[Federal Register Volume 81, Number 223 (Friday, November 18, 2016)]
[Rules and Regulations]
[Pages 82142-82269]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 2016-25348]



[[Page 82141]]

Vol. 81

Friday,

No. 223

November 18, 2016

Part IV





 Securities and Exchange Commission





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17 CFR Parts 270 and 274





 Investment Company Liquidity Risk Management Programs; Final Rule

Federal Register / Vol. 81 , No. 223 / Friday, November 18, 2016 / 
Rules and Regulations

[[Page 82142]]


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SECURITIES AND EXCHANGE COMMISSION

17 CFR Parts 270 and 274

[Release Nos. 33-10233; IC-32315; File No. S7-16-15]
RIN 3235-AL61


Investment Company Liquidity Risk Management Programs

AGENCY: Securities and Exchange Commission.

ACTION: Final rule.

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SUMMARY: The Securities and Exchange Commission is adopting new rules, 
a new form and amendments to a rule and forms designed to promote 
effective liquidity risk management throughout the open-end investment 
company industry, thereby reducing the risk that funds will be unable 
to meet their redemption obligations and mitigating dilution of the 
interests of fund shareholders. The amendments also seek to enhance 
disclosure regarding fund liquidity and redemption practices. The 
Commission is adopting new rule 22e-4, which requires each registered 
open-end management investment company, including open-end exchange-
traded funds (``ETFs'') but not including money market funds, to 
establish a liquidity risk management program. Rule 22e-4 also requires 
principal underwriters and depositors of unit investment trusts 
(``UITs'') to engage in a limited liquidity review. The Commission is 
also adopting amendments to Form N-1A regarding the disclosure of fund 
policies concerning the redemption of fund shares. The Commission also 
is adopting new rule 30b1-10 and Form N-LIQUID that generally will 
require a fund to confidentially notify the Commission when the fund's 
level of illiquid investments that are assets exceeds 15% of its net 
assets or when its highly liquid investments that are assets fall below 
its minimum for more than a specified period of time. The Commission 
also is adopting certain sections of Forms N-PORT and N-CEN that will 
require disclosure of certain information regarding the liquidity of a 
fund's holdings and the fund's liquidity risk management practices.

DATES: Effective Dates: This rule is effective January 17, 2017 except 
for the amendments to Form N-CEN (referenced in 17 CFR 274.101) which 
are effective June 1, 2018.
    Compliance Dates: The applicable compliance dates are discussed in 
section III.M. of this final rule.

FOR FURTHER INFORMATION CONTACT: Zeena Abdul-Rahman, John Foley, Andrea 
Ottomanelli Magovern, Naseem Nixon, Amanda Hollander Wagner, Senior 
Counsels; Thoreau Bartmann, Melissa Gainor, Senior Special Counsels; or 
Kathleen Joaquin, Senior Financial Analyst, Investment Company 
Rulemaking Office, at (202) 551-6792, Ryan Moore, Assistant Chief 
Accountant, or Matt Giordano, Chief Accountant at (202) 551-6918, 
Office of the Chief Accountant, 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 adopting new rules 22e-4 [17 CFR 270.22e-4] and 
30b1-10 [17 CFR 270.223], under the Investment Company Act of 1940 [15 
U.S.C. 80a-1 et seq.] (``Investment Company Act'' or ``Act''); new 
Form-N-LIQUID [referenced in 17 CFR 274.30b1-10] under the Investment 
Company 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.]; and adopting sections to 
Form N-PORT [referenced in 17 CFR 274.150] and Form N-CEN [referenced 
in 17 CFR 274.101] under the Investment Company Act.\1\
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    \1\ Unless otherwise noted, all references to statutory sections 
are to the Investment Company Act, and all references to rules under 
the Investment Company Act are to Title 17, Part 270 of the Code of 
Federal Regulations [17 CFR 270].
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Table of Contents

I. Introduction
II. Background
    A. Open-End Funds
    B. The Role of Liquidity in Open-End Funds
    C. Recent Developments in the Open-End Fund Industry
    D. Overview of Current Practices
    E. Rulemaking Adoption Overview
III. Discussion
    A. Program Requirement and Scope of Rule 22e-4
    B. Assessment, Management, and Review of Liquidity Risk
    C. Classifying the Liquidity of a Fund's Portfolio Investments, 
and Disclosure and Reporting Requirements Regarding Portfolio 
Investments' Liquidity Classifications
    D. Highly Liquid Investment Minimum
    E. Limitation on Funds' Illiquid Investments
    F. Policies and Procedures Regarding Redemptions in Kind
    G. Cross-Trades
    H. Board Approval and Designation of Program Administrative 
Responsibilities
    I. Recordkeeping Requirements
    J. ETFs
    K. Limitation on Unit Investment Trusts' Investments in Illiquid 
Investments
    L. Disclosure and Reporting Requirements Regarding Liquidity 
Risk and Liquidity Risk Management
    M. Effective and Compliance Dates
IV. Economic Analysis
    A. Introduction and Primary Goals of Regulation
    B. Economic Baseline
    C. Benefits and Costs, and Effects on Efficiency, Competition, 
and Capital Formation
V. Paperwork Reduction Act Analysis
    A. Introduction
    B. Rule 22e-4
    C. Form N-PORT
    D. Form N-LIQUID and Rule 30b1-10
    E. Form N-CEN
    F. Form N-1A
VI. Final Regulatory Flexibility Act Analysis
    A. Need for the Rule
    B. Significant Issues Raised by Public Comment
    C. Small Entities Subject to the Rule
    D. Projected Reporting, Recordkeeping, and Other Compliance 
Requirements
    E. Agency Action To Minimize Effect on Small Entities
VII. Statutory Authority and Text of Amendments
Text of Rules and Forms

I. Introduction

    Redeemability is a defining feature of open-end investment 
companies.\2\ At the time the Act was adopted, this feature was 
recognized as unique to open-end investment companies,\3\ and the Act's 
classification of management investment companies as either open-end 
(``open-end funds'' or ``funds'') \4\ or

[[Page 82143]]

closed-end, upon which several of the Act's other provisions depend, 
turns on whether the investment company's shareholders have the right 
to redeem their shares on demand. When the Investment Company Act was 
enacted, it was understood that redeemability meant that an open-end 
fund had to have a liquid portfolio.\5\ Since the 1940s, the Commission 
has stated that open-end funds should maintain highly liquid portfolios 
and recognized that this may limit their ability to participate in 
certain transactions in the capital markets.\6\ Section 22(e) of the 
Act enforces the shareholder's right of prompt redemption in open-end 
funds by compelling such funds to make payment on shareholder 
redemption requests within seven days of receiving the request. 
Potential dilution of shareholders' interests in open-end funds also 
was a significant concern of Congress when drafting the Act and was 
among the noted abuses that led to the enactment of the Act, as 
reflected in sections 22(a) and (c).\7\
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    \2\ See Investment Trusts and Investment Companies: Letter from 
the Acting Chairman of the SEC, A Report on Abuses and Deficiencies 
in the Organization and Operation of Investment Trusts and 
Investment Companies (1939), at n.206 (``[T]he salient 
characteristic of the open-end investment company . . . was that the 
investor was given a right of redemption so that he could liquidate 
his investment at or about asset value at any time that he was 
dissatisfied with the management or for any other reason.''). An 
open-end investment company 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 (``NAV'') 
next calculated by the fund after receipt of such redemption 
request.
    \3\ See Investment Trusts and Investment Companies: Hearings on 
S. 3580 before a Subcomm. of the Senate Comm. on Banking and 
Currency, 76th Cong., 3d Sess. (1940) (``1940 Senate Hearings 
Transcript''), at 453 (Statement of Mahlon E. Traylor) (``Open-end 
companies are unlike any other type of investment company, 
principally because of the highly important distinguishing feature 
that their shareholders can, by contract right, withdraw their 
proportionate interest at will simply by surrendering their shares 
to the company for redemption at liquidating value.'').
    \4\ In-Kind ETFs (as defined below) are included when we refer 
to ``funds'' or ``open-end funds'' throughout this Release, except 
in the sections discussing classifying the liquidity of a fund's 
portfolio positions and the highly liquid investment minimum 
requirement, from which In-Kind ETFs are excepted. We have done this 
for conciseness and we recognize that these naming conventions 
differ from the text of rule 22e-4. Additionally, while a money 
market fund is an open-end management investment company, money 
market funds are not subject to the rules and amendments we are 
adopting (except certain amendments to Form N-CEN and Form N-1A) and 
thus are not included when we refer to ``funds'' or ``open-end 
funds'' in this Release except where specified.
    \5\ See 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 57 (Statement 
of Robert E. Healy) (``due to the right of the stockholder to come 
in and demand a redemption, the [open-end fund] has to keep itself 
in a very liquid position. That is, it has to be able to turn its 
securities into money on very short notice.'').
    \6\ See Investment Trusts and Investment Companies: Report of 
the Securities and Exchange Commission (1942), at 76 (``Open-end 
investment companies, because of their security holders' right to 
compel redemption of their shares by the company at any time, are 
compelled to invest their funds predominantly in readily marketable 
securities. Individual open-end investment companies, therefore, as 
presently constituted, could participate in the financing of small 
enterprises and new ventures only to a very limited extent.'').
    \7\ See 1940 Senate Hearings Transcript, supra footnote 3, at 
37, 137-145 (stating that, among the abuses that served as a 
backdrop for the Act, were ``practices which resulted in substantial 
dilution of investors' interests'', including backward pricing by 
fund insiders to increase investment in the fund and thus enhance 
management fees, but causing dilution of existing investors in the 
fund).
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    Although the Investment Company Act provides funds with a seven-day 
window to pay proceeds upon an investor's redemption, the settlement 
period for open-end fund redemptions has shortened considerably over 
the years. There are several reasons for shorter settlement periods, 
including broker-dealer settlement cycle requirements,\8\ evolving 
industry standards, and technological advances in the settlement 
infrastructure.\9\ In addition, many funds state in their prospectuses 
that investors can ordinarily expect to receive redemption proceeds in 
shorter periods than seven days.\10\ At the same time, open-end funds 
have experienced significant growth,\11\ markets have grown more 
complex, and funds pursue more complex investment strategies, including 
fixed income and alternative investment strategies focused on less 
liquid asset classes. These trends have made the role of fund liquidity 
and liquidity management more important than ever in reducing the risk 
that a fund will be unable to meet its obligations to redeeming 
shareholders or other obligations under applicable law, while also 
minimizing the impact of those redemptions on the fund (i.e., 
mitigating investor dilution). Furthermore, recent events have 
demonstrated the significant adverse consequences to remaining 
investors in a fund when it fails to adequately manage liquidity.\12\
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    \8\ 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.
    \9\ Generally, settlement time frames for mutual fund shares 
have been shortening for decades. See Open-End Fund Liquidity Risk 
Management Programs; Swing Pricing; Re-Opening of Comment Period for 
Investment Company Reporting Modernization Release, Investment 
Company Act Release No. 31835 (Sept. 22, 2015) [80 FR 62274 (Oct. 
15, 2015)] (``Proposing Release''), at section II.C.2. See also, 
e.g., T+2 Industry Steering Committee, Shortening the Settlement 
Cycle: The Move to T+2 (2015), at n.18, available at http://www.ust2.com/pdfs/ssc.pdf (``In today's environment . . . open-end 
mutual funds settle through NSCC generally on a T+1 basis (excluding 
certain retail trades which typically settle on T+3).''). See also 
Amendment to Securities Transaction Settlement Cycle, Securities 
Exchange Act Release No. 34-78962 (September 29, 2016) [81 FR 69240 
(October 05, 2016)].
    \10\ See, e.g., Fidelity Commonwealth Trust rule 485(b) 
Registration Statement (June 29, 2016), available at https://www.sec.gov/Archives/edgar/data/205323/000137949116004602/filing776.htm (``Normally, redemptions will be processed by the next 
business day, but it may take up to seven days to pay the redemption 
proceeds if making immediate payment would adversely affect the 
fund.''); PIMCO Funds rule 485(b) Registration Statement (Feb. 26, 
2016), available at https://www.sec.gov/Archives/edgar/data/810893/000119312516481663/d149399d485bpos.htm#chapter_7_3686 (``Redemption 
proceeds will normally be mailed to the redeeming shareholder within 
three calendar days . . . [but] may take up to seven days.'').
    \11\ As of the end of 2015, there were 10,633 open-end funds 
(excluding money market funds, but including ETFs), as compared to 
5,279 at the end of 1996. See Investment Company Institute, 2016 
Investment Company Fact Book (2016) (``2016 ICI Fact Book''), 
available at https://www.ici.org/pdf/2016_factbook.pdf.
    \12\ For example, during the pendency of our proposal, the Third 
Avenue Focused Credit Fund, a non-diversified open-end fund, adopted 
a plan of liquidation, and requested and obtained exemptive relief 
to suspend shareholder redemptions, following a period of heavy 
redemption requests that the fund stated reduced the fund's 
portfolio liquidity. The Third Avenue Focused Credit Fund has yet to 
complete the liquidation of fund assets. Additionally, the fund 
reported that, as a result of the continuous liquidation of 
securities without reinvestment, the fund became increasingly more 
concentrated, which negatively impacted performance. See Third 
Avenue Trust and Third Avenue Management LLC, Investment Company Act 
Release No. 31943 (Dec. 16, 2015) (``Third Avenue Temporary 
Order''); Third Avenue Focused Credit Fund Semi-Annual Report to 
Shareholders (April 30, 2016), available at: http://thirdave.com/wp-content/uploads/2016/06/Q2-2016-TFCIX-Semi-Annual-Report.pdf (``The 
Fund is considerably more concentrated than it has ever been. As we 
have been liquidating securities and not recycling the cash, the top 
10 holdings have increased from 32.6% at March 31, 2015 to 
approximately 67% of the Fund. We are increasingly dependent on the 
top 10 names to drive performance.''). See also infra footnotes 81-
84 and accompanying text.
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    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. In developing the proposed rules, 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 extensive liquidity risk management programs, others have 
dedicated significantly fewer resources, attention and focus to 
managing liquidity risk in a formalized way. We believe 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 sought to address these goals with the proposal on fund 
liquidity risk management that we published in late 2015.\13\ This 
proposal would have required funds to: establish liquidity risk 
management programs, including classifying and monitoring each 
portfolio asset's level of liquidity and designating a minimum amount 
of highly liquid investments; provide additional reporting to us; and 
enhance disclosure to investors regarding the liquidity of fund 
portfolios and how funds manage liquidity risk and redemption 
obligations. In order to

[[Page 82144]]

provide funds with an additional tool to mitigate potential dilution 
and to manage fund liquidity, the proposal included 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 NAV of a 
fund's shares to pass on to purchasing or redeeming shareholders more 
of the costs associated with their trading activity.\14\
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    \13\ See Proposing Release, supra footnote 9.
    \14\ We note that we are adopting swing pricing, and associated 
changes to Form N-PORT and N-CEN in a companion release. See 
Investment Company Swing Pricing, Investment Company Act Release No. 
32316 (Oct. 13, 2016) (``Swing Pricing Adopting Release''). All 
comments on the proposed swing pricing rules and associated issues 
are discussed in that release.
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    We received more than 70 comment letters on the proposal.\15\ The 
majority of commenters generally supported a requirement that funds 
adopt a formal, written liquidity risk management program that is risk 
oriented and principles based, although many provided suggestions and 
alternatives for us to consider.\16\ Many commenters objected to 
certain aspects of the proposal, particularly the liquidity 
classification requirement, the three-day liquid asset minimum, and the 
requirement that funds publicly disclose the liquidity of each 
portfolio position.\17\ Several commenters specifically supported 
applying the liquidity risk management requirements to all open-end 
funds, with the exception of money market funds.\18\ Others expressed 
concerns with regard to ETFs, and recommended that the Commission 
exclude ETFs that primarily satisfy purchase and redemption orders in 
kind from the liquidity risk management requirements or develop a more 
tailored liquidity risk management program applicable to ETFs.\19\
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    \15\ The comment letters on the Proposing Release (File No. S7-
16-15) are available at http://www.sec.gov/comments/s7-16-15/s71615.shtml.
    \16\ See, e.g., Comment Letter of Investment Company Institute 
(Jan. 13, 2016) (``ICI Comment Letter I''); Comment Letter of 
BlackRock Inc. (Jan. 13, 2016) (``BlackRock Comment Letter''); 
Comment Letter of Charles Schwab Investment Management (Jan. 13, 
2016) (``Charles Schwab Comment Letter'').
    \17\ See, e.g., ICI Comment Letter I (arguing that the six-
category asset classification scheme and three-day liquid asset 
minimum are problematic and encourage a ``one-size-fits-all'' 
approach rather than a risk-based approach to liquidity management); 
Charles Schwab Comment Letter (arguing that public disclosure of the 
liquidity of each portfolio position may confuse and mislead 
investors).
    \18\ See, e.g., Comment Letter of HSBC Global Asset Management 
(Jan. 13, 2016) (``HSBC Comment Letter'') (supporting the exclusion 
of closed-end funds and money market funds from the liquidity risk 
management requirements); Charles Schwab Comment Letter (supporting 
the application of the risk management requirements to ETFs).
    \19\ See, e.g., ICI Comment Letter I; BlackRock Comment Letter 
(suggesting that the Commission should develop a separate and 
comprehensive rule addressing the different types of ETFs and their 
respective risks). The comments we received addressing exchange-
traded managed funds (``ETMFs'') suggested that the Commission treat 
ETMFs in the same manner as ETFs and did not recommend any further 
unique treatment of ETMFs. See Comment Letter of the American Bar 
Association (Feb. 11, 2016); Comment Letter of Financial Services 
Roundtable (Jan. 13, 2016) (``FSR Comment Letter'').
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    Today, after consideration of the many comments we received, we are 
adopting the proposal with a number of modifications to enhance the 
effectiveness and workability of the rule's liquidity risk management 
requirements. The Commission is adopting new rule 22e-4, which will 
require each fund to adopt and implement a written liquidity risk 
management program designed to assess and manage the fund's liquidity 
risk, which will be overseen by the fund's board. As discussed in more 
detail below, the Commission is modifying from the proposal some of the 
liquidity risk management program elements, including reducing the 
liquidity classification categories from six to four, providing 
tailored program requirements for ETFs, and revising the fund board 
oversight requirements.
    The new rule contains a highly liquid investment minimum 
requirement, which is similar to the proposed three-day liquid asset 
minimum. However, instead of barring a fund from purchasing securities 
other than highly liquid investments if the fund falls below its 
minimum as proposed for the three-day liquid asset minimum, under the 
adopted rules, if the fund falls below its highly liquid investment 
minimum, it would: (1) Report that occurrence to the fund board at its 
next scheduled meeting; (2) if it is below the minimum for more than a 
brief period of time, report the occurrence to the board and, on Form 
N-LIQUID, to the Commission within one business day; and (3) develop 
and provide to the board a plan for restoring the minimum within a 
reasonable period of time.
    We also are adopting a 15% limitation on funds' purchases of 
illiquid investments, largely as proposed, but the definition of 
investments considered illiquid and subject to this 15% limit has been 
enhanced and substantially harmonized with the classification system we 
are adopting today. Additionally, the Commission is adopting new 
reporting Form N-LIQUID, which will require a fund to confidentially 
notify the Commission within one business day if the fund's illiquid 
investment holdings exceed 15% of its net assets or if its highly 
liquid investments fall below its minimum for more than a brief period 
of time. Furthermore, much as proposed, the Commission is adopting 
reporting and disclosure requirements under Form N-CEN, Form N-PORT, 
and Form N-1A regarding liquidity risk and liquidity risk management. 
In response to commenters' concerns, a number of the additional 
reporting items on Form N-PORT will be non-public.\20\
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    \20\ If any provision of these rules, or the application thereof 
to any person or circumstance, is held to be invalid, such 
invalidity shall not affect other provisions or application of such 
provisions to other persons or circumstances that can be given 
effect without the invalid provision or application.
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    Taken together, these reforms are designed to provide investors 
with increased protection regarding how liquidity in their open-end 
funds is managed, thereby reducing the risk that funds will be unable 
to meet redemption or other legal obligations, and mitigating dilution 
of the interests of fund shareholders. These reforms also are intended 
to give investors better information to make investment decisions, and 
to give the Commission better information to conduct comprehensive 
monitoring and oversight of an ever-evolving fund industry.

II. Background

A. Open-End Funds

    As we discussed in the Proposing Release, individual and 
institutional investors increasingly have come to rely on investments 
in open-end funds to meet their financial needs and access the capital 
markets. At the end of 2015, 54.9 million households, or 44.1 percent 
of all U.S. households owned funds.\21\ 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.\22\
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    \21\ See 2016 ICI Fact Book, supra footnote 11, at 12.
    \22\ There are currently four primary kinds of open-end funds: 
Money market funds, mutual funds other than money market funds, 
ETFs, and ETMFs. Money market funds are a special kind of mutual 
fund that complies with the requirements of rule 2a-7 under the Act. 
ETFs 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 (A) is organized under a trust indenture, 
contract of custodianship or agency, or similar instrument, (B) does 
not have a board of directors, and (C) 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.

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    As noted above, investors in mutual funds can redeem their shares 
on each business day and, by law, must receive approximately their pro 
rata share of the fund's net assets (or its cash value) within seven 
calendar days after receipt of a redemption request.\23\ Under the 
Act's definition of redeemable security, open-end funds have the right 
to redeem shareholders in cash or in kind (that is, by delivering 
certain assets from the fund's portfolio, rather than cash, to a 
redeeming shareholder).\24\ However, while funds often reserve the 
right to redeem in kind for certain redemption requests, the majority 
of mutual funds redeem only in cash for a variety of reasons, including 
the limited ability and/or unwillingness of fund shareholders to 
receive securities rather than cash.\25\
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    \23\ See 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 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). See 
also rule 22c-1 (requiring that redeemable securities be transacted 
``at a price based on the current net asset value of such security 
which is next computed after receipt of a tender of such security 
for redemption or of an order to purchase or sell such security'').
    \24\ Prior to the adoption of the Act, open-end funds largely 
redeemed fund shares in cash and, as such, a redeemable security was 
generally understood to mean a security that was redeemable for 
cash. See, e.g., Investment Trusts and Investment Companies: Senate 
Report 1775 on S. 4108, 76th Cong., 3d Sess. (1940), at 2 (``[a 
redeemable security] is, a security which provides that the holder 
may tender it to the company at any time and receive a sum of money 
approximating the current market value of his proportionate interest 
in the company's assets.''[emphasis added]). However, section 
2(a)(32) has traditionally been interpreted to give funds the option 
of redeeming their shares in cash or in kind. See, e.g., Investment 
Trusts and Investment Companies: Report of the Securities and 
Exchange Commission Part I (1939) at 21 (``A company is of the 
`open-end' type if a shareholder has the right to require the 
company to purchase or redeem or cause the purchase or redemption of 
the shares representing his proportionate interest in the company's 
properties, or the cash equivalent of such interest.''); see also 
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.'').
    \25\ See Comment Letter of Invesco Advisers, Inc. (Jan. 13, 
2016) (``Invesco Comment Letter'') (``The primary problem with using 
redemptions in kind to meet large redemptions is the willingness and 
ability of the redeeming entity to receive securities instead of 
cash.''). See also Money 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 and accompanying text (stating that ``[m]any 
commenters believed that requiring 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 portfolio securities.'').
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    ETFs also offer investors an undivided interest in a pool of 
assets.\26\ ETF shares, similar to listed stocks, are bought and sold 
throughout the day by investors on an exchange through a broker-
dealer.\27\ In addition, like mutual funds, ETFs provide redemption 
rights on a daily basis, but, pursuant to exemptive orders, such 
redemption rights may be exercised only by certain large market 
participants--typically broker-dealers--called ``authorized 
participants.'' \28\ 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.\29\ 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 publicly 
declared by the ETF before the beginning of the trading day.\30\
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    \26\ Since 2003, the number of ETFs traded in U.S. markets has 
increased by more than 2,200 funds, and the assets held by ETFs have 
increased from $151 billion at the end of 2003 to $2.1 trillion at 
the end of 2015. See 2016 ICI Fact Book, supra footnote 11, at 60.
    \27\ See Exchange-Traded Funds, Investment Company Act Release 
No. 28193 (Mar. 11, 2008) [73 FR 14618 (Mar. 18, 2008)] (``ETF 
Proposing Release'').
    \28\ Authorized participants may purchase and redeem ETF shares 
at the ETF's NAV from the ETF.
    \29\ The ETF publicly declares the contents of the portfolio 
deposit before the beginning of the trading day. See 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 nn.19-20 and accompanying text.
    \30\ See ETF Proposing Release, supra footnote 27, at n.24 and 
accompanying text.
---------------------------------------------------------------------------

    ETMFs are a hybrid between a traditional mutual fund and an 
ETF.\31\ Like ETFs, ETMFs 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 are bought and sold 
at prices linked to NAV and seek to maintain the confidentiality of 
their current portfolio positions.
---------------------------------------------------------------------------

    \31\ The Commission approved ETMFs in 2014 and the first ETMFs 
have since been launched. See Eaton Vance Management, et al., 
Investment Company Act Release No. 31333 (Nov. 6, 2014) (notice of 
application) (``ETMF Notice'') and In the Matter of Eaton Vance 
Management, et al., Investment Company Act Release No. 31361 (Dec. 
2, 2014) (order) (``ETMF Order''). Given the similarities between 
ETFs and ETMFs and that the new requirements will apply to ETMFs as 
they do to ETFs, this Release generally includes ETMFs in the term 
``ETF'' and separately mentions ETMFs only if appropriate. See supra 
footnote 19.
---------------------------------------------------------------------------

B. The Role of Liquidity in Open-End Funds

1. 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, 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 
(although some funds may reserve the right to make redemptions in kind 
for certain redemption requests). As a practical matter, many investors 
expect to receive redemption proceeds in fewer than seven days as some 
mutual funds represent in their prospectuses that they will generally 
pay redemption proceeds on a next business day basis.\32\ Given the 
statutory and regulatory requirements for meeting redemption requests, 
as well as any potential liability for representations 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.
---------------------------------------------------------------------------

    \32\ See supra footnote 10; see also supra footnote 8 (noting 
that open-end funds that are redeemed through broker-dealers must 
meet redemption requests within three business days due to the 
application of rule 15c6-1 under the Exchange Act).
---------------------------------------------------------------------------

    Sufficient liquidity of ETF portfolio positions also is important. 
Many ETFs typically make in-kind redemptions of creation units, which 
can mitigate the need for ETFs to maintain cash compared to mutual 
funds, particularly if the in-kind redemptions are of a representative 
basket of the ETF's

[[Page 82146]]

portfolio assets that do not alter the ETF's liquidity profile. 
However, transferring illiquid or less liquid instruments to the 
redeeming authorized participants could result in a liquidity cost to 
the authorized participants or other market participants, which could 
increase the cost of their participation and interfere with their role 
in the ETF arbitrage mechanism, resulting in the ETF trading at 
increased bid-ask spreads and/or a premium or discount to its NAV and 
ultimately impacting investors.\33\ Declining liquidity in an ETF's 
basket assets also could affect the ability of an authorized 
participant or other market participants to readily assemble the basket 
for purchases of creation units and to sell securities received upon 
redemption of creation units.
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    \33\ 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 ETF. See infra footnote 843 
and accompanying text. Commenters noted that the effective 
functioning of this arbitrage mechanism has been pivotal to the 
operation of ETFs. See ICI Comment Letter I.
---------------------------------------------------------------------------

    In addition, all ETFs reserve the right to satisfy redemption 
requests in cash rather than in kind, but the extent to which ETFs 
satisfy redemption requests in cash varies. While many ETFs redeem in 
cash only rarely, some ETFs ordinarily redeem authorized participants 
in cash. ETFs that elect to redeem authorized participants in cash in 
more than a de minimis amount, like mutual funds, would need to ensure 
that they have adequate portfolio liquidity (in conjunction with any 
other liquidity sources) to meet shareholder redemptions.
    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, ETMFs would need to hold sufficiently liquid assets to 
meet such redemptions to the extent that the ETMFs satisfy the 
redemption requests in cash. As with ETFs, however, the ETMFs' practice 
of making in-kind redemptions could mitigate the need to maintain cash. 
Further, as ETMF market makers would not engage in the same kind of 
arbitrage as ETF market makers because the pricing of the ETMF shares 
is linked to the fund's NAV (subject to execution costs), the liquidity 
of an ETMF's portfolio is more relevant to an ETMF's ability to meet 
redemptions and the amount of execution costs than to an arbitrage 
function.
2. Statutory and Regulatory Requirements
    An open-end fund's failure to maintain sufficiently liquid assets 
or otherwise manage liquidity implicates multiple provisions of the 
Act, as well as other federal securities laws and regulations. Section 
2(a)(32) of the Act,\34\ when read together with sections 4(2) and 
5(a),\35\ creates an obligation on open-end funds and UITs to provide 
shareholders with approximately their proportionate share of NAV upon 
the presentation of a redemption request. Section 22(e) of the Act 
provides in turn that the right of redemption may not be suspended and 
payment of redemption proceeds may not be postponed for more than seven 
days after tender of a redeemable security absent specified unusual 
circumstances.\36\
---------------------------------------------------------------------------

    \34\ See supra footnote 23.
    \35\ Section 4(2) of the Act defines a ``unit investment trust'' 
as an investment company which, among other things, ``issues only 
redeemable securities.'' Section 5(a) of the Act defines an ``open-
end company'' as a ``management company which is offering for sale 
or has outstanding any redeemable security of which it is the 
issuer''.
    \36\ Section 22(e) of the Act 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. The Commission has rarely issued 
orders permitting the suspension of redemptions for periods of 
restricted trading or emergency circumstances but has issued orders 
``for such other periods'' under section 22(e)(3) 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)]; In the Matter of Municipal Lease Securities 
Fund, Inc., Investment Company Act Release No. 17245 (Nov. 29, 
1989); Third Avenue Temporary Order, supra footnote 12. Money market 
funds are able to suspend redemptions in certain limited 
circumstances. See rule 22e-3 under the Act; see also the Proposing 
Release, supra footnote 9, at n.155.
---------------------------------------------------------------------------

    For decades, the Commission has recognized that because open-end 
funds hold themselves out at all times as being prepared to meet these 
statutory redemption requirements, they have a responsibility to manage 
the liquidity of their investment portfolios in a manner consistent 
with those obligations and any other related representations.\37\ Thus, 
long-standing Commission guidelines contain a liquidity standard that 
generally limits an open-end fund's aggregate holdings of ``illiquid 
assets'' to no more than 15% of the fund's net assets (the ``15% 
guideline'').\38\ 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.\39\ 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 and certain other privately placed or restricted securities 
\40\ as well as certain instruments or transactions not maturing in 
seven days or less, including term repurchase agreements.\41\
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    \37\ See Statement 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.''); see also 
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 of 1933 (the ``Securities Act'')).
    \38\ Revisions of Guidelines to Form N-1A, Investment Company 
Act Release No. 18612 (Mar. 12, 1992) [57 FR 9828 (Mar. 20, 1992)] 
(``Guidelines Release''), 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.''). The Guidelines 
Release modified prior Commission guidance that set a 10% limit on 
illiquid assets for open-end funds. See Restricted Securities 
Release, supra footnote 37.
    \39\ Guidelines Release, supra footnote 38; see also ETF 
Proposing Release, supra footnote 27; 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)] 
(``Money Market Funds Release''); see also Rule 144A Release, supra 
footnote 37.
    \40\ See Restricted Securities Release, supra footnote 37. 
Securities offered pursuant to rule 144A under the Securities Act 
may be considered liquid under the 15% guideline depending on 
certain factors. See Rule 144A Release, supra footnote 37.
    \41\ See Periodic 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)] (``Interval Fund 
Proposing Release''). 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 under the 15% 
guideline. However, in the context of rule 144A securities, the 
Commission had provided ``examples of factors that would be 
reasonable for a [fund's] board of directors to take into account'' 
but which would not necessarily be determinative. See Rule 144A 
Release, supra footnote 37. 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.

---------------------------------------------------------------------------

[[Page 82147]]

    Relatedly, the Commission has recognized that the liquidity 
management practices of open-end funds implicate certain antifraud 
provisions of the securities laws.\42\ For example, section 34(b) of 
the Act makes it unlawful for any person to make any untrue statement 
of a material fact in any document filed with the Commission or 
transmitted pursuant to the Act, or the keeping of which is required by 
section 31(a) of the Act, or to omit to state any fact necessary in 
order to prevent the statements made therein, in light of the 
circumstances under which they were made, from being materially 
misleading.\43\
---------------------------------------------------------------------------

    \42\ See Restricted Securities Release, supra footnote 37 (``To 
the extent a material percentage of the assets of an open-end 
company consist of restricted securities which cannot publicly be 
sold without registration under the Securities Act, the ability of 
the company to comply with the provisions of the Investment Company 
Act relating to redemption, and to fulfill the implicit 
representations made in its prospectus with respect thereto, may be 
adversely affected. In any such situation, the investment company 
concerned and the persons responsible for the sale of its securities 
should give careful consideration to the possible application of the 
provisions of section 10(b) of the Exchange Act and Rule 10b-5 
thereunder.''); see also Money Market Funds Release, supra footnote 
39 (explaining that because ``most money market funds promise 
investors that they will receive proceeds much sooner'' than seven 
days and ``experience a greater and perhaps less predictable volume 
of redemption transactions than do other investment companies,'' 
they ``must have sufficient liquidity to meet redemption requests on 
a more immediate basis''). The Commission has considered the failure 
to take risk-limiting measures in other contexts to implicate 
antifraud provisions as well. See Adoption of Revisions to Rules 
Regulating Money Market Funds, Investment Company Act Release No. 
18005 (Feb. 20, 1991) (``The Commission believes that there is a 
significant danger of misleading investors if an investment company 
holds itself out as a money market fund when it engages in 
investment strategies not consistent with the risk-limiting 
conditions of rule 2a-7. It is therefore necessary and appropriate 
in the public interest and for the protection of investors for the 
Commission to adopt a new paragraph (b) of rule 2a-7 prohibiting an 
investment company from holding itself out as a `money market fund' 
unless it meets the risk-limited conditions of rule 2a-7.'').
    \43\ Exercising authority under section 34(b) and sections 9(b), 
38(a), and 42 of the Act, the Commission adopted paragraph (b) of 
rule 2a-7 in 1997, which provides that ``it shall be an untrue 
statement of a material fact within the meaning of section 34(b) of 
the Act for a registered investment company . . . to hold itself out 
to investors as a money market fund or the equivalent of a money 
market fund'' unless the fund complies with rule 2a-7. Under 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 adopted amendments to rule 
2a-7 in 2014 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. See 
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'').
---------------------------------------------------------------------------

    In addition, section 206(4) \44\ of the Investment Advisers Act of 
1940 (``Advisers Act'') and rule 206(4)-8 thereunder make it unlawful 
for any adviser to an investment fund to engage in any act, practice, 
or course of business which is fraudulent, deceptive, or 
manipulative.\45\ Additionally, section 10(b) of the Exchange Act and 
rule 10b-5 thereunder make it unlawful, among other things, for any 
person, in connection with the purchase or sale of securities, to 
employ any device, scheme, or artifice to defraud or to make any untrue 
statement of a material fact or to omit to state a material fact 
necessary in order to make the statements made not misleading, or 
engage in any act, practice, or course of business which operates or 
would operate as a fraud or deceit upon any persons. Finally, section 
17(a) of the Securities Act similarly makes it unlawful for any person 
in the offer or sale of any securities or any security-based swap 
agreement by the use of any means or instruments of transportation or 
communication in interstate commerce or by use of the mails, directly 
or indirectly, to employ any device, scheme, or artifice to defraud, to 
obtain money or property by means of any untrue statement of a material 
fact or any omission to state a material fact necessary in order to 
make the statements made, in light of the circumstances under which 
they were made, not misleading, or to engage in any transaction, 
practice, or course of business which operates or would operate as a 
fraud or deceit upon the purchaser.\46\
---------------------------------------------------------------------------

    \44\ Section 206(4) of the Advisers Act grants the Commission 
authority, by rules and regulations, to define and prescribe means 
reasonably designed to prevent such acts, practices, and courses of 
business as are fraudulent, deceptive, or manipulative.
    \45\ Additionally, section 206(1) of the Advisers Act makes it 
unlawful for an adviser to employ any device, scheme or artifice to 
defraud any client or prospective client, and section 206(2) makes 
it unlawful for an adviser to engage in any transaction, practice or 
course of business which operates as a fraud or deceit upon any 
client or prospective client. See Prohibition of Fraud by Advisers 
to Certain Pooled Investment Vehicles, Investment Advisers Act 
Release No. 2628 (August 3, 2007) [72 FR 44756 (August 9, 2007)], at 
n.3 and accompanying text.
    \46\ See In the Matter of Evergreen Investment Management 
Company, LLC and Evergreen Investment Services, Inc., Investment 
Company Act Release No. 28759 (June 8, 2009) (settled order) 
(``Evergreen Order'') (settlement of allegations that a mutual fund 
and its underwriter violated, and its adviser aided and abetted 
violations of, section 22(c) of the Act and rule 22c-1(a) through 
purchases and redemptions at materially overstated NAV. The order 
found that the fund's adviser materially misrepresented the fund's 
performance and NAV in reviewing and approving the fund's prospectus 
in violation of section 34(b) of the Act.).
---------------------------------------------------------------------------

    As the Commission has previously noted, an open-end fund 
``represents to investors, in its prospectus, that it will, as required 
by section 22(e) of the Act, redeem its securities at approximate net 
asset value within seven days after tender.'' \47\ Similarly, an open-
end fund that is redeemed through broker-dealers generally represents 
to investors that it will redeem its securities within three days, as 
required by rule 15c6-1.\48\ Failure by a fund to maintain a 
sufficiently liquid portfolio or to otherwise manage liquidity risk 
calls into question the fund's ability to fulfill the representations 
(explicit or implicit) made in its prospectus regarding its ability to 
meet its redemption obligations, as well as its status as an open-end 
fund. Such failure thus potentially exposes the fund, the investment 
adviser that manages the fund, and the persons responsible for the sale 
of the fund's securities to the possible application of the antifraud

[[Page 82148]]

provisions of the securities laws referenced above.\49\
---------------------------------------------------------------------------

    \47\ Restricted Securities Release, supra footnote 37.
    \48\ See also Proposing Release, supra footnote 9, at II.C.2 
(``We also have observed that some open-end 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.''). As the Commission has previously noted, most 
money market funds disclose that they will pay redemptions even more 
quickly, often on the same day that the request is received by the 
fund, and thus ``must have sufficient liquidity to meet redemption 
requests on a more immediate basis.'' Money Market Funds Release, 
supra footnote 39.
    \49\ See Restricted Securities Release, supra footnote 37; 
Proposing Release, supra footnote 9, at n.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 with seven days or 
any shorter time disclosed in the fund's prospectus or advertising 
materials.'') (citing 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); id. at n.109 (``[F]unds' 
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.''); id. at III.C (``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) . . . 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.''); id. at 
III.C.3.d (requesting public comment on whether liquid asset minimum 
requirements tighter than three days may be warranted ``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.'').
---------------------------------------------------------------------------

    In addition to the foregoing concerns, an insufficiently liquid 
portfolio implicates provisions of the Act and regulations thereunder 
concerning fund valuation.\50\ A fund's ability to properly value its 
portfolio securities is important, primarily because, under the Act, 
fund shareholders are entitled to their proportionate share of the 
fund's NAV upon redemption. Section 2(a)(41) of the Act and rule 2a-4 
thereunder provide that in determining NAV, funds must value 
``securities for which market quotations are readily available'' at 
current market value, and must value all other securities and assets at 
``fair value as determined in good faith by the board of directors.'' 
Illiquid or less liquid assets are less likely to have readily 
available market quotations, and thus are more likely to require a fair 
value determination. Determining the fair value of illiquid or less 
liquid assets consistent with section 2(a)(41) and rule 2a-4 can pose a 
number of challenges, some of which the Commission has previously 
described in the context of the acquisition of restricted 
securities,\51\ and improper valuation of such assets could result in 
liability under the antifraud provisions.\52\ The difficulties valuing 
illiquid or less liquid securities also implicate section 22(c) and 
rule 22c-1, which requires the use of the next-determined NAV for 
pricing purchases and redemptions. Transactions in such securities are 
more likely to be effected at prices that differ from fair value and, 
therefore, may result in increasing risk of investor dilution.\53\
---------------------------------------------------------------------------

    \50\ See Restricted Securities Release, supra footnote 37 
(describing the ``serious problems of valuation'' arising from fund 
acquisition of restricted securities); Guidelines Release, supra 
footnote 38 (noting that a fund ``must maintain a high degree of 
portfolio liquidity'' to meet the requirements under section 22(e), 
rule 22c-1(a) and rule 2a-4).
    \51\ See Restricted Securities Release, supra footnote 37 at n.1 
and accompanying text for a discussion of the various valuation 
challenges facing purchasers and sellers of restricted securities.
    \52\ See Restricted Securities Release, supra footnote 37. As 
the Commission explained there, ``[t]he offering price of securities 
issued by a management investment company is premised upon the net 
asset value of such shares as determined pursuant to [section 
2(a)(41)] of the Act and Rule 2a-4 thereunder and is so represented 
in its prospectus.'' Consequently, ``the improper valuation of 
restricted securities held by such a company would distort the net 
asset value of the shares being offered or, in the case of an open-
end company, redeemed, and would therefore constitute a fraud and 
deceit within the meaning of section 10(b) and Rule 10b-5.'' See 
also infra footnote 66.
    \53\ See Restricted Securities Release, supra footnote 37, at 
n.1 (``the valuation of restricted securities by reference to the 
market price for unrestricted securities of the same class assumes 
that the market price for unrestricted securities of the same class 
is representative of the fair value of the securities. This may not 
be the case when the market for the unrestricted securities is very 
thin, i.e., only a limited volume of shares are available for 
trading.'').
---------------------------------------------------------------------------

    A separate and independent issue arising from the failure to 
maintain a sufficiently liquid portfolio is the risk of shareholder 
dilution associated with improper fund pricing. Thus, section 
22(a),\54\ when read together with section 22(c),\55\ gives the 
Commission broad powers to regulate the pricing of redeemable 
securities for the purpose of eliminating or reducing so far as 
reasonably practicable any dilution of the value of the outstanding 
fund shares. In its 1969 guidance on restricted securities, the 
Commission observed that a fund with significant holdings of restricted 
securities may have to engage in private sales on short notice to meet 
redemption obligations, which could result in the fund ``receiving less 
than its carrying value of the restricted securities.'' \56\ That, in 
turn, would ``result in a preference in favor of the redeeming 
shareholders and a diminution of the NAV per share of shareholders who 
have not redeemed,'' further highlighting the need for funds to 
maintain ``a high degree of liquidity'' given the unpredictability of 
redemption demands or other exigencies.\57\ Similarly, here, as a 
general matter, to the extent a fund's portfolio is made up of a large 
amount of illiquid or less liquid securities, the fund may face 
difficulties meeting shareholder redemption requests while at the same 
time protecting the value of the shares of existing shareholders from 
dilution. Limited liquidity may hinder the portfolio manager's ability 
to defensively reposition the fund in anticipation of shifting or 
volatile markets because asset sales necessary to effectuate those 
shifts can be executed only with substantial liquidity costs. If 
limited liquidity in the fund's portfolio limits which assets the fund 
can sell to meet redemptions, such limited liquidity also could even 
result in the fund straying from its investment objective. Accordingly, 
a fund that does not effectively manage its liquidity risk may become 
constrained in its portfolio management, to the detriment of its 
investors and contrary to the way the fund represents its investment 
strategy to the public.\58\ Therefore, when constructing a fund's 
portfolio of securities, it is essential for the fund to take into 
account the importance of maintaining a portfolio that is liquid enough 
to fulfill the fund's obligations under these provisions.\59\
---------------------------------------------------------------------------

    \54\ Section 22(a) authorizes securities associations registered 
under section 15A of the Exchange Act to prescribe rules related to 
the method of computing purchase and redemption prices of redeemable 
securities and the minimum time period that must elapse after the 
sale or issue of such securities before any resale or redemption may 
occur, for the purpose of ``eliminating or reducing so far as 
reasonably practicable any dilution of the value of other 
outstanding securities of such company or any other result of such 
purchase, redemption, or sale which is unfair to holders of such 
other outstanding securities.''
    \55\ Section 22(c) authorizes the Commission to make rules and 
regulations applicable to registered investment companies and to 
principal underwriters of, and dealers in, the redeemable securities 
of any registered investment company, whether or not members of any 
securities association, to the same extent, covering the same 
subject matter, and for the accomplishment of the same ends as are 
prescribed in section 22(a) in respect of the rules which may be 
made by a registered securities association governing its members.
    \56\ See Restricted Securities Release, supra footnote 37.
    \57\ Id.
    \58\ See Restricted Securities Release, supra footnote 37 (``It 
is desirable that an open-end company retain maximum flexibility in 
the choice of portfolio securities which, on the basis of their 
relative investment merits, could best be sold where necessary to 
meet redemptions.'').
    \59\ Id.
---------------------------------------------------------------------------

    As previously discussed, in addition to the seven-day redemption 
requirement in section 22(e), rule 15c6-1 under the Exchange Act also 
affects 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

[[Page 82149]]

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.\60\
---------------------------------------------------------------------------

    \60\ See infra footnotes 73-76 and accompanying text for a 
discussion of why this calculation method is permitted under rule 
22c-1 and rule 2a-4.
---------------------------------------------------------------------------

    With the exception of money market funds subject to rule 2a-7 under 
the Act,\61\ the Commission has not promulgated rules requiring open-
end funds to invest in a minimum level of liquid assets.\62\ As 
discussed above, the Commission has historically taken the position 
that, in order to comply with section 22(e) and other applicable legal 
provisions, 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.\63\ In addition to a fund's ``general responsibility to 
maintain a level of portfolio liquidity that is appropriate under the 
circumstances,'' the Commission has stated that open-end funds must 
engage in ongoing portfolio liquidity monitoring to determine whether 
an adequate level of portfolio liquidity is being maintained in light 
of their redemption obligations.\64\
---------------------------------------------------------------------------

    \61\ See supra footnote 43.
    \62\ However, the Commission has issued guidelines concerning 
funds' portfolio liquidity. See supra footnote 38 and accompanying 
text.
    \63\ See Restricted Securities Release, supra footnote 37; see 
also Rule 144A Release, supra footnote 37.
    \64\ Guidelines Release, supra footnote 38, at n.11 (``[T]he 
Commission 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. 
For example, an equity fund that begins to experience a net outflow 
of assets because investors increasingly shift their money from 
equity to income funds should consider reducing its holdings of 
illiquid securities in an orderly fashion in order to maintain 
adequate liquidity.''). Therefore, under current SEC guidance, a 
fund experiencing net outflows may wish to consider managing its 
illiquid asset holdings to maintain adequate liquidity. Similarly, a 
fund may need to determine whether it is appropriate to take certain 
actions when the fund has determined that a previously liquid 
holding has become illiquid due to changed circumstances. See also 
Rule 144A Release, supra footnote 37, at n.61.
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    Registered investment companies and their investment advisers are 
subject to rules under the Act and the Advisers Act requiring them to 
adopt and implement written compliance policies and procedures 
reasonably designed to prevent various violations of laws and 
regulations. Rule 38a-1 under the Act requires registered investment 
companies to adopt and implement written policies and procedures 
reasonably designed to prevent violations of the federal securities 
laws by the fund, including policies and procedures that provide for 
the oversight of compliance by certain of the fund's service providers, 
including the fund's investment adviser; the rule also requires board 
approval and review of the service providers' compliance policies and 
procedures. Additionally, rule 206(4)-7 under the Advisers Act requires 
registered investment advisers to adopt and implement written 
compliance policies and procedures reasonably designed to prevent 
violations of the Advisers Act and the rules thereunder by the adviser 
or any of its supervised persons. Such compliance policies and 
procedures should be appropriately tailored to reflect each firm's 
particular compliance risks.\65\ For example, an open-end fund holding 
a significant portion of its assets in securities with long settlement 
periods or that trade infrequently may be subject to relatively greater 
liquidity risks than other open-end funds, and should appropriately 
tailor its policies and procedures in light of its particular risks and 
circumstances. The Commission has brought enforcement actions under the 
compliance rules against funds and their advisers for failures to adopt 
and/or implement policies and procedures reasonably designed to prevent 
violations relating to, for example, disclosure, valuation, and pricing 
for assets with limited liquidity.\66\
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    \65\ In the compliance rules adopting release, the Commission 
highlighted certain, non-exclusive examples of particular areas to 
be addressed in funds' and advisers' policies and procedures. For 
example, it stated that funds or advisers should adopt policies and 
procedures regarding valuation and the pricing of portfolio 
securities and fund shares, as well as the processing of fund 
shareholder transactions in accordance with rule 22c-1. 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 identified ``portfolio 
management processes'' as an issue that should be covered in the 
compliance policies and procedures of a fund or its adviser and 
indicated 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). The Commission further identified ``the accuracy of 
disclosures made to investors, clients, and regulators'' as an issue 
to be covered.
    \66\ See In re Citigroup Alternative Investments LLC & Citigroup 
Glob. Markets Inc., Investment Advisers Act Release No. 4174 (Aug. 
17, 2015) (settled order) (hedge fund adviser failed to adopt 
policies and procedures to prevent misrepresentations to private 
fund investors about fund performance and liquidity and violated 
rule 206(4)-7); In re J. Kenneth Alderman, CPA, et al., Investment 
Company Act Release No. 30557 (Jun. 13, 2013) (settled order) 
(respondent directors failed to exercise their responsibilities with 
respect to adoption and implementation of valuation policies and 
procedures by mutual funds holding securities with reduced liquidity 
and caused funds' violations of rule 38a-1); In re UBS Glob. Asset 
Mgmt. (Americas) Inc., Investment Company Act Release No. 29920 
(Jan. 17, 2012) (settled order) (mutual fund adviser failed to 
implement fair value pricing procedures with respect to subordinated 
fixed income securities without an active market and violated rule 
38a-1); In re Morgan Asset Mgmt., Inc., et al., Investment Company 
Act Release No. 29704 (June 22, 2011) (settled order) (mutual fund 
adviser failed to implement valuation procedures in pricing fixed 
income securities backed by subprime mortgages and violated rule 
38a-1).
---------------------------------------------------------------------------

    Thus, funds and their advisers already are required to adopt and 
implement written compliance policies and procedures reasonably 
designed to prevent violations of various provisions implicated by fund 
liquidity, including those provisions identified above. The liquidity 
risk management program requirements of rule 22e-4, which we are 
adopting here, in effect will provide more specific and enhanced 
requirements in certain areas already generally covered by the 
compliance program rules.
    In short, there are a number of statutory and regulatory provisions 
across the federal securities laws that bear on redemptions and the 
potential dilution of shareholders' interests. New rule 22e-4 advances 
the purposes of the Act by enhancing the ability of funds to meet their 
redemption obligations, reducing the risk of shareholder dilution, and 
reducing the potential for antifraud violations.\67\
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    \67\ One commenter argued that the Commission lacks the 
statutory authority to issue rule 22e-4. Comment Letter of Justin 
Banks (Jan. 13, 2016) (``Banks Comment Letter'') (considering the 
authority conferred by sections 22(c), 22(e), and 38 of the Act, 
although we note that in referring to our authority under section 
38, the commenter actually quoted and addressed the text of section 
39 of the Act.). We disagree. The Commission has ample authority 
under the Act, including sections 22(c), 22(e), and 38(a), as well 
as under the antifraud provisions of the federal securities laws, to 
require that open-end funds maintain adequate liquidity and adopt 
responsible liquidity risk management policies and procedures. See 
supra section II.B.2. Section 38(a), in particular, gives the 
Commission authority to issue rules, regulations, and orders ``as 
are necessary or appropriate to the exercise of the powers conferred 
upon the Commission elsewhere in this title.'' As discussed above, 
the liquidity risk management program required under rule 22e-4 is 
necessary and appropriate to reduce the risk that funds will be 
unable to meet their redemption obligations, to improve industry-
wide liquidity risk management practices, to mitigate potential 
dilution of the interests of non-redeeming shareholders, and to 
increase the likelihood that funds are able to fulfill 
representations made in their prospectuses and advertising materials 
and implicit in their open-end status.

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[[Page 82150]]

3. Liquidity Management by Open-End Funds
    Portfolio managers consider a variety of factors in addition to 
liquidity when constructing a fund's portfolio, including but not 
limited to the fund's investment strategies, economic and market 
trends, portfolio asset credit quality, and tax considerations. 
Nevertheless, meeting redemption obligations is fundamental for open-
end funds, and funds must manage liquidity in order to meet these 
obligations.\68\ Several factors influence how liquidity management by 
open-end funds affects the equitable treatment of investors in a fund, 
investor redemption behavior, and potentially the orderly operation of 
the markets when fulfilling redemption obligations.
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    \68\ See Comment Letter of Investment Company Institute on the 
Notice Seeking Comment on Asset Management Products and Activities, 
Docket No. FSOC-2014-0001(``FSOC Notice'') (Mar. 25, 2015) (``ICI 
FSOC Notice Comment Letter'') (``For mutual funds, the central 
importance of meeting redemptions means that liquidity management is 
a key element of regulatory compliance, investment risk management, 
and portfolio management--and a constant area of focus. Even before 
launching a mutual fund, the fund manager and fund board consider 
whether the fund's proposed investments and strategies are suitable 
for the mutual fund structure, including whether it will be able to 
satisfy applicable regulatory requirements on an ongoing basis. If 
not, the manager may decide to offer that strategy through a 
different vehicle (e.g., a closed-end fund or a private fund).''). 
See also supra footnotes 2, 3, and 5-7.
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    First, it is important to consider how a fund meets redemptions. 
When a fund receives redemption requests from shareholders, and the 
fund does not have cash on hand to meet those redemptions,\69\ the fund 
may sell portfolio assets to generate cash to meet the redemptions and 
generally has the discretion to determine which assets will be 
sold.\70\ It is possible that a fund would 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 need to 
adjust its portfolio so that the fund continues to follow its 
investment strategies. 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 adjusts the portfolio.\71\ 
An ETF redeeming in kind with its most liquid assets first would 
similarly leave remaining shareholders in a potentially less liquid and 
riskier fund. 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).\72\ 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. Similarly, an ETF redeeming in kind could 
use a pro rata strip of assets. Additionally, funds could choose to 
opportunistically pare back or eliminate holdings in a particular asset 
or sector to meet redemptions.
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    \69\ 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. See, e.g., Comment Letter of Fidelity 
Investments on the Notice Seeking Comment on Asset Management 
Products and Activities, Docket No. FSOC-2014-0001 (Mar. 25, 2015) 
(``Fidelity FSOC Notice Comment Letter''), 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.'').
    \70\ A fund may also obtain cash by other available means such 
as bank lines of credit, but funds infrequently utilize this method 
to meet redemptions. See Proposing Release, supra footnote 9, at 
n.35 and accompanying text. See also infra footnote 262 and 
accompanying text for a discussion of the use of interfund lending 
as an alternative source of cash for funds.
    \71\ See Proposing Release, supra footnote 9, at n.37 and 
accompanying text.
    \72\ There 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.
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    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 open-end fund on any 
particular day must receive the NAV next calculated by the fund after 
receipt of such redemption request.\73\ As most funds, with the 
exception of money market funds, calculate their NAV only 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.\74\ 
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.\75\ We allowed 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 on the trade date.\76\ As a 
practical matter, this calculation method also gave broker-dealers, 
retirement plan administrators, and other intermediaries additional 
time to receive transactions submitted before the cut-off time on the 
trade date, which then may be reflected in the fund's NAV on the 
business day following the trade date.
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    \73\ The process of calculating or ``striking'' the NAV of the 
fund's shares on any given trading day is based on several factors, 
including the market value of portfolio securities, fund 
liabilities, and the number of outstanding fund shares, among 
others.
    \74\ Commission rules do not require that a fund calculate its 
NAV at a specific time of day. 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).
    \75\ Rule 2a-4(a)(2)-(3).
    \76\ See 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)].
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    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. If these 
activities occur (and their associated costs are reflected in NAV) in 
days following redemption requests, the costs of providing liquidity to 
redeeming investors could be borne by the remaining investors in the 
fund, thus potentially diluting the interests of non-redeeming 
shareholders.\77\ The less liquid the fund's portfolio holdings, the 
greater these liquidity costs can become.\78\
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    \77\ The transaction costs associated with redemptions can vary 
significantly, with some costs having a more immediate impact on 
shareholders than others. For example, during times of heightened 
market volatility and wider bid-ask spreads for the fund's 
underlying holdings, selling the fund's investments to meet 
redemptions will necessarily result in costs to the fund, which in 
turn may negatively impact investors who chose to redeem in the days 
immediately following the stress event. The impact of such costs on 
the remaining fund investors can vary depending on when a 
shareholder chooses to redeem. See, e.g., Comment Letter of Mutual 
Fund Directors Forum on the Notice Seeking Comment on Asset 
Management Products and Activities, Docket No. FSOC-2014-0001 (Mar. 
25, 2015), at 6.
    \78\ See, e.g. Comment Letter of Morningstar, Inc. (Jan. 13, 
2016) (``Morningstar Comment Letter''). See also Proposing Release, 
supra footnote 9, at n.45 and accompanying text.
---------------------------------------------------------------------------

    There can be significant adverse consequences to remaining 
investors in a fund that does not adequately manage liquidity.\79\ As 
noted above, the

[[Page 82151]]

proportion of illiquid assets held by a fund can increase if the fund 
sells its more liquid portfolio assets to meet redemptions. This in 
turn could adversely affect the fund's risk profile and cause the fund 
to have difficulty meeting future shareholder redemptions.\80\ For 
example, during the pendency of our proposal, the Third Avenue Focused 
Credit Fund, a non-diversified open-end fund, adopted a plan of 
liquidation, and requested and obtained exemptive relief to suspend 
shareholder redemptions.\81\ The Commission noted that the fund 
represented that, at the time the fund and its investment adviser 
requested exemptive relief, it had experienced a significant level of 
redemption requests over the prior six-month period that reduced the 
fund's portfolio liquidity, as well as a significant decline in its 
NAV.\82\ The fund's board authorized the plan of liquidation after it 
determined that additional redemptions would have to be made at prices 
that would unfairly disadvantage the fund's remaining shareholders.\83\ 
This event highlights the extent to which shareholders can be harmed 
when a fund holding portfolio assets that entail significant liquidity 
risk does not adequately anticipate the effects of market deterioration 
and increased shareholder redemptions.\84\ Furthermore, if a fund finds 
that it can sell portfolio assets only at prices that incorporate a 
significant discount to the assets' stated value, the discounted sale 
prices can materially affect the fund's NAV.
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    \79\ See, 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).'').
    \80\ See, e.g., In re Heartland Advisors, Inc., et al., 
Investment Company Act Release No. 28136 (Jan. 25, 2008) 
(``Heartland Release'') (settled order) (finding 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).
    \81\ See Third Avenue Temporary Order, supra footnote 12. But 
see infra footnote 209 and accompanying text. We note that there is 
no assurance that the Commission would grant similar relief in the 
future. See also ICI Comment Letter I (``Third Avenue Focused Credit 
Fund experienced a significant level of redemption requests and an 
ongoing reduction in the liquidity of its portfolio securities, 
which consisted largely of junk bonds . . . The SEC granted a 
temporary order under section 22(e)(3) after expressing concerns 
with a board-approved plan of liquidation that provided for 
distribution to shareholders of the fund's remaining net cash and a 
separate transfer of the fund's other assets into a liquidating 
trust.''); BlackRock Comment Letter (``[A]s recently demonstrated by 
the issues meeting redemption requests that were experienced by the 
Third Avenue Focused Credit Fund, a small and highly concentrated 
portfolio can present its own liquidity challenges.''); see also 
infra footnote 84.
    \82\ Third Avenue Temporary Order, supra footnote 12. At the 
time that the fund adopted its plan of liquidation, the fund had 
experienced $1.1 billion in estimated net outflows for the year to 
date through December 9, 2015, which was more than 145% of the 
fund's total net assets as of that date. Furthermore, in November 
2015, the fund experienced a total of $317 million in estimated net 
redemptions and the fund's retail class NAV per share fell from 
$7.82 to $7.09.
    \83\ Id. See also Third Avenue Management, Press Release: Third 
Avenue Management Obtains Exemptive Relief for Focused Credit Fund 
(Dec. 16, 2015), available at: http://thirdave.com/news/press-release-third-avenue-management-obtains-exemptive-relief-for-focused-credit-fund/ (``As a result of the [SEC] exemptive order, 
redemptions are suspended for all shareholders, and . . . the 
[fund's adviser] will be able to conduct an orderly liquidation 
without having to resort to forced selling of securities at reduced 
or disadvantaged prices.'').
    \84\ See Comment Letter of Americans for Financial Reform (Jan. 
13, 2016) (``AFR Comment Letter'') (``By all accounts, Third Avenue 
was holding the great majority of its assets in illiquid distressed 
debt and had very limited cash reserves, a strategy that can 
increase returns but at the price of greatly increased risks for 
investors . . . While the Third Avenue fund may be an outlier in 
terms of the sheer volume of illiquid assets it holds, evidence also 
indicates that larger and more significant funds are also testing 
the bounds of previous SEC guidance on liquidity, and are holding a 
large fraction of potentially illiquid assets. If such funds come 
under selling pressure, the need to dispose of such assets could add 
to market stress in ways that have a negative impact on corporate 
credit and the real economy, as well as potentially harming 
investors.''); see also Heartland Release, supra footnote 80.
---------------------------------------------------------------------------

    These factors in fund redemptions--either individually or in 
combination--can create incentives in times of liquidity stress in the 
markets for shareholders to redeem quickly to avoid further losses (or 
a ``first-mover advantage'').\85\ If shareholder redemptions are 
motivated by this first-mover advantage, they can lead to increasing 
outflows, and as the level of outflows from a fund increases, the 
incentive for remaining shareholders to redeem may also increase. 
Additionally, a fund experiencing large outflows as a result of 
redemptions may be exposed to predatory trading activity in the 
securities it holds.\86\ Regardless of whether investor redemptions are 
motivated by a first-mover advantage or other factors, there can be 
significant adverse consequences to remaining investors in a fund when 
it fails to adequately manage liquidity.\87\ 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 significant dilution of remaining 
investors' interests in the fund.
---------------------------------------------------------------------------

    \85\ See infra footnotes 1086-1088 and accompanying text for a 
discussion of the first-mover advantage and its negative 
consequences. But see Comment Letter of Nuveen Investments on the 
Notice Seeking Comment on Asset Management Products and Activities, 
Docket No. FSOC-2014-0001 (Mar. 25, 2015) (``Nuveen FSOC Notice 
Comment Letter''), at 10 (stating that there is no evidence that 
shareholders are actually motivated by a first-mover advantage); 
Comment Letter of BlackRock on the Notice Seeking Comment on Asset 
Management Products and Activities, Docket No. FSOC-2014-0001 (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 Notice Seeking Comment on Asset Management Products and 
Activities, Docket No. FSOC-2014-0001 (Mar. 25, 2015), 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 Notice Seeking Comment on Asset 
Management Products and Activities, Docket No. FSOC-2014-0001 (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 footnote 68, 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.''). See 
also discussion of the potential first-mover advantage in the 
Proposing Release, supra footnote 9, at n.49.
    \86\ See, 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 
discussion of predatory trading concerns in the Proposing Release, 
supra footnote 9, at nn.805-809 and accompanying text.
    \87\ See Proposing Release, supra footnote 9, at n.37.
---------------------------------------------------------------------------

    There also is a potential for adverse effects on the markets when 
open-end funds fail to adequately manage

[[Page 82152]]

liquidity.\88\ 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. Depending on the asset and the level of 
stress, such liquidity stress on the assets held in the fund has the 
potential to transmit stress to other funds or portions of the market 
as well.\89\
---------------------------------------------------------------------------

    \88\ See, e.g., See Comment Letter of Americans for Financial 
Reform on the FSOC Notice (Mar. 27, 2015) (``AFR FSOC Notice Comment 
Letter'') (citing evidence that ``bond fire sales by mutual funds 
during the financial crisis created direct economic harm to real 
economy companies, reducing investment and profitability over a 
period of years.''); Fidelity FSOC Notice Comment Letter, supra 
footnote 69, 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.'').
    \89\ See Proposing Release, supra footnote 9, at n.54.
---------------------------------------------------------------------------

C. Recent Developments in the Open-End Fund Industry

    Recent industry developments have underlined our focus on the 
importance of sufficient liquidity and liquidity risk management 
practices in open-end funds.\90\ 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 
open-end funds. We will discuss each of these developments in turn.
---------------------------------------------------------------------------

    \90\ We note that, up until 1970, open-end funds had limited 
investments in the bond market. See Protecting Investors: A Half 
Century of Investment Regulation (May 1992) for a discussion of the 
regulatory and market developments that occurred between 1940 and 
1992.
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1. 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 (excluding 
ETMFs).\91\ As growth in fixed income fund assets was occurring, we 
increased our focus on fixed income market structure, publishing a 
report on the municipal securities markets in 2012 and holding a 
roundtable focused on the fixed income markets in 2013.\92\ In 
addition, Commissioners and Commission staff have spoken about the need 
to focus on potential risks relating to the fixed income markets and 
their underlying liquidity.\93\ 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, 2015, and 2016.\94\
---------------------------------------------------------------------------

    \91\ Assets in these funds grew from $1.5 trillion at the end of 
2008 to $3.6 trillion at the end of 2015, with net inflows exceeding 
$1.4 trillion during that period. These figures were obtained from 
staff analysis of Morningstar Direct data, and are based on fund 
categories defined by Morningstar. 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 44.7% in 2015. DERA Study, infra 
footnote 95, at Table 2. The statistics in the DERA Study were 
calculated through the end of 2014. Commission staff used the CRSP 
US Mutual Fund Database to update them as of the end of 2015.
    \92\ See Securities and Exchange Commission, 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); Securities and Exchange Commission, 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).
    \93\ See Proposing Release, supra footnote 9, at n.62.
    \94\ See, e.g., IM Guidance Update No. 2014-01, Risk Management 
in Changing Fixed Income Market Conditions (Jan. 2014) (``2014 Fixed 
Income Guidance Update''), available at https://www.sec.gov/divisions/investment/guidance/im-guidance-2014-1.pdf; National Exam 
Program, Office of Compliance Inspections and Examinations, 
Examination Priorities for 2016 (2016), available at https://www.sec.gov/about/offices/ocie/national-examination-program-priorities-2016.pdf (``Amidst the changes in fixed income markets 
over the past several years, we will examine advisers to mutual 
funds, ETFs, and private funds that have exposure to potentially 
illiquid fixed income securities. We will also examine registered 
broker-dealers that have become new or expanding liquidity providers 
in the marketplace. These examinations will include a review of 
various controls in these firms' expanded business areas, such as 
controls over market risk management, valuation, liquidity 
management, trading activity, and regulatory capital''); National 
Exam Program, Office of Compliance Inspections and Examinations, 
Examination Priorities for 2015 (2015) (``National Exam Program 2015 
Examination Priorities''), available at http://www.sec.gov/about/offices/ocie/national-examination-program-priorities-2015.pdf 
(``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.''); National Exam Program, Office of Compliance 
Inspections and Examinations, Examination Priorities for 2014 
(2014), available at http://www.sec.gov/about/offices/ocie/national-examination-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.'').
---------------------------------------------------------------------------

    We also have observed significant growth in alternative mutual 
funds over the last decade.\95\ Although the assets of open-end funds 
pursuing alternative strategies accounted for a relatively small 
percentage of the mutual fund market as of December 2014, the growth of 
assets in these funds has been substantial. Assets of open-end funds 
with alternative strategies grew from approximately $365 million at the 
end of 2005 to approximately $334 billion at the end of 2014.\96\
---------------------------------------------------------------------------

    \95\ Paul Hanouna, Jon Novak, Tim Riley & Christof Stahel, 
Liquidity and Flows of U.S. Mutual Funds, Division of Economic and 
Risk Analysis White Paper (Sept. 2015) (``DERA Study''), at 7-8, 
available at https://www.sec.gov/dera/staff-papers/white-papers/liquidity-white-paper-09-2015.pdf . 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 risk-adjusted 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.
    \96\ See Proposing Release, supra footnote 9 at nn.64-66 and 
accompanying text. See also id.
---------------------------------------------------------------------------

    Unlike alternative mutual funds and ETFs, private funds (such as 
hedge funds and private equity funds) and closed-end 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.\97\ In addition, investor expectations of private funds' 
redemption rights differ from the redemption expectations of typical 
retail investors in open-end funds.\98\ For example, investors in 
private equity funds typically commit their capital for the life of the 
fund.\99\
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    \97\ A 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 
Advisers Act.
    \98\ Hedge Funds often contain ``lock-up'' provisions and impose 
gates, suspensions of redemptions, and side pockets to manage 
liquidity stress. See Proposing Release, supra footnote 9, at n.69 
and accompanying text.
    \99\ See Comment Letter of the Private Equity Growth Capital 
Council on the Notice Seeking Comment on Asset Management Products 
and Activities, Docket No. FSOC-2014-0001 (Mar. 25, 2015).
---------------------------------------------------------------------------

    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

[[Page 82153]]

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 (excluding ETMFs), as well as 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 and a fund's representations about payment in 
less than seven days.\100\ Certain observations by the Commission's 
Division of Economic and Risk Analysis (``DERA'') have lent further 
support to our focus on liquidity risk management practices in this 
industry segment, as DERA's analysis has shown that alternative 
strategy mutual funds demonstrate cash flows that are significantly 
more volatile than other strategies, indicating that these funds may 
face higher levels of redemptions, and thus higher liquidity risk.\101\ 
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 
final rules 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.
---------------------------------------------------------------------------

    \100\ See Proposing Release, supra footnote 9, at n.72.
    \101\ See DERA Study, supra footnote 95.
---------------------------------------------------------------------------

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.\102\ Due to the adoption 
of rule 15c6-1 under the Exchange Act in 1993, the standard settlement 
time frame declined from five business days (T+5) to three business 
days (T+3).\103\ Furthermore, while standard settlement periods for 
securities trades in many 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 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,\104\ even though the 
settlement periods associated with some bank loans and participations 
may extend beyond the period of time the fund would be required to meet 
shareholder redemptions. This creates a potential mismatch between the 
timing of the receipt of cash upon sale of these assets and the payment 
of cash for shareholder redemptions.\105\
---------------------------------------------------------------------------

    \102\ See supra footnotes 7-9 and accompanying text.
    \103\ 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. See supra 
footnote 32.
    \104\ See supra section II.B.3.
    \105\ See discussion of this timing mismatch of the Proposing 
Release, supra footnote 9, at n.79 and accompanying text.
---------------------------------------------------------------------------

    Overall, the evolution of the market towards shorter settlement 
periods--and corresponding fund disclosures--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 and other 
legal obligations.

