 15% standard assets relative to its total holdings. Or, if the market value of a fund’s 15% standard assets rises relative to the market value of the fund’s other assets, the percentage of a fund’s assets invested in 15% standard assets could increase. Assets that are not 15% standard assets also could become 15% standard assets if market conditions deteriorate. See supra note 345 (discussing similar considerations with respect to a fund’s holdings of three-day liquid assets). 355As discussed above, under the 15% guideline, a portfolio security or other asset is considered illiquid if it cannot ‘‘be sold or disposed of in the ordinary course of business within seven days at approximately the value at which the mutual fund has valued the investment.’’ See supra note 93. Rule 2a–7(a)(20) defines the term ‘‘illiquid security’’ to mean ‘‘a security that cannot be sold or disposed of in the ordinary course of business within seven calendar days at approximately the value ascribed to it by the fund.’’ We understand the terms ‘‘approximately the value at which the . . . fund has valued the investment’’ and ‘‘approximately the value ascribed to it by the fund’’ to have identical meanings. For the sake of consistency with the language of current rule 2a–7, the definition of 15% standard asset incorporates the ‘‘approximately the value ascribed to it by the fund’’ formulation. 356See supra section II.D.2. with this requirement? Should we limit the extent to which a fund can fall below its three-day liquid asset minimum? If so, what extent should be the limit?

Should the board be required to
approve the fund’s three-day liquid asset minimum and any changes to the three-day liquid asset minimum? Why or why not? We request comment on how the three-day liquid asset minimum requirement (or a similar requirement) could affect the management of a fund’s liquidity risk, decrease the probability that the fund will be able to meet redemption obligations only through activities that could materially affect the fund’s NAV or risk profile, and mitigate dilution.
What range of levels of three-day
liquid assets do commenters anticipate different funds would determine to be appropriate, based on the factors the proposed rule would require a fund to consider? What types of securities do commenters anticipate that different funds would determine are or are not appropriate as three-day liquid asset minimum holdings?
How many funds today target a
minimum level of more liquid assets? If some funds indeed aim to invest a certain portion of their assets in more liquid assets for purposes of liquidity risk management, what types of assets do funds hold for these purposes, and how do funds determine what portion of their net assets they intend to invest in these assets? What burdens and other difficulties, if any, would funds have in initially complying with the three-day liquid asset minimum requirement?
What are the processes that
commenters anticipate a fund would use for determining and reviewing its three-day liquid asset minimum under the proposed rule? Do commenters generally agree with the guidance that the Commission has provided regarding the processes a fund could use to determine and review its three-day liquid asset minimum? Should the minimum frequency of the fund’s review of the adequacy of its three-day liquid asset minimum be shorter than semi-annually (such as quarterly) or longer (such as annually)?
Should the Commission specify
certain procedures that a fund must use in determining its three-day liquid asset minimum, such as requiring a fund to consider specific historical redemption scenarios? Should we require that the minimum not be less than, for example, a fund’s highest historical level of net redemptions, its average level of net redemptions over some time period, or a multiple (e.g., two times) of those levels? We request comment on the proposed factors that each fund would be required to consider in determining and reviewing its three-day liquid asset minimum.
To what extent do funds already
consider the proposed factors when determining the portion of fund assets that should be invested in more liquid assets for purposes of liquidity risk management? Do commenters believe it is appropriate for a fund to consider the same set of factors in determining and reviewing its three-day liquid asset minimum as it considers in assessing and reviewing its liquidity risk? Are there other factors that would be preferable?
Should any of the proposed factors
not be required to be considered by a fund in determining and reviewing its three-day liquid asset minimum? Should any of the proposed factors be modified? Are there any additional factors, besides the proposed factors, that a fund should be required to consider?
Instead of codifying the proposed
factors as part of proposed rule 22e–4, should the Commission provide guidance on factors that may be appropriate for a fund to consider in determining and reviewing its three-day liquid asset minimum? Should the Commission provide additional guidance on the proposed factors?

Portfolio Liquidity: Limitation on
Funds’ Investments in 15% Standard Assets a. 15% Standard Assets Included in proposed rule 22e–4 is a limit on a fund’s ability to acquire ‘‘15% standard assets.’’ Specifically, proposed rule 22e–4(b)(2)(iv)(D) would prohibit a fund from acquiring any 15% standard asset if, immediately after the acquisition, the fund would have invested more than 15% of its net assets in 15% standard assets. The provision would not require a fund to divest any holdings if 15% standard assets rise above 15% of its net assets.354 Under proposed rule 22e–4(a)(4), a 15% standard asset would be defined as any asset that may not be sold or disposed of in the ordinary course of business within seven calendar days at approximately the value ascribed to it by the fund.355 For purposes of the proposed definition, a fund would not be required to take into account the size of the fund’s position in the asset or the time period associated with receipt of proceeds of sale or disposition of the asset. We believe that assets included in the definition of 15% standard asset would be consistent with those currently classified as illiquid by funds under the 15% guideline, and that such a limit would be an important limitation on certain relatively illiquid holdings in funds’ portfolios, such as private equity investments, securities acquired in an initial public offering, and real estate assets. As noted above, we believe that the 15% guideline has generally caused funds to limit their exposure to particular types of securities that cannot be sold within seven days and the proposed limit on 15% standard assets would continue to limit these exposures. As discussed above, the Commission and staff have in the past provided guidance in connection with the 15% guideline.356 We propose to withdraw this guidance because we believe this proposal provides a more comprehensive framework for funds to evaluate the liquidity of their assets. We request comment below on whether additional guidance is needed in connection with the definition of 15% standard asset. We believe that the proposed limit on 15% standard assets and the proposed three-day liquid asset minimum each serve distinctly important, but interrelated, roles in managing liquidity risk. We therefore propose to require each fund to comply with the limit on 15% standard assets as well as the three-day liquid asset minimum requirement. While the three-day liquid

357Proposed rule 22e–4(a)(6).
358See supra section II.D.2. 359See proposed rule 22e–4(a)(4). asset minimum requirement would increase the likelihood that each fund holds adequate liquid assets to meet redemption requests without materially affecting the fund’s NAV, the limit on 15% standard assets would increase the likelihood that a fund’s portfolio is not concentrated in assets whose liquidity is limited and thus may serve as a limit on certain cases of fund illiquidity. While we considered requiring a different percentage-based ceiling on relatively illiquid holdings, we ultimately decided that proposing the 15% standard would effectively accomplish our intended goals while disrupting funds’ existing practices to the least extent possible. While this definition is similar to the definition of an asset that cannot be converted to cash within seven days under the proposed liquidity classification framework, we note several key differences between the definitions. When determining whether an asset may be sold or disposed of within seven calendar days for purposes of assessing whether the asset is a 15% standard asset, a fund need not consider whether it can receive the proceeds of such sale or disposition within the same seven-day time period. In contrast, the classification framework takes into consideration whether a fund could convert an asset to cash—that is, sell the asset and receive cash for the sale within this period. Also, the definition of 15% standard asset does not require a fund to consider any specific factors in determining the circumstances under which an asset may be sold or disposed of. The definition of less liquid asset, on the other hand, requires a fund to consider, as applicable, certain market, trading, and asset-specific factors set forth in proposed rule 22e–4(b)(2)(ii).357 These factors include the size of a fund’s position in a particular portfolio asset relative to the asset’s average daily trading volume and (as applicable) the number of units of the asset outstanding, which a fund is not required to assess in determining whether an asset is a 15% standard asset.358 To provide an example of the distinctions between the proposed 15% standard and the proposed three-day liquid asset minimum, consider a fund that holds a very large block of a particular security ‘‘X’’. Because the fund holds a large block of the issue, it may determine, based on the liquidity classification factors required to be considered under the proposed rule, that it could convert a certain percentage (e.g., 70%) of its position to cash in fewer than three business days, but that it would take more than three business days to convert the remainder of its position to cash. Under the proposed rule, 70% of the fund’s position in security ‘‘X’’ would be considered three-day liquid assets, and the other 30% would be considered to be less liquid assets. The fund would take these classifications into account when considering whether the further acquisition of less liquid assets would
cause the fund to not be in compliance with its three-day liquid asset minimum. However, even though 30% of the fund’s position in security ‘‘X’’ would be considered to be less liquid assets, the fund’s position in security ‘‘X’’ would not also be considered to be 15% standard assets. This is because, as discussed above, a fund is not required to assess position size in determining whether a particular portfolio asset is a 15% standard asset. Thus, if a fund can sell a standard size lot of its holdings in that position within seven days at approximately the value ascribed to it by the fund, the entire position would be deemed not to be a 15% standard asset. Consider as well a scenario in which a fund holds shares of security ‘‘Y,’’ and the fund determines, based on the liquidity classification factors required to be considered under the proposed rule, that it can sell security ‘‘Y’’ within seven days at approximately the value ascribed to it by the fund, but whose sale(s) will not also settle until the tenth day. Security ‘‘Y’’ would fall into the 8– 15 day liquidity classification category and would be considered a less liquid asset because it would not be able to be converted to cash within three business days. However, because the fund would be able to sell its shares of security ‘‘Y’’ within seven days at approximately the value ascribed to it by the fund, security ‘‘Y’’ would not be considered to be a 15% standard asset. This is because a fund is required to consider whether it would be able to sell an asset within seven days, but not also whether those asset sales would settle within this period, in determining whether a particular portfolio asset is a 15% standard asset.359 Conversely, consider a fund that holds shares of security ‘‘Z,’’ a privately placed security that the fund determines cannot be sold within seven days at approximately the value ascribed to it by the fund. Under the proposed rule, security ‘‘Z’’ would be considered a less liquid asset, because it would not be able to be converted to cash (that is, sold, with the sale settled) within three business days. Security ‘‘Z’’ also would be considered to be a 15% standard asset, because it would not be able to be sold within seven days at approximately the value ascribed to it by the fund. The fund would take these classifications into account when it is considering whether the further acquisition of less liquid assets or 15% standard assets would cause the fund to not be in compliance with its three-day liquid asset minimum or the 15% standard. The scenarios depicted in the preceding paragraphs demonstrate that the same asset could be deemed to be a less liquid asset but not also deemed to be a 15% standard asset, and also illustrate the different roles that the proposed three-day liquid asset minimum and the 15% standard play in liquidity risk management. The proposed 15% standard would provide an across-the-board limitation on the acquisition of certain relatively illiquid
holdings. The proposed definition of less liquid asset, on the other hand, is meant to identify those assets that would generally not be able to be converted to cash to meet redemption requests, and the proposed three-day liquid asset minimum is meant to tailor a fund’s acquisition of these holdings to correspond with its particular liquidity needs. Thus, the proposed 15% standard acts as a cap on the amount of relatively illiquid assets that a fund may hold, while the proposed three-day liquid asset minimum acts as a floor on the amount of three-day liquid assets that a fund must hold. b. Request for Comment We request comment on the proposed 15% standard.

Do commenters agree that the
Commission should include the 15% standard in proposed rule 22e–4? Would the 15% standard enhance funds’ ability to manage liquidity risk?
Do commenters agree that the threeday liquid asset minimum requirement
and the 15% standard serve distinct roles in managing liquidity risk? Is there a single alternative standard that would be an effective substitute for the threeday liquid asset minimum requirement and the 15% standard?
Should the Commission instead
adopt a different restriction on funds’ investments in assets whose liquidity is extremely limited, and if so, what should this restriction be? For example, should we adopt a different percentage limit on funds’ investments in 15% standard assets? Should we instead limit funds’ investments in some other subset of assets with extremely limited liquidity, such as assets that can only be converted to cash in over 7 days, over

360See Canadian Securities Administrators, National Instrument 81–102—Investment Funds at
section 2.4.
361Rule 2a–7(a)(20).
362See, e.g., Adoption of (1) Rule 18f–1 Under the Investment Company Act of 1940 to Permit Registered Open-End Investment Companies Which Have the Right to Redeem In Kind to Elect to Make Only Cash Redemptions and (2) Form N–18F–1, Investment Company Act Release No. 6561 (June 14, 1971) [36 FR 11919 (June 23, 1971)] (‘‘Rule 18f– 1 and Form N–18F–1 Adopting Release’’) (stating that the definition of ‘‘redeemable security’’ in
section 2(a)(32) of the Investment Company Act
‘‘has traditionally been interpreted as giving the issuer the option of redeeming its securities in cash or in kind.’’). 363See Karen Damato, ‘Redemptions in Kind’ Become Effective for Tax Management, Wall Street Journal (Mar. 10, 1999), available at http:// www.wsj.com/articles/SB921028092685519084 (‘‘ ‘Redemptions in kind’ are typically viewed by fund managers as an emergency measure, a step they could take to meet massive redemptions in the midst of a market meltdown.’’). Besides using in-kind redemptions as an emergency measure to manage liquidity risk, funds may also use in-kind redemptions for other reasons. For example, funds may wish to redeem certain investors (particularly, large, institutional investors) in kind, because in-kind redemptions could have a lower tax impact on the fund than selling portfolio securities in order to pay redemptions in cash. This, in turn, could benefit the remaining shareholders in the fund. See, e.g., id. (‘‘If a fund has to sell appreciated stocks to pay a redeeming shareholder, it realizes capital gains. Unless the fund has offsetting capital losses, those gains are distributed as taxable income to all remaining fund holders. By contrast, when funds distribute stocks from their portfolios, there is no tax event for the continuing holders.’’). 364See, e.g., Invesco FSOC Notice Comment Letter, supra note 35, at 11 (noting that while ‘‘Invesco has on occasion exercised rights to redeem in kind, in practice such rights are exercised infrequently’’). 365Money Market Fund Reform; Amendments to Form PF, Investment Company Act Release No. 30551 (June 5, 2013) [78 FR 36834 (June 19, 2013)] (‘‘2013 Money Market Fund Reform Proposing Release’’), at n.473. 366See, e.g., Fortune, supra note 270, at 47 (‘‘A fund redeeming in kind does so at the risk of its reputation and future business . . .’’). In the context of money market funds, we requested comment on whether we should require Continued 15 days, over 30 days, or over 90 days at a price that does not materially affect the value of that asset immediately prior to sale? If we did the latter, what should the limit be? Should it be a set percentage of fund assets established by the Commission (e.g., 5%, 10%, 20%, 30%), or should a fund be required to set its own limit, using the factors it would be required to consider in determining its three-day liquid asset minimum (or some other set of factors)? Should this limit apply to all funds, or only a subset of funds (e.g., only funds with certain investment strategies, or whose three-day liquid asset minimums are below a certain threshold)?

As noted above, the 15% standard
would be tested each time the fund acquires new assets, and a fund would be permitted to hold more than 15% of its net assets in 15% standard assets if it does so due to redemptions or market events. Once a fund rises above the 15% limit, any acquisition of new assets must be of non-15% standard assets until the fund is at or below the 15% standard. Would a requirement mandating that a fund divest excess 15% standard assets if its holdings of these assets rise above 15% of its net assets better facilitate funds’ liquidity risk management and promote investor protection? Or should we limit the time period (e.g., to 30 days, 60 days, or 90 days) in which a fund holds more than 15% of its net assets in 15% standard assets so that a fund cannot persistently be above the 15% standard? Alternatively, we note that certain Canadian mutual funds are subject to illiquid asset restrictions that provide that a fund: (i) Must not acquire illiquid assets if more than 10% of the fund’s net assets would be made up of illiquid assets; (ii) must not have invested more than 15% of the fund’s net assets in illiquid assets for a period of 90 days or more; and (iii) must, as quickly as is commercially reasonable, take all necessary steps to reduce the percentage of its net assets made up of illiquid assets to 15% or less if more than 15% of the fund’s net assets is made up of illiquid assets.360 Should we adopt similar requirements? Would such requirements better promote investor protection?
Should the Commission modify the
proposed definition of 15% standard assets to require that funds take into account the time period associated with receipt of proceeds of sale or disposition of an asset?
Do commenters agree with the
proposal to withdraw current guidance associated with the 15% guideline? Do commenters believe additional guidance is needed in connection with the proposed definition of 15% standard asset? If so, what guidance should the Commission provide?
What assets do funds currently
consider to be limited by the 15% guideline? Do commenters believe that assets that would meet the proposed definition of 15% standard asset are consistent with assets that funds currently classify as illiquid under the 15% guideline? If not, what types of assets would be classified differently?
What are funds’ current practices
for determining whether a portfolio asset is limited by the 15% guideline, and what factors do funds currently use to make this determination? Who at the fund and/or the adviser is tasked with determining whether a portfolio asset is limited by the 15% guideline, and how often is each asset reviewed? Do funds expect to engage in the same practices for determining whether an asset is a 15% standard asset?
Would it be beneficial to funds for
the Commission to include as part of the rule certain types of securities whose acquisition would be limited by the 15% standard, or other factors for funds to consider in determining whether an asset is a 15% standard asset? Do commenters believe that confusion could arise between the definition of a 15% standard asset and the definition of a less liquid asset under the proposed rule, and if so, how could this confusion be reduced?
Rule 2a–7 currently defines the
term ‘‘illiquid security’’ to mean ‘‘a security that cannot be sold or disposed of in the ordinary course of business within seven calendar days at approximately the value ascribed to it by the fund.’’ 361 Should we amend rule 2a–7 to clarify that ‘‘illiquid security’’ has the same definition as ‘‘15% standard asset?’’

Policies and Procedures Regarding
Redemptions in Kind a. Use of Redemptions in Kind Along with ETFs, which commonly redeem shares in kind, many mutual funds reserve the right to redeem their shares in kind instead of in cash.362 Mutual funds that reserve the right to redeem in kind may use in-kind redemptions to manage liquidity risk under exceptional circumstances.363 A fund, for example, could choose to redeem in kind when faced with significant redemptions, because this would result in the redeeming shareholder (and not the fund and its remaining shareholders) bearing any liquidity costs associated with dispositions of portfolio assets. We understand that many funds also use inkind redemptions if a large shareholder is redeeming to transition to a separately managed account with a similar investment strategy. There are often logistical issues associated with paying in-kind redemptions, and this limits the availability of in-kind redemptions under many circumstances.364 For instance, in-kind redemptions could entail complex operational issues that would be imposed on both the fund and on investors receiving portfolio securities.365 Moreover, some shareholders are generally unable or unwilling to receive in-kind redemptions.366 Some funds also have

redemptions in kind for redemptions in excess of a certain size threshold, to ease liquidity strains on the fund and reduce the risks and unfairness posed by significant sudden redemptions. See Money Market Fund Reform; Proposed Rule, Investment Company Act Release No. 28807 (June 30, 2009) [74 FR 32688 (July 8, 2009)] (‘‘2009 Money Market Fund Reform Proposing Release’’), at section III.B. Commenters generally opposed this type of reform for a variety of reasons, all of which likely would apply equally to funds other than money market funds. For example, most commenters stated that in-kind redemptions would be technically unworkable due to complex valuation and operational issues that would be imposed on both the fund and on investors receiving the in-kind distribution. See 2013 Money Market Fund Reform Proposing Release, supra note 365, at section III.B.9.c. 367Under rule 18f–1, any registered open-end fund that has the right to redeem in kind could file with the Commission, on Form N–18F–1, a notification of election committing itself to pay in cash all requests for redemptions by any shareholder of record, limited in amount during any ninety-day period to the lesser of $250,000 or 1 percent of the net asset value of the fund at the beginning of the period. See Rule 18f–1 and Form N–18F–1 Adopting Release, supra note 362. 368See proposed rule 22e–4(b)(2)(iv)(E). 369See infra notes 552–554 and accompanying text. 370See supra note 362 and accompanying text. 371See, e.g., SIFMA IAA FSOC Notice Comment Letter, supra note 16, at nn.73–75 (stating that 79% of SIFMA AMG survey respondents report having access to a line of credit to manage outflows from their mutual funds, that 64% have drawn on that line of credit at some point within the last five years, and that 8% of SIMFA AMG members surveyed state that they engage in interfund lending to address liquidity issues); BlackRock FSOC Notice Comment Letter, supra note 50, at 6 (statement that among several overarching principles that provide the foundation for a prudent market liquidity risk management framework for collective investment vehicles is identifying backup sources of liquidity such as temporary borrowings). But see Fidelity FSOC Notice Comment Letter, supra note 20, at 20 (‘‘During the time period since its inception in 2001, the committed bank line of credit has never been used.’’); Comment Letter of PIMCO on the FSOC Notice (Mar. 25, 2015), at Appendix–2 (‘‘In practice, it is rare for funds to . . . draw on these lines of credit.’’); Invesco FSOC Notice Comment Letter, supra note 35, at 12 (stating that it has a line waived the right to redeem in kind with respect to certain relatively small redemption requests under rule 18f–1 under the Investment Company Act, which allows a fund to abide by different in-kind redemption policies for different shareholders without being deemed to create a class of senior securities prohibited by section 18(f)(1) of the Act.367 We believe that, as part of
a fund’s management of its liquidity risk, a fund that engages in or reserves the right to engage in in-kind redemptions should adopt and implement written policies and procedures regarding in-kind redemptions, and we have included this requirement in proposed rule 22e–4.368 We expect these policies and procedures would address the process for redeeming in kind, as well as the circumstances under which the fund would consider redeeming in kind. Through staff outreach to funds, we understand that while many funds disclose that they have reserved the right to redeem in kind, most of these funds consider redemptions in kind to be a last resort or emergency measure, and many do not have policies or procedures in place that would govern in-kind redemptions. Because the management and personnel capacity of funds facing heavy redemptions and other liquidity stresses would likely be strained as funds attempt to manage these pressures, policies and procedures that dictate the fund’s in-kind redemption procedures (which, as discussed above, could be quite complicated and could apply differently to different types of shareholders) would increase the likelihood that inkind redemptions would be a feasible risk management tool.369 b. Requests for Comment

Our understanding is that
redemptions in kind are not used extensively outside ETFs. Is this assumption correct? Do funds that engage in redemptions in kind have policies and procedures regarding those redemptions? Are there steps that funds can take to make redemptions in kind easier to implement?
Under rule 18f–1, any registered
open-end fund that has the right to redeem in kind could file with the Commission a notification of election committing itself to pay in cash all requests for redemptions by any shareholder of record, limited in amount during any ninety-day period to the lesser of $250,000 or 1 percent of the net asset value of the fund at the beginning of the period.370 Would revisiting and eliminating funds’ ability to limit in-kind redemptions clarify that the Investment Company Act permits funds to redeem shares in kind as well as in cash?