D. Overview of Current Practices

    Over the last several years, Commission staff has observed through 
a variety of different events the current liquidity risk management 
practices at a cross-section of 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 and managing the liquidity of 
their portfolio assets.\106\
---------------------------------------------------------------------------

    \106\ There are varying degrees of formality in the adoption and 
implementation of these procedures. Several commenters also 
discussed existing liquidity risk management practices. See, e.g., 
Blackrock Comment Letter; ICI Comment Letter I; Comment Letter of 
Vanguard (Jan. 6, 2016) (``Vanguard Comment Letter'').
---------------------------------------------------------------------------

    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).\107\ 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 these funds determine their ability to 
meet redemption requests without significant dilution in various market 
conditions within the disclosed period for payment of redemption 
proceeds.
---------------------------------------------------------------------------

    \107\ See 2014 Fixed Income Guidance Update, supra footnote 94 
(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 Proposing Release, supra footnote 9, at n.151 and accompanying 
text.
---------------------------------------------------------------------------

    Funds observed by the staff that have implemented procedures for 
assessing 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 investments, setting 
minimum cash reserves, and establishing committed back-up lines of 
credit or interfund lending facilities.\108\ A few of the funds 
observed by staff conduct stress testing relating to the availability 
of liquid assets to cover possible levels of redemptions.\109\ Some of 
these funds' advisers also have periodic discussions with their boards 
of directors about how the funds approach liquidity risk management and 
what emerging risks they are observing relating to liquidity risk. The 
staff has 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 their risk profile or materially affecting their performance, 
and thus with less dilutive impacts.
---------------------------------------------------------------------------

    \108\ See Proposing Release, supra footnote 9, at n.100 and 
accompanying text.
    \109\ See Proposing Release, supra footnote 9, at n.101.
---------------------------------------------------------------------------

    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.\110\ Staff has observed 
that some of these funds, when faced with higher than normal 
redemptions, experienced particularly

[[Page 82154]]

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 as well as the risk that the 
fund will be unable to meet those redemptions.
---------------------------------------------------------------------------

    \110\ See Proposing Release, supra footnote 9, at n.102.
---------------------------------------------------------------------------

    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 
``back-office'' functions, with little indication that information 
generated from the risk management or trading functions informs the 
compliance determinations. This functional divide may be a by-product 
of the limitations of the 15% guideline as a stand-alone method for 
comprehensive liquidity risk management, a situation that our final 
liquidity risk management program framework is meant to address.\111\
---------------------------------------------------------------------------

    \111\ See supra section II.B.2 for a discussion of the 
limitations of the 15% guideline.
---------------------------------------------------------------------------

    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 and other legal 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 Adoption Overview

    Against this background, today we are adopting a set of reforms 
designed to promote effective liquidity risk management throughout the 
open-end fund industry and thereby reduce the risk that funds will not 
be able to meet redemption or other legal obligations and mitigate 
potential dilution of the interests of fund shareholders. We believe 
that limitations on illiquid holdings and more effective liquidity risk 
management among funds would, in turn, result in significant investor 
protection benefits and enhance the fair and orderly operation of the 
markets.\112\ The final amendments also seek to enhance reporting and 
disclosure regarding fund liquidity and redemption practices.
---------------------------------------------------------------------------

    \112\ See infra section IV.C.
---------------------------------------------------------------------------

    First, we are adopting new rule 22e-4, which requires each 
registered open-end fund, including open-end ETFs but not including 
money market funds, to adopt and implement a written liquidity risk 
management program reasonably designed to assess and manage the fund's 
liquidity risk.\113\ The new rule requires a fund's liquidity risk 
management program to incorporate certain specified elements. These 
include: (i) Assessment, management, and periodic review of the fund's 
liquidity risk; (ii) classification of the liquidity of each of the 
fund's portfolio investments,\114\ as well as at-least-monthly reviews 
of the fund's liquidity classifications; (iii) determining and 
periodically reviewing a highly liquid investment minimum--the 
percentage of its net assets that the fund invests in highly liquid 
investments that are assets; (iv) limiting the fund's investment in 
illiquid investments that are assets to no more than 15% of the fund's 
net assets; and (v) for funds that engage in, or reserve the right to 
engage in, redemptions in kind, the establishment of policies and 
procedures regarding how they will engage in such redemptions in kind.
---------------------------------------------------------------------------

    \113\ See rule 22e-4(b). Rule 22e-4, as adopted today, defines 
``liquidity risk'' as the risk that a fund could not meet requests 
to redeem shares issued by the fund without significant dilution of 
remaining investors' interests in the fund.
    \114\ As discussed in more detail below, rule 22e-4 as adopted 
requires a fund to classify each of the fund's portfolio 
investments, including investments that are liabilities of the fund 
(e.g., certain out-of-the-money derivatives transactions). See infra 
footnote 480 and accompanying text. As proposed rule 22e-4 would 
have required each fund to classify the liquidity of its portfolio 
positions (or portions of a position in a particular asset), but did 
not specifically address the treatment of a fund's holdings that are 
liabilities. Thus, in this Release, we use the term ``assets'' when 
referring to the proposed classification requirement and comments on 
the proposed requirement, and the term ``investments'' when 
referring to the adopted classification requirement.
---------------------------------------------------------------------------

    The liquidity risk assessment requirement generally provides a 
broad, principles-based foundational framework for a fund's liquidity 
risk management program, including a requirement that the fund assess 
whether its investment strategy is appropriate for an open-end fund. 
The final rule also provides for a tailored program for ETFs, requiring 
them to consider additional factors as part of their liquidity risk 
assessment and management that reflect potential liquidity-related 
concerns that could arise from the structure and operation of ETFs, and 
excepting ETFs that redeem in kind (``In-Kind ETFs'') from the 
classification and highly liquid investment minimum requirements.\115\ 
The final rule also provides that funds whose assets primarily consist 
of highly liquid investments need not adopt a highly liquid investment 
minimum.\116\ Additionally, rule 22e-4 will not apply to closed-end 
funds, and will apply to principal underwriters and depositors of UITs 
only to a limited degree, as discussed further below. The 
classification requirement will provide important liquidity profile 
information to the Commission and investors and reflects that liquidity 
may be viewed as falling on a spectrum rather than a binary conclusion 
that an investment is either ``liquid'' or ``illiquid.'' \117\ The 
highly liquid investment minimum requirement is aimed at decreasing the

[[Page 82155]]

likelihood that funds would be unable to meet their redemption 
obligations.
---------------------------------------------------------------------------

    \115\ Under the final rule, each ``In-Kind ETF,'' or an ETF that 
meets redemptions through in-kind transfers of securities, 
positions, and assets other than a de minimis amount of cash, will 
be subject to the tailored program requirement. See rule 22e-4(a)(9) 
(definition of ``In-Kind Exchange Traded Fund'' or ``In-Kind ETF''); 
rule 22e-4(b)(1)(i)(D) (incorporating additional factors that an ETF 
would be required to consider as applicable as part of its liquidity 
risk assessment and management that reflect liquidity-related risks 
that could be particularly relevant to the ETF). Under rule 22e-
4(a)(5), the term ``fund'' is defined to exclude an In-Kind ETF. As 
a result, rule 22e-4(b)(1)(ii) and rule 22e-4(b)(1)(iii), which 
apply to funds as defined in rule 22e-4(a)(5), exclude In-Kind ETFs 
from the classification and highly liquid investment minimum 
requirements, respectively.
    \116\ See rule 22e-4(b)(1)(iii) (applying the highly liquid 
investment minimum requirement only to a fund that does not 
primarily hold assets that are highly liquid investments).
    \117\ The Commission is adopting a classification framework 
consisting of four liquidity categories based on the number of days 
within which it is determined that the investment is reasonably 
expected to be convertible to cash (or, in the case of the least-
liquid categories, sold or disposed of) without the conversion (or, 
in the case of the least-liquid categories, sale or disposition) 
significantly changing the market value of the investment. More 
specifically, as discussed below, rule 22e-4 would require a fund to 
classify each of its portfolio investments into one of the following 
liquidity categories: Highly liquid investments (category based on 
fund's reasonable expectation that an investment can be converted to 
cash within three business days); moderately liquid investments 
(category based on fund's reasonable expectation that an investment 
can be converted to cash within four to seven calendar days); less 
liquid investments (category based on fund's reasonable expectation 
that an investment can be sold or disposed of in seven calendar days 
but the settlement is reasonably expected to be greater than seven 
calendar days); and illiquid investments (category based on fund's 
reasonable expectation that an investment cannot be sold or disposed 
of within seven calendar days).
---------------------------------------------------------------------------

    Rule 22e-4 includes board oversight provisions related to the 
liquidity risk management program. Specifically, a fund's board will 
approve, but not design, the fund's liquidity risk management program, 
as well as the fund's designation of the fund's investment adviser or 
officers as responsible for administering the day-to-day aspects of the 
fund's liquidity risk management program.\118\ A fund also will be 
subject to board reporting requirements to the extent that its 
investments in assets that are highly liquid investments fall below its 
minimum or its assets that are illiquid investments rise above 15% of 
its net assets.\119\ We anticipate that the new program requirement 
will result in investor protection benefits, as improved liquidity risk 
management could decrease the chance that a fund could meet its 
redemption obligations only with significant dilution of remaining 
investors' interests or changes to the fund's risk profile.
---------------------------------------------------------------------------

    \118\ Rule 22e-4(b)(2).
    \119\ Rule 22e-4(b)(1)(iii)(A)(3) and rule 22e-4(b)(1)(iv).
---------------------------------------------------------------------------

    Rule 22e-4, by requiring funds to limit illiquidity and manage 
liquidity, should reduce the potential likelihood and extent of 
dilution of non-transacting shareholders that otherwise could result 
from redemptions effected at prices determined in accordance with rules 
22c-1 and 2a-4. Thus, rule 22e-4, although it is numbered with 
reference to section 22(e), has a broader scope and also should 
separately help rule 22c-1 operate so as to reduce dilution, as 
contemplated by sections 22(a) and (c).
    Second, we are adopting certain public disclosure- and confidential 
reporting-related rules and amendments to provide shareholders and 
other users with additional information with respect to funds' 
liquidity risk profile as well as assist the Commission in its 
monitoring efforts. Specifically, we are adopting reporting 
requirements on Form N-PORT that will require a fund to report monthly 
position-level liquidity classification information and its highly 
liquid investment minimum to the Commission on a confidential 
basis.\120\ Form N-PORT will also require a fund to publicly disclose 
the aggregated percentage of its portfolio representing each of the 
four classification categories adopted by the Commission as of the end 
of each of its fiscal quarters.\121\
---------------------------------------------------------------------------

    \120\ We are adopting Form N-PORT today in a companion release. 
See Investment Company Reporting Modernization, Investment Company 
Act Release No. 32314 (October 13, 2016) (``Investment Company 
Reporting Modernization Adopting Release'') We discuss the Form N-
PORT reporting requirements related to rule 22e-4 in this Release, 
including the requirements that a fund report: (i) The liquidity 
classification assigned to each portfolio position (which may be 
based on asset type to the extent discussed below); (ii) the asset 
type label that the fund has assigned to each portfolio position, 
using any asset type labeling scheme the fund employs in its own 
portfolio management systems; and (iii) the fund's highly liquid 
investment minimum.
    \121\ This information will be reported monthly on Form N-PORT, 
but it will be disclosed to the public only for the third month of 
each fiscal quarter with a 60-day delay.
---------------------------------------------------------------------------

    We are adopting new rule 30b1-10 and Form N-LIQUID to require a 
fund to confidentially notify the Commission when the fund's illiquid 
investment holdings exceed 15% of its net assets or if its amount of 
highly liquid investments declines below its highly liquid investment 
minimum for more than a brief period of time. We also are adopting 
amendments to Form N-1A to require a fund to publicly disclose certain 
information regarding the fund's redemption procedures. Finally, we are 
adopting requirements for funds to provide information on Form N-CEN 
about funds' use of lines of credit and interfund lending.
    We anticipate that these new requirements will facilitate the 
Commission's risk and compliance monitoring efforts by providing 
greater transparency regarding the liquidity characteristics of fund 
portfolio holdings, as well as its ability to monitor and assess 
compliance with rule 22e-4. While Form N-PORT and Form N-CEN are 
primarily designed to assist the Commission, we believe that the 
requirements to publicly disclose certain information will also help 
investors and other potential users utilize information on particular 
funds' liquidity-related risks and redemption policies, which in turn 
may assist investors in making more informed investment choices.\122\ 
As further discussed below, we believe that these reporting 
requirements strike the right balance between protecting the funds from 
certain adverse effects that could arise from public disclosure of 
detailed portfolio liquidity information with the need to provide 
shareholders and other users with improved information about funds' 
liquidity risk profile.
---------------------------------------------------------------------------

    \122\ See, e.g., Comment Letter of Markit on the Notice Seeking 
Comment on Asset Management Products and Activities, Docket No. 
FSOC-2014-0001 (Mar. 25, 2015) (``[W]e 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.'').
---------------------------------------------------------------------------

III. Discussion

A. Program Requirement and Scope of Rule 22e-4

    Today the Commission is adopting rule 22e-4 under the Investment 
Company Act. This rule will require each registered open-end management 
investment company, including open-end ETFs but not including money 
market funds, to establish a written liquidity risk management program. 
Rule 22e-4 will not apply to closed-end funds, and will apply to UITs 
only to a limited degree, as discussed further below.
1. Liquidity Risk Management Program
    Rule 22e-4 generally will require each registered open-end 
management investment company to establish a written liquidity risk 
management program. The majority of commenters generally supported the 
proposed requirement for each fund to adopt a formal, written liquidity 
risk management program,\123\ although many commenters objected to 
certain aspects of the proposal and suggested modifications to certain 
proposed program elements, as discussed in more detail below. Other 
commenters opposed the proposed written program requirement, asserting 
that funds have a history of successfully managing their liquidity and 
that the proposed requirement was thus unnecessary.\124\ We continue to 
believe, as discussed in the Proposing Release, that the program 
requirement will produce significant investor protection benefits, in 
light of the fact that funds are not currently subject to specific 
requirements under

[[Page 82156]]

the federal securities laws or Commission rules obliging them to manage 
their liquidity risk. Outreach by Commission staff has identified 
practices at some funds that raise concerns regarding funds' ability to 
meet their redemption obligations and lessen the effects of 
dilution.\125\ The Commission is thus adopting, as proposed, a 
requirement for each fund to adopt and implement a written liquidity 
risk management program.\126\ However, we note that the program 
requirement we are adopting incorporates modifications to most of the 
proposed program elements.\127\
---------------------------------------------------------------------------

    \123\ See, e.g., Comment Letter of Alternative Investment 
Management Association (Jan. 13, 2016) (``AIMA Comment Letter''); 
Comment Letter of Capital Research and Management Company (Jan. 13, 
2016) (``CRMC Comment Letter''); Comment Letter of Cohen & Steers 
(Jan. 13, 2016) (``Cohen & Steers Comment Letter''); Comment Letter 
of Dechert LLP (Jan. 13, 2016) (``Dechert Comment Letter''); Comment 
Letter of Fidelity Management & Research Company (Jan. 13, 2016) 
(``Fidelity Comment Letter''); Comment Letter of Association of the 
Bar of the City of New York (Jan. 13, 2016) (``NYC Bar Comment 
Letter''); Comment Letter of Securities Industry and Financial 
Markets Association (Jan. 13, 2016) (Comments on Proposal to Require 
Liquidity Risk Management Programs and Related Liquidity 
Disclosures) (``SIFMA Comment Letter I''); Comment Letter of T. Rowe 
Price (Jan. 13, 2016) (``T. Rowe Comment Letter'').
    \124\ See Comment Letter of Cove Street Capital (Oct. 8, 2015) 
(``Cove Street Comment Letter''); Comment Letter of Jim H. Francis 
(Nov. 4, 2015); Comment Letter of Jordana Keefer (Jan. 7, 2016) 
(``Keefer Comment Letter''); Comment Letter of Don G. Powell (Oct. 
5, 2015); Comment Letter of John Wahh (Oct. 1, 2015) (``Wahh Comment 
Letter'').
    \125\ See Proposing Release, supra footnote 9, at section 
IV.C.1.b.
    \126\ See rule 22e-4(b).
    \127\ As discussed throughout this Release, we believe that 
these modifications respond appropriately to specific concerns noted 
by commenters and help to increase the effectiveness of the program 
requirement in advancing the Commission's goals, while at the same 
time reducing associated burdens.
---------------------------------------------------------------------------

    A fund may, as it determines appropriate, expand its liquidity risk 
management procedures and related disclosure concerning liquidity risk 
beyond the required program elements.\128\ While a fund would be 
required to adhere to certain requirements--such as the requirement to 
classify the liquidity of a fund's portfolio investments and determine 
a highly liquid investment minimum \129\--in other respects, the 
proposed program requirements would permit each fund to tailor its 
liquidity risk management program to the fund's particular risks and 
circumstances. Commenters stressed that many funds are currently 
engaged in operational practices that are designed to support fund 
liquidity and the redeemability of fund shares.\130\ Commenters also 
noted that funds' approaches to liquidity risk management should, and 
currently do, differ markedly depending on their individual risks.\131\ 
We believe that the program requirement will permit funds that already 
have programs that satisfy the rule requirements to continue to engage 
in the liquidity risk management practices that they have found to be 
effective. However, the program requirement's common obligations should 
strengthen liquidity risk management across the fund industry, while 
also providing important transparency into funds' liquidity profiles 
and risk management practices.
---------------------------------------------------------------------------

    \128\ See supra footnotes 113-115 and accompanying text for a 
description of the required program elements.
    \129\ In-Kind ETFs are excepted from the classification and 
highly liquid investment minimum requirements. See infra section 
III.J. In addition, funds whose portfolios consist primarily of 
highly liquid investments would not be required to determine a 
highly liquid investment minimum. See infra section III.D.5.
    \130\ See, e.g., ICI Comment Letter I; BlackRock Comment Letter; 
Invesco Comment Letter; Vanguard Comment Letter.
    \131\ See, e.g., ICI Comment Letter I; Dechert Comment Letter; 
Vanguard Comment Letter.
---------------------------------------------------------------------------

2. Scope of Rule 22e-4 and Related Disclosure and Reporting 
Requirements
    The liquidity risk management program requirements of rule 22e-4, 
as well as related disclosure and reporting requirements, will apply to 
all registered open-end funds, except money market funds.\132\ Rule 
22e-4 will apply to open-end ETFs, but incorporates tailored program 
requirements to reflect their particular liquidity-related risks.\133\ 
The final rule also excludes from the highly liquid investment minimum 
requirement funds whose portfolios consist primarily of highly liquid 
investments. Closed-end funds are excluded from the scope of rule 22e-
4,\134\ and UITs are not subject to the rule's general program 
requirement, although each UIT's principal underwriter or depositor 
will be required to determine, on or before the date of the initial 
deposit of portfolio securities into the UIT, that the portion of 
illiquid investments that the UIT holds or will hold at the date of 
deposit that are assets is consistent with the redeemable nature of the 
securities it issues.\135\ We discuss these scope determinations in 
more detail below.
---------------------------------------------------------------------------

    \132\ Although money market funds are excluded from the scope of 
rule 22e-4, they will be subject to the amendments to Form N-1A and 
Form N-CEN. See infra section III.A.2.a (``Inclusion of Funds with 
All Investment Strategies and Inclusion of ETFs within the Scope of 
Rule 22e-4''); section III.A.2.b (``Inclusion of Funds of All Sizes 
within the Scope of Rule 22e-4''); and section III.A.2.e 
(``Exclusion of Money Market Funds from the Scope of Rule 22e-4'').
    \133\ See infra section III.J.
    \134\ See infra section III.A.2.c (``Exclusion of Closed-End 
Funds from the Scope of Rule 22e-4'').
    \135\ See infra section III.K.
---------------------------------------------------------------------------

a. Inclusion of Funds With All Investment Strategies and Inclusion of 
ETFs Within the Scope of Rule 22e-4
    We are not excluding funds with any particular strategies from the 
scope of rule 22e-4.\136\ We proposed to apply rule 22e-4 to all open-
end funds (except money market funds) regardless of the fund's 
investment strategy, stating that even funds with investment strategies 
that have historically entailed little liquidity risk could experience 
liquidity stresses in certain environments.\137\ We also stated that 
different types of funds within the same broad investment strategy 
could demonstrate different levels of liquidity and relatedly, 
different levels of liquidity risk.
---------------------------------------------------------------------------

    \136\ But see infra section III.D.5 (discussing exclusion of In-
Kind ETFs as well as funds that primarily hold highly liquid 
investments from the highly liquid investment minimum requirement).
    \137\ See Proposing Release, supra footnote 9, at nn.123-125 and 
accompanying text.
---------------------------------------------------------------------------

    Some commenters expressed concern about the costs of some of the 
proposed requirements relative to the liquidity risks typically 
associated with certain investment strategies,\138\ as well as concerns 
about burdensome effects of some particular requirements for certain 
strategies.\139\ Other commenters, however, generally supported a 
program requirement that applies to all registered open-end funds, 
regardless of the fund's investment strategy.\140\ We believe the 
modifications to the proposal we are adopting (in particular, changes 
to the classification requirement and the proposed three-day liquid 
asset minimum requirement) appropriately address commenters' concerns 
and reflect support that some commenters provided for a program 
requirement that applies to all registered open-end funds.
---------------------------------------------------------------------------

    \138\ See, e.g., infra footnote 1107 and accompanying text.
    \139\ For example, some commenters expressed concerns about the 
extent to which the proposed liquidity classification factors were 
applicable to certain investment strategies, particularly funds that 
invest in fixed income or other OTC assets (see, e.g., Comment 
Letter of Federated Investors, Inc. (Jan. 13, 2016) (``Federated 
Comment Letter''); Comment Letter of Government Finance Officers 
Association (Jan. 13, 2016) (``GFOA Comment Letter''); Comment 
Letter of Nuveen Fund Advisors, LLC (Jan. 13, 2016) (``Nuveen 
Comment Letter''); Comment Letter of OppenheimerFunds (Jan. 13, 
2016) (``Oppenheimer Comment Letter'')). Commenters also expressed 
concerns about the extent to which a three-day liquid asset minimum 
requirement could impede an index fund's ability to track its index 
(see, e.g., BlackRock Comment Letter; HSBC Comment Letter; Invesco 
Comment Letter; SIFMA Comment Letter I).
    \140\ See, e.g., CRMC Comment Letter; Comment Letter of Eaton 
Vance Investment Managers (Jan. 13, 2016) (``Eaton Vance Comment 
Letter I'').
---------------------------------------------------------------------------

    As noted above, rule 22e-4 will apply to open-end ETFs, although we 
are adopting certain tailored program requirements for ETFs.\141\ Some 
commenters objected to all or certain proposed program requirements 
applying to ETFs.\142\ We respond in detail to these comments in 
section III.J below. We note, however, that while ETFs' liquidity risks 
can differ from the liquidity risks faced by other open-end funds, ETFs 
still have liquidity-related risks that could affect their 
shareholders, as well as the broader markets in which they operate. The 
tailored requirements that we are

[[Page 82157]]

adopting for ETFs respond to commenters' suggestions that the 
Commission tie these funds' liquidity risk management obligations to 
the particular risks that they face, as well as our assessment of how 
these funds' risks could most appropriately be addressed.\143\
---------------------------------------------------------------------------

    \141\ We note that rule 22e-4 only applies to ETFs that are 
structured as open-end funds. For ease of reference, however, unless 
indicated otherwise, when we refer to ETFs we mean open-end ETFs 
only.
    \142\ See infra footnotes 839-841 and accompanying text.
    \143\ See infra section III.J.
---------------------------------------------------------------------------

b. Inclusion of Funds of All Sizes Within the Scope of Rule 22e-4
    Also, as proposed, we are not excluding any fund from the scope of 
rule 22e-4 on the basis of size or adopting different liquidity 
requirements for relatively small funds. As discussed in the Economic 
Analysis section below, smaller funds tend to demonstrate relatively 
high flow volatility, and thus we believe they should be subject to the 
same liquidity risk management requirements as other funds.\144\ 
Conversely, some commenters argued that the proposed classification 
requirement could unduly burden larger funds by inappropriately making 
these funds appear to be less liquid than they actually are, and we 
have incorporated certain modifications to the proposed classification 
requirement that we believe respond to these concerns, as discussed 
below.\145\
---------------------------------------------------------------------------

    \144\ See infra footnote 1160 and accompanying text.
    \145\ See infra section III.C.3.b.
---------------------------------------------------------------------------

c. Exclusion of Closed-End Funds From the Scope of Rule 22e-4
    As proposed, rule 22e-4 would have excluded closed-end investment 
companies from the scope of rule 22e-4. As discussed in detail in the 
Proposing Release, closed-end funds' liquidity needs are different from 
those of open-end funds, because closed-end funds generally do not 
issue redeemable securities and are not subject to sections 22(c) and 
22(e) of the Investment Company Act.\146\ Although closed-end interval 
funds do have to comply with certain liquidity standards under rule 
23c-3 and therefore must manage their liquidity risk, we are not 
subjecting them to rule 22e-4 because they are already required to 
adopt written liquidity procedures under rule 23c-3(b)(10)(iii).\147\ 
Closed-end interval funds may be better able to anticipate their 
liquidity needs than open-end funds because closed-end interval funds 
do not permit daily redeemability, closed-end interval funds must limit 
the size and timing of repurchase offers, and rule 23c-3 requires 
shareholders who wish to tender their shares pursuant to a repurchase 
offer to provide advance notice thereof to such funds.\148\ Commenters 
uniformly agreed that closed-end funds should be excluded from the 
scope of rule 22e-4 and we continue to believe that closed-end funds 
(including closed-end interval funds) should be excluded from the 
rule's scope.
---------------------------------------------------------------------------

    \146\ See Proposing Release, supra footnote 9, at nn.132-135 and 
accompanying text. Certain closed-end funds (``closed-end interval 
funds'') do elect to repurchase their shares at periodic intervals 
pursuant to rule 23c-3 under the Investment Company Act.
    \147\ See Proposing Release, supra footnote 9, at n.134.
    \148\ See id., at text following n.135.
---------------------------------------------------------------------------

d. Separate Requirements for UITs Under Rule 22e-4
    As proposed, the scope of rule 22e-4 did not include UITs.\149\ As 
adopted today, the rule will require a limited liquidity review under 
which the UIT's principal underwriter or depositor determines, on or 
before the date of the initial deposit of portfolio securities into the 
UIT, that the portion of the illiquid investments that the UIT holds or 
will hold at the date of deposit that are assets is consistent with the 
redeemable nature of the securities it issues.\150\ UITs and their 
principal underwriters and depositors will not, however, be subject to 
any of the rule's other liquidity risk management program requirements.
---------------------------------------------------------------------------

    \149\ See Proposing Release, supra footnote 9, at section 
III.A.2.
    \150\ See rule 22e-4(c). The rule also requires UITs to maintain 
a record of that determination for the life of the UIT and for five 
years thereafter.
---------------------------------------------------------------------------

    While one commenter supported excluding UITs from the scope of rule 
22e-4,\151\ several other commenters argued that ETFs structured as 
UITs should be subject to the same rule requirements as ETFs structured 
as open-end funds.\152\ We respond in detail to these comments in 
section III.K below, including discussing how we believe the 
requirement to determine that a UIT's illiquid investment holdings are 
consistent with the redeemable nature of the UIT's securities responds 
to commenters' concerns.
---------------------------------------------------------------------------

    \151\ See ICI Comment Letter I.
    \152\ See, e.g., Comment Letter of Anonymous (Jan. 13, 2016) 
(``Anonymous Comment Letter I''); BlackRock Comment Letter.
---------------------------------------------------------------------------

e. Exclusion of Money Market Funds From the Scope of Rule 22e-4
    Finally, as proposed, money market funds are excluded from the 
scope of rule 22e-4. Money market funds are currently subject to 
extensive requirements concerning the liquidity of their portfolio 
assets that are more stringent in many respects than the requirements 
of rule 22e-4, due to the historical redemption patterns of money 
market fund investors and the characteristics of the assets held by 
money market funds.\153\ Money market funds also are already subject to 
broad liquidity-related disclosure and reporting requirements,\154\ and 
they have certain tools at their disposal to manage heavy redemptions 
that are not available to other open-end funds.\155\ For these reasons, 
we did not include money market funds within the scope of the proposed 
rule, and commenters uniformly agreed that money market funds should be 
excluded from the rule's scope.\156\ We continue to believe that money 
market funds should be excluded from the scope of rule 22e-4.
---------------------------------------------------------------------------

    \153\ See Proposing Release, supra footnote 9, at nn.145-150 and 
accompanying text.
    \154\ See id., at nn.151-152 and accompanying text.
    \155\ See id., at nn.153-155 and accompanying text.
    \156\ See, e.g., CRMC Comment Letter; Eaton Vance Comment Letter 
I; ICI Comment Letter I; Comment Letter of Voya Investment 
Management (Jan. 12, 2016) (``Voya Comment Letter'').
---------------------------------------------------------------------------

B. Assessment, Management, and Review of Liquidity Risk

    Section 22(e) of the Investment Company Act requires a registered 
investment company \157\ to make payment to shareholders for securities 
tendered for redemption within seven days of their tender.\158\ The 
legislative history of the Act indicates that shareholder dilution was 
a significant concern of the Act's framers.\159\ An open-end fund's 
ability to pay redeeming shareholders within this seven-day period 
without significant dilution is directly related to its liquidity. 
Thus, assessing and managing liquidity risk in a comprehensive manner 
is critical to an open-end fund's capacity to honor redemption requests 
within this seven-day period, as well as within any shorter time period 
disclosed in the fund's prospectus or advertising materials, while 
mitigating dilution.
---------------------------------------------------------------------------

    \157\ See supra footnote 4 and accompanying text.
    \158\ See supra footnote 36.
    \159\ See supra footnote 7 and accompanying text.
---------------------------------------------------------------------------

    Today we are adopting a new liquidity risk assessment and 
management framework for funds. Specifically, rule 22e-4 requires a 
fund to assess, manage, and periodically review its liquidity risk, 
considering certain factors as applicable. As discussed in more detail 
below, the requirements we are adopting incorporate a definition of 
``liquidity risk'' that focuses on whether a fund can meet redemption 
requests without significant dilution of remaining investors' interests 
rather than, as proposed, whether the fund can meet redemption requests 
without materially

[[Page 82158]]

affecting the fund's NAV.\160\ We are also adopting certain changes to 
the proposed factors that a fund would consider in assessing and 
managing its liquidity risk. These changes aim to simplify and 
streamline the proposed liquidity risk assessment and management 
factors, and reflect additional considerations that the Commission, 
along with certain commenters, believes could entail heightened 
liquidity risk. Notably, the proposed requirement to consider a fund's 
investment strategy and portfolio liquidity in assessing and managing 
liquidity risk now incorporates the instruction that this consideration 
includes whether the investment strategy is appropriate for an open-end 
fund, as well as whether the strategy involves a relatively 
concentrated portfolio or large positions in particular issuers.\161\ 
Additionally, the proposed requirement to consider a fund's short-term 
and long-term cash flow projections has been simplified to eliminate 
the five separate sub-considerations relevant to this factor that were 
incorporated in the proposed rule, but which now are discussed as 
guidance in this Release.\162\
---------------------------------------------------------------------------

    \160\ See infra section III.B.1.a.
    \161\ See infra section III.B.2.a.
    \162\ See infra section III.B.2.b.
---------------------------------------------------------------------------

    We proposed liquidity risk assessment and management program 
requirements with the primary goals of reducing the risk that funds 
would be unable to meet redemption and other legal obligations, 
minimizing dilution, and elevating the overall quality of liquidity 
risk management across the fund industry while at the same time 
providing funds with reasonable flexibility to adopt policies and 
procedures that would be most appropriate to assess and manage their 
liquidity risk.\163\ As we discuss throughout this section, we believe 
that the modified requirements we are adopting today continue to 
reflect these goals, while promoting a more efficient and workable 
framework.
---------------------------------------------------------------------------

    \163\ See Proposing Release, supra footnote 9, at paragraph 
following n.261.
---------------------------------------------------------------------------

1. Definition of ``Liquidity Risk''
    Rule 22e-4, as adopted today, defines ``liquidity risk'' as the 
risk that a fund could not meet requests to redeem shares issued by the 
fund without significant dilution of remaining investors' interests in 
the fund.\164\ This definition is largely similar to the proposed 
definition of ``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 NAV.\165\ However, 
in response to comments, the revised definition substitutes the phrase 
``without significant dilution of remaining investors' interests in the 
fund'' for the phrase ``without materially affecting the fund's net 
asset value.'' The definition also does not include references to 
redemption requests that are expected under normal conditions or 
reasonably foreseeable under stressed conditions. Instead, the final 
definition simply refers to ``requests to redeem.'' We believe our 
modifications to the liquidity risk factors used to assess a fund's 
liquidity risk, as discussed below, make any reference to market 
conditions within the definition of liquidity risk unnecessary, 
confusing, and duplicative.\166\
---------------------------------------------------------------------------

    \164\ When determining whether a fund's liquidity risk will 
cause significant dilution for purposes of this definition, a fund 
should consider the impact of liquidity risk on the total net assets 
of the fund and the adverse consequences such dilution will have on 
all the fund's remaining shareholders. Furthermore, as discussed 
above, a fund's inability to meet redemption requests may cause harm 
to shareholders. See, e.g., supra footnotes 81-84 and accompanying 
text for a discussion of the suspension of shareholder redemptions 
in the Third Avenue Focused Credit Fund following a period of heavy 
redemptions that the fund stated reduced the fund's portfolio 
liquidity.
    \165\ See proposed rule 22e-4(a)(7); see also Proposing Release, 
supra footnote 9, at text accompanying n.255.
    \166\ See rule 22e-4(b)(1)(i).
---------------------------------------------------------------------------

a. Evaluating Risk of Significant Dilution of Remaining Investors' 
Interests
    Multiple commenters objected to the proposed inclusion of any NAV-
impact standard in the definition of ``liquidity risk.'' One commenter 
argued that including the concept of ``without materially affecting the 
fund's net asset value'' in the definition of liquidity risk would 
inappropriately merge liquidity and valuation, which are subject to 
different regulatory and compliance controls.\167\ Many commenters also 
objected that including such a price concept in the definition of 
``liquidity risk'' would incorrectly indicate that market impact can be 
accurately identified and measured separate from market price movements 
generally.\168\ These commenters argued that many factors (including 
market volatility, portfolio composition, and trade execution and 
activity) influence the price at which a fund transacts in a security 
as well as the levels of cash the fund holds, and thus it is difficult 
to identify the effects of the fund's transaction activity on the 
fund's NAV. Finally, some commenters argued that the inclusion of a 
NAV-impact standard in the definition of ``liquidity risk'' could lead 
investors to believe that appropriate liquidity risk management will 
protect their investments from declining in value.\169\
---------------------------------------------------------------------------

    \167\ See SIFMA Comment Letter I.
    \168\ See, e.g., Comment Letter of Credit Suisse (Jan. 13, 2016) 
(``Credit Suisse Comment Letter''); Comment Letter of Dodge & Cox 
(Jan. 21, 2016) (``Dodge & Cox Comment Letter''); Comment Letter of 
MFS Investment Management (Jan. 13, 2016) (``MFS Comment Letter''); 
SIFMA Comment Letter I; Comment Letter of Investment Company 
Institute (May 17, 2016) (``ICI Comment Letter III'') (encouraging 
the Commission to adopt a definition of liquidity risk that 
incorporates language related directly to dilution rather than value 
impact on the NAV).
    \169\ See, e.g., ICI Comment Letter I; MFS Comment Letter; SIFMA 
Comment Letter I.
---------------------------------------------------------------------------

    While we agree that liquidity and valuation are distinct concepts, 
we consider these concepts as having certain inter-relationships. 
First, liquidity risk in an open-end fund inherently involves an 
assessment of the liquidity of the fund's investments. Common 
definitions of investment liquidity include consideration of the value 
impact or costs from trading that investment.\170\ Second, our staff 
has observed in its outreach many occasions when a fund was unwilling 
to transact

[[Page 82159]]

in certain portfolio investments when such sales would yield a price 
that the fund considered unacceptable.\171\ This relationship is clear 
in the Commission guidelines limiting a fund's investment in illiquid 
investments. These guidelines specify that an illiquid investment is 
one that cannot be sold or disposed of within seven days at 
approximately the value at which the fund has valued the investment'' 
(emphasis added).\172\ We continue to believe that the inclusion of a 
conceptual relationship between liquidity and sale price in the 
definition of ``liquidity risk'' is appropriate.\173\ Such a 
relationship indicates that liquidity risk involves the risk that a 
fund will not be able to meet redemption requests under any 
circumstances, as well as the risk that a fund could meet redemption 
requests, but only in a manner that adversely affects the fund's non-
redeeming shareholders through significant dilution.\174\
---------------------------------------------------------------------------

    \170\ See, e.g., Radhakrishnan Gopalan, et al., Asset Liquidity 
and Stock Liquidity, 47 J. Fin & Quant. Anal. 333 (2012), available 
at http://apps.olin.wustl.edu/faculty/gopalan/asset_stock_liquidity.pdf (``An asset is liquid if it can be 
converted into cash quickly and at a low cost.''); Yakov Amihud & 
Haim Mendelson, Liquidity, Asset Prices, and Financial Policy, 47 
Fin. Anal. J. 56 (1991), available at http://www.jstor.org/stable/4479488?seq=1#page_scan_tab_contents (``An asset is liquid if it can 
be bought or sold at the current market price quickly and at low 
cost.'').
    In addition, we note that many funds disclose liquidity risk as 
a principal investment risk in their prospectuses, and these 
disclosures often reference possible adverse value impacts from 
selling fund investments under certain conditions. See, e.g., Schwab 
Strategic Trust rule 485(b) Registration Statement (June 30, 2016), 
available at https://www.sec.gov/Archives/edgar/data/1454889/000119312516632635/d203200d485bpos.htm (``Liquidity Risk. The fund 
may be unable to sell certain securities, such as illiquid 
securities, readily at a favorable time or price, or the fund may 
have to sell them at a loss.''); Voya Variable Funds rule 485(b) 
Registration Statement (May 1, 2016), available at https://www.sec.gov/Archives/edgar/data/2664/000119312516562669/d124096d485bpos.htm (``Liquidity: If a security is illiquid, the 
[fund] might be unable to sell the security at a time when the 
[fund's] manager might wish to sell, or at all. Further, the lack of 
an established secondary market may make it more difficult to value 
illiquid securities, exposing the [fund] to the risk that the price 
at which it sells illiquid securities will be less than the price at 
which they were valued when held by the [fund]. The prices of 
illiquid securities may be more volatile than more liquid 
investments. The risks associated with illiquid securities may be 
greater in times of financial stress. The [fund] could lose money if 
it cannot sell a security at the time and price that would be most 
beneficial to the Portfolio.'').
    \171\ That is, the price that a portfolio manager could 
realistically receive for certain portfolio investments could, in 
effect, render such investments de facto illiquid if these pricing 
considerations cause the portfolio manager to refrain from selling 
them. See, e.g., Third Avenue Temporary Order, supra footnote 12 
(``On December 9, 2015, after considering the environment the Fund 
was in and the likelihood that incremental sales of portfolio 
securities to satisfy additional redemptions would have to be made 
at prices that would unfairly disadvantage all remaining 
shareholders, the Board determined that the fairest action on behalf 
of all shareholders would be to adopt a plan of liquidation.'').
    \172\ See supra footnote 39 and accompanying text.
    \173\ We also note that several commenters favorably discussed 
foreign and international regulators' liquidity risk management 
regimes, including ones that define the concepts of liquid (or 
illiquid) portfolio assets, as well as funds' liquidity risk, with 
reference to value impact or a discount that the fund may incur upon 
sale. See, e.g., Dechert Comment Letter (favorably discussing 
certain liquidity risk management requirements, including the 
definition of ``liquidity risk,'' under the UCITS Directive); ICI 
Comment Letter I (noting that the Commission could look to other 
jurisdictions, including the European Union, for support for a 
principles-based program rule); Invesco Comment Letter (also noting 
that the UCITS Directive provides a framework for a principles-based 
liquidity risk management program requirement); see also Commission 
Directive 2010/43/EU, OJ L 176 (2010), at Ch. 1, Art. 3(8) (defining 
``liquidity risk'' as ``the risk that a position in the UCITS 
portfolio cannot be sold, liquidated or closed at limited cost in an 
adequately short time frame and that the ability of the UCITS to 
comply at any time with its redemption obligation is thereby 
compromised''); Ontario Securities Commission, Report on Staff's 
Continuous Disclosure Review of Mutual Fund Practices Relating to 
Portfolio Liquidity, OSC Staff Notice 81-727 (June 25, 2015) 
(definition of ``illiquid asset'' refers to the ``ability to readily 
dispose of a portfolio asset through a market facility on which 
public quotations are available at a price that approximates the 
amount at which the portfolio asset is valued'').
     We note as well that U.S. banking regulators have defined 
``liquidity'' as ``a financial institution's capacity to meet its 
cash and collateral obligations at a reasonable cost.'' Interagency 
Policy Statement on Funding and Liquidity Risk Management, 75 FR 
13656 (Mar. 22, 2010), available at http://www.occ.gov/news-issuances/federal-register/75fr13656.pdf.
    \174\ See supra footnote 79 and accompanying text.
---------------------------------------------------------------------------

    We believe a definition of ``liquidity risk'' that includes a 
reference to the value impact from trading portfolio investments should 
not imply that mutual fund shareholders are guaranteed a protected NAV 
or that the fund cannot sell investments at a loss due to market risk, 
credit deterioration, or liquidity risk. Indeed, funds' narrative risk 
disclosure in their registration statements and other shareholder 
communications generally should make clear those risks that could 
adversely affect the fund's NAV, yield, and total return, including 
liquidity-related risks.\175\ However, we believe defining liquidity 
risk clarifies what funds must manage under rule 22e-4, and, for the 
reasons discussed above, we believe impacts on valuation may play a 
significant role in evaluating the ability to effectively meet 
shareholder redemptions while lessening the effects of dilution.
---------------------------------------------------------------------------

    \175\ See, e.g., Item 4(b) of Form N-1A.
---------------------------------------------------------------------------

    Nonetheless, we agree with commenters that using the proposed 
specific standard of ``materially affecting the fund's NAV'' may pose 
certain challenges. We recognize that it may be difficult to calculate 
the particular market impact that a fund's transactions in an 
investment will have on that investment's price, which some commenters 
suggested was inherent to the proposed standard. There could be other 
reasons for a fund's NAV fluctuating, separate from the fund's sales of 
portfolio investments to meet redemption requests as well.
    Accordingly, in the final rule we have modified the NAV-impact 
standard in the definition of ``liquidity risk'' to substitute the 
phrase ``without significant dilution of remaining investors' interests 
in the fund'' for the phrase ``without materially affecting the fund's 
net asset value.'' This revised standard more directly corresponds to 
the concerns of the Act \176\ and rule 22e-4 by focusing on meeting 
investor redemptions without dilution.
---------------------------------------------------------------------------

    \176\ See supra footnote 32and accompanying text for a 
discussion of the liquidity concerns of the Act.
---------------------------------------------------------------------------

    We also note that commenter interpretations of the term 
``materially'' varied, with some commenters adopting very narrow 
interpretations \177\ of the term and others taking a more broad 
view.\178\ We note that, for purposes of this definition, the term 
``significant'' is not meant to reference slight NAV movements, the 
causes of which may not be easily distinguishable, nor is it limited 
only to fire-sale situations. Instead, a fund's liquidity risk 
management program should focus on the fund's ability to meet 
redemptions in a manner that does not harm shareholders.\179\ In 
particular, ``significant'' dilution of remaining investors' interests 
in the fund can occur at much lower levels of dilution than what would 
occur in a fire sale situation. We believe ``significant'' conveys more 
effectively than ``materially'' that the definition is not meant to 
reference slight NAV movements, while avoiding the confusion around the 
term ``materially'' evident in the comment letters and better focusing 
the rule on the level of dilution that would harm remaining investors' 
interests even in the absence of a fire sale.
---------------------------------------------------------------------------

    \177\ See Comment Letter of Interactive Data Pricing and 
Reference Data (Dec. 18, 2015) (``Interactive Data Comment Letter'') 
(noting that there are several possible interpretations of the term, 
including an NAV price impact based on a one penny movement, among 
others.).
    \178\ See SIFMA Comment Letter I (proposing the Commission 
substitute the phrase ``assuming no fire-sale discounting'' for the 
phrase ``without materially affecting the fund's net assets'' and 
arguing that a fire-sale standard is a more appropriate outer 
boundary for price movements.). We believe that adopting a fire-sale 
standard as the outer boundary for price movements would be 
inappropriate because such an extreme outer boundary would fail to 
capture a fund's liquidity risk exposure during normal and stressed 
conditions and would, thus, inadequately address the liquidity risk 
management concerns of rule 22e-4.
    \179\ The classification requirements under rule 22e-4 include a 
value impact standard as well, which is based on the number of days 
within which it is determined that an investment would be 
convertible to cash (or, in the case of the less-liquid and illiquid 
categories, sold or disposed of) without the conversion (or, in the 
case of the less-liquid and illiquid categories, sale or 
disposition) significantly changing the market value of the 
investment. See infra section III.C and accompanying text.
---------------------------------------------------------------------------

    Under rule 22e-4, a fund would be required to adopt a liquidity 
risk management program that is ``reasonably designed to assess and 
manage the fund's liquidity risk.'' A fund's liquidity risk management 
program should be appropriately tailored to reflect that fund's 
particular liquidity risks. Therefore, while a fund is required to 
consider certain liquidity risk factors specified in rule 22e-4 as 
applicable, a fund may also, as it determines appropriate, expand its 
liquidity risk management program beyond the required program elements, 
and must do so to the extent it would be necessary to effectively 
assess and manage its liquidity risk.\180\ This

[[Page 82160]]

requirement, however, requires a fund to assess and manage liquidity 
risk and does not require a fund to eliminate all adverse impacts of 
liquidity risk, which would be incompatible with an investment product 
such as a mutual fund or ETF, whose NAV may fluctuate for a variety of 
reasons, including changing liquidity conditions.
---------------------------------------------------------------------------

    \180\ Rule 22e-4(b) requires that a fund ``adopt and implement a 
written liquidity risk management program that is reasonably 
designed to assess and manage its liquidity risk,'' and identifies 
certain specific elements that a fund must consider in doing so.
---------------------------------------------------------------------------

b. Expected and Reasonably Foreseeable Redemption Requests
    As proposed, the definition of ``liquidity risk'' would have 
required funds to consider redemption requests that are expected under 
normal conditions, as well as those that are reasonably foreseeable 
under stressed conditions. Some commenters stated that the concept of 
redemption requests that are reasonably foreseeable under stressed 
conditions was vague and could subject funds to ex-post second 
guessing.\181\ One commenter suggested that the Commission clarify: (i) 
Whether funds should address both normal and reasonably foreseeable 
stressed conditions (or select one set of conditions) in assessing 
liquidity risk; and (ii) the level of market stress that funds should 
assume in conducting a liquidity risk assessment.\182\
---------------------------------------------------------------------------

    \181\ See Federated Comment Letter; NYC Bar Comment Letter.
    \182\ See AFR Comment Letter.
---------------------------------------------------------------------------

    The final definition of liquidity risk eliminates references to 
redemption requests that are expected under normal conditions or 
reasonably foreseeable under stressed conditions. The final definition 
simply refers to ``requests to redeem.'' We believe our modifications 
to the liquidity risk factors used to assess a fund's liquidity risk, 
including the clarification that a fund must consider certain liquidity 
risk factors both during normal and reasonably foreseeable stressed 
conditions, makes any reference to market conditions within the 
definition of liquidity risk unnecessary, confusing and duplicative. We 
believe the revised definition also addresses commenters' concerns that 
the proposed definition was unclear. We have provided guidance below 
regarding each liquidity risk factor and the need to consider normal 
and reasonably foreseeable stressed market conditions.
2. Liquidity Risk Factors
    Rule 22e-4 will require each fund to assess, manage, and 
periodically review (with such review occurring no less frequently than 
annually) its liquidity risk, considering the following factors as 
applicable:
     Investment strategy and liquidity of portfolio investments 
during both normal and reasonably foreseeable stressed conditions 
(including whether the investment strategy is appropriate for an open-
end fund, the extent to which the strategy involves a relatively 
concentrated portfolio or large positions in particular issuers, and 
the use of borrowings for investment purposes and derivatives);
     Short-term and long-term cash flow projections during both 
normal and reasonably foreseeable stressed conditions; and
     Holdings of cash and cash equivalents, as well as 
borrowing arrangements and other funding sources.\183\
---------------------------------------------------------------------------

    \183\ See rule 22e-4(b)(1)(i). We note that rule 22e-4 as 
adopted also includes two additional factors that an ETF will have 
to consider as applicable in assessing, managing, and periodically 
reviewing its liquidity risk, which reflect potential liquidity-
related concerns that could arise from the structure and operation 
of ETFs (including In-Kind ETFs). These are: (i) The relationship 
between the ETF's portfolio liquidity and the way in which, and the 
prices and spreads at which, ETF shares trade, including, the 
efficiency of the arbitrage function and the level of active 
participation by market participants (including authorized 
participants); and (ii) the effect of the composition of baskets on 
the overall liquidity of the ETF's portfolio. These factors are 
discussed in more detail below. See infra section III.J.
---------------------------------------------------------------------------

    A fund may incorporate other considerations, in addition to these 
factors, in evaluating its liquidity risk.
    Like the rule we are adopting today, rule 22e-4 as proposed would 
have required each fund to assess its liquidity risk, taking certain 
specified factors into account.\184\ Specifically, the proposed rule 
would have required each fund to take the following factors into 
account in assessing the fund's liquidity risk: (i) Short-term and 
long-term cash flow projections, considering 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 long-term cash flow projections; (ii) the fund's investment 
strategy and liquidity of portfolio investments; (iii) use of 
borrowings and derivatives for investment purposes; and (iv) holdings 
of cash and cash equivalents, as well as borrowing arrangements and 
other funding sources.\185\ The person(s) designated to administer the 
liquidity risk management program must also conduct reviews of the 
adequacy and effectiveness of the implementation of the liquidity risk 
management program, and such reviews must occur no less frequently than 
annually.\186\ Commenters generally supported the requirement for a 
fund to assess its liquidity risk.\187\ Additionally, some commenters 
expressed support for the proposed liquidity risk factors, as well as 
the proposed requirement to consider these factors in assessing 
liquidity risk.\188\ However, several commenters objected to the 
proposed requirement for a fund to consider certain specified factors 
and suggested instead that consideration of the factors be permissive 
instead of mandatory.\189\
---------------------------------------------------------------------------

    \184\ See Proposing Release, supra footnote 9, at section 
III.C.1.
    \185\ See proposed rule 22e-4(b)(2)(iii).
    \186\ See id.
    \187\ See, e.g., AFR Comment Letter; Comment Letter of CFA 
Institute (Jan. 12, 2016) (``CFA Comment Letter''); FSR Comment 
Letter; ICI Comment Letter I.
    \188\ See, e.g., AFR Comment Letter; CRMC Comment Letter; ICI 
Comment Letter I; Invesco Comment Letter.
    \189\ See, e.g., CFA Comment Letter; MFS Comment Letter; Voya 
Comment Letter.
---------------------------------------------------------------------------

    We continue to believe that the factors are central to evaluating 
and managing a fund's liquidity risk and that requiring each fund to 
consider, as a baseline, a standard set of factors for assessing and 
managing liquidity risk would promote effective and thorough liquidity 
risk management across the fund industry. However, we recognize that 
some of the proposed factors may not be applicable in assessing and 
managing the liquidity risk of certain funds or types of funds.\190\ 
One commenter requested that we clarify that a fund only needs to 
consider factors relevant to its operations, which may include some or 
all of the factors outlined in rule 22e-4, and others not 
enumerated.\191\ We agree, and to the extent any liquidity risk factor 
specified in rule 22e-4 is not applicable to a particular fund, the 
fund will not be required to consider it in assessing and managing its 
liquidity risk. We have therefore added the words ``as applicable'' in 
the rule's instruction to consider the specified factors.\192\ For 
example, a fund will not be required to consider the use of borrowings 
for investment purposes and derivatives, as specified under rule 22e-
4(b)(1)(i)(A), if that fund does not engage in borrowing

[[Page 82161]]

or use derivatives. Similarly, a fund that maintains borrowing sources 
for investment purposes will be required to consider the use of 
borrowings for investment purposes as specified under the rule. We also 
believe that condensing and simplifying the proposed factors helps 
respond to commenters' concerns that the proposed factors were overly 
complex \193\ and potentially inapplicable to certain funds.\194\
---------------------------------------------------------------------------

    \190\ See Proposing Release, supra footnote 9, at section 
III.C.1.
    \191\ See ICI Comment Letter I.
    \192\ See rule 22e-4(b)(1)(i) (requiring a fund to consider, 
``as applicable,'' certain factors); see also FSR Comment Letter 
(supporting the proposed liquidity risk assessment requirement and 
agreeing with the Commission's position in the proposal that a fund 
would not be required to consider those factors that are not 
applicable to that particular fund).
    \193\ See, e.g., Comment Letter of Better Markets, Inc. (Jan. 
13, 2016) (``Better Markets Comment Letter'').
    \194\ See, e.g., ICI Comment Letter I; MFS Comment Letter.
---------------------------------------------------------------------------

    As noted above, this list of liquidity risk factors is not meant to 
be exhaustive. In assessing, managing, and periodically reviewing its 
liquidity risk, a fund may take into account considerations in addition 
to the factors set forth in rule 22e-4 and must do so to the extent 
necessary to adequately assess and manage the fund's liquidity 
risk.\195\ For example, as discussed in the Proposing Release, if a 
fund elects to conduct stress testing to determine whether it has 
sufficient liquid investments to cover different levels of redemptions, 
a fund may wish to incorporate the results of this stress testing into 
its liquidity risk assessment and management.\196\ We continue to 
believe that stress tests that analyze the proposed factors could be 
particularly useful to a fund in evaluating its liquidity risk.
---------------------------------------------------------------------------

    \195\ See note 180 and accompanying text.
    \196\ See Proposing Release, supra footnote 9, at paragraph 
accompanying n.266.
---------------------------------------------------------------------------

    Below we provide guidance on specific issues associated with each 
of the liquidity risk factors and also discuss the Commission's 
decision to adopt each of these factors (some with modifications).
a. Investment Strategy and Portfolio Liquidity
    We are adopting the proposed requirement for a fund to consider its 
investment strategy and portfolio liquidity in assessing, managing, and 
periodically reviewing its liquidity risk, but with certain 
modifications in response to commenters.\197\ The principal changes 
include a requirement to consider whether the investment strategy is 
appropriate for an open-end fund, as well as the extent the strategy 
involves a relatively concentrated portfolio or large positions in 
particular issuers, and a clarification that this factor should be 
assessed both during normal and reasonably foreseeable stressed 
conditions.
---------------------------------------------------------------------------

    \197\ See rule 22e-4(b)(1)(i)(A).
---------------------------------------------------------------------------

    We continue to believe that various aspects of a fund's investment 
strategy--including whether the fund is actively or passively managed 
\198\ and a fund's portfolio management decisions that are meant in 
part to decrease an undesirable tax impact on the fund \199\-- could 
significantly affect the fund's liquidity risk. Also the extent to 
which the fund is diversified, including a fund's status as a regulated 
investment company under Subchapter M of the Internal Revenue Code, as 
well as its principal investment strategies as disclosed in its 
prospectus, could affect its liquidity risk in that the fund could be 
limited by its diversification obligations in its ability to sell 
certain portfolio securities.\200\ We note, for example, that the Third 
Avenue Focused Credit Fund stated that its status as a regulated 
investment company under Subchapter M limited the fund's ability to 
return cash to its shareholders after it suspended redemptions because 
of its need to comply with certain asset diversification tests to 
maintain its regulated investment company status.\201\ As discussed in 
the Proposing Release, we also continue to caution that while a fund's 
investment strategy is an important factor in evaluating a fund's 
liquidity risk, different types of funds within the same broad 
investment strategy may demonstrate different levels of liquidity, (and 
thus, presumably, different levels of liquidity risk).\202\
---------------------------------------------------------------------------

    \198\ See Proposing Release, supra footnote 9, at paragraph 
accompanying nn.292-295 (discussing factors that could increase or 
decrease the liquidity risk associated with index-based strategies 
versus actively-managed strategies).
    \199\ See Proposing Release, supra footnote 9, at paragraph 
accompanying n.299 (detailing the ways in which a fund's tax 
management strategy could make its portfolio managers unwilling to 
sell certain portfolio assets in order to meet redemptions, which 
could in turn increase the fund's liquidity risk compared to a 
similarly situated fund).
    \200\ See Proposing Release, supra footnote 9, at paragraph 
accompanying nn.296-298 (discussing 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, including the ways that various 
diversification requirements could constrain its ability to sell 
certain portfolio securities in order to meet redemptions).
    \201\ See Third Avenue Focused Credit Fund Update (Mar. 8, 
2016), available at http://thirdave.com/wp-content/uploads/2016/04/03-09-16-FCF-Call-Transcript-1.pdf (noting that, because one of the 
diversification tests under Subchapter M would require the fund to 
have less than 50% of its assets in concentrated positions, the fund 
needed to retain cash in order not to violate this test, in light of 
the manner in which it chose to manage the fund's liquidation of its 
other assets).
    \202\ See Proposing Release, supra footnote 9, at n.301 and 
accompanying text.
---------------------------------------------------------------------------

Consideration of Strategy Appropriateness for Open-End Fund Structure
    We are adopting several modifications to the proposed requirement 
to consider a fund's investment strategy and portfolio liquidity in 
assessing, managing, and periodically reviewing its liquidity risk. 
First, we clarify in final rule 22e-4 that consideration of investment 
strategy must take into account whether the fund's strategy is 
appropriate for an open-end fund. This clarification reflects several 
commenters' suggestions that a fund's liquidity risk management program 
could (or should) involve a consideration of whether the fund's 
investment strategy and permissible holdings are suitable for the open-
end structure.\203\
---------------------------------------------------------------------------

    \203\ See BlackRock Comment Letter (``[W]e recommend that the 
Commission consider whether funds should be required to explicitly 
address the level of position concentration that is appropriate for 
the fund's investment strategy and investor profile in [liquidity 
risk management] policies and procedures''); ICI Comment Letter I 
(``A risk-based liquidity management program could require a fund 
manager, when launching a new mutual fund, to assess whether the 
fund's investment strategy and permissible holdings are suitable for 
the open-end structure in light of [its] liquidity 
characteristics.''); see also CRMC Comment Letter (encouraging the 
Commission to consider whether certain funds may be inappropriate 
for the open-end fund structure).
---------------------------------------------------------------------------

    We agree with this suggestion raised by commenters. As discussed 
above, all open-end funds are subject to section 22(e) of the 
Investment Company Act, which requires a fund to pay redemption 
proceeds within seven days after receipt of a redemption request, and 
hold themselves out at all times as being able to meet redemptions (in 
many cases within an even shorter period of time).\204\ To the extent 
that a fund's investment strategy involves investing in securities 
whose liquidity is limited, or otherwise entails a significant degree 
of liquidity risk, the fund may not be able to meet its redemption and 
other legal obligations, or may not meet redemptions without diluting 
its shareholders' interests in the fund. We understand that it is a 
common best practice for a fund and its management to consider the 
appropriateness of a fund's investment strategy in the context of 
launching an open-end fund, and then for an open-end fund to continue 
to manage its liquidity risk such that its strategy and holdings remain 
appropriate for the open-end structure. However, not all funds appear 
to consider this. Also, as we have observed funds beginning to pursue 
more complex investment