Discussion of Additional Liquidity
Risk Management Tools
While proposed rule 22e–4 specifies that each fund would be required to adopt a liquidity risk management program incorporating certain specified elements, a fund’s program could incorporate liquidity risk management tools beyond the requirements of the proposed rule. We understand that many funds currently engage in certain practices that would not be required by proposed rule 22e–4, but which could enhance funds’ ability—in conjunction with the policies and procedures required to be adopted under the proposed rule—to manage liquidity risk. Specifically, we understand based on staff outreach that it is relatively common for funds to establish lines of credit to manage liquidity risk, and that funds may use borrowed money or draw on other funding sources to meet shareholder redemptions, typically during periods of significantly limited market liquidity. We also understand that it is relatively common for certain funds (particularly, funds with strategies involving investment in relatively less liquid portfolio securities) to invest in ETFs to enhance the liquidity of the fund’s portfolio. Below we provide guidance funds may wish to consider in using these tools and their role in a fund’s liquidity risk management program. We note that the liquidity risk management tools discussed below do not comprise an exhaustive list of liquidity risk management controls or procedures that a fund could consider implementing, nor are we currently proposing to mandate that a fund use these tools as
part of its liquidity risk management
program.
In addition, there are currently several tools that a fund could use, generally under emergency circumstances, to pay redeeming shareholders during periods in which the fund encounters limited liquidity. As discussed above, many funds reserve the right to redeem their shares in kind instead of in cash, although we understand that many funds that do so consider in-kind redemptions to be a last resort or emergency measure. As a separate emergency measure, money market funds (but not other funds) are currently permitted, under certain circumstances, to permanently suspend shareholder redemptions and liquidate the fund. Below we request comment on whether this tool would be useful and appropriate for the Commission to make available to funds besides money market funds. a. Borrowing Arrangements and Other Funding Sources As discussed above, entering into borrowing arrangements and agreements with other potential funding sources could strengthen a fund’s management of liquidity risk, as they could be used to pay redeeming shareholders without the need to sell portfolio securities at significantly discounted prices. For example, a fund could establish a committed or uncommitted line of credit with a commercial bank, engage in interfund lending within a family of funds, or use repurchase transactions to generate liquidity.371 Proposed rule

of credit for its floating rate fund and senior loan portfolio ETF, but that it has been used on a very infrequent basis). 372See supra notes 315–318 and accompanying and following text. 373See supra notes 320–322 and accompany and following text. 374See, e.g., Nuveen FSOC Notice Comment Letter, supra note 45, at 9–10 (‘‘Funds without credit lines face the possibility of not being able to sell sufficient assets to raise cash to fund redemption requests, or having to sell assets at significantly discounted values. To the extent that a fund draws on a credit line to meet net redemptions (and thus temporarily leverages itself), it increases its market risk at a time when markets are stressed. While this can be potentially beneficial to long-term performance if the asset class recovers, it increases the risk of loss to remaining shareholders if markets continue to weaken.’’). 375See, e.g., Katy Burne, Institutions Pour Cash Into Bond ETFs, Wall Street Journal (Mar. 1, 2015), available at http://www.wsj.com/articles/ institutions-pour-cash-into-bond-etfs-1425250969. Funds’ investments in ETFs are subject to the Investment Company Act’s limitations on investments in shares issued by other registered investment companies. See section 12(d)(1)(A) of the Investment Company Act. 376The Commission’s 2015 Request for Comment on Exchange-Traded Products requested comment on whether investors’ expectations of the nature of the liquidity of an exchange-traded product (including an ETF) holding relatively less liquid portfolio securities differ from their expectations of the liquidity of the underlying portfolio securities. See 2015 ETP Request for Comment, supra note 11, at Question #49. See e.g., Comment Letter of Vanguard on the 2015 ETP Request for Comment (Aug. 17, 2015) (stating that the disclosures made by ETFs in prospectuses, shareholder reports, and Web sites ‘‘ensures that investors and market participants have the necessary information to make informed investment decisions’’); Comment Letter of ETF Radar on the 2015 ETP Request for Comment (Aug. 8, 2015) (stating that investor expectations of liquidity depend on the skill of the investor); Comment Letter of Danny Reich on the 2015 ETP Request for Comment (July 2, 2015) (stating that there is a ‘‘false assumption’’ that underlying assets have the same liquidity as the ETP, particularly with respect to bond ETPs). 377See supra note 24 and accompanying text; see also Tyler Durden, What Would Happen if ETF Holders Sold All at Once?, ETF Daily News (Mar. 26, 2015), available at http://etfdailynews.com/ 2015/03/26/what-would-happen-if-etf-holders-soldall-at-once/2/ (‘‘Thus we can’t get away from depending on the liquidity of the underlying high yield bonds. The ETF can’t be more liquid than the underlying, and we know the underlying can become highly illiquid.’’). 378See supra note 29 and accompanying text. 379See supra note 82. 380See supra note 155 and accompanying text. 381See 2009 Money Market Fund
Reform Proposing Release, supra note 366. 382See Comment Letter of the Committee on Federal Regulation of Securities, Section of Business Law of the American Bar Association on Money Market Fund Reform (Sept. 9, 2009); Comment Letter of Bankers Trust Company, N.A. on Money Market Fund Reform (Aug. 28, 2009). 22e–4(b)(2)(iii)(D) would require a fund to consider its borrowing arrangements and other funding sources in assessing its liquidity risk, and above we provide guidance on particular aspects of these activities that could affect a fund’s liquidity risk.372 We anticipate that a fund could consider this guidance in assessing whether entering into borrowing or other funding arrangements would assist the fund in managing its liquidity risk, as well as determining the terms under which such arrangements would best help the fund to manage its liquidity risk. We also anticipate that this guidance could be used in reviewing existing borrowing arrangements and the use of other funding sources to assess whether these activities would continue to help the fund effectively manage its liquidity risk. In evaluating borrowing arrangements or other funding sources for purposes of managing liquidity risk, a fund should take into account restrictions on affiliated transactions and leverage under the Investment Company Act and rules under the Act.373 A fund also may wish to consider any negative impact on the fund resulting from borrowing funds for liquidity risk management purposes, as opposed to managing liquidity through the fund’s portfolio construction.374 b. Use of ETF Portfolio Holdings as a Liquidity Risk Management Tool We understand that certain funds, particularly funds with investment strategies involving relatively less liquid portfolio securities (such as micro-cap equity funds, high-yield bond funds and bank loan funds), may invest a portion of their assets in ETFs with strategies similar to the fund’s investment strategy because they view ETF shares as having characteristics that enhance the liquidity of the fund’s portfolio.375 Specifically, funds that invest in ETF shares have stated to Commission staff that they find that these shares are more readily tradable, are less expensive to trade, and have shorter settlement periods than other types of portfolio investments.376 And unlike investments in cash, cash equivalents, and other highly liquid instruments, funds have suggested that investing in ETFs with the same (or a similar) strategy as the fund’s investment strategy permits the fund to remain fully invested in assets that reflect the fund’s investment concentrations, risks, and performance potential. While we appreciate that ETFs’ exchange-traded nature could make these instruments useful to funds in managing purchases and redemptions (for example, ETFs’ settlement times could more closely reflect the time in which a fund has disclosed that it will typically redeem fund shares), funds should consider the extent to which relying
substantially on ETFs to manage liquidity risk is appropriate. As discussed above, the liquidity of an ETF, particularly in times of declining market liquidity, may be limited by the liquidity of the market for the ETF’s underlying securities.377 Thus, shares of an ETF whose underlying securities are relatively less liquid (taking into account the factors discussed in proposed rule 22e–4(b)(2)(ii)) may not be able to be counted on as an effective liquidity risk management tool during times of liquidity stress. In the case of a significant decline in market liquidity, if authorized participants were unwilling or unable to trade ETF shares in the primary market, and the majority of trading took place among investors in the secondary market, the ETF’s shares could trade continuously at a premium or a discount to the value of the ETF’s underlying portfolio securities. This could frustrate the expectations of secondary market investors who count on the creation and redemption process to align the prices of ETF shares and their underlying portfolio securities.378 We therefore encourage funds to assess the liquidity characteristics of an ETF’s underlying securities, as well as the characteristics of the ETF shares themselves, in classifying an ETF’s liquidity under proposed rule 22e– 4(b)(2)(i). We also encourage funds to consider the portion of a fund’s threeday liquid assets that is invested in ETF shares, taking into account the foregoing concerns.
c. Suspension of Redemptions
Section 22(e) of the Investment
Company Act permits a fund to suspend redemptions in specified unusual circumstances, including for any period during which an emergency exists (only as determined by Commission rules and regulations) as a result of which it is not reasonably practicable for the fund to liquidate its portfolio securities, or fairly determine the value of its net assets.379 Rule 22e–3 exempts money market funds from section 22(e), permitting a money market fund to suspend redemptions and postpone payment of redemption proceeds in an orderly liquidation of the fund if, subject to other requirements, the fund’s board makes certain findings.380 The Commission has previously requested comment on whether the relief provided by rule 22e–3 should be available to types of open-end funds besides money market funds.381 The Commission received only limited comments addressing the topic, with a few commenters generally supportive of extending the rule to all open-end funds,382 and one commenter arguing that open-end funds should be required

383See Comment Letter of Federated Investors, Inc. on Money Market Fund Reform (Sept. 8, 2009). 384See, e.g., BlackRock FSOC Notice Comment Letter, supra note 50, at 40 (stating that the Commission should ‘‘extend the authority to suspend redemptions under extraordinary redemptions, including an unmanageable spike in redemptions, to fund boards.’’). 385See supra note 71 and accompanying text. 386See supra note 154 and accompanying text. 387See supra text accompanying note 379. 388See supra note 82. 389See 2014 Money Market Fund Reform Adopting Release, supra note 85, at section III.A.1. 390See supra note 320 and accompanying text. 391Rule 17a–7 under the Investment Company Act provides an exemption from section 17(a)’s prohibitions so long as certain conditions are met. In summary, rule 17a–7 requires, among other things, that: (i) The transaction at issue is a purchase or sale, for no consideration other than cash, for a security for which market quotations are readily available; (ii) the transaction be effected at the independent current market price for the security at issue; (iii) the transaction must be consistent with the policy of each fund participating in the transaction as set forth in its registration statement and reports filed under the Investment Company Act; (iv) no brokerage commission, fee (except for customary transfer fees) or other remuneration be paid in connection with the transaction; and (v) the fund’s board, including a majority of the independent directors, adopts procedures that are reasonably designed to provide that the rule 17a–7 transactions comply with the conditions of the rule, approve changes to the procedures as the board deems necessary, and determines no less frequently than quarterly that all rule 17a–7 transactions made during the preceding quarter were effected in compliance with the approved procedures. 392As noted above, rule 17a–7 requires that each cross-trade be consistent with the policy of each fund participating in the transaction and that no to seek individual exemptive orders from the Commission to obtain the relief provided by rule 22e–3.383 We request specific comment below on whether proposing a rule similar to rule 22e–3, which would permit open-end funds other than money market funds to suspend redemptions and postpone payment of redemption proceeds in an orderly liquidation of the fund under certain circumstances, would protect the interests of its investors if the fund were to liquidate. We also request comment below on whether the Commission should consider proposing rules that would permit funds to suspend redemptions under other circumstances not involving the liquidation of the fund.384 As discussed above, private funds are often able to impose gates and suspend redemptions to manage liquidity stress,385 and rule 2a–7 likewise permits money market funds to temporarily suspend redemptions under certain circumstances.386 Registered funds that are not money market funds, however, are
significantly more limited in their current ability to suspend redemptions under the Investment Company Act.387 Specifically, open-end funds may suspend redemptions for any period during which the NYSE is closed (other than customary weekend and holiday closings) and in three additional situations only if the Commission has made certain determinations.388 These limited suspension rights are aimed at preventing funds and their advisers from interfering with shareholders’ redemption rights for improper purposes,389 and recognize the importance that shareholders place on daily redeemability of fund shares. d. Request for Comment We request comment on the above discussion and guidance regarding certain tools that a fund could use to manage liquidity risk beyond the requirements specified in proposed rule 22e–4.

Are there any specific liquidity risk
management policies or procedures, beyond those that would be required by proposed rule 22e–4(b)(2)(iv)(A)–(E), that funds should be required to implement? What procedures, separate from any that resemble those required by proposed rule 22e–4(b)(2)(iv)(A)–(E), do funds currently use to manage liquidity risk?
Do commenters generally agree
with our guidance discussed above on the use of borrowing arrangements and other funding sources, the use of ETFs to manage portfolio liquidity, and the use of redemptions in kind? Is any additional guidance needed on the liquidity risk management tools described in this section? Are there any other issues associated with specific liquidity risk management tools or techniques about which we should provide guidance? To the extent that funds use liquidity risk management tools outside those mentioned in this
section, what guidance, if any, is needed
regarding those tools?
Regarding borrowing arrangements
and other funding sources, would additional guidance be useful regarding specific types of borrowing arrangements?
When using ETFs to manage
liquidity, do funds consider the liquidity of the ETFs’ portfolio securities? Why or why not? We also request specific comment on several current rules that touch on liquidity risk management issues and the suspension of shareholder redemptions.
Would proposing a rule similar to
rule 22e–3 for funds other than money market funds protect the interests of fund investors if the fund were to liquidate? If so, under what circumstances should funds be permitted to suspend redemptions and postpone payment of redemption proceeds, and should a fund’s board be required to make any finding in connection with a fund’s suspension of redemptions?
Should we consider proposing rules
that would permit funds to suspend redemptions under other circumstances, such as rules that would specify certain emergency circumstances that would permit funds to suspend redemptions under section 22(e)? How could we define such emergency circumstances? For example, should we define emergency circumstances to include situations where redemptions exceeded a high level over a certain period of time or where asset price volatility in the markets exceeded a certain level making it difficult for the fund to accurately price?

Cross-Trades
Funds, subject to the requirements of the Investment Company Act, are permitted to engage in ‘‘cross-trading,’’ that is, securities transactions with certain of their affiliated persons, including other funds within the fund family. Some funds may seek to use cross-trading as an additional liquidity risk management tool. Rule 17a–7, however, includes conditions that limit the portfolio assets that may be crosstraded, and as discussed below, crosstrades that involve certain less liquid assets may not be eligible to rely on the rule. We propose below guidance relating to the use of cross-trading in response to investor redemptions.
Section 17 of the Investment
Company Act restricts transactions between an ‘‘affiliated person of a registered investment company or an affiliated person of such affiliated person’’ and that investment company— for example, transactions between a fund and another fund managed by the same adviser.390 A fund must therefore obtain exemptive relief from the Commission before entering into purchase or sale transactions with an affiliated fund, or execute such transactions subject to the provisions of rule 17a–7 under the Investment Company Act (permitting purchase and sale transactions among affiliated funds and other accounts, under certain circumstances).391 Cross-trading can benefit funds and their shareholders, for example by allowing funds that are mutually interested in a securities transaction that is consistent with the investment strategies of each fund to conduct such a transaction without incurring transaction costs and without generating a market impact.392 However, crossmstockstill on DSK4VPTVN1PROD with PROPOSALS2

brokerage commissions, fees or other remuneration be paid in connection with the transaction. Because cross-trades are conducted privately between funds, they are not transparent to market trading reporting systems and thus are unlikely to generate a market impact. 393Exemption of Certain Purchase or Sale Transactions Between a Registered Investment Company and Certain Affiliated Persons Thereof, Investment Company Act Release No. 11136 (Apr. 21, 1980) [45 FR 29067 (May 1, 1980)]. 394See rule 17a–7(b). 395Exemption of Certain Purchase or Sale Transactions Between a Registered Investment Company and Certain Affiliated Persons Thereof, Investment Company Act Release No. 11676 (Mar. 10, 1981) [45 FR 17011 (Mar. 17, 1981)]. The Commission historically declined to expand rule 17a–7 to cross-trades for which market quotations were not readily available and where independent current market prices were not available because these conditions increase the potential for abuse through cross-trades. See id. 396See supra section III.B.2 (discussing proposed factors for classifying the liquidity of a portfolio position). 397See, e.g., In the Matter of Western Asset Management Co., Investment Company Act Release No. 30893 (Jan. 27, 2014) (settled action) (the adviser to funds engaging in cross-trading ‘‘has a fiduciary duty of loyalty to its clients and also must seek to obtain best execution for both its buying and selling clients’’). 398 In this release, we refer to directors who are not ‘‘interested persons’’ of the fund as ‘‘independent directors.’’ Section 2(a)(19) of the Investment Company Act identifies persons who are ‘‘interested persons’’ of a fund. 399See Investment Trusts and Investment Companies: Hearings on H.R. 10065 Before a Subcomm. of the House Comm. on Interstate and Foreign Commerce, 76th Cong., 3d Sess. 112 (1940) at 109 (describing the board as an ‘‘independent check’’ on management); Burks v. Lasker, 441 U.S. 471 (1979) (citing Tannenbaum v. Zeller, 552 F.2d 402, 406 (2d. Cir. 1979)) (describing independent directors as ‘‘independent watchdogs’’). See also Comment Letter of the Independent Directors Council on the FSOC Notice (Mar. 25, 2015), at 5 (‘‘A fund board oversees the adviser’s management of the portfolio’s liquidity as part of its oversight of the fund’s compliance program and portfolio management more generally.’’). trades also have the potential for abuse. As the Commission has said, ‘‘[f]or example, an unscrupulous investment adviser might ‘‘dump’’ undesirable securities on a registered investment company or transfer desirable securities from a registered investment company to another more favored advisory client in the complex. Moreover the transaction could be effected at a price which is disadvantageous to the registered investment company.’’ 393 Accordingly, rule 17a–7 requires that any cross-trades satisfy certain conditions designed to prevent such abuses, including the requirement that market quotations be readily
available for each traded security and that if the security is only traded over the counter, the cross-trade be conducted at the average of the highest current independent bid and lowest current independent offer determined on the basis of reasonable inquiry.394 In requiring market quotations for crosstraded securities, the Commission has stated that ‘‘[r]eliance upon such market quotations provides an independent basis for determining that the terms of the transaction are fair and reasonable to each participating investment company and do not involve overreaching.’’ 395 Certain less liquid assets may be ineligible to trade under rule 17a–7 due to this requirement. Indeed, the less liquid an asset is, the more likely it may not satisfy rule 17a–7.396 Accordingly, for assets that do not trade in active secondary markets, a fund should consider whether ‘‘market quotations are readily available’’ and a ‘‘current market price’’ is available and thus whether the asset may be cross-traded in accordance with rule 17a–7. In addition, when considering whether cross-trading would be an effective and appropriate liquidity risk management tool, a fund’s adviser should consider its duty to seek best execution for each fund potentially involved in the cross-trading transaction, as well as its duty of loyalty to each fund.397 An adviser should not cause funds to enter into a cross-trade unless doing so would be in the best interests of each fund participating in the transaction. In assessing these factors, a fund should consider any negative impact on the fund resulting from the purchase of assets by one fund from an affiliated fund (that is, whether any risk-shifting between funds that results from trading assets is appropriate, considering the funds’ strategies, risk profile, and liquidity needs before the transaction takes place) given the policy of each fund as recited in its registration statement and reports under the Act. We request comment on our guidance relating to cross-trading.