[[Page 82162]]

strategies,\205\ we believe it is appropriate to require that each 
open-end fund consider whether it has a liquidity risk management 
framework in place that corresponds with the liquidity risks inherent 
in its strategy and its structure as a fund that offers redeemable 
securities.
---------------------------------------------------------------------------

    \204\ See supra footnotes 34-36, 42-47 and accompanying text.
    \205\ See supra footnote 11 and accompanying text.
---------------------------------------------------------------------------

    We believe that specifically requiring an open-end fund to consider 
whether its investment strategy is appropriate for the open-end 
structure would supplement existing practices and provide an important 
additional layer of shareholder protection. For example, this 
requirement will likely cause funds to evaluate the suitability of 
investment strategies that will be permitted under the 15% illiquid 
investment requirement, but still could entail significant liquidity 
risk--such as strategies involving highly concentrated portfolios, or 
strategies involving investment in portfolio investments that are so 
sensitive to stressed conditions that funds may not be able to find 
purchasers for those investments during stressed periods.\206\ 
Furthermore, funds that have significant holdings of securities with 
extended settlement periods may face challenges operating as open-end 
funds and should take these holdings into account when determining 
whether the fund's portfolio is appropriate for an open-end fund.\207\ 
For example, primarily holding securities with extended settlement 
periods beyond seven days may not be appropriate for an open-end fund, 
as primarily having such extended settlement holdings may raise 
concerns with the fund's ability to meet redemptions within seven days, 
particularly if the fund has not established adequate other sources of 
liquidity.
---------------------------------------------------------------------------

    \206\ We note that, when a fund files its initial registration 
statement and post-effective amendments thereto with the 
Commission's Division of Investment Management for review, 
Commission staff could request information from the fund regarding 
the fund's basis for determining that its investment strategy is 
appropriate for the open-end structure, just as staff currently may 
request information from a fund to support its disclosure reflecting 
the fund's compliance with various provisions of the Investment 
Company Act and rules thereunder.
    \207\ See infra footnote 378 and accompanying text.
---------------------------------------------------------------------------

    Because a fund will be required to consider the liquidity risk 
factors (as applicable) in periodically reviewing its liquidity risk, 
the final rule requires a fund's periodic liquidity risk review to 
include a consideration of whether the fund's investment strategy is 
appropriate for an open-end fund.\208\ For example, if a fund's 
illiquid investments exceed 15% of net assets, this could indicate that 
the fund is encountering liquidity pressures that could significantly 
impair the fund's ability to meet its redemption and other legal 
obligations. In this case, we believe it would be appropriate for a 
fund to review and potentially update its liquidity risk management 
procedures for handling the fund's high levels of illiquid investment 
holdings. In circumstances in which it appears unlikely that the fund 
will be able to reduce its illiquid investment holdings to or below 15% 
within a period of time commensurate with its redemption obligations, a 
fund's periodic liquidity risk review could lead the fund to reconsider 
its continued operation as an open-end fund.\209\
---------------------------------------------------------------------------

    \208\ See infra section III.B.3.
    \209\ Moreover, we note that actions that either directly or 
indirectly extinguish the rights of shareholders to redeem their 
shares could, depending on the facts and circumstances, involve 
violations of section 22(e) and other provisions of the Act, such as 
section 48(a) (prohibiting a person from doing indirectly, through 
another person, what that person is prohibited by the Act from doing 
directly).
---------------------------------------------------------------------------

Consideration of Portfolio Concentration, and Holdings of Large 
Portfolio Positions
    We also are adopting a modification to the proposed liquidity risk 
factors to clarify that consideration of a fund's investment strategy 
must include an evaluation of whether the strategy involves a 
relatively concentrated portfolio or large positions in particular 
issuers. Some commenters suggested that funds with extraordinarily 
concentrated portfolios may have particular liquidity risks that could 
make redeemability from these funds especially challenging.\210\ Our 
evaluation of these comments, together with recent events discussed 
below, have led us to revise the proposed ``investment strategy'' 
liquidity risk factor to focus on fund concentration issues.
---------------------------------------------------------------------------

    \210\ See, e.g., BlackRock Comment Letter; CRMC Comment Letter; 
ICI Comment Letter I; Invesco Comment Letter.
---------------------------------------------------------------------------

    We believe that this component of a fund's investment strategy is a 
particularly significant factor in evaluating the extent to which 
investment strategy contributes to liquidity risk. As we noted in the 
Proposing Release, while a fund with a relatively more diversified 
portfolio that needs to sell portfolio investments to build liquidity 
may be able to select investments for sale based on whether the markets 
for those investments are favorable, a relatively less diversified fund 
may have fewer options (i.e., because it has less choice of investments 
to sell or because the markets for its portfolio investments are 
uniform or correlated) and could thus be compelled to transact in 
unfavorable markets.\211\ In addition, as discussed below, holding a 
large portion of a particular issue could adversely affect a fund's 
ability to convert the position to cash without a value impact, and 
this can hamper a fund's portfolio management flexibility due to the 
higher liquidity risk in its positions.\212\ Thus, we believe that 
investment strategies that involve holding large portions of a 
particular issue--particularly if the market for these securities is 
thinly traded \213\ or if the fund's strategy involves investment in a 
relatively small number of holdings--could notably increase a fund's 
liquidity risk. As discussed above, the recent suspension of 
redemptions by Third Avenue Focused Credit Fund, which had a 
concentrated portfolio and large holdings of particular issues, 
illustrates how these methods of concentration directly affect 
liquidity risk, which in turn could adversely affect shareholders to 
the extent that they are not able to redeem their shares, or redeem 
their shares only at a significant discount.\214\
---------------------------------------------------------------------------

    \211\ See Proposing Release, supra footnote 9, at paragraph 
accompanying nn.296-298.
     However, as also discussed above, the extent to which a fund is 
required to be diversified, including a fund's status as a regulated 
investment company under Subchapter M of the Internal Revenue Code, 
could affect its liquidity risk in that the fund could be limited by 
its diversification obligations in its ability to sell certain 
portfolio securities. See supra footnotes 200-201 and accompanying 
text.
    \212\ See infra footnote 440 and accompanying text; infra 
paragraph accompanying footnote 450.
    \213\ See infra footnote 544 and accompanying text.
    \214\ See, e.g., Jeffrey Ptak & Sarah Bush, Third Avenue Focused 
Credit Abruptly Shuttered, Morningstar (Dec. 11, 2015), available at 
http://ibd.morningstar.com/article/article.asp?id=733021&CN=brf295,http://ibd.morningstar.com/archive/archive.asp?inputs=days=14;frmtId=12,%20brf295 (noting that ``Third 
Avenue Focused Credit stood out for its large, concentrated 
allocation to distressed and other low-quality fare''); see also 
Third Avenue Temporary Order, supra footnote 12 (noting that 
``Applicants further state that relief permitting the Fund to 
suspend redemptions in connection with its liquidation would permit 
the Fund to liquidate its assets in an orderly manner and prevent 
the Fund from being forced to sell assets at unreasonably low prices 
to meet redemptions.'').
---------------------------------------------------------------------------

Use of Borrowings for Investment Purposes and Derivatives
    We have incorporated the proposed requirement to consider a fund's 
use of borrowings for investment purposes and derivatives within the 
requirement to consider investment strategy in assessing, managing, and 
periodically reviewing a fund's liquidity risk.\215\ As

[[Page 82163]]

proposed, this consideration was not included within the investment 
strategy factor, but instead was a stand-alone liquidity risk factor. 
However, we believe that including this consideration within the 
general investment strategy factor is clearer, because a fund's use of 
borrowings for investment purposes and derivatives may be viewed as a 
component of its investment strategy. We note that we have also revised 
the phrase ``use of borrowings and derivatives for investment 
purposes'' that was used in the Proposing Release, and instead are 
using the term, ``use of borrowings for investment purposes and 
derivatives'' in the final rule. We have made this revision in order to 
clarify that funds should consider all derivatives, including those 
used for hedging purposes. As proposed, this provision could 
potentially have been read to exclude the consideration of derivatives 
used for hedging, which was not the intent of the proposed requirement. 
We believe this clarification will make clear that the requirement is 
for a fund to consider both use of borrowings for investment purposes 
and use of derivatives in general. One commenter stated that it agreed 
that funds should consider the use of derivatives when assessing 
liquidity risk, including the extent and types of derivatives used, as 
well as the structure and terms of a fund's derivatives 
transactions.\216\ No commenters suggested that a fund's use of 
borrowings for investment purposes and derivatives is inapplicable to a 
fund's liquidity risk (provided that the fund engages in borrowing or 
uses derivatives \217\).
---------------------------------------------------------------------------

    \215\ See proposed rule 22e-4(b)(2)(iii)(C); rule 22e-
4(b)(1)(i)(A).
    \216\ See CFA Comment Letter.
    \217\ See supra footnotes 191-192 and accompanying text 
(clarifying that, to the extent one of the factors specified in rule 
22e-4(b)(1)(i) is not applicable to a particular fund, the fund 
would not be required to consider that factor in assessing its 
liquidity risk).
---------------------------------------------------------------------------

    We continue to believe that the potential effects of the use of 
borrowings for investment purposes and derivatives are relevant to 
assessing, managing, and periodically reviewing a fund's liquidity 
risk.\218\ As we noted in the Proposing Release, borrowing for 
investment purposes, whether from a bank \219\ or through financing 
transactions such as reverse repurchase agreements and short 
sales,\220\ may affect a fund's liquidity risk.\221\ Similarly, a 
fund's use of derivatives such as futures, forwards, swaps and written 
options may affect a fund's liquidity risk as well.\222\ We note that 
in addition to the liquidity of the derivatives positions themselves, 
assessing, managing, and periodically reviewing 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.\223\ To the extent the fund is required 
to make payments to a derivatives counterparty, those assets would not 
be available to meet shareholder redemptions.
---------------------------------------------------------------------------

    \218\ See Proposing Release, supra footnote 9, at section 
III.C.1.c.
    \219\ See id., at n.303 and accompanying text (noting that, in 
addition to the asset coverage limitations imposed by section 18 of 
the Investment Company Act, any borrowing from a bank 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).
    \220\ See id., at nn.304-305 and accompanying text (noting that 
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 certain Commission 
guidance, under which funds cover their obligations under such 
transactions by segregating certain liquid assets, and discussing 
the effects of asset segregation on funds' liquidity risk).
    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. See Securities 
Trading Practices of Registered Investment Companies, Investment 
Company Act Release No. 10666 (Apr. 18, 1979) [44 FR 25128 (Apr. 27, 
1979)] (``Release 10666''). This means that a fund that receives 
significant redemption requests may need to exit a portion of its 
financing transactions in order make more liquid investments 
available for sale to fulfill such requests. Furthermore, if a fund 
seeks to exit 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 investments it has available to meet redemptions. 
Consequently, a fund's assessment and management of its liquidity 
risk must include an evaluation of the nature and extent of its 
borrowings and the potential impact of borrowings on the fund's 
overall liquidity profile.
    \221\ We note that borrowings for investment purposes pose a 
variety of liquidity risks, including the risk that redemptions may 
require the sale of securities in amounts exceeding the amount of 
the redemption, resulting in a reduction of the fund's borrowings. 
Additionally, even without redemptions, the fund may need to sell 
securities and reduce borrowings if its investment values decline, 
which may have negative effects on the fund's liquidity.
    \222\ See Proposing Release, supra footnote 9, at paragraph 
accompanying nn.306-307 (discussing how the use of derivatives may 
affect a fund's liquidity risk). 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 no-action 
letters issued by our staff, and therefore segregate liquid assets 
in respect of their obligations under derivatives transactions. See 
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)], at 13-17; see 
also Use of Derivatives by Registered Investment Companies and 
Business Development Companies, Investment Company Act Release No. 
31933 (Dec. 1, 2015) [80 FR 80884 (Dec. 28, 2015)] (``2015 
Derivatives Proposing Release''), at n.47 and accompanying text; see 
also supra footnote 220. Derivatives may therefore raise concerns 
that are similar to those discussed at footnote 220 in the context 
of borrowings. Funds also may be required to dispose of assets in 
order to post required margin 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 exit such transactions.
    \223\ See In re OppenheimerFunds, Inc., et al., Investment 
Company Act Release No. 30099 (June 6, 2012) (settled action) 
(``OppenheimerFunds Release'') (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.'').
---------------------------------------------------------------------------

Consideration of Investment Strategy and Portfolio Liquidity During 
Normal and Reasonably Foreseeable Stressed Conditions
    Finally, we also are modifying the proposed liquidity risk 
assessment requirement to clarify that certain liquidity risk factors 
must be considered during both normal and reasonably foreseeable 
stressed conditions. As proposed, rule 22e-4 did not specify whether a 
consideration of these factors should consider normal conditions, 
stressed conditions, or both. One commenter stated that the proposed 
rule's treatment of stressed conditions was unclear,\224\ and another 
said that the proposed rule was unclear about what needed to be 
considered in assessing ``stress.'' \225\ For those liquidity risk 
factors that could vary depending on market conditions (i.e., a fund's 
portfolio liquidity and cash flow projections), we believe that it is 
appropriate to require a fund to evaluate those factors in normal and 
reasonably foreseeable stressed conditions. Thus, if a fund's portfolio 
strategy involves investing in securities whose liquidity is likely to 
decline in stressed conditions, a fund should take this into account in 
determining how its portfolio liquidity could contribute to its overall 
liquidity risk. For example, a fund's portfolio liquidity could 
decrease in stressed conditions if such conditions led to market 
participants pulling back on transacting in the fund's portfolio 
securities, or if stressed conditions affecting other assets or asset 
classes were to have correlated effects on the fund's portfolio 
securities. In considering normal and reasonably foreseeable stressed 
conditions, funds should consider historical experience but should 
recognize that such

[[Page 82164]]

experience may not necessarily be indicative of future outcomes, 
depending on changes in market conditions and the fund's particular 
circumstances.
---------------------------------------------------------------------------

    \224\ See BlackRock Comment Letter.
    \225\ See AFR Comment Letter.
---------------------------------------------------------------------------

    We note that ``stressed'' conditions will likely entail different 
scenarios for different types of funds. For example, differing levels 
of changes in interest rates and/or interest rates' implied volatility 
could affect two bond funds very differently, depending on factors such 
as the maturity, coupon rates and other characteristics of the funds' 
portfolio holdings. Assessment of stressed conditions also should take 
into account stresses originating outside of market stress. For 
example, certain funds could be significantly affected by geopolitical 
stresses, such as an emerging markets debt fund whose holdings' 
liquidity is affected by factors such as economic uncertainty in the 
holdings' countries of issuance. The extent to which stressed 
conditions are reasonably foreseeable will vary depending on the fund's 
facts and circumstances.
b. Cash Flow Projections
    We are adopting the requirement for a fund to consider its short-
term and long-term cash flow projections, during both normal and 
reasonably foreseeable stressed conditions, in assessing and managing 
its liquidity risk.\226\ The proposed rule also included the 
requirement for a fund to consider its cash flow projections in 
assessing its liquidity risk. However, we are adopting some 
modifications to this proposed requirement. Most significantly, 
although the proposed rule specified five separate considerations a 
fund would have to take into account in evaluating the extent to which 
its cash flow projections contribute to its liquidity risk, rule 22e-4 
as adopted today does not enumerate these five considerations. Instead, 
we are discussing these five considerations as guidance that funds 
should generally take into account in evaluating their cash flow 
projections, as discussed in more detail below.
---------------------------------------------------------------------------

    \226\ See rule 22e-4(b)(1)(i)(B).
---------------------------------------------------------------------------

    We continue to believe, as discussed in the Proposing Release, that 
understanding a fund's cash flows is important in determining whether 
the fund will have sufficient cash to satisfy redemption requests.\227\ 
We also continue to 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.\228\ 
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. This type of selling, 
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.\229\ To the extent a fund understands the 
composition of its shareholder base (for example, among retirement 
investors, other individual investors, or discretionary accounts), it 
may be able to better predict fund flows in response to market events 
or fund performance.
---------------------------------------------------------------------------

    \227\ See Proposing Release, supra footnote 9, at nn.267-268 and 
accompanying text.
    \228\ See id., at n.269 and accompanying text. See also Fidelity 
Comment Letter (noting that the predictability of fund cash flows 
varies depending on the predictability of the redemption behavior of 
the fund's shareholder base. ``[F]unds whose shareholders include 
investors who purchased shares distributed through a retirement 
program or other planned savings program may exhibit redemption 
patterns that are relatively more predictable.''); BlackRock Comment 
Letter (noting that funds may need additional data from their 
distributors and transfer agents regarding shareholder redemption 
activity to allow funds to make short-term and long-term cash 
projections).
    \229\ See Proposing Release, supra footnote 9, at n.270 and 
accompanying text.
---------------------------------------------------------------------------

Consideration of Cash Flow Projections During Normal and Reasonably 
Foreseeable Stressed Periods
    We also are revising the rule to require a fund to consider its 
short-term and long-term cash flow projections during both normal and 
reasonably foreseeable stressed conditions.\230\ As discussed above, 
proposed rule 22e-4 would have required a fund, in evaluating short-
term and long-term cash flow projections, to consider the size, 
frequency, and volatility of historical purchases and redemptions of 
fund shares during normal and stressed periods.\231\ Although we are 
not including a specific requirement for a fund to consider historical 
purchases and redemptions in considering its cash flow projections, we 
believe continuing to incorporate the concept of normal and reasonably 
foreseeable stressed conditions within the requirement to consider cash 
flow projections is critical for a fund to obtain a complete picture of 
how its cash flows may affect its liquidity risk, particularly because 
greater, more frequent, or more volatile outflows during stressed 
conditions could exacerbate a fund's liquidity risk.\232\ A fund and 
its portfolio and/or risk managers should review the guidance we 
provide below regarding funds' evaluation of the size, frequency, and 
volatility of historical purchases and redemptions of fund shares 
during normal and reasonably foreseeable stressed circumstances, as 
well as similar funds' purchases and redemptions, in determining how 
normal and reasonably foreseeable stressed market conditions could 
affect a fund's cash flows and contribute to the fund's liquidity 
risk.\233\
---------------------------------------------------------------------------

    \230\ See rule 22e-4(b)(1)(i)(B).
    \231\ See proposed rule 22e-4(b)(2)(iii)(A)(1).
    \232\ See Proposing Release, supra footnote 9, at text 
accompanying and following n.273.
    \233\ See infra footnotes 236-239 and accompanying text.
---------------------------------------------------------------------------

Guidance on Evaluating a Fund's Cash Flow Projections
    As discussed above, rule 22e-4 as adopted today requires a fund to 
consider its short-term and long-term cash flow projections during both 
normal and reasonably foreseeable stressed conditions in assessing, 
managing, and periodically reviewing liquidity risk. This liquidity 
risk factor simplifies the rule as proposed, which would have codified 
five separate considerations that would comprise a fund's consideration 
of its cash flow projections--namely, (i) the size, frequency, and 
volatility of historical purchases and redemptions of fund shares 
during normal and reasonably foreseeable stressed periods, (ii) the 
fund's redemption policies, (iii) the fund's shareholder ownership 
concentration, (iv) the fund's distribution channels, and (v) the 
degree of certainty associated with the fund's short-term and long-term 
cash flow projections. Instead of enumerating these five considerations 
in the text of rule 22e-4, we are discussing each of them as guidance 
in this Release (together, the ``cash flow guidance considerations'').
    We are not codifying the cash flow guidance considerations to 
simplify the rule 22e-4 liquidity risk factors and to alleviate certain 
commenter concerns about the complexity of the proposed factors. 
Commenters argued that the requirement to consider a specified list of 
multiple liquidity risk factors is overly complex--making compliance 
more difficult for funds, and oversight more difficult for the 
Commission.\234\ Commenters discussed the dangers of an analysis that 
mandates consideration of multiple factors becoming a generic 
``checklist'' approach to liquidity risk management that does not fully 
capture

[[Page 82165]]

the business practices, strategies, and risks that are germane to 
certain funds.\235\ We agree that requiring an overly complex liquidity 
risk assessment analysis could lead to this result, to the detriment of 
investors. Such procedures could appear to be robust, but in actuality 
may not reflect (or may underweight) a fund's most significant risk 
factors because of the perceived requirement to focus on enumerated 
factors that may not be particularly important to a fund's operations 
and risks. Thus, we believe that simplifying the cash flow liquidity 
risk factor in rule 22e-4 will benefit funds and their shareholders and 
continue to advance the Commission's goal of promoting meaningful 
liquidity risk analysis.
---------------------------------------------------------------------------

    \234\ See, e.g., Better Markets Comment Letter.
    \235\ See, e.g., MFS Comment Letter.
---------------------------------------------------------------------------

    With respect to the size, frequency, and volatility of historical 
purchases and redemptions of fund shares, we continue to believe, as 
discussed in the Proposing Release, that funds whose historical 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.\236\ 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 normal and 
reasonably foreseeable stressed periods (keeping in mind that 
historical experience may not necessarily be indicative of future 
outcomes).\237\ In addition to considering its own historical flow 
data, a fund, particularly a fund without substantial operating 
history, should consider purchase and redemption activity in funds with 
similar investment strategies.\238\ A fund may wish to evaluate whether 
the size, frequency, and volatility of its shareholder flows follow any 
discernible patterns (for example, patterns relating to seasonality, 
shareholder tax considerations, fund advertising, changes in fund 
performance ratings provided by third-party rating agencies, and the 
fund's investment strategy and size).\239\
---------------------------------------------------------------------------

    \236\ See Proposing Release, supra footnote 9, at nn.272 and 
accompanying text.
    \237\ See supra footnotes 230-233 and accompanying text. 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).
    \238\ See Proposing Release, supra footnote 9, at text following 
n.273. We note that 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.
    \239\ See Proposing Release, supra footnote 9, at nn.274-279 and 
accompanying text (discussing how a fund's investment strategy could 
contribute to its shareholder flows and noting that smaller funds 
may experience greater flow volatility). 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.
---------------------------------------------------------------------------

    We also continue to believe that a fund generally should consider 
its normal redemption policies and practices in evaluating the extent 
to which its cash flow projections may contribute to its liquidity 
risk. Specifically, as discussed in the Proposing Release, a fund 
should generally consider its disclosed or advertised time period for 
paying (or endeavoring to pay) redemption proceeds and whether this 
time period varies based on the payment method the fund employs.\240\ 
For example, a fund whose policies require it to typically pay 
redeeming shareholders on a next-day basis may have fewer options for 
managing high levels of redemptions than a fund whose policies require 
it to typically pay redeeming shareholders on a T + 3 basis.\241\
---------------------------------------------------------------------------

    \240\ See Item 6(b) of Form N-1A (requiring a fund to briefly 
identify the procedures for redeeming shares); infra section III.M.1 
(discussing amendments to Item 11 of Form N-1A).
    \241\ 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 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 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. See, e.g., Proposing Release, supra 
footnote 9, at n.270.
---------------------------------------------------------------------------

    A fund's shareholder ownership concentration also could affect its 
cash flow projections, as a fund that has a concentrated set of 
beneficial owners could experience considerable cash outflows from 
redemptions by a single or small number of shareholders, or by the 
decisions of an intermediary that has discretionary power over a 
significant number of shareholder accounts.\242\ This in turn could 
hamper a fund's management of liquidity risk if the fund does not have 
procedures in place to manage large redemptions. For these reasons, we 
believe a 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).
---------------------------------------------------------------------------

    \242\ We note that a relatively concentrated fund shareholder 
base may make it easier for funds to communicate with those 
shareholders or intermediaries about anticipated future redemptions, 
and thus plan liquidity demands. However, those shareholders are 
under no legal obligation to forewarn the fund of their redemptions 
and, particularly in times of stress, may not do so.
---------------------------------------------------------------------------

    We also continue to believe that a fund should consider how its 
distribution channels could affect its cash flows, including the 
predictability of its cash flows. For example, a fund may wish to 
consider the extent to which its redemption practices could depend on 
its distribution channels,\243\ as well as whether its distribution 
channels (particularly, whether the fund's shares are held through 
omnibus accounts) could make it difficult for a fund to be fully aware 
of the composition of its underlying investor base,\244\ including 
investor characteristics that could affect the fund's short-term and 
long-term flows.\245\ A fund's distribution channels could affect its 
cash flow predictions because certain distribution channels are 
generally correlated with particular purchase and redemption 
patterns.\246\ Additionally, we note that investors in mutual funds 
distributed through certain channels also may have similar purchase and 
redemption characteristics relating to their financial and tax-related 
needs.\247\
---------------------------------------------------------------------------

    \243\ For example, mutual funds that are sold through broker-
dealers will generally have to meet redemption requests within three 
business days, because rule 15c6-1 under the Exchange Act 
effectively establishes a T+3 settlement period for purchases and 
sales of securities (other than certain types of securities exempted 
by the rule) effected by a broker or dealer, unless a different 
settlement period is expressly agreed to by the parties at the time 
of the transaction.
    \244\ See, e.g., Comment Letter of Coalition of Mutual Fund 
Investors (Jan. 18, 2016) (``CMFI Comment Letter'') (raising 
concerns regarding omnibus account transparency).
    \245\ These investor characteristics could include whether 
ownership in the mutual fund is relatively concentrated, as well as 
whether the types of underlying investors in the fund typically 
share common investment goals affecting redemption frequency and 
timing.
    \246\ For instance, investors in mutual funds distributed 
through a retirement plan channel or other planned savings channel 
(such as a qualified tuition plan authorized by section 529 of the 
Internal Revenue Code) 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.
    \247\ 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. See 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; see also supra footnote 239 and 
accompanying text (discussing seasonality in mutual fund flows).

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[[Page 82166]]

    Finally, we continue to believe that a fund should consider the 
degree of certainty surrounding its short-term and long-term cash flow 
projections. A fund could consider the length of its operating history 
(including the fund's experience during points of market instability, 
illiquidity, or volatility) and any purchase and redemption patterns. A 
fund may use ranges in considering cash flow projections and their 
relationship to liquidity risk. If a fund has implemented policies to 
encourage certain shareholders (e.g., large shareholders or 
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 probability surrounding its cash flow 
projections.\248\
---------------------------------------------------------------------------

    \248\ We understand, based on staff outreach, that advance 
notification procedures are a relatively common liquidity risk 
management tool that funds currently employ. See Comment Letter of 
Invesco on the Notice Seeking Comment on Asset Management Products 
and Activities, Docket No. FSOC-2014-0001 (Mar. 25, 2015), at 11 
(``Invesco FSOC Notice Comment Letter'') (noting that Invesco has 
advance notification arrangements regarding anticipated redemptions 
above certain levels in place with certain distribution partners).
---------------------------------------------------------------------------

c. Holdings of Cash and Cash Equivalents, Borrowing Arrangements, and 
Other Funding Sources
    We are adopting the requirement for a fund to consider its holdings 
of cash and cash equivalents, as well as its borrowing arrangements and 
other funding sources, in assessing, managing, and periodically 
reviewing its liquidity risk, as proposed.\249\ As discussed in the 
Proposing Release, current U.S. Generally Accepted Accounting 
Principles (``GAAP'') 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.\250\ While we understand based on staff outreach and the 
comments we received on the proposal that many asset managers establish 
minimum cash and cash equivalent targets as part of their liquidity 
risk management practices,\251\ commenters stated that significant cash 
and cash equivalent holdings are not necessarily appropriate for all 
funds and as a stand-alone tool do not necessarily entirely mitigate 
liquidity risk.\252\ We agree with commenters that the amount of cash 
and cash equivalent holdings appropriate for liquidity risk management 
depends on a particular fund's facts and circumstances. Similarly, we 
agree with commenters that significant holdings of cash and cash 
equivalents could still be insufficient to protect a fund with large 
holdings of illiquid investments (or investments whose liquidity 
decreases significantly during stressed periods) if the fund were faced 
with heavy redemptions.\253\ But we continue to believe that holdings 
of cash and cash equivalents can be a valuable liquidity risk 
management tool because these holdings tend to remain very liquid under 
nearly all market conditions.\254\ Thus, a fund could use its cash and 
cash equivalent holdings in normal and stressed conditions to meet some 
redemption requests without significant dilution of remaining 
investors' interests. Holdings of cash and cash equivalents also could 
provide a fund's portfolio manager with flexibility to readjust its 
portfolio as it deems advantageous (either in terms of performance or 
risk management) under changing market circumstances. We therefore 
believe it is appropriate for a fund to consider its holdings of cash 
and cash equivalents as part of its liquidity risk assessment.
---------------------------------------------------------------------------

    \249\ See rule 22e-4(b)(1)(i)(C).
    \250\ See Proposing Release, supra footnote 9, at n.311 and 
accompanying text.
    \251\ See, e.g., Comment Letter of Pacific Investment Management 
Company LLC (Jan. 13, 2016) (``PIMCO Comment Letter'').
    \252\ See, e.g., ICI Comment Letter I (noting that fund 
complexes that specialize in U.S. equity funds, especially those 
focusing on large-cap stocks, are likely to be able to meet 
redemptions with only modest holdings of cash or cash equivalents 
because the U.S. equity market is so liquid); see also infra 
footnote 662 and accompanying text (discussing commenters' concerns 
that the proposed three-day liquid asset minimum requirement would 
be construed to require a fund specifically to hold cash and cash 
equivalents, which commenters argued could prevent funds from 
meeting their principal investment strategies and could give 
investors a false sense of security that cash buffers will eliminate 
liquidity risk).
    \253\ We also note that a substantial investment in cash and 
cash equivalents could decrease a fund's total return and/or cause 
the fund to diverge from its investment strategy, and thus a fund 
may wish to calibrate its holdings of these instruments to manage 
its liquidity risk while taking these concerns into consideration.
    \254\ We note that cash and cash equivalent holdings and 
borrowing arrangements are just two of several liquidity management 
tools that are at a fund's disposal. Though we are requiring funds 
to consider these tools, the rule neither creates a substantive 
obligation on funds to maintain specific levels of cash and cash 
equivalents nor requires funds to procure any specific borrowing 
arrangements.
---------------------------------------------------------------------------

    Several commenters discussed the extent to which a fund's borrowing 
arrangements and other funding sources could shape the fund's liquidity 
risk. Some commenters strongly supported the use of borrowing 
arrangements to help mitigate liquidity risk, asserting that funds 
historically have generally succeeded in managing liquidity risk, 
partly due to lines of credit and interfund lending.\255\ Commenters 
also asserted that obtaining access to backup sources of liquidity like 
lines of credit, interfund lending arrangements, and repurchase 
agreements should be considered beneficial as the flexibility to use 
these liquidity sources has value to a fund's shareholders.\256\ 
However, another commenter argued that asset managers should not meet 
redemptions through the use of borrowing facilities other than to meet 
short-term settlement mismatches, as this could potentially 
disadvantage non-redeeming investors.\257\
---------------------------------------------------------------------------

    \255\ See, e.g., Comment Letter of Independent Directors Council 
(Jan. 13, 2016) (``IDC Comment Letter'').
    \256\ See, e.g., BlackRock Comment Letter; Oppenheimer Comment 
Letter.
    \257\ See HSBC Comment Letter.
---------------------------------------------------------------------------

    We continue to believe that entering into borrowing or other 
funding arrangements could assist a fund in meeting redemption requests 
in certain cases (for example, by bridging any timing mismatches 
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).\258\ However, we have concerns that, in some situations, 
borrowing arrangements may not be beneficial to a fund's liquidity risk 
management to the extent that the fund's use of borrowings to meet 
redemptions leverages the fund at the expense of non-redeeming 
investors. In such a case, non-redeeming shareholders would effectively 
bear the costs of borrowing and the increased risk to the fund created 
by leverage.\259\ Thus, we believe that funds should consider the 
likely overall benefits and risks in including such borrowing or other 
funding arrangements within a liquidity risk management program.
---------------------------------------------------------------------------

    \258\ See Proposing Release, supra footnote 9, at n.314 and 
accompanying text.
    \259\ See Heartland Release, supra footnote 80.
---------------------------------------------------------------------------

    In evaluating the extent to which a fund's borrowing arrangements 
could help the fund manage its liquidity risk, a fund may wish to 
consider any aspects of those arrangements that could limit the fund's 
ability to borrow. For instance, a fund generally may wish to consider 
the terms of the credit facility (e.g. whether the credit facility is 
committed or uncommitted), as well as the financial health of the 
institution(s) providing the facility. A fund also generally should 
consider whether a credit facility would be shared among multiple funds 
within a fund family.

[[Page 82167]]

When a credit facility is shared, a fund should assess the extent the 
facility mitigates its liquidity risk given the liquidity risk 
associated with the other funds sharing the facility.\260\ Similarly, 
with respect to interfund lending within a family of funds, the terms 
of an interfund lending arrangement and any conditions required under 
exemptive relief permitting the arrangement \261\ (including 
limitations on the circumstances in which interfund lending may be 
used) will shape the role that interfund lending has in a fund's 
overall liquidity risk management.\262\
---------------------------------------------------------------------------

    \260\ See Proposing Release, supra footnote 9, at paragraph 
accompanying nn.314-317.
    \261\ See, e.g., Nationwide Mutual Fund, et al., Investment 
Company Act Release No. 32115 (May 16, 2016) [81 FR 31988 (May 20, 
2016)] (notice of application) (``Nationwide Exemptive Relief''); 
TCW Alternative Funds, et al., Investment Company Act Release No. 
32113 (May 11, 2016) [81 FR 30585 (May 17, 2016)] (notice of 
application) (``TCW Exemptive Relief''); see also Proposing Release, 
supra footnote 9, at paragraph accompanying nn.318-319.
    \262\ For example, it is common for such 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. Under these conditions, this 
type of borrowing would tend to be low risk, and thus entail less 
liquidity risk than borrowing money to pay redemptions without 
already having secured a price at which the assets used to cover the 
borrowing will be sold.
     Funds may only engage in interfund lending when it is in the 
best interests of both the lending and the borrowing fund. The 
exemptive relief anticipates a fund family's interfund lending 
arrangements include an assessment of: (i) If the fund participates 
as a lender, any effect its participation may have on the fund's 
liquidity risk; and (ii) if the fund participates as a borrower, 
whether the fund's portfolio liquidity is sufficient to satisfy its 
obligation to repay the loan along with its other liquidity needs. 
See Nationwide Exemptive Relief, supra footnote 261; TCW Exemptive 
Relief, supra footnote 261. For example, the relief is not intended 
to permit a fund to act as lender of last resort to a borrowing 
fund.
---------------------------------------------------------------------------

3. Periodic Review of a Fund's Liquidity Risk
    Rule 22e-4 as adopted includes the requirement for a fund to 
periodically review the fund's liquidity risk, taking into account the 
same liquidity risk factors a fund would have to consider in initially 
assessing and managing its liquidity risk.\263\ The proposed rule also 
included the requirement for a fund to periodically review its 
liquidity risk, considering those factors it would evaluate in 
initially assessing its liquidity risk.\264\ Commenters generally 
supported the proposed liquidity risk review requirement.\265\ 
Specifically, some commenters agreed that this requirement will help 
further the Commission's goals,\266\ expressed support for the proposed 
liquidity risk review factors,\267\ and agreed with the Commission's 
general approach of permitting funds to develop their own policies and 
procedures for conducting periodic liquidity risk reviews.\268\ Other 
commenters objected to the requirement for a fund to consider certain 
specified liquidity risk review factors and suggested instead that 
consideration of the factors be made permissive instead of 
mandatory.\269\ Still another commenter argued that the proposed 
liquidity risk review approach gives funds too much discretion and 
recommended that the Commission adopt a baseline standard for the 
frequency of funds' liquidity risk reviews (i.e., adopt an annual or 
quarterly review requirement).\270\
---------------------------------------------------------------------------

    \263\ See rule 22e-4(b)(1)(i).
    \264\ See proposed rule 22e-4(b)(2)(iii).
    \265\ See, e.g., CRMC Comment Letter; CFA Comment Letter; 
Fidelity Comment Letter; ICI Comment Letter I.
    \266\ See CRMC Comment Letter.
    \267\ See, e.g., CRMC Comment Letter; ICI Comment Letter I.
    \268\ See, e.g., CFA Comment Letter; Fidelity Comment Letter.
    \269\ See, e.g., MFS Comment Letter; Voya Comment Letter.
    \270\ See Better Markets Comment Letter.
---------------------------------------------------------------------------

    We are adopting a periodic review requirement substantially as 
proposed. As discussed above, we have revised the liquidity risk 
factors that a fund must consider in assessing, managing, and 
periodically reviewing its liquidity risk. A fund will not have to 
consider any factor that is not applicable to a particular fund.\271\ 
This requirement is principles-based, and thus each fund may develop 
and adopt procedures to review the fund's liquidity risk tailored as 
appropriate to reflect the fund's particular facts and circumstances.
---------------------------------------------------------------------------

    \271\ See supra footnote 192 and accompanying text.
---------------------------------------------------------------------------

    After evaluating commenters' concerns about the liquidity risk 
assessment factors, we continue to believe that these factors, modified 
as discussed above, are central to reviewing a fund's liquidity risk. 
We also continue to believe that requiring each fund to consider a 
baseline set of factors, as applicable, in reviewing liquidity risk 
would promote effective liquidity risk management across the fund 
industry. As discussed above,\272\ we believe that our changes to the 
proposed liquidity risk factors--which highlight particular risks but 
also condense and simplify some proposed factors--strike an appropriate 
balance between promoting consistency in funds' consideration of a 
standard set of liquidity risk factors and easing burdens associated 
with this analysis.
---------------------------------------------------------------------------

    \272\ See supra footnotes 193-194 and accompanying text.
---------------------------------------------------------------------------

    We considered a commenter's suggestion that the Commission adopt a 
minimum frequency for funds' liquidity risk review, and we have 
modified the proposed rule to clarify that a fund's periodic review of 
its liquidity risk must occur no less frequently than annually.\273\ As 
discussed below, we are adopting a requirement that a fund periodically 
review, no less frequently than annually its highly liquid investment 
minimum (as determined considering the same factors that a fund would 
reference in periodically reviewing its liquidity risk).\274\ Because 
this review of a fund's highly liquid investment minimum would, de 
facto, necessitate a fund's review of its liquidity risk, we believe it 
is appropriate to align the minimum periods for these reviews. 
Similarly, as discussed further below, we also are adopting a 
requirement that a fund's board must review, no less frequently than 
annually, a written report that describes a review of the adequacy of 
the fund's liquidity risk management program.\275\ Accordingly, the 
minimum period for the liquidity risk review will be aligned with the 
period in which this report will be presented to the fund's board, 
creating further synergies. We note, however, that a fund may determine 
that it is appropriate for its liquidity risk to be reviewed more 
frequently than annually, depending on the extent to which the required 
review factors could vary based on market- or sector-wide developments, 
as well as changes to the fund's operations or other fund-specific 
circumstances.
---------------------------------------------------------------------------

    \273\ See rule 22e-4(b)(1)(i).
    \274\ See infra section III.D.4.
    \275\ See infra section III.H.2.
---------------------------------------------------------------------------

C. Classifying the Liquidity of a Fund's Portfolio Investments, and 
Disclosure and Reporting Requirements Regarding Portfolio Investments' 
Liquidity Classifications

    Today we are adopting requirements for each fund, with the 
exception of In-Kind ETFs, to classify the liquidity of its portfolio 
investments. Rule 22e-4 as adopted today requires a fund to classify 
the liquidity of each portfolio investment based on the number of days 
within which it determined that it reasonably expects an investment 
would be convertible to cash (or, in the case of the less-liquid and 
illiquid categories, sold or disposed of) without the conversion (or, 
in the case of the less-

[[Page 82168]]

liquid and illiquid categories, sale or disposition) significantly 
changing the market value of the investment. Specifically, rule 22e-4 
will require a fund to classify each of its portfolio investments, 
including its derivatives transactions,\276\ into one of four liquidity 
categories:
---------------------------------------------------------------------------

    \276\ See rule 22e-4(b)(1)(ii). The final rule requires a fund 
to classify all portfolio investments, including investments that 
are liabilities of the fund. See infra section III.C.3.c.
---------------------------------------------------------------------------

     Highly liquid investments, defined as cash and any 
investment reasonably expected to be convertible to cash in current 
market conditions in three business days or less without the conversion 
to cash significantly changing the market value of the investment.
     Moderately liquid investments, defined as any investment 
reasonably expected to be convertible to cash in current market 
conditions in more than three calendar days but in seven calendar days 
or less without the conversion to cash significantly changing the 
market value of the investment.
     Less liquid investments, defined as any investment 
reasonably expected to be sold or disposed of in current market 
conditions in seven calendar days or less without the sale or 
disposition significantly changing the market value of the investment, 
but where the sale or disposition is reasonably expected to settle in 
more than seven calendar days.
     Illiquid investments, defined as any investment that may 
not reasonably be expected to be sold or disposed of in current market 
conditions in seven calendar days or less without the sale or 
disposition significantly changing the market value of the investment.
    This determination must be based on information obtained after 
reasonable inquiry; the term ``convertible to cash'' in the category 
definitions refers to the ability to be sold, with the sale settled. 
The final rule requires a fund to take into account relevant ``market, 
trading, and investment-specific considerations'' in classifying its 
portfolio investments' liquidity, but the rule does not detail a list 
of factors comprising these considerations.\277\ This Release does 
include, however, guidance on certain considerations that a fund may 
wish to evaluate in taking into account relevant market, trading, and 
investment-specific considerations when classifying the liquidity of 
its portfolio investments.\278\ The fund may classify portfolio 
investments based on asset class, so long as the fund or its 
adviser,\279\ after reasonable inquiry, does not have information about 
any market, trading, or investment-specific considerations that are 
reasonably expected to significantly affect the liquidity 
characteristics of an investment that would suggest a different 
classification for that investment.\280\ As discussed in more detail 
below, the fund also must consider the investment's market depth in 
classifying the investment.\281\ The fund also must review its 
portfolio investments' classifications at least monthly and more 
frequently if changes in relevant market, trading, and investment-
specific considerations are reasonably expected to materially affect 
one or more of its investments' classifications.\282\ Finally, the fund 
must take into account certain considerations for highly liquid 
investments that it has segregated to cover certain derivatives 
transactions.\283\
---------------------------------------------------------------------------

    \277\ See rule 22e-4(b)(1)(ii).
    \278\ See infra section III.C.4.
    \279\ The term ``adviser'' as used in this Release and rule 22e-
4 generally refers to any person, including a sub-adviser, that is 
an ``investment adviser'' of an investment company as that term is 
defined in section 2(a)(20) of the Investment Company Act. See infra 
paragraph accompanying footnote 818 (discussing the coordination of 
liquidity risk management efforts undertaken by various service 
providers, including a fund's sub-adviser(s)).
    \280\ See rule 22e-4(b)(1)(ii)(A).
    \281\ More specifically, the fund must determine whether trading 
varying portions of a position in a particular investment, in sizes 
that the fund would reasonably anticipate trading, is reasonably 
expected to significantly affect the liquidity of that investment, 
and if so, the fund must take this determination into account when 
classifying the liquidity of that investment. See rule 22e-
4(b)(1)(ii)(B).
    \282\ See rule 22e-4(b)(1)(ii); see also rule 22e-4(b)(1)(i) 
(imposing an ongoing responsibility on the fund to assess and manage 
its liquidity risk).
    \283\ More specifically, with respect to the fund's derivatives 
transactions that it has classified as moderately liquid 
investments, less liquid investments, and illiquid investments, it 
must identify the percentage of the fund's highly liquid investments 
that it has segregated to cover, or pledged to satisfy margin 
requirements in connection with, derivatives transactions in each of 
these classification categories. See rule 22e-4(b)(1)(ii)(C); see 
also rule 22e-4(b)(1)(iii)(B) (addressing such percentage of highly 
liquid investments in connection with determining whether a fund 
primarily holds highly liquid investments).
---------------------------------------------------------------------------

    Rule 22e-4 as proposed would have required each fund to classify 
the liquidity of its portfolio positions (or portions of a position in 
a particular asset) and review the liquidity classification of each 
position on an ongoing basis.\284\ In classifying and reviewing the 
liquidity of portfolio assets, proposed rule 22e-4 would have required 
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.\285\ Based on this 
determination, made using information obtained after reasonable 
inquiry, the proposed rule would have required a fund to classify each 
of its positions in a portfolio asset (or portions thereof) into one of 
six liquidity categories: (i) Convertible to cash within 1 business 
day; (ii) convertible to cash within 2-3 business days; (iii) 
convertible to cash within 4-7 calendar days; (iv) convertible to cash 
within 8-15 calendar days; (v) convertible to cash within 16-30 
calendar days; and (vi) convertible to cash in more than 30 calendar 
days.\286\ The proposed rule would have required a fund to consider 
certain specified factors, to the extent applicable, in determining the 
time period in which a portfolio position (or portion thereof) would be 
convertible to cash.\287\
---------------------------------------------------------------------------

    \284\ See Proposing Release, supra footnote 9, at section III.B.
    \285\ Proposed rule 22e-4(b)(2)(i).
    \286\ Proposed rule 22e-4(b)(2)(i).
    \287\ Proposed rule 22e-4(b)(2)(ii); see also infra section 
III.C.4.
---------------------------------------------------------------------------

    Although some commenters acknowledged potential benefits to the 
proposed classification requirement, most commenters were generally 
opposed to the proposed six-category liquidity classification 
framework. As discussed further below, commenters' primary objections 
were concerns that the proposed classification framework would: (i) Not 
reflect current liquidity risk management practices or industry ``best 
practices''; (ii) require funds to make overly subjective projections 
about asset liquidity, particularly to the extent that they would have 
to project a fund's ability to sell and settle a position well into the 
future; (iii) place undue reliance on third-party data vendors and 
analysts; (iv) incorporate a materiality standard that is unclear and 
impractical to apply; and (v) inappropriately require funds to take 
position size and settlement timing into account when classifying the 
liquidity of a portfolio position.
    Commenters suggested many alternatives to the proposed 
classification requirement--both changes to the structure of the 
proposed classification requirement, as well as suggestions about more 
granular aspects of the proposed requirement. Although the details 
vary, commenters raised three primary structural alternatives to the 
proposed classification requirement: (i) A ``principles-based'' 
liquidity classification approach, where each fund would have to 
classify the liquidity of its portfolio assets, but the Commission 
would not require any

[[Page 82169]]

specific classification scheme; \288\ (ii) a simplified version of the 
proposed classification system, with fewer classification categories 
based on shorter time projections than the proposal; \289\ and (iii) an 
approach with new classification categories based on qualitative 
distinctions in the market- and trading-related characteristics of 
different asset classes under different market conditions, which 
generally would rely on the Commission mapping different asset classes 
to each of these new classification categories.\290\
---------------------------------------------------------------------------

    \288\ See, e.g., AIMA Comment Letter; Comment Letter of the Loan 
Syndications and Trading Association (Jan. 13, 2016) (``LSTA Comment 
Letter''); Comment Letter of State Street Global Advisors (Jan. 13, 
2016) (``State Street Comment Letter''); Comment Letter of 
Wellington Management Company LLP (Jan. 13, 2016) (``Wellington 
Comment Letter'').
    \289\ See, e.g., Eaton Vance Comment Letter I; Interactive Data 
Comment Letter; Comment Letter of Markit (Jan. 13, 2016) (``Markit 
Comment Letter''); Comment Letter of Wells Fargo Funds Management, 
LLC (Jan. 13, 2016) (``Wells Fargo Comment Letter''). Commenters 
generally suggested three, four, or five classification categories.
    \290\ See, e.g., BlackRock Comment Letter; MFS Comment Letter; 
Nuveen Comment Letter; Comment Letter of Systemic Risk Council (Jan. 
13, 2016) (``SRC Comment Letter'').
---------------------------------------------------------------------------

    Our adopted liquidity classification requirement most closely 
resembles the second alternative described above and is designed to 
respond to commenters' concerns while also continuing to advance the 
Commission's goals. As discussed in the Proposing Release, we 
understand that funds today employ different practices for assessing 
the liquidity of their portfolios.\291\ After considering comments, 
however, we continue to believe that a liquidity classification 
framework based on a days-to-cash determination, with certain 
modifications from the proposal, is an effective approach to further 
our goals of creating a meaningful, uniform framework for reporting to 
the Commission and providing public disclosure about funds' liquidity 
profiles. To achieve this goal, we believe the rule must provide a 
consistent methodology for assessing portfolio liquidity. This 
methodology also will form the basis for the highly liquid investment 
minimum and illiquid investment limit, each of which we believe will 
play an important role in fund liquidity risk management, as discussed 
in detail below. We also believe this classification system maintains 
the benefits of a spectrum-based liquidity analysis while responding to 
concerns about the burden and level of precision implied by the 
proposed approach.
---------------------------------------------------------------------------

    \291\ See Proposing Release, supra footnote 9, at section III.B.
---------------------------------------------------------------------------

    While we agree that the suggested ``principles-based'' alternative 
approach would have benefits in terms of flexibility and funds' ability 
to leverage their existing procedures for assessing portfolio 
liquidity,\292\ this approach would not provide a uniform methodology 
for funds' liquidity assessment procedures. It thus would not 
meaningfully advance our goal of establishing a foundation for 
reasonably comparable reporting to the Commission and disclosure to the 
public about funds' portfolio liquidity.\293\ In particular, this 
approach would not permit detailed reporting about funds' portfolio 
investments' liquidity in a structured data format, as with reports on 
Form N-PORT, and thus would not provide an efficient basis for the 
Commission and its staff to monitor funds' portfolio liquidity and 
liquidity risk.
---------------------------------------------------------------------------

    \292\ See, e.g., supra footnote 288; see also section IV.C.
    \293\ See infra section III.C.6.
---------------------------------------------------------------------------

    We likewise believe the third alternative classification system, 
based on liquidity characteristics of different asset classes--as 
opposed to a days-to-cash framework--may not provide clear distinctions 
between each liquidity category without the Commission assigning 
specific asset classes to each classification category. Given the size 
of the fund industry and the wide variety and types of asset classes 
held by funds, we believe that it would be impractical for the 
Commission or its staff to attempt to prescriptively categorize every 
asset class by liquidity. Further, the classification requirement is 
designed to provide information regarding the liquidity of portfolio 
investments under current market conditions. We are concerned that a 
classification system by which the Commission assigns specific asset 
classes to specific liquidity categories would not be sufficiently 
flexible to account for the impact changing market conditions may have 
on the liquidity of fund investments.
    Relatedly, some commenters suggested an alternative classification 
system could be based on notions of liquidity other than ``days-to-
cash,'' including, in whole or in part, on the fraction of average 
daily trading volume that each position size corresponds to, the 
expected behavior of bid-ask spreads in a given asset, or more 
qualitative liquidity buckets (e.g. ``converted to cash quickly under 
most circumstances'').\294\ Other commenters suggested that all of the 
classification categories be defined based on a days-to-cash or days-
to-trade determination,\295\ while some recommended that only certain 
of the categories (generally, the relatively more liquid categories) be 
defined based on a days-to-cash or days-to-trade determination.\296\ 
After considering comments, we have chosen to adopt a classification 
system that most closely resembles the second alternative raised by 
commenters and includes days-to-cash determinations for the more liquid 
categories. As noted below, some of the more specific criteria 
suggested by commenters in place of days-to-cash may not be appropriate 
for all asset classes, while more qualitative criteria make it more 
difficult to compare classifications across funds relative to the days-
to-cash approach in the rule.\297\
---------------------------------------------------------------------------

    \294\ See, e.g., AFR Comment Letter; BlackRock Comment Letter; 
SRC Comment Letter.
    \295\ AFR Comment Letter; Cohen & Steers Comment Letter; PIMCO 
Comment Letter; Charles Schwab Comment Letter.
    \296\ Oppenheimer Comment Letter; SIFMA Comment Letter I; T. 
Rowe Comment Letter.
    \297\ See infra section IV.C.1.
---------------------------------------------------------------------------

1. Primary Elements of Classification Framework
a. Consolidation of Proposed Classification Categories
    Similar to the proposed classification requirement, the final 
classification requirement is generally based on a framework that would 
require a fund to determine the number of days in which each portfolio 
investment is convertible to cash. However, the final classification 
framework reduces the number of classification categories from six (as 
proposed) to four. In addition, a fund may classify portfolio 
investments based on asset class under the final classification 
requirement, so long as the fund or its adviser does not have 
information about any market, trading, or investment-specific 
considerations that are reasonably expected to significantly affect the 
liquidity characteristics of an investment and that would require a 
different classification for that investment. When we proposed the rule 
22e-4 classification requirement, we noted that the framework was meant 
to promote a more nuanced approach than a classification requirement 
under which a fund would simply designate assets as liquid or 
illiquid.\298\ The proposed approach also was meant to provide the 
basis for detailed reporting and disclosure about the liquidity of 
funds' portfolio positions in a structured data format, as the six 
liquidity categories described above would be incorporated

[[Page 82170]]

into the fund's portfolio holdings reported on proposed Form N-
PORT.\299\
---------------------------------------------------------------------------

    \298\ See Proposing Release, supra footnote 9, at n.174 and 
accompanying and following text.
    \299\ See id.
---------------------------------------------------------------------------

    Multiple commenters expressed concerns about the proposed six-
category classification framework. Many argued that the proposed 
classification method would require funds to make overly subjective 
projections about asset liquidity because predicting the time to 
liquidate a position for cash at a given price--particularly well into 
the future--is limited by required assumptions and market data 
availability, even for sophisticated asset managers.\300\ They stated 
that making relatively subjective liquidity determinations would render 
liquidity assessments inconsistent across funds, and any appearance of 
objectivity and comparability among funds' liquidity assessments thus 
would be false.\301\ Relatedly, commenters also maintained that the 
proposed liquidity classification categories were overly granular and 
therefore could present a false appearance of precision about portfolio 
assets' liquidity.\302\ For example, commenters argued that determining 
whether an asset can be converted to cash in 15 calendar days versus 16 
calendar days (that is, distinguishing between the fourth and fifth 
proposed classification categories) cannot realistically be known or 
predicted with accuracy.\303\ Some commenters advocated reducing the 
number of classification categories \304\ and expressed concern that 
the proposal would entail overly subjective classification analysis, 
which would give funds too much discretion to determine which assets 
are relatively liquid and thus make enforcement difficult and hinder 
meaningful risk mitigation.\305\ Finally, commenters also predicted 
that the complexity of analyses inherent in the proposed six-category 
classification framework, and related operational burdens, could cause 
many funds to either shift their classification obligations to third-
party analysts entirely, or to rely heavily on data provided by third-
party vendors to help simplify funds' own classification analyses.\306\
---------------------------------------------------------------------------

    \300\ See, e.g., Comment Letter of Michael Aguilar, et al. (Jan. 
12, 2016) (``Aguilar Comment Letter''); Credit Suisse Comment 
Letter; Comment Letter of J.P. Morgan Asset Management (Jan. 13, 
2016) (``J.P. Morgan Comment Letter''); Voya Comment Letter.
    \301\ See, e.g., AIMA Comment Letter; CRMC Comment Letter; T. 
Rowe Comment Letter; Vanguard Comment Letter.
    \302\ See, e.g., Cohen & Steers Comment Letter; MFS Comment 
Letter; Nuveen Comment Letter; SIFMA Comment Letter I.
    \303\ See, e.g., Credit Suisse Comment Letter.
    \304\ See AFR Comment Letter; see also Better Markets Comment 
Letter (expressing concern about the complexity of the proposed 
classification requirement).
    \305\ See Better Markets Comment Letter; SRC Comment Letter.
    \306\ See, e.g., FSR Comment Letter; Comment Letter of Brian 
Reid, Chief Economist, Investment Company Institute (Jan. 13, 2016) 
(``ICI Comment Letter II''); Charles Schwab Comment Letter; Wells 
Fargo Comment Letter.
---------------------------------------------------------------------------

    After considering these comments, we agree that the level of 
precision implied by the proposed six-category classification system 
could have unintended negative consequences. We also agree that the six 
liquidity classification categories that we proposed could lead to 
varying liquidity assessments and could give rise to an appearance of a 
level of precision about liquidity determinations that may not be 
achievable for some funds or asset classes. However, we continue to 
believe that a classification approach that involves funds evaluating 
investments' liquidity across a liquidity spectrum (as opposed to 
making a binary determination of whether an investment is liquid or 
illiquid) provides a basis for more meaningful reporting and disclosure 
about funds' portfolio liquidity. Our opinion corresponds with many 
commenters' views that there are significant benefits associated with 
evaluating portfolio assets' liquidity across a spectrum.\307\
---------------------------------------------------------------------------

    \307\ See, e.g., CRMC Comment Letter; HSBC Comment Letter; J.P. 
Morgan Comment Letter; Comment Letter of MSCI (Jan. 13, 2016) 
(``MSCI Comment Letter'').
---------------------------------------------------------------------------

    We believe that condensing the six proposed categories into four 
categories should decrease the variability in funds' liquidity 
assessments, since funds will not be required to make liquidity 
distinctions that are as detailed as would have been required under the 
proposal. The adopted categories also should reduce inconsistency in 
funds' liquidity assessments because the new categories do not include 
time periods in the least-liquid categories that are as granular or 
projected as far in the future as under the proposal. Furthermore, we 
believe that the adopted categories could decrease variability in some 
funds' liquidity assessments because we understand that the four 
adopted categories may correspond more closely than the proposed 
categories with classification methods and categories that some funds 
currently use in evaluating their portfolio liquidity.\308\ For 
example, the time frames referenced in the moderately liquid, less 
liquid, and illiquid classification categories are tied to the seven-
calendar-day period in which funds are required to pay redeeming 
shareholders under section 22(e) of the Investment Company Act. We 
understand through staff outreach conducted prior to the proposal that 
certain funds already classify their portfolios across a number of 
liquidity categories, taking into account days-to-cash determinations 
and focusing on assets that can be used to meet redemptions in the 
short- and medium-term.\309\ Certain commenters likewise acknowledged 
that some asset managers may currently classify portfolio positions 
with categories that take days-to-cash or days-to-trade determinations 
into account, although not at the level of detail suggested by the 
proposal or for all classes of portfolio assets.\310\
---------------------------------------------------------------------------

    \308\ See infra text accompanying footnotes 366, 375, 383.
    \309\ See Proposing Release, supra footnote 9, at paragraph 
accompanying n. 183.
    \310\ See, e.g., HSBC Comment Letter; MFS Comment Letter; Nuveen 
Comment Letter; Wellington Comment Letter.
---------------------------------------------------------------------------

    We recognize that, although we are providing a uniform 
classification framework, different funds may still classify the 
liquidity of similar investments differently, based on the facts and 
circumstances informing their analyses. This simply reflects the fact 
that different funds likely have different views on liquidity based on 
considerations such as their assessment of various market, trading, and 
investment-specific factors, and the size of their position in a 
particular investment. We acknowledge that liquidity can be difficult 
to estimate and that there is no agreed-upon measure of liquidity for 
all asset classes.\311\ Nevertheless, we believe the reporting of the 
liquidity classification information to us, and aggregated information 
to the public, will provide important information about fund liquidity.
---------------------------------------------------------------------------

    \311\ Indeed our recognition of these facts is part of what has 
lead us to adopt requirements that the more detailed liquidity 
classification of each individual portfolio investment be reported 
to us confidentially, with only the aggregated fund liquidity 
profile reported publicly, as discussed in section III.C.6 below.
---------------------------------------------------------------------------

b. Market, Trading, and Investment-Specific Considerations
    Rule 22e-4 as adopted today requires a fund to take into account 
``relevant market, trading, and investment-specific considerations'' in 
classifying and reviewing its portfolio investments' liquidity.\312\ 
Rule 22e-4 as proposed did not include this requirement but instead 
included an enumerated list of nine separate factors that a fund would 
be specifically required to consider, as applicable, in classifying and 
reviewing the liquidity of its portfolio assets.\313\

[[Page 82171]]

The Proposing Release requested comment generally on whether the 
Commission should codify the proposed list of nine liquidity 
classification factors. While one commenter agreed that the factors 
should be codified,\314\ most opposed codification and stated that 
funds should be permitted, but not required, to consider the 
factors.\315\ Commenters stated that codifying the proposed factors 
would mandate a classification process that would be overly burdensome 
on funds' resources \316\ and could limit portfolio managers' ability 
to rely on industry expertise in evaluating portfolio assets' 
liquidity.\317\ One commenter specifically expressed concern that ``the 
scope and complexity of the required analysis may excessively burden 
fund boards of directors and may actually act to distract fund managers 
and directors from the assessment of liquidity and redemption risk, 
which we view as the more important analysis.'' \318\ Commenters also 
argued that a codified list of liquidity assessment factors could 
create a presumption that a fund must consider each factor in 
evaluating each portfolio holding, even if certain factors would not be 
useful or relevant to evaluating certain portfolio assets' 
liquidity.\319\ Some commenters also stated that a codified list of 
factors could lead funds to place undue reliance on third-party data 
vendors,\320\ and such reliance could result in these vendors being 
viewed as ``rating agencies'' for liquidity, which could lead to 
potential systemic risk issues.\321\ In addition, they expressed more 
granular concerns about certain of the proposed factors, which are 
discussed in detail in section III.C.4 below.
---------------------------------------------------------------------------

    \312\ See rule 22e-4(b)(1)(ii).
    \313\ Rule 22e-4 as proposed would have required a fund to take 
into account the following nine factors, to the extent applicable, 
when classifying the liquidity of each portfolio position in a 
particular asset: (1) 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; (2) 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); (3) volatility of trading prices for the asset; (4) 
bid-ask spreads for the asset; (5) whether the asset has a 
relatively standardized and simple structure; (6) for fixed income 
securities, maturity and date of issue; (7) restrictions on trading 
of the asset and limitations on transfer of the asset; (8) 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 (9) relationship of the asset to another 
portfolio asset. See proposed rule 22e-4(b)(2)(ii). These proposed 
factors are discussed in more detail in infra section III.C.4.
    \314\ See, e.g., CRMC Comment Letter.
    \315\ See, e.g., AFR Comment Letter; Invesco Comment Letter; 
J.P. Morgan Comment Letter; Vanguard Comment Letter.
    \316\ See, e.g., CFA Comment Letter; LSTA Comment Letter; 
Oppenheimer Comment Letter.
    \317\ See, e.g., Federated Comment Letter; Charles Schwab 
Comment Letter.
    \318\ See AFR Comment Letter.
    \319\ See, e.g., ICI Comment Letter I (``We are concerned that 
[the proposed factors'] inclusion in the rule could create a 
presumption that funds consider each factor in evaluating each 
portfolio holding . . .''); Oppenheimer Comment Letter (``As an 
example, a fund that invests solely in equity securities of large 
capitalization issuers that are traded on U.S. exchanges might 
reasonably determine that the frequency of trades in those equity 
securities and their average daily trading volumes are sufficient 
factors to determine their liquidity, and that consideration of 
factors such as bid-ask spread and volatility of trading prices are 
not useful or informative in a liquidity assessment. However, 
because these securities have observable bid-ask spreads and 
volatility, the fund would nonetheless be required to obtain and 
consider such data.'').
    \320\ See, e.g., Dechert Comment Letter; Dodge & Cox Comment 
Letter; Comment Letter of the Mutual Fund Directors Fund (``MFDF 
Comment Letter''); T. Rowe Comment Letter.
    \321\ See, e.g., Federated Comment Letter; ICI Comment Letter 
II; MFDF Comment Letter; SIFMA Comment Letter I.
---------------------------------------------------------------------------

    After considering commenters' suggestions and concerns, we are not 
including the classification factors in the rule as proposed because we 
are concerned that including this list in rule 22e-4 could lead funds 
to focus too heavily on evaluating certain factors that may not be 
particularly relevant to the liquidity of a specific fund's portfolio 
investments, the evaluation of which may not help produce meaningful 
outcomes in terms of effective classification. This could operate to 
the detriment of efficient and appropriate liquidity assessments that 
focus on the liquidity characteristics most directly affecting a 
particular asset class or investment.
    We are instead adopting a principles-based requirement that a fund 
take into account relevant market, trading, and investment-specific 
considerations in classifying its portfolio investments. We understand 
based on staff outreach that it is common for some funds, in assessing 
the liquidity of their portfolio investments, to look only at basic 
structural characteristics of an investment (such as asset class or 
restrictions on transfer) and not to supplement this analysis with 
market information or other potentially relevant factors.\322\ This 
could lead to circumstances in which a fund's liquidity classifications 
do not reflect a fund's actual ability to sell its portfolio 
investments without significant dilution to meet redemptions within a 
given time period, or do not otherwise result in an accurate picture of 
a fund's liquidity profile. Thus, we believe that the classification 
requirement must require funds to evaluate relevant considerations in 
making liquidity determinations. We believe the requirement to take 
into account relevant market, trading, and investment-specific 
considerations achieves this goal and is broad and flexible enough to 
be relevant for all investment strategies and fund risk profiles. In 
addition, we continue to believe that the proposed classification 
factors could help funds in evaluating relevant market, trading, and 
investment-specific considerations, and thus we have included guidance 
on many of these areas in section III.C.4 of this Release that may be 
relevant to a fund's assessment of portfolio investments' liquidity 
characteristics.
---------------------------------------------------------------------------

    \322\ See, e.g., infra section III.E.
---------------------------------------------------------------------------