Does our guidance (combined with
existing guidance) relating to rule 17a– 7 provide sufficient protections for cross-trades involving assets that are only traded over the counter and, depending on the facts and circumstances, may be less liquid? If not, what additional guidance or protections might be warranted to protect funds and investors from unfairness or abuse in cross-trades? D. Board Approval and Designation of Program Administrative Responsibilities

Initial Approval of Liquidity Risk
Management Program
Proposed rule 22e–4(b)(3)(i) would require each fund to obtain initial approval of its written liquidity risk management program from the fund’s board of directors, including a majority of independent directors.398 The proposed rule specifies that this approval is required to include the fund’s three-day liquid asset minimum. Directors, and particularly independent directors, play a critical role in overseeing fund operations, although they may delegate day-to-day management to a fund’s adviser.399 Given the board’s historical oversight role, we believe it is appropriate to require a fund’s board to approve the fund’s liquidity risk management program. This requirement is designed to facilitate independent scrutiny by the board of directors of the liquidity risk management program—an area where there may be a conflict of interest between the investment adviser and the fund. For example, an adviser might have an incentive to set a low three-day liquid asset minimum in order to permit the fund to invest in additional less liquid assets (because such assets may result in higher total returns for a fund), even though a low minimum may not reflect an appropriate alignment between the fund’s portfolio liquidity profile and the fund’s liquidity needs. Directors may satisfy their obligations with respect to this initial approval by reviewing summaries of the liquidity risk management program prepared by the fund’s investment adviser or officers administering the program, legal counsel, or other persons familiar with the liquidity risk management program. The summaries should familiarize directors with the salient features of the program and provide them with an understanding of how the liquidity risk management program addresses the required assessment of the fund’s liquidity risk, including how the fund’s investment adviser or officers administering the program determined the fund’s three-day liquid asset minimum. In considering whether to approve a fund’s liquidity risk management program, the board may wish to consider the nature of the fund’s liquidity risk exposure. A board also may wish to consider the adequacy of the fund’s liquidity risk management program in light of recent experiences regarding the fund’s liquidity, including any redemption pressures experienced by the fund.
Approval of Material Changes to
Liquidity Risk Management Program and Oversight of the Three-Day Liquid Asset Minimum Proposed rule 22e–4(b)(3)(i) also would require each fund to obtain approval of any material changes to the fund’s liquidity risk management program, including changes to the

400Rule 38a–1 requires that the fund’s chief compliance officer provide a written annual report to the fund’s board addressing, among other things, any material changes made to the fund’s compliance policies and procedures since the date of the last report and any material changes to the fund’s compliance policies and procedures recommended as a result of the fund’s annual review of the adequacy of such policies and procedures and the effectiveness of their implementation. 401Rule 38a–1 contains several provisions ‘‘designed to promote the independence of the chief compliance officer from the management of the fund.’’ See Rule 38a–1 Adopting Release, supra note 90. These include: Rule 38a–1(a)(4)(i) (designation and compensation of the chief compliance officer must be approved by the fund’s board, including a majority of the fund’s independent directors); rule 38a–1(a)(4)(ii) (the chief compliance officer can only be discharged from his or her responsibilities with the approval of the fund’s board, including a majority of the fund’s independent directors); rule 38a–1(a)(4)(iii) (the chief compliance officer must provide an annual report to the board addressing: (i) The operation of the policies and procedures of the fund and certain service providers since the last report; (ii) any material changes to the policies and procedures since the last report; (iii) any recommendations for material changes to the policies and procedures as a result of the annual review; and (iv) any material compliance matters since the date of the last report); and rule 38a– 1(a)(4)(iv) (requiring the chief compliance officer to meet separately with the fund’s independent directors at least once a year). 402Proposed rule 22e–4(b)(3)(ii). 403See Federal Regulation Of Securities Committee, American Bar Association, Fund Director’s Guidebook (4th ed. 2015), at p. 82 (‘‘Determining the liquidity of a security is primarily an investment decision that is delegated to the investment adviser, but directors may establish guidelines and standards for determining liquidity.’’). 404See Rule 38a–1 Adopting Release, supra note 90 (noting, in the case of a rule 38a–1 compliance program, that ‘‘[s]erious compliance issues must, of course, always be brought to the board’s attention promptly’’). fund’s three-day liquid asset minimum, from the fund’s board of directors, including a majority of independent directors. As with the initial approval of a fund’s liquidity risk management program, the requirement to obtain approval of any material changes to the fund’s liquidity risk management program from the board is designed to facilitate independent scrutiny of material changes to the liquidity risk management program by the board of directors. We note that our proposal to require directors to approve material changes to the fund’s liquidity risk management program differs from the requirements under rule 38a–1 under the Act, which does not require a fund board to approve changes to a fund’s
compliance policies and procedures.400 Given that the fund’s liquidity risk management program will be administered by a fund’s investment adviser or officers (rather than a chief compliance officer),401 we believe that board approval of material changes in this context will provide an important independent check on such administration. The fund’s board would be responsible under the proposed rule for reviewing a written report from the fund’s investment adviser or officers administering the fund’s liquidity risk management program, provided no less frequently than annually, that reviews the adequacy of the fund’s liquidity risk management program, including the fund’s three-day liquid asset minimum, and the effectiveness of its implementation.402 This aspect of the proposed rule is designed to facilitate board oversight over the adequacy and effectiveness of the fund’s liquidity risk management program, including the three-day liquid asset minimum and whether the three-day liquid asset minimum is providing an appropriate level of minimum liquidity to the fund in light of changes in the markets, the fund, and its shareholder base over time. To the extent that the board is being asked to approve a change in a fund’s three-day liquid asset minimum, the written report should also provide directors with an understanding of how a change to the fund’s three-day liquid asset minimum was determined to be appropriate. We believe that this review and its related report will provide the board with sufficient information to provide oversight over the adequacy and effective implementation of the fund’s liquidity risk management program. As with the initial approval of each fund’s liquidity risk management program, directors may also wish to consider the nature of the fund’s liquidity risk exposure in approving any material changes, particularly with respect to the fund’s three-day liquid asset minimum.
3. Designation of Administrative
Responsibilities to Fund Investment Adviser or Officers Proposed rule 22e–4(b)(3)(iii) would expressly require a fund to designate the fund’s investment adviser or officers (which may not be solely portfolio managers of the fund) responsible for administering the fund’s liquidity risk management program, which designation must be approved by the fund’s board of directors. Designating the fund’s investment adviser or officers responsible for the administration of the fund’s liquidity risk management program, subject to board oversight, is consistent with the way we understand most funds currently manage liquidity.403 The proposed designation also tasks the persons who are in a position to manage the fund’s liquidity risks on a real-time basis with responsibility for administration of the liquidity risk management program. In administering a fund’s liquidity risk management program, the fund’s investment adviser or officers may wish to consult with the fund’s portfolio manager, traders, risk managers, and others as necessary or appropriate (e.g., to obtain information used in classifying the liquidity of a new portfolio position), but we note that the fund’s portfolio managers may not be solely responsible for administering the program. We understand, based on staff outreach, that some funds employ a dedicated risk management officer and task liquidity risk management to this officer, in consultation with the fund’s portfolio management function. The board of a fund that employs a dedicated risk management officer (or an officer whose role includes risk management among other duties) may find it appropriate to designate administration of the fund’s liquidity risk management program to this officer. We request comment below on whether a fund should be required to specifically task administration of the fund’s liquidity risk management program to a dedicated risk officer, or whether we should otherwise specify the officer who must administer the fund’s liquidity risk management program. Because the administration of a fund’s liquidity risk management program would be designated to a fund’s investment adviser or officers, the investment adviser or officers should provide the board with enough information to oversee such administration. As discussed above, the fund’s investment adviser or officers would therefore be required to provide the board with a written report on the adequacy of the fund’s liquidity risk management program, including the three-day liquid asset minimum, and the effectiveness of its implementation, at least annually. To the extent that a serious compliance issue arises under the program, it may be appropriate to consider whether the event should be brought to the board’s attention promptly.404 We understand that, in certain circumstances, a fund’s service providers may assist a fund and its investment adviser in monitoring factors relevant to a fund’s liquidity risk and managing the fund’s liquidity risk. For example, third
parties could provide data relevant to assessing fund flows. Also, a sub-adviser’s portfolio management responsibilities would involve investing a fund’s assets in accordance with the fund’s three-day

405A fund could also formally designate a fund’s sub-adviser as responsible for the fund’s liquidity risk management program. 406Proposed rule 22e–4(c)(1). 407Proposed rule 22e–4(c)(2); see also proposed rule 22e–4(b)(3)(i)–(ii). 408Proposed rule 22e–4(c)(3). liquid asset minimum and any other liquidity-related portfolio requirements adopted by the fund.405 While we understand that such actions could provide useful assistance to a fund in assessing, monitoring, and managing liquidity risk, we note that the primary parties responsible for a fund’s liquidity risk management are the fund itself and any parties to whom the fund has designated responsibility for administering the fund’s liquidity risk management program. A fund (or its investment adviser, to the extent the investment adviser has been given liquidity risk management responsibility) should thus oversee any liquidity risk monitoring or risk management activities undertaken by the fund’s service providers, and we encourage a fund (or its investment adviser, as appropriate) to communicate regularly with its service providers as a
part of its oversight and to coordinate
the liquidity risk management efforts undertaken by various parties.
4. Request for Comment
We request comment on the proposed board approval and oversight requirements.

Do fund boards currently approve
procedures for classifying the liquidity of portfolio assets? Do fund boards take any additional steps to oversee the liquidity of portfolio assets? Should the Commission require boards, including a majority of independent directors, to approve the initial liquidity risk management program, including the three-day liquid asset minimum?
Should the Commission require
boards to approve material changes to a fund’s liquidity risk management program, including any changes to a fund’s three-day liquid asset minimum? Should the Commission define what would constitute a ‘‘material change’’ to a fund’s liquidity risk management program or provide additional guidance regarding what changes would constitute material changes? Alternatively, should the Commission require boards to approve all changes to a fund’s liquidity risk management program? Or, similar to rule 38a–1 regarding a fund’s compliance program, should there be no requirement for board approval of changes to the liquidity risk management program?
Does the release provide adequate
guidance to fund boards regarding their approval of the liquidity risk management program? Should we provide any additional guidance in this regard?
Do commenters agree that it would
be appropriate to require a fund to designate the fund’s adviser or officers responsible for administering a fund’s liquidity risk management program, subject to board approval? Is it appropriate to specify that those administering the program may not be solely the fund’s portfolio managers? Would any small fund complexes have difficulty meeting the proposed requirement that the program may not be solely administered by the fund’s portfolio manager? Is it appropriate to allow a fund to designate a fund subadviser responsible for administering a fund’s liquidity risk management program? Should the Commission require a fund to task administration of the fund’s liquidity risk management program to a specific officer of the fund? Should the Commission require that a fund have a chief risk officer or risk committee administer the fund’s liquidity risk management program?
Should the Commission specify a
shorter or longer frequency for review of a report on the fund’s liquidity risk management program? Should the report to the board cover both the adequacy and effectiveness of the fund’s liquidity risk management program as well as the adequacy of the fund’s threeday liquid asset minimum? Alternatively, would a report reviewing the adequacy of the fund’s three-day liquid asset minimum likely provide a review of the fund’s liquidity risk management program overall given the factors that must be assessed in setting the three-day liquid asset minimum?
Are there other aspects of the fund’s
liquidity risk management program about which the fund’s investment adviser or officers responsible for administering the program should report to the board? Should we provide any additional guidance to fund boards in connection with the approval and oversight of a fund’s liquidity risk management program? E. Liquidity Risk Management Program Recordkeeping Requirements We are proposing to require that each fund maintain a written copy of the policies and procedures adopted as part of its liquidity risk management program for five years, in an easily accessible place.406 Each fund also would be required to maintain copies of any materials provided to its board in connection with the board’s initial approval of the fund’s liquidity risk management program and approvals of any subsequent material changes to the program, including any changes to the fund’s three-day liquid asset minimum, and copies of written reports provided to the board that review the adequacy of the fund’s liquidity risk management program, including the fund’s three-day liquid asset minimum, and the effectiveness of its implementation.407 Funds would have to maintain such records for at least five years after the end of the fiscal year in which the documents were provided to the board, the first two years in an easily accessible place. Finally, we are proposing to require that each fund keep a written record of how its three-day liquid asset minimum, and any adjustments thereto, were determined, including the fund’s assessment and periodic review of its liquidity risk in light of the factors incorporated in paragraphs (b)(2)(iii)(A) through (D) of proposed rule 22e–4.408 Funds would have to maintain such records for a period of not less than five years, the first two years in an easily accessible place, following the determination of, and each change to, the fund’s three-day liquid asset minimum. The records discussed above are designed to provide our examination staff with a basis to determine whether a fund has adopted a liquidity risk management program in compliance with the requirements of proposed rule 22e–4. Specifically, such records would help our staff to determine whether a fund’s program incorporates the elements required to be included under paragraph (b)(2) of proposed rule 22e–

We also anticipate that these records
would assist our staff in identifying weaknesses in a fund’s liquidity risk management if violations do occur or are uncorrected. The five-year retention period in proposed rule 22e–4(c) is consistent with that in rule 38a–1(d) under the Act. We believe consistency in these retention periods is appropriate because funds currently have program-related recordkeeping procedures in place incorporating a five-year retention period, which we believe would lessen the compliance burden to funds slightly, compared to choosing a different retention period, such as the six-year recordkeeping retention period under rule 31a–2 of the Act. Taking this into account, we believe a five-year retention period is a sufficient period of time for our examination staff to evaluate whether a fund is in compliance (and

409See sections 30(c)(2)(A), 30(c)(2)(B), and 31(a)(2) of the Investment Company Act. 410See rule 22c–1(a). Prior to adoption of rule 22c–1, investor orders to purchase and redeem could be executed at a price computed before receipt of the order, allowing investors to lock-in a low price in a rising market and a higher price in a falling market. The forward pricing provision of rule 22c–1 was designed to eliminate these trading practices and the dilution to fund shareholders which occurred as a result of backward pricing. Pricing of Redeemable Securities for Distribution, Redemption, and Repurchase, Investment Company Act Release No. 14244 (Nov. 21, 1984) [49 FR 46558 (Nov. 27, 1984)], at text following n.2. 411See supra note 41 and accompanying text. 412See rule 2a–4(a)(2) (providing that changes in holdings of portfolio securities shall be reflected in the fund’s current NAV no later than in the first calculation on the first business day following the trade date); rule 2a–4(a)(3) (providing that changes in the number of outstanding shares of the registered company resulting from distributions, redemptions, and repurchases shall be reflected in the fund’s current NAV no later than in the first calculation on the first business day following such change); see also BlackRock, Swing Pricing: The Dilution Effects of Trading Activity (Dec. 2011), available at http://www2.blackrock.com/content/ groups/internationalsite/documents/literature/ 1111157589.pdf (‘‘BlackRock Swing Pricing Paper’’). 413See Association of the Luxembourg Fund Industry, Swing Pricing: Survey, Reports & Guidelines (Feb. 2011), available at http:// www.alfi.lu/sites/alfi.lu/files/ALFI_Swing_ Pricing.pdf (‘‘Luxembourg Swing Pricing Survey, Reports & Guidelines’’), at 13 (‘‘[T]he single price at which investors buy and sell the fund’s shares only reflects the value of its net assets. It does not take into account the dealing costs that arise when the portfolio manager trades as a result of capital activity incurring a spread on the underlying securities. In other words, the charges incurred fall not on the client who has just traded, but on all investors in the fund.’’). To the extent that a fund were to apply a purchase fee or redemption fee, shareholders would, at least to a certain extent, bear the transaction-related costs associated with their purchase and redemption requests. See infra notes 421–422 and accompanying text; see also Securities and Exchange Commission, Mutual Fund Fees and Expenses, available at http://www.sec.gov/answers/ mffees.htm. has been in compliance) with the liquidity risk management program requirements of the rule and anticipate that such information would become less relevant if extended beyond a fiveyear retention period. Furthermore, we believe that the proposed five-year retention period appropriately balances recordkeeping-related burdens on funds. We request comment on the proposed liquidity risk management program recordkeeping requirements. D
Do commenters agree that the proposed recordkeeping requirements are appropriate? Specifically, are there any additional records associated with a fund’s liquidity risk management program that a fund should be required to keep? Should a fund be required to keep a written record of how the liquidity classifications of each of the fund’s positions in a portfolio asset were determined, including assessment of the factors set forth in proposed rule 22e– 4(b)(2)(ii)? Should a fund be required to keep a written record of what liquidity classifications were determined for each of the fund’s positions in a portfolio asset? Do commenters anticipate that, to the extent that data regarding certain factors that a fund would be required to consider in classifying its portfolio positions’ liquidity could be obtained largely through automated systems, it would be possible to easily re-create a record of how past liquidity classifications assigned to a fund’s portfolio positions were determined? Are there feasible alternatives to the proposed rule that would minimize recordkeeping burdens, including the costs of maintaining the required records? D Do commenters agree that the fiveyear retention period for records that would be required to be kept pursuant to proposed rule 22e–4(c) is appropriate? If not, what retention period would commenters recommend? Would commenters recommend a sixyear retention period? Why or why not? D We specifically request comment on any alternatives to the proposed recordkeeping requirements that would minimize recordkeeping burdens on funds, the utility and necessity of the proposed recordkeeping requirements in relation to the associated costs and in view of the public benefits derived, and the effects that additional recordkeeping requirements would have on funds’ internal compliance policies and procedures.409 F. Swing Pricing Rule 22c–1 under the Investment Company Act, the ‘‘forward pricing’’ rule, requires funds, their principal underwriters, dealers in fund shares, and other persons designated in a fund’s prospectus, to sell and redeem fund shares at a price based on the current NAV next computed after receipt of an order to purchase or redeem.410 When a fund trades portfolio assets as a result of purchase or redemption requests, costs associated with this trading activity can dilute the value of the existing shareholders’ interests in the fund. This dilution occurs because the price at which shareholders transact in fund shares reflects the shares’ current NAV that is next computed after the fund’s receipt of the shareholders’ purchase and redemption requests (generally, the fund’s NAV calculated as of the close of the fund’s primary underlying market, which is typically 4 p.m. Eastern Time),411 but the fund’s NAV will not generally reflect changes in holdings of the fund’s portfolio assets and changes in the number of the fund’s outstanding shares until the first business day following the fund’s receipt of the
shareholders’ purchase and redemption requests.412 Thus, the price that a purchasing shareholder pays for fund shares customarily does not take into account the market impact costs and trading costs that arise when the fund buys portfolio assets in order to invest proceeds of shareholder purchases. Likewise, the price that a redeeming shareholder receives for fund shares customarily does not take into account the market impact costs and trading costs that arise when the fund sells portfolio assets in order to meet shareholder redemptions. Going forward, however, the NAV of the fund shares held by existing shareholders does reflect these costs, and thus these costs are borne not by the purchasing or redeeming shareholders but by all existing fund shareholders.413 While forward pricing captures the changes in portfolio assets’ value that arise as a result of market-wide trading, it does not necessarily reflect any disparity between the market price of a portfolio asset at the end of the day (as determined for purposes of striking a fund’s NAV) and the price that a fund receives for trading that asset. This scenario could arise, for example, in situations in which an asset’s value changes throughout the day, and the price that a fund receives when trading that asset differs from the market value of the asset at the end of the day. It also could arise if a fund were forced to sell a relatively less liquid asset at an inopportune time, and thus had to accept a price for that asset that incorporates a significant discount to the asset’s stated value. To provide an illustration of a situation in which forward pricing may not result in a fund’s NAV reflecting the price that a fund actually received when it sold portfolio assets, consider the following example. If a fund has valued portfolio asset X at $10 at the beginning of day 1, and market activity on day 1 (including the fund’s sale of portfolio asset X) decreases the market value of portfolio asset X to $9 at the end of day 1, the fund’s remaining holdings of portfolio asset X at the end of day 1 would be valued at $9 to reflect the asset’s market value on that day. However, staff outreach has shown that it is common industry practice, as permitted by rule 2a–4, for the fund’s current NAV to not reflect the actual price at which the fund has sold the

414See 2a–4(a)(2) (providing that changes in holdings of portfolio securities shall be reflected in the fund’s current NAV no later than in the first calculation on the first business day following the trade date). The next day’s NAV would generally reflect the cash receivable from the sale instead of the value of the shares that were sold (although if the shares were sold and settled within a T+0 or T+1 timeframe, the next day’s NAV would reflect the value of the shares that were sold). 415Market impact costs are incurred when the price of a security changes as a result of the effort to purchase or sell the security. Stated formally, market impacts are the price concessions (amounts added to the purchase price or subtracted from the selling price) that are required to find the opposite side of the trade and complete the transaction. Market impact cost cannot be calculated directly. It can be roughly estimated by comparing the actual price at which a trade was executed to prices that were present in the market at or near the time of the trade. See Concept Release: Request for Comments on Measures to Improve Disclosure of Mutual Fund Transaction Costs, Investment Company Act Release No. 26313 (Dec. 18, 2003) [68 FR 74819 (Dec. 24, 2003)] (‘‘Transaction Cost Concept Release’’). 416Spread costs are incurred indirectly when a fund buys a security from a dealer at the ‘‘asked’’ price (slightly above current value) or sells a security to a dealer at the ‘‘bid’’ price (slightly below current value). The difference between the bid price and the asked price is known as the ‘‘spread.’’ See Transaction Cost Concept Release, supra note 415. For equity securities listed on an exchange, the costs associated with trading the security typically take the form of brokerage commissions, as opposed to spread costs. 417See, e.g., Luxembourg Swing Pricing Survey, Reports & Guidelines, supra note 413; Association Francaise de la Gestion Financie`re, Charte de bonne conduit pour le Swing Pricing et les droits d’entre´e et de sortie ajustables acquis aux fonds (2014), available at http://www.afg.asso.fr/index.php ?option=com_content&view=article&id=5459 %3Acharte-de-bonne-conduite-pour-le-swingpricing-et-les-droits-dentree-et-de-sortie-ajustablesacquis-aux-fonds&catid=527%3A2014&lang=fr. The European Commission’s 2009 revised Undertakings for Collective Investment in Transferable Securities (‘‘UCITS’’) Directive does not specifically provide for swing pricing, but does provide that ‘‘[t]he rules for the valuation of assets and the rules for calculating the sale or issue price and the repurchase or redemption price of the units of a UCITS shall be laid down in the applicable national law, in the fund rules or in the instruments of incorporation of the investment company.’’ Directive 2009/65/EC of the European Parliament and of the Council of 13 July 2009 on the coordination of laws, regulations, and administrative provisions relating to undertakings for collective
investment in transferable securities, Official J. of the European Union (Nov. 2009), available at http://eur-lex.europa.eu/LexUriServ/ LexUriServ.do?uri=OJ:L:2009:302:0032 :0096:en:PDF, at Article 85. 418See Luxembourg Swing Pricing Survey, Reports & Guidelines, supra note 413; see also BlackRock Swing Pricing Paper, supra note 412 (discussing the results of the ALFI survey). The results of the ALFI survey indicated that the majority of respondents were already using swing pricing, and the number of fund managers using swing pricing had tripled over the previous five years. 419See supra note 16. 420See Comment Letter of AllianceBernstein L.P. on the FSOC Notice (Mar. 25, 2015) (noting that UCITS funds may utilize swing pricing to ‘‘accurately reflect the costs borne by other shareholders stemming from transaction costs’’); BlackRock FSOC Notice Comment Letter, supra note 50, at 5 and 39 (recommending that policy makers consider a ‘‘mechanism to allocate transaction costs to redeeming shareholders as a way to provide a price signal for the price of market liquidity and to reimburse or buffer a fund’s remaining shareholders’’); see also Nuveen FSOC Notice Comment Letter, supra note 45, at n.26 (‘‘The SEC could also study proposals to change the pricing mechanisms for mutual fund subscriptions and redemptions in such a way that, under certain pre-specified circumstances, subscribing and redeeming shareholders would bear the cost of portfolio transactions necessary to invest cash for new subscriptions and to fund redemptions.’’); Occupy the SEC FSOC Notice Comment Letter, supra note 45, at 13 (stating that investors buying or selling large amounts of fund shares impose costs on the fund that results in inequitable outcomes as long-term investors subsidize those who trade more actively and that for funds that hold illiquid assets these externalities can become quite material). 421See, e.g., Mutual Fund Redemption Fees, Investment Company Act Release No. 26782 (Mar. 11, 2005) [70 FR 13328 (Mar. 18, 2005)] (‘‘Rule 22c– 2 Adopting Release’’) at n.7 and accompanying text. 422Rule 22c–2 prohibits a fund from redeeming shares within seven days after the share purchase unless the fund meets three conditions. See rule 22c–2(a). First, the board of directors must either:
(i) Approve a redemption fee (in an amount not to exceed two percent of the value of shares redeemed), or (ii) determine that imposition of a redemption fee is either not necessary or not appropriate. Second, the fund (or its principal underwriter or transfer agent) must enter into a written agreement with each financial intermediary under which the intermediary agrees to, among other things: (i) Provide, at the fund’s request, identity and transaction information about shareholders who hold their shares through an account with the intermediary; and (ii) execute instructions from the fund to restrict or prohibit Continued portfolio assets until the next business day following the sale.414 In the example above, if the fund selling portfolio asset X sold the asset during the day at $8 on day 1, the price that the fund received for these asset sales would not be reflected in the fund’s NAV until day 2. Thus, redeeming shareholders would have received an exit price that would reflect portfolio asset X being valued at the close of the market at $9 on day 1, whereas remaining shareholders would hold shares on day 2 whose value reflects portfolio asset X being sold at $8 (the actual price that the fund received when it sold the asset on day one). Similarly, as noted above, the price that a purchasing shareholder pays for fund shares normally does not take into account trading and market impact costs that arise when the fund buys portfolio assets to invest the proceeds received from shareholder purchases. For example, when a fund experiences net inflows, it may invest the proceeds of shareholder purchases over several days following the purchase of fund shares. Thus, the purchase price that shareholders receive on day 1 would not reflect any transaction fees associated with investing the proceeds of shareholder purchases on subsequent days, or any market activity (including the fund’s purchase of portfolio assets) that increases the value of the fund’s portfolio assets. To illustrate, if the fund’s NAV on day 1 (and the purchase price an incoming shareholder were to receive on day 1) reflects portfolio asset X being valued at $10, but the fund were to purchase additional shares of portfolio asset X on day 2 at $11, the price that a purchasing shareholder pays on day 1 would not reflect the costs of investing the proceeds of the shareholder’s purchases of fund shares. These costs instead would be reflected in the fund’s NAV on days following the shareholder’s purchase, and thus would be borne by all of the investors in the fund, not only the shareholders who purchased on day 1. Certain foreign funds currently use ‘‘swing pricing,’’ the process of adjusting the fund’s NAV to effectively pass on the market impact costs,415 spread costs,416 and transaction fees and charges stemming from net capital activity (i.e., flows into or out of the fund) to the shareholders associated with that activity, in order to protect other shareholders from dilution arising
from these costs. Investment management industry representative associations operating in certain European jurisdictions have adopted guidelines on swing pricing procedures in recent years,417 and a survey conducted by the Association of the Luxembourg Fund Industry (‘‘ALFI’’) several years ago confirmed a strong directional trend towards the adoption of swing pricing among major market participants in that jurisdiction, which is a significant jurisdiction for the organization of UCITS funds in Europe.418 Likewise, several comments from asset managers received in response to the FSOC Notice 419 noted favorably that funds regulated under the UCITS Directive use swing pricing to allocate transaction costs to purchasing and redeeming shareholders.420 Commission rules and guidance do not currently address the ability of a fund to use swing pricing to mitigate potential dilution of fund shareholders. The Commission has previously recognized that excessive trading of mutual fund shares could dilute the value of long-term investors’ shares,421 however, and in response to this, the Commission adopted rule 22c–2 under the Investment Company Act. Rule 22c– 2, among other things, permits a fund to impose a fee of up to two percent on shareholders’ redemptions and requires fund boards to consider imposing redemption fees under certain circumstances.422 While redemption