    We understand that some third-party service providers currently 
provide data and analyses assessing the relative liquidity of a fund's 
portfolio investments, and that many of these service providers assess 
certain market, trading, and investment-specific considerations in 
doing so. We believe that a fund could appropriately use this type of 
data to inform or supplement its own consideration of the liquidity of 
an asset class or investment. However, a fund would not be required to 
do so.\323\ Also, we generally believe that a fund should consider 
having the person(s) at the fund or investment adviser designated to 
administer the fund's liquidity risk management program review the 
quality of any 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 its portfolio holdings' liquidity 
characteristics. 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. As discussed above, certain commenters expressed 
concern that the proposed six-category classification framework, 
including the proposed codification of certain factors that a fund 
would be required to consider (as applicable) in classifying its 
portfolio holdings, would place undue reliance on data vendors and 
analysts, and that such reliance could produce potential systemic risk 
issues.\324\ We believe that our decisions to simplify the proposed 
classification framework and not to include the proposed classification

[[Page 82172]]

factors as part of rule 22e-4, together with the guidance on the 
appropriate use of data vendors discussed in this paragraph, should 
largely mitigate these concerns.
---------------------------------------------------------------------------

    \323\ See Nuveen Comment Letter (requesting that the Commission 
confirm that data from third-party vendors may be used in a fund's 
assessment of liquidity, but that funds are not required to use data 
provided by third-party vendors in classifying the liquidity of 
their portfolio assets).
    \324\ See supra footnotes 320-321 and accompanying text.
---------------------------------------------------------------------------

c. Value Impact Standard
    As discussed further below, in a modification to the proposed 
standard, each of the liquidity categories included in the 
classification requirement we are adopting requires a fund to determine 
the time period in which an investment would be reasonably expected to 
be converted to cash (or in some cases, sold or disposed of) in current 
market conditions without the conversion to cash (or in some cases, 
sale or disposition) significantly changing the market value of the 
investment.\325\ This modification highlights that the standard does 
not require a fund to actually re-value or re-price the investment for 
classification purposes, nor does the standard require the fund to 
incorporate general market movements in liquidity determinations or 
estimate market impact to a precise degree.
---------------------------------------------------------------------------

    \325\ See rule 22e-4(a)(6); 22e-4(a)(8); 22e-4(a)(10); and 22e-
4(a)(12). We note the term ``market value'' as used in the value 
impact standard includes the value of investments that are fair 
valued.
---------------------------------------------------------------------------

    Many commenters opposed the value impact standard incorporated in 
the proposed liquidity classification requirement--that the asset was 
convertible to cash ``at a price that does not materially affect the 
value of that asset immediately prior to sale.'' \326\ Many suggested 
that the value impact component of the proposed standard was 
inappropriate for liquidity analyses \327\ and should be eliminated 
from the classification requirement.\328\ Commenters particularly were 
concerned that a ``materiality'' standard could be difficult and 
impractical to apply because they argued any sale of an asset could 
impact its market value to some degree.\329\ They stated that it is 
difficult to separate and quantify the market impact of a fund's trades 
in a particular asset from other reasons that an asset's price could 
move (such as market events), particularly in dynamic markets, and that 
projections of future market impact are difficult to make.\330\ 
Furthermore, they stated that without further guidance from the 
Commission funds may not know what ``material'' should mean in the 
context of the proposed classification requirement.\331\ Some 
commenters specifically noted that the proposed value impact standard 
differed from the value impact standard incorporated in the 
Commission's guidelines limiting funds' illiquid asset holdings, which 
is based on whether a fund could sell an asset at approximately the 
value at which the fund has valued it, and that conflicting standards 
could raise confusion and operational difficulties.\332\ Finally, 
several commenters argued that the inclusion of the value impact 
standard in the proposed classification categories could give fund 
shareholders the false impression that the fund guarantees a protected 
NAV.\333\
---------------------------------------------------------------------------

    \326\ See, e.g., BlackRock Comment Letter; MFS Comment Letter; 
Comment Letter of Milliman Financial Risk Management LLC (Jan. 7, 
2016) (``Milliman Comment Letter''); Vanguard Comment Letter.
    \327\ See, e.g., Eaton Vance Comment Letter I; Fidelity Comment 
Letter; PIMCO Comment Letter; Vanguard Comment Letter.
    \328\ See, e.g., CRMC Comment Letter; J.P. Morgan Comment Letter 
(recognizing, however, the concern underlying the proposed 
standard--``namely that if funds sell assets at `fire sale' prices 
there can be negative price pressure on those assets as well as 
correlated assets, which could transmit stress to other funds or 
portions of the market''); PIMCO Comment Letter; Vanguard Comment 
Letter.
    \329\ See, e.g., CRMC Comment Letter; IDC Comment Letter; PIMCO 
Comment Letter; T. Rowe Comment Letter.
    \330\ See, e.g., BlackRock Comment Letter; CRMC Comment Letter; 
MFS Comment Letter; Voya Comment Letter.
    \331\ See, e.g., Aguilar Comment Letter; Markit Comment Letter; 
Milliman Comment Letter; SIFMA Comment Letter I.
    \332\ See, e.g., Interactive Data Comment Letter; NYC Bar 
Comment Letter; see also infra text accompanying footnotes 341-342 
(discussing the harmonization of the value impact standard 
incorporated in the definition of ``illiquid asset'' that we are 
adopting with the standard incorporated in the rule 22e-4 
classification requirement generally).
    \333\ See, e.g., BlackRock Comment Letter; ICI Comment Letter 
III; PIMCO Comment Letter; SIFMA Comment Letter I.
---------------------------------------------------------------------------

    As we noted when discussing the definition of ``liquidity risk,'' 
we continue to believe that incorporating a value impact analysis into 
liquidity considerations is appropriate because it indicates that 
liquidity risk for a fund captures not just the risk of being unable to 
meet redemption requests, but also the risk that a fund could only meet 
redemption requests in a manner that significantly dilutes the funds' 
non-redeeming shareholders. Separately, as we noted above, the 
inclusion of some consideration of value impact is common in 
regulators' characterization of portfolio liquidity and fund liquidity 
risk.\334\ Because we believe that the liquidity of portfolio 
investments is a significant component of a fund's overall liquidity 
risk,\335\ we continue to believe that the inclusion of a value impact 
standard in the rule 22e-4 classification categories is appropriate. We 
also understand that many current trade order management systems 
estimate value impacts that may result from trades, which may assist 
funds in making these estimates.
---------------------------------------------------------------------------

    \334\ See supra footnote 173.
    \335\ See rule 22e-4(b)(1)(i)(A) (requiring a fund to consider 
its portfolio investments' liquidity in assessing its liquidity 
risk).
---------------------------------------------------------------------------

    Nevertheless, we have determined that certain modifications to the 
proposed value impact standard are warranted to address certain 
concerns raised by commenters. First, we recognize that in complying 
with the value impact standard, funds will be making assessments about 
the trading behavior of certain asset classes (and individual 
investments, for investments that need to be treated on an exception 
basis in the final classification framework we are adopting today). 
Accordingly, funds should be able to rely on their reasonable 
expectations at the time they make these assessments, and we do not 
expect them to estimate to a precise degree the market impact of 
trading that investment or the value of that investment as the trades 
occur.\336\ As a result, we have modified the final rule to provide 
that an investment's classification be based a fund's reasonable 
expectations in current market conditions (emphasis added).\337\ We 
also expect that the consolidation of the liquidity classification 
categories into ones that only require days-to-cash projections out to 
seven days should also mitigate commenters' concerns about the 
uncertainty involved in these value impact projections because the 
consolidated categories do not involve projections as far into the 
future as the proposed categories.
---------------------------------------------------------------------------

    \336\ In the proposal, we noted that the proposed term 
``immediately prior to sale'' was not meant to require a fund to 
anticipate and determine in advance the precise current value of an 
asset at the moment before the fund would sell the asset. We believe 
that the alterations to the final value impact standard reinforce 
this intent. See Proposing Release, supra footnote 9, at text 
following n.170
    \337\ A fund's reasonable expectations pertain to each aspect of 
the definition of highly liquid investments, moderately liquid 
investments, less liquid investments, and illiquid investments--
i.e., a fund may rely on its reasonable expectations as to the 
fund's ability to convert the investment to cash (or, in some cases, 
sell or dispose of the investment) in current market conditions in a 
certain number of days and a fund may rely on its reasonable 
expectations as to whether the conversion to cash (or, in some 
cases, sale or disposition) of the investment can be done without 
significantly changing the market value of the investment.
---------------------------------------------------------------------------

    We also changed the standard to capture only value impacts that 
significantly change the investment's market value, rather than the 
proposed standard that focused on materially affecting the value of the 
asset immediately prior to sale (emphasis added). We believe that funds 
will be less likely to interpret significant changes in market value as 
capturing very small movements in price, and

[[Page 82173]]

thus this change should address commenters' concern that the proposal 
would create a value impact standard that is impractical to apply 
because any sale of an investment could affect its market value to some 
degree. We also believe that a fund's classification policies and 
procedures should address what it would consider to be a significant 
change in market value. Common alternatives that commenters suggested 
in place of the proposed value impact standard included an ``assuming 
no fire sale discounting'' (or similar) standard \338\ or various 
quantitative materiality standards.\339\ We believe a standard based on 
fire sale discounting would be too high of a value impact threshold, 
whereas suggested quantitative standards would be too precise and 
require burdensome calculations. However, we believe that the final 
value impact standard of ``without the conversion to cash (or in some 
cases, sale or disposition) significantly changing the market value'' 
appropriately balances our desire to capture the risk of dilution in 
cases of inadequate liquidity, while not also requiring funds to 
account for every possible value movement.
---------------------------------------------------------------------------

    \338\ See, e.g., SIFMA Comment Letter I; T. Rowe Comment Letter; 
see also AFR Comment Letter (suggesting standard should be that an 
asset could be sold at a price that does not create harm to fund 
shareholders due to the fund being forced to accept disadvantageous 
terms of sale in order to find a buyer).
    \339\ See, e.g., Interactive Data Comment Letter (asset could be 
sold at a price that has a less than 5% impact on the value of that 
asset; asset could be sold at a price that does not create a 1 penny 
or more impact on the fund's NAV; fund could use volatility measures 
to determine security-specific materiality thresholds).
---------------------------------------------------------------------------

    Finally, we note that the final value impact standard does not 
require the fund to incorporate general market movements in liquidity 
determinations. We recognize that there can be many reasons for the 
market value of a particular investment to fluctuate, separate from the 
fund's transactions in those investments. We do not intend for the 
value impact standard to capture movements in an investment's value due 
to market events. For this reason, we are not adopting a value impact 
standard based on the fund's most recent valuation of that investment 
as suggested by some commenters.\340\ This type of standard may have 
required a fund to compare the investment's traded price with the 
fund's prior day valuation of the investment--such a comparison likely 
would reflect the effects of general market movements. The value impact 
standard we are adopting today only requires a fund to consider the 
market value impact of a hypothetical sale of an investment.
---------------------------------------------------------------------------

    \340\ IDC Comment Letter; NYC Bar Comment Letter.
---------------------------------------------------------------------------

    We recognize that the value impact standard incorporated in the 
``illiquid investment'' definition is slightly different from the 
standard used in the definition of ``illiquid asset'' under the 
Commission's current guidelines, as the latter is based on whether a 
fund could sell an asset at ``approximately the value at which the fund 
has valued the investment.'' \341\ We believe the revised value impact 
standard in the illiquid investment definition is preferable both 
because it prevents confusion by harmonizing the value impact standards 
within the classification framework and because, as just discussed, it 
removes any confusion that the value impact standard incorporates 
general market movements that would occur between when a fund strikes 
its NAV and when it trades the investment.\342\
---------------------------------------------------------------------------

    \341\ See supra section II.B.2
    \342\ See also infra section III.C.2.d.
---------------------------------------------------------------------------

    With respect to commenters' concerns that the inclusion of a value 
impact standard in the rule 22e-4 classification categories could give 
fund shareholders the false impression that the fund guarantees a 
protected NAV, we do not believe that the final rule's classification 
categories imply a protected NAV. As noted in our discussion of the 
rule 22e-4 definition of ``liquidity risk,'' we believe that funds' 
narrative risk disclosure in their registration statements and other 
shareholder communications generally should make clear those risks that 
could adversely affect the fund's NAV, yield, and total return, 
including liquidity-related risks. All open-end funds are required to 
disclose that loss of money is a risk of investing in the fund.\343\
---------------------------------------------------------------------------

    \343\ See Item 4(b)(1)(i) of Form N-1A.
---------------------------------------------------------------------------

d. Consideration of Current Market Conditions
    The definition of each liquidity category in the classification 
requirement we are adopting today specifically requires a fund to 
consider the time period in which an investment can be converted to 
cash (or, in some cases, sold or disposed of) in current market 
conditions.\344\ The ``current market conditions'' specification is a 
change from the proposed classification requirement, which did not 
explicitly require that a fund consider current market conditions in 
making liquidity classification determinations.\345\ The proposal, 
however, did require a fund to ``engage in an ongoing review'' of the 
liquidity of each of its portfolio positions.\346\ The Commission 
suggested in the Proposing Release that a fund's policies and 
procedures for reviewing the liquidity of its portfolio positions 
generally should include procedures for assessing market-wide 
developments, as well as security- and asset-class-specific 
developments that could demonstrate a need to change the liquidity 
classification of a portfolio position.\347\ The proposal's ongoing 
review standard (as opposed to the at-least-monthly review standard we 
are adopting today \348\) thus would have implicitly required that a 
fund's liquidity determinations reflect current market conditions.
---------------------------------------------------------------------------

    \344\ See rule 22e-4(a)(6); 22e-4(a)(8); 22e-4(a)(10); and 22e-
4(a)(12). See also infra section III.C.5. (discussing the 
requirement to review liquidity classifications at least monthly and 
more frequently if changes in relevant market, trading, and 
investment-specific considerations are reasonably expected to 
materially affect one or more of a fund's classifications of 
investments) and section III.E. (discussing the prohibition on 
acquiring illiquid investments if, immediately after acquisition, 
the fund would have invested more than 15% of its net assets in 
illiquid investments that are assets).
    \345\ See proposed rule 22e-4(b)(2)(i).
    \346\ Id.
    \347\ See Proposing Release, supra footnote 9, at text following 
n.253.
    \348\ See section III.C.5.
---------------------------------------------------------------------------

    Multiple commenters requested guidance and provided suggestions 
regarding the market conditions a fund should consider in classifying 
its portfolio assets' liquidity. Some commenters requested clarity on 
whether a fund would be required to classify the liquidity of its 
portfolio assets based on an assessment of normal market conditions or 
stressed market conditions.\349\ One commenter suggested that the 
Commission provide additional guidance on how to assess the value 
impact that a fund's sale of portfolio assets could have under future 
stressed market conditions.\350\ Additionally, one commenter suggested 
that any final liquidity classification framework should incorporate an 
assessment of reasonably foreseeable stressed conditions instead of 
current market conditions.\351\
---------------------------------------------------------------------------

    \349\ See, e.g., AFR Comment Letter; HSBC Comment Letter.
    \350\ See ICI Comment Letter II.
    \351\ See AFR Comment Letter.
---------------------------------------------------------------------------

    In addition to the commenters who requested clarification or made 
suggestions about the market conditions referenced in the proposed 
liquidity classification framework, multiple commenters suggested 
alternative classification schemes that would more explicitly define 
liquidity categories based on distinctions in how a particular asset 
would trade under normal versus stressed market

[[Page 82174]]

conditions.\352\ One commenter suggested that this alternative method 
of defining liquidity classification categories would reflect directly 
the extent to which assets' liquidity can dynamically change as market 
conditions evolve.\353\
---------------------------------------------------------------------------

    \352\ See, e.g., BlackRock Comment Letter; J.P. Morgan Comment 
Letter; SIFMA Comment Letter III; T. Rowe Comment Letter.
    \353\ See BlackRock Comment Letter. This commenter also noted 
that ``the time needed to liquidate a position at a given price in a 
normal market environment will not be reflective of the market 
impact incurred when liquidating positions during stressed 
markets.''
---------------------------------------------------------------------------

    After considering commenters' suggestions and concerns, we are 
adopting liquidity classification categories that reflect current 
market conditions. We appreciate commenters' concerns that liquidity 
classifications based on current market conditions capture only a 
moment-in-time picture of a fund's portfolio liquidity, which may not 
accurately reflect liquidity in changing market conditions. We also 
appreciate commenters' concerns that investments that are relatively 
liquid under normal conditions may exhibit significantly reduced 
liquidity during times of stress.\354\ However, we are concerned that 
requiring a fund to predict how an investment may trade in stressed 
market conditions would introduce an additional layer of subjectivity 
into the classification process. Specifically, we are concerned that 
funds would likely assume varying levels of stress when classifying the 
liquidity of their portfolio investments. We believe that liquidity 
categories requiring consideration of stressed conditions thus could 
impede our goals of promoting consistency in funds' processes for 
assessing portfolio investments' liquidity and enhancing the data 
quality of funds' liquidity-related reporting and disclosure. 
Conversely, we believe the requirement to assess current market 
conditions would increase consistency among funds' liquidity 
determinations by limiting the number of variables informing funds' 
classification determinations. Although we understand that the adopted 
classification scheme may not produce absolute consistency in how funds 
classify the liquidity of their portfolio investments as funds' 
assumptions and individual facts and circumstances may differ,\355\ 
classifying based on current market conditions will result in all 
funds' classifications at a given time reflecting the same market 
conditions.
---------------------------------------------------------------------------

    \354\ See generally MFS Comment Letter; NYC Bar Comment Letter.
    \355\ As discussed above, we recognize that funds are likely to 
make different assumptions in classifying the liquidity of their 
portfolio investments depending on the facts and circumstances 
relating to funds and their trading practices. See supra paragraph 
accompanying footnote 311.
---------------------------------------------------------------------------

    We believe that it would be informative to Commission staff to 
understand how the same set of market conditions could disparately 
affect different funds' assessments of their liquidity and that of 
different asset classes. Also, we note that, to the extent that the 
markets in which funds' portfolio investments trade are currently 
stressed, consideration of current market conditions would de facto 
reflect consideration of stressed market conditions. Therefore, the 
requirement to consider current market conditions, along with the 
requirement for funds to review the liquidity of their portfolio 
investments at least monthly \356\ and the Form N-PORT reporting 
requirements concerning funds' liquidity classifications,\357\ will 
provide data that will help the staff evaluate the role of changing 
market conditions on funds' liquidity by comparing liquidity data 
across different sets of current market conditions over time. We 
believe this liquidity data would be more useful than data based on 
projected stressed market conditions, because it would reflect funds' 
assessments in light of actual, not anticipated, market stresses.
---------------------------------------------------------------------------

    \356\ See infra section III.C.5.
    \357\ See infra section III.C.6.b.
---------------------------------------------------------------------------

    Finally, we note that while we are not incorporating a requirement 
to evaluate potential future stressed market conditions in the 
portfolio investment liquidity classification requirement, we continue 
to believe that it is appropriate to require funds to consider 
reasonably foreseeable stressed conditions as part of the liquidity 
risk assessment and management requirements.\358\ We believe that 
funds' liquidity risk assessment should inform the extent to which 
funds are prepared to manage their liquidity under both normal and 
reasonably foreseeable stressed conditions--particularly because, for 
many asset classes, liquidity is adversely affected by market stress 
and funds need to have a liquidity risk management program that is 
resilient under all market conditions. Thus, as discussed throughout 
this Release, a fund must establish liquidity risk management policies 
and procedures appropriate in light of both normal and reasonably 
foreseeable stressed market conditions.
---------------------------------------------------------------------------

    \358\ See supra section III.B. In discussing funds' liquidity 
risk assessment obligations under rule 22e-4, we note above that if 
a fund conducts stress testing to determine whether it has 
sufficient liquid investments to cover different levels of 
redemptions, a fund should incorporate the results of this stress 
testing into its liquidity risk assessment. See supra footnote 196.
---------------------------------------------------------------------------

2. Discussion of Specific Classification Categories
a. Highly Liquid Investments
    The classification requirement we are adopting today requires a 
fund to identify its ``highly liquid investments,'' that is, cash held 
by a fund and investments that the fund reasonably expects to be 
convertible to cash in current market conditions in three business days 
or less without the conversion to cash significantly changing the 
market value of the investment. This category condenses the first two 
liquidity classification categories in the proposed classification 
requirement (assets convertible to cash within one business day, as 
well as two-to-three business days) to simplify the proposed 
classification framework. Multiple commenters who suggested simplified 
alternatives to the proposed approach suggested including a 
classification category based on portfolio assets' convertibility to 
cash within three days.\359\ One such commenter suggested that ``highly 
liquid assets'' should include cash and any asset that can be converted 
to cash in the ordinary course of business within three business 
days.\360\ Additionally, another commenter agreed that, given current 
redemption practices, funds should assess how much liquidity they may 
need over a three-day period.\361\
---------------------------------------------------------------------------

    \359\ See, e.g., Federated Comment Letter; Fidelity Comment 
Letter; SIFMA Comment Letter I; Vanguard Comment Letter.
    \360\ See Vanguard Comment Letter.
    \361\ See MFDF Comment Letter (stating in the context of the 
proposed three-day liquid asset minimum, that ``[g]iven current 
redemption practices in the industry, we agree with the Commission 
that funds should assess how much liquidity they may need, both in 
normal and stressed market conditions, over a three-day period to 
effectively meet anticipated redemption requests.'').
---------------------------------------------------------------------------

    We continue to believe, as discussed in the Proposing Release, that 
it is important for funds to determine what percentage of their 
portfolio is convertible to cash--that is, available to meet 
redemptions--within the relatively short term. We understand that most 
funds typically pay redemption proceeds within a fairly short period 
(typically, one to three days) after receiving a shareholder's 
redemption request, even though a fund may disclose that it reserves 
the right to delay payment for up to seven calendar days, as permitted 
by section 22(e) of the Act.\362\ Likewise, funds may find it useful to 
identify portfolio investments

[[Page 82175]]

that may be converted to cash quickly in order to meet unexpected or 
unusually high redemption requests, or to rebalance or otherwise adjust 
a portfolio's composition in all market conditions.
---------------------------------------------------------------------------

    \362\ See supra footnote 9 and accompanying text.
---------------------------------------------------------------------------

    We also understand that funds often consider which portfolio 
investments can be sold and settled on a T + 1 to T + 3 basis when 
determining their very liquid investments.\363\ While such an analysis 
may be useful, our decision to define highly liquid investments to 
include any investment that the fund reasonably expects to be 
convertible into cash in current market conditions in three business 
days or less is founded in our belief that funds should understand what 
portion of their investments are convertible to cash in a short period 
of time taking into account current market conditions, not solely on 
which asset transactions can be settled in three days or less from the 
trade date. An investment that takes two days to sell but one day to 
settle, for example, would be convertible to cash in a short period of 
time. Conversely, an asset that may settle two days after trade date, 
but which is reasonably expected to take at least three days to trade, 
would not be available in a short period of time. Accordingly, we 
believe we have appropriately defined ``highly liquid investments'' 
under rule 22e-4 notwithstanding initiatives to shorten the standard 
settlement cycle for most broker-dealer transactions from T + 3 to T + 
2.\364\
---------------------------------------------------------------------------

    \363\ See supra footnote 309.
    \364\ See supra footnote 9.
---------------------------------------------------------------------------

    In addition, we emphasize that the highly liquid investment 
category (and the related highly liquid investment minimum) should not 
be interpreted as the Commission suggesting that a fund should, as a 
matter of routine practice, meet redemptions first by selling its 
highly liquid investments. Rather, we believe part of a thorough 
understanding of a fund's liquidity profile includes an understanding 
of the nature and level of the fund's highly liquid holdings.\365\ As 
noted above, we understand that funds currently place significance on 
understanding the portion of their portfolio representing very liquid 
investments, as it is not unusual for funds to determine the percentage 
of their portfolio that can be liquidated in the short-to-medium 
term.\366\ We anticipate that a fund could determine that a broad 
variety of investments within different asset classes could be 
classified as highly liquid investments, depending on facts and 
circumstances.\367\
---------------------------------------------------------------------------

    \365\ See infra footnote 374 and accompanying text (discussing 
the use of moderately liquid assets to meet redemption requests).
    \366\ See supra footnote 363 and accompanying text.
    \367\ See infra section III.D.
---------------------------------------------------------------------------

    We note that, as with the proposal, the highly liquid investment 
category measures the time period in which an investment could be 
converted to cash in business days, as opposed to the other liquidity 
categories, which use calendar days. Some commenters suggested that, 
instead of the references to both business days and calendar days, the 
categories that the Commission adopts should only reference business 
days.\368\ One commenter stated that basing all classification 
categories on business days instead of calendar days would be 
``preferable from a consistency standpoint, and reasonable given the 
lack of expectations around receiving cash flows on non-business 
days.'' \369\ Other commenters suggested alternative liquidity 
classification categories that, like the proposed categories, would 
reference both business days and calendar days.\370\
---------------------------------------------------------------------------

    \368\ See, e.g., Interactive Data Comment Letter; Nuveen Comment 
Letter.
    \369\ See Interactive Data Comment Letter; see also ICI Comment 
Letter I; T. Rowe Comment Letter (noting that the proposed 
classification categories could require a fund to make difficult 
distinctions in determining which assets can be converted to cash in 
three business days versus four calendar days). The note to rule 
22e-4(b)(1)(ii) addresses situations where the period to convert an 
investment to cash depends on the calendar or business day 
convention. See infra footnotes 376 and accompanying text.
    \370\ See, e.g., Markit Comment Letter; PIMCO Comment Letter.
---------------------------------------------------------------------------

    After considering these comments, we are continuing to reference 
business days in the highly liquid investment definition we are 
adopting, while referencing calendar days in the other liquidity 
classification categories. We appreciate commenters' concerns that 
classification categories that reference both business days and 
calendar days could add some complexity in the assumptions and models 
that funds may use in classifying the liquidity of their portfolio 
investments. However, as discussed below, we believe it is important to 
tie the time frames referenced in the moderately liquid, less liquid, 
and illiquid classification categories to the seven-calendar-day period 
in which funds are required to pay redeeming shareholders under section 
22(e) of the Investment Company Act.\371\ Although we could have 
referenced calendar days instead of business days in the highly liquid 
investment definition to help standardize the time periods referenced 
in all of the classification categories, we continue to reference 
business days in this classification category for several reasons. 
First, for short time periods, a calendar day standard could be 
unworkable and create absurd results if the time period were to 
encompass weekends or holidays, during which trading cannot be expected 
to occur. Second, many of the alternate classification categories that 
commenters suggested incorporated categories that referenced a three-
business-day period,\372\ and we understand from these comments and 
staff outreach that this is a workable (and, for some fund complexes, 
currently-used) period for a fund to consider in assessing the 
liquidity of its portfolio investments.\373\
---------------------------------------------------------------------------

    \371\ See infra sections III.C.2.b-d.
    \372\ See, e.g., Fidelity Comment Letter; Invesco Comment 
Letter; T. Rowe Comment Letter; Vanguard Comment Letter.
    \373\ We also note that rule 15c6-1 under the Exchange Act, 
which was adopted in 1993 and became effective in 1995, established 
three business days as the standard settlement period for securities 
trades effected by a broker-dealer. Thus, we understand that many 
funds pay redemption proceeds within three business days after 
receiving a redemption request, because a broker or dealer will be 
involved in the redemption process. See supra footnote 32 and 
accompanying text. See also supra footnote 366.
---------------------------------------------------------------------------

b. Moderately Liquid Investments
    A fund also will be required to identify its ``moderately liquid 
investments,'' that is, those investments the fund reasonably expects 
to be convertible into cash in current market conditions in more than 
three calendar days, but in seven calendar days or less, without the 
conversion to cash significantly changing the market value of the 
investment. These investments are those that are not immediately or 
very quickly convertible to cash, but that nevertheless may 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) of the Investment Company Act. We expect that this 
classification category will be an important component of the Form N-
PORT reporting obligations because it will provide the Commission with 
information regarding the portion of a fund's portfolio that is not on 
the most liquid end of the spectrum, but still is sufficiently liquid 
to meet redemption requests within the statutory seven-day period 
without causing significant dilution. We also anticipate that the 
public will have an interest in gaining transparency into this 
information on an aggregate basis.\374\ Several commenters who 
suggested simplified alternatives to the proposed classification 
approach

[[Page 82176]]

recommended including a classification category based on portfolio 
investments' convertibility to cash within seven days.\375\
---------------------------------------------------------------------------

    \374\ See infra section III.C.6.c.
    \375\ See, e.g., Federated Comment Letter; Fidelity Comment 
Letter; PIMCO Comment Letter; Vanguard Comment Letter.
---------------------------------------------------------------------------

    We understand that circumstances could arise in which the sale and 
settlement period for a particular portfolio position could be viewed 
as within 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 sale and settlement period could be viewed either as within 
three business days or four calendar days. This situation could cause 
ambiguity for reporting purposes. Thus, rule 22e-4, similar to the 
proposed rule, includes a note stating that a fund should classify the 
portfolio position based on the shorter period (i.e., as a highly 
liquid investment).\376\
---------------------------------------------------------------------------

    \376\ See note to rule 22e-4(b)(1)(ii); see also note to 
proposed rule 22e-4(b)(2)(i); see also supra footnote 369 
(discussing comments that noted situations where the period to 
convert an asset to cash depends on the calendar or business day 
convention).
---------------------------------------------------------------------------

c. Less Liquid Investments
    Additionally, a fund will be required to identify its ``less liquid 
investments,'' that is, those investments that the fund reasonably 
expects to be able to sell or dispose of in current market conditions 
in seven calendar days or less a without the sale or disposition 
significantly changing the market value of the investment, but where 
the sale or disposition is reasonably expected to settle in more than 
seven calendar days. Thus, the less liquid investments category focuses 
on investments whose sale cannot be settled quickly. For example, 
transactions in certain types of securities--such as certain foreign 
securities \377\ and U.S. bank loan participations \378\--have 
historically entailed settlement periods that are longer than standard 
settlement periods in the broader securities markets. If a fund were to 
determine that securities within these asset classes, or other asset 
classes with longer-than-standard settlement periods, were able to be 
sold within seven calendar days, but could not be settled within this 
period, the fund should classify these securities as less liquid 
investments. As an example, certain foreign securities may be able to 
be sold in seven calendar days or less, but may be subject to capital 
controls that would limit the extent to which the foreign currency 
could be repatriated or converted to dollars within this time frame. 
Thus, these securities would be considered to be less liquid 
investments because they would be reasonably expected to settle in more 
than seven calendar days. We note that trades in certain investments, 
however, may take an extended period of time to settle.\379\ In the 
event of an extended settlement period, at some point, a fund may need 
to consider re-classifying such an investment as illiquid.\380\ We also 
note that if a fund holds a forward contract on a security, such as a 
forward in a transaction in the ``To-Be-Announced'' (``TBA'') 
market,\381\ the convert to cash determination for that instrument may 
be based on the forward contract and not on the underlying securities 
to be received.\382\
---------------------------------------------------------------------------

    \377\ See, 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 www.gfma.org/Initiatives/Foreign-Exchange-(FX)/GFMA-FX-Division-
Submits-Comments-to-the-HKMA-on-the--Treatment-of-Securities-
Conversion-Transactions-under-the-Margin-and-Other-Risk-Mitigation-
Standards (``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).'').
    \378\ See, e.g., BlackRock, Who Owns the Assets? A Closer Look 
at Bank Loans, High Yield Bonds and Emerging Market Debt, Viewpoint 
(Sept. 2014) (``Who Owns the Assets?''), available at https://www.blackrock.com/corporate/en-fi/literature/whitepaper/viewpoint-closer-look-selected-asset-classes-sept2014.pdf; 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; Comment Letter of 
OppenheimerFunds on the Notice Seeking Comment on Asset Management 
Products and Activities, Docket No. FSOC-2014-0001 (Mar. 25, 2015) 
(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.''). See also LSTA Comment Letter.
    \379\ See infra footnote 416 and accompanying text.
    \380\ See rule 22e-4(b)(1)(ii) (requiring review of portfolio 
classifications at least monthly, and more frequently, if changes in 
relevant market, trading, and investment-specific considerations are 
reasonably expected to materially affect one or more of its 
investments' classifications).
    \381\ In the TBA market, lenders enter into forward contracts to 
sell agency mortgage-backed securities and agree to deliver such 
securities on a settlement date in the future. The specific agency 
mortgage-backed securities that will be delivered in the future may 
not yet be created at the time the forward contract is entered into. 
The purchaser will contract to acquire a specified dollar amount of 
mortgage-backed securities, which may be satisfied when the seller 
delivers one or more mortgage-backed securities pools at settlement. 
For a discussion of the TBA market, see Task Force on Mortgage-
Backed Securities Disclosure, Staff Report: Enhancing Disclosure in 
the Mortgage-Backed Securities Markets (Jan. 2003), at section 
II.E.2, available at http://www.sec.gov/news/studies/mortgagebacked.htm.
    \382\ See ICI Comment Letter I (noting that the ``TBA market is 
similar to the futures market, in which physically-settled futures 
contracts may trade continuously (e.g., daily) but the underlying 
reference assets are delivered at a later date (e.g., once every 3 
months).'').
---------------------------------------------------------------------------

    The ``less liquid investments'' category, like the ``moderately 
liquid investments'' category and the ``illiquid investments'' 
category, directly reflects the statutorily required seven-day period 
for meeting redemption requests. The ``less liquid investments'' 
category is meant to identify for the Commission and its staff, as well 
as investors and other potential users, the portion of a fund's 
portfolio investments that may be available to meet redemption requests 
within seven days, but only to the extent that the fund addresses the 
lengthier settlement period associated with these investments. Because 
less liquid investments are those that may be sold, but not settled, 
within seven days, a fund generally could use less liquid investments 
to meet redemptions within seven days only if the fund obtained an 
additional source of financing (for example, a line of credit) to 
bridge the period until the sales would settle, or if the fund used its 
cash holdings to meet the redemptions while simultaneously selling the 
less liquid investment and then replenishing its cash holdings upon 
settlement.
    Transparency regarding the portion of a fund's portfolio held in 
less liquid investments also could demonstrate those investments that 
could be liquidated in order to meet redemptions that would occur more 
than a week in the future, if a fund were to enter into a period of 
extended redemptions that it anticipates would last for multiple days. 
Because an open-end fund has an obligation to meet redemption requests 
within seven days, we believe it is important for funds to identify 
those investments that could pose certain challenges in being used to 
meet redemption requests within that time period, for purposes of the 
fund's own liquidity risk assessment and management,\383\ as well as to 
provide transparency into certain funds or strategies that could have 
relatively limited liquidity compared to peer funds.
---------------------------------------------------------------------------

    \383\ For example, a fund's holdings of less liquid investments 
typically would be a relevant consideration when assessing whether 
its strategy is appropriate for an open-end fund and determining its 
highly liquid investment minimum. See supra section III.B; see also 
infra section III.D.2.
---------------------------------------------------------------------------

d. Illiquid Investments
    A fund also will be required to identify those investments that it

[[Page 82177]]

considers to be ``illiquid investments.'' Rule 22e-4 as adopted today 
defines an illiquid investment as any investment that a fund reasonably 
expects cannot be sold or disposed of in current market conditions in 
seven calendar days or less without the sale or disposition 
significantly changing the market value of the investment. Like the 
``less liquid investments'' and ``moderately liquid investments'' 
category, the ``illiquid investments'' category references the 
statutorily required seven-day period for meeting redemption requests. 
However, while the ``less liquid investments'' and ``moderately liquid 
investments'' categories are based on the time period in which 
investments are convertible to cash--that is, sold with the sale 
settled--the ``illiquid investments'' category only reflects the period 
for selling (or otherwise disposing of) an investment and does not also 
consider settlement timing.
    Rule 22e-4 as proposed would have included a limit on funds' 
ability to acquire ``15% standard assets,'' or 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.\384\ Under the proposal, 15% standard assets were not a category 
in the classification framework. In determining whether an asset was a 
15% standard asset, a fund would not have been required to take into 
account any specific market or other factors, or assess position size 
as it could reflect market depth, in determining whether it could sell 
the asset within seven days without the specified value impact.\385\ 
The proposed limit was intended to be consistent with the Commission's 
guidelines limiting funds' holdings of illiquid assets to 15% of net 
assets \386\ and most commenters supported the proposed 15% limit.\387\
---------------------------------------------------------------------------

    \384\ See proposed rule 22e-4(b)(2)(iv)(D).
    \385\ See Proposing Release, supra footnote 9, at text following 
n.355.
    \386\ See id., at section III.C.4.
    \387\ See, e.g., Federated Comment Letter; Fidelity I Comment 
Letter; SIFMA Comment Letter I; State Street Comment Letter.
---------------------------------------------------------------------------

    We understand, however, that funds have engaged in a variety of 
practices in determining the illiquidity of investments. It has been 
our staff's experience that some of these practices are less robust 
than others. We believe that the definition of illiquid investments we 
are adopting today will provide a clear standard for determining the 
illiquidity of investments and will better ensure that all funds are 
determining the illiquidity of investments more consistently. We 
recognize, however, that as a result of this new definition, some funds 
may take into account relevant market, trading, and investment-specific 
considerations, as well as market depth, for the first time and 
therefore, as discussed below, some funds may determine that a greater 
percentage of holdings are illiquid.\388\
---------------------------------------------------------------------------

    \388\ See infra paragraph accompanying footnote 419.
---------------------------------------------------------------------------

    We note that some commenters suggested strengthening the current 
illiquid asset guidelines.\389\ Many commenters also suggested that 
these assets continue to be referred to as ``illiquid assets'' (not 15% 
standard assets) and be harmonized with any classification system that 
the Commission ultimately adopts.\390\ Additionally, commenters 
requesting such a harmonization also stated that value impact standards 
should be consistent between the 15% standard asset definition and the 
categories used in the classification.\391\
---------------------------------------------------------------------------

    \389\ See infra footnotes 399-401 and accompanying text.
    \390\ See, e.g., AFR Comment Letter; BlackRock Comment Letter; 
Interactive Data Comment Letter; Markit Comment Letter.
    \391\ See, e.g., AFR Comment Letter; Markit Comment Letter.
---------------------------------------------------------------------------

    We have determined to incorporate an illiquid investment category 
into rule 22e-4's broader classification requirement for several 
reasons. Specifically, harmonizing funds' illiquid investment 
determinations with the general liquidity classification framework will 
create consistency in the value impact standards across liquidity 
categories.\392\ As noted above, the illiquid investment value impact 
standard in final rule 22e-4 has been changed from whether a fund could 
sell an investment at ``approximately the value at which the fund has 
valued the investment,'' to whether a fund could sell the investment 
``without the sale or disposition significantly changing the market 
value of the investment.'' \393\ We are adopting this new value impact 
standard for illiquid investment determinations in part as a response 
to commenters' concerns about confusion that could arise from 
conflicting standards. Accordingly, the value impact standard for 
illiquid investments is substantially identical to the value impact 
standard for all other classification categories.\394\ As discussed in 
more detail above, the final classification value impact standard 
highlights that: (i) The standard does not require a fund to actually 
re-value or re-price an investment for classification purposes; and 
(ii) the standard does not require the fund to incorporate general 
market movements in liquidity determinations or estimate market impact 
to a precise degree.\395\
---------------------------------------------------------------------------

    \392\ See supra section III.C.1.c.
    \393\ See rule 22e-4(a)(8).
    \394\ Compare rule 22e-4(a)(8) with rule 22e-4(a)(6), (10) and 
(12).
    \395\ See supra section III.C.1.c.
---------------------------------------------------------------------------

    Significantly, in harmonizing features of the illiquid investment 
category with other categories in the liquidity classification 
framework, we also are replacing existing Commission guidance on 
identifying illiquid assets with new regulatory requirements regarding 
the process for determining that certain investments are illiquid.\396\ 
In the Proposing Release, we noted that we were proposing to withdraw 
Commission guidance because we believed the proposal would provide ``a 
more comprehensive framework for funds to evaluate the liquidity of 
their assets.'' \397\ We also requested comment on whether additional 
guidance is needed in connection with the proposed codification of the 
Commission's illiquid asset guidelines. Although many commenters 
supported the proposed codification of the Commission's guidelines on 
illiquid assets,\398\ most did not specifically comment on the 
Commission's proposal to withdraw the guidance associated with its 
illiquid asset guidelines. However, certain commenters suggested that 
stronger requirements and guidance regarding assets subject to the 15% 
limit could be appropriate.\399\ One commenter expressed concern that 
the Commission's guidelines today are having only a ``limited impact on 
fund behavior'' and that the current 15% limit ``applies to an 
inappropriately narrow range of assets and is therefore ineffective as 
an investor protection mechanism.'' \400\ This commenter suggested that 
the limit should encompass not only those assets that are not able to 
be sold within seven days at approximately the value ascribed by the 
fund, but also those assets that cannot be converted to cash (that is, 
sold with the sale settled) within this same period, taking into 
account this same value impact standard.\401\
---------------------------------------------------------------------------

    \396\ See infra footnote 561 and accompanying text.
    \397\ See Proposing Release, supra footnote 9, at text following 
n.356.
    \398\ See supra footnote 387.
    \399\ See, e.g., AFR Comment Letter; see also Keefer Comment 
Letter; Wahh Comment Letter (both suggesting that the 15% standard 
not just be limited to the time of purchase, but instead should be 
an ongoing requirement).
    \400\ See AFR Comment Letter.
    \401\ Id.
---------------------------------------------------------------------------

    We agree with those commenters that suggested the Commission's 
current guidelines, together with many funds' interpretation of these 
guidelines today,

[[Page 82178]]

may result in funds only focusing on certain largely structural 
features that can lessen the liquidity of an investment (such as 
transfer restrictions and trading halts) rather than more market- and 
trading-based features. This can result in funds considering only an 
artificially narrow set of portfolio investments to be illiquid. As we 
discussed in the Proposing Release, we understand that today it is 
common--even for complexes with generally robust liquidity risk 
management procedures--to treat the process for determining whether an 
investment is illiquid under the current Commission guidelines as a 
compliance or ``back-office'' function, with little indication that 
information generated from the risk or portfolio management functions 
informs the compliance determinations. Thus, we understand that some 
funds currently may determine that an investment is liquid, rather than 
illiquid, primarily based on certain structural characteristics of the 
investment without assessing market or trading information or other 
potentially relevant factors. Such investments include private equity 
securities and certain other privately placed or restricted 
securities,\402\ as well as certain instruments or transactions that by 
their structure do not mature and are not readily transferable in seven 
days or less, including term repurchase agreements.\403\ While a focus 
on structural features alone may be appropriate in some circumstances 
(for example, an across-the-board assumption that all securities with a 
trading halt are illiquid, without an additional assessment of market 
or trading factors), in other circumstances the failure to consider 
market, trading, and other relevant information could result in a fund 
considering an investment to be liquid even if the fund cannot 
reasonably expect to sell amounts it reasonably anticipates trading 
without the sale or disposition significantly changing the market value 
of the investment within seven calendar days.
---------------------------------------------------------------------------

    \402\ See Restricted Securities Release, supra footnote 37; see 
also Rule 144A Release, supra footnote 37.
    \403\ See Interval Fund Proposing Release, supra footnote 41.
---------------------------------------------------------------------------

    For these reasons, rule 22e-4 as adopted today, requires a fund to 
incorporate certain additional considerations in determining whether an 
investment is illiquid. We are withdrawing existing guidance and 
replacing it with new regulatory requirements and guidance regarding 
the process for determining whether a portfolio investment is 
illiquid.\404\ A fund would have to take into account ``relevant 
market, trading, and investment-specific considerations'' when 
determining whether an investment is an illiquid investment.\405\
---------------------------------------------------------------------------

    \404\ See rule 22e-4(b)(1)(ii), (iv).
    \405\ See rule 22e-4(b)(1)(ii).
---------------------------------------------------------------------------

    The guidance the Commission provides below on matters funds might 
consider in assessing market, trading, and investment-specific 
considerations reflects factors that the Commission has previously said 
are reasonable examples of factors to evaluate in determining whether a 
rule 144A security is liquid and makes them more generally applicable 
to assessing liquidity of other investments.\406\ Thus, this guidance 
draws on past Commission guidance for evaluating whether a certain type 
of investment is liquid or illiquid, and extends this process to a 
fund's liquidity determinations regarding all types of investments. We 
recognize that the guidance in the Rule 144A Release anticipates that 
fund boards will determine whether certain securities are liquid or 
illiquid.\407\ While we have considered the specific guidance factors 
discussed in the Rule 144A Release in the context of the guidance we 
provide herein with respect to classifying the liquidity of portfolio 
investments, neither our guidance nor the final rule places the 
responsibility for determining whether a specific security is liquid or 
illiquid on the fund's board. The board would, however, be responsible 
for approving the fund's liquidity risk management program, which 
provides the framework for evaluating the liquidity of the fund's 
investments, and for reviewing (at least annually) a written report 
that describes a review of the program's adequacy and the effectiveness 
of its implementation. Overall, a fund must classify its investments by 
focusing on those market, trading, and investment-specific 
considerations that are relevant to its portfolio. We believe that this 
principles-based approach should result in funds making realistic and 
well-informed determinations about investments' liquidity (or 
illiquidity) based on analysis beyond simple decisions solely about 
structural features of an asset class.
---------------------------------------------------------------------------

    \406\ See infra footnotes 560 and 561 and accompanying text.
    \407\ See Rule 144A Release, supra footnote 37 (stating 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.'').
---------------------------------------------------------------------------

    As with other liquidity classification categories and as discussed 
in more detail in section III.C.3.a below, funds can determine illiquid 
investments on an asset-class basis, with exceptions for investments 
whose liquidity characteristics significantly differ from the class. 
For example, a fund could employ procedures whereby certain asset 
classes are initially considered liquid, and then further evaluated to 
decide whether relevant market, trading, and investment-specific 
considerations should result in a particular investment being treated 
as an exception and a change to the initial liquidity 
determination.\408\ A fund could use the specific guidance factors we 
discuss in section III.C.4 below as part of its process for taking into 
account relevant market, trading, and investment-specific 
considerations in determining whether an investment is illiquid. For 
example, a fund that generally considers certain high-yield bonds not 
to be illiquid (for instance, a fund that typically considers high-
yield domestic corporate bonds to be moderately liquid investments) 
could determine that certain securities within this class are actually 
illiquid investments, based on restrictions on trading that could occur 
if one of these bonds' issuers were to enter bankruptcy and the debt 
were to become distressed. Conversely, a fund that generally considers 
certain investments to be illiquid (such as rule 144A securities) could 
determine that some of these investments should be included in another 
liquidity category based on relevant market, trading, and investment-
specific considerations.\409\
---------------------------------------------------------------------------

    \408\ See infra section III.C.3.a (discussing that, under rule 
22e-4, a fund would generally be permitted to classify its portfolio 
investments according to their asset class, but if it has 
information that a particular investment has different liquidity 
characteristics than other investments within the same asset class, 
it would need to treat that investment as an exception to the way 
that the fund classifies its other holdings within the same asset 
class).
    \409\ See rule 22e-4(b)(ii). See also section III.C (discussing 
the various considerations required when classifying the liquidity 
of fund securities).
---------------------------------------------------------------------------

    We also understand, based on staff outreach, that some fund 
complexes make determinations of whether a portfolio investment is 
liquid (or illiquid) under the current Commission guidelines based on 
whether a single trading lot for the investment can be sold within 
seven days under normal market circumstances. Certain funds interpret 
this to allow them to declare an entire holding to be liquid even if 
they could only sell a very small portion of it without a significant 
value impact. Staff has observed that these fund practices and 
interpretations of current

[[Page 82179]]

Commission guidelines may result in a fund determining that very few, 
if any, portfolio investments are illiquid under the current 
guidelines, even in situations in which the liquidity of a large 
portion of a fund's portfolio is fairly limited.
    Given the practices described above when funds did not consider 
market depth in making liquidity determinations and considering the 
comments discussed above regarding the proposed illiquid asset limit, 
under the final rule, a fund will be required to consider market depth 
in determining whether to classify portfolio investments as illiquid 
investments. To the extent that the fund determines that trading 
varying portions of a position is reasonably expected to significantly 
affect the liquidity characteristics of that investment--that is, the 
market depth for the investment is reasonably expected to significantly 
affect its liquidity--the fund would need to take this into account in 
classifying the investment as illiquid.\410\ These are the same market 
depth considerations a fund would have to take into account in 
classifying the liquidity of its portfolio investments generally, as 
discussed in detail below.\411\
---------------------------------------------------------------------------

    \410\ Rule 22e-4(b)(1)(ii).
    \411\ See infra III.C.3.b.
---------------------------------------------------------------------------

    Members of the fund industry have argued that because a fund will 
not likely need to sell its entire position in a particular investment 
under normal market circumstances, liquidity determinations should be 
based on the sale of a single trading lot for that investment, except 
in unusual circumstances.\412\ However, a fund could encounter 
situations in which it needs to liquidate larger portions than one 
trading lot of its positions in order to meet redemption requests, but 
cannot do so within the seven-day time period required under section 
22(e). As discussed below, we believe that the market depth 
considerations required by the final classification requirement will 
appropriately require a fund to consider situations in which the size 
of a fund's holdings could significantly affect those holdings' 
liquidity and impact the fund's ability to manage its liquidity risk--
that is, when portfolio liquidity may be significantly constrained by 
the fund's ability to trade meaningful sizes of its portfolio holdings. 
We believe this assessment of market depth will assist in illiquidity 
determinations incorporating a realistic analysis of a fund's ability 
to meet redemption requests without significant dilution, and thus in 
funds better managing liquidity risk.
---------------------------------------------------------------------------

    \412\ See Investment Company Institute, Valuation and Liquidity 
Issues for Mutual Funds (Feb. 1997), at 42.
---------------------------------------------------------------------------

    As discussed above, one commenter suggested extending the 
definition of illiquid assets to encompass not only those assets that 
are not able to be sold within seven days at approximately the value 
ascribed by the fund, but also those assets where the sale cannot be 
settled within this same period, taking into account the same value 
impact standard.\413\ After considering this suggestion, we have 
ultimately decided that the ``illiquid investments'' category under 
rule 22e-4 should reflect only the period for selling or disposing of 
an investment and not also consider settlement timing. Instead, the 
``less liquid'' category reflects those investments that could be sold, 
but not settled, within seven days without a significant value impact. 
Investments that cannot be sold within seven days without a significant 
value impact (illiquid investments, under rule 22e-4) have different 
liquidity characteristics and are essentially less liquid than 
investments that can be sold within seven days without a significant 
value impact, but whose sale cannot be settled within this period (less 
liquid investments, under rule 22e-4).\414\ As discussed above, less 
liquid investments could still be considered a limited source of 
liquidity for meeting redemptions within the seven-day period specified 
under section 22(e) of the Act, with the caveat that a fund may have to 
address certain challenges associated with their settlement, whereas a 
fund's illiquid investments are structurally or as a matter of market 
dynamics less liquid and a fund may be unable to use them to meet 
redemptions within seven days.\415\
---------------------------------------------------------------------------

    \413\ See supra footnote 401 and accompanying text.
    \414\ When a fund sells an asset (even if the transaction has 
not yet settled), the fund has a receivable on its books, and any 
potential loss from the sale of that asset will be reflected in the 
fund's NAV. If the fund has an asset it cannot sell, however, the 
fund continues to be exposed to the risk of unknown potential loss 
until the asset can be sold.
    \415\ See supra paragraph accompanying footnote 383 (discussing 
less liquid investments and the extent to which less liquid 
investments may be available to meet redemption requests within 
seven days if a fund addresses certain challenges associated with 
their sale and settlement).
---------------------------------------------------------------------------

    However, we note that trades in certain investments may take an 
extended period of time to settle. Trades in some low quality loans, 
for example, may not settle for a number of months.\416\ A fund that 
holds less liquid investments with extended settlement periods must 
develop a liquidity risk management program that takes into account the 
liquidity risks associated with extended settlement periods.\417\ These 
policies and procedures could include limits on the amount of less 
liquid investments with extended settlement periods a fund will hold or 
more frequent liquidity classification reviews for this type of 
holding. Such a fund may also wish to consider the circumstances in 
which it would seek to obtain expedited settlement (where possible) and 
establish tailored policies and procedures regarding how and when it 
would seek expedited settlement. Funds may also wish to consider 
whether to obtain an additional source of financing (for example, a 
committed line of credit dedicated to that fund) to bridge the period 
until the sales would settle.
---------------------------------------------------------------------------

    \416\ See e.g., Michael Mackenzie and Tracy Alloway, Lengthy US 
loan settlements prompt liquidity fears, Financial Times (May 1, 
2014), available at http://www.ft.com/cms/s/0/32181cb6-d096-11e3-9a81-00144feabdc0.html#axzz4HQiQv5wj (noting that a quarter of new 
loans being issued were taking more than 30 days to settle).
    \417\ Such extended settlement period securities have the 
potential to pose heightened liquidity risks for funds, and thus 
policies and procedures that are reasonably designed to assess and 
manage the liquidity risk of a fund that holds such securities would 
take into account the particular liquidity risks raised by such 
holdings. See rule 22e-4(b)(1)(i).
---------------------------------------------------------------------------

    We believe that the new requirement to take into account market, 
trading, and investment-specific considerations, as well as to consider 
market depth, in identifying illiquid investments responds to the 
concern that the way illiquid investments are currently defined has 
only limited effects on funds' liquidity risk management and the 
liquidity of their portfolios.\418\ We understand that, to the extent a 
fund is not currently taking into account market, trading, and 
investment-specific considerations or market depth when assessing the 
illiquidity of its investments, the new regulatory requirements 
regarding the process for determining that certain investments are 
illiquid under the rule are likely to result in the fund determining 
that a greater percentage of its holdings are illiquid than under the 
guidelines. In extreme circumstances, this--in combination with the 
limitation on funds' illiquid investment holdings to 15% of its net 
assets discussed at section III.E below--could cause certain funds to 
have to modify their investment strategies or reconsider their 
structure as open-end funds. We also understand that these requirements 
will entail additional operational costs, to

[[Page 82180]]

the extent that funds today do not generally take into account relevant 
market, trading, and investment-specific considerations, or market 
depth, in determining whether their portfolio investments are illiquid. 
However, as discussed in detail in the Economic Analysis section below, 
we believe that these costs are justified by the investor protection 
benefits that we believe will result from better portfolio liquidity 
assessments.\419\
---------------------------------------------------------------------------

    \418\ See supra footnote 400 and accompanying text.
    \419\ See infra section 0.C.
---------------------------------------------------------------------------

3. Required Classification Procedures
a. Classification Based on Asset Class
    Rule 22e-4, as adopted today, generally permits a fund to, as a 
starting point, classify the liquidity of its portfolio investments 
according to their asset class.\420\ Notwithstanding this general 
approach, a fund will be required to separately classify any investment 
if the fund or its adviser, after reasonable inquiry, has information 
about any market, trading, or investment-specific considerations that 
are reasonably expected to significantly affect the liquidity 
characteristics of that investment as compared to the fund's other 
portfolio holdings within that asset class.\421\ For example, if the 
fund or its adviser were to know that particular large-capitalization 
equity was affected by adverse events at the issuer that caused it to 
have different liquidity characteristics than the asset class as a 
whole, it would be required to treat that investment as an exception 
and classify it separately. As another example, a fund could decide 
that high credit quality corporate bonds generally fall into a 
particular liquidity category, but if the fund or its adviser had 
information that certain bonds' bid-ask spreads are significantly wider 
or more volatile than those of their peers, it would be required under 
rule 22e-4 to separately assess these bonds and potentially classify 
them into a less-liquid category than the fund's other holdings within 
the same asset class. We expect that, based on a fund's responsibility 
under the rule to classify each of its investments after reasonable 
inquiry and taking into account relevant market, trading, and 
investment-specific considerations, there are some asset classes, such 
as those encompassing some bespoke complex derivatives or complex 
structured securities,\422\ that have such a range of liquidity 
characteristics that each position would need to be classified 
individually.
---------------------------------------------------------------------------

    \420\ See rule 22e-4(b)(1)(ii)(A).
    \421\ Id.
    \422\ See 2015 Derivatives Proposing Release, infra footnote 222 
(discussing bespoke complex derivatives).
---------------------------------------------------------------------------

    Rule 22e-4 as proposed would not have allowed a fund to, as a 
starting point, classify its portfolio investments according to asset 
class. The proposed rule instead would have required a fund to classify 
each of its positions in a portfolio asset (or portions of a position) 
according to the liquidity categories included in the rule.\423\ In the 
Proposing Release, we requested comment on whether the proposed 
classification requirement and associated liquidity categories 
reflected the manner in which funds currently assess and categorize the 
liquidity of their portfolio holdings as part of their portfolio and 
risk management.
---------------------------------------------------------------------------

    \423\ Proposed rule 22e-4(b)(2)(i).
---------------------------------------------------------------------------

    Many commenters objected to the proposed position-level 
classification requirement, arguing that it does not reflect recognized 
liquidity risk management practices and does not reflect industry best 
practices.\424\ Commenters likewise maintained that, instead of 
assessing portfolio liquidity on a position-by-position basis, asset 
managers tend to focus on the liquidity of certain asset classes and/or 
generally view liquidity at the portfolio level based on a ``top-down'' 
analysis.\425\ On the other hand, some commenters acknowledged that 
certain asset managers may classify the liquidity of individual 
portfolio positions within a range of categories, albeit not at the 
level of detail suggested by the proposal, or for all classes of 
portfolio assets.\426\
---------------------------------------------------------------------------

    \424\ See, e.g., Credit Suisse Comment Letter; Dodge & Cox 
Comment Letter; PIMCO Comment Letter; Vanguard Comment Letter.
    \425\ See, e.g., Dodge & Cox Comment Letter; ICI Comment Letter 
III; IDC Comment Letter; Charles Schwab Comment Letter.
    \426\ See CFA Comment Letter; MFS Comment Letter; Nuveen Comment 
Letter; Wellington Comment Letter.
---------------------------------------------------------------------------

    Commenters stated that considering portfolio liquidity on the basis 
of asset class, at least as a starting point, has practical, 
operational, and conceptual benefits compared to considering the 
liquidity of each portfolio position individually.\427\ Commenters 
stated that assets with certain similar characteristics are often 
``highly comparable and substitutable from a liquidity perspective,'' 
\428\ and liquidity assessments based on asset class would permit a 
fund manager to account for differences in market structure and 
portfolio management objectives among asset classes.\429\ Commenters 
also argued that evaluating and classifying each portfolio asset 
individually would be ``overly burdensome and near-impossible to 
manage,'' as a fund complex may collectively hold hundreds of thousands 
of individual portfolio assets,\430\ and the data required to classify 
each asset individually may not be readily available for all asset 
types (particularly for fixed income or other OTC assets).
---------------------------------------------------------------------------

    \427\ See, e.g., Dechert Comment Letter; HSBC Comment Letter; 
ICI Comment Letter I; Wellington Comment Letter.
    \428\ See ICI Comment Letter I.
    \429\ See Vanguard Comment Letter.
    \430\ See Fidelity Comment Letter.
---------------------------------------------------------------------------

    Relatedly, multiple commenters suggested alternative liquidity 
classification schemes that would be based on an ``asset-type mapping 
with exceptions'' analysis.\431\ These alternatives used an approach 
where a fund's portfolio assets' liquidity generally would be 
classified by asset class--with exceptions to the extent a particular 
portfolio asset demonstrates liquidity characteristics that differ from 
the liquidity of its asset class generally and that are deemed to make 
the position substantially more or less liquid.\432\ Assets treated on 
an exception basis could be placed in a different liquidity category 
than the rest of their asset class, which could be either higher or 
lower.\433\ The asset class analysis provisions of final rule 22e-4 
generally take this approach. The primary difference between 
commenters' ``asset-type mapping with exceptions'' suggested approaches 
and the approach incorporated in final rule 22e-4 is that commenters' 
suggested approaches would rely on the Commission (or an industry 
group) assigning default liquidity categories to each asset class, 
whereas the approach we are adopting would depend on each fund 
performing this exercise based on its adviser's individual experience 
in the markets.
---------------------------------------------------------------------------

    \431\ See SIFMA Comment Letter III; see also BlackRock Comment 
Letter; T. Rowe Comment Letter.
    \432\ See, e.g., SIFMA Comment Letter III.
    \433\ Id.
---------------------------------------------------------------------------

    We believe that this approach strikes an appropriate balance 
between lessening operational burdens associated with classification 
and recognizing that many investments within an asset class may be 
considered interchangeable from a liquidity perspective, on one hand, 
and providing reasonably precise liquidity classifications that 
appropriately reflect investments' liquidity characteristics, on the 
other hand. This approach also should leverage fund managers' current 
practices to a greater degree than under the proposal. A fund's asset-
class-based classification procedures should incorporate sufficient 
detail to meaningfully distinguish between asset

[[Page 82181]]

classes and sub-classes. For example, a fund may wish to distinguish 
how it classifies its equity securities based on factors such as the 
market(s) in which the security's issuer is based, market 
capitalization, and whether the security is common or preferred stock. 
As another example, a fund may wish to distinguish its fixed income 
securities based on factors such as issuer type, the market(s) in which 
the issuer is based, seniority, age, and credit quality, and to 
distinguish its holdings of structured products based on tranche 
seniority and credit quality. We do not consider it appropriate for a 
fund to use very general asset class categories (e.g., ``equities,'' 
``fixed income,'' and ``other'') in classifying the liquidity of its 
portfolio investments, as these broad categories would likely not 
permit a fund to identify investments with fungible liquidity 
characteristics. A fund's asset-class-based classification procedures 
also should include procedures for updating default asset-class 
liquidity classifications as relevant market, trading, and investment-
specific considerations warrant.\434\
---------------------------------------------------------------------------

    \434\ See rule 22e-4(b)(1)(ii) (requiring funds to classify 
their investments taking into account relevant market, trading, and 
investment-specific considerations and to review their portfolio 
investments' classifications if changes in these considerations are 
reasonably expected to materially affect one or more of their 
investments' classifications).
---------------------------------------------------------------------------

    A fund would be required to separately classify any investment 
within an asset class if the fund or its adviser were to have 
information about any market, trading, or investment specific 
considerations that are reasonably expected to significantly affect the 
liquidity characteristics of that investment as compared to the fund's 
other portfolio holdings within that asset class (its ``exception 
processes'').\435\ Rule 22e-4 does not specify precisely how a fund 
must identify investments that should be classified separately as part 
of its exception processes. However, reasonably designed policies and 
procedures would likely include specifying the sources of inputs that 
inform its exception processes (for example, inputs from the fund's 
portfolio management, risk management, and/or trading functions), as 
well as particular variables that could affect the fund's 
classification of certain investments. For example, a fund could 
determine that a particular investment should be classified differently 
than other investments within its asset class if the market for that 
particular investment were exceptional in terms of size, breadth, or 
depth, or if the investment's typical bid-ask spreads were generally 
wider, narrower, or more volatile than the bid-ask spreads of other 
assets within the asset class. A fund could incorporate an assessment 
of the liquidity classification guidance factors discussed below, as 
the fund determines appropriate, in its exception processes.\436\
---------------------------------------------------------------------------

    \435\ See rule 22e-4(b)(1)(ii)(A).
    \436\ See infra section III.C.4.
---------------------------------------------------------------------------

b. Required Procedures for Considering Market Depth
    Under rule 22e-4 as adopted today, a fund would be required to 
determine whether trading varying portions of a position in a 
particular portfolio investment, in sizes that the fund would 
reasonably anticipate trading, is reasonably expected to significantly 
affect the liquidity characteristics of that investment.\437\ To the 
extent that the fund determines that trading varying portions of a 
position is reasonably expected to significantly affect the liquidity 
characteristics of that investment--that is, the market depth for the 
investment is reasonably expected to significantly affect its 
liquidity--the fund would need to take this into account in classifying 
the liquidity of that investment.\438\ As discussed in more detail 
below, this requirement would have a fund consider portions of a 
portfolio position that are larger than a single trading lot, but not 
necessarily the position's full size, in assessing its portfolio 
investments' liquidity.
---------------------------------------------------------------------------

    \437\ See rule 22e-4(b)(1)(ii)(B).
    \438\ Id.
---------------------------------------------------------------------------

    These market depth-related requirements are meant to substitute 
for, and modify, the language of proposed rule 22e-4 that would have 
effectively required a fund to consider position size in classifying 
the liquidity of its portfolio investments. As discussed above, 
proposed rule 22e-4 would have had a fund consider, for each portfolio 
position, the amount of time it would take to convert the entire 
position, or portions thereof, to cash.\439\ Under this proposed 
requirement, if a fund were to conclude that it would take the fund 
longer to convert its entire position in an asset to cash, it could 
determine, for example, that 50% of the position should be classified 
in one liquidity category, and the remaining 50% should be classified 
in another category.
---------------------------------------------------------------------------

    \439\ See proposed rule 22e-4(b)(2)(i); see also supra section 
III.C.2.d.
---------------------------------------------------------------------------