future purchases or exchanges. Third, the fund must maintain a copy of each written agreement with a financial intermediary for six years. 423For example, adjusting a fund’s NAV in order to effectively require shareholders who are purchasing or redeeming shares of the fund to bear the costs associated with their purchases or redemptions could be viewed as a temporary change in a fund’s valuation policies that might conflict with long-standing Commission guidance that a fund’s valuation policies be ‘‘consistently applied.’’ See Accounting for Investment Securities by Registered Investment Companies, Investment Company Act Release No. 6295 (Dec. 23, 1970) [35 FR 19986 (Dec. 31, 1970)] (‘‘ASR 118’’). 424See Rule 38a–1 Adopting Release, supra note 90, at text following n.40 (noting that the pricing requirements of the Investment Company Act are ‘‘critical to ensuring fund shares are purchased and redeemed at fair prices and that shareholder interests are not diluted.’’). 425See rule 2a–7. 426Proposed rule 22c–1(a)(3)(v)(A) would define ‘‘exchange-traded fund’’ as ‘‘an open-end management investment company or a class thereof, the shares of which are traded on a national securities exchange, and that operates pursuant to an exemptive order granted by the Commission or in reliance on an exemptive rule adopted by the Commission.’’ 427Proposed rule 22c–1(a)(3). Under the proposed rule, ‘‘swing pricing’’ would be defined as ‘‘the process of adjusting a fund’s current net asset value per share to mitigate dilution of the value of its outstanding redeemable securities as a result of shareholder purchase and redemption activity, pursuant to the requirements set forth in [proposed rule 22c–1(a)(3)].’’ See proposed rule 22c– 1(a)(3)(v)(C). 428For purposes of this section III.F and the discussions of proposed rule 22c–1(a)(3) in this document, the term ‘‘fund’’ denotes a fund as defined in proposed rule 22c–1(a)(3), that is, ‘‘a registered open-end management investment company (but not a registered open-end management investment company that is regulated as a money market fund under § 270.2a–7 or an exchange traded fund as defined in [proposed rule 22c–1(a)(3)(v)(A)]).’’ 429Proposed rule 22c–1(a)(3)(ii)(A). 430Proposed rule 22c–1(a)(3)(i). 431Proposed rule 22c–1(a)(3)(i)(A). Under the proposed rule, ‘‘swing factor’’ would be defined as ‘‘the amount, expressed as a percentage of the fund’s net asset value and determined pursuant to the fund’s swing pricing procedures, by which a fund adjusts its net asset value per share when the level of net purchases or net redemptions from the fund has exceeded the fund’s swing threshold.’’ Proposed rule 22c–1(a)(3)(v)(B). We request comment on this definition in section III.F.1.e below. ‘‘Swing threshold’’ would be defined as ‘‘the amount of net purchases into or net redemptions from a fund, expressed as a percentage of the fund’s net asset value, that triggers the initiation of swing pricing.’’ Proposed rule
22c–1(a)(3)(v)(D). We request comment on this definition in section III.F.1.c below. 432Proposed rule 22c–1(a)(3)(i)(D). 433Proposed rule 22c–1(a)(3)(ii)(A). 434Proposed rule 22c–1(a)(3)(ii)(B). 435See infra section III.F.1.g; proposed rule 22c– 1(a)(3)(iii); proposed amendment to rule 31a– 2(a)(2). 436See infra section III.F.1.f. 437Proposed rule 22c–1(a)(3)(i)(A). fees (or purchase fees) could mitigate dilution arising from shareholder transaction activity, implementing a fee requires coordination with the fund’s service providers, which could entail operational complexity. On the other hand, adjusting a fund’s NAV, like imposing a fee, could pass on transaction-related costs to purchasing and redeeming shareholders, but could be simpler to implement because this adjustment would occur pursuant to the fund’s own procedures (as opposed to involving the intermediaries’ systems) and would be factored into the process by which a fund strikes its NAV. However, the Commission has not addressed whether a fund might adjust its current NAV to lessen dilution of the value of a fund’s outstanding securities, and the Commission’s current valuation guidance could raise questions about making such a NAV adjustment.423 Because we believe that swing pricing could be a useful tool in mitigating potential dilution of fund shareholders, we are proposing rule 22c–1(a)(3), which would permit certain mutual funds (but not ETFs or money market funds) to use swing pricing under certain circumstances. Proposed rule 22c–1(a)(3) specifies the conditions under which we believe swing pricing would be appropriately used. Below we describe in detail the proposed requirements that a fund using swing pricing would be obliged to follow, the objectives of the proposed rule, and certain considerations that a fund should generally assess in determining whether swing pricing would be an effective tool to prevent fund dilution and promote fairness among all its shareholders. The proposed rule is designed to promote all shareholders’ interests and promote practices that seek to ensure that a fund’s shares are purchased and redeemed at a fair price.424 We also believe that the proposed rule would provide a set of operational standards that would allow U.S. funds to gain comfort using swing pricing as a new means of mitigating potential dilution. We recognize that implementing swing pricing could give rise to a number of operational issues and questions, and we provide guidance and request comment on relevant operational considerations below.

Proposed Rule 22c–1(a)(3)
a. Overview and Objectives of Proposed Rule Under proposed rule 22c–1(a)(3), a registered open-end investment company (but not a registered investment company that is regulated as a money market fund,425 and not including an exchange-traded fund 426) would be permitted to establish and implement policies and procedures providing for the fund to adjust its current NAV to mitigate dilution of the value of its outstanding redeemable securities as a result of shareholder purchase and redemption activity.427 Specifically, a fund 428 would be permitted to establish and implement swing pricing policies and procedures that would require a fund to adjust its NAV under certain circumstances, provided that the fund’s board (including a majority of directors who are not interested persons of the fund) 429 must approve these policies and procedures, and the policies and procedures must include certain specified elements.430 A fund’s swing pricing policies and procedures must provide that the fund will adjust its NAV by an amount designated as the ‘‘swing factor’’ once the level of net purchases into or net redemptions from the fund has exceeded a specified percentage of the fund’s net asset value known as the ‘‘swing threshold.’’ 431 A fund would be required to adopt policies and procedures for determining and periodically reviewing its swing threshold. A fund’s swing pricing policies and procedures also would be required to include policies and procedures for determining a swing factor that would be used to adjust the fund’s NAV when the fund’s swing threshold is breached. While the swing factor could vary depending on the facts and circumstances, a fund’s policies and procedures for determining its swing factor must take certain specified factors into account.432 A fund’s board must approve the swing pricing policies and procedures (including the fund’s swing threshold), as well as any material change thereto,433 and the board would be required to designate the fund’s adviser or officers responsible for administering the policies and procedures.434 A fund would be required to abide by certain recordkeeping requirements relating to its swing pricing policies and procedures and any NAV adjustments made pursuant to these policies and procedures.435 In determining whether the fund’s level of net purchases or net redemptions has exceeded the fund’s swing threshold, the person(s) responsible for administering the fund’s swing pricing policies and procedures 436 would be permitted to make such determination on the basis of information obtained after reasonable inquiry.437 As discussed below, swing pricing requires the net cash flows for a fund to be known, or reasonably estimated, before determining whether to adjust the fund’s NAV on a particular

438See infra section III.F.2.a.
439Proposed rule 22c–1(a)(3)(i)(A).
440See BlackRock Swing Pricing Paper, supra note 412. 441See Luxembourg Swing Pricing Survey, Reports & Guidelines, supra note 413, at 12. But see infra paragraph following note 447 (noting that swing pricing could increase the volatility of a fund’s NAV in the short term, which could increase tracking error and could make a fund’s performance deviate from the fund’s benchmark during the period of volatility to a greater degree than if swing pricing had not been used). 442See Luxembourg Swing Pricing Survey, Reports & Guidelines, supra note 413, at 12. The Commission has previously recognized that costs arising from certain types of redemption activity (namely, short-term trading strategies, such as market timing) could dilute the value of long-term investors’ shares. See Rule 22c–2 Adopting Release, supra note 421. 443As discussed above, the Commission has previously recognized that excessive trading of fund shares could dilute the value of long-term investors’ shares, and in response to this, adopted rule 22c– 2, which permits a fund to impose redemption fees, and requires fund boards to consider imposing redemption fees, under certain circumstances. See supra notes 421–422. In addition, money market funds are permitted to use liquidity fees under rule 2a–7. See 2014 Money Market Fund Reform Adopting Release, supra note 85, at section III.A.5; see also discussion of money market fund liquidity fees in section III.F.1.b infra. Liquidity fees (including ‘‘dilution levies’’ used by certain UCITS) are also used in some foreign jurisdictions, as a distinct liquidity risk management tool separate from swing pricing. See infra notes 467–468 and accompanying text. 444See supra note 422 and accompanying and following text. 445See, e.g., supra note 423 for a discussion of different methods of valuing portfolio assets, as considered in ASR 118. day.438 Because the deadline by which a fund must strike its NAV may precede the time that a fund receives final information concerning daily net flows from the fund’s transfer agent or principal underwriter, we believe it is appropriate to permit the person responsible for administering swing pricing policies and procedures to determine whether net purchases or net redemptions have exceeded the fund’s swing threshold on the basis of information obtained after reasonable inquiry. The operational processes associated with swing pricing are discussed in more detail below at
section III.F.2.a.
Under the proposed rule, in-kind purchases and in-kind redemptions would be excluded from the calculation of net purchases and net redemptions for purposes of determining whether a fund’s net purchases or net redemptions exceed its swing threshold.439 When a fund investor purchases or redeems shares of a fund in kind as opposed to in cash, this does not necessarily cause the fund to trade any of its portfolio assets. We therefore believe that the risk of dilution as a result of shareholder purchase and redemption activity is lower with respect to in-kind purchases and in-kind redemptions, and thus swing pricing would not be permitted unless a fund’s net purchases or net redemptions that are made in cash (and not in kind) exceed the fund’s swing threshold. We are proposing rule 22c–1(a)(3) to provide funds with a tool to mitigate the potentially dilutive effects of shareholder purchase and redemption activity. Funds would be able to adopt swing pricing policies and procedures in their discretion (although, once these policies and procedures are adopted, a fund would be required to adjust its NAV when net purchases or net redemptions cross the swing threshold, unless the fund’s board approves a change to the fund’s swing threshold). When a fund that has adopted swing pricing experiences net purchases exceeding the swing threshold, it would adjust its NAV upward, which would effectively require purchasing shareholders to cover near-term costs associated with the fund investing in additional portfolio assets. Conversely, when a fund that has adopted swing pricing experiences net redemptions exceeding the swing threshold, it would adjust its NAV downward, which would effectively require redeeming shareholders to cover near-term costs associated with the fund selling portfolio assets. In both cases, swing pricing would result in the costs of trading portfolio assets (along with transaction fees and charges relating to these trades) being passed on to purchasing and redeeming shareholders. As discussed above, some foreign funds currently use swing pricing, which suggests that these funds consider swing pricing to be a valuable and effective means of decreasing dilution. Indeed, one investment manager conducted a study of its funds whose prices swung over a one-year period (over fifty funds) and found that the performance of each of these funds would have been impaired, in some cases quite considerably, had the manager not implemented a swing pricing policy.440 Likewise, ALFI has noted that studies have shown that ‘‘[f]unds that apply swing pricing show superior performance over time compared to funds (with identical investment strategies and trading patterns) that do not employ antidilution measures,’’ and that ‘‘[s]wing pricing helps preserve investment returns as the value to long-term investors normally exceeds the value of the swing factor applied on entry to or exit from the fund.’’ 441 We believe that the swing pricing policies contemplated by
the proposed rule, which are similar to those used by some foreign funds, could mitigate dilution arising from shareholders’ purchase and redemption activity.442 As opposed to purchase and redemption fees or liquidity fees, which could also prevent fund dilution arising from purchase or redemption activity,443 swing pricing would occur pursuant to the fund’s own procedures and would not require coordination with the fund’s service providers because the swing pricing adjustment would be factored into the process by which a fund strikes its NAV.444 In addition to mitigating potential dilution arising from purchase and redemption activity, swing pricing also could help deter redemptions motivated by any first-mover advantage. That is, if remaining shareholders understood that redeeming shareholders would bear the estimated costs of their redemption activity, it would reduce their incentive to redeem quickly because there would be less risk that they would bear the costs of other shareholders’ redemption activity. In considering the swing pricing proposal, we considered proposing a rule that would permit ‘‘dual pricing’’ as opposed to swing pricing. We understand that certain foreign funds use dual pricing as an alternative means of mitigating potential dilution arising from shareholder transaction activity. A fund using dual pricing would not adjust the fund’s NAV by a swing factor when it faces high levels of net purchases or net redemptions, but instead would quote two prices—one for incoming shareholders (reflecting the cost of buying portfolio securities at the ask price in the market), and one for outgoing shareholders (reflecting the proceeds the fund would receive from selling portfolio securities at the bid price in the market).445 While we believe that dual pricing also could mitigate potential dilution, we believe that swing pricing is a preferable alternative because we believe it would be simpler to implement and for investors to understand. Swing pricing would permit a fund to continue to transact using one price, as they do today (instead of transacting using separate prices for purchasing and redeeming shareholders), and also would permit a fund to price its shares without adjustment unless the level of net purchases or net redemptions were to cross the fund’s swing threshold. We recognize that swing pricing may involve potential disadvantages to funds as well as potential advantages, and the provisions of proposed rule 22c–1(a)(3) are designed to maximize the relative

446But see supra notes 440–441 and accompanying text (noting that swing pricing has been found to benefit fund performance over the long term). 447But see Luxembourg Swing Pricing Survey, Reports & Guidelines, supra note 413, at 6 (of the respondents surveyed by ALFI, the majority employed a partial swing approach, with only a select few choosing the full swing method). 448See Luxembourg Swing Pricing Survey, Reports & Guidelines, supra note 413, at 17. 449For example, a fund may not need to sell portfolio assets to pay redemptions below a certain threshold if it maintains a certain percentage of its net assets in cash or cash equivalents. 450See infra section III.F.1.f. 451See Luxembourg Swing Pricing Survey, Reports & Guidelines, supra note 413, at 8 (of the respondents surveyed by ALFI, the majority of those that used swing pricing ‘‘were reluctant to advantages and respond to potential concerns associated with swing pricing. While swing pricing protects against dilution at the fund level and could act as a deterrent against redemptions motivated by any first-mover advantage, the potential disadvantages of swing pricing (described in more detail below) include increased performance volatility and the fact that the precise impact of swing pricing on particular purchase and redemption requests would not be known in advance and thus may not be fully transparent to investors. Under proposed rule 22c–1(a)(3), swing pricing would be a voluntary tool for funds, and thus a fund would be able to weigh the potential advantages and disadvantages of swing pricing in relation to the fund’s particular circumstances and risks, as well as the other tools the fund uses to manage risks relating to dilution and liquidity. The swing pricing requirements in proposed rule 22c–1(a)(3) aim to minimize NAV volatility (and related tracking error) associated with swing pricing to the extent possible. Swing pricing could increase the volatility of a fund’s NAV in the short term, because NAV adjustments would occur when the fund’s net purchases or net redemptions pass the fund’s swing threshold. Thus, the fund’s NAV would show greater fluctuation than would be the case in the absence of swing pricing. This volatility might increase tracking error (i.e., the difference in return based on the swung NAV compared to the fund’s benchmark) during the period of NAV adjustment, and could make a fund’s short-term performance deviate from the fund’s benchmark to a greater degree than if swing pricing had not been used.446 Volatility and tracking error related to swing pricing could, therefore, result in investors incorrectly perceiving the short-term relative performance of a fund. This could potentially cause market distortions if investors were to incorrectly rate the performance of funds that use swing pricing compared to funds that do not, and shifted their invested assets from funds that use swing pricing to funds that do not as a result of this perception. Volatility and
tracking error related to swing pricing also may activate alerts in monitoring systems that follow fund performance, which could in turn trigger purchases or redemptions in automated fund advisory services whose algorithms are driven by fund performance. However, we believe that the use of partial swing pricing, described below, would significantly reduce the performance volatility potentially associated with swing pricing. In addition, swing pricing should have a minimal effect on longerterm performance volatility and longerterm tracking error. Taking these considerations into account, we do not believe that volatility would generally be a significant deterrent to funds using swing pricing. We do request comment below on the potential effects of swing pricing on funds’ performance volatility and any potential market distortions that could result if some funds adopt swing pricing but other, similarly situated funds do not. Proposed rule 22c–1(a)(3) envisions partial swing pricing (that is, a NAV adjustment would not be permitted unless net purchases or net redemptions exceed a threshold set by the fund and approved by the fund’s board) and not full swing pricing (that is, a NAV adjustment any time the fund experiences net purchases or net redemptions). Some foreign funds employ full swing pricing,447 and there are certain advantages to full swing pricing (e.g., a fund using full swing pricing would not be required to determine an appropriate swing threshold).448 However, we believe partial swing pricing would generally cause lower NAV volatility than full swing pricing. The use of partial swing pricing also recognizes that net purchases and net redemptions below a certain threshold might not require a fund to trade portfolio assets,449 and therefore a NAV adjustment, and any associated NAV volatility, might not be appropriate if purchases and redemptions would not result in costs associated with asset purchases and sales. We recognize that there are other trade-offs that a fund would have to consider in determining to implement swing pricing. For example, application of a swing factor would affect all purchasing and redeeming shareholders equally, regardless of whether the size of an individual shareholder’s purchases or redemptions alone would create material trading costs for the fund. This could cause certain shareholders to experience benefits or costs, relative to the other shareholders in the fund, that otherwise would not exist. For example, an investor who purchases fund shares on a day when a fund adjusts its NAV downward would pay less to enter the fund than if the fund had not adjusted is NAV on that day. And, while a small investor’s redemption requests would not likely create significant liquidity costs for the fund on its own, if this investor were to redeem on the same day that the fund’s net redemptions cross the swing threshold, his or her redemption proceeds would be reduced by the NAV adjustment. These concerns, however, are
partially mitigated by the fact that shareholders could be assured that the same threshold level of net purchase and net redemption activity (as approved by the fund’s board) would consistently trigger the use of swing pricing, unless the fund’s board and a majority of the fund’s independent directors were to approve a change in the fund’s swing threshold.450 Furthermore, we believe that investors who purchase shares on a day that a fund adjusts its NAV downward would not create dilution for non-redeeming shareholders (even though the purchasing shareholders may be receiving a lower price than would be the case if the NAV was not adjusted downward). Under these circumstances, shareholders’ purchase activity would provide liquidity to the fund, which could reduce the fund’s liquidity costs and thereby could decrease the swing factor. This could potentially help redeeming shareholders to receive a more favorable redemption price than they otherwise would have if there had been less purchase activity on that day, but would not affect the interests of non-redeeming investors. We believe that an adequate level of transparency about swing pricing is critical for investors to understand the risks associated with investing in a particular fund. As discussed in section III.G below, proposed disclosure and reporting requirements regarding swing pricing would assist shareholders in understanding whether a particular fund has implemented swing pricing policies and procedures and has used swing pricing. We are not, however, proposing to require a fund to publicly disclose its swing threshold, because of concerns that certain shareholders may attempt to time their transactions based on this information,451 as well as

disclose the level of [swing] threshold they apply . . . [and some] commented that the act of disclosing these details was contradictory to the principle of investor protection and therefore avoided disclosing the threshold.’’ ALFI noted that ‘‘[o]n balance it appears that the majority of promoters prefer not to disclose thresholds to ensure clients do not actively manage trades below the trigger level of the partial swing.’’). concerns that disclosure could be confusing or potentially misleading insofar as it could give an inaccurate view of funds’ relative risks and benefits. For example, a shareholder might assume that Fund X with a swing threshold of 5% is inherently more risky and thus a ‘‘worse’’ investment than Fund Y with a swing threshold of 7% because a lower level of net flows would cause Fund X to adjust its NAV than Fund Y. But the relative performance and risks of both funds could depend on additional considerations, even excluding differences in the various market, credit, liquidity, and other risks associated with the funds’ portfolio assets. These considerations could include the swing factors the funds would use to adjust their NAV and the frequency with which each fund would encounter net purchases or net redemptions that cross the fund’s swing threshold. Although funds would not be required to disclose their swing threshold, the use of partial swing pricing as opposed to full swing pricing could give shareholders comfort that, under circumstances in which the fund is experiencing relatively low purchases or redemptions, the fund’s NAV will likely not be adjusted. Request for Comment We seek comment on the general swing pricing process as contemplated by proposed rule 22c–1(a)(3). We seek specific comment on the process a fund would use to determine and review its swing threshold and to calculate the swing factor it would use to adjust its NAV, and on the proposed approval and oversight requirements associated with swing pricing policies and procedures, below.

Do commenters agree that swing
pricing could be a useful tool for U.S. registered funds in mitigating potential dilution of fund shareholders? Do commenters believe that dilution arising from costs associated with certain purchases or redemptions of fund shares is a significant problem that funds currently face, have historically faced under certain market conditions, or might be expected to face in the future?
Do commenters agree that the
proposed rule should require a fund that adopts swing pricing policies and procedures to adjust the fund’s NAV when the fund’s level of net purchases or redemptions exceeds the fund’s swing threshold? Or should the proposed rule instead only require a fund that adopts swing pricing policies and procedures to adjust the fund’s NAV when the fund’s level of net redemptions exceeds the swing threshold? Alternatively, should the proposed rule permit a fund to choose whether to adopt swing pricing policies and procedures that would: (i) Require the fund to adjust its NAV when the fund’s level of net purchases or redemptions exceeds the fund’s swing threshold; or (ii) require the fund to adjust its NAV only when the fund’s level of net redemptions exceeds the fund’s swing threshold? Are there greater concerns about the potential for dilution associated with net redemptions than those associated with net purchases?
Should a fund be permitted to use
full swing pricing, as opposed to the partial swing pricing contemplated by the proposed rule? Why or why not?
Under the proposed rule, when net
purchases or net redemptions of a fund that has adopted swing pricing policies and procedures exceed the fund’s swing threshold, the price that all purchasing or redeeming shareholders would receive for fund shares would be adjusted pursuant to the fund’s swing pricing policies and procedures. Should a fund instead be permitted to exempt certain shareholders (for example, purchasing shareholders on days when the fund’s share price is adjusted downward, or small shareholders whose purchase or redemption activity would not likely create significant liquidity costs for the fund) from receiving an adjusted share price on a day when the fund’s net purchases or redemptions exceed the swing threshold? Why or why not?
Would the use of purchase fees,
redemption fees and/or liquidity fees (either separately or in combination) be a more or less effective means of mitigating potential dilution than swing pricing? Why or why not? Would the use of purchase fees, redemption fees and/or liquidity fees (either separately or in combination) entail burdens and costs that are higher or lower than the burdens and costs associated with swing pricing? What types of operational challenges would arise with swing pricing as opposed to purchase fees, redemption fees, and liquidity fees? Are purchase fees, redemption fees, and liquidity fees feasible for those funds whose shares are primarily held through third-party intermediaries?
Would the use of dual pricing be a
more or less effective means of mitigating potential dilution than swing pricing? What types of operational challenges would arise with swing pricing vs. dual pricing?
Would allowing funds to require
certain investors to accept in-kind redemptions in certain circumstances be a more or less effective means of mitigation potential dilution than swing pricing in those circumstances?
Do commenters agree that the swing
pricing framework contemplated by proposed rule 22c–1(a)(3) responds as effectively as possible to the potential concerns associated with swing pricing? Specifically, we request comment on the extent to which the swing pricing requirements incorporated into the proposed rule would reduce volatility and respond to transparency-related concerns. Would any performance volatility that could result from swing pricing result in market distortions if some funds adopt swing pricing but other, similarly situated funds do not? Do commenters believe that the use of partial swing pricing, as opposed to full swing pricing, would mitigate concerns that the swing pricing would increase a fund’s volatility? Do these proposed requirements also effectively respond to transparency-related concerns associated with swing pricing, and would the proposed disclosure requirements regarding swing pricing also respond to transparency concerns? Would any alternative or additional swing pricing requirements more effectively respond to potential concerns about volatility or transparency (or any other concerns) associated with swing pricing?
As proposed, rule 22c–1(a)(3)
would permit, but not require, a fund to adopt swing pricing policies and procedures. What process do commenters anticipate that a fund may use to weigh the potential advantages and disadvantages of swing pricing in relation to the fund’s particular circumstances and risks? Should each fund’s board be required to determine whether swing pricing is appropriate for each fund? Should all funds, or a particular subset of funds (e.g., funds whose three-day liquid asset minimums are below a certain level, or whose less liquid assets are above a certain level) be required to use swing pricing? Do commenters expect funds would decide that swing pricing would be an effective anti-dilution tool, in spite of potential concerns about volatility or transparency (or any other potential concerns)?
Proposed rule 22c–1(a)(3) would
permit the person(s) responsible for administering a fund’s swing pricing policies and procedures to make the

452As discussed above, for purposes of the proposed amendments to rule 22c–1, ‘‘exchangetraded fund’’ includes an ETMF. 453Rule 2a–7 provides exemptions from rule 22c– 1 for money market funds, to permit certain money market funds to use the amortized cost method and/ or the penny-rounding method to calculate its NAV, and to permit a money market fund to impose liquidity fees and temporarily suspend redemptions. See rule 2a–7(c)(1)(i); rule 2a–7(c)(2). 454Outside the U.S., it is a common industry practice for funds within a fund complex each to have an individual swing threshold, or for some funds within a complex to use swing pricing while others do not. See, e.g., BlackRock Swing Pricing Paper, supra note 412; J.P. Morgan Asset Management, Swing pricing: The J.P. Morgan Asset Management Approach in the Luxembourg Domiciled SICAVs, JPMorgan Funds and JPMorgan Investment Funds Insight (June 2014), available at http://www.jpmorganassetmanagement.de/DE/dms/ Swing%20Pricing%20%5bMKR%5d%20%5bIP_ EN%5d.pdf (‘‘J.P. Morgan Asset Management Swing Pricing Paper’’). 455See supra note 439 and accompanying paragraph. 456See, e.g., supra notes 136 and 141 and accompanying text. 457See supra section III.A.2. 458As discussed previously, ETMF market makers would not engage in the same arbitrage as ETF market makers because all trading prices of ETMF shares are linked to NAV. See supra note 32 and accompanying text. ETMFs would charge transaction fees that mitigate the risk of dilution, and therefore we do not propose to include ETMFs within the scope of proposed rule 22c–1(a)(3). 459See, e.g., supra note 14 and accompanying text. 460See supra note 451 and accompanying paragraph (noting that a fund would not be required to disclose its swing threshold under the proposed rule). determination of whether the fund’s level of net purchases or redemptions has exceeded the fund’s swing threshold ‘‘on the basis of information obtained after reasonable inquiry.’’ Do commenters agree that this would be appropriate? Why or why not? Is the phrase ‘‘information obtained after reasonable inquiry’’ clear? If not, how could this term be clarified within the context of the proposed rule?

As proposed, rule 22c–1(a)(3)
would require a fund to exclude any purchases or redemptions that are made in kind and not in cash when determining whether the fund’s level of net purchases or net redemptions has exceeded the fund’s swing threshold. Is this exclusion appropriate? Why or why not? b. Scope of Proposed Rule Proposed rule 22c–1(a)(3) would apply to all registered open-end management investment companies, with the exception of money market funds and ETFs.452 While rule 22c–1(a) generally applies to all registered investment companies issuing redeemable securities,453 we believe that only open-end mutual funds (and, as discussed below, not UITs or ETFs) are generally susceptible to the risk that shareholder redemption activity could dilute the value of outstanding shares held by existing shareholders. And as discussed below, we believe money market funds, while potentially susceptible to this risk, already have extensive tools at their disposal to mitigate potential shareholder dilution. All investment companies that fall within the scope of proposed rule 22e– 4, with the exception of ETFs, would be permitted to use swing pricing under proposed rule 22c–1(a)(3), and a fund may decide to adopt swing pricing policies and procedures as part of the liquidity risk management program it would be required to implement under proposed rule 22e–4. Under proposed rule 22c–1(a)(3), swing pricing would be voluntary for funds, and some fund complexes may decide to use swing pricing for certain funds within the complex but not others, or establish different swing thresholds for different funds within the complex.454 As discussed above, funds would be required to exclude any purchases and redemptions that are made in kind, and not in cash, in determining whether the fund’s level of net purchases or net redemptions has exceeded the fund’s swing threshold.455 This could functionally limit the ability of a fund that often permits in-kind purchases and in-kind redemptions to use swing pricing, or discourage such a fund from adopting swing pricing policies and procedures, because the fund’s level of net purchases or net redemptions as calculated pursuant to proposed rule 22c–1(a)(3) may never (or rarely) reach the fund’s swing threshold as determined pursuant to the proposed rule. We are not proposing to include closed-end investment companies, UITs, ETFs or money market funds within the scope of proposed rule 22c–1(a)(3). Closed-end investment companies do not issue redeemable securities and therefore would not incur costs associated with shareholder purchase and redemption activity that would necessitate swing pricing. Similarly, where a UIT sponsor maintains a secondary market in units of a UIT series, we believe that the series is unlikely to ever need to use swing pricing. In addition, since UITs do not frequently trade their underlying securities, but instead maintain a relatively fixed portfolio, investor flows do not generally affect the portfolio, and thus purchases and sales of
UIT shares would not likely produce dilutive effects to existing shareholders.456 Although we believe that ETFs could experience liquidity risk and thus have included them within the scope of proposed rule 22e–4,457 we are proposing not to include ETFs within the scope of proposed rule 22c–1(a)(3) because we believe—as described more fully below—that ETFs’ purchase and redemption practices do not generally entail the risk of dilution as a result of authorized participants’ purchase and redemption activity, and that swing pricing could impede the effective functioning of an ETF’s arbitrage mechanism. Unlike mutual funds, which typically internalize the costs associated with purchases and redemptions of shares, ETFs typically externalize these costs by charging a fixed and/or variable fee to authorized participants who purchase creation units from, and sell creation units to, an ETF. The fixed and/or variable fees are imposed to offset both transfer and other transaction costs that may be incurred by the ETF (or its service providers), as well as brokerage, tax-related, foreign exchange, execution, market impact and other costs and expenses related to the execution of trades resulting from such transaction. The amount of these fixed and variable fees typically depends on whether the authorized participant effects transactions in kind versus in cash and is related to the costs and expenses associated with transaction effected in kind versus in cash. When an authorized participant redeems ETF shares by selling a creation unit to the ETF, for example, the fees imposed by the ETF defray the costs of the liquidity that the redeeming authorized participant receives, which in turn mitigates the risk that dilution of nonredeeming authorized participants would result when an ETF redeems its shares. In addition to our belief that ETFs’ purchase and redemption practices would generally not entail the risk of dilution for existing shareholders, we are also not including ETFs within the scope of the proposed rule because we believe that swing pricing could impede the effective functioning of an ETF’s arbitrage mechanism.458 As discussed above, the effective functioning of the arbitrage mechanism is necessary in order for an ETF’s shares to trade at a price that is at or close to the NAV of the ETF.459 If an ETF were to adopt swing pricing policies and procedures, as conceptualized under the proposed rule, an authorized participant would not know whether the ETF’s NAV would be adjusted by a swing factor on any given day and therefore may not be able to assess whether an arbitrage opportunity exists.460 The Commission

461See, e.g., Spruce ETF Trust, et al., Investment Company Act Release No. 31301 (Oct. 21, 2014) [79 FR 63964 (Oct. 27, 2014)] (notice of application for exemptive relief) (to the extent that investors would have to exit at a price substantially below the NAV of the ETF, this would be ‘‘contrary to the foundational principle underlying section 22(d) and rule 22c–1 under the Act that all shareholders be treated equitably when buying and selling their fund shares’’); Precidian ETFs Trust, et al., Investment Company Act Release No. 31300 (Oct. 21, 2014) [79 FR 63971 (Oct. 27, 2014)] (notice of application for exemptive relief) (‘‘A close tie between market price and NAV per share of the ETF is the foundation for why the prices at which retail investors buy and sell ETF shares are similar to the prices at which Authorized Participants are able to buy and redeem shares directly from the ETF at NAV. This close tie between prices paid by retail investors and Authorized Participants is important because section 22(d) and rule 22c–1 under the Act are designed to require that all fund shareholders be treated equitably when buying and selling their fund shares.’’). 462See rule 2a–7(c)(2); see also 2014 Money Market Fund Reform Adopting Release, supra note 85, at section III.A. 463See, e.g., 2014 Money Market Fund Reform Adopting Release, supra note 85, at n.139 and accompanying text. 464See id. at n.120. 465See supra note 462. 466For example, retail and government money market funds are permitted to maintain a stable NAV, reflecting in part our understanding that investors in these products have a low tolerance for NAV volatility. See 2014 Money Market Fund Reform Adopting Release, supra note 85, at section III.B.3.c. Investors in floating NAV money market funds also could be sensitive to principal volatility, as we recognized in adopting requirements that all money market funds disclose their daily net asset value (rounded to the fourth decimal place) on their Web sites, and as we discussed in the economic analysis of the 2014 Money Market Fund Reform Adopting Release. See id. at section III.E.9 and
section III.K.
467See, e.g., BlackRock Fund Structures Paper, supra note 30, at 6; see also supra note 422 and accompanying and following text (discussing redemption fees that are currently permitted under rule 22c–2 and noting that, while redemption fees could mitigate dilution arising from redemption activity, implementing a fee requires coordination with the fund’s service providers, which could entail operational complexity). 468See BlackRock Fund Structures Paper, supra note 30, at 6. has historically considered the effective functioning of the arbitrage mechanism to be central to the principle that all shareholders be treated equitably when buying and selling their fund shares.461 Therefore, we believe that the implementation of swing pricing by an ETF could raise concerns about the equitable treatment of shareholders, to the extent that swing pricing could impede the effective functioning of the arbitrage mechanism. We are also not proposing to include money market funds within the scope of proposed rule 22c–1(a)(3). Money market funds are subject to extensive requirements concerning the liquidity of their portfolio assets. Also, a money market fund (other than a government fund) is permitted to impose a liquidity fee on redemptions if its weekly liquid assets fall below a certain threshold, and these fees serve a similar purpose as the NAV adjustments contemplated by swing pricing.462 That is, money market fund liquidity fees allocate at least some of the costs of providing liquidity to redeeming rather than existing shareholders,463 and also generate additional liquidity to meet redemption requests.464 We therefore believe that money market funds already have liquidity risk management tools at their disposal that could accomplish comparable goals to the swing pricing that would be permitted under proposed rule 22c–1(a)(3). We also believe that the liquidity fee regime permitted under rule 2a–7 is a more appropriate tool for money market funds to manage the allocation of liquidity costs than swing pricing. First, while funds would be able to adopt swing pricing policies and procedures at their discretion, rule 2a–7 requires a money market fund under certain circumstances to impose a 1% liquidity fee on each shareholder’s redemption, unless the fund’s board of directors (including a majority of its independent directors) determines that such fee is not in the best interests of the fund, or determines that a lower or higher fee (not to exceed 2%) is in the best interests of the fund.465 Money market funds also have unique minimum liquid asset requirements, and we believe the use of liquidity fees is appropriately tied to those requirements. Finally, we anticipate that open-end funds that adopt swing pricing policies and procedures would be required under such procedures to adjust their NAV on a relatively regular basis (whenever the fund’s net purchases or net redemptions exceed the fund’s swing threshold). In contrast, money market fund investors
(particularly, investors in stable-NAV money market funds) are particularly sensitive to price volatility,466 and we anticipate liquidity fees will be used only in times of stress when money market funds’ internal liquidity has been partially depleted. We note that some foreign jurisdictions have a similar conception of liquidity fees as a distinct tool separate from swing pricing. For example, in Europe, UCITS may use swing pricing and apply ‘‘dilution levies.’’ 467 While many UCITS use swing pricing as a matter of normal course, dilution levies may be considered a liquidity risk management tool that is used in connection with stressed conditions.468 Request for Comment We seek comment on the scope of proposed rule 22c–1(a)(3).

Do commenters agree that the
proposed rule should apply to all registered open-end management investment companies except money market funds and open-end ETFs?
Do commenters agree that the risk
of investor dilution is low for closedend investment companies and UITs, and thus closed-end investment companies and UITs should not be included within the scope of proposed rule 22c–1(a)(3)?
Do commenters agree that the risk
of investor dilution is low for ETFs, whether ETFs purchase and redeem in cash or in kind? Why or why not? Do commenters agree that swing pricing could adversely affect the effective functioning of an ETF’s arbitrage mechanism? Why or why not? Regardless of these considerations, should ETFs be permitted to use swing pricing, and do commenters anticipate that ETFs would use swing pricing if the scope of proposed rule 22c–1(a)(3) were expanded to include ETFs?
If the scope of the proposed rule
were expanded to include ETFs, are there any swing pricing operational considerations specific to ETFs that we should address? For example, if an ETF were to adopt swing pricing, how should we address any shareholder fairness implications that could result if certain authorized participants were to transact in cash and others were to transact in kind on a day when the fund swings its NAV? Should ETFs be permitted to use swing pricing in addition to imposing transaction fees on authorized participants, or as an alternative to such fees? Should we address implications of the proposed rule on exemptive relief that has been granted to existing ETFs? Should we also consider the implications of the proposed rule on an ETF that operates as a share class of a fund that also offers mutual fund share classes, or on an ETF that operates as a feeder fund investing in a master fund alongside mutual fund feeder funds?
We seek comment on how the
utilization of swing pricing by an ETF could affect the capital markets, in particular, market-making in the ETF. If the scope of the rule were expanded to include ETFs, would market makers and other market participants that contribute to ETF market-making be less willing to do so if it were unclear when an ETF that has adopted swing pricing policies and procedures would adjust its NAV, and to what extent swing pricing would affect the ETF’s end-of-day NAV?

469See ETMF Notice, supra note 15.
470Proposed rule 22c–1(a)(3)(i)(A). Under the proposed rule, ‘‘swing threshold’’ would be defined as ‘‘the amount of net purchases into or net redemptions from a fund, expressed as a percentage of the fund’s net asset value, that triggers the initiation of swing pricing.’’ Proposed rule 22c– 1(a)(3)(v)(D). We request comment on this definition at the end of this section III.F.1.c. 471Proposed rule 22c–1(a)(3)(i)(B). 472See infra section III.F.1.f. 473Proposed rule 22c–1(a)(3)(i)(B). These factors overlap significantly with factors that we understand are commonly considered by funds that use swing pricing in other jurisdictions, in order to determine a fund’s swing threshold. For example, the Luxembourg Swing Pricing Survey, Reports & Guidelines provides that factors influencing the determination of the swing threshold ordinarily include: (i) Fund size; (ii) type and liquidity of securities in which the fund invests; (iii) costs (and hence, the dilution impact) associated with the markets in which the fund invests; and (iv) investment manager’s investment policy and the extent to which the fund can retain cash (or near cash) as opposed to always being fully invested). See Luxembourg Swing Pricing Survey, Reports & Guidelines, supra note 413, at 14. 474See proposed rule 22e–4(b)(2)(iii)(A)(1), proposed rule 22e–4(b)(2)(iii)(B), proposed rule 22e–4(b)(2)(iii)(D) (requiring a fund to consider, in assessing its liquidity risk, the ‘‘size, frequency, and volatility of historical purchases and redemptions of fund shares during normal and stressed periods,’’ the fund’s ‘‘investment strategy and liquidity of portfolio assets,’’ and the fund’s ‘‘holdings of cash and cash equivalents, as well as borrowing arrangements and other funding sources,’’ respectively). 475See proposed rule 22e–4(a)(7).