    This aspect of the proposed requirement arose from our belief that 
a fund should consider its ability to trade larger portions of a 
portfolio asset than a single trading lot in assessing its portfolio 
investments' liquidity. The ability to quickly trade larger portions of 
a particular position is a reflection of market depth for a particular 
asset, which is a well-recognized aspect of assessing liquidity.\440\ 
In the Proposing Release, we responded to arguments that because a fund 
will not likely need to sell its entire position in a particular asset 
under normal market conditions, liquidity determinations should be 
based on the sale of a single trading lot for that asset, except in 
unusual circumstances.\441\ We noted that, although we agreed that a 
fund not being able to convert its entire position in an asset to cash 
at a price that does not materially affect the value of that asset 
should not, by itself, be dispositive of a portfolio asset's liquidity, 
assessing liquidity only on the basis of the ability to sell and 
receive cash for a single trading lot of an asset ignores the fact that 
a fund may need to sell all (or a significant portion) of its 
position.\442\
---------------------------------------------------------------------------

    \440\ See infra footnote 526 and accompanying text.
    \441\ See Proposing Release, supra footnote 9, at n.177 and 
accompanying text.
    \442\ See id., at paragraph accompanying n.177. For example, a 
fund needing to sell certain assets in order to meet redemptions may 
need to sell more than one trading lot of a particular asset. In 
addition, a fund may determine 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.
---------------------------------------------------------------------------

    Multiple commenters expressed concern about the proposed 
requirement to consider full position size in classifying the liquidity 
of a fund's portfolio assets.\443\ Commenters argued that many industry 
participants currently assess asset liquidity by trading lot (as 
opposed to evaluating whether a fund can exit an entire position within 
a certain time period), reflecting that a fund generally would not need 
to liquidate an entire large position unexpectedly.\444\ Commenters 
also contended that this aspect of the proposal could result in large 
funds' portfolio liquidity appearing artificially low compared to 
smaller funds because large funds are more likely to hold larger 
positions and determine that they could not quickly liquidate these 
positions entirely without a value impact.\445\ Commenters argued that 
it could be misleading for large funds to

[[Page 82182]]

appear to be less liquid than smaller funds, because large funds' 
portfolios might actually entail less liquidity risk compared to 
smaller funds (because each position, while large in absolute size, is 
a smaller portion of the overall portfolio than may be the case in 
smaller funds), and large funds may have greater resources than smaller 
funds to manage liquidity effectively.\446\ For example, one commenter 
stated that large funds often have more diversified holdings than 
smaller funds and may wield more negotiating power with broker-
dealers.\447\
---------------------------------------------------------------------------

    \443\ See, e.g., BlackRock Comment Letter; IDC Comment Letter; 
SIFMA Comment Letter I; Wellington Comment Letter.
    \444\ See, e.g., ICI Comment Letter I; Charles Schwab Comment 
Letter; Vanguard Comment Letter.
    \445\ See, e.g., BlackRock Comment Letter; ICI Comment Letter I; 
Oppenheimer Comment Letter; SIFMA Comment Letter I.
    \446\ See, e.g., SIFMA Comment Letter I; see also BlackRock 
Comment Letter; Oppenheimer Comment Letter; Vanguard Comment Letter; 
Wellington Comment Letter.
    \447\ See BlackRock Comment Letter.
---------------------------------------------------------------------------

    The market depth approach we are adopting takes commenters' 
concerns into account, although as discussed above we continue to 
believe that an investment strategy involving large positions in 
particular issuers--particularly if the fund's portfolio is relatively 
concentrated--is relevant to assessing liquidity risk.\448\ We 
appreciate that, in many cases, a fund may not have to trade large 
portions of its portfolio holdings in relatively short time periods in 
order to meet redemptions, or to otherwise manage its liquidity risk. 
For example, a fund may not need to often quickly convert large 
portions of its portfolio investments to cash, based on its cash flow 
projections (e.g., if the fund's investors are known to be primarily 
long-term investors) and other liquidity risk assessment factors.\449\ 
We also recognize that there could be situations in which the 
requirement to consider entire position size in classifying a fund's 
portfolio investments, regardless of the size of trades a fund 
typically engages in, could make a fund appear to be less liquid than 
the fund's actual trading experiences in light of its portfolio 
investments' market depth. This could be misleading if the fund were 
actually able to trade a large percentage of its holdings fairly 
quickly without the fund's trades significantly moving the investments' 
prices. We believe that the required market depth considerations 
incorporated into the final classification requirement will permit a 
fund to more realistically assess the liquidity of its portfolio 
investments because they allow a fund to classify and review its 
portfolio investments taking into account position sizes that the fund 
would reasonably anticipate trading.
---------------------------------------------------------------------------

    \448\ See supra footnotes 210-212 and accompanying text.
    \449\ See rule 22e-4(b)(1)(i).
---------------------------------------------------------------------------

    We believe that if a fund reasonably anticipates trading sizeable 
portions of its portfolio positions, the fund's portfolio liquidity 
could be adversely affected by a lack of market depth for its portfolio 
investments. A fund could reasonably anticipate trading sizeable 
portions of its portfolio positions if it often trades relatively large 
portions of its portfolio positions. Likewise, a fund may not trade 
larger portions of its portfolio positions on a regular basis, but 
could reasonably anticipate, based on past flow patterns or current 
market conditions that it could encounter larger-than-typical 
redemptions that would necessitate larger portfolio trades. In both of 
these examples, such a fund could conclude that it may be difficult to 
find trading partners for a particular portfolio investment, or may be 
difficult to sell the investment within a particular time frame without 
this sale causing a significant value impact. For this reason, rule 
22e-4 requires a fund to consider the sizes of a particular investment 
that the fund would reasonably anticipate trading and whether trading 
in such sizes could significantly affect the investment's liquidity. If 
so, the fund would be required to take this into account in classifying 
the liquidity of that portfolio investment.\450\ If the fund 
determined, after conducting the required market depth analysis, that a 
downward adjustment in the liquidity classification of a particular 
investment is appropriate, the new liquidity classification that the 
fund assigns to this investment would apply to the entirety of the 
fund's position in that investment (not, as proposed, to portions of 
that position). This approach is meant to lessen burdens on funds, as 
well as respond to commenters' concerns, by focusing a fund's market 
depth considerations on circumstances in which a fund's practices in 
trading varying portions of its portfolio positions could have a 
disproportionate effect on its portfolio investments' liquidity.
---------------------------------------------------------------------------

    \450\ See rule 22e-4(b)(1)(ii)(B).
---------------------------------------------------------------------------

    Rule 22e-4 directs a fund to consider sizes that the fund would 
reasonably anticipate trading in assessing the impact of market depth 
on an investment's liquidity.\451\ Depending on the liquidity risk 
factors that a fund must consider under rule 22e-4(b)(1)(i), as well as 
other factors including the fund's size, a fund could reasonably 
anticipate selling various portions of its position in a particular 
portfolio investment, or various dollar amounts or block sizes of a 
particular portfolio investment.\452\ For example, it may be 
appropriate for a fund with a highly liquid portfolio, with very stable 
and minimal cash flow projections and significant cash holdings and 
operating in very stable market conditions, to adopt policies and 
procedures that consider whether trading relatively small fractions of 
each of the fund's portfolio holdings would result in significant 
liquidity impacts. On the other hand, we would generally consider it 
appropriate for a fund whose holdings are relatively illiquid and/or 
fairly concentrated, with unpredictable cash flow projections or 
deteriorating market conditions in the markets in which it invests, to 
consider whether trading larger portions of its portfolio holdings 
would result in significant liquidity impacts.
---------------------------------------------------------------------------

    \451\ Id.
    \452\ See, e.g., Kapil Phadnis, Block Trading in Today's 
Electronic Markets, Bloomberg Tradebook (May 20, 2015), available at 
http://www.bloombergtradebook.com/blog/block-trading-in-todays-electronic-markets/ (discussing block trading in the equity markets 
and noting that New York Stock Exchange Rule 72 defines a ``Block'' 
as at least 10,000 shares or $200,000, whichever is less); Got 
Liquidity?, BlackRock Investment Institute (Sept. 2012) (``Got 
Liquidity?''), at 6, available at https://www.blackrock.com/investing/literature/whitepaper/got-liquidity-us-version.pdf 
(indicating that, from 2010-2012, block trades of over $5 million 
represented between approximately 30%-45% of the U.S. investment 
grade corporate bond market's trading volume).
---------------------------------------------------------------------------

c. Classification Issues Arising With Respect to Derivatives 
Transactions
    Rule 22e-4 requires that the liquidity classification and review 
requirements cover each of the fund's investments, including 
derivatives transactions, and that a fund take into account relevant 
market, trading, and investment-specific considerations in classifying 
the liquidity of its investments.\453\ The rule also states that for 
derivatives transactions that a fund has classified as moderately 
liquid investments, less liquid investments, and illiquid investments, 
the fund must identify the percentage of its highly liquid investments 
that are segregated to cover, or pledged to satisfy margin requirements 
in connection with, derivatives transactions in each of these 
classification categories.\454\ A fund also will be required to 
disclose these percentages on its Form N-PORT filings.\455\ We believe 
a fund's disclosure of this percentage will permit

[[Page 82183]]

the Commission and its staff to understand what percentage of a fund's 
highly liquid investment minimum is composed of encumbered assets, and 
will allow the public to better understand that a certain percentage of 
a fund's highly liquid investments may not be immediately available for 
liquidity risk management purposes. The final rule does not require the 
fund to determine or disclose the percentage of the fund's moderately 
liquid investments or less liquid investments that the fund has 
segregated to cover, or pledged in connection with, its derivatives 
transactions, because we understand that funds are less likely to post 
moderately or less liquid investments as margin or collateral. We also 
expect that investors and others will find most valuable information 
regarding the extent to which the fund's highly liquid investments are 
segregated or pledged in connection with derivatives transactions 
because understanding that percentage may give investors a better 
understanding of whether such assets are truly available to make 
redemptions.
---------------------------------------------------------------------------

    \453\ Rule 22e-4(b)(1)(ii).
    \454\ Rule 22e-4(b)(1)(ii)(C). Because, as discussed below, a 
fund generally will segregate certain liquid assets in order to 
cover the fund's obligations under its derivatives transactions, 
rule 22e-4 assumes that a fund would not segregate any of its assets 
identified as illiquid investments to cover its derivatives 
transactions. See infra footnote 462 and accompanying text.
    \455\ See infra section III.C.6.b.
---------------------------------------------------------------------------

    These requirements replace the proposed requirement for a fund to 
consider the ``relationship of [an] asset to another portfolio asset'' 
in classifying and reviewing the liquidity of its portfolio 
assets,\456\ as well as the derivatives-focused guidance that the 
Commission provided in the Proposing Release regarding this proposed 
classification factor.\457\ The Commission's guidance was meant to give 
direction to funds' liquidity classification of derivatives 
transactions and the assets that a fund may segregate to cover its 
obligations under these transactions.\458\ As discussed below, we are 
not adopting the proposed factors that a fund would have had to 
consider in classifying the liquidity of its portfolio holdings, 
including the ``relationship of [an] asset to another portfolio asset'' 
factor.\459\ However, we are adopting new classification provisions in 
rule 22e-4 that will apply to derivatives transactions \460\ as well as 
a provision that will address assets segregated to cover derivatives 
transactions \461\ so that funds consistently consider certain unique 
aspects of these transactions, and also to respond to commenters' 
concerns stemming from the treatment of derivatives under the proposal.
---------------------------------------------------------------------------

    \456\ See proposed rule 22e-4(b)(2)(ii)(I).
    \457\ See Proposing Release, supra footnote 9, at section 
III.B.2.i.
    \458\ Id.
    \459\ Instead, we are requiring that a fund must take into 
account market, trading, and investment-specific considerations in 
classifying the liquidity of its portfolio investments. See rule 
22e-4(b)(1)(ii); see also supra section III.C.1.b. We provide 
guidance below on specific factors that a fund may find appropriate 
to consider in furtherance of this requirement. See infra section 
III.C.4.
    \460\ See rule 22e-4(b)(1)(ii).
    \461\ See rule 22e-4(b)(1)(ii)(C). This provision also applies 
to assets pledged to satisfy margin requirements in connection with 
derivatives transactions.
---------------------------------------------------------------------------

    In the Proposing Release, we noted that 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.\462\ We applied this framework to certain financing 
transactions in Release 10666, issued in 1979,\463\ and also understand 
that funds today apply this framework to certain derivatives, based on 
the guidance we provided in Release 10666 and on no-action letters 
issued by our staff.\464\ We explained in Release 10666 that ``[a] 
segregated account freezes certain assets of the investment company and 
renders such assets unavailable for sale or other disposition.'' \465\ 
We also stated in Release 10666 that only certain types of liquid 
assets should be placed in a segregated account.
---------------------------------------------------------------------------

    \462\ See Proposing Release, supra footnote 9, at section 
III.B.2.i.
    \463\ Release 10666, supra footnote 220. In December 2015, the 
Commission proposed a new exemptive rule, rule 18f-4, which would 
permit funds to enter into derivatives transactions and financial 
commitment transactions notwithstanding section 18 of the Investment 
Company Act, provided that the funds comply with the conditions of 
the proposed rule. In proposing rule 18f-4, the Commission noted 
that, should the rule be adopted, it would rescind Release 10666 and 
relevant staff no-action letters. See 2015 Derivatives Proposing 
Release, supra footnote 222, at section III.I.
    \464\ See generally 2015 Derivatives Proposing Release, supra 
footnote 222, at section II.B (providing background information on 
the application of section 18 and Release 10666 to derivatives and 
certain other transactions).
    \465\ See 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).
---------------------------------------------------------------------------

    Thus, we noted in the Proposing Release that, although assets used 
by a fund to cover derivatives and other transactions should be liquid 
when considered in isolation, when evaluating their liquidity for 
purposes of proposed rule 22e-4, 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.'' \466\ We stated that 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. We also provided guidance 
that, when a formerly segregated asset is no longer segregated, a fund 
generally should assess, as part of the proposed ongoing liquidity 
classification review requirement, whether the liquidity classification 
given to the portfolio asset when it was segregated continues to be 
appropriate. Finally, we noted in the Proposing Release that in 
addition to the liquidity of a fund's derivatives positions themselves, 
assessing a fund's 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.\467\
---------------------------------------------------------------------------

    \466\ See Proposing Release, supra footnote 9, at section 
III.B.2.i.
    \467\ See id., at n.309 and accompanying text.
---------------------------------------------------------------------------

    The Proposing Release included a request for comment on the 
proposed ``relationship of [an] asset to another portfolio asset'' 
liquidity classification factor, which included asking whether rule 
22e-4 should 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, and whether the Commission 
should 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.\468\ Multiple commenters 
raised concerns about the proposed ``relationship of [an] asset to 
another portfolio asset'' liquidity classification factor and 
accompanying guidance in the Proposing Release.\469\ Many stated that 
the Commission's guidance as to classifying segregated assets using the 
liquidity of the derivative instrument they are covering would be 
unworkable and would raise costly operational burdens, because funds 
currently do not identify individual liquid assets to cover specific 
derivatives transactions.\470\ Instead,

[[Page 82184]]

commenters noted that it is common in the fund industry for a fund to 
review its outstanding obligations under its derivatives positions on a 
portfolio basis and determine an aggregate amount of liquid assets that 
must be segregated in connection with the transactions requiring 
coverage.\471\ One commenter suggested that, instead of the proposed 
``relationship of [an] asset to another portfolio asset'' liquidity 
classification factor, the Commission alternatively could require funds 
to assign liquidity classifications to cover assets on an aggregate 
portfolio basis in amounts corresponding to the aggregate amount of 
derivatives exposure in each liquidity category.\472\
---------------------------------------------------------------------------

    \468\ See id., at section III.B.2.j.
    \469\ See, e.g., Dechert Comment Letter; Milliman Comment 
Letter; T. Rowe Comment Letter; Vanguard Comment Letter.
    \470\ See, e.g., Dechert Comment Letter; ICI Comment Letter I; 
Invesco Comment Letter; Vanguard Comment Letter. But see Nuveen 
Comment Letter (suggesting that, for purposes of the alternative 
liquidity classification approach that it recommends, a security 
used specifically to cover a derivatives transaction that cannot be 
unwound within seven days (and thus the derivative would be 
classified as ``illiquid'' under the commenter's recommended 
approach) also would be considered to be ``illiquid'' under that 
approach).
    \471\ See Dechert Comment Letter.
    \472\ See id.; see also ICI Comment Letter I (suggesting that 
the Commission add an item to Form N-PORT's Schedule of Portfolio 
Investments that permits a fund to note whether an asset (or portion 
thereof) is encumbered or linked to other assets as of the reporting 
date, without separately tying to or identifying a ``linked'' 
asset).
---------------------------------------------------------------------------

    Some commenters also argued that the guidance provided in the 
proposal could make an otherwise liquid but segregated asset appear to 
be less liquid than it actually is when considered in isolation.\473\ 
For example, if a cash equivalent security were used to cover a 
derivative that the fund determined to be convertible to cash within 8-
15 days, under the Commission's guidance, the cash equivalent also 
would be classified as an asset that could be converted to cash within 
8-15 days. However, the fund would be able to replace the cash 
equivalent as a coverage asset with another liquid asset at any time, 
which would immediately unencumber the cash equivalent (but would 
encumber other liquid assets with the same value).
---------------------------------------------------------------------------

    \473\ See ICI Comment Letter I; T. Rowe Comment Letter.
---------------------------------------------------------------------------

    Finally, commenters generally discussed features of derivatives 
transactions informing the way that their liquidity would be classified 
under proposed rule 22e-4. One commenter noted that the proposal seemed 
to suggest that derivatives are inherently more risky and present 
greater liquidity risk than other, more traditional assets.\474\ This 
commenter maintained that, in some situations, derivatives may be more 
liquid than more traditional assets. Another commenter stated that, 
while the liquidity of a derivatives transaction depends on the 
derivative's underlying reference asset to some degree, its liquidity 
also largely stems from the needs of other market participants for that 
kind of derivative.\475\
---------------------------------------------------------------------------

    \474\ See T. Rowe Comment Letter.
    \475\ See Milliman Comment Letter.
---------------------------------------------------------------------------

    The requirements in rule 22e-4 regarding the classification of a 
fund's derivatives transactions are meant to clarify and simplify the 
application of the classification requirements to derivatives 
transactions and respond to commenters' concerns. First, rule 22e-4 
specifies that the liquidity classification and review requirements 
apply to each of the fund's investment transactions (including 
derivatives) and requires a fund to take into account relevant market, 
trading, and investment-specific considerations in classifying 
derivatives' liquidity.\476\ In addition, we have modified rule 22e-4 
from the proposal to require a fund to classify each of the fund's 
portfolio investments.\477\ We have made this change to clarify that 
the classification requirement (and the other requirements of rule 22e-
4) applies to all of a fund's investment positions, regardless of 
whether they are assets or liabilities, as the proposal intended.\478\ 
The proposed classification requirement, which would have required each 
fund to classify the liquidity of its portfolio positions (or portions 
of a position in a particular asset), could potentially have been read 
to exclude certain derivatives and other transactions that are 
classified as liabilities on the fund's balance sheet.\479\ Final rule 
22e-4 thus requires the liquidity of all derivatives transactions to be 
classified, regardless of if they are classified as assets or 
liabilities on a fund's balance sheet, for the sake of operational 
simplicity, completeness (e.g., to help reduce confusion regarding a 
fund's liquidity profile as disclosed on Form N-PORT), and because all 
derivatives transactions could implicate portfolio liquidity insofar as 
other assets are segregated to cover these derivatives and derivatives 
in a liability position involve transactions for which a fund would be 
required to pay fund assets to exit the transaction.\480\
---------------------------------------------------------------------------

    \476\ Rule 22e-4(b)(1)(ii). As with other portfolio investments, 
funds may classify derivatives transactions by asset class, so long 
as the fund or its adviser does not have information about any 
market, trading, or investment-specific considerations that are 
reasonably expected to significantly affect the liquidity 
characteristics of a particular derivative that would require a 
different classification for that derivative. Rule 22e-
4(b)(1)(ii)(A).
    \477\ We note that in the Proposing Release, we requested 
comment on whether the rule should ``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.'' See Proposing Release, supra footnote 
9, at text following n.155.
    \478\ We note that use of the term ``investments'' is consistent 
with other reporting requirements on Form N-PORT, and reflects the 
proposal's discussions of the classification requirement applying to 
all of a fund's portfolio positions, not just those that are assets. 
See, e.g., id., at section III.B. (``[W]e are proposing new 
requirements for classifying and monitoring the liquidity of funds' 
portfolio positions.''; ``The proposed liquidity categorization 
process would be in addition to the existing 15% guideline (which 
would be retained, as discussed below) 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.'' [emphasis 
added]). See also Investment Company Reporting Modernization 
Adopting Release, supra footnote 120.
    \479\ We note, however, that no commenters suggested that the 
proposal's use of the terms ``assets'' and ``positions'' 
interchangeably would lead to derivatives or other investments that 
are liabilities not being subject to the rule, and that many 
commenters discussed the impact of the classification requirement on 
a variety of derivatives and other transactions that could be 
liabilities. See, e.g., ICI Comment Letter (discussing 
classifications of derivatives and TBA transactions); HSBC Comment 
Letter (noting that ``[T]o the extent that this is possible, Asset 
Managers should attempt to take all liabilities into account when 
trying to calculate liquidity for a given fund.''). Nonetheless, to 
eliminate any potential confusion, we are changing the term 
``assets'' to ``investments'' throughout rule 22e-4, related 
reporting items and definitions on Form N-PORT and Form N-LIQUID.
    \480\ See rule 22e-4(b)(1)(ii) (requiring funds to classify each 
of the portfolio investments, including each of the fund's 
derivatives transactions). We have made corresponding changes to 
each of the liquidity categories to account for the classification 
of all portfolio investments (i.e., the liquidity categories under 
rule 22e-4 as adopted are highly liquid investments, moderately 
liquid investments, less liquid investments, and illiquid 
investments).
---------------------------------------------------------------------------

    Besides specifying that the liquidity of a derivatives transaction 
must be classified taking into account relevant market, trading, and 
investment-specific considerations, rule 22e-4 provides no derivatives-
specific factors that a fund would have to evaluate in classifying a 
derivatives transactions' liquidity. We generally agree with 
commenters' suggestions that the liquidity of a derivatives transaction 
may depend on market demand for that kind of derivative, as well as the 
liquidity of the derivative's underlying reference asset.\481\ Whether 
a derivatives transaction is centrally cleared also could indicate that 
the transaction is more liquid than an equivalent transaction that is 
not cleared.\482\ In classifying and reviewing the liquidity of a 
derivatives transaction, like classifying the liquidity of any 
portfolio investment, a fund should consider the guidance factors 
discussed in this Release, to the extent the factors are applicable and 
the fund deems their

[[Page 82185]]

consideration to be appropriate.\483\ The provision in rule 22e-4 
stating that a fund may generally classify its portfolio investments 
according to their asset class applies to the fund's derivatives 
transactions,\484\ as do the rule's market depth provisions.\485\ The 
definitions of ``highly liquid investment,'' ``moderately liquid 
investment,'' and ``less liquid investment'' that refer to the ability 
to convert an investment to cash or dispose of an investment within a 
specified period, with respect to derivatives transactions that the 
fund classifies as liabilities on its balance sheet,\486\ should be 
read to refer to the time period in which the fund reasonably expects 
to be able to exit a transaction.
---------------------------------------------------------------------------

    \481\ See supra footnotes 474-475 and accompanying text.
    \482\ See, e.g., Deutsche Bank Research, Liquidity Is Key for 
the Central Clearing of Derivatives (Mar. 12, 2015), available at 
https://www.dbresearch.com/PROD/DBR_INTERNET_EN-PROD/PROD0000000000352403/Liquidity_is_key_for_the_central_clearing_of_deriv.pdf; see also 
infra footnote 552.
    \483\ See infra section III.C.4.
    \484\ Rule 22e-4(b)(1)(ii)(A).
    \485\ Rule 22e-4(b)(1)(ii)(B).
    \486\ See supra footnote 480 and accompanying text.
---------------------------------------------------------------------------

    Along with classifying the liquidity of each of its derivative 
transactions, final rule 22e-4 requires a fund to identify, for 
derivatives transactions that a fund has classified as moderately 
liquid investments, less liquid investments, and illiquid investments, 
the percentage of the fund's highly liquid investments that are 
segregated to cover, or pledged to satisfy margin requirements in 
connection with, the transactions in each of these classification 
categories.\487\ When a fund's assets are segregated or pledged in 
connection with derivatives transactions, they are only available for 
sale to meet redemptions once the related derivatives position is 
disposed of or unwound (or if other assets are segregated or pledged in 
their place). Thus, even if the segregated or pledged assets would, on 
their own, be considered extremely liquid, they would effectively not 
be able to be used to meet redemption requests or to rebalance or 
otherwise adjust a portfolio's composition in order to manage liquidity 
risk. As discussed below, we believe that it is important, for purposes 
of transparency regarding a fund's portfolio liquidity, to provide 
clarity that certain percentages of a fund's investments may not be 
functionally available to meet redemptions or for other liquidity risk 
management purposes.\488\
---------------------------------------------------------------------------

    \487\ Rule 22e-4(b)(1)(ii)(C).
    \488\ See infra section III.C.6.
---------------------------------------------------------------------------

    We believe that requiring a fund to determine the percentage of 
highly liquid investments that are segregated to cover, or pledged to 
satisfy margin requirements in connection with, its derivatives 
transactions classified in each of the ``moderately liquid,'' ``less 
liquid,'' and ``illiquid'' classification categories strikes an 
appropriate balance between providing this transparency and reducing 
burdens on funds. Under this approach, a fund generally would not need 
to specifically identify particular assets that are segregated or 
pledged to cover specific derivatives transactions, but instead a fund 
will calculate the percentage of highly liquid investments segregated 
or pledged to cover derivatives transactions that include derivatives 
transactions classified in each of the other three classification 
categories. For purposes of calculating these percentages, a fund that 
has segregated or pledged non-highly liquid investments as well as 
highly liquid investments to cover derivatives transactions, should 
first use segregated or pledged assets that are highly liquid 
investments to cover derivatives transactions classified in the three 
lower liquidity classification categories.\489\ This approach should 
promote consistency and comparability across funds. In the absence of 
such an instruction, some funds might instead take the opposite 
approach, and assume that segregated non-highly liquid investments 
first cover these less liquid derivatives transactions, creating 
inconsistencies between funds.
---------------------------------------------------------------------------

    \489\ See note to rule 22e-4(b)(1)(ii)(C). However, if a fund 
has specifically identified individual assets that are not highly 
liquid investments as being segregated to cover such derivatives 
transactions, the fund may match those specific segregated assets to 
specific derivatives transactions and need not assume that 
segregated highly liquid assets cover those derivatives.
---------------------------------------------------------------------------

    The approach in the final rule responds to commenters' concerns 
that funds rarely identify and segregate a specific liquid asset 
against an individual derivative on a one-for-one relationship,\490\ 
and would reduce burdens that could result if the Commission's 
liquidity classification rules were to require a fund to do so. It also 
responds to commenters' concerns that linking the liquidity of specific 
segregated assets to the liquidity of a fund's derivatives transactions 
could understate the liquidity of those segregated assets, since a fund 
may be able to readily substitute another liquid asset for the 
segregated asset.\491\ However, the Commission's approach also would 
provide the basis for needed transparency for the Commission, its 
staff, and the public into the way that a fund's segregated or pledged 
assets may affect the fund's overall portfolio liquidity. Rule 22e-4, 
which requires a fund only to determine percentages of segregated or 
pledged assets comprising the fund's highly liquid investments, 
reflects our belief that this transparency is especially important with 
respect to funds' highly liquid investments. As noted above, a fund's 
disclosure of percentages of its highly liquid investments that are 
segregated or pledged assets would permit the Commission and its staff 
to understand what percentage of a fund's highly liquid investment 
minimum is composed of encumbered assets, and would allow the public to 
better understand that a certain percentage of a fund's highly liquid 
investments may not be immediately available for liquidity risk 
management purposes.
---------------------------------------------------------------------------

    \490\ See supra footnote 470 and accompanying text.
    \491\ See supra footnote 473 and accompanying paragraph. We 
note, however, that the ability to substitute may not improve the 
overall liquidity of the portfolio.
---------------------------------------------------------------------------

    While a fund will not need to identify which of its particular 
assets are segregated in connection with particular derivatives 
transactions, it will need to identify the percentage of its highly 
liquid investments that are segregated or pledged with respect to 
derivatives transactions classified in each of the moderately liquid, 
less liquid, and illiquid classification categories. We recognize that 
these requirements will likely entail additional evaluation of the 
liquidity character of a fund's segregated assets compared to what a 
fund might do today as part of its current asset segregation 
procedures.\492\ We believe these burdens are justified, however, by 
the important transparency benefits of identifying the percentages of 
highly liquid investments that are segregated or pledged assets.
---------------------------------------------------------------------------

    \492\ See infra section IV.C.1.
---------------------------------------------------------------------------

    We also note that these burdens are further reduced because under 
the rule a fund need not identify the percentage of segregated or 
pledged assets covering derivatives that are highly liquid investments, 
or the percentage of segregated or pledged assets that are moderately 
liquid investments or less liquid investments.\493\ A fund would be 
permitted to exclude its derivatives transactions that are classified 
as highly liquid investments in determining the percentages of highly 
liquid investments that are segregated or pledged assets since the fund 
could dispose of or exit these derivatives transactions within three 
business days and the segregated or pledged assets also would be 
available to the fund for liquidity risk management purposes within 
three business days. Furthermore, as described in the preceding 
paragraph, the rule's requirement to identify the percentages of a 
fund's highly liquid investments that are also segregated or

[[Page 82186]]

pledged assets reflects our belief that asset segregation or margin 
transparency is most important with respect to a fund's highly liquid 
investments.
---------------------------------------------------------------------------

    \493\ See rule 22e-4(b)(1)(ii)(C).
---------------------------------------------------------------------------

4. Guidance on Liquidity Classification Factors
    Unlike rule 22e-4 as proposed, final rule 22e-4 does not include an 
enumerated list of factors that a fund would be specifically required 
to consider in classifying and reviewing the liquidity of its portfolio 
investments. The rule instead generally requires a fund to take into 
account ``relevant market, trading, and investment-specific 
considerations'' in classifying and reviewing its portfolio 
investments' liquidity.\494\ In contrast, under the proposed rule a 
fund would have been required to take the following nine factors into 
account, to the extent applicable, when classifying the liquidity of 
each portfolio position in a particular asset:
---------------------------------------------------------------------------

    \494\ See supra section III.C.1.b.
---------------------------------------------------------------------------

     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.\495\
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    \495\ Proposed rule 22e-4(b)(2)(ii).
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    The Proposing Release requested comment generally on whether the 
Commission should codify a list of liquidity classification factors (as 
discussed above) \496\ and also requested comments relating to the 
usefulness of the proposed factors generally, as well as specific 
comments on the proposed factors.\497\ With respect to the general 
usefulness of the proposed factors, multiple commenters suggested that 
the proposed factors would be largely informative in assessing assets' 
relative liquidity,\498\ but others advised that the proposed factors 
would not be useful in assisting fund management in making liquidity 
determinations.\499\ Some who objected to the proposed factors argued 
that their usefulness would be limited by the fact that they would be 
based on backward-looking data and thus may not reflect future 
conditions.\500\ Some commenters also argued that some of the proposed 
factors (e.g., frequency of trades or quotes for an asset and average 
daily trading volume of an asset) are generally more appropriate for 
assessing the liquidity of exchange-traded securities than securities 
that are traded over-the-counter (``OTC'') and that evaluating certain 
OTC securities using the proposed factors may make these securities 
appear to be less liquid than they actually are.\501\ For example, 
multiple commenters contended that certain fixed income securities tend 
to trade infrequently on any given day, but these securities' liquidity 
is nevertheless quite high because a fund would generally be able to 
sell them fairly quickly.\502\ As discussed specifically below, 
commenters also expressed more granular concerns about certain of the 
proposed factors (specifically, frequency of trades or quotes for an 
asset, trading price volatility, position size, and relationship of an 
asset to another portfolio asset \503\).
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    \496\ See supra section III.C.1.b.
    \497\ See Proposing Release, supra footnote 9, at section 
III.B.2.j.
    \498\ See, e.g., CRMC Comment Letter; ICI Comment Letter I; J.P. 
Morgan Comment Letter; Nuveen Comment Letter.
    \499\ See, e.g., Cove Street Comment; GFOA Comment Letter; MFS 
Comment Letter; Vanguard Comment Letter.
    \500\ See, e.g., Cove Street Comment; Dodge & Cox Comment 
Letter; Vanguard Comment Letter.
    \501\ See, e.g., Banks Comment Letter; LSTA Comment Letter; 
Milliman Comment Letter; Wells Fargo Comment Letter.
    \502\ See, e.g., GFOA Comment Letter; MFS Comment Letter; T. 
Rowe Comment Letter; Vanguard Comment Letter.
    \503\ For a discussion of commenters' concerns about this 
proposed factor in the context of derivatives transactions, see 
supra section III.C.3.c.
    Commenters also expressed concerns about this proposed factor in 
the context of assets used for hedging or risk mitigation purposes. 
In the Proposing Release, we stated that, when a fund purchases an 
asset (a ``hedging asset'') in order to hedge or mitigate the risks 
associated with another asset (a ``hedged asset''), the fund should 
consider the liquidity of the hedged asset when evaluating the 
liquidity of the hedging asset. Commenters stated that current 
industry practice often involves hedging aggregate portfolio 
exposures, not specific securities. See, e.g., ICI Comment Letter I; 
Milliman Comment Letter; Oppenheimer Comment Letter; T. Rowe Comment 
Letter. These commenters argued that the Commission's guidance 
instructing a fund to classify the liquidity of hedging assets in 
consideration of the hedged asset's liquidity classification would 
therefore be unworkable and would raise costly operational burdens, 
because funds do not currently link hedging assets and hedged assets 
on a one-for-one basis.
    Unlike in the context of derivatives transactions, in which we 
have stated that a fund must segregate assets to cover derivatives 
transactions, and this renders the segregated assets ``frozen'' and 
``unavailable for sale or other disposition'' (see supra footnote 
465 and accompanying text), we have not previously stated that 
purchasing assets with the intent to hedge or mitigate the risks 
associated with another asset makes those hedging assets unavailable 
for sale. We thus do not view the linkages between hedging and 
hedged assets to be directly analogous with the linkages between 
derivatives transactions and assets segregated to cover those 
derivatives transactions, and we are not stating in this Release the 
guidance we included in the Proposing Release regarding the proposed 
``relationship of an asset to another portfolio asset'' in the 
context of assets used for hedging or risk mitigation purposes.
---------------------------------------------------------------------------

    As discussed above, we are not codifying the proposed factors in 
part because we understand that certain factors would be more 
informative to some funds than others, depending on the fund's 
investment strategy and liquidity risk profile. We also are concerned 
that codifying the factors, particularly if applied in a ``check-the-
box'' fashion, could lead funds to adopt classification processes that 
do not reflect the extent of a fund's ability to sell its portfolio 
investments to meet redemptions within a given time period without a 
market impact, or do not otherwise result in an accurate picture of a 
fund's liquidity profile.\504\ However, we continue to believe that the 
proposed classification factors could be useful and relevant as aspects 
of the general market, trading, and investment-specific considerations 
that a fund must take into account under the final rule. Thus, in this 
section III.C.4, we discuss each of the factors that funds could 
consider in evaluating portfolio investments' liquidity characteristics 
and managing liquidity risk.\505\ Based on staff outreach across the 
fund industry, we understand that certain of these factors reflect 
certain common considerations that funds often take into account in 
evaluating their portfolio investments' liquidity.\506\ Moreover, as 
discussed above, multiple commenters stated that the proposed rule 
included factors that, largely, are useful for assessing a fund's 
assets' relative liquidity.\507\ For example, some

[[Page 82187]]

commenters agreed that factors such as those incorporated in the 
proposal are generally relevant considerations to use when evaluating 
asset liquidity and would help promote effective liquidity risk 
assessments,\508\ and that portfolio assets' liquidity should be 
evaluated using a variety of inputs such as those that the proposed 
factors represent.\509\ Some suggested that the Commission discuss the 
factors as guidance accompanying its adoption of rule 22e-4.\510\ 
Overall, we believe this approach provides flexibility that should 
facilitate meaningful liquidity analyses, and encourages funds to 
consider relevant information.
---------------------------------------------------------------------------

    \504\ Cf. supra paragraph accompanying footnote 322.
    \505\ Our discussion of factors that could be considered by 
funds does not include the proposed ``relationship of [an] asset to 
another portfolio asset'' factor because guidance on this factor, as 
discussed above, has been replaced by requirements in rule 22e-4 
regarding classification issues that arise with respect to 
derivatives transactions. See supra footnotes 456-461 and 
accompanying text; see also supra footnote 503 (discussing this 
proposed factor in the context of assets used for hedging or risk 
mitigation purposes).
    \506\ See Proposing Release, supra footnote 9, at text preceding 
n.200.
    \507\ See supra footnote 498 and accompanying text.
    \508\ See, e.g., CRMC Comment Letter; Fidelity Comment Letter; 
J.P. Morgan Comment Letter; Nuveen Comment Letter.
    \509\ See, e.g., HSBC Comment Letter; MSCI Comment Letter.
    \510\ See, e.g., IDC Comment Letter; Invesco Comment Letter; 
J.P. Morgan Comment Letter; SIFMA Comment Letter I.
---------------------------------------------------------------------------

    We acknowledge, as stated by some commenters, that certain of these 
factors may involve consideration of backward-looking data and thus may 
not account for ways in which changing market conditions could affect 
the liquidity of certain asset classes or investments.\511\ But we 
believe analyzing past data, while considering how that data may change 
in the future, is an inherent aspect of all risk management and does 
not render such analysis fruitless. In addition, the review 
requirements embedded in the classification framework, when combined 
with the liquidity risk assessment requirement to consider portfolio 
liquidity during normal and reasonably foreseeable stressed periods, 
further responds to this critique. We also are cognizant that, for 
certain fixed income or other OTC assets or asset classes, certain of 
the proposed liquidity classification factors, if considered standing 
alone, may appear to make these assets or classes to appear less liquid 
than they actually are. In the guidance below, we discuss special 
concerns that may be relevant to funds' consideration of the liquidity 
characteristics of fixed income or other OTC assets.\512\
---------------------------------------------------------------------------

    \511\ See supra footnote 500 and accompanying text.
    \512\ See, e.g., text accompanying infra footnotes 536-538 and 
545-558.
---------------------------------------------------------------------------

    As discussed above, a fund generally is permitted to classify the 
liquidity of its portfolio investments according to their asset class. 
Thus, a fund may wish to consider the guidance discussed below in 
assessing the general liquidity characteristics of the asset classes in 
which it invests. For investments that the fund determines must be 
treated as an ``exception'' and classified separate from their asset 
class,\513\ the guidance provided below could assist funds in 
identifying and classifying those investments that may demonstrate 
liquidity characteristics that are distinct from the fund's other 
portfolio holdings within that same asset class.
---------------------------------------------------------------------------

    \513\ See rule 22e-4(b)(1)(ii)(A).
---------------------------------------------------------------------------

    The guidance we provide below is not meant to cover an exhaustive 
list of considerations that a fund may take into account in evaluating 
its portfolio investments' liquidity. Also, we recognize that specific 
liquidity concerns appropriate for consideration could vary depending 
on the issuer and the particular investment.\514\ Even if a fund's 
liquidity classification policies and procedures were to incorporate 
all of the guidance factors discussed below, a fund may decide that it 
is appropriate to focus more heavily on certain factors and less on 
others in evaluating its portfolio investments' liquidity.
---------------------------------------------------------------------------

    \514\ See, e.g., Fidelity Comment Letter; LSTA Comment Letter; 
Nuveen Comment Letter; T. Rowe Comment Letter (each suggesting that 
the Commission clarify that not every factor is required to be 
considered to evaluate the liquidity of each of a fund's portfolio 
assets).
---------------------------------------------------------------------------

    In the following sections, we discuss certain factors that a fund 
could consider in assessing the liquidity of its portfolio investments 
and provide guidance on specific issues associated with each of these 
factors. We also discuss comments we received on the proposed 
classification factors.
a. Existence of Active Market for an Asset Class or Investment; 
Exchange-Traded Nature of an Asset Class or Investment
    We continue to believe that the manner in which a fund may sell an 
asset class (or particular portfolio investment), including whether an 
asset class or investment is generally listed on an exchange, may 
affect the liquidity of that asset class or investment.\515\ While in 
general, being listed on a developed and recognized exchange may 
increase an investment's liquidity,\516\ we note, as certain commenters 
mentioned,\517\ the fact that an investment is exchange-traded does not 
necessarily mean that a fund would be able to sell or convert that 
investment to cash within a relatively short period.\518\ 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, as commenters discuss, we agree that certain securities 
that are traditionally traded in OTC markets, such as corporate bonds, 
may not typically be designed to be traded frequently and instead are 
more often ``bought and held,'' but certain of these securities 
nevertheless may be readily saleable without the conversion to cash (or 
in some cases, sale or disposition) significantly changing their market 
value.\519\ Additionally, 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.\520\
---------------------------------------------------------------------------

    \515\ See Proposing Release, supra footnote 9, at section 
III.B.2.a (discussing the proposed requirement for a fund to 
consider, to the extent applicable, the existence of an active 
market for an asset, including whether the asset is listed on an 
exchange, as well as the number, diversity, and quality of market 
participants, in classifying the liquidity of each portfolio 
position in a particular asset).
    \516\ See, 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 FSOC Notice Comment 
Letter, supra footnote 85 (``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.'').
    \517\ See, e.g., ICI Comment Letter I.
    \518\ We note that in certain cases the exchange on which an 
investment is listed may not be the primary market for that 
security. For example, we understand that certain bonds that are 
exchange listed trade predominantly in the OTC markets. See, e.g., 
Types of Bonds, How Big Is the Market, and Who Buys?, available at 
http://www.investinginbonds.com/learnmore.asp?catid=5&subcatid=18&id=174 (``[T]he vast majority of 
bond transactions, even those involving exchange-listed issues, take 
place in [OTC] market.'').
    \519\ See id.
    \520\ See 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 readily-marketable 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)).
---------------------------------------------------------------------------

    In assessing the effect that being traded on an exchange could have 
on an asset class's or investment's liquidity, a fund generally should 
evaluate how this consideration informs the liquidity characteristics 
of any ETF shares in which it invests. We understand that certain 
funds, particularly funds with

[[Page 82188]]

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.\521\ Specifically, in discussions with Commission 
staff, funds that invest in ETF shares have suggested 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.\522\ In addition, unlike investments in cash, 
cash equivalents, and other highly liquid instruments, funds also have 
suggested to Commission staff 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.\523\
---------------------------------------------------------------------------

    \521\ See, 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 Act. 
Currently, these practices do not concern ETMFs.
     The 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 footnote 29, at 
Question 49. Commenters expressed a range of views on the question. 
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).
    \522\ See Proposing Release, supra footnote 9, at section 
III.C.6.b.
    \523\ See id.
---------------------------------------------------------------------------

    While we appreciate that ETFs' exchange-traded nature could make 
these instruments useful to funds in managing purchases and redemptions 
under certain conditions (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. The liquidity of an ETF, particularly in times of 
declining market liquidity, is limited by the liquidity of the market 
for the ETF's underlying securities and, in fact, may be impaired based 
on factors not directly related to the liquidity of the underlying 
securities.\524\ Thus, shares of an ETF whose underlying securities are 
relatively less liquid may not be able to be counted on to provide 
liquidity to a fund investing in these shares during times of 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 
participants who count on the creation and redemption process to align 
the prices of ETF shares and their underlying portfolio securities. 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 the liquidity of ETF shares under 
rule 22e-4(b)(1)(ii).
---------------------------------------------------------------------------

    \524\ See ETF Proposing Release, supra footnote 27, at section 
III.A.1; see also Tyler Durden, What Would Happen if ETF Holders 
Sold All at Once? Howard Marks Explains, Zero Hedge (Mar. 26, 2015), 
available at http://www.zerohedge.com/news/2015-03-26/what-would-happen-if-etf-holders-sold-all-once-howard-marks-explains (``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.''). But see, 
e.g., Shelly Antoniewicz, Plenty of Players Provide Liquidity for 
ETFs, ICI Viewpoints (Dec. 2, 2014), available at http://www.ici.org/viewpoints/view_14_ft_etf_liquidity (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).
---------------------------------------------------------------------------

Other Trading Mechanism Considerations
    The means of trading a particular asset class or investment can 
affect its liquidity regardless of whether the investment is a security 
traded on an exchange. For example, whether an asset class or 
investment is generally traded in a bilateral transaction with a single 
dealer, or through an electronic auction mechanism where a trader can 
simultaneously contact multiple counterparties, can have different 
effects on its liquidity.\525\ The liquidity effects associated with 
choice of trading mechanism may differ depending on the asset class or 
investment 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 
class or investment being traded. For this reason, a fund may wish to 
consider past experience in using different trading mechanisms to sell 
a certain asset class or investment.
---------------------------------------------------------------------------

    \525\ See, e.g., Terrence Hendershott & Ananth Madhavan, Click 
or Call? Auction versus Search in the Over-the-Counter Market., 70 
J. of Fin. 419 (Feb. 2015), available at http://faculty.haas.berkeley.edu/hender/Click_Call_OTC.pdf.
---------------------------------------------------------------------------

Diversity and Quality of Market Participants
    In addition, the diversity and quality of market participants for a 
particular asset class or investment also could contribute to the 
liquidity of that asset class or investment. A fund may wish to 
consider the number of market makers on both the buying and selling 
sides of transactions. A fund also may wish to consider the quality of 
market participants purchasing and selling a particular asset class or 
investment, 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 may be 
meaningful in assessing a portfolio investment's liquidity because it 
is common for relatively liquid asset classes and investments to have 
active sale or repurchase markets at all times with diverse market 
participants.\526\ The presence of multiple active market makers may be 
a sign that a market is liquid.\527\ Diversity of market participants, 
on both the buying and selling sides of transactions, may also be a 
significant point for a fund to consider because it tends to reduce 
market concentration and may facilitate a

[[Page 82189]]

market remaining liquid during periods of stress.\528\
---------------------------------------------------------------------------

    \526\ See, 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.'').
    \527\ See, e.g., Sunil Wahal, Entry, Exit, Market Makers, and 
the Bid-Ask Spread, 10 Rev. of Fin. Stud. 871 (1997), available at 
https://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.'').
    \528\ See, e.g., Amir Rubin, Ownership Level, Ownership 
Concentration, and Liquidity, 10 J. Fin. Markets 219 (Aug. 2007), 
available at http://www.sciencedirect.com/science/article/pii/S1386418107000134 (``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.'').
---------------------------------------------------------------------------

b. Frequency of Trades or Quotes; Average Daily Trading Volume
    In general, we continue to believe that a high frequency of trades 
or quotes for a particular asset class or investment tends to indicate 
that a particular asset class or investment has relatively high 
liquidity.\529\ However, as many commenters raised and as discussed 
below, low trading frequency and trading volume does not necessarily 
indicate low liquidity, particularly for asset classes and investments 
that are not exchange-traded.\530\ Also, we note that the frequency of 
trades or quotes for a particular asset class or investment is not a 
perfect or complete measure of liquidity, and a fund may wish to also 
consider trade size in assessing the relationship between trade 
frequency and liquidity.\531\ In evaluating the frequency of trades 
(and bid and ask quotes) for an asset class or investment, a fund may 
wish to generally consider, among other relevant factors, the number of 
dealers quoting prices for that asset class or investment, the number 
of other potential purchasers and sellers, and dealer undertakings to 
make a market in the asset class or investment.
---------------------------------------------------------------------------

    \529\ See Proposing Release, supra footnote 9, at section 
III.B.2.b (discussing the proposed requirement for a fund to 
consider, to the extent applicable, the frequency of trades or 
quotes for a particular asset, as well as the asset's average daily 
trading volume (regardless of whether the asset is a security traded 
on an exchange), in classifying the liquidity of each portfolio 
position in a particular asset).
    \530\ See infra footnotes 536-538 and accompanying text.
    \531\ 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. See Erik 
Banks, Liquidity Risk: Managing Funding and Asset Risk (2nd ed. 
2013), at 169.
---------------------------------------------------------------------------

    High average trading volume also tends to be correlated with 
greater liquidity, particularly for exchange-traded asset classes and 
investment. In general, high average daily trading volume for a 
particular asset class or investment indicates a deep market for that 
asset class or investment, which in turn indicates that a fund may be 
able to convert its holdings in that asset class or investment to cash 
without the conversion (or in some cases, sale or disposition) 
significantly changing the market value.\532\ Especially for exchange-
traded asset classes or investments, a fund may wish to consider the 
number of days of zero or very low trading volume during the prior 
month, year, or other relevant period, as this could indicate 
particularly limited liquidity. As one commenter suggested, and we 
agree, a fund may wish to consider not only the historical average 
trading volume of the asset class or assets in which its invests, but 
also whether trading volume is likely to change under different or 
stressed market conditions.\533\ High trading volume is not always 
indicative of available liquidity for a particular asset class or 
investment, however. For example, high trading volumes might be 
associated with high selling pressure on the asset class or investment, 
and trades at that time may have a high value impact.\534\ Also, as one 
commenter suggested, even if a particular asset class or investment 
were to exhibit high trading volume, the ability to convert the asset 
class or investment to cash without the conversion (or in some cases, 
sale or disposition) significantly changing the market value may also 
depend on other factors such as investors' appetite for risk and the 
perceived ``safety'' of specific securities in ``risk-off'' flight-to-
quality market conditions.\535\
---------------------------------------------------------------------------

    \532\ See id.; see also Fidelity FSOC Notice Comment Letter, 
supra footnote 69 (``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 & 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.
    \533\ See Interactive Data Comment Letter (suggesting that the 
Commission consider requiring a fund to consider the potential daily 
trading volume of its portfolio assets instead of, as proposed, the 
average daily trading volume of its assets).
    \534\ See, e.g., HSBC Comment Letter; see also 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).
    \535\ See HSBC Comment Letter.
---------------------------------------------------------------------------

    Multiple commenters stressed that, particularly for fixed income 
and other typically OTC asset classes and assets, relatively low 
trading volume does not necessarily correlate with low liquidity. For 
example, many commenters discussed the low turnover of the corporate 
bond market, which is driven by factors such as the buy-and-hold nature 
of bond investing, the distribution of an issuer's borrowing across 
many different bond issues, and the fact that portfolio managers may 
deem many bonds to be substitutes for one another based on common 
characteristics such as issuer, sector, credit quality, and 
maturity.\536\ Commenters argued that, despite the relatively low 
turnover that is typical in the corporate bond market, these assets are 
commonly considered to be readily tradable at market-clearing 
prices.\537\ Commenters made similar arguments about the dynamics of 
the municipal bond market, noting that municipal securities' trading 
volume is not normally high, particularly during stable financial 
periods, but municipal securities (especially those that are investment 
grade) are commonly considered to be easily saleable.\538\ We generally 
agree with commenters' concerns that the consideration of trading 
volume as a liquidity indicator should not by itself imply that low 
trading volume necessarily indicates low liquidity. Rather, it may 
indicate that other information needs to be assessed to make a 
liquidity determination. For asset classes and investments that 
typically demonstrate low trading volume, funds may wish to consider 
how the other liquidity characteristics of those asset classes and 
investments, including but not limited to other guidance factors 
discussed in this Release, may affect the time period and value impact 
associated with the class's or investment's ability to be converted to 
cash. Analysis of capital structure and credit quality of a particular 
asset class or investment, as well as bid-ask spreads and maturity/date 
of issue, may be particularly useful in considering the liquidity of 
investments whose trading volume is normally low.
---------------------------------------------------------------------------

    \536\ See, e.g., Nuveen Comment Letter; Vanguard Comment Letter.
    \537\ See, e.g., Nuveen Comment Letter; Vanguard Comment Letter.
    \538\ See, e.g., GFOA Comment Letter; Nuveen Comment Letter.

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[[Page 82190]]

c. Volatility of Trading Prices
    We continue to believe that trading price volatility is potentially 
a valuable metric to consider in evaluating an asset class's or 
investment's liquidity.\539\ In general, there is an inverse 
relationship between liquidity and volatility,\540\ as lack of 
liquidity in a particular investment tends to amplify price volatility 
for that asset.\541\ Additionally, the Commission 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'' \542\ and the October 2014 ``flash crash.'' 
\543\ As one commenter suggested, and we agree, if a fund holds asset 
classes or investments that are thinly traded, the fund may wish to 
consider volatility of evaluated pricing information in assessing the 
liquidity of those asset classes or investments.\544\
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    \539\ See Proposing Release, supra footnote 9, at section 
III.B.2.c (discussing the proposed requirement for a fund to 
consider, to the extent applicable, the volatility of trading prices 
for its portfolio assets, in classifying the liquidity of each 
portfolio asset).
    \540\ See, 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.newyorkfed.org/research/staff_reports/sr164.pdf (finding that unexpected liquidity and 
volatility shocks are positively and significantly correlated across 
stock and bond markets).
    \541\ See, 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 footnote 69, at 21 
(``Liquidity management is linked to portfolio managers' attention 
to market risks indicated by . . . increasing market- and security-
specific volatility.'').
    \542\ 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 Christopher Condon & Jeff Kearns, 
Fed Worried About Triggering Another `Taper Tantrum', Bloomberg 
(Oct. 8, 2014), available at http://www.bloomberg.com/news/articles/2014-10-08/fed-worried-about-triggering-another-taper-tantrum-.
    \543\ See Joint Staff Report: The U.S. Treasury Market on 
October 15, 2014 (July, 13, 2015), available at https://www.treasury.gov/press-center/press-releases/Documents/Joint_Staff_Report_Treasury_10-15-2015.pdf (``On October 15, 2014, 
the market for U.S. Treasury securities, futures, and other closely 
related financial markets experienced an unusually high level of 
volatility and a very rapid round-trip in prices. Although trading 
volumes were high and the market continued to function, liquidity 
conditions became significantly strained.'').
    \544\ See Interactive Data Comment Letter (suggesting that the 
Commission consider replacing the proposed ``volatility of trading 
prices for the asset'' classification factor with ``volatility of 
traded or evaluated pricing information,'' to make this proposed 
factor more applicable to fixed income assets and other asset 
classes that may be thinly traded).
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d. Bid-Ask Spreads
    Bid-ask spreads--the difference between bid and offer prices for a 
particular investment--have historically been viewed as a useful 
measure for assessing the liquidity of assets,\545\ and we continue to 
believe that a fund may consider this factor useful in classifying the 
liquidity of a particular asset class or investment.\546\ The bid-ask 
spread of a particular investment is related to the riskiness of that 
investment, as well as the length of time that a broker-dealer believes 
it will have to hold the investment before selling it.\547\ In general, 
high bid-ask spreads for a particular asset class or investment 
correlate with a lack of liquidity in that asset class or investment. 
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.\548\ However, bid-ask spreads alone do not 
necessarily provide a comprehensive understanding of an investment's 
liquidity. For instance, bid-ask spreads are often constrained by the 
increments in which prices are quoted.\549\ Additionally, as one 
commenter noted, bid-ask spreads do not take into account the volume 
and scale of a portfolio manager's intended buy and sell 
transactions.\550\
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    \545\ See, e.g., Michael J. Fleming, Measuring Treasury Market 
Liquidity, Federal Reserve Bank of New York Economic Policy Review 
(Sept. 2003), available at https://www.newyorkfed.org/medialibrary/media/research/epr/03v09n3/0309flempdf.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 footnote 69, 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)'').
    \546\ See Proposing Release, supra footnote 9, at section 
III.B.2.d (discussing the proposed requirement for a fund to 
consider, to the extent applicable, its portfolio assets' bid-ask 
spreads when assessing its portfolio assets' liquidity).
    \547\ See MarketAxess, The MarketAxess Bid-Ask Spread Index 
(BASI): 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-index-BASI.pdf (discussing methodology for developing an index that tracks 
bid-ask spreads of U.S. corporate bonds).
    \548\ See, e.g., Got Liquidity?, supra footnote 452, at 7; see 
also Rich Estabrook, Diminished Liquidity in the Corporate Bond 
Market: Implications for Fixed Income Investors, Oppenheimer (Mar. 
16, 2015), at 1, available at http://www.opco.com/trend-analysis/final_liquidity_report-031615.pdf.
    \549\ See, 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 https://www.researchgate.net/publication/4978467_Eighths_Sixteenths_and_Market_Depth_Changes_in_Tick_Size_and_Liquidity_Provision_on_the_Nyse (``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 
odd-eighth quotes. This finding provides support for 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.'').
    \550\ See HSBC Comment Letter.
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e. Standardization and Simplicity of Asset Class's or Investment's 
Structure
    We continue to believe that whether an asset class or investment 
has a relatively standardized and simple structure is generally 
relevant to a fund's evaluation of an asset class's or investment's 
liquidity.\551\ Investments that trade OTC with terms set at issuance 
such as sizes, maturities, coupons, and payment dates may be relatively 
more liquid compared to similarly situated investments without 
standardized terms. 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. 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 investments' liquidity, as 
measured by factors such as the bid-ask spreads for these investments 
and the number of dealers providing quotes for these

[[Page 82191]]

investments.\552\ However, standardization alone may not be indicative 
of an investment's liquidity. For example, corporate bond issuers 
commonly have large numbers of bonds outstanding, and trading can be 
fragmented among that universe of bonds.\553\ However, as discussed 
above, we understand that market participants may consider many 
corporate bonds to be highly comparable and substitutable from a 
liquidity perspective, to the extent that they share common 
characteristics such as issuer, sector, credit quality, and 
maturity.\554\
---------------------------------------------------------------------------

    \551\ See Proposing Release, supra footnote 9, at section 
III.B.2.e (discussing the proposed requirement for a fund to 
consider, to the extent applicable, the standardization and 
simplicity of structure of its portfolio assets when assessing its 
portfolio assets' liquidity).
    \552\ See, 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=2176561 (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 non-cleared 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/wp-content/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).
    \553\ 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. See BlackRock, Corporate Bond Market Structure: The 
Time for Reform Is Now, Viewpoint (Sept. 2014), at 7, available at 
https://www.blackrock.com/corporate/en-mx/literature/whitepaper/viewpoint-corporate-bond-market-structure-september-2014.pdf.
    \554\ See supra footnote 536 and accompanying text.
---------------------------------------------------------------------------

f. Maturity and Date of Issue of Fixed Income Securities
    We continue to believe that, with respect to the fixed income 
investments a fund holds in its portfolio, those investments' maturity, 
as well as their date of issue, are significant indicators of their 
liquidity.\555\ 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.\556\ 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).\557\ Because high trading volume generally 
suggests relatively high liquidity,\558\ 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.
---------------------------------------------------------------------------

    \555\ See Proposing Release, supra footnote 9, at section 
III.B.2.f (discussing the proposed requirement for a fund to 
consider, with respect to fixed income assets, these assets' 
maturity and date of issue when assessing their liquidity).
    \556\ See, 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.
    \557\ The 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. 1-24 (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. of 
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%'').
    \558\ See supra section III.C.4.b.
---------------------------------------------------------------------------

g. Restrictions on Trading; Limitations on Transfer
    We continue to believe that restrictions on trading certain 
investments, as well as limitations on an investment's transfer, may 
adversely affect those investments' liquidity.\559\ For example, 
although we are replacing existing Commission guidance on identifying 
illiquid assets (including the specific factors listed in the Rule 144A 
Release regarding the liquidity of a rule 144A security) \560\ with new 
regulatory requirements regarding the process for determining that 
certain investments are illiquid, we believe that the restricted nature 
of a rule 144A security is one factor that generally should be 
considered by a fund in evaluating the liquidity of a rule 144A 
security.\561\ Regardless of whether a portfolio investment 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.\562\ Portfolio investments furthermore 
may be subject to certain contractual limitations on transfer.\563\ 
Securities subject to transfer limitations in general are less liquid 
than securities without such limitations.
---------------------------------------------------------------------------

    \559\ See Proposing Release, supra footnote 9, at section 
III.B.2.g (discussing the proposed requirement for a fund to 
consider restrictions on trading and limitations on transfer in 
classifying the liquidity of each portfolio asset).
    \560\ See Rule 144A Release, supra footnote 37, at text 
following n.62.
    \561\ See id. While we are withdrawing the guidance in the Rule 
144A Release, including the guidance that boards are responsible for 
determining if a security is liquid or illiquid, we note that the 
guidance factors discussed in the Rule 144A Release are consistent 
with certain of the guidance factors discussed in this Release.
    \562\ See, e.g., HSBC Comment Letter; HSBC Global Research, 
Emerging Markets Currency Guide 2012 (Dec. 2011), available at 
https://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 footnote 520, 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).
    \563\ See, e.g., Stephen H. Bier, Julien Bourgeois & Joseph 
McClain, Mutual Funds and Loan Investments, The Investment Lawyer: 
Covering Legal and Regulatory Issues of Asset Management, Vol. 22, 
No. 3 (Mar. 2015), at 2, available at http://www.dechert.com/files/Uploads/Documents/FSG/Mutual%20Funds%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.'').