The proposed definition of
‘‘exchange-traded fund’’ in rule 22c–1 would include ETMFs. While no ETMF has been launched yet, if an ETMF were to begin operations pursuant to applicable exemptive relief, it would arrange for an independent third party to disseminate the intraday indicative value of the ETMF’s shares, which an investor would use to estimate the number of shares to buy or sell based on the dollar amount in which the investor wants to transact.469 To what extent would a NAV adjustment effected by swing pricing make an investor’s estimate less accurate, given that such adjustment would not be reflected in the intraday indicative value of the ETMF’s shares disseminated during the trading day?
Do commenters agree that money
market funds already have liquidity risk management tools at their disposal that could accomplish comparable goals to swing pricing, and that the liquidity fee regime permitted under rule 2a–7 is a more appropriate tool for money market funds to manage the allocation of liquidity costs than swing pricing? Would there be any reason to extend the scope of proposed rule 22c–1(a)(3) to floating NAV money market funds?
c. Determining the Fund’s Swing
Threshold
Under proposed rule 22c–1(a)(3), a fund’s swing pricing policies and procedures must provide that the fund is required to adjust its NAV once the level of net purchases or net redemptions from the fund has exceeded a set, specified percentage of the fund’s net asset value known as the ‘‘swing threshold.’’ 470 A fund would be required to adopt policies and procedures for determining its swing threshold,471 and as discussed below, the swing threshold and any changes thereto must be approved by the fund’s board of directors.472 In specifying its swing threshold, a fund would be required to consider:
Æ The size, frequency, and volatility of historical net purchases or net redemptions of fund shares during normal and stressed periods; Æ The fund’s investment strategy and the liquidity of the fund’s portfolio assets; Æ The fund’s holdings of cash and cash equivalents, as well as borrowing arrangements and other funding sources; and Æ The costs associated with transactions in the markets in which the fund invests.473 In order to effectively mitigate possible dilution arising in connection with shareholder purchase and redemption activity, a fund’s swing threshold should generally reflect the estimated point at which net purchases or net redemptions would trigger the fund’s investment adviser to trade portfolio assets in the near term, to a degree or of a type that may generate material liquidity or transaction costs for the fund. As discussed below, we believe that a consideration of the factors set forth above would permit a fund to estimate this point. The liquidity or transaction costs associated with purchase or redemption activity can dilute the value of existing shareholders’ interests in the fund, and the purpose of swing pricing is to lessen this potential dilution. Trading assets to meet purchase or redemption requests is not in and of itself an indication that a fund will incur material liquidity or transaction costs. For example, trading smaller levels of very liquid assets would likely not produce significant costs to the fund. However, trading portfolio assets to a significant degree, or trading relatively less liquid assets within a short time frame in order to invest proceeds from purchases or satisfy redemption requests, could generate material costs to the fund that could dilute the value of fund shares held by existing investors. We believe that evaluating the factors that proposed rule 22c–1(a)(3) would require a fund to consider in specifying its swing threshold would assist a fund in determining what level of net purchases or net redemptions would generally lead to a trade of portfolio assets that would result in material costs to the fund. Assessing the size, frequency, and volatility of historical net purchases and net redemptions of fund shares would permit a fund to determine its typical levels of net purchases and net redemptions and the levels the fund could expect to encounter during periods of unusual market stress, as well as the frequency with which the fund could expect to see periods of unusually high purchases or redemptions. We believe that comparing the fund’s historical flow patterns with the fund’s investment strategy, the liquidity of the fund’s portfolio holdings, the fund’s holdings of cash and cash equivalents and borrowing arrangements and other funding sources, and the costs associated with transactions in the markets in which the fund invests would allow a fund to predict what levels of purchases and redemptions would result in material costs under a variety of scenarios. The first three factors that
proposed rule 22c–1(a)(3)(i)(B) would require a fund to consider in specifying the fund’s swing threshold correspond with certain of the factors a fund would be required to consider in assessing its liquidity risk.474 This is because evaluating a fund’s liquidity risk, or the risk that the fund could not meet expected and reasonably foreseeable requests to redeem its shares without materially affecting the fund’s NAV,475 is a similar exercise to determining the fund’s swing threshold (which, as discussed above, should generally reflect the estimated point at which net purchases or net redemptions would trigger the fund’s investment manager to trade portfolio assets in the near term, to a degree or of a type that may generate material liquidity or transaction costs for the fund). For this reason, we believe that the issues a fund would consider in assessing the extent to which the (i) size, frequency, and volatility of historical purchases and redemptions of fund shares during normal and stressed periods, (ii) the fund’s investment strategy and portfolio liquidity, and (iii) the fund’s holdings of cash and cash equivalents, borrowing arrangements and other funding sources would affect the fund’s liquidity risk also are relevant when a fund determines its swing

476See supra sections III.C.1.a, III.C.1.b, and III.C.1.d. 477See supra note 415. 478See supra note 416. 479A fund would be required to take transaction fees and charges into account when determining the swing factor that would be used to adjust the fund’s NAV when the level of net purchases or net redemptions from the fund has exceeded the fund’s swing threshold. Proposed rule 22c–1(a)(3)(i)(D)(1). See infra note 493 for a discussion of the proposed definition of ‘‘transaction fees and charges.’’ 480We note that, in Europe, there are no acrossthe-board swing threshold floors applicable to UCITS that use swing pricing. 481See supra paragraph accompanying note 451. 482However, as proposed earlier this year, a fund would be required to disclose flow information on proposed Form N–PORT monthly, and information contained on reports for the last month of each fiscal quarter would be made public. See infra note 561. 483Like selective disclosure of fund portfolio holdings, we believe that selective disclosure of a fund’s swing threshold could facilitate fraud and have adverse ramifications for a fund’s investors if certain investors are given the opportunity to use this information to their advantage to the detriment of other investors. See, e.g., Disclosure Regarding Market Timing and Selective Disclosure of Portfolio Holdings, Investment Company Act Release No. 26418 (Apr. 16, 2004) [69 FR 22300 (Apr. 23, 2004)] (discussing harm that could result from selective disclosure of fund portfolio holdings and adopting amendments to Form N–1A that would—among other things—require funds to disclose their policies and procedures with respect to the disclosure of their portfolio securities and any ongoing arrangements to make available information about their portfolio securities). 484Proposed rule 22c–1(a)(3)(i)(C). 485 Id. threshold. These issues are discussed in detail above.476 In assessing the fourth factor, the costs associated with transactions in the markets in which the fund invests, a fund may wish to consider, as applicable, market impact costs 477 and spread costs 478 that the fund typically incurs when it trades its portfolio assets (or assets with comparable characteristics if data concerning a particular portfolio asset is not available to the fund). A fund also may wish to consider, as applicable, the transaction fees and charges that the fund typically is required to pay when it trades portfolio assets.479 These could include brokerage commissions and custody fees, as well as other charges, fees, and taxes associated with portfolio asset purchases or sales (for example, transfer taxes and repatriation costs for certain foreign securities, or transaction fees associated with portfolio investments in other investment companies). We understand that because proposed rule 22c–1(a)(3) does not specify a minimum ‘‘floor’’ for a fund’s swing threshold, a fund could set a swing threshold representing a very low level of net purchases or net
redemptions. This could result in the fund effectively practicing full swing pricing (that is, adjusting the fund’s NAV whenever there is any level of net purchases or net redemptions) instead of partial swing pricing. However, we do not anticipate that a fund would generally wish to set a very low swing threshold, because we believe that a fund would not want to incur the increased NAV volatility associated with full (or nearly full) swing pricing. We also are not currently proposing a swing threshold floor because we believe that different levels of net purchases and net redemptions would create a risk of dilution for funds with different strategies, shareholder bases, and other liquidity-related characteristics, and thus it would be difficult to determine a swing threshold floor that would be appropriate across the scope of funds that would be permitted to use swing pricing.480 We recognize that requiring a fund to adopt a swing threshold could create the potential for shareholder gaming behavior because a fund’s shareholders could attempt to time their purchases and redemptions based on the likelihood that a fund would or would not adjust its NAV. However, we do not think that potential gaming is a significant concern, because it would be difficult for shareholders to determine when the fund’s net purchases or net redemptions cross the swing threshold. As discussed above, a fund would not be required to publicly disclose its swing threshold.481 Also, funds are not required to disclose their daily net flows and do not usually do so.482 For a shareholder to effectively ‘‘game’’ the swing pricing, it would have to know the daily flows on the day that shareholder was purchasing or redeeming and those flows would have to not materially change after the shareholder placed its order, all of which may be unlikely. Accordingly, even if a fund were to reveal its swing threshold, it may be difficult for shareholders to determine when the fund’s net purchases or net redemptions exceed the swing threshold. We note that, to the extent a fund does decide to disclose its swing threshold, we believe it would not be appropriate for a fund to disclose it selectively to certain investors (e.g., to only disclose the fund’s swing threshold to institutional investors), as we believe this could assist certain groups of shareholders in strategically timing purchases and redemptions of fund shares, potentially disadvantaging shareholders who do not know the fund’s swing threshold.483 Request for Comment We request comment on the definition of ‘‘swing threshold’’ set forth in proposed rule 22c–1(a)(3) and the process a fund would use to determine its swing threshold.

Is the definition of ‘‘swing
threshold,’’ as set forth in proposed rule 22c–1(a)(3) appropriate and clear? If not, how could this definition be clarified or made more effective within the context of the proposed rule?
Should a fund be permitted to
adopt two swing thresholds—one for net redemptions and one for net purchases? Would this be more operationally difficult than adopting one swing threshold that would be used for net redemptions as well as net purchases, and if so, why?
Should any of the proposed factors
not be required to be considered by a fund in determining and reviewing its swing threshold? Should any be modified? Are there any additional factors, besides the proposed factors, that a fund should be required to consider? Should we set a minimum floor for a fund’s swing threshold (e.g., one percent, or some other percentage, of the fund’s net asset value) to prevent a fund from setting a very low swing threshold? If so, what should it be and why?
Do commenters agree that the swing
threshold requirements under proposed rule 22c–1(a)(3) would not raise significant concerns regarding the potential for shareholder gaming behavior, because it would be difficult for shareholders to determine when the fund’s net purchases or net redemptions cross the swing threshold? If commenters believe that the swing pricing framework contemplated by proposed rule 22c–1(a)(3) would raise significant concerns regarding the potential for shareholder gaming behavior, how could these concerns best be alleviated? d. Periodic Review of a Fund’s Swing Threshold Proposed rule 22c–1(a)(3) would require a fund’s swing pricing policies and procedures to include policies and procedures providing for the periodic review, no less frequently than annually, of the fund’s swing threshold.484 In conducting such review, a fund would be required to consider the factors included in proposed rule 22c–1(a)(3)(i)(B).485 Any change to the fund’s swing threshold, including those deemed appropriate as a result of this review would be deemed to be a material change to the fund’s swing pricing policies and procedures that must be approved by the fund’s

486Proposed rule 22c–1(a)(3)(ii)(A) (‘‘The fund’s board of directors, including a majority of directors who are not interested persons of the fund, shall approve . . . any material change to the [fund’s swing pricing] policies and procedures (including any change to the fund’s swing threshold).’’). 487See supra section III.C.2.a. 488Proposed rule 22c–1(a)(3)(i)(A). Under the proposed rule, ‘‘swing factor’’ would be defined as ‘‘the amount, expressed as a percentage of the fund’s net asset value and determined pursuant to the fund’s swing pricing procedures, by which a fund adjusts its net asset value when the level of net purchases into or net redemptions from the fund has exceeded the fund’s swing threshold.’’ Proposed rule 22c–1(a)(3)(v)(B). We request comment on this definition at the end of this
section III.F.1.e.
489Proposed rule 22c–1(a)(3)(i)(D).
490 Id.
491 Id.
492See supra notes 415–416.
493 ‘‘Transaction fees and charges’’ would be defined in proposed rule 22c–1(a)(3) to mean ‘‘brokerage commissions, custody fees, and any other charges, fees, and taxes associated with portfolio asset purchases and sales.’’ Proposed rule 22c–1(a)(3)(v)(E). We request comment on the proposed definition of this term at the end of this
section III.F.1.e.
494The proposed costs that a fund would be required consider in determining its swing factor overlap significantly with costs that we understand funds that use swing pricing in other jurisdictions commonly consider when determining their swing factor. For example, the Luxembourg Swing Pricing Survey, Reports & Guidelines provides that the following should be considered when determining the swing factor: (i) The bid-offer spread of a fund’s underlying portfolio assets, (ii) net broker commissions paid by the fund, (iii) custody transaction charges, (iv) fiscal charges (e.g., stamp duty and sales tax), (v) any initial charges or exit fees applied to trades in underlying investment funds, and (vi) any swing factors or dilution amounts or spreads applied to underlying investment funds or derivative instruments. See Luxembourg Swing Pricing Survey, Reports & Guidelines, supra note 413, at 7, 15–16. 495See supra section III.B.2. 496See proposed rule 22e–4(b)(2)(ii)(B). board.486 Beyond specifying certain factors that a fund would be required to consider in reviewing its swing threshold, proposed rule 22c–1(a)(3) does not include prescribed review procedures, nor does it specify the required risk review period or incorporate specific developments that a fund should consider as part of its review. A fund may wish to adopt procedures specifying that the swing threshold will be reviewed more frequently than annually (i.e., semiannually or monthly), and/or specifying any circumstances that would prompt ad-hoc review of the fund’s swing threshold in addition to the periodic review required by the proposed rule (as well as the process for conducting any ad-hoc reviews). Like a fund’s liquidity risk review procedures, we believe that funds should generally consider procedures for evaluating market-wide, and fund-specific developments affecting each of the proposed rule 22c– 1(a)(3)(i)(B) factors in developing comprehensive procedures for reviewing a fund’s swing threshold.487 Request for Comment We request comment on the process a fund would use to review its swing threshold.

Are there certain procedures that
we should require, and/or on which we should provide guidance, regarding a fund’s periodic review of its swing threshold? Should we expand our guidance on the market-wide, and fundspecific developments that a fund’s swing threshold review procedures should cover?
Do commenters agree that a fund
that adopts swing pricing policies and procedures should be required to review its swing threshold at least annually? Do commenters anticipate that a fund that adopts swing pricing procedures would voluntarily choose to review its swing threshold any more frequently than annually? Alternatively, should a fund be required to review its swing threshold any more or less frequently than annually? e. Calculating the Swing Factor the Fund Will Use To Adjust Its NAV Under proposed rule 22c–1(a)(3), a fund’s swing pricing policies and procedures would be required to provide that the fund must adjust its NAV by an amount designated as the ‘‘swing factor’’ each time the fund’s net purchases or net redemptions have exceeded the fund’s swing threshold.488 A fund’s swing pricing policies and procedures would be required to specify how the swing factor to be used to adjust the fund’s NAV will be determined.489 As discussed in more detail below, the swing factor would be the amount, expressed as a percentage of the fund’s net asset value, that takes into account any near-term costs expected to be incurred by the fund as a result of net purchases or net redemptions that occur on the day the swing factor is used to adjust the fund’s NAV.490 It also must take into account information about the value of assets purchased or sold by the fund to satisfy net purchases or net redemptions that occur on the day the swing factor is used to adjust the fund’s NAV (if that information would not be reflected in the current NAV of the fund computed on that day).491 We anticipate that, because these considerations could vary depending on the facts and circumstances, the swing factor that a fund would determine appropriate to use in adjusting its NAV also could vary. We therefore believe that procedures for determining the swing factor generally should detail how each of the factors a fund would be required to consider under the proposed rule would assist the fund in calculating the swing factor. Below we provide examples of methods that a fund may wish to consider employing in calculating the swing factor. We are proposing rule 22c–1(a)(3) to provide funds with a tool to mitigate the potentially dilutive effects of shareholder purchase and redemption activity, and the factors a fund would be required to consider in determining its swing factor are meant to enhance a fund’s ability to estimate the costs associated with purchase and redemption activity that could dilute the value of the existing shareholders’ interests in the fund. These costs include both market-related costs (that is, market impact costs and spread costs 492) and transaction fees and charges associated with the fund trading portfolio assets.493 The proposed swing factor determination requirement incorporates an assessment of multiple sources of potential dilution, in order to cause a fund to take all relevant considerations into account when making this determination. Specifically, proposed rule 22c–
1(a)(3)(i)(D)(1) would require a fund’s policies and procedures for determining the swing factor to take into account any near-term costs that are expected to be incurred as a result of net purchases or net redemptions that occur on the day the swing factor is used to adjust the fund’s NAV, including any market impact costs, spread costs, and transaction fees and charges arising from asset purchases or asset sales in connection with those purchases or redemptions, as well as any borrowingrelated costs associated with satisfying those redemptions.494 While a fund may be able to determine some of these costs with precision (e.g., transaction fees and charges, and borrowing-related costs), we understand that other costs may only be able to be estimated by the fund, and the swing factor therefore would represent an estimate of the combined near-term costs associated with purchase or redemption activity. A fund may wish to consider certain of the factors it would evaluate for purposes of classifying the liquidity of its portfolio positions 495 in order to assess the costs associated with purchasing or selling portfolio assets. For example, a fund could use a portfolio asset’s average daily trading volume 496 in determining the portion of a particular portfolio holding that it could sell each day without market impact. Likewise, a fund

497See proposed rule 22e–4(b)(2)(ii)(D). 498See supra section III.C.5.a. 499See supra note 412 and accompanying text. 500We understand that funds that use swing pricing in other jurisdictions may use reasonable estimates, such as those discussed in this paragraph, when determining their swing factor. See, e.g., Luxembourg Swing Pricing Survey, Reports & Guidelines, supra note 413, at 15. 501See infra section III.F.1.f and note 517. 502See supra section III.F.1.a. could refer to bid-ask spreads for a particular asset 497 to estimate the purchase price that the fund would pay for that asset. Indications of decreasing liquidity (for example, widening bid-ask spreads) would likely indicate increased market-related costs associated with certain portfolio assets. We anticipate that the particular transaction fees and charges that a fund would likely consider would include brokerage commissions and custody fees, as well as other charges, fees, and taxes associated with portfolio asset purchases or sales (for example, transfer taxes and repatriation costs for certain foreign securities, or transaction fees associated with portfolio investments in other investment companies). If a fund were to draw on a line of credit, or otherwise borrow money, in order to pay redemptions, this borrowing activity could result in costs to the fund that, like the costs associated with purchasing and selling portfolio assets, could dilute the value of the shares held by existing shareholders.498 We are therefore proposing to require that a fund consider these costs, along with the costs associated with investing the proceeds from net purchases or assets sales to satisfy net redemptions, in determining the swing factor. The proposed rule specifies that the determination of a fund’s swing factor must take into account the near-term costs expected to be incurred by the fund as a result of net purchases or net redemptions that occur on the day the swing factor is used to adjust the fund’s NAV (emphasis added). The phrase ‘‘near-term’’ is meant to reflect that investing proceeds from net purchases or satisfying net redemptions could involve costs that may not be incurred by the fund for several days. For example, a fund could use cash to satisfy redemptions, which may result in minimal costs to the fund, but rebalancing the fund’s portfolio to rebuild cash balances in the next several days could cause the fund to incur costs that would be borne by the existing shareholders. The rule text specifies that the costs to be considered are those that are expected to be incurred by the fund as a result of the net purchase or net redemption activity that occurred on the day the swing factor is used to adjust the fund’s NAV; this specification is designed to help ensure that the costs to be taken into account are those that are directly related to the purchases or redemptions at issue. Thus, while the term ‘‘near-term costs’’ does not envision a precise number of days, we believe that, in
context, this term would not likely encompass costs that are significantly removed in time from the purchases or redemptions at issue. Under proposed rule 22c– 1(a)(3)(i)(D)(2), a fund’s policies and procedures for determining the swing factor would be required to consider information about the value of assets purchased or sold by the fund as a result of the net purchases or net redemptions that occur on the day the swing factor is used to adjust the fund’s NAV, if that information would not be reflected in the current NAV of the fund computed that day. This factor is meant to reflect the fact that a fund’s NAV will generally not reflect changes in holdings of the fund’s portfolio assets and changes in the number of the fund’s outstanding shares until the first business day following the fund’s receipt of the shareholder’s purchase or redemption requests.499 Thus, the price that a shareholder receives for his or her purchase or sale of fund shares customarily does not take into account market-related costs that arise when the fund trades portfolio assets in order to meet shareholder purchases or redemptions. But these costs could dilute the value of fund shares held by existing shareholders and thus should be considered in determining the fund’s swing factor. A fund could take a variety of approaches to determining its swing factor, in light of the fact that the relevant factors to be used in determining the swing factor could vary, as well as the likelihood that the persons administering the fund’s swing pricing policies and procedures may (to the extent that net purchases or net redemptions cannot be ascertained or reasonably estimated until close to the time that the fund must strike its NAV) have limited time to determine the swing factor each day the fund’s net purchases or net redemptions exceed the swing threshold. For example, a fund may wish to set a ‘‘base’’ swing factor, and adjust it as appropriate if certain aspects required to be considered in determining the swing factor deviate from a range of predetermined norms (for example, if spread costs generally exceed a certain pre-determined level). Alternatively or additionally, we request comment below on the extent to which a fund that uses swing pricing may wish to incorporate into its policies and procedures a formula or algorithm that includes the factors required to be considered for determining the swing factor. We also understand that it may be difficult to determine certain costs (particularly, certain market impact costs and spread costs) with precision, while other factors that a fund would be required to consider in determining its swing factor may be able to be ascertained more exactly (for example, transaction fees and charges, borrowingrelated costs, and the value of assets purchased or sold by the fund as a result of net purchases or net redemptions that occur on the day the swing factor is used to adjust the fund’s NAV). For this reason, in establishing policies and
procedures for determining the swing factor, a fund may wish to incorporate the use of reasonable estimates in these policies and procedures, to the extent the fund determines necessary or appropriate.500 We are not proposing to require an upper limit on the swing factor that a fund would be permitted to use, on account of the difficulty of establishing an appropriate across-the-board limit that would permit funds with different investment strategies, under all market conditions, to determine a swing factor that reflects the costs associated with the potential shareholder purchase or redemption activity. These costs could vary widely across funds and under different market conditions, and we do not wish to limit the extent to which swing pricing could mitigate the dilution of existing shareholders. We believe that the lack of an upper limit on a fund’s swing factor would not result in inappropriately high NAV adjustments, because the swing factor would be required to be determined with reference to the factors discussed above, and the policies and procedures for determining the swing factor would be required to be approved by the fund’s board, which has an obligation to act in the interests of the fund.501 We do recognize that if we were to require an upper limit on the amount that a fund would be permitted to adjust its NAV, this could mitigate volatility, tracking error, and transparency concerns that could arise from the use of swing pricing.502 A required swing factor limit would act as an upper bound on the extent to which a fund would be able to adjust its NAV and the NAV volatility resulting from this adjustment. Also, capping the swing factor that a fund would be permitted to use would provide transparency

503See supra notes 447–449 and accompanying text. 504See supra paragraph accompanying note 451. 505See proposed rule 22c–1(a)(3)(i)(D). 506Luxembourg Swing Pricing Survey, Reports & Guidelines, supra note 413, at 7. 507 Id. 508See infra section III.F.1.f. 509See id.; proposed rule 22c–1(a)(3)(ii)(A). 510See infra note 517 and accompanying text. 511Proposed rule 22c–1(a)(3)(i)(D). 512Proposed rule 22c–1(a)(3)(ii)(A). 513Proposed rule 22c–1(a)(3)(ii)(B). regarding the maximum amount that a shareholder could expect the share price that he or she receives upon purchase or redemption to be adjusted on account of swing pricing. However, as discussed above, we believe that the use of partial swing pricing could significantly reduce the performance volatility potentially associated with swing pricing,503 and that proposed disclosure and reporting requirements regarding swing pricing will enhance transparency surrounding the use of swing pricing.504 Although we are not proposing to require an upper limit on the swing factor that a fund would be permitted to use, a fund would be permitted to adopt an upper limit on the swing factor it would apply, as part of the fund’s swing pricing policies and procedures.505 We understand that certain foreign domiciled funds that use swing pricing voluntarily limit the level of the swing factor to be applied, with such limits generally ranging from 1%–3%.506 These funds usually disclose the swing factor upper limit in the fund’s offering documents.507 To the extent that a fund chooses to adopt a swing factor upper limit as part of its swing pricing policies and procedures, this limit would be required to be approved by the fund’s board (as part of the fund’s swing pricing policies and procedures, which are subject to board approval).508 Likewise, a change to a fund’s swing factor upper limit would be deemed to be a material change to the fund’s swing pricing policies and procedures that would require board approval.509 As fund directors have an obligation to act in the interests of the fund,510 we expect that a fund board approving a swing factor upper limit would generally determine that capping the swing factor would not unduly limit the extent to which swing pricing could mitigate the potentially dilutive effects of shareholder purchase and redemption activity. Also, because the upper limit would affect the swing factor a fund would use to adjust its NAV when net purchases or net redemptions exceed the fund’s swing threshold, the determination of the upper limit must take into account the same factors the fund would be required to consider in determining the swing factor.511 We request comment below on whether to require an upper limit on the swing factor that a fund would be permitted to use, and if so, the appropriate level of such limit. We also request comment on whether a fund should be permitted to adopt an upper limit on the swing factor it would apply, as part of the fund’s swing pricing policies and
procedures. Request for Comment We request comment on the definition of ‘‘swing factor’’ set forth in proposed rule 22c–1(a)(3) and the process a fund would use to calculate the swing factor that the fund would use to adjust its NAV.

Is the definition of ‘‘swing factor,’’
as set forth in proposed rule 22c–1(a)(3) appropriate and clear? If not, how could this definition be clarified or made more effective within the context of the proposed rule?
We request comment on each of the
considerations that a fund would be required to take into account in determining the swing factor, pursuant to proposed rule 22c–1(a)(3)(i)(D). Would these considerations reflect the estimated or actual costs associated with purchasing or selling portfolio assets in order to meet purchases or redemptions of fund shares? Should any aspect of proposed rule 22c–1(a)(3)(i)(D) not be required to be considered by a fund in calculating the swing factor? Should any of the considerations be modified, and is the definition of ‘‘transaction fees and charges,’’ as set forth in the proposed rule, appropriate and clear? Instead of codifying certain considerations that a fund must take into account in determining the swing factor, should we instead provide guidance on factors a fund may wish to consider in calculating the swing factor? Instead of using a swing factor to adjust a fund’s NAV, is there an alternate means by which a fund should be permitted to adjust its NAV to mitigate potential dilution stemming from purchase or redemption activity (e.g., pricing its assets on the basis of bid prices, as opposed to pricing using the mean of bid and asked prices)?
We request comment on the
approaches commenters believe a fund may take to determine its swing factor. For example, do commenters anticipate that a fund would set a ‘‘base’’ swing factor, and adjust it as appropriate if certain elements required to be considered in the swing factor deviate from a range of pre-determined norms? Do commenters believe that it would be feasible and likely that a fund may wish to use a formula or algorithm approach for determining the swing factor? What other approaches to determining the swing factor do commenters anticipate that a fund would be likely to take?
Do commenters agree that the
Commission should not require an upper limit on the swing factor that a fund would be permitted to use? Why or why not? If not, what upper limit would be appropriate (e.g., 2%, or some other limit), and why? Should we specify different limits for different types of funds or investment strategies?
Do commenters agree that a fund
should be permitted to adopt an upper limit on the swing factor it would apply, as part of the fund’s swing pricing policies and procedures? Why or why not? To the extent that a fund does adopt an upper limit on the swing factor it would apply, should the fund be required to disclose this upper limit to shareholders? Should each fund that adopts swing pricing policies and procedures be required, not only permitted, to adopt an upper limit on the swing factor it would apply? f. Approval and Oversight of Swing Pricing Policies and Procedures Proposed rule 22c–1(a)(3)(ii)(A) would require a fund that has determined to engage in the use of swing pricing to obtain initial approval of its swing pricing policies and procedures (including the fund’s swing threshold and any swing factor upper limit specified under the fund’s swing pricing policies and procedures) from the fund’s board, including a majority of independent directors. The proposed rule also would require a fund’s board, including a majority of independent directors, to approve any material change to the fund’s swing pricing policies and procedures (including any change to the fund’s swing threshold, a change to any swing factor upper limit, or any decision to suspend or terminate the fund’s swing pricing policies and procedures).512 However, a fund’s board would not be required to manage the administration of the fund’s swing pricing policies and procedures. The proposed rule instead provides that a fund’s board is required to designate the fund’s investment adviser or officers responsible for administering the fund’s swing pricing policies and procedures and determining the swing factor that would be used to adjust the fund’s NAV when the fund’s swing threshold is breached.513 This proposed designation requirement tasks administration for the fund’s swing pricing policies and procedures to persons who we believe would be in a better position to evaluate

514See, e.g., section 2(a)(41)(B) of the Investment Company Act and rule 2a–4 thereunder (when market quotations are not readily available for a fund’s portfolio securities, the Investment Company Act requires the fund’s board of directors to determine, in good faith, the fair value of the securities); rule 2a–7(c)(1)(i) and rule 2a– 7(g)(1)(i)(A)–(C) (a stable NAV money market fund that qualifies as a retail or government money market fund may use the amortized cost method of valuation to compute the current share price provided, among other things, the board of directors believes that the amortized cost method of valuation fairly reflects the market-based NAV and does not believe that such valuation may result in material dilution or other unfair results to investors or existing shareholders). 515See, e.g., ASR 118, supra note 423 (a board, consistent with its responsibility to determine the fair value of each issue of restricted securities in good faith, determines the method of valuing each issue of restricted securities in the company’s portfolio and the actual valuation calculations may be made by persons acting pursuant to the board’s direction; the board must continuously review the appropriateness of the method used in valuing each issue of security in the company’s portfolio); Rule 38a–1 Adopting Release, supra note 90, at text accompanying n.46 (stating that rule 38a–1 requires fund directors to approve written compliance policies and procedures that require each fund to ‘‘provide a methodology or methodologies by which the fund determines the fair value of the portfolio security’’). 516See Rule 38a–1 Adopting Release, supra note 90, at nn.39–47 and accompanying text. 517See, e.g., Role of Independent Directors of Investment Companies, Investment Company Act Release No. 24082 (Oct. 14, 1999) [64 FR 59826 (Nov. 3, 1999)] (discussing directors’ duties of care and loyalty). 518See id. 519Proposed rule 22c–1(a)(3)(ii)(B). 520See, e.g., BlackRock Swing Pricing Paper, supra note 412; J.P. Morgan Asset Management Swing Pricing Paper, supra note 454; Franklin Templeton Investments, Swing pricing: Investor protection against fund dilution, last visited Apr. 15, 2015, available at http:// www.franklintempleton.co.uk/ downloadsServlet?docid=hjs17mth (‘‘Franklin Templeton Investments Swing Pricing Paper’’). 521See, e.g., BlackRock Swing Pricing Paper, supra note 412 (swing pricing committee meets at least monthly); J.P. Morgan Asset Management Swing Pricing Paper, supra note 454 (swing pricing committee meets at least quarterly); Franklin Templeton Investments Swing Pricing Paper, supra note 520 (swing pricing committee meets at least quarterly). fund flows on a real-time basis than the fund’s board. The proposed oversight requirements for a fund’s board and its independent directors reflect the historical role that a fund’s board and independent directors have held with respect to issues involving valuation. A fund’s board historically has held
significant responsibility regarding valuation- and pricing-related matters,514 as well as in approving valuation and compliancerelated policies and procedures.515 Additionally, in the past we have stated that a fund’s compliance policies and procedures, which must be approved by the fund’s board (including a majority of independent directors), should include procedures for the pricing of portfolio securities and fund shares.516 We believe that the proposed board and independent director approval requirements would help ensure that a fund establishes and implements swing pricing policies and procedures that are in the best interests of all the fund’s shareholders. Because fund directors have an obligation to act in the interests of the fund,517 a board approving swing pricing policies and procedures might do so under the premise that such policies and procedures would not unduly disadvantage any particular group of shareholders, and that any disadvantages that could affect certain shareholders would generally be outweighed by the benefits to the fund as a whole. Furthermore, the proposed approval requirements would serve to assure shareholders that the same level of net purchase or net redemption activity would consistently trigger the use of swing pricing, unless the fund’s board and a majority of the fund’s independent directors were to approve a change in the fund’s swing threshold. We believe that shareholders’ interests would be best served by requiring the majority of a fund’s independent directors, along with the fund’s board, to approve the fund’s swing pricing policies and procedures. As we have stated before, a fund’s independent directors serve to guard investors’ interests.518 The decision to implement swing pricing, and determining the terms of swing pricing policies and procedures to be adopted by a fund, could occasionally produce conflicts for the fund and its adviser, and we believe that the proposed independent director approval requirement would help ensure that a fund’s use of swing pricing would operate to the benefit of the fund’s shareholders (even if this may not be in the best interest of the fund’s adviser). For example, a fund’s adviser could be reluctant to implement swing pricing to the extent it may make the fund’s performance stray too far from, or appear more volatile than, the fund’s benchmark, which could impact the ability of the fund to attract new investments. Approval of swing pricing policies and procedures by a majority of a fund’s independent directors could make certain that the fund would use swing pricing in circumstances in which the board has determined swing pricing would serve shareholders’ best interests, even if these interests may conflict with the adviser’s. While a fund’s board would be required to approve the fund’s swing pricing policies and procedures, the board would be required to designate the fund’s adviser or officers responsible for the administration of these policies and procedures,
including responsibility for determining a swing factor that would be used to adjust the fund’s NAV when the fund’s swing threshold is breached.519 It is currently common industry practice for foreign domiciled funds that use swing pricing to appoint a committee to administer the fund’s swing pricing operations.520 A fund’s board may wish to consider requiring the fund’s swing pricing policies and procedures to be administered by a committee, and to specify the officers or functional areas that comprise the committee (taking into account any possible conflicts for the fund and the adviser related to swing pricing). The persons or committee tasked with swing pricing oversight may wish to meet periodically to determine the swing factor(s) the fund would use in a variety of circumstances, taking into account the factors and considerations discussed above in section III.F.1.e. A fund may wish to consider delineating the frequency with which these persons would meet in its policies and procedures; for example, a fund’s policies and procedures might specify that these persons shall meet periodically, such as monthly or quarterly, or more frequently if market conditions require.521 Because a fund may decide to adopt swing pricing policies and procedures as part of its liquidity risk management program, the fund’s board may wish to provide that the persons (or functional areas) in charge of implementing these policies and procedures overlap with the persons (or functional areas) in charge of administering the liquidity risk management program. Proposed rule 22c–1(a)(3) would require the determination of the swing factor to be reasonably segregated from the portfolio management function of the fund. For example, if a committee were tasked with determining the swing factor(s) the fund would use in a variety of circumstances, we believe it would be appropriate for the fund’s portfolio manager to provide inputs to be used by that committee in determining the swing factor, but not to decide how those inputs would be employed in the swing factor determination. We believe that, in determining the swing factor, independence from portfolio management is important because the incentives of portfolio managers may not always be consistent with determining a swing factor that most effectively prevents dilution of existing

522See supra note 446 and accompanying text; infra section III.F.2.b. 523Proposed rule 22c–1(a)(3)(iii). 524See rule 31a–2(a)(2) (every registered investment company shall . . . ‘‘[p]reserve for a period not less than six years from the end of the fiscal year in which any transactions occurred, the first two years in an easily accessible place . . . all schedules evidencing and supporting each computation of net asset value of the investment company shares’’). 525See proposed amendment to rule 31a–2(a)(2). 526See id. shareholders’ interests in the fund. For example, a fund’s portfolio manager could have an incentive to determine a swing factor that is as low as possible, because the portfolio manager could be reluctant for the fund’s short-term performance to appear relatively poor compared to other funds and the fund’s benchmark.522 A fund’s board would not be required to approve each swing factor that would be used to adjust the fund’s NAV when the fund’s swing threshold is breached, although the board would be required to approve the policies and procedures for determining the swing threshold. This approval framework—along with the proposed segregation of the swing factor determination from the portfolio management function—is meant to strike a balance between ensuring appropriate board oversight over the policies and procedures for determining the swing factor, and independence with respect to the swing factor determination process, while recognizing that it may not be practicable for a fund’s directors to be directly involved in the process of determining each swing factor. Because the persons administering the fund’s swing pricing policies and procedures may have limited time to determine each swing factor to the extent that net purchases or net redemptions cannot be ascertained or reasonably estimated until close to the time that the fund must strike its NAV, we do not believe that it would generally be operationally feasible for a fund’s board to approve each swing factor. Also, we do not believe that requiring a fund’s board to approve each swing factor would be consistent with boards’ historical oversight role. Request for Comment We seek comment on the proposed approval and oversight requirements associated with a fund’s swing pricing policies and procedures.

Do commenters agree that a fund’s
board, including a majority of the fund’s independent directors, should be required to approve the fund’s swing pricing policies and procedures (including the fund’s swing threshold, and any swing factor upper limit specified under the fund’s swing pricing policies and procedures), and any material changes thereto? Would these approval requirements ensure that a fund establishes and implements swing pricing policies and procedures that are in the interests of all of the fund’s shareholders? Do commenters agree that the proposed independent director approval requirement would ensure that a fund’s use of swing pricing benefits the fund’s shareholders? Should the board be provided the option to not use swing pricing in a particular situation when swing pricing would have been warranted pursuant to a fund’s swing pricing policies and procedures?
Do commenters agree that it would
be appropriate to require a fund’s board to designate the fund’s adviser or officers responsible for the administration of swing pricing policies and procedures, including responsibility for determining a swing factor that would be used to adjust the fund’s NAV when the fund’s swing threshold is breached? Do commenters agree that the determination of the swing factor should be reasonably segregated from the portfolio management of the fund? Would this pose any difficulty for particular types of entities, for example funds managed by small advisers? Is there a better way to prevent conflicts between the portfolio manager’s incentives and the process of determining a swing factor that most effectively prevents dilution of existing shareholders’ interests in the fund? What officers (or functional areas) of a fund do commenters anticipate a fund’s board would select to administer the fund’s swing pricing policies and procedures, and do commenters anticipate that these persons (or functional areas) would overlap with the administrators of a fund’s liquidity risk management program?
Do commenters agree that a fund’s
board should not be required to approve each swing factor that would be used to adjust the fund’s NAV when the fund’s swing threshold is breached, although the board would be required to approve the policies and procedures for determining the swing threshold? Why or why not?
Should the Commission provide
guidance as to the circumstances in which a possible misapplication of a firm’s swing pricing policy could result in a material NAV error? For example, should the Commission explain whether an error would occur when the fund makes estimates under its swing pricing policy that is applied correctly, but the information, such as final shareholder flows, subsequently changes to a material degree? Should funds be required to have specific policies and procedures to address possible NAV errors? g. Recordkeeping Requirements Proposed rule 22c–1(a)(3) would require a fund to maintain a written copy of swing pricing policies and procedures adopted by the fund that are in effect, or at any time within the past six years were in effect, in an easily accessible place.523 Additionally, we are proposing to expand current rule 31a– 2(a)(2), which requires a fund to keep records evidencing and supporting each computation of the fund’s NAV,524 to reflect the NAV adjustments based on a fund’s swing pricing policies and procedures. Specifically, a fund that adopts swing pricing policies and procedures would be required to preserve records evidencing and supporting each computation of an adjustment to the fund’s NAV based on the fund’s swing pricing policies and procedures.525 For each NAV adjustment, such records should generally include, at a minimum, the fund’s unswung NAV, the level of net purchases or net redemptions that the fund encountered (or estimated) that triggered the application of swing pricing, the swing factor that was used to adjust the fund’s NAV, and relevant data supporting the calculation of the swing factor. The records required under the proposed amendments to rule 31a–2(a)(2) would be required to be preserved for at least six years from the date that the NAV adjustment occurred, the first two years in an easily accessible place.526 The proposed six-year period for a fund to maintain a copy of its swing pricing policies and procedures in proposed rule 22c–1(a)(3) corresponds with the six-year recordkeeping period currently incorporated in rule 31a–2(a)(2). We believe that consistency in these retention periods is appropriate in order to permit a fund or Commission staff to review historical instances of NAV adjustments effected pursuant to the fund’s swing pricing policies and procedures in light of the policies and procedures that were actually in place at the time the NAV adjustments occurred. These proposed recordkeeping requirements would help our examination staff to ascertain whether a fund that has adopted swing pricing policies and procedures has done so in compliance with the requirements of proposed rule 22c–1(a)(3). They also would help our staff to determine whether a fund is taking into account

527See proposed rule 22c–1(a)(3)(i)(A) (permitting the person(s) responsible for administering the fund’s swing pricing policies and procedures to use ‘‘information obtained after reasonable inquiry’’ in determining whether the fund’s level of net purchases or net redemptions has exceeded the fund’s swing threshold). 528We have previously stated that a fund should adopt compliance policies and procedures that provide for monitoring shareholder trades or flows of money in and out of the fund for purposes of detecting market timing activity. See Rule 38a–1 Adopting Release, supra note 90, at nn.66–69 and accompanying text. 529See Luxembourg Swing Pricing Survey, Reports & Guidelines, supra note 413, at 21 (discussing swing pricing considerations relevant to funds with multiple share classes). 530See Items 13, 26 of Form N–1A. 531Rule 482(d), 17 CFR 230.482. 532Section 205(a)(1) of the Investment Advisers Act generally restricts an investment adviser from entering into, extending, renewing, or performing an investment advisory contract that provides for compensation to the adviser based on a share of capital gains on, or capital appreciation of, the funds of a client. However, there are certain exemptions to this general restriction. See section 205(b)(2) of the Investment Advisers Act (providing that the section 205(a)(1) restriction does not apply to an investment adviser charging performance fees to a registered investment company if the fee is structured to comply with four requirements: (i) The fee is based on the investment company’s NAV; (ii) the NAV is averaged over a ‘‘specified period’’; (iii) the fee increases or decreases proportionately with the investment company’s ‘‘investment performance’’ over the specified period; and (iv) the investment company’s investment performance relates to the ‘‘investment record’’ of an ‘‘appropriate index’’ of securities prices or another measure of investment performance as specified by the Commission by rule, regulation, or order); see also rule 205–3 under the Investment Advisers Act 17 CFR 275.205–3 (providing an exemption to the
section 205(a)(1) restriction and permitting an
investment adviser to charge performance fees if the adviser’s client is a ‘‘qualified client’’ as defined in rule 205–3(d)(1) (generally, a client having at least $1 million under management with the adviser immediately after entering into an advisory contract with the adviser, or a client the adviser reasonably believed had a net worth of more than $2 million at the time the contract was entered into)). 533See Luxembourg Swing Pricing Survey, Reports & Guidelines, supra note 413, at 18–19 (discussing swing pricing considerations relevant to fund mergers). the factors required to be considered under proposed rule 22c–1(a)(3)(i)(D) in calculating the swing factor. Request for Comment We seek comment on the proposed recordkeeping requirements associated with a fund’s swing pricing policies and procedures.

Do commenters agree that the
proposed recordkeeping requirements are appropriate? Are there any additional records associated with a fund’s swing pricing policies and procedures that a fund should be required to keep? Should rule 31a– 2(a)(2) be amended to specifically require a fund to keep records evidencing the fund’s consideration of each of the factors required to be considered in determining each swing factor used to adjust the fund’s NAV? Do commenters agree that the six-year record retention period in proposed rule 22c–1(a)(3) and the proposed amendments to rule 31a–2(a)(2) is appropriate?

Guidance on Operational
Considerations Relating To Swing Pricing a. Operational Processes Associated With Swing Pricing Swing pricing requires the net cash flows for a fund to be known, or estimated using information obtained after reasonable inquiry,527 before determining whether to adjust the fund’s NAV on any particular day (and, if the fund’s swing factor varies depending on its net flows, to determine the swing factor that the fund will use to adjust its NAV). A fund using swing pricing would need to monitor shareholder trades or flows of money in and out of the fund for purposes of determining whether the fund’s net purchases or net redemptions would give rise to an NAV adjustment under its swing pricing policies and procedures.528 Because the deadline by which a fund must strike its NAV may precede the time that a fund receives final information concerning daily net flows from the fund’s transfer agent, a fund may wish to arrange for interim feeds of flows from its transfer agent or distributor in order to reasonably estimate its daily net flows for swing pricing purposes. A fund also may wish to implement formal or informal policies to encourage effective communication channels between the persons charged with implementing the fund’s swing pricing policies and procedures, the fund’s investment professionals, and personnel charged with day-to-day pricing responsibility (to the extent different persons comprise each of these groups). In addition, there are unique operational considerations applicable to funds with multiple share classes. A fund with multiple share classes that uses swing pricing should consider the net purchase or net redemption activity of all share classes in determining whether its swing threshold has been breached.529 Like a fund with only one share class, the purchase or redemption activity of certain shareholders (or a class of shareholders) within a multishare-class fund could dilute the value of the existing shareholders’ (or class of shareholders’) interests in the fund. b. Performance Reporting and Calculation of NAV-Based Performance Fees For purposes of calculating the financial highlights and performance data to be included in a fund’s prospectus and shareholder reports,530 a fund using swing pricing should consider its NAV at the beginning and end of a reporting period, as well as its ‘‘ending redeemable value’’ on a particular day, to be its NAV as adjusted pursuant to its swing pricing policies and procedures (as applicable). Because a fund using swing pricing to adjust its NAV would, under certain circumstances, use the adjusted NAV as the price that shareholders receive for the purchase or redemption of shares, the adjusted NAV is the ‘‘net asset value calculated on the last business day before the first day of each [performance] period’’ and the ‘‘price calculated on the last business day of each [performance] period,’’ as referenced in the instructions to Item 13 (‘‘Financial Highlights Information’’) of Form N–1A. For the
same reason, the adjusted NAV is the ‘‘ending redeemable value’’ of the fund’s shares, as referenced in Item 26 (‘‘Calculation of Performance Data’’) of Form N–1A. Likewise, because rule 482 under the Securities Act references Form N–1A with respect to performance data,531 a fund using swing pricing also should use its adjusted NAV when calculating the standardized performance data to be included in the fund’s advertising materials. If a fund using swing pricing pays NAV-based performance fees to its adviser,532 the fund’s NAV for purposes of calculating performance fees should be the NAV as adjusted pursuant to its swing pricing policies and procedures (as applicable). As discussed above, a fund’s NAV used for performance reporting purposes would be the NAV as adjusted pursuant to swing pricing policies and procedures. We believe that the reported NAV and the NAV used for calculating performance fees (to the extent used) should be consistent in order to promote transparency regarding any performance fees paid to the fund’s adviser, and to reflect the fact that the fund’s performance likely has been affected by the transaction costs associated with shareholders’ purchases and redemptions.
c. Fund Merger Considerations
When funds merge, and at least one of the merging funds uses swing pricing, there are a number of considerations relating to swing pricing that the funds generally should consider when determining the terms of the merger.533

534 Directors overseeing fund mergers must take into account rule 17a–8 under the Investment Company Act (which sets forth requirements for mergers of affiliated investment companies), if applicable, as well as any relevant state law requirements. Rule 17a–8 requires a board, including a majority of the independent directors, to consider the relevant facts and circumstances with respect to a merger of affiliated funds and determine that the merger is in the best interests of each of the merging funds and that the interests of the shareholders of both the fund being acquired and the acquiring fund are not being diluted. We expect swing pricing considerations could be relevant to this determination. See Luxembourg Swing Pricing Survey, Reports & Guidelines, supra note 413, at 18–19 (discussing issues associated with the use of swing pricing to adjust the value of the absorbed fund’s assets). 535See, e.g., supra paragraph accompanying notes 296–298. 536See supra note 534. 537See proposed rule 22c–1(a)(3)(ii)(A). 538See Luxembourg Swing Pricing Survey, Reports & Guidelines, supra note 413, at 21–22 (discussing swing pricing considerations relevant to master-feeder fund structures). 539See proposed rule 22c–1(a)(3)(iv). 540Proposed rule 22c–1(a)(3) clarifies that, although feeder funds would not be permitted to use swing pricing, master funds would be permitted to do so. See proposed rule 22c–1(a)(3)(iv). The boards of merging funds should consider whether a swing factor should be used to adjust the value of the absorbed fund’s assets, if the absorbing fund uses swing pricing and it is applied on the day of the merger.534 Although the manager of the absorbing fund may need to sell certain of the assets of the absorbed fund following the merger (e.g., for consistency with the absorbing fund’s investment strategy, or to comply with certain regulatory requirements 535), we do not believe that the NAV of either the absorbing fund or the absorbed fund should be adjusted to counter any dilution resulting from these sales, because costs associated with these sales would result from the merger and would not be caused by shareholders’ purchase or redemption activity. In light of potential complications arising when funds using swing pricing merge, the boards of merging funds should consider whether to temporarily suspend a fund’s swing pricing policies and procedures ahead of the merger.536 Under proposed rule 22c–1(a)(3), such suspension would be considered a material change to the fund’s swing pricing policies and procedures and thus could be accomplished only by vote of the fund’s board, including a majority of the fund’s independent directors.537 In any event, the swing threshold of the absorbing fund should be reviewed following a merger. Likewise, the persons in charge of administering the absorbing fund’s swing pricing policies and procedures should consider the effects of the merger when considering what swing factor would be appropriate to use if the
fund’s swing threshold is breached following the merger. d. Request for Comment We seek comment on the Commission’s guidance discussed above regarding certain operational and accounting considerations relating to swing pricing. Do commenters generally agree with the Commission’s guidance in this section III.F.2? Along with this general request for comment on the Commission’s guidance, we request specific comment on a number of individual guidance items.