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[[Page 82192]]

5. Liquidity Classification Review Requirement
    Under rule 22e-4 as adopted today, a fund would be required to 
review its portfolio investments' classifications at least monthly in 
connection with reporting the liquidity classification for each 
portfolio investment on Form N-PORT, as well as more frequently if 
changes in relevant market, trading, and investment-specific 
considerations are reasonably expected to materially affect one or more 
of its investments' classifications.\564\ A fund generally could 
classify and review the liquidity classifications of its portfolio 
investments according to their asset class; however, the fund must 
separately classify and review any investment within an asset class if 
the fund or its adviser, after reasonable inquiry, has information 
about any market, trading, or investment-specific considerations that 
are reasonably expected to significantly affect the liquidity 
characteristics of that investment as compared to other securities 
within that asset class.\565\
---------------------------------------------------------------------------

    \564\ See rule 22e-4(b)(1)(ii).
    \565\ See rule 22e-4(b)(1)(ii)(A).
---------------------------------------------------------------------------

    As discussed in the Proposing Release, 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.'' 
\566\ 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.\567\ While we agree that a fund 
should monitor the liquidity of its portfolio holistically, we note 
that the decreased liquidity of individual portfolio components can 
directly affect the ability of a fund to meet its redemption 
obligations without significant dilution of remaining investors' 
interests in the fund.\568\ We thus believe that specifically requiring 
a fund to review the classifications of its portfolio investments made 
under rule 22e-4 would reduce the risk that a fund would be unable to 
meet its redemption obligations without significant investor dilution.
---------------------------------------------------------------------------

    \566\ See Proposing Release, supra footnote 9, at nn.246-248 and 
accompanying text (citing Guidelines Release, supra footnote 38, at 
section II).
    \567\ See id., at n.247 (citing Investment Company Institute, 
Valuation and Liquidity Issues for Mutual Funds (Feb. 1997), at 45).
    \568\ See, e.g., Third Avenue Temporary Order, supra footnote 12 
(``On December 9, 2015, after considering the environment the Fund 
was in and the likelihood that incremental sales of portfolio 
securities to satisfy additional redemptions would have to be made 
at prices that would unfairly disadvantage all remaining 
shareholders, the Board determined that the fairest action on behalf 
of all shareholders would be to adopt a plan of liquidation.''); see 
also Heartland Release, supra footnote 80.
---------------------------------------------------------------------------

    As proposed, rule 22e-4 would have required a fund to review its 
liquidity classifications on an ongoing basis.\569\ Also, like the 
proposed classification requirement, the proposed review requirement 
would have required a fund to take into account a list of specified 
factors, as the fund determines applicable, in reviewing its portfolio 
assets' liquidity.\570\ In the Proposing Release, we stated that a fund 
may wish to determine the frequency of 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.\571\ In addition, we noted in the Proposing 
Release that, at a minimum, a fund would review its liquidity 
classifications at least monthly in order to accurately report this 
information on proposed Form N-PORT.\572\ Proposed rule 22e-4 did not 
include provisions that would permit a fund to review its portfolio 
assets' liquidity on an asset-class basis.
---------------------------------------------------------------------------

    \569\ Proposed rule 22e-4(b)(2)(i).
    \570\ Proposed rule 22e-4(b)(2)(ii).
    \571\ See Proposing Release, supra footnote 9, at text 
accompanying n.252.
    \572\ See id., at n.253.
---------------------------------------------------------------------------

    We sought comment in the Proposing Release about the proposed 
ongoing review requirement. Several commenters suggested that the 
Commission adopt a general liquidity classification review requirement, 
without incorporating specific factors that a fund would be required to 
consider during the course of its review.\573\ One commenter argued 
that the frequency of the proposed review requirement was unclear and 
recommended that the Commission adopt more specific standards 
associated with review frequency.\574\ Multiple commenters expressed 
concerns about the potential burden associated with an ``ongoing'' 
review requirement \575\ and suggested that these concerns could be 
mitigated by replacing the proposed requirement to classify the 
liquidity of each portfolio position with a ``top-down'' requirement 
permitting funds to classify their portfolio assets' liquidity on an 
asset-class basis.\576\
---------------------------------------------------------------------------

    \573\ See, e.g., CFA Comment Letter; Vanguard Comment Letter.
    \574\ See Better Markets Comment Letter.
    \575\ See, e.g., Dechert Comment Letter; ICI Comment Letter I; 
LSTA Comment Letter; T. Rowe Comment Letter.
    \576\ See, e.g., LSTA Comment Letter.
---------------------------------------------------------------------------

    We believe that the review requirement we are adopting, together 
with the rule provision specifying that a fund would generally be 
permitted to review its liquidity classifications with reference to its 
holdings' asset classes, advances our goal of requiring funds to 
appropriately re-evaluate the liquidity of their portfolio holdings, 
while responding to commenters' concerns. As discussed in the Proposing 
Release, we understand that some funds currently may not review the 
liquidity of their portfolio investments on a continuing basis after 
they are acquired.\577\ In particular, we understand that certain funds 
may initially determine that certain investments are liquid or illiquid 
but will not regularly re-evaluate these initial classifications, even 
in light of changing market conditions. We understand that some funds, 
on the other hand, currently reassess the liquidity of their portfolio 
investment regularly based on market-wide developments, as well as 
events affecting particular securities or asset classes.\578\
---------------------------------------------------------------------------

    \577\ See Proposing Release, supra footnote 9, at paragraph 
accompanying n.250.
    \578\ See id., at n.250 and accompanying text; see also ICI 
Comment Letter I.
---------------------------------------------------------------------------

    Rule 22e-4 as adopted requires a fund to review its liquidity 
classifications at least monthly, in connection with reporting its 
liquidity classifications monthly on Form N-PORT.\579\ This requirement 
responds to the recommendation that the Commission adopt more specific 
standards associated with review frequency. Moreover, in order to 
determine whether its holdings are consistent with the fund's highly 
liquid investment minimum, as well as the rule 22e-4 limitation on 
illiquid investments, a fund would have to determine whether its 
initial classification determinations have changed based on market 
conditions or other developments. Therefore, rule 22e-4 also includes 
the requirement for a fund to review its liquidity classifications more 
frequently than monthly if changes in relevant market, trading, and 
investment-specific considerations are reasonably expected to 
materially affect one or more of its investment classifications.\580\ 
For example, relevant market-wide 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

[[Page 82193]]

events such as natural disasters or political upheaval.\581\ Asset-
class and investment-specific developments that a fund may wish to 
consider include, among others, regulatory changes affecting certain 
asset classes and corporate events (such as bankruptcy, default, 
pending restructuring, or delisting, as well as reputational events). 
We believe that the rule's requirement that a fund review its liquidity 
classifications at least monthly, as well as more frequently in light 
of market-related and other changes that could materially affect a 
fund's investment classifications, will provide funds with more 
direction as to the frequency of their classification reviews, as well 
as circumstances that could lead to a classification review, than the 
proposed ongoing review requirement.
---------------------------------------------------------------------------

    \579\ See rule 22e-4(b)(1)(ii).
    \580\ See id.
    \581\ See, e.g., 2014 Fixed Income Guidance Update, supra 
footnote 94.
---------------------------------------------------------------------------

    We believe that the review requirement we are adopting, as opposed 
to the proposed ongoing review requirement, permits funds to tailor 
their review of liquidity classifications in light of the liquidity 
character of a fund's portfolio investments. The modifications to rule 
22e-4 clarify that we do not expect a fund to constantly reassess all 
of its portfolio investments' liquidity. Also, the review requirement 
that we are adopting would not require a fund to consider a detailed 
list of specific factors in the course of conducting its liquidity 
classification reviews. Instead, as discussed above, it would require a 
fund to take into account ``relevant market, trading, and investment-
specific considerations'' in reviewing its investments' liquidity.\582\
---------------------------------------------------------------------------

    \582\ See rule 22e-4(b)(1)(ii).
---------------------------------------------------------------------------

    Finally, the review requirement that we are adopting, like the rule 
22e-4 classification requirement, would permit a fund to generally 
review its portfolio investments' liquidity according to their asset 
class (provided that the fund must identify, and separately review, any 
investment within an asset class that the fund determines should be 
reviewed separately based on its liquidity characteristics).\583\ We 
believe that this approach will permit funds to increase their 
efficiency in classifying and reviewing portfolio investments' 
liquidity.
---------------------------------------------------------------------------

    \583\ See rule 22e-4(b)(1)(ii)(A).
---------------------------------------------------------------------------

6. Liquidity Classification Reporting and Disclosure Requirements
    In connection with the liquidity classification requirement of rule 
22e-4, we are requiring, largely as proposed and with certain 
modifications in response to comments, a fund to report the liquidity 
classification assigned to each of the fund's portfolio investments on 
Form N-PORT.\584\ Position-level liquidity classification information 
will be reported to the Commission in a structured data format on a 
confidential basis rather than released every three months to the 
public.\585\ Under the final rules, a fund will also be required to 
publicly report on Form N-PORT the aggregated percentage of its 
portfolio investments that falls into each of the four liquidity 
classification categories outlined above.\586\ This aggregate 
information will be disclosed to the public only for the third month of 
each fiscal quarter with a 60-day delay. While we acknowledge that 
liquidity classification determinations may be to some extent 
subjective and that such information reported on Form N-PORT may be 
non-standardized, we believe that, on balance, our staff, investors, 
and other potential users would benefit from the information that will 
be reported on Form N-PORT that currently may not be reported or 
disclosed by funds. We believe that this greater transparency about 
liquidity at the fund-level will provide our staff, investors, and 
other potential users with a helpful picture of the general liquidity 
characteristics of funds and help them better understand the liquidity 
risks associated with a particular fund. We also believe that this 
information will help investors make more informed investment 
decisions.
---------------------------------------------------------------------------

    \584\ Rather than report the liquidity classification among six 
categories as under the proposal, funds will be required to report 
liquidity classifications among four liquidity categories, which may 
be based on asset type to the extent discussed above. See Item C.7. 
of Form N-PORT. We have modified the numbering convention for items 
within Form N-PORT from the proposal to be consistent with Form N-
PORT as adopted in the Investment Company Reporting Modernization 
Adopting Release.
    \585\ See General Instruction F of Form N-PORT.
    \586\ Item B.8.a. of Form N-PORT. We note that such reporting is 
designed to serve as a snapshot of a fund's liquidity on the last 
business or calendar day of the month. See rule 30b1-9 under the 
Investment Company Act (requiring reporting on Form N-PORT to be 
current as of the last business day, or last calendar day, of the 
month). Accordingly, the aggregate percentage of portfolio 
investments in each of the four liquidity classification categories 
need not reflect pending transactions, but instead should reflect 
the balance of investments in each category on the last business or 
calendar day of the month.
---------------------------------------------------------------------------

    As part of this public disclosure, a fund would publicly disclose 
the percentages of its highly liquid investments that are segregated to 
cover, or pledged to satisfy margin requirements in connection with, 
the fund's derivatives transactions that the fund has classified in the 
moderately liquid, less liquid, and illiquid investments classification 
categories in light of the requirement in rule 22e-4 that the liquidity 
classification cover each of the fund's derivatives transactions, 
discussed above.\587\ This derivatives transactions information will 
also be made public for the third month of each fiscal quarter with a 
60-day delay.
---------------------------------------------------------------------------

    \587\ Item B.8.b. of Form N-PORT. This derivatives transactions 
reporting requirement corresponds to the modification in rule 22e-
4(b)(1)(ii)(C), discussed above.
---------------------------------------------------------------------------

    Most commenters opposed the proposed Form N-PORT reporting 
requirement, and particularly objected to having position-level 
liquidity information reported on Form N-PORT made public.\588\ We 
believe that the additions to Form N-PORT adopted today in this Release 
address many of these concerns. We discuss these additions, the 
comments we received on the proposal, as well as modifications we made 
to the proposal in response to comments, in more detail below.
---------------------------------------------------------------------------

    \588\ See, e.g., Cohen & Steers Comment Letter; NYC Bar Comment 
Letter; SIFMA Comment Letter I; Wellington Comment Letter.
---------------------------------------------------------------------------

a. Reporting Liquidity Classification of Portfolio Investments
    We proposed to require a fund to report on Form N-PORT the 
liquidity classification of each of the fund's positions (or portions 
of a position) in a portfolio asset using the proposed classification 
system of rule 22e-4.\589\ As discussed above, most commenters opposed 
the proposed classification regime, and many offered varied 
classification alternatives for fund liquidity risk management and 
reporting purposes. As discussed previously, we are today adopting a 
liquidity classification requirement under rule 22e-4 based on a 
``days-to-cash'' framework as proposed, but with a number of 
modifications informed by commenter recommendations that we believe 
address many commenters' concerns about the classification process 
itself.
---------------------------------------------------------------------------

    \589\ See Proposing Release, supra footnote 9, at section 
III.G.2.a.
---------------------------------------------------------------------------

    A number of commenters supported reporting liquidity 
classifications to the Commission on Form N-PORT, provided that it was 
not publicly disclosed.\590\ For example, one

[[Page 82194]]

commenter expressed support for reporting position-level liquidity 
classifications to the Commission, noting that the Commission should 
have the data it needs to monitor fund holdings and liquidity 
determinations, examine potential outliers, and, if an unexpected 
market event occurs (e.g., the default of a significant institution), 
quickly assess the potential impact on mutual funds it supervises.\591\ 
Another commenter expressed the belief that the proposed liquidity 
classifications data could be appropriate for Commission oversight 
purposes.\592\
---------------------------------------------------------------------------

    \590\ See, e.g., Dechert Comment Letter; Interactive Data 
Comment Letter; J.P. Morgan Comment Letter; Nuveen Comment Letter. 
Some commenters suggested that the Commission evaluate reported 
classification data for a period of time to determine whether the 
information is appropriate for public disclosure. See BlackRock 
Comment Letter; Fidelity Comment Letter; SIFMA Comment Letter III.
    \591\ See J.P. Morgan Comment Letter.
    \592\ See State Street Comment Letter.
---------------------------------------------------------------------------

    On the other hand, a few commenters objected to reporting liquidity 
classifications, as proposed, even if such information is disclosed 
only to the Commission.\593\ Some commenters stated that there is 
limited utility in the proposed classification information for the 
Commission since the information would be subjective and methodology-
specific, which would lead to results that would preclude comparisons 
across funds, limiting the utility of this information for the 
Commission's monitoring of industry-wide data.\594\ In addition, one 
commenter expressed concerns about the security of sensitive 
information filed with the Commission due to recent high-profile 
cybersecurity breaches both in the governmental and private 
sectors.\595\
---------------------------------------------------------------------------

    \593\ See Federated Comment Letter; Fidelity Comment Letter; 
Invesco Comment Letter; SIFMA Comment Letter I.
    \594\ See, e.g., BlackRock Comment Letter; Fidelity Comment 
Letter; Wellington Comment Letter.
    \595\ See Invesco Comment Letter.
---------------------------------------------------------------------------

    We continue to believe that requiring funds to report the liquidity 
classification of their portfolio investments is vital to our ongoing 
monitoring and oversight efforts. A key goal of the rulemaking is to 
allow us to monitor funds' liquidity profiles (both on a fund-by-fund 
basis and across funds) over time, and respond as appropriate. Absent 
the required reporting on Form N-PORT, our ability to engage in such 
efforts would be limited and less efficient. We believe that the 
changes made to the classification system discussed above should serve 
to mitigate commenters' concerns about the difficulties of making 
comparisons across the industry, in light of the reduced number of 
categories for classification. We recognize that there is still likely 
to be variation between funds in how they classify certain asset 
classes and investments, and believe that despite any variations, this 
liquidity information will be useful and valuable to us. We will be 
able to identify different fund liquidity classification practices, and 
use that information to gain insight into how different funds view 
liquidity in the market, and whether there are any identifiable 
liquidity concerns. We also note that despite any concerns about 
variation of practices across funds limiting comparability, we expect 
that the reported information will allow us to generally monitor 
specific funds' liquidity on a consistent basis across time, and 
identify how their views of the liquidity of their investments change.
    We believe that such information will assist us in better assessing 
liquidity risk in the open-end fund industry, which can inform our 
policy and guidance. We also believe that this information will assist 
us in monitoring for compliance with rule 22e-4 and identifying 
potential outliers in fund liquidity classifications for further 
inquiry, as appropriate. We recognize that liquidity classifications, 
similar to valuation- and pricing-related matters, inherently involve 
judgment and estimations by funds. We also understand that the 
liquidity classification of an asset class or investments may vary 
across funds depending on the facts and circumstances relating to the 
funds and their trading practices.\596\ We do not believe that data 
based on estimations of market conditions on a fund-by-fund basis is 
uninformative or of limited utility because of the information's 
sometimes fund-specific, subjective nature.\597\ Rather, we believe 
that even with potential variances in determinations, the liquidity 
information reported will be informative to the Commission. 
Furthermore, we believe that members of the fund industry are generally 
in the best position to provide current information on the conditions 
of fund liquidity since they are in the markets every day trading 
securities and observe how markets are evolving and related liquidity 
characteristics are changing.
---------------------------------------------------------------------------

    \596\ See, e.g., Comment Letter of the Investment Company 
Institute on Investment Company Reporting Modernization Release 
(Aug. 11, 2015) (``These [liquidity] judgments may differ among 
personnel and certainly among fund complexes.''); Comment Letter of 
Invesco Advisers, Inc. on Investment Company Reporting Modernization 
Release (Aug. 11, 2015) (``Invesco and other fund complexes could 
reasonably differ in their assessments of the liquidity of a 
particular security, even though both complexes have a sound method 
for determining liquidity and follow their own reasonable 
procedures.'').
    \597\ See supra footnote 594 and accompanying text.
---------------------------------------------------------------------------

    In sum, we believe that the modified reporting requirements on Form 
N-PORT will provide the Commission with meaningful data concerning the 
liquidity of portfolio investments across the fund industry and at the 
same time lessen burdens on funds classifying and reporting liquidity 
information (compared to the proposal). Accordingly, we are adopting 
the requirement for funds to report the liquidity classification of 
their portfolio investments to the Commission.
b. Non-Public Disclosure of Liquidity Classification Information 
Reported on Form N-PORT
    We proposed that liquidity classification information reported on 
Form N-PORT at the portfolio position level be disclosed to the public 
for the third month of each fiscal quarter with a 60-day delay. One 
commenter expressed general support for regulatory initiatives aimed at 
improving transparency.\598\ Several commenters expressed support for 
public disclosure of liquidity information if the framework for 
classification was modified from the proposed six-category liquidity 
classification framework to alternative frameworks proposed by 
commenters that generally measured the liquidity of portfolio positions 
based on asset type and included less classification categories.\599\
---------------------------------------------------------------------------

    \598\ See Interactive Data Comment Letter.
    \599\ See, e.g., Charles Schwab Comment Letter; FSR Comment 
Letter; Nuveen Comment Letter; Vanguard Comment Letter.
---------------------------------------------------------------------------

    On the other hand, most commenters opposed the proposed public 
disclosure of the liquidity classification. Some commenters expressed 
concerns that the value to the public of the position-level liquidity 
classification information on Form N-PORT, as proposed, would be 
limited.\600\ Many other commenters expressed concerns that the public 
disclosure of the position-level liquidity classification information 
could be potentially misleading to investors for various reasons. For 
example, many commenters contended that, while the position-by-position 
information reported would be subjective, the numeric days-to-
settlement presentation proposed on Form N-PORT could imply a false 
sense of precision of the data to

[[Page 82195]]

fund investors.\601\ Many of these commenters also argued that 
providing subjective, position-level liquidity classification 
information to the public could potentially result in misleading 
comparisons across funds,\602\ with some commenters noting that such 
comparisons could disadvantage certain funds over others.\603\ While 
reports on Form N-PORT would be submitted to the Commission within 30 
days after month end, some commenters voiced concerns that the 
liquidity data presented on Form N-PORT would be stale for the public 
given that the reports, as proposed, would be available every third 
month of a fund's fiscal quarter with a 60-day delay, adding to the 
risk of misleading investors about the real-time state of a portfolio's 
liquidity.\604\
---------------------------------------------------------------------------

    \600\ See, e.g., Better Markets Comment Letter (expressing 
concerns that the proposal's three-day liquid asset minimum and 15% 
standard assets are determined by the fund and that the liquidity 
classifications reported on Form N-PORT would be stale information 
for the public); Morningstar Comment Letter (also stating concerns 
that the information available to the public under the proposal 
would be stale and expressing the belief that investors could find 
it difficult to compare the liquidity characteristics of portfolios 
from different funds).
    \601\ See, e.g., Dechert Comment Letter; Eaton Vance Comment 
Letter I; Federated Comment Letter; LSTA Comment Letter; Morningstar 
Comment Letter.
    \602\ See, e.g., BlackRock Comment Letter; IDC Comment Letter; 
J.P. Morgan Comment Letter; Voya Comment Letter.
    \603\ See, e.g., BlackRock Comment Letter; IDC Comment Letter; 
ICI Comment Letter I; Wellington Comment Letter.
    \604\ See, e.g., FSR Comment Letter; LSTA Comment Letter; 
Morningstar Comment Letter (noting that given public disclosure on 
N-PORT would be provided infrequently, the information might well be 
very out of date when an investor reviews it, thereby providing 
little benefit to investors); NYC Bar Comment Letter.
---------------------------------------------------------------------------

    Many commenters also expressed concerns that public disclosure of 
the proposed position-level liquidity classification information would 
ultimately harm fund shareholders and the fund market for a variety of 
reasons. Some commenters argued that public reporting would facilitate 
predatory trading practices, particularly during periods of liquidity 
stress, ultimately harming fund investors.\605\ Commenters expressed 
the belief that public reporting of liquidity classifications at the 
position-level exacerbates these concerns, noting, for example, that in 
the event a fund experiences a liquidity issue, public information 
about its portfolio-level liquidity classifications may expose the fund 
to predatory trading.\606\ In addition, several commenters expressed 
concern that public reporting of position-level liquidity 
classifications could be harmful to the fund market, arguing that such 
reporting would incentivize homogenized liquidity determinations and 
comparative liquidity ``ratings'' from third-party service 
providers,\607\ as well as ``window dressing'' at period ends prior to 
disclosure, increasing the potential for systemic risks in the fund 
industry. \608\ Other commenters suggested that the Commission evaluate 
reported classification data for a period of time to determine whether 
the information is appropriate for public disclosure.\609\
---------------------------------------------------------------------------

    \605\ See BlackRock Comment Letter (stating that publicly 
available position-level data exacerbated Third Avenue's troubles as 
other market participants knew of the holdings of the Focused Credit 
Fund and used that information to the detriment of the fund). See 
also e.g., Federated Comment Letter; ICI Comment Letter I; SIFMA 
Comment Letter I; Voya Comment Letter.
    \606\ See, e.g., SIFMA Comment Letter I.
    \607\ See, e.g., Charles Schwab Comment Letter; Wellington 
Comment Letter; Comment Letter of Wellington Management Company LLP 
(June 10, 2016) (``Wellington Comment Letter II''); Wells Fargo 
Comment Letter.
    \608\ See, e.g., Dechert Comment Letter; LSTA Comment Letter; 
NYC Bar Comment Letter; Oppenheimer Comment Letter.
    \609\ See, e.g., BlackRock Comment Letter; Fidelity Comment 
Letter; SIFMA Comment Letter I.
---------------------------------------------------------------------------

    While many of these commenters objected to the proposed position-
level public disclosure of liquidity classifications, several 
commenters did not object to making more aggregated portfolio-level 
disclosure of liquidity data available to the public.\610\ These 
commenters suggested that, while position-level liquidity data may pose 
concerns as discussed above, providing the public a portfolio-level 
``roll up'' of the liquidity levels of the fund may provide useful data 
and would be unlikely to raise the same kind of issues.\611\
---------------------------------------------------------------------------

    \610\ See, e.g., Nuveen Comment Letter; T. Rowe Comment Letter.
    \611\ See, e.g., Nuveen Comment Letter; T. Rowe Comment Letter.
---------------------------------------------------------------------------

    We recognize that the level of position-level detail necessary for 
the Commission and our staff to effectively monitor fund liquidity may 
not be necessary for other users. We understand that some data 
collectors would prefer to use information reported on Form N-PORT 
proposed under the Investment Company Reporting Modernization proposal 
(which we are adopting concurrently), such as monthly portfolio 
holdings data, rather than the classification information proposed in 
the liquidity proposal.\612\ Furthermore, we understand that for many 
investors, the proposed specific position-level liquidity data would be 
likely unnecessarily detailed, and that aggregated or ``rolled up'' 
portfolio-level information about fund liquidity may be more easily 
understandable and usable. As discussed below, such aggregated 
information will likely result in more user friendly and digestible 
portrayals of fund liquidity, and at the same time we expect will avoid 
many of the potential harms suggested by commenters that might result 
from position-level disclosure to the public. Such a layered reporting 
and disclosure regime should allow the Commission and investors each to 
access the liquidity information likely most useful for their purposes.
---------------------------------------------------------------------------

    \612\ See Morningstar Comment Letter.
---------------------------------------------------------------------------

    We also appreciate the limitations and subjectivity of the 
liquidity classification process, and thus understand the risks of 
investors potentially giving too much weight to a fund manager's 
individual liquidity classification choices. The classification of 
portfolio investments at the position-level under the days-to-cash 
framework involves a number of assumptions and methodologies that could 
result in classifications that vary from fund to fund. As a result, the 
liquidity classification information reported for the same or similar 
asset classes and investments could vary because of complex differences 
in methodologies and assumptions that may not be reported on Form N-
PORT nor easily explained to investors but would be available to the 
Commission in inspections.\613\
---------------------------------------------------------------------------

    \613\ A fund has the option of providing explanatory notes 
related to its filing to explain any of its methodologies, including 
related assumptions, in Part E of Form N-PORT. See Instruction G to 
Form N-PORT.
---------------------------------------------------------------------------

    We appreciate the concerns raised by commenters that reporting 
publicly position-level data could imply a false sense of precision 
about the liquidity profile of a fund and that, given the delay in the 
public reporting of portfolio-level classification information (60 days 
after quarter-end), the position-level information will likely be out 
of date when reviewed by investors. While we can take these potential 
variances in liquidity classifications of assets into account in 
evaluating and using the data for the Commission's purposes in 
observing potential trends in liquidity profiles across the fund 
industry, it may be more difficult to explain them to investors. 
Furthermore, the Commission would receive portfolio-level 
classification information within 30 days of month-end, thereby 
increasing the utility of the classification information for Commission 
purposes. We expect that providing only aggregated liquidity 
classification information on the funds' portfolio assets publicly may 
mitigate some of these concerns. This level of detail should 
appropriately focus investors on the fund's general liquidity profile 
and general trends in fund liquidity rather than individual security-
level liquidity decisions, in light of the concerns discussed above.
    Some commenters also raised concerns that public reporting of

[[Page 82196]]

liquidity classifications at the position level could potentially 
expose investors to harm, including, for example, potentially exposing 
a fund to predatory trading, particularly during periods of liquidity 
stress.\614\ We believe, however, that the aggregated public disclosure 
on Form N-PORT once each quarter with a 60-day lag would alleviate 
these predatory trading concerns given that those engaged in predatory 
trading would not have information about a fund's own assessment of its 
liquidity characteristics in real-time and would not have the detailed 
position-level information in real time necessary to pursue such 
strategies.
---------------------------------------------------------------------------

    \614\ See, e.g., ICI Comment Letter; Cohen and Steers Comment 
Letter; Dechert Comment Letter; Nuveen Comment Letter.
---------------------------------------------------------------------------

    For these reasons, we find that it is neither necessary nor 
appropriate in the public interest or for the protection of investors 
to make liquidity classification information for each portfolio 
investment publicly available.\615\ We also are adopting amendments to 
Form N-PORT to require a fund to publicly disclose the aggregated 
percentage of its portfolio assets representing each of the four 
classification categories outlined in Form N-PORT and related rule 22e-
4,\616\ as discussed in more detail below. We believe that providing 
liquidity classification data attributable to each portfolio investment 
to the Commission and fund-level data to investors is an efficient 
approach to present liquidity information in a manner that both 
satisfies the Commission's need for position-level liquidity data for 
its regulatory oversight purposes and provides useful fund liquidity 
information to investors.
---------------------------------------------------------------------------

    \615\ See section 45(a) of the Investment Company Act, which 
requires information in investment company forms to be made 
available to the public, unless we find that public disclosure is 
neither necessary nor appropriate in the public interest or for the 
protection of investors. See also General Instruction F of Form N-
PORT.
    \616\ See Item B.8. of Form N-PORT.
---------------------------------------------------------------------------

    In addition, the Commission recognizes the importance of sound data 
security practices and protocols for non-public information, including 
information that may be competitively sensitive. The Commission has 
substantial experience with storage and use of non-public information 
reported on Form PF and delayed public disclosure of information on 
Form N-MFP (although the Commission no longer delays public disclosure 
of reports on Form N-MFP), as well as other non-public information that 
the Commission handles in its ordinary course of business. Commission 
staff is carefully evaluating the data security protocols that will 
apply to non-public data reported on Form N-PORT in light of the 
specific recommendations and concerns raised by commenters. Drawing on 
its experience, the staff is working to design controls and systems for 
the use and handling of Form N-PORT data in a manner that reflects the 
sensitivity of the data and is consistent with the maintenance of its 
confidentiality.\617\ In advance of the compliance date, we expect that 
the staff will have reviewed the controls and systems in place for the 
use and handling of non-public information reported on Form N-PORT.
---------------------------------------------------------------------------

    \617\ See Reporting by Investment Advisers to Private Funds and 
Certain Commodity Pool Operators and Commodity Trading Advisors on 
Form PF, Investment Advisers Act Release No. 3308 (Oct. 31, 2011) 
[76 FR 71228 (Nov. 16, 2011)]. We recognize that there are 
differences between the N-PORT reporting requirements and the Form 
PF reporting requirements, such as frequency, granularity, and 
registration status, and our recognition of these differences guides 
our evaluation of appropriate measures for preservation of data 
security for reported information.
---------------------------------------------------------------------------

c. Public Fund-Level Aggregate Liquidity Profile Reporting
    As previously discussed, we are adopting, with modifications, the 
proposed requirement that funds report to the Commission on a non-
public basis the liquidity classification assigned to each portfolio 
position on Form N-PORT. Some commenters expressed concerns that the 
value to the public of the position-level liquidity classification 
information on Form N-PORT, as proposed, would be limited.\618\ Other 
commenters recommended that, as an alternative to the proposal, the 
Commission make available to the public a general assessment of the 
liquidity of the portfolio at the fund level, rather than the 
individual security level,\619\ with more detailed information, 
including the fund's assessment of the liquidity of each asset at the 
individual security level, provided to the Commission but kept 
confidential.\620\
---------------------------------------------------------------------------

    \618\ See, e.g., Better Markets Comment Letter; Morningstar 
Comment Letter.
    \619\ See, e.g., Dechert Comment Letter; Federated Comment 
Letter; LSTA Comment Letter; NYC Bar Comment Letter.
    \620\ See, e.g., SIFMA Comment Letter I; Charles Schwab Comment 
Letter.
---------------------------------------------------------------------------

    We appreciate these comments and recognize that position-level 
liquidity classification data, while valuable for Commission purposes, 
may be of limited use for everyday investors. We find persuasive 
commenters' recommendations to provide the public with a general 
assessment of the liquidity of a portfolio at the fund level as an 
approach to provide everyday investors useful information on fund 
liquidity. As a result, we are adopting amendments to Form N-PORT to 
require a fund to publicly report for the third month of each fiscal 
quarter with a 60-day delay the aggregate percentage of its portfolio 
representing each of the four classification categories outlined in 
Form N-PORT and related rule 22e-4.\621\ For purposes of this reporting 
item, a fund would report the aggregate percentage of investments that 
are assets in each liquidity category compared to total portfolio 
investments that are assets (not including liabilities) of the 
fund.\622\
---------------------------------------------------------------------------

    \621\ See Item B.8.a. of Form N-PORT.
    \622\ See id.
---------------------------------------------------------------------------

    In order to avoid misleading investors about the actual 
availability of highly liquid investments to meet redemptions, a fund 
also will be required to publicly report on Form N-PORT the percentage 
of its highly liquid investments that it has segregated to cover, or 
pledged to satisfy margin requirements in connection with, derivatives 
transactions that are classified as moderately liquid, less liquid, or 
illiquid investments.\623\ As discussed above, we proposed to require a 
fund to consider the relationship of an asset to another portfolio 
asset in classifying the liquidity of its portfolio assets reported on 
Form N-PORT and to consider guidance that a fund should classify the 
liquidity of assets segregated to cover derivatives obligations using 
the liquidity of the derivative instruments such assets are 
covering.\624\ One commenter suggested that the Commission add an item 
to the Schedule of Portfolio Investments on Form N-PORT that permits a 
fund to note whether an asset (or portion thereof) is encumbered or 
linked to other assets as of the reporting date.\625\ Another commenter 
suggested that the Commission require funds to assign liquidity 
classifications to cover assets on an aggregate portfolio basis in 
amounts corresponding to the aggregate amount of derivatives exposure 
in each liquidity category.\626\
---------------------------------------------------------------------------

    \623\ See Item B.8.b. of Form N-PORT; see also supra section 
III.C.3.c.
    \624\ See Proposing Release, supra footnote 9, at section 
III.B.2; see also supra section III.C.3.c.
    \625\ See ICI Comment Letter I; see also supra section 
III.C.3.c.
    \626\ See Dechert Comment Letter; see also supra section 
III.C.3.c.
---------------------------------------------------------------------------

    In consideration of the commenters' recommendations, we believe 
that our modification to the proposal to require a fund to report 
publicly the percentage of the fund's highly liquid investments that 
are segregated to cover, or pledged to satisfy margin requirements in 
connection with, the fund's derivatives

[[Page 82197]]

transactions that are classified in each liquidity category strikes an 
appropriate balance between providing investors with useful information 
about the impact of derivatives coverage obligations on the percentage 
of a fund's highly liquid investments and lessening operational burdens 
associated with classifying investments. Since the public will only 
receive asset liquidity classification information on an aggregate 
level and only the Commission will receive liquidity classifications on 
an investment-by-investment basis, we believe that the suggested 
alternative to add an item to the Schedule of Portfolio Investments on 
Form N-PORT linking an asset encumbered to other assets in connection 
with derivatives transactions would not be a helpful means to inform 
investors about the connection between derivatives obligations and the 
availability of highly liquid investments to meet redemptions. We 
believe that without public reporting of the percentage of a fund's 
highly liquid investments that are segregated to cover, or pledged to 
satisfy margin requirements in connection with, a fund's derivatives 
transactions that are not themselves highly liquid investments, the 
reported percentage of a fund's highly liquid investments could be 
potentially misleading to investors if a portion of highly liquid 
investments are not available to meet redemptions due to derivatives 
transactions obligations.
    Overall, we continue to believe that investors currently have 
limited information about the liquidity of fund investments and would 
benefit from enhanced information to evaluate funds and assess the 
potential for returns and risks of a particular fund. We expect that 
many investors will use liquidity reporting information to better 
understand the liquidity risks associated with a particular fund for 
purposes of making more informed investment decisions and will benefit 
from aggregate information about a fund's overall liquidity. Moreover, 
we believe that requiring a fund to publicly disclose only the 
aggregate percentage of its portfolio assets representing each of the 
four classification categories balances commenters' concerns about 
certain adverse effects that could arise from public reporting of 
detailed portfolio liquidity information with investors' need for 
improved information about funds' liquidity risk profiles.
d. Illiquid Investments
    As discussed above, rule 22e-4, as adopted, combines a fund's 
illiquid investment determinations with the general liquidity 
classification framework reported on Form N-PORT.\627\ In the Proposing 
Release, in connection with the codification of the 15% guideline that 
an open-end fund may not invest in the aggregate more than 15% of its 
net assets in ``illiquid securities,'' we proposed to require funds to 
report on Form N-PORT whether each portfolio asset is a ``15% standard 
asset,'' as defined under the proposal,\628\ in addition to reporting 
the liquidity of each of the fund's positions (or portions of a 
position) in a portfolio asset using six proposed categories.\629\ One 
commenter opposed requiring reporting of the 15% standard asset at the 
individual portfolio asset level, raising concerns that public 
disclosure could have adverse effects on funds.\630\ Another commenter 
opposed reporting of the 15% standard asset at the individual portfolio 
asset level if publicly disclosed in addition to the proposed six 
liquidity classification categories, stating that the distinction 
between the two pieces of data would make sense to industry experts but 
would be confusing and potentially misleading to typical 
investors.\631\
---------------------------------------------------------------------------

    \627\ See supra section III.C.2.d.
    \628\ See Proposing Release, supra footnote 9, at section 
III.G.2.b.
    \629\ See Proposing Release, supra footnote 9, at section 
III.G.2.a.
    \630\ See Cohen & Steers Comment Letter.
    \631\ See Federated Comment Letter.
---------------------------------------------------------------------------

    After considering these comments, we agree that presenting to the 
public liquidity classification information and the 15% standard asset 
designation separately could potentially confuse investors. As 
discussed in more detail in section III.C previously, we believe that 
it is more appropriate to harmonize the rule 22e-4 limit on illiquid 
investments, referred to as 15% standard assets under the proposal, 
with the rule's broader liquidity classification requirement by 
incorporating an illiquid investment category into the classification 
requirement. Likewise, we believe that this harmonization should be 
reflected in reports on Form N-PORT. Thus, we are adopting, modified 
from the proposal, an illiquid investment category into Form N-PORT 
that corresponds with rule 22e-4's broader classification 
requirement.\632\ By doing this, a fund's exposure to illiquid 
investments may be viewed as part of the fund's overall liquidity 
profile in a more clear and concise manner. Furthermore, we are 
persuaded by some of the concerns raised by commenters regarding the 
unintended adverse effects that public disclosure of illiquid 
investment information on the portfolio position level could have on 
funds and fund investors. As adopted, liquidity classification 
information reported on the portfolio position level will be non-public 
on Form N-PORT, as discussed in more detail above.
---------------------------------------------------------------------------

    \632\ See Item C.7. of Form N-PORT.
---------------------------------------------------------------------------

    We expect to use this information to monitor fund compliance with 
the prohibition of acquiring illiquid investments if the fund would 
have invested more than 15% of its net assets in illiquid investments 
that are assets and analyze liquidity trends in the fund industry. 
Overall, we believe that maintaining this information on illiquid 
investments as part of the liquidity classification information 
reported on Form N-PORT will provide the Commission with meaningful 
data, including information regarding exposure to illiquid investments 
across the fund industry.

D. Highly Liquid Investment Minimum

    Today we are adopting a requirement that each fund determine its 
``highly liquid investment minimum,'' or the minimum amount of the 
fund's net assets that the fund invests in highly liquid investments 
that are assets.\633\ In determining its highly liquid investment 
minimum, a fund will be required to consider the factors the fund also 
has to consider, as applicable, in assessing its liquidity risk under 
rule 22e-4.\634\ Additionally, in determining whether a fund is meeting 
its highly liquid investment minimum, the fund will look only to its 
investments that are assets of the fund.\635\ Rule 22e-4 as adopted 
today also requires a fund to adopt and implement policies and 
procedures for responding to a shortfall in a fund's highly liquid 
investments below its highly liquid investment minimum.\636\ These 
policies and procedures must include reporting to the fund's board of 
directors, no later than the board's next regularly scheduled meeting, 
regarding any shortfall of the fund's highly liquid investments 
compared to its minimum. A fund is required to report to its board

[[Page 82198]]

within one business day, and submit a non-public report to the 
Commission, if its highly liquid investment minimum shortfall lasts 
more than seven consecutive calendar days.\637\ A fund's board of 
directors is not normally required to specifically approve the fund's 
highly liquid investment minimum, although during a time that a fund's 
highly liquid investments are below the fund's determined minimum 
level, a fund's highly liquid investment minimum can be changed only 
with board approval.\638\ Additionally, a discussion of the fund's 
minimum must be included in the written annual report to the board on 
the adequacy and effectiveness of the fund's liquidity risk management 
program. Funds whose portfolio assets consist primarily of highly 
liquid investments, as well as In-Kind ETFs, are not subject to the 
highly liquid investment minimum requirement.\639\
---------------------------------------------------------------------------

    \633\ Rule 22e-4(a)(7). Rule 22e-4(a)(7) refers to highly liquid 
investments that are ``assets'' to make clear that when evaluating 
whether a fund is meeting its highly liquid investment minimum, the 
fund should look to its investments with positive values. Highly 
liquid investments that have negative values should not be netted 
against highly liquid investments that have positive values when 
calculating whether the fund is meeting its highly liquid investment 
minimum. Thus, only highly liquid investments that have positive 
values (i.e., ``assets'') should be used in the numerator. Cf. infra 
footnote 744 (discussing the use of the term ``assets'' in the 15% 
limit on illiquid investments).
    \634\ Rule 22e-4(b)(1)(iii)(A)(1).
    \635\ Rule 22e-4(a)(7).
    \636\ Rule 22e-4(b)(1)(iii)(A)(3).
    \637\ Id. See also Item D.1 of new Form N-LIQUID.
    \638\ Rule 22e-4(b)(1)(iii)(A)(1).
    \639\ Rule 22e-4(b)(1)(iii)(A); see also rule 22e-4(a)(5) 
(excluding money market funds and In-Kind ETFs from the definition 
of ``fund'').
---------------------------------------------------------------------------

    As described in more detail below, this requirement is a 
modification of the proposed ``three-day liquid asset minimum,'' which 
also would have required a fund to determine the percentage of the 
fund's net assets to be invested in relatively liquid assets (under the 
proposal, ``three-day liquid assets,'' or cash and any asset 
convertible to cash within three business days at a price that does not 
materially affect the value of that asset immediately prior to 
sale).\640\ In determining its three-day liquid asset minimum, the 
proposed rule would have required a fund to consider the factors the 
fund would have to consider, as applicable, in assessing its liquidity 
risk under rule 22e-4.\641\ Under the proposal, a fund would have been 
prohibited from acquiring any asset other than a three-day liquid asset 
if, after acquisition, the fund would hold fewer three-day liquid 
assets than the percentage specified under its three-day liquid asset 
minimum.\642\ Also under the proposal, a fund's board would have had to 
approve the fund's three-day liquid asset minimum and any changes 
thereto.\643\
---------------------------------------------------------------------------

    \640\ Proposed rule 22e-4(a)(8); proposed rule 22e-
4(b)(2)(iv)(A)-(C).
    \641\ Proposed rule 22e-4(b)(2)(iv)(A).
    \642\ Proposed rule 22e-4(b)(2)(iv)(C).
    \643\ Proposed rule 22e-4(b)(3)(i).
---------------------------------------------------------------------------

    The goal of the proposed three-day liquid asset minimum requirement 
was to increase the likelihood that a fund would hold adequate liquid 
assets to meet redemption requests without materially affecting the 
fund's NAV.\644\ The proposed three-day liquid asset minimum also was 
intended to be structured in a way that would foster consistency in 
funds' consideration of relevant liquidity risk factors, while 
permitting flexibility in implementing this liquidity risk management 
tool as appropriate given the diverse range of funds it would 
cover.\645\ It was intended to work together with other aspects of the 
proposed liquidity risk management program designed to help ensure that 
while funds would consider the spectrum of liquidity in their 
portfolios (in part through the proposed classification requirement), 
they would pay particular attention to the most liquid and least liquid 
ends of this spectrum.\646\
---------------------------------------------------------------------------

    \644\ See Proposing Release, supra footnote 9, at section 
III.C.3.
    \645\ Id.
    \646\ See id., at sections III.B.1, III.C and III.C.3.
---------------------------------------------------------------------------

    Many commenters agreed that a requirement for a fund to determine a 
minimum--or, per some commenters' suggestions, a target--amount of 
relatively liquid assets would assist funds in effectively meeting 
redemption requests under a variety of market conditions.\647\ Some, on 
the other hand, suggested that a minimum or target requirement would 
not necessarily enhance a fund's ability to meet shareholder 
redemptions because the amount of liquid assets a fund may need is 
dynamic and unpredictable, and in extraordinary stressed market 
conditions no particular amount of liquid assets may end up being 
sufficient to meet redemptions.\648\ Commenters also objected to the 
structure of the proposed minimum requirement, particularly the fact 
that the requirement would not permit a fund to acquire relatively less 
liquid assets if the fund were to fall below its minimum, arguing that 
the requirement could actually increase shareholder redemptions during 
times of stress.\649\ In addition, commenters expressed concerns that 
the proposed requirement could prevent funds from meeting their 
principal investment strategies \650\ and that it could effectively 
prevent funds from holding or acquiring favorable, but relatively less 
liquid, assets under certain circumstances, which could intensify 
market stress as well as adversely affect a fund's NAV.\651\ Finally, 
some commenters expressed concerns about the potential operational 
burdens associated with the proposed three-day liquid asset minimum 
requirement.\652\
---------------------------------------------------------------------------

    \647\ See, e.g., AFR Comment Letter; Charles Schwab Comment 
Letter; CRMC Comment Letter; Wells Fargo Comment Letter.
    \648\ See, e.g., Dechert Comment Letter; HSBC Comment Letter; 
Invesco Comment Letter; MFS Comment Letter.
    \649\ See, e.g., BlackRock Comment Letter; SIFMA Comment Letter 
I.
    \650\ See, e.g., Invesco Comment Letter; Oppenheimer Comment 
Letter; Cohen & Steers Comment Letter; ICI Comment Letter I.
    \651\ See, e.g., BlackRock Comment Letter; Credit Suisse Comment 
Letter; ICI Comment Letter I; NYC Bar Comment Letter.
    \652\ See, e.g., Federated Comment Letter; ICI Comment Letter I.
---------------------------------------------------------------------------

    Some commenters also suggested alternatives to the proposed three-
day liquid asset minimum. As discussed further below, a number of 
commenters suggested requiring funds to maintain a ``target'' or 
threshold amount of certain liquid assets.\653\ Other commenters 
suggested requiring funds to consider whether to maintain a target 
amount of liquid assets \654\ or to adopt policies and procedures to 
address shareholder redemptions, which could include targets or 
ranges.\655\ As discussed below, we believe the highly liquid 
investment minimum requirement we are adopting strikes an appropriate 
balance in promoting the benefits intended by the proposed three-day 
liquid asset minimum requirement, including consistency in funds' 
consideration of certain factors relevant to their liquidity risk 
management procedures, while at the same time lessening the likelihood 
of certain adverse consequences identified by commenters.
---------------------------------------------------------------------------

    \653\ See, e.g., Invesco Comment Letter (suggesting that funds 
be required to maintain a ``target'' range of three-day and/or 
seven-day liquid assets); PIMCO Comment Letter (suggesting that a 
minimum cash target could be established by the investment manager); 
BlackRock Comment Letter (suggesting that funds could be required to 
take several steps to ensure an appropriate level of Tier 1 and Tier 
2 assets, which could be articulated as a range or target); Credit 
Suisse Comment Letter.
    \654\ See, e.g., SIFMA Comment Letter I; Oppenheimer Comment 
Letter.
    \655\ See, e.g., Dechert Comment Letter; IDC Comment Letter.
---------------------------------------------------------------------------

1. Anticipated Benefits of Highly Liquid Investment Minimum
    Like the proposed three-day liquid asset requirement, we believe 
that the highly liquid investment minimum requirement will increase the 
likelihood that a fund would be prepared to meet redemption requests 
without significant dilution of remaining investors' interests in the 
fund. Some commenters noted that it is common for funds to assess how 
much liquidity they may need under various market conditions in order 
to meet redemptions over a relatively short time horizon and suggested 
that targeting a certain level of relatively liquid assets is an 
appropriate way for a fund to manage its liquidity

[[Page 82199]]

risk.\656\ To the extent that a fund already aims to invest a specified 
portion of its portfolio in relatively liquid assets, we anticipate 
that such funds may already be substantially in compliance with the 
highly liquid investment minimum requirement we are adopting today. 
More importantly, it would require those funds that do not currently 
consider what an appropriate baseline level of liquidity might be to do 
so.
---------------------------------------------------------------------------

    \656\ See, e.g., supra footnote 653.
---------------------------------------------------------------------------

    As with the proposal, we believe that the final highly liquid 
investment minimum requirement will help encourage consistency in 
funds' consideration of certain factors relevant to their liquidity 
risk management procedures. This is an important benefit compared to 
some commenters' suggestions that funds simply be required to have 
policies and procedures to address shareholder redemptions (which could 
include liquid asset minimums or targets), but not to specify any 
particular procedures within this general requirement.\657\ As with the 
proposal, we believe that the approach we are adopting appropriately 
encourages regularity and thoroughness in funds' consideration of 
certain risk factors, while at the same time promoting flexibility in 
funds' management of this risk. Under rule 22e-4 as adopted, a fund 
will be able to determine its own highly liquid investment minimum, as 
well as (within a fairly broad range) the assets it will hold to 
satisfy its minimum.\658\ We believe that the requirement we are 
adopting provides important additional flexibility to funds' liquidity 
risk management practices in that a fund will be required to adopt 
policies and procedures, but would be permitted to design them as 
appropriate to respond to shortfalls in highly liquid investments 
relative to the fund's minimum.
---------------------------------------------------------------------------

    \657\ See supra footnote 655; see also infra section IV 
(discussing other reasonable alternatives to the highly liquid 
investment minimum requirement).
    \658\ See rule 22e-4(b)(1)(iii)(A)(1).
---------------------------------------------------------------------------

    As noted above, some commenters suggested that a minimum 
requirement would not necessarily enhance funds' ability to meet 
shareholder redemptions. We agree that the highly liquid investment 
minimum requirement we are adopting, standing alone, may not be a 
sufficient safeguard for funds to manage liquidity risk under all 
market conditions. However, we believe that, together with the rest of 
the liquidity risk management program requirements we are adopting, it 
is a central tool to help put a fund in a solid position to meet 
redemption requests without significant dilution of remaining 
investors' interests. The highly liquid investment minimum requirement, 
together with the classification requirement and the 15% limitation on 
a fund's investments in illiquid investments that are assets, is meant 
to be a primary component of a fund's overall approach to liquidity 
risk management. While the classification requirement would illustrate 
the spectrum of a fund's portfolio liquidity, the highly liquid 
investment minimum requirement and the 15% limitation on illiquid 
investments would focus the fund's attention on each end of that 
liquidity spectrum--the fund's most liquid and least liquid 
investments, respectively.
    Based on a fund's liquidity risk assessment, the fund could 
determine what additional liquidity risk management tools, if any, 
together with the highly liquid investment minimum requirement and the 
15% limitation on illiquid investments, would best permit the fund to 
meet redemptions and help prevent significant investor dilution. We 
also believe that the highly liquid investment minimum requirement will 
be a useful liquidity risk management tool because we understand, based 
on staff outreach and comments that we received on the proposal, that 
the requirement we are adopting is similar to liquidity risk management 
strategies that many funds currently use.\659\
---------------------------------------------------------------------------

    \659\ See supra footnote 656 and accompanying text.
---------------------------------------------------------------------------

    While certain commenters expressed concern that the proposed three-
day liquid asset minimum requirement could unduly encourage funds to 
use only their most liquid assets in meeting redemptions (which 
commenters argued could lead to additional redemptions from funds in 
stressed periods),\660\ we note that the minimum requirement--both as 
proposed and as adopted--was never meant to suggest that a fund should 
only, or primarily, use its most liquid investments to meet shareholder 
redemptions.\661\ Nor is it meant, as commenters argued, to suggest 
that funds should hold cash-like buffers that investors may 
inappropriately assume will eliminate funds' liquidity risk.\662\ 
Indeed, we noted in the Proposing Release that assets eligible for 
inclusion in a fund's three-day liquid asset minimum holdings could 
include a broad variety of securities, as well as cash and cash 
equivalents.\663\ Moreover, because the final highly liquid investment 
minimum requirement would not prohibit a fund from acquiring 
investments other than highly liquid investments if a fund were to fall 
below its minimum, we believe that the final requirement may convey 
more effectively than the proposal that a fund is not guaranteed to 
hold a certain level of cash or highly liquid investments at all times.
---------------------------------------------------------------------------

    \660\ See, e.g., BlackRock Comment Letter.
    \661\ See, e.g., Proposing Release, supra footnote 9, at section 
II.B.2 (discussing how funds may choose to sell assets in ``strips'' 
or in a range of liquidity).
    \662\ See, e.g., CFA Comment Letter.
    \663\ See Proposing Release, supra footnote 9, at paragraph 
following n.343.
---------------------------------------------------------------------------

    As with the proposed three-day liquid asset minimum requirement, we 
believe an important feature of the highly liquid investment minimum 
requirement we are adopting is the flexibility it provides for a fund 
to determine an appropriate highly liquid investment minimum 
considering its particular risk factors, as well as (within a fairly 
broad range) the assets it will hold to satisfy its minimum. We 
acknowledge that, for certain funds that currently have relatively less 
liquid portfolios, the highly liquid investment minimum requirement 
could cause a fund to modify its investment strategy if, after 
consideration of the required factors, the fund were to determine it is 
appropriate to invest in higher amounts of highly liquid investments. 
In these circumstances, we believe such a modification would be 
appropriate. We discuss the costs associated with any modifications to 
funds' investment strategies that could result from the final highly 
liquid investment minimum requirement in the Economic Analysis section 
below.
2. Consideration of Liquidity Risk Factors
    Rule 22e-4 requires a fund to consider the liquidity risk factors 
set forth in the rule, as applicable, in determining its highly liquid 
investment minimum.\664\ Under the proposed rule, a fund likewise would 
have been required to consider the proposed rule's liquidity risk 
assessment factors in determining its three-day liquid asset 
minimum.\665\ Several commenters suggested that these factors should be 
guidance that funds may consider in setting a minimum or target for 
relatively liquid assets, but should not be mandatory considerations a 
fund would be required to assess.\666\ Commenters also objected to the 
requirement that funds determine their three-day liquid asset minimum 
based

[[Page 82200]]

on liquidity risk under both normal and reasonably foreseeable stressed 
conditions, arguing that this requirement would result in funds being 
forced to maintain artificially high levels of three-day liquid 
assets.\667\ Some commenters also discussed more granular objections to 
certain of the proposed factors to be used in determining a fund's 
three-day liquid asset minimum, such as certain aspects of the proposed 
requirements to consider a fund's shareholder concentration \668\ and 
borrowing arrangements.\669\
---------------------------------------------------------------------------

    \664\ Rule 22e-4(b)(1)(iii)(A)(1).
    \665\ Proposed rule 22e-4(b)(2)(iv)(A)-(B).
    \666\ See, e.g., Oppenheimer Comment Letter; Charles Schwab 
Comment Letter; SIFMA Comment Letter I.
    \667\ See, e.g., NYC Bar Comment Letter; SIFMA Comment Letter I.
    \668\ See SIFMA Comment Letter I.
    \669\ See Cohen & Steers Comment Letter.
---------------------------------------------------------------------------

    We continue to believe it is appropriate for a fund to be 
required--not only permitted--to consider a specified set of liquidity 
risk factors in determining its highly liquid investment minimum. We 
believe requiring every fund to consider multiple aspects of its 
history, policies, strategy, and operations in determining its highly 
liquid investment minimum will lead to a general industry-wide baseline 
for the minimum requirement. However, we are making certain 
modifications to the proposed liquidity risk factors, including only 
requiring funds to consider applicable factors, to respond to 
commenters' concerns about this aspect of the requirement.
a. Modifications to Proposed Requirement To Consider Liquidity Risk 
Factors
    As discussed above, the liquidity risk factors we are adopting 
today incorporate certain modifications to the proposed factors,\670\ 
and thus these modifications flow through with respect to a fund's 
consideration of these factors in determining its highly liquid 
investment minimum. We believe that the guidance that we provide in 
section III.B.2 regarding a fund's consideration of these factors in 
assessing its liquidity risk also is appropriate for a fund to take 
into account when determining its highly liquid investment minimum. 
With the exception of the recommendations about specific factors or 
guidance discussed below, we did not receive comments on the proposed 
factors or the guidance provided in the Proposing Release regarding 
these factors.
---------------------------------------------------------------------------

    \670\ See supra section III.B.2.
---------------------------------------------------------------------------

    Some commenters recommended that the Commission confirm that funds 
may consider and weigh the factors as they deem appropriate and 
relevant for purposes of the proposed minimum requirement,\671\ and we 
agree that a fund should give the most weight to the factors that it 
deems most relevant for determining its highly liquid investment 
minimum. Moreover, to the extent any liquidity risk assessment factor 
is not applicable to a particular fund, the fund would not be required 
to consider that factor in determining its highly liquid investment 
minimum. We have therefore added the words ``as applicable'' in the 
rule,\672\ and we note that, in this context, the phrase ``as 
applicable'' is meant to refer to those factors that are relevant to a 
fund's particular facts and circumstances. For example, a fund would 
not be required to consider the use of borrowings for investment 
purposes, as specified under rule 22e-4(b)(1)(i)(A), if that fund does 
not engage in borrowing.\673\ Conversely, however, a fund that 
maintains borrowing sources for investment purposes would be required 
to consider the use of borrowings for investment purposes as specified 
under the rule. The addition of ``as applicable'' should help respond 
to commenters' concerns that codifying a list of required factors as a 
provision of the proposed minimum requirement would ``create an overly 
rigid structure and a one-size-fits-all approach that may result in 
unnecessary focus on factors that are irrelevant to certain funds.'' 
\674\
---------------------------------------------------------------------------

    \671\ See, e.g., Oppenheimer Comment Letter; SIFMA Comment 
Letter I.
    \672\ See rule 22e-4(b)(1)(iii)(A)(1); see also supra footnote 
192 and accompanying text.
    \673\ See supra section III.B.2.
    \674\ See SIFMA Comment Letter I; see also e.g., Charles Schwab 
Comment Letter; Oppenheimer Comment Letter (suggesting that it is 
critically important that funds be afforded a certain amount of 
flexibility in setting the fund's three-day liquid asset minimum).
---------------------------------------------------------------------------

    We continue to believe that a fund should consider both normal and 
reasonably foreseeable stressed conditions in determining the amount of 
highly liquid investments it will hold, based on the liquidity risk 
assessment factors. However, in a change from the proposal, the rule 
specifies that only those stressed conditions that are reasonably 
foreseeable during the period until the next review of the highly 
liquid investment minimum (emphasis added) should be considered when a 
fund determines its highly liquid investment minimum.\675\ As discussed 
above, some commenters expressed concern that the requirement for funds 
to consider normal and reasonably foreseeable stressed conditions in 
determining their three-day liquid asset minimum could suggest that all 
funds should hold a high level of cash or other highly liquid assets at 
all times, which could in turn encourage funds to maintain portfolio 
liquidity levels that are disproportionate relative to their liquidity 
risk.\676\ We believe that requiring consideration of only those 
stressed conditions that are reasonably foreseeable during the period 
until the next review of the highly liquid investment minimum should 
address commenters' concerns and should help ensure that the highly 
liquid investment minimum requirement leads funds to hold levels of 
portfolio liquidity that are appropriate in light of their reasonably 
anticipated liquidity risk.
---------------------------------------------------------------------------

    \675\ See rule 22e-4(b)(1)(iii)(A)(1); see also rule 22e-
4(b)(1)(iii)(A)(2) (requiring funds to periodically review, no less 
frequently than annually, the highly liquid investment minimum).
    \676\ See supra footnote 667 and accompanying text. Commenters 
argued that this, in turn, could lead to declines in fund 
performance, which shareholders would experience in the form of 
lower returns. See, e.g., Fidelity Comment Letter; Invesco Comment 
Letter; J.P. Morgan Comment Letter; Wells Fargo Comment Letter.
---------------------------------------------------------------------------

    This change also responds to commenters' concerns about perceived 
ambiguity in the length of time over which the proposed rule would have 
required funds to forecast the effect of stressed conditions on the 
liquidity risk factors.\677\ Under the final rule, funds are required 
to periodically review, no less frequently than annually, their highly 
liquid investment minimum. Thus, the requirement to consider stressed 
conditions only to the extent they are reasonably foreseeable during 
the period until the next review of the highly liquid investment 
minimum, limits consideration of stressed conditions to whatever time 
frame the fund has determined for review of its highly liquid 
investment minimum, but no longer than one year. We note that if a fund 
encounters extremely stressed market conditions, beyond those that were 
reasonably foreseeable during the period until the next review of the 
highly liquid investment minimum, that could increase its liquidity 
risk to unusual levels, the fund should consider adjusting its highly 
liquid investment minimum at that time, and indeed a fund should 
generally review its highly liquid investment minimum more frequently 
than annually if circumstances warrant.
---------------------------------------------------------------------------

    \677\ See, e.g., MFS Comment Letter (noting that the proposal 
fails to indicate the period of time over which the estimate of 
foreseeable redemptions is to be calculated); see also SIFMA Comment 
Letter I (``We do not agree, however, that in making their Highly 
Liquid Asset Target determinations, funds should be required to 
forecast the timing, severity or potential impact of stressed market 
conditions or other events affecting the fund that have occurred in 
the past but for which there is no reasonable way to accurately 
predict their recurrence.'').