To what extent is it currently
typical for a fund to receive interim feeds of flows from its transfer agent or distributor, and do these interim feeds generally permit a fund to reasonably estimate its net flows at the end of a business day? To what extent do financial intermediaries or other third parties provide interim feeds of flows?
Should the Commission amend the
proposed rule or provide guidance regarding pricing errors in the context of swing pricing? How do commenters anticipate that a fund using swing pricing may wish to update its pricing policies to provide clarity as to the application of swing pricing to the fund’s policies concerning pricing errors? What policies do commenters anticipate that a fund’s pricing policies could incorporate with respect to circumstances in which the fund’s NAV was swung (or not swung) based on an estimate of net purchases or net redemptions that was later determined to be incorrect, but was based on information obtained after reasonable inquiry pursuant to proposed rule 22c– 1(a)(3)(i)(A)?
Do commenters agree that it is
appropriate to require that a fund calculate performance fees based on the fund’s NAV as adjusted pursuant to the fund’s swing pricing policies and procedures (as applicable)? Why or why not? We specifically request comment on whether calculating a performance fee based on a fund’s adjusted NAV could be viewed as inappropriately increasing or decreasing the fee (e.g., depending on whether the NAV was adjusted at the beginning or end of a measurement period).
Besides the issues discussed in this
section, what specific operational
challenges do funds anticipate associated with swing pricing? Do commenters anticipate there would be circumstances in which a fund’s structure (e.g., a fund with multiple share classes, as discussed in section III.F.2.a) would cause swing pricing to be particularly complex to implement?
With respect to a fund with
multiple share classes that uses swing pricing, do commenters agree that the fund should consider the net purchase or net redemption activity of all share classes in determining whether its swing threshold has been breached? Or should a fund instead be permitted to consider the net purchase or redemption activity of each share class separately (which potentially could lead to NAV adjustments for certain share classes and not others, or different NAV adjustments for each share class, on the same day)? If so, should we amend rule 18f–3 to expressly allow this? What operational or other difficulties could result from permitting a fund with multiple share classes that uses swing pricing to consider the net purchase or redemption activity of each share class separately, and to potentially make different NAV adjustments for each share class on the same day?
Besides the issues discussed in this
section, are there any other operational
issues associated with swing pricing about which we should provide guidance?

Master-Feeder Funds
With respect to master-feeder funds, we believe the use of swing pricing would generally be appropriate only with respect to the level (or levels) of the fund structure that actually transact in underlying portfolio assets as a result of net purchase or redemption activity.538 For example, if shareholders of a feeder fund were to redeem feeder fund shares, the feeder fund would redeem from the master fund (and not sell portfolio assets) in order to pay redeeming shareholders. Likewise, if investors were to purchase shares of a feeder fund, the feeder fund would invest in the master fund with cash received from the feeder fund purchasing shareholders, and the master fund would invest this cash in portfolio assets. Thus, a feeder fund would not be permitted to use swing pricing under the proposed rule.539 The master fund, on the other hand, would potentially need to purchase portfolio assets in order to invest purchasing shareholders’ cash (as transferred through the feeder fund), or sell portfolio assets in order to pay redemption proceeds in exchange for feeder fund shares. Thus, to the extent that net purchases into or redemptions from the master fund (by one or more feeder funds, or any other investors in the master fund) exceed the fund’s swing threshold, the swing factor should thus be applied to the master fund’s NAV.540 In this example, because

541See 17 CFR 210.6–04.19.
542See proposed amendments to 210.6–04.19. We also propose amending Regulation S–X rule 6–02 to add a definition of swing pricing. Swing pricing would be defined as having the meaning given in proposed rule 22c–1(a)(3)(v)(C). See proposed 210.6–02(g). 543See 17 CFR 210.6–09.4(b). 544See Item 13 of Form N–1A. 545ASC 946–205–50–7 requires specific per share information to be presented in the financial highlights for registered investment companies, including disclosure of the per share amount of purchase premiums, redemption fees, or other capital items. 546See proposed amendments to rule 6–03(n) of Regulation S–X. the feeder fund invests in the master fund, the master fund’s adjusted NAV would indirectly affect the NAV of the feeder fund. Request for Comment We seek comment on the application of swing pricing to master-feeder funds. Do commenters generally agree that feeder funds should not be permitted to use swing pricing? Why or why not?
4. Financial Statement Disclosure
Regarding Swing Pricing
The application of swing pricing would impact a fund’s financial statements and disclosures in a number of areas, including a fund’s statement of assets and liabilities, statement of changes in net assets, financial highlights and the notes to the financial statements. Currently, funds are required by Regulation S–X rule 6–
04.19 541 to state the NAV on the
statement of assets and liabilities. Similar to ‘‘ending redeemable value’’ discussed in performance reporting in
section III.F.2.b above, for purposes of
reporting the NAV in a fund’s statement of assets and liabilities, a fund using swing pricing should consider its ‘‘purchase price’’ or ‘‘redemption price’’ on a particular day to be its NAV as adjusted pursuant to its swing pricing policies and procedures. We believe that disclosure of this price is important, as it allows investors to understand the value they would receive had they purchased or redeemed shares on the financial reporting period end date. Different from redemption fees, which may be charged to specific shareholders based on the length of time that the shareholder has owned shares of the fund, all shareholders in a fund would receive the NAV as adjusted pursuant to its swing pricing policies and procedures. As all shareholders would receive the NAV as adjusted pursuant to the fund’s swing pricing policies and procedures, we are proposing to amend Regulation S–X rule 6–04.19 to require funds to disclose the NAV as adjusted pursuant to its swing pricing policies and procedures (if applicable).542 Swing pricing also would impact disclosures of capital share transactions included in a fund’s statement of changes in net assets. A fund using swing pricing to adjust its NAV would make payments for shares redeemed and receive payments for shares purchased net of the swing pricing adjustment. For example, if a fund had an unadjusted NAV of $10.00 on a given day and the adjusted NAV pursuant to the fund’s swing pricing policies and procedures was $9.90, shareholders would transact at $9.90 multiplied by the number of shares purchased or redeemed. The $0.10 difference between the adjusted and unadjusted NAV would be retained by the fund to offset transaction and liquidity costs. This $0.10 difference per share should be accounted for as a capital transaction and not included as income to the fund, because it is designed to reflect the near-term transactional and liquidity costs incurred as a result of satisfying shareholder transactions. Funds are required by Regulation S–X rule 6– 09.4(b) to disclose the number of shares and dollar amounts received for shares sold and paid for shares redeemed.543 In this example, Regulation S–X would require the dollar amount disclosed to be based on the $9.90 per share that was actually used for shareholder transactions. Consistent with presentation of the impact of swing pricing on the statement of changes in net assets and performance reporting described in
section III.F.2.b, a fund should include
the impact of swing pricing in its financial highlights.544 The per share impact of amounts retained by the fund due to swing pricing should be included in the fund’s disclosures of per share operating performance.545 Accordingly, we are proposing to amend Item 13 of Form N–1A to specifically require the per share impact of amounts related to swing pricing to be disclosed below the total distributions line in a fund’s financial highlights. In order to properly reconcile with the adjusted NAV reported on the statement of assets and liabilities, we also are proposing to clarify that ‘‘Net Asset Value, Beginning of Period’’ and ‘‘Net Asset Value, End of Period’’ are each the NAV as adjusted pursuant to the fund’s swing pricing policies and procedures, if applicable. Similarly, a fund’s calculation of total return should use the NAV as adjusted pursuant to a fund’s swing pricing policies and procedures as the redemption price calculated on the last business day of the period. We are proposing to amend Instructions 3(a) and 3(d) to Item 13 of Form N–1A to explicitly require funds to assume the NAV calculated on the last business day before the first day of each period and the price calculated on the last business day of each period shown should each be adjusted for the impact of swing pricing, if applicable. We believe that it is important for investors to understand the impact of swing pricing on the return that they would have received for the period presented in the fund’s financial statements. We also are proposing to amend instructions to Item 26 regarding calculation of performance data to clarify that ‘‘ending redeemable value’’ should assume a value adjusted pursuant to swing pricing policies and procedures. Finally, we are proposing to require funds that adopted swing pricing policies and procedures to state in a note to their financial statements the general methods used in determining whether the fund’s net asset value per share will swing, whether the fund’s net asset value per share has swung during the year, and a general description of the effects of swing pricing on the fund’s financial statements.546 We believe this information would be useful in further understanding the impact of swing pricing on a fund. Request for Comment We seek comment on the financial statement disclosure considerations relating to swing pricing. Do commenters generally agree with the Commission’s guidance discussed above regarding financial statement disclosure, as well as the proposed amendments to Regulation S–X? Along with this general request for comment, we request specific comment on a number of individual issues discussed above.

Should the Commission allow a
fund to disclose the total return calculation on an unadjusted NAV basis as a supplement to the total return calculation in the financial highlights
table, and/or in a fund’s advertising
materials?
Should the dollar amount of
purchases and redemptions disclosed in a fund’s financial statements be presented based on unadjusted NAV, with the dollar amount retained by the fund because of swing pricing separately disclosed? Alternatively, should the dollar amount of purchases and redemptions be presented as the actual value received by the fund or paid to shareholders, which would include the impact of swing pricing? Why or why not?

547See Item 11(c) of Form N–1A.
548See proposed Item 11(c)(7) of Form N–1A. 549 Id. 550See proposed Item 11(c)(8) of Form N–1A. 551Funds also may use swing pricing to address transaction costs associated with shareholder purchases or redemptions. We have proposed amendments to Form N–1A regarding disclosure of swing pricing. See proposed Item 6(d) of Form N– 1A. 552See Item 11(c)(3) of Form N–1A. 553See supra section III.C.5.c. 554 Id. 555See proposed Item 28(h) of Form N–1A. 556See supra section III.C.5.a.

Should funds be required to
disclose only the NAV as adjusted pursuant to a fund’s swing pricing policies and procedures on the statement of assets and liabilities? Alternatively, should funds be required to disclose both unadjusted NAV and the NAV as adjusted pursuant to a fund’s swing pricing policies and procedures on the statement of assets and liabilities?
Should we require additional
disclosures in notes to fund financial statements regarding swing pricing? If so, what additional information should be disclosed? Do commenters believe that any of the proposed disclosures should be modified? Are any of the proposed disclosures unnecessary? Why or why not?
Do commenters have any
accounting or auditing concerns in connection with swing pricing? If so, please describe specific concerns. G. Disclosure and Reporting Requirements Regarding Liquidity Risk and Liquidity Risk Management Investors receiving relevant information about the operations of a fund and the principal risks associated with an investment in a particular fund are important in facilitating investor choice regarding the appropriate investments for their risk tolerances. Investors in open-end funds generally expect funds to pay redemption proceeds promptly following their redemption requests based, in part, on representations made by funds in their disclosure documents. Accordingly, information about how redemptions will be made and when investors will receive payment is significant to investors. Currently, funds are not expressly required to disclose how they manage the liquidity of their assets, and therefore limited information is available regarding whether the liquidity of a fund’s portfolio securities corresponds with its liquidity needs related to redemption obligations. In addition to the proposed amendments to Form N–1A and Regulation S–X discussed above regarding financial reporting related to swing pricing, we are proposing amendments to Form N– 1A, Regulation S–X, proposed Form N– PORT and proposed Form N–CEN to improve the ability of investors, the Commission staff, and other potential users to analyze and better understand a fund’s redemption practices, its management of liquidity risks, and how liquidity risk management can affect shareholder redemptions. We are also proposing amendments to Form N–1A regarding disclosure of swing pricing.

Proposed Amendments to Form N–1A
a. Redemption of Fund Shares Form N–1A is used by funds to register under the Investment Company Act and to register offerings of their securities under the Securities Act. In particular, Form N–1A requires funds to describe their procedures for redeeming fund shares, including restrictions on redemptions and any redemption charges.547 Disclosure regarding other important redemption information, such as the timing of payment of redemption proceeds to fund shareholders, varies across funds as today there are no specific requirements for this disclosure under the form. Some funds disclose that they will redeem shares within a specific number of days after receiving a redemption request, other funds disclose that they will honor such requests within seven days (as required by section 22(e) of the Act), and others provide no specific time periods. Some funds disclose differences in the timing of payment of redemption proceeds based on the distribution channel through which the fund shares are redeemed, while others do not. We believe that requiring consistency in disclosures and increasing the level of information provided among funds regarding the timing of payment after shareholder redemption of fund shares would give investors fuller information about their investments. Improvements are needed to enhance the ability of investors to evaluate and compare redemption policies across funds and to understand when a fund will actually pay redemption proceeds. Accordingly, we are proposing amendments to Item 11 of Form N–1A that would require a fund to disclose the number of days in which the fund will pay redemption proceeds to redeeming shareholders.548 If the number of days in which the fund will pay redemption proceeds differs by distribution channel, the fund also would be required to disclose the number of days for each distribution channel.549 We also are proposing amendments to Item 11 of Form N–1A that would require a fund to disclose the methods that the fund uses to meet redemption requests.550 Under this requirement funds would have to disclose whether they use the methods regularly to meet redemptions or only in stressed market conditions. Methods to meet redemption requests may include, for example, sales of portfolio assets, holdings of cash or cash equivalents, lines of credit, interfund lending, and ability to make in-kind redemptions. To address transaction costs associated with shareholder activity, funds also may use redemption fees.551 Currently, Item 11(c)(3) of Form N–1A requires funds to disclose whether they reserve the right to redeem their shares in kind instead of in cash.552 We propose to incorporate this disclosure requirement into proposed Item 11(c)(8) discussed above. We understand that the use of in-kind redemptions (outside of the ETF context) historically has been rare and that many funds reserve the right to redeem in kind only as a tool to manage liquidity risk under emergency circumstances or to manage the redemption
activity of a fund’s large institutional investors.553 We also are aware that there are often logistical issues associated with redemptions in kind and that these issues can limit the availability of in-kind redemptions as a practical matter.554 A fund should consider whether adding relevant detail to its disclosure regarding in-kind redemptions, or revising its disclosure if the fund would be practically limited in its ability to redeem its shares in kind, would provide more accurate information to investors. We are also proposing to amend Item 28 of Form N–1A to require a fund to file as an exhibit to its registration statement any agreements related to lines of credit for the benefit of the fund.555 As previously mentioned, we understand based on staff outreach that it is relatively common for funds to establish lines of credit to manage liquidity risk and meet shareholder redemptions, typically during periods of significantly limited market liquidity.556 We believe that requiring funds to include such agreements as exhibits to registration statements will increase Commission, investor, and market participant knowledge concerning the arrangements funds have made in order to strengthen their ability to meet shareholder redemption requests and manage liquidity risk and the terms of those arrangements. We also propose to include an instruction related to credit agreements noting that the specific fees paid in connection with the credit

557See Item 11(a)(1) of Form N–1A.
558 Id.
559See supra section III.F.
560See proposed Item 6(d) of Form N–1A. 561Submissions on Form N–PORT would be required to be filed no later than 30 days after the close of each month. As proposed, only information reported for the third month of each fund’s fiscal quarter on Form N–PORT would be publicly available, and such information would not be made public until 60 days after the end of the third month of the fund’s fiscal quarter. See Investment Company Reporting Modernization Release, supra note 104. agreements need not be disclosed in the exhibit filed with the Commission to preserve the confidentiality of this information. Overall, we believe that requiring funds to provide additional disclosure concerning the methods they use and the funding sources they have to fulfill their redemption obligations and whether those methods are used on a regular basis or only in stressed market conditions would improve shareholder and market participant knowledge regarding fund redemption procedures and liquidity risk management. In particular, increased knowledge of how and when a fund’s redemption procedures may affect whether, for example, a shareholder would receive cash or securities in kind or pay a redemption fee would be helpful for investors to better understand the impact of a fund’s redemption procedures on shareholders. b. Swing Pricing Form N–1A currently requires a fund to describe its procedures for pricing fund shares, including an explanation that the price of fund shares is based on the fund’s NAV and the method used to value fund shares.557 If the fund is an ETF, an explanation that the price of fund shares is based on market price is required.558 As discussed above, under proposed rule 22c–1(a)(3), a fund (with the exception of a money market fund or ETF) would be permitted, under certain circumstances, to use swing pricing to adjust its current NAV as an additional tool to lessen dilution of the value of outstanding redeemable securities through shareholder purchase and redemption activity.559 We are proposing to amend Item 6 of Form N–1A to account for this pricing procedure. Specifically, the proposed amendment would require a fund that uses swing pricing to explain the circumstances under which swing pricing would be required to be used as well as the effects of using swing pricing.560 For a fund that invests in other funds (e.g., fund-of-funds, masterfeeder funds), the fund would be required to include a statement that its NAV is calculated based on the NAVs of the funds in which the fund invests, and that the prospectuses for those funds explain the circumstances under which those funds will use swing pricing and the effects of using swing pricing. We believe that these proposed disclosures would improve public understanding regarding a fund’s use of swing pricing as well as the potential advantages and disadvantages of using swing pricing to manage dilution arising from shareholder purchase and redemption activity.
c. Request for Comment
We request comment on all aspects of the proposed amendments to Form N– 1A.

Would the proposed amendments
regarding payment of redemption proceeds be helpful to fund shareholders? Should we modify the proposed disclosures, and if so, how?
In addition to the proposed
disclosure requirements, should Form N–1A be amended to require certain funds to incorporate enhanced disclosure regarding liquidity risk into their summary prospectuses? If so, what funds should be subject to such enhanced disclosure requirements (e.g., funds with certain investment strategies, whose three-day liquid asset minimums are below a certain threshold, or that hold above a certain percentage of their portfolio (for instance, 5%, 10%, 20%, 30%) in assets with extremely limited liquidity, such as assets that can only be converted to cash in over 7 days, over 15 days, over 30 days, or over 90 days at a price that does not materially affect the value of that asset immediately prior to sale)? What specific liquidity risk disclosure requirements should apply to these funds?
Are there any challenges associated
with funds disclosing when they expect to pay redemption proceeds? Should funds be required to disclose the expected period in normal and stressed market conditions?
Are there any challenges associated
with funds disclosing the methods that they use to meet redemption requests and whether those methods are used regularly or only in stressed market conditions? Would disclosure of this information overly complicate prospectus disclosures?
In cases where the number of days
in which a fund will pay redemption proceeds differs by distribution channel, are there any challenges associated with funds disclosing the number of days for each distribution channel? Do funds pay all redemption proceeds at the same time irrespective of distribution channel (although when the shareholder actually receives redemption proceeds may differ by distribution channel)?
Would the proposed amendments
provide useful information to shareholders about how funds plan to satisfy redemption requests? Is there any additional information about fund redemption policies that shareholders should be aware of that is not discussed above? If so, would such additional information already be covered under existing Form N–1A requirements, or would we need to make any amendments to the form or its instructions?
Would the proposed amendment to
Item 28 of Form N–1A that would require a fund to file as exhibits to its registration statement any agreements related to lines of credit for the benefit of the fund be useful to fund shareholders and market participants? Why or why not? Are there any issues associated with funds filing such credit agreements? For example, even if specific fees paid in connection with the credit agreements are redacted, do funds have confidentiality concerns regarding filing such credit agreements? Should funds be required to file credit agreements if we adopt the proposed amendments to proposed Form N–CEN that require a fund to disclose information regarding lines of credit available to the fund?
Would the proposed amendments
to Form N–1A regarding swing pricing be useful to fund shareholders? Should funds be required to disclose additional information regarding swing pricing, and if so, what information should be disclosed?

Proposed Amendments to Proposed
Form N–PORT
The Commission, investors, and other market participants currently have limited information about the liquidity of portfolio investments of funds, and we believe that all would benefit from more detailed reporting and disclosure of the liquidity of a fund’s portfolio investments. On May 20, 2015, we proposed requiring registered management investment companies and ETFs organized as unit investment trusts, other than registered money market funds or small business investment companies, to electronically file with the Commission monthly portfolio investment information on proposed Form N–PORT.561 As we discussed in the Investment Company Reporting Modernization Release, the information that would be filed on proposed Form N–PORT would enhance the Commission’s ability to effectively oversee and monitor the activities of

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