---------------------------------------------------------------------------

[[Page 82201]]

b. Role of Liquidity Risk Factors in Determining the Highly Liquid 
Investment Minimum
    As noted above, rule 22e-4 requires a fund to consider the 
liquidity risk factors set forth in the rule, as applicable, in 
determining its highly liquid investment minimum. In summary, a fund 
must consider, as applicable, its: (i) Investment strategy and 
portfolio liquidity during normal conditions, and during stressed 
conditions to the extent such conditions are reasonably foreseeable 
during the period until the next review of the highly liquid investment 
minimum; (ii) short-term and long-term cash flow projections during 
normal conditions, and during stressed conditions to the extent such 
conditions are reasonably foreseeable during the period until the next 
review of the highly liquid investment minimum; and (iii) holdings of 
cash and cash equivalents, as well as borrowing arrangements and other 
funding sources.\678\ In addition to these factors, an ETF also must 
consider, as applicable: (i) The relationship between the ETF's 
portfolio liquidity and the way in which, and the prices and spreads at 
which, ETF shares trade, including the efficiency of the arbitrage 
function and the level of active participation by market participants 
(including authorized participants); and (ii) the effect of the 
composition of baskets on the overall liquidity of the ETF's 
portfolio.\679\
---------------------------------------------------------------------------

    \678\ Rule 22e-4(b)(1)(i)(A)-(C); rule 22e-4(b)(1)(iii)(A)(1).
    \679\ Rule 22e-4(b)(1)(i)(D); rule 22e-4(b)(1)(iii)(A)(1); see 
also infra section III.J. (discussing liquidity risk management 
program elements tailored to ETFs).
---------------------------------------------------------------------------

    With respect to a fund's consideration of its investment strategy 
and portfolio liquidity in determining its highly liquid investment 
minimum, we continue to believe that the less liquid a fund's overall 
portfolio investments are, the higher a fund may want to establish its 
highly liquid investment minimum. Similarly, funds with certain 
investment strategies that typically have had greater volatility of 
flows than other investment strategies--such as alternative funds and 
emerging market debt funds--would generally need highly liquid 
investment minimums that are higher than funds whose strategies tend to 
entail less flow volatility. For funds that use borrowings for 
investment purposes and derivatives, we continue to believe that, all 
else equal, a fund with a leveraged strategy (e.g., a fund with 
leverage through bank borrowings or that has significant fixed 
obligations to derivatives counterparties) generally would need a 
highly liquid investment minimum that is higher than a fund that does 
not.\680\ Similarly, when setting the fund's highly liquid investment 
minimum, we believe a fund that has or expects to have a significant 
amount of highly liquid investments segregated to cover derivatives 
transactions or pledged to satisfy margin requirements in connection 
with derivatives transactions should take into account the fact that 
such segregated or pledged highly liquid investments may not be 
available to meet redemptions. However, this guidance is not meant to 
suggest that a fund should only, or primarily, use highly liquid 
investments to meet shareholder redemptions. Rather, in the examples 
provided in this paragraph, we believe that holding a relatively high 
level of assets that are highly liquid investments would both support a 
fund in meeting redemption requests in a manner that does not dilute 
non-redeeming shareholders, and assist the fund in readjusting its 
portfolio as necessary to handle stressed conditions, weathering 
periods of heightened volatility, and managing its obligations to 
derivatives counterparties.
---------------------------------------------------------------------------

    \680\ See Proposing Release, supra footnote 9, at paragraphs 
accompanying n.339. As discussed in the Proposing Release, we 
believe that 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. See, e.g., OppenheimerFunds Release, supra 
footnote 223.
---------------------------------------------------------------------------

    Regarding a fund's cash flow projections, we continue to believe 
that the Commission's cash flow guidance considerations could be useful 
to a fund in setting its highly liquid investment minimum.\681\ We 
generally expect that a fund would evaluate the Commission's guidance 
on these considerations and determine whether each would be useful and 
relevant in setting the fund's highly liquid investment minimum. In 
addition, a fund may wish to consider employing some form of stress 
testing \682\ or consider specific historical redemption scenarios in 
determining its highly liquid investment minimum.
---------------------------------------------------------------------------

    \681\ See supra section III.B.2.b. These five guidance 
considerations include: (i) The size, frequency, and volatility of 
historical purchases and redemptions of fund shares during normal 
and reasonably foreseeable stressed periods; (ii) the fund's 
redemption policies; (iii) the fund's shareholder ownership 
concentration; (iv) the fund's distribution channels; and (v) the 
degree of certainty associated with the fund's short-term and long-
term cash flow projections.
    \682\ See supra footnote 196 and accompanying text.
---------------------------------------------------------------------------

    Each of the cash flow guidance considerations--either standing 
alone, but especially viewed in combination with one another--are 
potentially significant features that could materially affect the risk 
of significant redemptions and thus could influence a fund's 
determination of its highly liquid investment minimum. 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 minimum level for its assets that are highly liquid 
investments than a fund that, all else equal, does not face these 
risks.
    In setting a highly liquid investment minimum, a fund should 
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 substantial 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 the reliability of those 
projections. In these circumstances, a fund should consider setting its 
highly liquid investment 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.
    One commenter objected that shareholder ownership concentration, 
which is discussed in this Release as a guidance factor that could be 
used in evaluating cash flows (but in the proposal would have been 
required to be considered in analyzing a fund's cash flow projections), 
should not be a

[[Page 82202]]

determinative consideration for a fund in establishing its appropriate 
level of relatively liquid assets.\683\ This commenter expressed 
concern that ``accentuating the significance of this sub-factor in the 
context of new or recently launched funds, which may have a small 
number of shareholders relative to more established funds, could have a 
severe anti-competitive effect and create an unwarranted barrier to the 
introduction of new funds.'' We agree that emphasizing shareholder 
concentration could lead new funds to increase their holdings of 
relatively liquid investments. However, we note that substantial 
shareholder concentration, even for new or recently launched funds, 
could give rise to significant liquidity risk, and thus this 
consideration should not be discounted when a fund whose investor base 
is significantly concentrated determines its highly liquid investment 
minimum.\684\ New or recently launched funds that have a concentrated 
shareholder base should consider disclosing the risk of redemption by 
one or more such shareholders in the fund's prospectus.\685\ To the 
extent that a new fund's shareholder base becomes significantly less 
concentrated as the fund matures, the fund may wish to take this into 
consideration in reviewing its highly liquid investment minimum and 
adjusting it as it determines appropriate.
---------------------------------------------------------------------------

    \683\ See SIFMA Comment Letter I.
    \684\ As discussed above, a fund may also take into account the 
types of shareholders in the fund and whether those shareholders 
share common investment goals affecting redemption frequency and 
timing. Additionally, a fund may take into account other liquidity 
risk management tools available to it, such as redemption fees, when 
determining its highly liquid investment minimum.
    \685\ See SIFMA Comment Letter I (suggesting that the Commission 
encourage such prospectus disclosure). We recognize that other 
factors, such as the size of a fund's positions and the liquidity of 
those positions, could impact the extent to which this risk could 
affect the fund.
---------------------------------------------------------------------------

    With respect to a fund's consideration of its holdings of cash and 
cash equivalents in determining its highly liquid investment minimum, 
we continue to believe that these holdings may provide funds with 
important flexibility to manage their liquidity risks. Our staff has 
observed that it is relatively common for fund complexes to target a 
minimum amount of cash or cash equivalent holdings in the fund, with 
the assumption that cash and cash equivalent holdings would allow the 
fund to meet redemptions in a stressed period without realizing 
significant discounts to its holdings' carrying values when they are 
sold. Holding cash or cash equivalents also could readily permit funds 
to rebalance or otherwise adjust a portfolio's composition in order to 
manage liquidity risk. Similarly, the availability of a line of credit 
or other funding sources to meet redemptions could assist a fund in 
managing liquidity risk, although as discussed below, depending on the 
nature of use, the use of a line of credit could raise other 
issues.\686\ To the extent that a fund determines that any of these 
considerations could indicate decreased liquidity risk, these 
considerations could provide important inputs regarding the level that 
the fund deems appropriate for its highly liquid investment minimum.
---------------------------------------------------------------------------

    \686\ See infra footnote 688 and accompanying text.
---------------------------------------------------------------------------

    Certain commenters indicated that the Commission should permit a 
fund to reduce its required holdings of relatively liquid assets by the 
amount of other sources of liquidity available to the fund, such as a 
committed line of credit.\687\ Under these commenters' views, if a fund 
were to determine that its highly liquid investment minimum would 
typically be x% of the fund's net assets, a fund with a committed line 
of credit representing y% of the fund's net assets should be able to 
reduce its highly liquid investment minimum to x% minus y% of the 
fund's net assets. We disagree with this approach for several reasons. 
First, we believe that a mechanical subtraction of the amount of a 
credit line available to a fund from the fund's highly liquid 
investment minimum is inappropriate under circumstances in which all or 
part of the line of credit is not guaranteed to be available to a 
fund--for example, because it is a committed line of credit that may be 
shared among other members of the fund family. Even if the credit 
facility was committed just to the fund, the amount ultimately 
available could depend on the financial health of the institution 
providing the facility, as well as the terms and conditions of the 
facility. Finally, as discussed in the Proposing Release, while a line 
of credit can facilitate a fund's ability to meet unexpected 
redemptions and can be taken into consideration when determining its 
highly liquid investment minimum, we continue to believe that liquidity 
risk management is better conducted primarily through construction of a 
fund's portfolio.\688\
---------------------------------------------------------------------------

    \687\ See, e.g., Cohen & Steers Comment Letter; Oppenheimer 
Comment Letter.
    \688\ See Proposing Release, supra footnote 9, at section 
III.C.3; see also, e.g., HSBC Comment Letter (``The degree to which 
a fund employs leverage can have a material impact on its liquidity 
demands, particularly during periods of market stress. As such, 
attempts to model liquidity risk should incorporate an assessment of 
leverage and the extent to which this might intensify liquidity 
demands for a given fund during different scenarios compared to 
unleveraged funds.''); Nuveen FSOC Notice Comment Letter, supra 
footnote 85 (``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.'').
---------------------------------------------------------------------------

    As with the proposed three-day liquid asset minimum requirement, a 
fund would be required to maintain a written record of how its highly 
liquid investment minimum was determined, including an assessment of 
each of the factors.\689\ This would permit our examination staff to 
ascertain that funds are indeed considering the required factors, as 
applicable. As discussed in the Proposing Release, we continue to 
generally believe that it would be extremely difficult to conclude, 
based on the factors that a fund would be required to consider, that a 
highly liquid investment minimum of zero would be appropriate.\690\
---------------------------------------------------------------------------

    \689\ See rule 22e-4(b)(3)(iii); see also infra section III.I.
    \690\ See Proposing Release, supra footnote 9, at paragraphs 
accompanying and following n.341.
---------------------------------------------------------------------------

3. Highly Liquid Investment Minimum Shortfall Policies and Procedures
    Under rule 22e-4, a fund will be required to adopt specific 
policies and procedures for responding to a shortfall in the fund's 
assets that are highly liquid investments below its highly liquid 
investment minimum (for purposes of this section, a fund's ``shortfall 
policies and procedures''). A fund's shortfall policies and procedures, 
as described in more detail below, must include reporting to the fund's 
board of directors no later than the board's next regularly scheduled 
meeting with a brief explanation of the causes of the shortfall, the 
extent of the shortfall, and any actions taken in response.\691\ Also, 
a fund's shortfall policies and procedures must include reporting 
within one business day to the fund's board if a shortfall lasts more 
than seven consecutive calendar days, including an explanation of how 
the fund plans to restore its minimum within a reasonable period of 
time.\692\
---------------------------------------------------------------------------

    \691\ See rule 22e-4(b)(1)(iii)(A)(3).
    \692\ See id.
---------------------------------------------------------------------------

a. Shortfall Policies and Procedures Requirement
    Rule 22e-4 as proposed did not include the requirement for a fund 
to adopt shortfall policies and procedures. This requirement replaces 
the proposed prohibition against acquiring any asset

[[Page 82203]]

other than a three-day liquid asset if a fund's holdings of three-day 
liquid assets were to drop below its three-day liquid asset minimum 
(for purposes of this section, the ``proposed acquisition 
limit'').\693\ As discussed above, commenters expressed concerns that 
the proposed acquisition limit could have adverse effects on funds, 
their shareholders, and the markets in which funds operate. 
Specifically, commenters cautioned that shareholder redemptions could 
increase if shareholders observe that a large redemption has taken 
place and assume that the fund will not be able to effectively employ 
its investment strategy due to the proposed prohibition on acquiring 
any assets that are not three-day liquid assets.\694\ Commenters 
suggested that this, in turn, could incentivize shareholders to redeem 
quickly in times of stress, which could spark additional redemptions 
from funds in stressed periods. Some commenters also argued that the 
proposed acquisition limit could lead index funds to hold a level of 
relatively liquid assets that causes them to deviate from the 
construction of their indices \695\ and could cause funds that are 
managed relative to a benchmark to experience higher tracking 
error.\696\ Commenters also maintained that the proposed acquisition 
limit could impair actively managed funds to the extent that it could 
limit portfolio managers' discretion to purchase assets that they 
believe would maximize funds' returns.\697\
---------------------------------------------------------------------------

    \693\ See proposed rule 22e-4(b)(2)(iv)(C).
    \694\ See, e.g., BlackRock Comment Letter.
    \695\ See, e.g., Invesco Comment Letter; Dechert Comment Letter; 
Oppenheimer Comment Letter.
    \696\ See, e.g., HSBC Comment Letter; ICI I Comment Letter.
    \697\ See, e.g., PIMCO Comment Letter; ICI I Comment Letter; 
Federated Comment Letter.
---------------------------------------------------------------------------

    In addition, commenters argued that the proposed acquisition limit 
could effectively prevent funds from holding or acquiring favorable, 
but relatively less liquid, assets under certain circumstances, which 
could intensify market stress as well as adversely affect a fund's 
NAV.\698\ For example, some commenters suggested that a fund whose 
three-day liquid asset holdings were to fall below its minimum could 
feel pressure to sell less liquid assets in order to replenish its 
three-day liquid assets, which could lead to excessive sales of less 
liquid assets during times of market stress that could adversely affect 
the fund's NAV.\699\ Relatedly, commenters suggested that the proposed 
acquisition limit could produce harmful market effects if it were to 
significantly increase the demand for relatively liquid assets, which 
could conversely decrease demand for other asset types (making them 
less liquid) and exacerbate market volatility.\700\ Commenters 
expressed concern that any ``herding'' behavior that could result from 
the proposed acquisition limit could become especially pronounced 
during stressed periods.\701\ Commenters also argued that the proposed 
acquisition limit could prevent a fund manager from purchasing certain 
investments that it views as undervalued in a downturn, when the fund's 
holdings of three-day liquid assets are at or below the fund's 
minimum.\702\ They contended that this in turn could reduce the fund's 
universe of potential investments and ability to invest in contrarian 
and countercyclical ways,\703\ which could eliminate a potential pool 
of buyers and thus could exacerbate an already stressed 
environment.\704\
---------------------------------------------------------------------------

    \698\ See, e.g., BlackRock Comment Letter; SIFMA I Comment 
Letter; Wells Fargo Comment Letter.
    \699\ See, e.g., Oppenheimer Comment Letter.
    \700\ See, e.g., Invesco Comment Letter; Cohen & Steers Comment 
Letter; ICI Comment Letter I; Wells Fargo Comment Letter.
    \701\ See, e.g., ICI Comment Letter I; Wellington Comment Letter 
II.
    \702\ See, e.g., ICI Comment Letter I.
    \703\ See, e.g., BlackRock Comment Letter; ICI Comment Letter I; 
Wells Fargo Comment Letter.
    \704\ See, e.g., SIFMA Comment Letter I; Invesco Comment Letter
---------------------------------------------------------------------------

    A significant number of commenters suggested that the Commission 
adopt a liquid asset target in lieu of the proposed three-day liquid 
asset minimum requirement--indeed, this was the most common alternative 
suggestion to the proposed three-day liquid asset minimum 
requirement.\705\ One primary distinction between the target 
requirements that commenters recommended and the proposed three-day 
liquid asset minimum requirement is that a target requirement would not 
prohibit a fund from acquiring certain assets if a fund's holdings of 
relatively liquid assets were to fall below the target. Instead, some 
commenters stated that a fund should have a reasonable period to 
respond to a shortfall of relatively liquid assets below the fund's 
target, and/or that any such shortfalls must be reported to the fund's 
board.\706\
---------------------------------------------------------------------------

    \705\ See, e.g., supra footnote 653 and accompanying text; see 
also infra section IV.C (discussing other reasonable alternatives to 
the highly liquid investment minimum requirement).
    \706\ See, e.g., Invesco Comment Letter; PIMCO Comment Letter; 
Federated Comment Letter; J.P. Morgan Comment Letter.
---------------------------------------------------------------------------

    We continue to believe that fund shareholders' interests are 
generally best served when the percentage of a fund's assets invested 
in relatively liquid investments is at (or above) the level deemed 
appropriate by the fund.\707\ The highly liquid investment minimum 
requirement we are adopting would not prohibit a fund from acquiring 
assets other than highly liquid investments when a fund's highly liquid 
investments fall below its minimum. However, we believe that the 
shortfall policies and procedures requirement we are adopting--which 
replaces the proposed acquisition limit--provides flexibility while 
also promoting effective liquidity management practices. We believe 
this requirement also responds to concerns about a flat prohibition 
against purchasing certain assets when the fund's assets that are 
highly liquid investments drop below a certain level.
---------------------------------------------------------------------------

    \707\ See Proposing Release, supra footnote 9, at n.346 and 
accompanying text.
---------------------------------------------------------------------------

    Additionally, we believe that the shortfall policies and procedures 
requirement responds appropriately to commenters' concerns that there 
could be appropriate reasons for a fund to acquire an investment other 
than a highly liquid investment if a fund were to fall below its 
minimum. The final highly liquid investment minimum requirement will 
require that funds determine a level of assets that are highly liquid 
investments designed to help them manage the fund through stressed 
conditions or opportunistically readjust their portfolios, while 
permitting a fund's portfolio liquidity to fall below this level when 
determined appropriate from a risk management perspective or on account 
of extenuating circumstances. The shortfall policies and procedures 
requirement, including the reporting requirement, is meant to foster 
discussion among the fund's management (and board) if its assets that 
are highly liquid investments fall below the level the fund determined 
to be an appropriate minimum. We further believe that the final highly 
liquid investment minimum requirement appropriately responds to 
commenters' concerns that the proposed acquisition limit could restrict 
funds' ability to meet their principal investment strategies, to the 
detriment of fund investors. The final requirement provides fund 
managers more leeway than the proposed requirement to structure and 
modify their portfolios because--as would be the case in the target 
requirement commenters suggested--fund managers would not be prevented 
from purchasing certain assets when a fund's holdings of assets that 
are highly liquid investments drop below its highly liquid investment 
minimum.
    The highly liquid investment minimum requirement we are adopting, 
together with the shortfall policies and

[[Page 82204]]

procedures requirement, also responds to commenters' concerns that the 
proposed acquisition limit could exacerbate potential market stresses 
and lead to other harmful market effects. Under the final rule, a fund 
that falls below its highly liquid investment minimum would not be 
restricted to acquiring only highly liquid investments, if acquiring 
other investments were consistent with the fund's shortfall policies 
and procedures. Also, as discussed above, the requirement that a fund 
determine its highly liquid investment minimum taking into account only 
those stressed conditions that are reasonably foreseeable during the 
period until the next review of the highly liquid investment minimum 
should decrease the probability that a fund could overweight its assets 
that are highly liquid investments relative to its liquidity risk. This 
also, in turn, should lessen demand for highly liquid investments 
compared to the possible market effects of the proposed requirement.
    Finally, we believe that the final highly liquid investment minimum 
requirement, in conjunction with the shortfall policies and procedures 
requirement, will help to mitigate some of the operational burdens that 
commenters argued would accompany the proposal,\708\ while continuing 
to advance the Commission's goals. We note that the highly liquid 
investment minimum requirement will involve monitoring a fund's 
portfolio investments' liquidity for compliance. We recognize that this 
monitoring may result in operational costs, which could be greater for 
funds with multiple sub-advisers to the extent that these funds would 
need to build or otherwise implement systems to coordinate portfolio 
liquidity information provided by each sub-adviser.\709\ However, we 
expect that the operational costs associated with the final highly 
liquid investment minimum requirement would be significantly less 
compared to the proposal, which would have entailed the additional 
costs of building systems that would bar the purchase of less liquid 
investments if the fund were to fall below its minimum. We understand 
that some fund complexes today already track a liquid asset minimum or 
target, and for these funds, operational costs associated with the 
final minimum requirement would only entail adjustments to their 
current processes and not the costs of an entirely new systems build-
out.
---------------------------------------------------------------------------

    \708\ See, e.g., Federated Comment Letter (suggesting that the 
proposed requirement could present significant operational and 
technological challenges because a fund's trade order management 
system would need to maintain the liquidity classification for each 
security in order to accurately monitor compliance with the fund's 
three-day liquid asset minimum); ICI Comment Letter I (noting that 
the proposed requirement would raise operational difficulties for 
funds with multiple sub-advisers because compliance would 
necessitate consideration of portfolio assets' liquidity at the fund 
level, and thus the proposal would require a significant amount of 
coordination among sub-advisers).
    \709\ See also infra paragraph accompanying footnote 818 
(discussing the coordination of liquidity risk management efforts 
undertaken by various service providers, including a fund's sub-
adviser(s)).
---------------------------------------------------------------------------

b. Operation of Shortfall Policies and Procedures Requirement
    Rule 22e-4 provides flexibility as to the particular shortfall 
policies and procedures a fund may adopt because we believe that 
different facts and circumstances could result in different funds 
taking different approaches to address a decline in assets that are 
highly liquid investments.\710\ We also recognize that it may be 
difficult to contemplate or specify all appropriate factors to consider 
(or their weighting) in advance of a shortfall, and that part of the 
decision process requires an evaluation of the current stress event and 
a determination of whether it is likely to persist (and for how long). 
Nonetheless, a fund's shortfall policies and procedures could specify 
some of the actions that a fund could consider taking to respond to a 
highly liquid investment minimum shortfall under different conditions, 
as well as market- and fund-specific circumstances that could shape a 
fund's response to a particular shortfall occasion. For example, the 
policies and procedures could outline some of the circumstances under 
which it could be appropriate for a fund to purchase assets that are 
not highly liquid investments, despite being below its minimum. If, for 
example, the fund reasonably expected inflows in the near future (e.g., 
from a retirement plan platform), it may determine it is acceptable to 
pursue an attractive buying opportunity despite a decline below the 
fund's highly liquid investment minimum that it expects to be short-
term. It also could be appropriate, for example, for a fund to consider 
selling certain relatively less liquid holdings over a period of time 
and investing some of the proceeds in highly liquid investments.
---------------------------------------------------------------------------

    \710\ For example, a fund may handle a shortfall due to changes 
in market conditions differently than a shortfall due to increased 
redemptions.
---------------------------------------------------------------------------

    Similarly, as part of its shortfall policies and procedures, a fund 
could set forth how it would set out a time frame by which it plans to 
bring its assets that are highly liquid investments back up to the 
level of its highly liquid investment minimum.\711\ If a fund 
encounters highly liquid investment minimum shortfalls regularly, a 
fund's liquidity risk management program administrator, potentially 
together with the fund's broader risk management function, should 
consider whether the fund's risk management policies and procedures 
should be modified. We note that a fund's shortfall policies and 
procedures could, but will not be required to, specify the persons who 
will typically determine how, if at all, to respond to a shortfall (for 
example, the person designated by the board to administer the fund's 
liquidity risk management program, in conjunction with the fund's risk 
managers and portfolio managers).
---------------------------------------------------------------------------

    \711\ If a fund's highly liquid investment minimum shortfall 
lasts more than seven consecutive calendar days, reporting to the 
fund's board within one business day is required, including an 
explanation of how the fund plans to restore its minimum within a 
reasonable period of time. See rule 22e-4(b)(1)(iii)(A)(3).
---------------------------------------------------------------------------

    As discussed below, although we are not requiring a fund's board to 
specifically approve its highly liquid investment minimum, we continue 
to believe that the board should play an oversight role with respect to 
the minimum.\712\ A requirement to inform the board when a fund drops 
below its highly liquid investment minimum, as well as the 
circumstances leading to the fund's highly liquid investment minimum 
shortfall and actions taken in response, will permit the board better 
to understand circumstances that may give rise to heightened liquidity 
risk. It also will provide important context for the board in 
evaluating the effectiveness of the fund's highly liquid investment 
minimum and the fund's liquidity risk management program generally. 
Many commenters suggested that the Commission should adopt a board 
reporting requirement when a fund's holdings of relatively liquid 
assets drop below the level that the fund has generally targeted as 
appropriate.\713\ Rule 22e-4 as adopted generally reflects these 
suggestions.
---------------------------------------------------------------------------

    \712\ See infra section III.H.3.
    \713\ See, e.g., J.P. Morgan Comment Letter (suggesting a breach 
would necessitate a report to the board); SIFMA I Comment Letter 
(suggesting a ``highly liquid asset target'' and noting that 
``[i]nstances where a fund dipped below its target percentage 
[could] be reported to the fund board with an explanation from 
management as to why the fund dipped below its target and any 
resulting impact on the fund's liquidity risk profile''); Invesco 
Comment Letter; Dechert Comment Letter.
---------------------------------------------------------------------------

    As fund boards are charged with oversight and not day-to-day 
management of funds' liquidity risk, we

[[Page 82205]]

believe that it is appropriate not to require that the fund's board be 
informed that the fund has dropped below its highly liquid investment 
minimum immediately when this occurs. Thus, rule 22e-4 requires that a 
fund's board be informed of a highly liquid investment minimum 
shortfall at the board's next regularly scheduled meeting.\714\ If a 
fund were to drop below its highly liquid investment minimum multiple 
times prior to the next regularly scheduled board meeting, fund 
management could provide a single report to the board at that meeting 
discussing each of these occurrences.
---------------------------------------------------------------------------

    \714\ See rule 22e-4(b)(1)(iii)(A)(3).
---------------------------------------------------------------------------

    However, we believe that when a fund's assets that are highly 
liquid investments are below its minimum for an extended period of 
time, this could indicate especially heightened liquidity risk, and 
thus under these circumstances it is appropriate to report a highly 
liquid investment minimum shortfall to the board within a shorter time 
frame. We are therefore adopting the requirement for a fund to report 
to its board of directors within one business day if its shortfall 
lasts longer than seven consecutive calendar days. Rule 22e-4 requires 
that this accelerated reporting include an explanation of how the fund 
plans to restore the fund's highly liquid investment minimum within a 
``reasonable'' period of time. Fund management generally should take 
into account the fund's level of liquidity risk, as well as the facts 
and circumstances leading to the highly liquid investment minimum 
shortfall, in determining a reasonable time for returning the fund's 
assets that are highly liquid investments to the fund's minimum level.
4. Periodic Review of Highly Liquid Investment Minimum
    Rule 22e-4 requires a fund to periodically review, no less 
frequently than annually, the fund's highly liquid investment 
minimum.\715\ The proposed rule also included a periodic review 
requirement with respect to the proposed three-day liquid asset 
minimum, but instead of an annual minimum review requirement, the 
proposed rule would have required that the periodic review be conducted 
at least semi-annually.\716\ We requested comment on this proposed 
review requirement generally, including the proposed minimum frequency 
of a fund's review. We received few comments on the proposed review 
requirement separate from general comments on the proposed three-day 
liquid asset minimum, although we received general support for a review 
requirement concerning a fund's target level of liquid assets.\717\
---------------------------------------------------------------------------

    \715\ See rule 22e-4(b)(1)(iii)(A)(2).
    \716\ See proposed rule 22e-4(b)(2)(iv)(B).
    \717\ See, e.g., Oppenheimer Comment Letter.
---------------------------------------------------------------------------

    We continue to believe, as discussed in the Proposing Release, that 
a periodic review is a central component of the highly liquid 
investment minimum requirement we are adopting.\718\ Although we 
proposed a minimum semi-annual review requirement, we are adopting a 
minimum annual review requirement primarily in order to correlate the 
minimum period for a fund's highly liquid investment minimum review 
with the minimum period in which a fund's board would be required to 
review a written report describing the adequacy of the fund's liquidity 
risk management program, as described in more detail below.\719\ The 
minimum annual review period also would correlate with the requirement 
for a fund to review its liquidity risk periodically, but no less 
frequently than annually.\720\ We believe that correlating the time 
periods for each review requirement in rule 22e-4 will reduce 
compliance burdens and mitigate potential confusion that could arise 
from disparate review periods.
---------------------------------------------------------------------------

    \718\ See Proposing Release, supra footnote 9, at paragraph 
following n.352.
    \719\ See infra section III.H.2.
    \720\ See supra section III.B.3.
---------------------------------------------------------------------------

    We also do not believe that extending the highly liquid investment 
minimum review period from a minimum of semi-annually to annually will 
adversely affect funds or investors as a fund generally should review 
its highly liquid investment minimum more frequently if circumstances 
warrant. Additionally, as discussed above, a fund's board will be 
regularly informed of any highly liquid investment minimum shortfalls. 
Thus, the board will be aware of any liquidity risk management issues 
that might warrant reconsideration of the fund's risk management 
procedures or its highly liquid investment minimum.
    Like the requirement for a fund to periodically review its 
liquidity risk, the highly liquid investment minimum review requirement 
will permit each fund to develop and adopt its own procedures for 
conducting this review, taking into account the fund's particular facts 
and circumstances. Additionally, we believe that in developing 
comprehensive 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 more frequent review of the fund's highly liquid investment 
minimum in addition to the annual minimum review required by the rule 
(as well as the process for conducting more frequent reviews).\721\
---------------------------------------------------------------------------

    \721\ See, e.g., supra footnote 273 and accompanying paragraph; 
see also supra section III.D.2.a.
---------------------------------------------------------------------------

5. Exclusion for Funds Primarily Holding Assets That Are Highly Liquid 
Investments
    Rule 22e-4, as adopted, excludes a fund that primarily holds assets 
that are highly liquid investments (a ``primarily highly liquid fund'') 
from the requirements to determine and review a highly liquid 
investment minimum, and to adopt shortfall policies and 
procedures.\722\ We sought comment in the Proposing Release about 
whether we should exclude certain funds from the proposed three-day 
liquid asset minimum, such as funds that only invest in three-day 
liquid assets. Commenters argued that a requirement for a fund to 
determine a minimum portion of assets that it will invest in relatively 
liquid assets is not suitable for funds that primarily invest in highly 
liquid investment classes, given that a significant portion of the 
fund's portfolio would be composed of such assets, and thus the 
benefits associated with the three-day liquid asset minimum requirement 
would not justify the burdens.\723\ After considering these comments 
and reevaluating the costs and benefits of the proposal, we agree that 
a primarily highly liquid fund should not be required to determine and 
review a highly liquid investment minimum, or adopt shortfall policies 
and procedures. We agree with commenters that the benefits associated 
with these requirements as applied to

[[Page 82206]]

primarily highly liquid funds would not justify the associated 
burdens.\724\
---------------------------------------------------------------------------

    \722\ See rule 22e-4(b)(1)(iii)(A).
    \723\ See, e.g., FSR Comment Letter (``[T]he Commission should 
consider alternative regulatory approaches for index funds that seek 
to track the performance of indices that are comprised of highly 
liquid assets . . . .''); Dechert Comment Letter (citing Statement 
on Open-End Fund Liquidity Risk Management Programs and Swing 
Pricing, Commissioner Daniel M. Gallagher, Securities and Exchange 
Commission (Sept. 22, 2015) (``Furthermore, for funds that invest 
solely in assets that can be settled in three days or less--for 
example, a fund that limits its investments to equity securities of 
S&P 500 companies--the `three-day bucket' has no functional value. 
Requiring such a fund to set its three-day bucket--whether it be at 
1%, or 20% or even 90%--would be a meaningless exercise given that 
the entire portfolio would be comprised of assets settled in three 
days or less.'')).
    \724\ For more discussion about the costs and burdens associated 
with the highly liquid investment minimum requirement, see infra 
section IV.C.
---------------------------------------------------------------------------

    Under rule 22e-4, a fund whose portfolio consists primarily of 
assets that are highly liquid investments would be excluded from the 
highly liquid investment minimum requirement.\725\ Thus, we anticipate 
that a primarily highly liquid fund would address in its liquidity risk 
management program how it determines that it primarily holds assets 
that are highly liquid investments, including, for example, how it 
defines ``primarily.'' \726\ If a fund were to modify its investment 
strategy or encounter strategy ``drift'' such that it no longer 
primarily held assets that were highly liquid investments, it would be 
required to adopt and review a highly liquid investment minimum, as 
well as adopt and implement policies and procedures for responding to a 
shortfall of the fund's assets that are highly liquid investments below 
its minimum. We therefore believe that if a fund's investment strategy 
is such that it cannot generally be predicted whether the fund would 
primarily hold assets that are highly liquid investments (for example, 
if the strategy were to entail a significant amount of volatility in 
terms of the fund's portfolio liquidity), it would be difficult for the 
fund's management to conclude that the fund should appropriately be 
excluded from the highly liquid investment minimum requirement.
---------------------------------------------------------------------------

    \725\ See rule 22e-4(b)(1)(iii)(A). Money market funds and In-
Kind ETFs also would be excluded from the highly liquid investment 
minimum requirement. See rule 22e-4(a)(5) (defining ``fund,'' for 
purposes of the rule as excluding money market funds and In-Kind 
ETFs).
    \726\ As noted by commenters, a highly liquid index fund would 
be one example of a fund whose portfolio consists primarily (in the 
case of these index funds, almost entirely) of assets that are 
highly liquid investments. See supra footnote 723. In our view, if a 
fund held less than 50% of its assets in highly liquid investments 
it would be unlikely to qualify as ``primarily'' holding assets that 
are highly liquid investments.
---------------------------------------------------------------------------

    For purposes of determining whether a fund primarily holds assets 
that are highly liquid investments, a fund must exclude from its 
calculations the percentage of the fund's assets that are highly liquid 
investments that it has segregated to cover derivatives transactions 
that the fund has classified as moderately liquid investments, less 
liquid investments, and illiquid investments, or pledged to satisfy 
margin requirements in connection with those derivatives transactions, 
as determined pursuant to rule 22e-4(b)(1)(ii)(C).\727\ As discussed 
above, when a fund's assets are segregated or pledged in connection 
with derivatives transactions, they may not be immediately available 
for liquidity risk management purposes.\728\ Thus, a fund whose assets 
that are highly liquid investments that are segregated or pledged in 
connection with derivatives transactions may not have the same level of 
liquidity risk management flexibility as a fund whose assets are highly 
liquid investments that are not similarly segregated or pledged. While 
we believe that the benefits associated with the highly liquid 
investment minimum requirements as applied to primarily highly liquid 
funds would not justify associated burdens,\729\ we believe that this 
consideration is appropriate only to the extent a fund primarily holds 
assets that are highly liquid investments that are not segregated or 
pledged in connection with derivatives transactions. As an extreme 
example, if a fund were to hold only assets that were highly liquid 
investments that were segregated or pledged in connection with 
derivatives transactions and that were not themselves classified as 
highly liquid investments, none of its assets that were highly liquid 
investments would be available to meet redemptions or otherwise manage 
liquidity risk. Thus, we believe that such fund's assets that were 
highly liquid investments would likely not be commensurate with its 
liquidity risk profile as determined with reference to the liquidity 
risk factors it would be required to consider under rule 22e-4.\730\
---------------------------------------------------------------------------

    \727\ Rule 22e-4(b)(1)(iii)(B). As described above, a fund would 
be permitted to exclude its derivatives transactions that are 
classified as highly liquid investments in determining the 
percentage of highly liquid investments that are segregated or 
pledged assets because, since the fund could dispose of or exit 
these derivatives transactions within three business days, the 
associated segregated or pledged assets also would be available to 
the fund for liquidity risk management purposes within three 
business days. See supra text following footnote 493.
    \728\ See supra section III.C.3.c.
    \729\ See supra footnote 724 and accompanying text.
    \730\ See supra section III.D.2 (discussing the rule 22e-4 
requirement for a fund to consider certain liquidity risk factors in 
determining its highly liquid investment minimum).
---------------------------------------------------------------------------

6. Highly Liquid Investment Minimum Reporting and Disclosure 
Requirements
    We proposed to amend Form N-PORT to add a new item that would 
require each fund to disclose its three-day liquid asset minimum, as 
such term was proposed to be defined in proposed rule 22e-4. One 
commenter supported reporting the three-day liquid asset minimum in a 
structured data format to the public as proposed.\731\ Certain other 
commenters supported reporting the three-day liquid asset minimum in a 
structured data format as proposed but to the Commission only.\732\ One 
commenter did not support public disclosure of a fund's three-day 
liquid asset minimum, as proposed, but said it would support public 
disclosure of a fund's three-day liquid asset minimum if the Commission 
adopted a recommended alternative to such definition.\733\
---------------------------------------------------------------------------

    \731\ See Charles Schwab Comment Letter (noting that information 
about the fund's liquidity risk management program will be 
particularly helpful to investors, as will disclosure of a fund's 
overall liquidity picture and a fund's three-day liquid asset 
minimum).
    \732\ See, e.g., CFA Comment Letter; Voya Comment Letter.
    \733\ See Vanguard Comment Letter.
---------------------------------------------------------------------------

    Some commenters, however, opposed public disclosure of both the 
three-day liquid asset minimum as proposed and recommended alternatives 
to the three-day liquid asset minimum. Commenters expressed concerns 
that public disclosure could be misleading to investors, arguing that 
any minimum reported on Form N-PORT would be subjective, presented 
without context, and may not reflect a fund's actual portfolio 
management approach at the time the data is being relied upon by 
investors.\734\ Other commenters contended that public disclosure could 
interfere with a fund's investment strategy and promote unwarranted, 
and potentially destabilizing, redemption activity by fund 
shareholders, especially during times of stress.\735\ One commenter 
stated that public disclosure of a liquidity minimum would also give 
undue emphasis to a single element of a fund's liquidity risk 
management program and could potentially encourage third parties to use 
a single numerical figure as a basis for comparing funds, further 
encouraging undue reliance on the liquidity minimum figure by 
investors.\736\ Certain other commenters expressed concern that public 
disclosure could potentially expose a fund to predatory trading 
activity if the fund is seen as vulnerable to liquidity risks or is 
under stress.\737\ In addition, one commenter contended that 
comparisons of three-day liquid asset minimums could result in 
competitive pressures for relatively

[[Page 82207]]

uniform minimums among funds with similar investment strategies, 
ultimately harming fund investors.\738\
---------------------------------------------------------------------------

    \734\ See, e.g., Eaton Vance Comment Letter I; J.P. Morgan 
Comment Letter; NYC Bar Comment Letter; Voya Comment Letter.
    \735\ See, e.g., Eaton Vance Comment Letter I; J.P. Morgan 
Comment Letter; Wells Fargo Comment Letter.
    \736\ See SIFMA Comment Letter I.
    \737\ See, e.g., Eaton Vance Comment Letter I; SIFMA Comment 
Letter.
    \738\ See NYC Bar Comment Letter.
---------------------------------------------------------------------------

    We are persuaded by some of the concerns expressed by commenters 
regarding the potential risks to funds and fund investors of public 
reporting of a fund's three-day liquid asset minimum, as proposed, or 
any alternative formulation, including a fund's highly liquid 
investment minimum, as adopted today. In response to comments, we are 
adopting amendments to require a fund to report its highly liquid 
investment minimum on Form N-PORT to the Commission on a non-public 
basis.\739\ We believe that the requirement that a fund report to its 
board when the fund's assets that are highly liquid investments fall 
below the fund's highly liquid investment minimum, discussed above, is 
a more appropriate tool to assist fund boards in their oversight of 
fund liquidity risks, thereby ultimately protecting shareholder 
interests in the fund.\740\
---------------------------------------------------------------------------

    \739\ See General Instruction F of Form N-PORT.
    \740\ See supra section III.D.3.
---------------------------------------------------------------------------

    In light of the changes we are making to the way the highly liquid 
investment minimum is established, the final modifications to Form N-
PORT require that if a fund's minimum has changed during the reporting 
period, any prior minimums established by the fund during the reporting 
period also be reported.\741\ Because, as discussed previously, we are 
not requiring the fund's board to approve changes to the highly liquid 
asset minimum, we believe it is important that any changes to the 
minimum during a reporting period be included in Form N-PORT to help 
mitigate the possibility of window dressing a fund's highly liquid 
asset minimum at the end of the reporting period, and allow us to 
monitor for changes to a fund's minimum. In addition, considering the 
changes we have made to the way the minimum works from the proposal, 
and consistent with the board and Commission reporting requirements we 
are adopting relating to shortfalls of a fund's minimum, the final 
amendments to Form N-PORT also require that if a fund is below its 
minimum during the reporting period, a fund needs to report the number 
of days it is below its minimum during the reporting period.\742\ We 
believe that this reporting requirement will enhance our monitoring of 
fund's compliance with the minimum and the board and Commission 
reporting requirements contained elsewhere in rule 22e-4. These 
additional reporting requirements also would be non-public, for the 
same reasons discussed above.
---------------------------------------------------------------------------

    \741\ See Item B.7.c. of Form N-PORT.
    \742\ See Item B.7.b. of Form N-PORT.
---------------------------------------------------------------------------

    Overall, we believe that such board oversight together with 
confidential reporting to the Commission is a regulatory approach that 
balances commenters' concerns about certain adverse effects that could 
arise from public reporting of liquid investment minimums with the need 
for enhanced investor protections and meaningful information for 
Commission regulatory oversight responsibilities. We believe that it is 
neither necessary nor appropriate in the public interest or for the 
protection of investors to make information regarding a fund's highly 
liquid investment minimum publicly available at this time.\743\
---------------------------------------------------------------------------

    \743\ See section 45 of the Act, which provides, in summary, 
that the information contained in any report or other document filed 
with the Commission pursuant to the Act shall be made available to 
the public, unless by rules and regulations upon its own motion, or 
by order upon application, the Commission finds that public 
disclosure is ``neither necessary nor appropriate in the public 
interest or for the protection of investors.''
---------------------------------------------------------------------------

E. Limitation on Funds' Illiquid Investments

    Rule 22e-4 includes a limit on a fund's ability to acquire illiquid 
investments. Specifically, the rule prohibits a fund from acquiring any 
illiquid investment if, immediately after the acquisition, the fund 
would have invested more than 15% of its net assets in illiquid 
investments that are assets.\744\ The rule's 15% limit on funds' 
illiquid investments applies to all funds (including In-Kind 
ETFs).\745\ Additionally, as discussed below, a fund will be required 
to notify its board, and confidentially the Commission, when its 
illiquid investments that are assets exceed 15% of its net assets. 
Moreover, the person(s) designated to administer the liquidity risk 
management program must explain in a report to the board the extent and 
causes of the occurrence, and how the fund plans to bring its illiquid 
investments that are assets to or below 15% of its net assets within a 
reasonable period of time.\746\ If the amount of the fund's illiquid 
investments that are assets is still above 15% of its net assets 30 
days from the occurrence (and at each consecutive 30 day period 
thereafter), the board of directors, including a majority of its 
independent directors,\747\ must assess whether the plan presented to 
it continues to be in the best interest of the fund.
---------------------------------------------------------------------------

    \744\ Rule 22e-4(b)(1)(iv). Rule 22e-4(b)(1)(iv) refers to 
investments that are ``assets'' to make clear that the 15% limit on 
illiquid investments applies to investments with positive values. 
Illiquid investments that have negative values should not be netted 
against illiquid investments that have positive values when 
calculating compliance with the 15% limit. Thus, only illiquid 
investments that have positive values (i.e., ``assets'') should be 
used in the numerator.
    \745\ See id.; see also rule 22e-4(a)(5) and (9) (defining the 
terms ``fund'' and ``In-Kind ETF'' for purposes of the rule).
    \746\ Rule 22e-4(b)(1)(iv)(A).
    \747\ ``Independent directors'' as used herein refers to 
directors who are not ``interested persons'' of a fund or In-Kind 
ETF, as applicable, as that term is defined in section 2(a)(19) of 
the Investment Company Act.
---------------------------------------------------------------------------

    The limitation on funds' illiquid investments is similar to the 
limitation on ``15% standard assets'' in proposed rule 22e-4,\748\ in 
that both requirements would limit the acquisition of assets that 
cannot be sold or disposed of within seven days. However, there are 
several key differences between the proposed and adopted requirements. 
Specifically, the proposed rule would have had a fund identify 15% 
standard assets in a process separate from the requirement to classify 
portfolio assets' liquidity, whereas rule 22e-4 as adopted today 
generally incorporates classification of portfolio investments as 
illiquid into the process for classifying the liquidity of a fund's 
portfolio investments generally. As discussed in sections III.C.1.b and 
III.C.3.b above, a fund is required to take into account ``relevant 
market, trading, and investment-specific considerations,'' and also is 
required to consider market depth, in classifying an investment as 
illiquid. Also as discussed above in section III.C.2.d, rule 22e-4 
incorporates a modified value impact standard in the definition of 
``illiquid investment'' from the value impact standard reflected in

[[Page 82208]]

the proposed definition of ``15% standard asset.''
---------------------------------------------------------------------------

    \748\ See Proposing Release, supra footnote 9, at section 
III.C.4. Under the proposed rule, ``15% standard asset'' was defined 
as ``an 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.'' Proposed rule 22e-4(a)(4). For 
purposes of this definition, a fund would not have needed to 
consider the size of the fund's position in the asset or the number 
of days associated with receipt of proceeds of sale or disposition 
of the asset. Id.
    We note that, as proposed, the text of rule 22e-4 would have 
limited the acquisition of 15% standard assets if, immediately after 
the acquisition, the fund would have invested more than 15% of its 
total assets (as opposed to net assets) in 15% standard assets. See 
proposed rule 22e-4(b)(2)(iv)(D). This reference to ``total assets'' 
in the proposed rule text was intended to read ``net assets,'' as 
was evident in the discussion of this rule provision in Proposing 
Release, section III.C.4 (and elsewhere in the Proposing Release), 
which consistently discussed the provision as limiting a fund's 
acquisition of 15% standard assets if, immediately after the 
acquisition, the fund would have invested more than 15% of its net 
assets in 15% standard assets. Rule 22e-4 as adopted refers to ``net 
assets'' instead of ``total assets.''
---------------------------------------------------------------------------

    The majority of commenters supported the codification of the 
Commission's 15% guideline as proposed. Many commenters stated that the 
15% guideline is an important investor protection measure and posited 
that the guideline has proven to be a highly effective safeguard 
against liquidity risk.\749\ One commenter specifically noted that 
assets of open-end funds should be predominantly liquid and replacing 
the guideline with a formal regulatory mandate would promote investor 
protection.\750\ Another commenter viewed the 15% guideline as a clear 
safeguard against liquidity risk that has the benefits of simplicity, 
clarity, and easy administration.\751\ One commenter stated that 
setting reasonable controls on, and monitoring the use of, illiquid 
asset classes to ensure that they do not compromise the liquidity 
offered to investors within the fund is an important element of 
properly managing open-end funds.\752\ Finally, one commenter suggested 
that the proposed codification of the 15% guideline would both increase 
the likelihood that funds hold adequate liquid assets to meet 
redemption requests without significant dilution and increase the 
likelihood that a fund's portfolio is not concentrated in assets whose 
liquidity is limited.\753\
---------------------------------------------------------------------------

    \749\ See, e.g., Cohen & Steers Comment Letter; Eaton Vance 
Comment Letter I; FSR Comment Letter; LSTA Comment Letter.
    \750\ See State Street Comment Letter.
    \751\ See Better Markets Comment Letter.
    \752\ See BlackRock Comment Letter.
    \753\ See CRMC Comment Letter.
---------------------------------------------------------------------------

    In addition, several commenters supported a limit on the amount of 
illiquid assets that can be held by a fund generally, but suggested 
alternatives to how the 15% standard would operate or the proposed 
definition of 15% standard assets.\754\ In fact, most commenters who 
expressed concerns regarding the proposed 15% limit did so in the 
context of suggesting alternatives to the proposal or the proposed 
definition of ``15% standard asset.'' Multiple commenters who discussed 
the proposed limit suggested that the Commission should harmonize its 
codification of the existing 15% guideline with the proposed 
requirement for a fund to classify the liquidity of its portfolio 
assets generally (i.e., they suggested that illiquid assets be the 
least liquid classification category).\755\ Some commenters suggested 
that any limit on illiquid assets should not just limit the acquisition 
of illiquid assets, but also should require the fund to adjust its 
portfolio if it exceeds the 15% limit.\756\ Finally, some commenters 
suggested that a fund be required to notify its board and the 
Commission if it exceeds the 15% limit.\757\ All other comments on the 
proposed limit were comments regarding the definition of ``15% standard 
asset'' and are discussed above in section III.C.2.d.
---------------------------------------------------------------------------

    \754\ See, e.g., AFR Comment Letter; Blackrock Comment Letter; 
Keefer Comment Letter; Wahh Comment Letter. In general, the comments 
we received on the 15% standard did not specifically address the 
amount of the limit; cf. footnote 761 and accompanying text.
    \755\ See, e.g., Eaton Vance Comment Letter I; Federated Comment 
Letter; SIFMA Comment Letter I; Markit Comment Letter.
    \756\ See, e.g., Fidelity Comment Letter; Keefer Comment Letter; 
Wahh Comment Letter. But see HSBC Comment Letter (arguing that 
imposing a fixed time period in which holdings above the 15% 
threshold must be divested would not be appropriate because it may 
force sales at depressed prices to the detriment of investors).
    \757\ See BlackRock Comment Letter; ICI Comment Letter I; SIFMA 
Comment Letter III.
---------------------------------------------------------------------------

    We agree with commenters who stated that codifying a limit on 
funds' illiquid investments should be a central element of managing 
open-end funds' liquidity risk, which in turn would further the 
protection of investors. While we believe that the highly liquid 
investment minimum requirement will increase the likelihood that each 
fund holds adequate liquid assets to meet redemption requests without 
significant dilution of remaining investors' interests in the fund, the 
limit on illiquid investments also should increase the likelihood that 
a fund's portfolio is not concentrated in investments whose liquidity 
is extremely limited, and thus will serve as an across-the-board limit 
on fund illiquidity. As discussed above, the Commission and staff have 
in the past provided guidance in connection with the 15% guideline. 
Today we are withdrawing this guidance along with the 15% guideline and 
replacing it with new requirements for determining that an investment 
is illiquid, as well as new guidance in this Release regarding these 
requirements. We believe that the limit on illiquid investments that 
are assets that we are adopting, together with the new definition of 
``illiquid investments'' that encompasses additional elements for 
determining that an investment is illiquid,\758\ provides a more 
comprehensive framework for funds to evaluate the liquidity of their 
investments.
---------------------------------------------------------------------------

    \758\ See supra section III.C.2.d.
---------------------------------------------------------------------------

    We also agree, as discussed in more detail in section III.C.2.d 
above, that it is appropriate to harmonize the rule 22e-4 limit on 
illiquid investments with the rule's broader liquidity classification 
requirement by incorporating an illiquid investment category into the 
classification requirement. We believe that this harmonization will 
reduce confusion that could arise if we were to adopt requirements for 
identifying illiquid investments that differed from the requirements 
for classifying the liquidity of investments that are not 
illiquid.\759\ Additionally, we believe the harmonization responds to 
commenter concerns that, in practice, many funds believe very few of 
their portfolio investments are subject to the 15% limit on illiquid 
securities, since funds will be required to take into account 
``relevant market, trading, and investment-specific considerations'' in 
identifying illiquid investments and incorporate market depth 
considerations as part of the rule's liquidity classification 
requirement.\760\ A fund also will be required to consider a modified 
value impact standard in determining if an investment is illiquid, 
which as discussed above, we believe will help funds make more accurate 
liquidity assessments, particularly for asset classes or investments 
that are subject to intra-day price volatility.
---------------------------------------------------------------------------

    \759\ See supra footnotes 392-395 and accompanying text.
    \760\ See supra footnotes 399-401 and accompanying text.
---------------------------------------------------------------------------

    One commenter suggested that, if the Commission adopts requirements 
that would expand the set of assets that is subject to the 15% limit on 
illiquid assets, it could consider extending the limit beyond 15%, or 
extending the time-to-sale period associated with the definition of 
``illiquid asset'' beyond seven days, in order to limit market 
disruptions.\761\ We have considered this suggestion and have decided 
that it is not necessary.\762\ We continue to believe that 15% is an 
appropriate limit on illiquid investments that are assets. The 
compliance period we are adopting for rule 22e-4 will permit funds to 
come into compliance with the revised 15% illiquid investment limit 
while minimizing market disruptions.\763\
---------------------------------------------------------------------------

    \761\ See AFR Comment Letter.
    \762\ As noted above, no other commenters specifically addressed 
the amount of the limit.
    \763\ See infra section III.M.1.
---------------------------------------------------------------------------

    In the proposal, we requested comment as to whether we should 
require a fund to divest its assets in excess of the 15% limit or 
whether we should limit the time period in which a fund can exceed the 
15% limit. As noted above, some commenters suggested that the 15% limit 
should be a maintenance test, rather than an acquisition test, 
requiring the fund to adjust its portfolio if it exceeds the 15%

[[Page 82209]]

limit.\764\ Another commenter argued that imposing a fixed time period 
in which holdings above the 15% threshold must be divested would not be 
appropriate because it may force sales at depressed prices to the 
detriment of investors.\765\ In addition, one commenter noted the 
importance of ensuring oversight once a fund breaches the 15% limit and 
that efforts are made to reduce the fund's illiquid asset holdings 
(when possible).\766\
---------------------------------------------------------------------------

    \764\ See supra footnote 756 and accompanying text.
    \765\ See HSBC Comment Letter.
    \766\ See BlackRock Comment Letter; cf. PIMCO Comment Letter 
(suggesting that, with respect to the proposed three day liquid 
asset minimum, if a fund breaches the minimum, its manager should be 
afforded a reasonable period of time to reposition the portfolio).
---------------------------------------------------------------------------

    We believe that requiring a fund to divest illiquid investments if 
the fund's holdings of illiquid investments that are assets exceed 15% 
of net assets--which, as suggested by a commenter, could result in the 
fund needing to sell the illiquid investments at prices that 
incorporate a significant discount to the investments' stated value, or 
even at fire sale prices--could adversely affect shareholders and could 
potentially negate the liquidity risk management benefits of the 
illiquid investment limit. Therefore, under the final rule, a fund will 
be prohibited from acquiring any illiquid investment if, immediately 
after the acquisition, its illiquid investments that are assets would 
exceed 15% of its net assets.\767\
---------------------------------------------------------------------------

    \767\ We recognize that some index funds currently implement 
their strategies by using a full replication technique--i.e., by 
investing in all of the component securities of an index. To the 
extent an index tracked by an index fund would require a fund using 
a full replication technique to invest more than 15% of its net 
assets in illiquid investments that are assets, such fund could not 
make those investments and would need to consider whether it should 
continue to seek to track the performance of such index or whether 
it should use a different investment technique, such as sampling, to 
track the index.
---------------------------------------------------------------------------

    We further believe, however, that a fund should not be permitted to 
exceed the 15% limit on illiquid investments for an extended period of 
time without board oversight. Therefore, because we believe that if a 
fund's illiquid investments that are assets exceed the 15% limit it 
could indicate that the fund is encountering harmful liquidity 
pressures, the final rule requires, as suggested by commenters,\768\ 
that a fund promptly report such occurrence to its board and the 
Commission.\769\ Specifically, the final rule requires funds that hold 
more than 15% of their net assets in illiquid investments that are 
assets to report such an occurrence to their boards of directors within 
one business day, including an explanation of the extent and causes of 
the occurrence and how they plan to bring their illiquid investments 
that are assets to or below 15% of their net assets within a reasonable 
period of time.\770\ We also anticipate that if a fund exceeds the 15% 
limit on illiquid investments that are assets at any point during the 
year, the written report to the board of directors regarding the 
adequacy and effectiveness of the liquidity risk management program 
would discuss the breach of the limit and, if the fund is still 
breaching the 15% limit at the time of the report, the plan to bring 
the fund's illiquid investments that are assets to or below 15% of its 
net assets within a reasonable period of time.\771\ In addition, if the 
amount of the fund's illiquid investments that are assets is still 
above 15% of its net assets 30 days from the occurrence (and at each 
consecutive 30 day period thereafter), the fund's board of directors, 
including a majority of directors who are not interested persons of the 
fund, must assess whether the plan presented to it, as described above, 
continues to be in the best interest of the fund or in kind ETF.\772\ 
We believe these requirements appropriately balance our concerns 
regarding the overall liquidity of the fund's portfolio with the 
potential adverse effects that the forced sale of illiquid investments 
could have on a fund and its shareholders. These requirements should 
not result in funds selling their illiquid investments at fire sale 
prices or at inopportune times because such a sale would likely not be 
in the best interests of a fund and its shareholders. However, we 
believe that board oversight is important when a fund's illiquid 
investments exceed 15% of its net assets for an extended period of 
time.
---------------------------------------------------------------------------

    \768\ See supra footnote 757.
    \769\ See infra section III.H.4 (discussing board oversight of 
the illiquid investment limit).
    \770\ Rule 22e-4(b)(1)(iv)(A); see also infra section III.H.4.
    \771\ See infra section III.H.2 (discussing the written report 
to the board on the adequacy and effectiveness of the liquidity risk 
management program); see also rule 22e-4(b)(2)(iii).
    \772\ See rule 22e-4(b)(1)(iv)(A) and (B).
---------------------------------------------------------------------------

    We acknowledge that requiring a board assessment of the 
appropriateness of the fund's plan to decrease its level of illiquid 
investments every 30 days a fund holds illiquid assets in excess of 15% 
of its net assets may impose burdens on boards and funds. Nonetheless, 
we believe that such a requirement is appropriate in light of the 
serious consequences that can result when a fund's liquidity becomes 
impaired or further deteriorates, particularly for extended periods of 
time.\773\ We expect that this requirement will appropriately focus 
boards and funds on resolving liquidity impairments in a reasonable 
period of time and in the best interests of the fund and its 
shareholders. In light of the risks attendant in holding larger 
proportions of illiquid investments, we believe it is important that 
the board is provided sufficient information and regular updates so 
that it can make an informed judgment. Accordingly, we believe this 
periodic reassessment requirement in the rule is appropriate.
---------------------------------------------------------------------------

    \773\ See, e.g., Discussion of liquidity issues associated with 
the Third Avenue Focused Credit fund at n. 81.
---------------------------------------------------------------------------

    Additionally, as discussed in section III.M.2 below, a fund will be 
required to confidentially notify the Commission when its illiquid 
investments that are assets exceed 15% of its net assets. As discussed 
below, reporting of this information will assist Commission staff in 
its monitoring efforts of liquidity, including monitoring not only the 
reporting fund but also funds that may have comparable characteristics 
to the reporting fund and may be similarly affected by market events. 
The percentage of the fund's holdings invested in illiquid investments 
that are assets also will be disclosed on Form N-PORT to the public on 
a quarterly basis, with a 60-day delay, as discussed in section III.C.6 
above, which will lead to increased transparency of the fund's profile 
regarding holdings of illiquid investments at particular points in 
time.

F. Policies and Procedures Regarding Redemptions in Kind

    Many funds reserve the right to redeem their shares in-kind instead 
of with cash.\774\ Mutual funds that reserve the right to redeem in 
kind may use such redemptions to manage liquidity risk under 
exceptional circumstances.\775\ While many funds

[[Page 82210]]

disclose that they have reserved the right to redeem in kind, most 
funds often consider redemptions in kind to be a last resort or 
emergency measure, and thus many do not have specific policies or 
procedures in place governing such in-kind redemptions.\776\ Like the 
proposal, the final rule requires a fund that engages in or reserves 
the right to engage in in-kind redemptions to adopt and implement 
written policies and procedures regarding in-kind redemptions as part 
of the management of its liquidity risk.\777\ These policies and 
procedures generally should address the process for redeeming in kind, 
as well as the circumstances under which the fund would consider 
redeeming in kind.
---------------------------------------------------------------------------

    \774\ See, e.g., Rule 18f-1 and Form N-18F-1 Adopting Release, 
supra footnote 24 (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.'').
    \775\ See 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.'').
    \776\ See Proposing Release, supra footnote 9, at section 
III.C.5
    \777\ Rule 22e-4(b)(v). This requirement also applies to In-Kind 
ETFs that are subject to the tailored regime discussed below. Id.
---------------------------------------------------------------------------

    Multiple commenters welcomed efforts by the Commission to 
facilitate funds' ability to use redemptions in kind and stated that 
they considered redemptions in kind an important liquidity risk 
management tool for allocating the cost of selling securities to meet 
redemptions to redeeming investors.\778\ These commenters also 
generally agreed that as part of a fund's management of its liquidity 
risk, a fund should adopt and implement written policies and procedures 
regarding in-kind redemptions.\779\ Commenters noted that there are 
often logistical issues associated with paying in-kind redemptions, and 
that this limits the availability of in-kind redemptions under many 
circumstances.\780\ Commenters also noted that some shareholders are 
generally unable or unwilling to receive in-kind redemptions, which may 
limit its utility.\781\ These commenters agreed that requiring funds to 
implement policies and procedures on in-kind redemptions in advance 
would promote a focus on addressing any legal or operations issues 
before the fund's use of redemptions in kind, thus making such 
redemptions a more practical and effective liquidity management 
tool.\782\
---------------------------------------------------------------------------

    \778\ BlackRock Comment Letter (noting that redemptions in kind 
allow costs to be externalized from the fund without the use of 
mechanisms such as swing pricing).
    \779\ See, e.g., BlackRock Comment Letter; Invesco Comment 
Letter.
    \780\ See, e.g., Invesco FSOC Notice Comment Letter, supra 
footnote 248 (noting that while ``Invesco has on occasion exercised 
rights to redeem in kind, in practice such rights are exercised 
infrequently'').
    \781\ See Peter Fortune, Mutual Funds, Part I: Reshaping the 
American Financial System, New England Econ. Rev. (July/Aug. 1997) 
(``Fortune'') at 47 (``A fund redeeming in kind does so at the risk 
of its reputation and future business . . .''), available at http://www.bostonfed.org/economic/neer/neer1997/neer497d.htm; Invesco 
Comment Letter.
    \782\ ICI Comment Letter I; BlackRock Comment Letter.
---------------------------------------------------------------------------

    Commenters also suggested that the Commission provide guidance on 
the appropriate use of in-kind redemptions for funds.\783\ We expect 
that effective fund policies and procedures on in-kind redemptions 
would contemplate a variety of issues and circumstances. Well-designed 
policies and procedures would likely address the particular 
circumstances in which a fund might employ in-kind redemptions, for 
example, detailing whether a fund would use in-kind redemptions at all 
times, or only under stress, and what types of events may lead the fund 
to use them. Such policies and procedures would also likely address 
whether a fund would use in-kind redemptions for all redemption 
requests or only for requests over a certain size.\784\
---------------------------------------------------------------------------

    \783\ See, e.g., BlackRock Comment Letter.
    \784\ One commenter suggested that fund sponsors should consider 
redemptions in kind if withdrawal requests exceed a certain 
percentage of a fund's total assets. See BlackRock Comment Letter.
---------------------------------------------------------------------------

    Funds may also wish to consider having policies and procedures that 
address the ability of investors to receive in-kind redemptions, 
potentially including different procedures for different shareholder 
types. For example, the policies and procedures might provide that 
retail shareholders (who may not be operationally equipped to receive 
in-kind redemptions) may be provided cash redemptions, but that 
institutional investors who may be able to receive such securities, 
would be paid out in-kind under certain circumstances. These procedures 
may also consider whether holdings through omnibus accounts pose any 
unique issues that should be addressed. Well-designed policies and 
procedures would likely also address potential operational issues with 
providing in-kind redemptions to various kinds of investors, and plan 
out methods for addressing such operational issues. These might include 
notifying large shareholders that may be subject to redemptions in kind 
and setting up securities transfer processes for those shareholders in 
advance.
    Effective policies and procedures would also likely address how the 
fund would determine which securities it would use in an in-kind 
redemption (for example would it use illiquid or restricted 
securities), or whether it plans to redeem securities in kind as a pro 
rata ratio of the fund's securities holdings, or whether it would 
redeem in a non-pro rata manner. For a fund that redeems pro rata, 
policies and procedures might address how the fund plans in-kind 
redemptions of odd lots or small lots of securities, and if a fund were 
to do such odd lot transactions, how to process such transactions. They 
may also consider how they would accomplish in-kind redemptions of 
illiquid securities or securities that have restrictions on their 
transferability, and the extent to which these securities would not be 
redeemed in kind.
    If a fund chooses not to redeem in a pro rata manner, effective 
policies and procedures would likely address that securities redeemed 
are selected and distributed in a manner that is fair and does not 
disadvantage either the redeeming shareholder or the remaining 
investors in the fund. We caution that if a fund redeems an investor's 
interests in a fund by transferring an unrepresentative set of 
securities to the investor, this may raise questions of shareholder 
discrimination and unfairness (as well as potentially cherry picking 
and favoritism), which should be addressed in the fund's policies and 
procedures. For example, policies and procedures could address how to 
ensure that any securities that are redeemed in kind in a non-pro rata 
manner are valued properly, to ensure that the securities transferred 
represent the proportionate share of the fund NAV.\785\ They might also 
address how the fund would determine that shareholders are treated 
fairly, and are not redeemed with securities the fund deems undesirable 
or securities that have significant tax consequences. Relatedly, the 
policies and procedures may also address how the fund evaluates the tax 
consequences to the fund and the redeeming shareholder of distributing 
certain securities, for example, whether distributing certain 
securities that have significant capital gains or losses built in would 
have inequitable results.
---------------------------------------------------------------------------

    \785\ See section 2(a)(32) (definition of redeemable security). 
Such a transaction may have significant negative consequences to the 
redeeming recipient, particularly if the security provided was fair 
valued improperly, was restricted, or was in other ways impaired.
---------------------------------------------------------------------------

    Because the management and personnel capacity of funds facing heavy 
redemptions and other liquidity stresses will likely be strained as 
funds attempt to manage these pressures, the Commission believes that 
requiring funds to have policies and procedures

[[Page 82211]]

dictating how fund's will implement in-kind redemptions will increase 
the likelihood that in-kind redemptions will be a feasible risk 
management tool, and may address any potential fund or shareholder 
inequities. Accordingly, we are adopting this requirement largely as 
proposed.\786\
---------------------------------------------------------------------------

    \786\ The rule text has been slightly modified to make clear 
that redemption in kind policies and procedures must address not 
just how the fund will engage in redemptions in kind, but also when 
it will do so. Rule 22e-4(b)(1)(v).
---------------------------------------------------------------------------

G. Cross-Trades

    Today, under rule 17a-7, funds may make certain affiliated 
securities transactions between funds and certain affiliates (``cross 
trades''), provided they meet certain protective conditions.\787\ Rule 
17a-7 includes conditions that limit the portfolio assets that may be 
cross-traded, and, as discussed below, cross-trades involving certain 
less liquid assets may not be eligible to rely on the rule. As 
discussed in the Proposing Release, some funds may consider engaging in 
cross-trades to be a useful liquidity risk management tool. Cross-
trading can benefit funds and their shareholders by allowing funds that 
are mutually interested in a securities transaction that is consistent 
with the investment strategies of each fund to conduct the transaction 
without incurring transaction costs and without generating a market 
impact.\788\ However, cross-trades also have significant potential for 
abuse. For example, as the Commission has previously stated, ``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.'' \789\ 
Cross-trade transactions also may be inconsistent with the investment 
objectives, investment strategies, or risk profiles of participating 
investment companies and other advisory clients.\790\
---------------------------------------------------------------------------

    \787\ Section 17 of the 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. 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).
    \788\ As 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 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.
    \789\ Exemption 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)]. See also Evergreen Order, supra 
footnote 46 (fund's adviser failed to seek best execution in trading 
fund securities and favored one client over another, thereby 
engaging in transactions that operated as a fraud or deceit upon its 
client in violation of section 206(2) of the Advisers Act).
    \790\ A fund that provided a non-pro rata distribution of cash, 
securities or other property to a shareholder that owns 5% or more 
of the fund and/or gives any election to the shareholder about which 
assets to receive may also raise affiliated transaction concerns 
under section 17(a) and rule 17a-5, as such a transaction would fall 
outside the exemption provided by rule 17a-5 and thus might be 
viewed as a sale to or purchase from the fund by an affiliated 
person.
---------------------------------------------------------------------------

    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.\791\ In requiring market quotations for 
cross-traded 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 or other advisory client and 
do not involve overreaching.'' \792\ Rule 17a-7 also requires that a 
cross-trade transaction be ``consistent with the policy of each 
registered investment company and separate series of a registered 
investment company participating in the transaction, as recited in its 
registration statement and reports filed under the Act.'' \793\
---------------------------------------------------------------------------

    \791\ See rule 17a-7(b).
    \792\ Exemption 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 has 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.
    \793\ See rule 17a-7(c).
---------------------------------------------------------------------------

    We noted in the Proposing Release that less liquid assets are less 
likely to satisfy rule 17a-7 than highly liquid investments.\794\ Some 
commenters expressed concern that this assertion would prohibit funds 
from, or create a presumption against, cross-trading any assets deemed 
less liquid,\795\ or directly incorporate liquidity classification 
decisions into rule 17a-7 eligibility determinations.\796\ One 
commenter, disagreeing with the assertion that less liquid assets are 
less likely to satisfy rule 17a-7 than highly liquid assets, stated ``a 
less actively traded security may be less liquid, but nonetheless have 
readily available market quotations, and a fund may determine that 
independent bid and offer prices are available in the market. The 
relative illiquidity of the security itself will not alone be 
determinative of whether prices are available for Rule 17a-7 
purposes.'' \797\
---------------------------------------------------------------------------

    \794\ See Proposing Release, supra footnote 9, at n.396 and 
accompanying text.
    \795\ See ICI Comment Letter I.
    \796\ See Comment Letter of Simpson Thacher & Bartlett LLP (Jan. 
14, 2016) (``Simpson Thacher Comment Letter'').
    \797\ See Fidelity Comment Letter.
---------------------------------------------------------------------------

    We note that less liquid assets, by definition, are less likely to 
trade in highly active markets that produce readily available market 
quotations, which may make it more difficult to ensure that the terms 
of a cross-trade transaction are fair and reasonable to each 
participating investment company or other advisory client and do not 
involve overreaching. As one commenter noted, ``rule 17a-7 broadly 
requires the availability of accurate valuation information with 
respect to any security proposed to be traded from one adviser-directed 
account to another. This effectively requires such securities to be 
relatively liquid.'' \798\ Moreover, the absence of highly active 
markets for less liquid assets may exacerbate the concern discussed 
above relating to ``dumping'' undesirable securities, because limited 
markets for such assets indicates that there are fewer alternate 
options for disposing of the assets. Similarly, the absence of highly 
active markets for less liquid assets may exacerbate the concern 
relating to a transfer of assets that is inconsistent with the 
investment objective, investment strategies, or risk profile of each 
participating investment company or other advisory client.
---------------------------------------------------------------------------

    \798\ See id.
---------------------------------------------------------------------------

    We agree that an assessment of an asset's liquidity, without more, 
would not determine whether the asset is eligible for a cross-trade 
transaction under rule 17a-7. However, as noted above, we believe that 
any assets used in a cross-trade transaction should be scrutinized to 
ensure that they satisfy all of rule 17a-7's requirements. Due to the 
particular risks associated with cross-trading less liquid assets, it 
may be

[[Page 82212]]

prudent for advisers to subject less liquid assets to careful review 
(and potentially even a heightened review compared to other more liquid 
assets) before engaging in such transactions.
    We note that cross trading also implicates a fund's adviser's duty 
to seek best execution for each fund or other advisory client, as well 
as its duty of loyalty to each fund or other advisory client.\799\ An 
adviser should not cause funds or other clients to enter into a cross-
trade unless doing so would be in the best interests of each fund or 
other client participating in the transaction. Advisers should be 
particularly sensitive to the possibility of heightened conflicts when 
one or both of the clients is experiencing stress at the time of 
consideration of a cross trade.
---------------------------------------------------------------------------

    \799\ See, e.g., In re Western Asset Management Co., Investment 
Company Act Release No. 30893 (Jan. 27, 2014) (settled action) 
(stating that the adviser to funds and other advisory clients 
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'' and finding that the adviser aided and 
abetted and caused violations of section 17(a) and violated Advisers 
Act section 206).
---------------------------------------------------------------------------

    Under rule 38a-1, a fund's compliance policies and procedures 
related to rule 17a-7 generally should contemplate how the fund meets 
the rule's requirements with regard to less liquid assets. For example, 
as part of these policies and procedures, a fund might consider 
conducting a review of less liquid assets before cross-trading them to 
ensure that ``market quotations are readily available,'' that a 
``current market price'' is available, that the transaction is in line 
with each participating investment company's or other advisory client's 
investment objective, investment strategies and risk profile, and that 
the cross-trade satisfies all other requirements set forth in rule 17a-
7. Reasonably designed policies and procedures thus would likely 
specifically address how a fund would determine that such less liquid 
securities are appropriately used when meeting the requirements of rule 
17a-7. The specific review of a less liquid asset would likely vary 
depending on the characteristics of the market or markets in which the 
asset transacts, the characteristics of the asset itself, and the 
nature of the funds potentially involved in the cross trade.
    In crafting policies and procedures reasonably designed to address 
the particular risks of cross-trading less liquid assets, a fund could 
consider specifying the sources of the readily available market 
quotations to be used to value the assets and establish specific 
criteria for determining whether market quotations are current and 
readily available, and include potential back-up sources if the primary 
sources are not available. Funds should consider including in their 
policies and procedures periodic reviews of the continuing 
appropriateness of those sources of readily available market 
quotations.
    In addition, a fund's policies and procedures might also provide 
for assessing the quality of quotations provided by dealers. The 
quality of dealer quotations may vary depending upon, among other 
things, the extent to which a dealer makes a market in or retains an 
inventory in the particular security, or in similar securities, such 
that the dealer maintains an awareness of changes in market factors 
affecting the value of the security.\800\ ``Indications of interest'' 
and ``accommodation quotes,'' may not necessarily reflect the current 
market values of the securities and thus are not ``market quotations'' 
or ``market values'' for the purposes of rule 17a-7.\801\
---------------------------------------------------------------------------

    \800\ Dealers do not necessarily purport to provide quotations 
for securities that reflect their current market values. Some 
dealers may provide only ``indications of interest,'' i.e., non-firm 
expressions of interest to trade that do not constitute quotations 
or ``accommodation quotes''. See, e.g., Regulation NMS, Securities 
Exchange Act Release No. 49325 (Feb. 26, 2004) [69 FR 11126 (Mar. 9, 
2004)], at n.257. Cf. Rules 600(b)(8) and (62) under Regulation NMS 
[17 CFR 242.600(b)(8) and 242.600(b)(62)] (defining ``bid or offer'' 
as ``the bid price or the offer price communicated by a member of a 
national securities exchange or member of a national securities 
association to any broker or dealer, or to any customer, at which it 
is willing to buy or sell one or more round lots of an NMS security, 
as either principal or agent, but shall not include indications of 
interest,'' and defining ``quotation'' as ``a bid or an offer'').
    \801\ Id. We also note that evaluated prices provided by pricing 
services are not, by themselves, readily available market 
quotations. See 2014 Money Market Fund Reform Adopting Release, 
supra footnote 43, at n.895 and accompanying text.
---------------------------------------------------------------------------

    In addition, reasonably designed policies and procedures likely 
would also include compliance monitoring to help ensure that the 
investment objective, investment strategies and risk profile of each 
participating investment company or other advisory client are 
scrutinized in conjunction with the characteristics of any cross-traded 
asset to evaluate whether the asset transfer is not in line with any 
objective or strategy or inappropriately shifts risk from one 
investment company or other advisory client to another. Whether a 
cross-trade is in the best interest of an investment company or other 
client purchasing an asset may depend, in part, on the relative 
liquidity of the purchaser's existing portfolio assets and the level of 
redemptions that may be reasonably anticipated by the purchaser.

H. Board Approval and Designation of Program Administrative 
Responsibilities

    Directors, and particularly independent directors, play a critical 
role in overseeing fund operations, although they generally may 
delegate day-to-day management to a fund's adviser.\802\ As discussed 
below, we are adopting as proposed the requirement for a fund's board 
of directors to approve the investment adviser, officer, or officers 
who are responsible for administering the program and to approve the 
fund's written liquidity risk management program. However, in a change 
from the proposal, the board will not be required to specifically 
approve the fund's highly liquid investment minimum (except in the 
limited circumstances that a fund below its minimum seeks to change it) 
or to approve material changes to the program. Instead, similar to rule 
38a-1, the board will be required to review, no less than annually, a 
written report prepared by the investment adviser, officer, or officers 
designated to administer the liquidity risk management program that 
describes a review of the program's adequacy and effectiveness, 
including, if applicable, the operation of the highly liquid investment 
minimum, and any material changes to the program.\803\ As discussed in 
detail below, the final rule retains a role for the board in overseeing 
the fund's liquidity risk management program, but in response to 
commenters, eliminates certain of the more specific and detailed 
approval requirements.
---------------------------------------------------------------------------

    \802\ See 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, 484 (1979) (citing Tannenbaum v. Zeller, 552 
F.2d 402, 406 (2d. Cir. 1979)) (describing independent directors as 
``independent watchdogs'').
    \803\ See rule 22e-4(b)(2).
---------------------------------------------------------------------------

    We believe the role of the board under the rule is one of general 
oversight, and consistent with that obligation we expect that directors 
will exercise their reasonable business judgment in overseeing the 
program on behalf of the fund's investors. As discussed in the 
Proposing Release, 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, officer, 
or officers administering the program, legal counsel, or other persons 
familiar with the liquidity risk management

[[Page 82213]]

program.\804\ 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.
---------------------------------------------------------------------------

    \804\ See Proposing Release, supra footnote 9, at section III.D.
---------------------------------------------------------------------------

    Many commenters expressed general support for board oversight of 
the liquidity risk management program, although several objected to 
certain of the board's specific responsibilities required under the 
rule, in particular their approval of the three-day highly liquid asset 
minimum and of material changes to the program.\805\ Given the board of 
directors' historical oversight role, the Commission continues to 
believe it is appropriate to require a fund's board to oversee the 
fund's liquidity risk management program. The rule's requirements are 
designed to facilitate the board's oversight of the adequacy and 
effectiveness of the fund's liquidity risk management program.
---------------------------------------------------------------------------

    \805\ See, e.g., ICI Comment Letter I; IDC Comment Letter; SIFMA 
Comment Letter I.
---------------------------------------------------------------------------

    Several commenters asked that the final rule include an express 
standard of care (i.e., the business judgment rule) to which the 
Commission would hold a fund's board accountable in this area.\806\ One 
commenter requested that the final rule provide fund boards with a safe 
harbor in approving specific elements of the program and clarification 
that a board is not required to consider all of the enumerated factors 
(specifically, any non-applicable factors) when setting and adjusting 
the three-day liquid asset minimum.\807\ We believe that the changes 
made to the board oversight role from the proposal should largely 
address the commenters' concerns. In addition, we believe that the 
board oversight role here is substantially similar to its role and 
responsibilities in other contexts under the Investment Company Act, 
and that providing a different standard of care for board action here 
would not be appropriate.\808\
---------------------------------------------------------------------------

    \806\ Fidelity Comment Letter; FSR Comment Letter; MFDF Comment 
Letter; T. Rowe Comment Letter. See also NYC Bar Comment Letter 
(suggesting codifying a good-faith, reasonable, business judgment 
standard). One commenter also suggested that the proposed 
requirement of keeping records of the board's determination related 
to the factors considered when approving the three-day liquid asset 
minimum is not appropriate in light of the board's historical role. 
T. Rowe Comment Letter. We note that as discussed below, the board 
will not specifically approve the highly liquid investment minimum, 
thereby addressing the commenters' concerns about keeping records of 
the factors used in the board's determination.
    \807\ T. Rowe Comment Letter.
    \808\ See, e.g., 2014 Money Market Fund Reform Adopting Release, 
at text accompanying nn.266-267 (discussing the board's role under 
the Investment Company Act).
---------------------------------------------------------------------------

1. Designation of Administrative Responsibilities to Fund Investment 
Adviser, Officer, or Officers
    We are adopting substantially as proposed the requirements that the 
fund's board of directors approve the designation of the fund's 
investment adviser, officer, or officers (which could not be solely 
portfolio managers of the fund) responsible for administering the 
fund's liquidity risk management program.\809\ We are also adopting, 
substantially as proposed, the requirement that the administrator of 
the program provide the board with a written report on the adequacy of 
the fund's liquidity risk management program, including the highly 
liquid investment minimum, and the effectiveness of its implementation, 
at least annually.\810\ The Commission continues to believe this 
approach properly tasks the person(s) 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. Designating 
the fund's investment adviser, officer, or officers responsible for the 
administration of the fund's liquidity risk management program, subject 
to board approval, is consistent with the way the Commission 
understands most funds manage liquidity.\811\
---------------------------------------------------------------------------

    \809\ See rule 22e-4(b)(2)(ii).
    \810\ See rule 22e-4(b)(2)(iii). We note that a fund's sub-
adviser could be designated as the administrator of the program if 
appropriate.
    \811\ See American Bar Association, Fund Director's Guidebook, 
Federal Regulation Of Securities Committee, (4th ed. 2015), at 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.'').
---------------------------------------------------------------------------

    We received little comment on this aspect of the proposal. A few 
commenters agreed with the proposal that the board's responsibilities 
should include approval of the program's administrator.\812\ We 
continue to believe that requiring that the board approve the 
designation of the administrator of the liquidity risk program is an 
important step in board oversight of the program. We believe that 
having the board approve the administrator should help enhance board 
oversight of the program and allow for boards to better understand who 
is responsible for administering it.
---------------------------------------------------------------------------

    \812\ IDC Comment Letter; Voya Comment Letter.
---------------------------------------------------------------------------

    One commenter argued that portfolio managers should administer the 
program, contending that liquidity risk management requires investment 
skills and swiftness during stress to manage redemptions.\813\ This 
commenter believed that if a program administrator were independent 
from portfolio management, then liquidity assessment might become 
divorced from the investment process, which the commenter argued would 
be disadvantageous to the fund and investors. We agree that portfolio 
management provides valuable input into the liquidity risk management 
process. However, we are concerned that if only portfolio managers run 
the program, the program might not be administered with sufficient 
independence to accomplish the goal of managing the risk of the fund's 
liquidity. We believe that a fund generally should consider the extent 
of influence portfolio managers may have on administration of the 
program, and seek to provide independent voices and administration of 
the program as a check on any potential conflicts of interest to the 
extent appropriate. However, as the proposal noted, although the fund's 
portfolio managers cannot be solely responsible for administering the 
program, the administrator of the program might wish to consult with 
the fund's portfolio manager, traders, risk managers, and others as 
necessary or appropriate in administering a fund's liquidity risk 
management program.\814\ Portfolio managers may also be a part of any 
committee or group designated to administer the program, if more than 
one person is so designated. The Commission understands that some funds 
currently employ a dedicated risk management officer who consults with 
the fund's portfolio management team. One commenter noted, and we 
agree, that portfolio managers should provide day-to-day management of 
funds, with an additional layer of oversight provided by the risk and 
compliance framework.\815\ After review of the comments received, we 
continue to believe that requiring the officer or officers responsible 
for administering the fund's liquidity risk management program not to 
be solely portfolio managers strikes the appropriate balance between 
independence and expertise.
---------------------------------------------------------------------------

    \813\ Invesco Comment Letter.
    \814\ See Proposing Release, supra footnote 9, at section 
III.D.3.
    \815\ BlackRock Comment Letter.
---------------------------------------------------------------------------

    The Commission recognizes that, in certain circumstances, a fund's 
service providers might assist a fund and its investment adviser by 
providing information relevant to a fund's assessing and managing 
liquidity

[[Page 82214]]

risk.\816\ We note, however, that the primary parties responsible for a 
fund's liquidity risk management are the fund itself and any parties to 
whom the fund has delegated responsibility for administering the fund's 
liquidity risk management program.
---------------------------------------------------------------------------

    \816\ See Proposing Release, supra footnote 9, at section 
III.D.3.
---------------------------------------------------------------------------

    One commenter requested further guidance on what responsibilities 
the administrator could delegate and to what extent the administrator 
could rely upon third parties.\817\ The Proposing Release provided two 
examples of when a fund's service providers could assist a fund and its 
investment adviser in monitoring factors relevant to a fund's liquidity 
risk and managing the fund's liquidity risk: Third parties could 
provide data relevant to assessing fund flows, and a sub-adviser 
necessarily would be responsible for investing a fund's assets in 
accordance with the fund's three-day liquid asset minimum and any other 
liquidity-related portfolio requirements adopted by the fund.\818\ As 
proposed, the final rules require a fund to oversee any liquidity risk 
monitoring or risk management activities undertaken by the fund's 
service providers. We encourage the fund 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.
---------------------------------------------------------------------------

    \817\ Voya Comment Letter.
    \818\ See Proposing Release, supra footnote 9, at section 
III.D.3.
---------------------------------------------------------------------------

2. Oversight of the Liquidity Risk Management Program
    Under the final rule, a fund will be required to obtain initial 
approval of its written liquidity risk management program from the 
fund's board of directors, including a majority of its independent 
directors.\819\ Additionally, the fund's board will be required to 
review a written report from the administrator of the fund's liquidity 
risk management program, provided no less frequently than annually, 
that addresses the operation of the program and assesses its adequacy 
and effectiveness of implementation.\820\ In a change from the 
proposal, a fund will not be required to obtain approval of any 
material changes to the fund's liquidity risk management program from 
the fund's board of directors, but instead such material changes will 
be described in the report.\821\
---------------------------------------------------------------------------

    \819\ See rule 22e-4(b)(2)(i).
    \820\ As noted above, more frequent reports to the board may be 
appropriate in certain circumstances. See supra footnote 771.
    \821\ See rule 22e-4(b)(2).
---------------------------------------------------------------------------

    Commenters raised concerns that the proposed rule imposed 
management responsibilities on the fund's board of directors and 
suggested that the Commission clarify that the board's role is to 
provide oversight through approval of policies and procedures, whereas 
management's role is to devise the specific details of the 
program.\822\ Commenters contended that the final rule should mirror 
rule 38a-1, requiring fund managers to explain material changes to the 
program (including changes to the three-day liquid asset minimum) in an 
annual report to the board, not to submit those changes for prior board 
approval.\823\ These commenters felt that a requirement to discuss 
material changes to the liquidity risk management program in an annual 
update to the fund's board would strike an appropriate balance between 
allowing the fund manager the flexibility to make changes to liquidity 
risk management as market conditions might require, while also keeping 
the fund's board informed.\824\
---------------------------------------------------------------------------

    \822\ See, e.g., Cohen & Steers Comment Letter; FSR Comment 
Letter; HSBC Comment Letter; NYC Bar Comment Letter.
    \823\ See, e.g., BlackRock Comment Letter; FSR Comment Letter; 
ICI Comment Letter I; Invesco Comment Letter.
    \824\ See, e.g., BlackRock Comment Letter; Dechert Comment 
Letter; Voya Comment Letter.
---------------------------------------------------------------------------

    We agree with commenters that requiring funds to obtain approval 
from fund boards before making material changes to a liquidity risk 
management program risks the program becoming stale and outdated as 
market changes occur, and is not consistent with the approach taken 
under rule 38a-1. Accordingly, the final rule does not require prior 
approval of material changes to the fund's liquidity risk management 
program from the fund's board of directors. However, under the final 
rule, the board is still required to approve the program initially and 
to provide oversight of it, as well as review a report on the adequacy 
and effectiveness of the program's implementation, which must include a 
description of any material changes made to the program during the 
period. We believe that this oversight role is consistent with the 
board's historical responsibilities with respect to overseeing fund 
operations.
3. Oversight of the Highly Liquid Investment Minimum
    In a change from the proposal, under the final rule, boards will 
not be required to approve the highly liquid investment minimum, nor 
approve changes to it, except in the limited circumstances where a fund 
seeks to change the minimum while the fund is below the pre-established 
minimum. Commenters argued that because liquidity risk management, 
including management of three day-liquid assets, is both technical and 
fact-intensive and often requires day-to-day judgments, fund managers 
should develop and administer the program, subject to board 
review.\825\ Commenters were concerned that the requirement for a fund 
to obtain board approval for setting and changing the three-day minimum 
may cause delay that might harm fund shareholders.\826\ For example, 
one commenter argued that requiring board approval, which might be 
difficult to obtain on a timely basis, could cause a fund to stand idle 
as market conditions changed, missing opportunities as board approval 
was sought.\827\
---------------------------------------------------------------------------

    \825\ See, e.g., CRMC Comment Letter; FSR Comment Letter; State 
Street Comment Letter; Dodge & Cox Comment Letter.
    \826\ Id.
    \827\ Dechert Comment Letter.
---------------------------------------------------------------------------

    We agree with commenters that requiring boards to approve the 
highly liquid investment minimum may reduce its utility, as the minimum 
may need to be revised on a more timely basis so that it can best 
reflect the liquidity management needs of the fund under current market 
conditions. In addition, we understand commenters' concerns that 
requiring mutual fund boards to make day-to-day determinations 
regarding the minimum amount of cash or liquid assets the fund should 
hold may lead to a more detailed managerial role for the board.
    However, in the limited circumstances where the program 
administrator seeks to change the fund's highly liquid investment 
minimum while the fund is below the pre-established minimum, the final 
rules require the board to approve such a change. In the absence of 
such a requirement, the administrator could simply change the minimum 
if the fund dropped below it, avoiding the accountability of the board 
approval requirements as well as reducing the minimum's utility as a 
liquidity risk management tool. The final rule also requires the board 
to receive a report whenever the fund falls below its highly liquid 
investment minimum at its next regularly scheduled meeting and a report 
of such a shortfall if the fund is below its highly liquid investment 
minimum for more than 7 consecutive calendar days, within one business 
day thereafter. The Commission believes these requirements properly 
balance the ability of funds to move quickly in response to shifting 
environments with

[[Page 82215]]

the boards' oversight of the liquidity risk management program.
4. Oversight of Illiquid Investment Limit
    In a change from the proposal, the final rule will also require 
that a fund board be informed within one business day if the fund's 
holdings of illiquid investments exceed 15% of its net assets. In the 
proposal, we requested comment as to whether additional aspects of a 
fund's liquidity management program should be reported to a fund's 
board. For the reasons discussed in the section on Form N-LIQUID, if a 
fund's holdings of illiquid investments exceed 15% for any reason (for 
example, if a fund experiences net redemptions leading to increased 
holdings of illiquid investments) it may raise significant concerns 
regarding the fund's management of its liquidity and ability to 
continue to meet its redemption obligations. Accordingly, we believe 
that such an event should be reported to the board immediately, as it 
may have significant impacts on the ability of the fund to meet its 
redemption obligations, and may compromise its liquidity risk 
management.
    As discussed in the section on Form N-LIQUID below, a number of 
commenters also expressed support for the addition of an early warning 
notification provision, under which funds would be required to notify 
the Commission (or take other action) when illiquid investments held at 
the end of a business day exceed 15% of net assets and continue to 
exceed 15% of net assets three business days after the threshold was 
first exceeded.\828\ As discussed in the section on Form N-LIQUID, we 
are adopting a requirement that a fund report to the Commission within 
one business day if the fund's holdings of illiquid investments exceed 
15% percent of its net assets. One commenter suggested that such a 
requirement would impose greater discipline on the oversight of fund 
holdings of illiquid assets, and that a fund would likely consult with 
the fund board in developing how to proceed in response.\829\ We agree, 
and believe that if a fund were to file Form N-LIQUID because the 
fund's holdings of illiquid investments exceeded 15% of its net assets, 
a fund board should be informed, and should be informed quickly, so 
that the board can provide oversight as the fund determines how to 
address the level of illiquidity in the fund's portfolio. Accordingly, 
as a complement to this new N-LIQUID requirement, the final rules 
require that if a fund's holdings of illiquid investments exceed 15% of 
its net assets, the fund board be informed of that fact within one 
business day after the occurrence, with an explanation of the extent 
and causes of the occurrence and how the fund plans to bring its 
illiquid investments that are assets to or below 15% of its net assets 
within a reasonable period of time.
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    \828\ See, e.g., ICI Comment Letter III; SIFMA Comment Letter 
III (noting that this early warning notification could respond to 
concerns raised by the Third Avenue Fund liquidation); see also 
Third Avenue Temporary Order, supra footnote 12.
    \829\ See ICI Comment Letter III.
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I. Recordkeeping Requirements

    Under the final rules, and as we proposed, each fund will be 
required to 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.\830\ Additionally, each fund will 
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 copies of written reports provided to the 
board on the adequacy of the fund's liquidity risk management program, 
including the fund's highly liquid investment minimum, and the 
effectiveness of its implementation 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.\831\ In a 
change from the proposal, funds would also need to keep records of any 
materials provided to the board related to the fund dropping below its 
highly liquid investment minimum. As with the proposal, the final rules 
also require each fund to keep a written record of how its highly 
liquid investment minimum, and any adjustments thereto, were 
determined, including the fund's assessment and periodic review of its 
liquidity risk 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 highly liquid investment minimum.\832\
---------------------------------------------------------------------------

    \830\ See rule 22e-4(b)(3)(i). These policies and procedures 
would include any shortfall policies and procedures adopted by a 
fund. See id.
    \831\ See rule 22e-4(b)(3)(ii).
    \832\ See rule 22e-4(b)(3)(iii).
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    One commenter found the recordkeeping requirements consistent with 
similar recordkeeping requirements that funds are currently required to 
maintain.\833\ The recordkeeping requirement is designed to provide our 
examination staff with a basis to evaluate a fund's compliance with the 
requirements of rule 22e-4. We also anticipate that these records would 
assist our staff in identifying weaknesses in a fund's liquidity risk 
management. The five-year retention period is also consistent with the 
period provided in rule 38a-1(d) under the Act. We believe consistency 
in these retention periods is appropriate because funds currently have 
compliance program-related recordkeeping procedures in place 
incorporating a five-year retention period, which we believe lessen the 
compliance burden to funds, compared to choosing a different retention 
period, such as the six-year recordkeeping retention period under rule 
31a-2 of the Act.
---------------------------------------------------------------------------

    \833\ CFA Comment Letter.
---------------------------------------------------------------------------

    The Commission continues to believe that the rule appropriately 
balances recordkeeping-related burdens on funds and our examination 
staff's ability to evaluate a fund's liquidity risk management program 
in light of the requirements of rule 22e-4. We are therefore adopting 
this aspect of the rule substantially as proposed.

J. ETFs

    We are adopting certain tailored liquidity risk management program 
requirements for ETFs.\834\ In assessing, managing, and periodically 
reviewing its liquidity risk, an ETF will be required to consider 
certain additional factors, as applicable, that take into account its 
unique operation, as discussed further below.\835\ Like all funds, each 
ETF also will be required to limit its investments in illiquid 
investments to no more than 15% of its net assets and obtain certain 
board approvals regarding the program. Certain ETFs that qualify as 
``In-Kind ETFs,'' \836\ (generally ETFs that redeem shares in kind 
except to a de minimis extent and that publish their holdings daily) 
however, will not be required to classify their portfolio investments 
or comply with the highly liquid investment minimum requirement.\837\

[[Page 82216]]

We believe these adjusted program requirements recognize and 
appropriately require management of the unique liquidity risks found in 
ETFs, and in particular In-Kind ETFs.
---------------------------------------------------------------------------

    \834\ References to ETFs in this section are to both in-kind and 
other open-end ETFs, but not UIT ETFs (which are not subject to the 
liquidity risk management program requirements), except where 
specifically indicated otherwise. See infra section III.K for a 
discussion of limited liquidity review requirements for principal 
underwriters and depositors of UITs.
    \835\ See rule 22e-4(b)(1)(i).
    \836\ References to ``In-Kind ETFs'' include both ETFs and ETMFs 
that meet the requirements in rule 22e-4(a)(9)) (defining an ``In-
Kind ETF''). See infra footnote 851 and accompanying text 
(discussing a requirement that ETFs report their status as an ``In-
Kind ETF,'' when applicable, on Form N-CEN).
    \837\ ETFs that redeem in cash, or that do not qualify otherwise 
as ``In-Kind ETFs'' (as defined in rule 22e-4(a)(9)) will be subject 
to the full set of liquidity risk management program elements, 
including the classification and highly liquid investment minimum 
requirements. See rule 22e-4(b)(1)(i)-(iii). Throughout the 
discussion of liquidity risk management programs in this Release, 
references to ``funds'' include ETFs that redeem in cash, except 
where specifically indicated otherwise.
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    A number of commenters on the proposal highlighted how ETFs differ 
from mutual funds, and stated in particular that In-Kind ETFs do not 
present the same type of liquidity risks as other funds.\838\ These 
commenters suggested that the Commission: (i) Exempt either ETFs or In-
Kind ETFs entirely from proposed rule 22e-4; \839\ (ii) exempt either 
ETFs or In-Kind ETFs from certain requirements of proposed rule 22e-4 
(notably the portfolio liquidity classification and three-day liquid 
asset requirements); \840\ or (iii) develop a more tailored liquidity 
risk management program applicable to ETFs.\841\
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    \838\ See, e.g., ICI Comment Letter; BlackRock Comment Letter; 
Invesco Comment Letter; SIFMA Comment Letter I.
    \839\ See, e.g., Invesco Comment Letter (suggesting an exemption 
for all ETFs); FSR Comment Letter (suggesting an exemption for In-
Kind ETFs); SIFMA Comment Letter I (suggesting an exemption for In-
Kind ETFs).
    \840\ See, e.g., State Street Comment Letter (suggesting an 
exemption for In-Kind ETFs from the portfolio liquidity 
classification and three-day liquid asset requirements); Dechert 
Comment Letter (suggesting an exemption for all ETFs from the three-
day liquid asset requirements); ICI Comment Letter I (suggesting an 
exemption for In-Kind ETFs from the three-day liquid asset 
requirements); BlackRock Comment Letter (stating that the days-to-
cash framework in the portfolio liquidity classification 
requirements is irrelevant for ETFs and suggesting an exemption for 
at least In-Kind ETFs from the three-day liquid asset requirements).
    \841\ See BlackRock Comment Letter; FSR Comment Letter.
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    As noted above, we believe that ETFs, like mutual funds, face 
liquidity risks.\842\ But we agree that In-Kind ETFs have different 
liquidity risks than funds (including ETFs) that redeem in cash. This 
is particularly the case because the redeeming shareholder (i.e., 
authorized participant or its customer), rather than the ETF, typically 
will bear the direct costs associated with its liquidity needs, given 
that if that authorized participant (or its customer) wants cash, it 
must sell the in-kind assets and bear the costs of doing so. Therefore, 
after further analysis, including carefully considering the comments 
received, we are adopting tailored liquidity risk management program 
requirements for ETFs as discussed further below.
---------------------------------------------------------------------------

    \842\ We note, as discussed previously, that ETFs will be 
subject to the requirement to implement an overall liquidity risk 
management program, including the requirement that the fund 
determine whether its investment strategy is appropriate for an 
open-end fund.
---------------------------------------------------------------------------

    We decline to exempt all ETFs from the rule entirely, because we 
believe ETFs that redeem more than a de minimis amount in cash can have 
substantially similar liquidity risks as mutual funds, and we believe 
that all ETFs have certain unique additional risks discussed below. In 
addition, while we agree that the classification and highly liquid 
investment minimum components of the liquidity risk management program 
we are adopting for other funds are not necessary for In-Kind ETFs, we 
believe that In-Kind ETFs must maintain sufficient liquidity and assess 
liquidity-related risks that could affect their shareholders. In this 
regard, the liquidity of an ETF's portfolio positions is a factor that 
may contribute to the bid-ask spread, the effective functioning of the 
ETF's arbitrage mechanism and the ETF's shares trading at a price that 
is at or close to NAV.\843\ For example, if an ETF holds illiquid or 
less liquid investments, this will be reflected in the redemption 
basket transferred to a redeeming authorized participant (or its 
customer), which might result in a liquidity cost to the authorized 
participant (or its customer or other market participants). This 
increased cost could alter the authorized participant's decisions 
regarding exactly when or whether to create or redeem the ETF's 
creation units, possibly resulting in the ETF trading at increased 
spreads and/or a price that deviates significantly from its NAV and 
ultimately adversely impacting the ETF's investors.
---------------------------------------------------------------------------

    \843\ By this we mean that, and we generally expect that, each 
day and over time an ETF's shares will trade at or close to the 
ETF's intraday value. See 2015 ETP Request for Comment, supra 
footnote 29 (``When providing exemptive or no-action relief under 
the Exchange Act, the Commission and its staff have analyzed and 
relied upon the representations from ETP issuers regarding the 
continuing existence of effective and efficient arbitrage to help 
ensure that the secondary market prices of ETP Securities do not 
vary substantially from the value of their underlying portfolio or 
reference assets.''); infra footnote 857. Because an ETF does not 
determine its NAV in real time throughout the trading day, in 
assessing whether this expectation is met, one looks to the 
difference between the ETF shares' closing market price and the 
ETF's end-of-day net asset value (i.e., its ``premium'' or 
``discount''). See 2015 ETP Request for Comment, supra footnote 29. 
With regard to ETMFs, as noted in the Proposing Release, ETMF market 
makers would not engage in the same kind of arbitrage as ETF market 
makers because all trading prices of ETMF shares are linked to NAV. 
See Proposing Release, supra footnote 9, at n.458.
---------------------------------------------------------------------------

    Over the years, the Commission and staff have explored the 
structural and operational differences between ETFs (including those 
that redeem in kind) and other open-end funds (that redeem in cash), 
solicited public comment, including on issues related to the potential 
effects of illiquidity on the operation of ETFs and evaluated the 
trading of ETFs in times of market stress.\844\ In 2015, the Commission 
solicited public comment on topics related to the listing and trading 
of exchange-traded investment products (``ETPs'') on national 
securities exchanges and sales of these products by broker-
dealers.\845\ Of relevance here, the Commission sought comment on all 
aspects of the arbitrage mechanism for ETPs (including ETFs), including 
what characteristics of an ETP would facilitate or hinder the alignment 
of secondary market share prices with the value of the underlying 
portfolio reference assets and how arbitrage mechanisms work in the 
case of ETPs with less-liquid underlying or reference assets. The 
questions posed in this Release, as well as the comments received, 
demonstrate the importance of assessing liquidity risks and liquidity 
needs for all ETFs, including In-Kind ETFs. We considered the comments 
received on the 2015 ETP Request for Comment in formulating the 
proposed rule and the final rule we are adopting today.
---------------------------------------------------------------------------

    \844\ See, e.g., ETF Proposing Release, supra footnote 27; Staff 
of the Office of Analytics and Research, Division of Trading and 
Markets, Research Note: Equity Market Volatility on August 24, 2015 
(Dec. 2015) (``August 24 Staff Report''), available at https://www.sec.gov/marketstructure/research/equity_market_volatility.pdf.
    \845\ See 2015 ETP Request for Comment, supra footnote 29 at 
n.10. The 2015 ETP Request for Comment did not address ETMFs' 
listing and trading given that, at the time, no ETMFs were listed or 
traded on an exchange.
---------------------------------------------------------------------------

1. Definitions
    Under the final rule, all ETFs must consider certain additional 
liquidity risk assessment factors, if applicable, but only In-Kind ETFs 
will be excluded from the classification and highly liquid investment 
minimum requirements.\846\ We are defining an exchange-traded

[[Page 82217]]

fund or ``ETF'' as ``an open-end management investment company (or 
series or class thereof), the shares of which are listed and traded on 
a national securities exchange, and that has formed and operates under 
an exemptive order under the Act granted by the Commission or in 
reliance on an exemptive rule adopted by the Commission.'' \847\ We are 
defining an ``In-Kind ETF'' to mean an ETF that meets redemptions 
through in-kind transfers of securities, positions, and assets other 
than a de minimis amount of cash and that publishes its portfolio 
holdings daily.\848\ The definition of ``In-Kind ETF'' is intended to 
distinguish this type of ETF, which, as described throughout this 
Release, has a unique structure and raises different liquidity risks 
than other open-end funds (that in most cases redeem shares in cash). 
As discussed below, we believe that this definition of an In-Kind ETF 
facilitates this distinction by limiting an ETF's redemption basket to 
in-kind securities and other assets, and no more than a de minimis 
amount of cash. In addition, the definition requires that an In-Kind 
ETF publish the ETF's holdings daily.\849\ This daily publishing of ETF 
holdings (or ``daily transparency'') is a condition of many of our ETF 
orders, and we understand that even for ETFs not subject to that 
condition, most provide this daily transparency as a matter of 
course.\850\ We believe that requiring this daily transparency will 
permit the sophisticated authorized participants that directly interact 
with the ETF to effectively evaluate the liquidity of the ETF's 
holdings. We also note that we are requiring an ETF to report publicly 
to the Commission on Form N-CEN its designation as an In-Kind ETF as 
defined in the final rule so that there is clarity on which ETFs meet 
this definition and are thus subject to the tailored liquidity risk 
management program.\851\
---------------------------------------------------------------------------

    \846\ We note that an in-kind ETF may not be able to avail 
itself of the tailored liquidity risk management program where the 
in-kind ETF operates as a class of a fund that also has mutual fund 
classes. In such a case, for example, the liquidity classification 
requirement would apply to the entire portfolio, thus applying to 
both in-kind ETFs and other funds (e.g., mutual funds). UITs, 
including ETFs structured as UITs, will not be subject to the 
majority of the liquidity risk management program requirements. See 
supra section III.A.2.d and infra section III.K (discussing rule 
22e-4(c), that requires, on or before the date of initial deposit of 
portfolio securities into a registered UIT (including ETF UITs), the 
principal underwriter or depositor to determine that the portion of 
the illiquid investments that the UIT holds or will hold at the date 
of deposit that are assets is consistent with the redeemable nature 
of the securities it issues and maintain a record of that 
determination for the life of the UIT and for five years 
thereafter).
    \847\ See rule 22e-4(a)(4). We note that this definition is 
substantially the same as the definition of ETF that we had proposed 
as amendments to rule 22c-1. We also note that this definition is 
substantially the same as the definition in Form N-1A.
    \848\ See rule 22e-4(a)(9). Cash means cash held in U.S. 
dollars, and would not include, for example, cash equivalents or 
foreign currency.
    \849\ Today, such daily publishing of ETF holdings involves 
posting on the ETF's Web site on each day that the national 
securities exchange on which the fund's shares are listed is open 
for business, before commencement of trading of fund shares on the 
exchange, the identities and quantities of the securities, assets or 
other positions held by the fund, or its respective master fund, 
that will form the basis for the fund's calculation of net asset 
value at the end of the business day.
    \850\ See, e.g., Foreside ETF Trust, et al., Investment Company 
Act Release No. 32284 (Sep. 26, 2016) [81 FR 68079 (Oct. 3, 2016)] 
(notice of application). We note that ETMFs are not required to 
provide such daily transparency under their orders, and thus would 
need to choose to provide such daily transparency if they wished to 
take advantage if this provision.
    \851\ See Item E.5 of Form N-CEN (``Is the Fund an `In-Kind 
Exchange-Traded Fund' as defined in rule 22e-4 under the Act?''). In 
addition, ETFs (including In-Kind ETFs) will be required to report 
on Form N-CEN the average percentage value of creation units 
purchased and redeemed both with in-kind securities and assets and 
with cash, during the reporting period. See Investment Company 
Reporting Modernization Adopting Release, supra footnote 120.
---------------------------------------------------------------------------

    Consistent with our exemptive orders, we recognize that there may 
be circumstances under which an In-Kind ETF may use cash to meet 
redemptions (in addition to securities and other non-cash assets). For 
example, today an ETF that typically redeems in-kind may use cash to: 
(i) Make up any difference between the NAV attributable to a creation 
unit and the aggregate market value of the creation basket exchanged 
for the creation unit (generally referred to as the ``balancing 
amount'' in an ETF's exemptive order); (ii) correspond to uninvested 
cash in the fund's portfolio (which, to the extent that this amount of 
cash equals the fund's cash position in the portfolio, would be an 
``in-kind'' redemption); or (iii) substitute for a portfolio position 
or asset that is not eligible to be transferred in kind (e.g., a 
derivative instrument that, pursuant to contract, is not 
transferrable).\852\ By their nature, ``balancing amounts'' are small 
amounts and thus would be de minimis. Accordingly, there are a number 
of reasons, including those described above, why an In-Kind ETF may 
find it prudent or necessary to use a de minimis amount of cash to meet 
redemptions. However, if an In-Kind ETF were to use more than a de 
minimis amount of cash (as determined in accordance with its written 
policies and procedures) to meet redemptions (for any of the reasons 
discussed above or otherwise), it would not qualify as an In-Kind ETF 
and would need to comply with the liquidity risk management program 
requirements applicable to other ETFs.\853\ By way of example, an ETF 
that normally redeems in-kind, but delivers all cash to a single 
authorized participant that elects to receive cash, would not be an ETF 
that uses a de minimis amount of cash. However, depending on the 
circumstances, an ETF that delivers cash only on one occasion may be 
able to conclude that it qualifies as an In-Kind ETF in later years if 
such circumstances are not repeated.
---------------------------------------------------------------------------

    \852\ We note that depending on the size of the position being 
substituted for, such a transaction may not always be de minimis, 
and thus the ETF may no longer be eligible to qualify for this 
provision.
    \853\ In-Kind ETFs are subject to rule 22e-4, including the 
obligation to establish written policies and procedures for a 
liquidity risk management program. As part of these written policies 
and procedures, we would expect that an In-Kind ETF would determine 
the amount of cash and the types of transactions that it will treat 
as de minimis. If for any reason, an In-Kind ETF was not able to 
meet redemptions with more than a de minimis amount of cash 
consistent with those policies and procedures, such a fund would no 
longer qualify as an In-Kind ETF and would thus no longer be 
eligible to rely on this provision. See rule 22e-4(b)(1)(ii).
---------------------------------------------------------------------------

    An In-Kind ETF generally should describe in its written policies 
and procedures for its liquidity risk management program,\854\ to the 
extent applicable, how the fund analyzes the ability of the ETF to 
redeem in-kind in all market conditions such that it is unlikely to 
suddenly fail to continue to qualify for this exception to the 
classification and highly liquid investment minimum requirements, the 
circumstances in which the In-Kind ETF may use a de minimis amount of 
cash to meet a redemption, and what amount of cash would qualify as 
such. As part of its policies and procedures, an In-Kind ETF generally 
should also describe how the ETF will manage and/or approve any portion 
of a redemption that is paid in cash and document the ETF's 
determination that such a cash amount is de minimis. In making these 
determinations, an In-Kind ETF may consider, if applicable: (i) The 
amount (both in dollars and as a percentage of the entire redemption 
basket) and frequency with which cash is used to meet redemptions; and 
(ii) the circumstances and rationale for using cash to meet 
redemptions.
---------------------------------------------------------------------------

    \854\ Rule 22e-4 requires that an In-Kind ETF adopt and 
implement a written liquidity risk management program reasonably 
designed to assess and manage the fund's liquidity risk. See rule 
22e-4(b).
---------------------------------------------------------------------------

    As discussed above, in-kind redemptions mitigate certain liquidity 
risks, but only to the extent that the fund can use in-kind 
redemptions. This factor is particularly important for an In-Kind ETF 
because such a fund may only include in its redemption basket a de 
minimis amount of cash if it wants to qualify for the exclusion from 
the classification and highly liquid investment minimum requirements. 
If, for example, market conditions change and the fund can no longer 
meet redemptions without more than a de minimis amount of cash, the 
fund would no longer qualify as an In-Kind ETF. As a result, the ETF 
would be required to comply with additional requirements under its 
liquidity risk management program (including liquidity portfolio 
classifications and highly liquid investment minimum).

[[Page 82218]]

2. Tailored Program Elements for ETFs
    By adopting certain tailored liquidity risk management program 
requirements for ETFs, we recognize, consistent with comments received, 
that both ETFs that redeem in cash and In-Kind ETFs present unique 
liquidity risks as compared to other funds. Some of these unique risks 
were not specifically addressed in the generally applicable liquidity 
risk management program as proposed, while still other aspects of the 
general program were less applicable to the actual operation of In-Kind 
ETFs, particularly those that offer daily transparency of holdings. Our 
final rule is designed to address both issues. Accordingly, an ETF will 
be required to adopt and implement a tailored liquidity risk management 
program that has the unique elements discussed below, in addition to 
the elements discussed elsewhere in this Release.
Liquidity Risk Assessment
    An ETF, like other open-end funds, will be required to assess and 
manage the fund's ``liquidity risk''--defined as the risk that a fund 
could not meet requests to redeem shares issued by the fund without 
significant dilution of remaining investors' interests in the 
fund.\855\ As discussed above, we believe that this definition, 
modified from the proposal as informed by commenter input, is 
appropriate for all open-end funds, whether the fund redeems in cash or 
in kind and whether the fund is a mutual fund or an ETF.\856\
---------------------------------------------------------------------------

    \855\ See rule 22e-4(a)(11) (defining liquidity risk); rule 22e-
4(b) (requiring each fund and in-kind ETF to adopt and implement a 
written liquidity risk management program).
    \856\ See supra section III.B.1 for a discussion of the 
definition of liquidity risk, including comments received and 
modifications made from the proposal.
---------------------------------------------------------------------------

    Illiquidity in an ETF's portfolio or its basket assets can 
adversely impact investors by imposing costs on market participants 
that could then potentially be reflected in a widening of the bid-ask 
spread of the ETF shares. This widening could result in shareholders 
transacting in an ETF's shares at market prices that do not maintain a 
``close tie'' to the NAV per share of the ETF. As we have previously 
stated, a close tie between ETF share market prices and the ETF's NAV 
per share is important because section 22(d) and rule 22c-1 under the 
Act are designed to require that all fund shareholders be treated 
equitably.\857\ In addition, declining liquidity in an ETF's portfolio 
also could affect a market maker's ability or willingness to make a 
market in the product because arbitrage opportunities would be more 
difficult to evaluate.\858\ This, in turn, could affect the liquidity 
of the ETF shares, making it difficult for market participants to 
price, trade and hedge.
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    \857\ See generally H.R. REP. NO. 2639, 76th Cong., 3d Sess., 8 
(1940). See also Investment Trusts and Investment Companies: Report 
of the Securities and Exchange Commission, H.R. Doc. No. 279, 76th 
Cong., 1st Sess., pt. 3, at 860-874 (1939); Spruce ETF Trust, et 
al., Investment Company Act Release No. 31301 (Oct. 21, 2014) [79 FR 
63964 (Oct. 27, 2014)] (notice of application) (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) (``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.'').
    \858\ See supra footnote 843 and accompanying text.
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    Under the final rule, ETFs will be required to assess, manage, and 
periodically review the fund's liquidity risk and needs, taking into 
account, as applicable, the liquidity risk factors for all funds (as 
modified from the proposal) discussed previously.\859\ ETFs also must 
consider the following additional factors, as applicable, that are 
specific to the structure and operation of ETFs:
---------------------------------------------------------------------------

    \859\ See supra section III.B.2 (discussing the factors as 
proposed and how the factors have been amended in the final rule to 
address commenter concerns). We recognize that not all of these 
factors may be applicable to all ETFs (and that some mutual funds 
would not need to consider certain factors relevant only to ETFs).
---------------------------------------------------------------------------

     The relationship between the ETF's portfolio liquidity and 
the way in which, and the prices and spreads at which, ETF shares 
trade, including the efficiency of the arbitrage function and the level 
of active participation by market participants (including authorized 
participants); \860\ and
---------------------------------------------------------------------------

    \860\ We note that this factor will not be applicable to ETMFs 
to the same extent it applies to ETFs. ETMF market makers will not 
engage in the same kind of arbitrage as ETF market makers and will 
assume no intraday market risk with their positions in ETMF shares 
as all trading prices are linked to NAV. See ETMF Notice, supra at 
note 31 at n.21 and accompanying text.
---------------------------------------------------------------------------

     The effect of the composition of baskets on the overall 
liquidity of the ETF's portfolio.
    We considered, in establishing these factors, comments received on 
the Proposing Release and the 2015 ETP Request for Comment, as well as 
the unique structure and operation of ETFs. We discuss these factors in 
more detail below. As we noted with regard to other open-end funds, the 
list of liquidity risk assessment factors for ETFs is not meant to be 
exhaustive. Rather, an ETF generally should incorporate other 
considerations in assessing its liquidity risk that it considers 
appropriate.
ETF Trading--Arbitrage Function and Level of Activity of Market 
Participants
    As discussed above, the ETF structure permits only authorized 
participants to purchase or redeem shares from an ETF and to transact 
in the ETF's shares at the NAV per share. The combination of the 
creation and redemption process with secondary market trading in ETF 
shares provides arbitrage opportunities that, if effective, keep the 
market price of the ETF's shares at or close to the NAV per share of 
the ETF.\861\ If an ETF has a significant amount of illiquid securities 
in its portfolio, market participants may find it more difficult to 
evaluate opportunities and ultimately participate in the arbitrage 
process (because of challenges in pricing, trading, and hedging their 
exposure to the ETF). If the arbitrage function fails to operate 
efficiently, investors could buy and sell the ETF shares at prices that 
are not at or close to the NAV per share of the ETF, which may raise 
concerns relating to section 22(d) of and rule 22c-1 under the Act 
regarding whether all fund shareholders (authorized participants and 
retail investors) are being treated equitably.\862\ We discussed in the 
Proposing Release how 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) and how 
the liquidity of the ETF's portfolio positions is a factor that 
contributes to the effective functioning of this arbitrage 
mechanism.\863\
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    \861\ We recognize that an ETF is not as likely as a mutual fund 
to sell or in-kind transfer its portfolio holdings in order to meet 
redemptions because an authorized participant generally will not 
seek to create or redeem a basket with the ETF until there is a 
sufficient deviation between the ETF shares' market price and the 
ETF's NAV. As discussed previously, ETMF market makers would not 
engage in the same kind of arbitrage as ETF market makers because 
all trading prices of ETMF shares are linked to NAV. See supra 
footnote 836.
    \862\ See supra footnote 857.
    \863\ See Proposing Release, supra footnote 9, at nn.23-30 and 
accompanying text.
---------------------------------------------------------------------------

    Commenters to the 2015 ETP Request for Comment also highlighted the 
importance of portfolio liquidity on the efficiency of the ETF 
arbitrage mechanism. During an extraordinary period of market 
volatility on August 24, 2015 (``the August 24th Market Events''), for 
example, many ETFs traded at prices materially different from the NAV 
of the funds' underlying

[[Page 82219]]

portfolio assets.\864\ One commenter on the 2015 ETP Request for 
Comment, in observing the August 24th Market Events, noted that there 
are many reasons an ETF may trade at a substantial difference from the 
NAV of its underlying constituent stocks, including a lack of liquidity 
in the ETF constituents and a lack of liquidity in the ETF shares 
themselves.\865\ Another commenter suggested that, where the market for 
an underlying asset is illiquid, no amount of arbitrage will be 
sufficient to equalize market discrepancies between underlying assets 
and the fund's price, especially during times of market stress.\866\ In 
addition, the level of active participation by market participants, 
including market makers and authorized participants, in the trading of 
ETF shares is important to the way in which, and the prices and spreads 
at which, shares trade. As one commenter on the 2015 ETP Request for 
Comment noted, the more authorized participants that are active in the 
market, the more opportunities there are to trade and provide 
liquidity.\867\ For these reasons, we are requiring that an ETF 
consider the relationship between the liquidity of its portfolio and 
the arbitrage function in assessing its liquidity risk (where 
applicable).
---------------------------------------------------------------------------

    \864\ August 24 Staff Report, supra footnote 844, at 5 
(discussing large ETFs that traded at ``substantial discounts'' to 
the ETFs' NAVs).
    \865\ See Comment Letter of Modern Markets Initiative on 2015 
ETP Request for Comment (Sept. 14, 2015), available at https://www.sec.gov/comments/s7-11-15/s71115-39.pdf.
    \866\ See Comment Letter of Occupy the SEC on 2015 ETP Request 
for Comment (Aug. 21, 2015), available at https://www.sec.gov/comments/s7-11-15/s71115-32.pdf.
    \867\ See Comment Letter of Flow Traders Group on 2015 ETP 
Request for Comment (Aug. 17, 2015), available at https://www.sec.gov/comments/s7-11-15/s71115-25.pdf.
---------------------------------------------------------------------------

Basket Composition
    In-Kind ETFs create and redeem using baskets of securities and 
other assets. These baskets may be highly correlated to the ETF's 
overall portfolio. As we noted in the Proposing Release, the 
composition of the basket can affect the liquidity of the ETF's 
portfolio.\868\ For example, an ETF whose basket does not reflect a pro 
rata share of the fund's portfolio may alter the liquidity profile of 
the ETF's portfolio and may adversely affect the fund's future ability 
to meet cash redemptions or mitigate shareholder dilution.\869\ We 
recognize that certain market incentives exist to mitigate the 
likelihood of significant or frequent divergence between an ETF's 
basket and the fund's portfolio. For example, if an ETF's basket is not 
correlated with the fund's portfolio, the ETF likely will develop a 
higher tracking error. Nonetheless, such divergence may occur, with 
potentially adverse consequences to the remaining shareholders in the 
fund. Accordingly, we are requiring an ETF to consider the effect of 
its basket composition on the fund's overall portfolio liquidity (even 
if an ETF's creation and redemption baskets reflect a pro rata share of 
the ETF's portfolio).\870\
---------------------------------------------------------------------------

    \868\ See Proposing Release, supra footnote 9, at nn.23-24, 156-
157 and accompanying text.
    \869\ Under limited circumstances, an index ETF's redemption 
basket also may differ from the portfolio deposit made by the 
authorized participant.
    \870\ One commenter on the 2015 ETP Request for Comment, 
discussing the potential effects of basket composition on an ETF's 
overall liquidity, noted that an ETF whose basket reflects a pro 
rata share of the ETF's portfolio will have a larger number of 
securities in the basket, with the size of each individual position 
potentially being smaller. This commenter suggested that, as a 
result: (i) The smaller lots can be more difficult for an authorized 
participant to trade efficiently, thereby increasing the bid/ask 
spreads of the ETF; and (ii) the pro rata basket is more likely to 
include less liquid or even illiquid securities that an ETF not 
subject to the pro rata requirement can exclude. See Comment Letter 
of Charles Schwab & Co. on the on 2015 ETP Request for Comment (Aug. 
17, 2015), available at https://www.sec.gov/comments/s7-11-15/s71115-28.pdf.
---------------------------------------------------------------------------

    A few commenters also suggested that increasing ETF basket 
flexibility and eliminating the two percent limitation on redemption 
fees for ETFs would help enhance ETF liquidity and the orderly and 
efficient operation of the arbitrage function.\871\ We are not 
addressing these issues here because they are beyond the scope of this 
rulemaking.
---------------------------------------------------------------------------

    \871\ See, e.g., BlackRock Comment Letter; ICI Comment Letter I; 
Fidelity Comment Letter.
---------------------------------------------------------------------------

Portfolio Liquidity Classification
    Under the final rule, an open-end fund (other than an In-Kind ETF) 
will be required to classify each of the fund's portfolio investments 
(generally by asset class) into one of four categories: Highly liquid 
investments; moderately liquid investments; less liquid investments; 
and illiquid investments. A number of commenters noted, as the 
Commission recognized in the Proposing Release and as we reiterate 
above, that an open-end fund (including an open-end ETF) that redeems 
in cash has a different nature of liquidity risk than an ETF that 
redeems through in-kind transfers of securities, positions, and other 
assets.\872\
---------------------------------------------------------------------------

    \872\ See, e.g., BlackRock Comment Letter; Proposing Release, 
supra footnote 9.
---------------------------------------------------------------------------

    We note, for example, that when a mutual fund experiences daily net 
redemptions, the fund will likely be required to sell its portfolio 
holdings in order to generate cash to meet redemptions. To the extent 
that a fund must sell a less liquid security in order to generate the 
cash proceeds required, there is enhanced liquidity risk--that is, risk 
that a fund cannot meet redemptions without significant dilution of 
remaining investors. Therefore, we believe that it is appropriate for 
such a fund to assess its liquidity risk by analyzing the amount of 
time it will take, in current market conditions, to convert its 
portfolio assets (without the conversion (or in some cases, sale or 
disposition) significantly changing the market value of the 
investments).
    As discussed above, an In-Kind ETF's liquidity risk is different 
from the liquidity risk of a fund that generally meets redemptions in 
cash. Rather than liquidity risk affecting investors directly in their 
ability to receive cash redemption proceeds, illiquidity in an ETF's 
portfolio or its basket assets can adversely impact investors by 
contributing to a widening of the bid-ask spread of the ETF shares. 
This widening could result in shareholders transacting in an ETF's 
shares at market prices that do not maintain a ``close tie'' to the NAV 
per share of the ETF. The declining liquidity in an ETF's portfolio 
also could affect the arbitrage function related to the ETF, as 
discussed above.
    Despite our concern about the specific liquidity-related risks in 
ETFs described above, we view the liquidity classification information 
for In-Kind ETFs as less necessary for the Commission, investors, and 
other potential users of this information because, unlike for mutual 
funds, the daily identity and weightings of ETF portfolio holdings are 
well known to authorized participants and other ETF liquidity 
providers, and would be required to be disclosed daily under our final 
rules to qualify for the exemption from the classification 
requirement.\873\

[[Page 82220]]

Authorized participants are the only shareholders that are permitted to 
transact with the ETF at NAV, and these sophisticated broker-dealers 
are more likely to be able to readily discern the ETF's liquidity 
profile from this daily portfolio information.
---------------------------------------------------------------------------

    \873\ See rule 22e-4(a)(9). See also, Precidian ETFs Trust, et 
al., Investment Company Act Release No. 31300 (Oct. 21, 2014) [79 FR 
63971 (Oct. 27, 2014)] (notice of application) (``The Commission 
therefore has granted such exemptive relief to date only to those 
actively managed ETFs that have provided daily transparency of their 
portfolio holdings.''). The identity and weightings of the 
constituents of affiliated indices are required by exemptive 
application condition to be made publicly available on a daily 
basis. See, e.g., Columbia ETF Trust I, et. al., Investment Company 
Act Release No. 32134 (May 31, 2016) (order) (related application 
with conditions available at: https://www.sec.gov/Archives/edgar/data/1233991/000119312516578039/d194333d40appa.htm). The identity 
and weightings of the constituents of non-affiliated indexes are not 
required to be made publicly available on a daily basis. However, 
because: (1) These index compositions are generally broadly 
available to liquidity providers either publicly, by subscription or 
by license; and (2) index-based ETFs publish their purchase and 
redemption baskets daily, and those baskets generally are tracking 
baskets that represent either a pro rata replication of the index or 
a sampling of the index, authorized participants and other ETF 
liquidity providers should nonetheless be able to determine the 
liquidity profile of a non-affiliated, index-based ETF on a daily 
basis. Unlike ETFs, ETMF are only required to provide the same 
disclosure about the identity and weightings of their portfolio 
holdings as mutual funds.
---------------------------------------------------------------------------

    We continue to believe that it is important that an In-Kind ETF 
maintain sufficient liquidity in its portfolio. Accordingly, the final 
rule requires that an In-Kind ETF, in assessing liquidity risk, take 
into account certain factors that are more tailored to the way in which 
such funds operate and the resulting liquidity risks. For example, 
those factors include considering the relationship between portfolio 
liquidity and the arbitrage function, as well as the effect of the 
composition of in-kind baskets on the overall liquidity of the fund's 
portfolio. However, given the more limited utility of this 
classification information for the reasons described above, and 
considering the burdens of tracking and reporting it to us, we do not 
believe that it is appropriate to require an In-Kind ETF to classify 
its portfolio investments into liquidity categories based on a ``days-
to-cash'' framework and report that information to the Commission.\874\
---------------------------------------------------------------------------

    \874\ In the Proposing Release, we proposed to apply the 
portfolio liquidity classification requirement to open-end ETFs (in 
addition to other open-end funds), in part, because, ETFs permit 
authorized participants to redeem in cash (even if these funds 
typically redeem in kind). See Proposing Release, supra footnote 9, 
at n. 129 and accompanying text. Accordingly, we determined that it 
was appropriate to require that all ETFs classify their portfolio 
liquidity by assessing the fund's ability to convert portfolio 
positions into cash. The final rule, however, establishes a more 
tailored regulatory regime for In-Kind ETFs, that, by definition, do 
not meet redemptions through more than a de minimis amount of cash. 
Thus, under the final rule, we do not believe it is necessary to 
require that In-Kind ETFs be subject to the portfolio liquidity 
classification requirement (which is based on a ``days-to-cash'' or 
``days-to-sell'' framework).
---------------------------------------------------------------------------

Highly Liquid Investment Minimum
    Under the final rule, an open-end fund (other than an In-Kind ETF) 
will be required to determine a percentage of the fund's net assets 
that it will invest in assets that are highly liquid investments. The 
fund will determine its highly liquid investment minimum using the 
first category in the liquidity classification requirement (i.e., cash 
and assets convertible into cash within three business days). The fund 
also will be required to take certain actions when the fund's highly 
liquid investments fall below its minimum.\875\
---------------------------------------------------------------------------

    \875\ See supra section III.D; rule 22e-4(b)(1)(iii).
---------------------------------------------------------------------------

    In determining to adopt a highly liquid investment minimum for 
certain open-end funds, we considered comments received on proposed 
rule 22e-4, which would have required a ``three-day liquid asset 
minimum.'' \876\ Multiple commenters suggested that the concept of a 
three-day liquid asset minimum does not take into account the unique 
structural aspects of ETFs.\877\ One commenter suggested that the 
concept of ``convertible into cash within three business days'' has 
little relevance to an ETF that does not liquidate securities to meet 
cash redemptions.\878\
---------------------------------------------------------------------------

    \876\ See supra section III.D.
    \877\ See, e.g., Dechert Comment Letter; ICI Comment Letter I; 
BlackRock Comment Letter; SIFMA Comment Letter I.
    \878\ See BlackRock Comment Letter.
---------------------------------------------------------------------------

    Consistent with the comments received, we are not requiring that an 
In-Kind ETF adopt a highly liquid investment minimum. First, an open-
end fund will be required to establish its highly liquid investment 
minimum using its ``highly liquid investment'' portfolio 
classification. As discussed earlier, we have determined that it is not 
necessary to require that an In-Kind ETF classify its portfolio 
liquidity (e.g., into ``highly liquid investment,'' or ``moderately 
liquid investment''). The portfolio liquidity classifications 
incorporate a ``convertible to cash'' concept that is generally not 
relevant for an In-Kind ETF (except in managing cash holdings to no 
greater than a de minimis amount of cash). Because the highly liquid 
investment minimum incorporates the same ``convertible to cash'' 
concept as the portfolio liquidity classifications (which, for the 
reasons discussed above, we are not requiring for In-Kind ETFs), we do 
not believe it is appropriate to require that an In-Kind ETF establish 
a highly liquid investment minimum.
    Second, the highly liquid investment minimum, as discussed above, 
is intended to increase the likelihood that an open-end fund meets 
redemption requests without significant dilution of remaining 
investors. Open-end funds that redeem in cash and In-Kind ETFs operate 
differently, and therefore evaluate liquidity risk differently. We 
believe, for example, that it is necessary for an open-end fund that 
meets redemptions in cash (including an ETF) to manage its liquidity 
risk by establishing a minimum amount of highly liquid investments 
that, as defined in the final rule, are quickly convertible to cash 
(within 3 business days). In this way, the highly liquid investment 
minimum increases the likelihood that the fund will be able to meet 
redemption requests in cash without significant dilution of remaining 
investors. Conversely, we believe, for example, that it is more 
appropriate for an In-Kind ETF that meets redemptions through in-kind 
transfers of securities, positions, and other assets (and no more than 
a de minimis amount of cash) to, among other things, assess its 
liquidity risk through consideration of the factors we have discussed 
above (e.g., assessing the relationship between portfolio liquidity and 
the arbitrage function). For these reasons, we are excluding In-Kind 
ETFs from the highly liquid investment minimum requirement in rule 
22e4.
    We discussed above the requirement that funds (including ETFs) 
other than In-Kind ETFs establish a highly liquid investment 
minimum.\879\ One commenter noted that the three-day liquid asset 
minimum might increase tracking error, or force an ETF to either 
violate the terms of its exemptive order,\880\ or refuse in-kind 
purchase requests from authorized participants, thus interfering with 
the arbitrage mechanism that keeps ETF market prices close to their 
underlying NAV.\881\ An ETF that does not qualify as an In-Kind ETF 
necessarily meets redemptions through more than a de minimis amount of 
cash. For the reasons discussed above, we believe that it is 
appropriate to require a fund that meets redemptions, at least 
partially in cash, to comply with the liquidity classification and 
highly liquid investment minimum requirements.\882\ With regard to 
tracking error, an ETF with an index-based strategy, like other open-
end funds, needs to balance its implementation of its investment 
strategy with the need for appropriate liquidity risk management given 
its obligation to meet redemptions without significant dilution. We 
recognize that this balancing may result in tracking error, and such a 
fund may wish to address and manage this risk through appropriately 
designed policies and procedures. This concern, along with the concerns 
regarding potentially violating an exemptive order, or

[[Page 82221]]

refusing an in-kind purchase request from an authorized participant, 
are also mitigated by the additional flexibility provided for in the 
final rule. Under the final rule (as compared with the proposal), a 
fund that breaches its highly liquid investment minimum will be subject 
to certain board reporting requirements, but will not be barred from 
purchasing non-conforming assets (as would have been required as 
proposed).\883\ Under the final rule, therefore, a fund will have 
flexibility to address potentially adverse situations, including 
tracking error, that may arise as a result of complying with the highly 
liquid investment minimum.
---------------------------------------------------------------------------

    \879\ See supra section III.D.
    \880\ See ICI Comment Letter I (noting that if an ETF was 
prohibited from accepting a less liquid asset, the ETF may violate a 
requirement that that all creation baskets correspond pro rata to 
the ETF's portfolio positions).
    \881\ Id.
    \882\ An ETF that does not qualify as an In-Kind ETF would not 
be required to determine and periodically review a highly liquid 
investment minimum if it holds primarily highly liquid investments. 
See supra section III.D.
    \883\ See supra section III.D.
---------------------------------------------------------------------------

K. Limitation on Unit Investment Trusts' Investments in Illiquid 
Investments

    As noted above, the proposed scope of rule 22e4 did not include 
UITs, although we requested comment on whether UITs should be included 
within its scope, and whether we should include specific limitations on 
UIT's holdings of illiquid assets at inception.\884\ As adopted today, 
UITs remain excluded from the rule's liquidity risk management program 
requirements. However, as suggested by some commenters, we are now 
requiring a limited liquidity review for UITs. Under the final rules, 
the UIT's principal underwriter or depositor must determine, on or 
before the initial deposit of portfolio securities into the UIT, that 
the portion of the illiquid investments that the UIT holds or will hold 
at the date of deposit that are assets is consistent with the 
redeemable nature of the securities it issues.\885\
---------------------------------------------------------------------------

    \884\ See supra section III.A.2.d; Proposing Release, supra 
footnote 9 at section III.A.3 and comment requests following n 156 
(``alternatively, should we require UITs to meet certain minimum 
liquidity requirements at the time of deposit of the securities . . 
.'').
    \885\ See rule 22e-4(c). The rule also requires UITs to maintain 
a record of that determination for the life of the UIT and for five 
years thereafter. See also Rule 144A Release supra footnote 37 at 
n.61 (discussing liquidity requirements for UITs prior to the 
adoption of rule 22e-4).
---------------------------------------------------------------------------

    As discussed in detail in the Proposing Release, most UITs serve as 
separate account vehicles used to fund variable annuity and variable 
life insurance contracts,\886\ and these UITs essentially function as 
pass-through vehicles, investing principally in securities of one or 
more open-end investment companies that would be subject to rule 22e-
4.\887\ Also, UITs are not actively managed, and thus certain 
provisions of rule 22e-4 that require a fund's board to approve and 
oversee the fund's liquidity risk management program and the fund's 
adviser, officer, or officers to administer it are inapposite to the 
management structure of a UIT.\888\
---------------------------------------------------------------------------

    \886\ See Proposing Release, supra footnote 9, at n.139 and 
accompanying text. We currently estimate that approximately 92.9% of 
UITs serve as separate account vehicles (based on data as of 
December 31, 2015).
    \887\ See id., at nn.139-140 and accompanying text.
    \888\ See id., at nn.141-143 and accompanying text.
---------------------------------------------------------------------------

    Several commenters argued (in the context of ETFs organized as 
UITs) that UITs may be subject to liquidity risk comparable to other 
funds.\889\ As discussed previously, in recognition of the different 
unmanaged organizational structure of UITs, we continue to believe that 
including UITs within the scope of rule 22e-4's liquidity risk 
management program requirements (or even the tailored program 
requirements for ETFs that redeem in kind) would not be feasible. 
However, we recognize that UITs may in some circumstances be subject to 
liquidity risk (particularly where the UIT is not a pass-through 
vehicle and the sponsor does not maintain an active secondary market 
for UIT shares) as investor redemption requests may lead to dissipation 
of UIT assets, forcing a UIT to sell securities that it holds to meet 
redemptions.
---------------------------------------------------------------------------

    \889\ See Anonymous Comment Letter I; BlackRock Comment Letter. 
One of these commenters also observed that, while there are few ETFs 
that are UITs, some of the largest ETFs in the world (by volume/
value traded) are UIT ETFs, and thus any liquidity risks faced by 
these UIT ETFs could lead to significant adverse market 
consequences. The commenter also expressed concern that excluding 
UIT ETFs from the scope of rule 22e-4 may prompt more ETF sponsors 
to structure ETFs as UITs rather than open-end funds to avoid being 
subject to the liquidity risk management program requirement. See 
Anonymous Comment Letter I. We recognize the risks of excluding 
UIT's from 22e-4, and thus are adopting the liquidity review 
requirement discussed in this section, as a tailored approach that 
fits the unique unmanaged structure of UITs, including ETFs that are 
structured as UITs. (ETMFs are not structured as UITs because, as 
they are structured today, they are actively managed and thus cannot 
operate as UITs.)
---------------------------------------------------------------------------

    Accordingly, today we are adopting a limited liquidity review 
requirement for UITs to require that a UIT's principal underwriter or 
depositor determine upon initial deposit of a registered UIT that the 
level of illiquid investments it will hold is consistent with the 
redeemable nature of the securities it issues.\890\ Though commenters 
focused their discussion on UITs that are ETFs, we believe it is 
appropriate for the principal underwriter or depositor of any 
registered UIT to conduct the initial liquidity assessment described 
above on or before the date of the initial deposit of securities into 
the UIT. The securities that the UIT is expected to hold should be 
examined so that they are consistent with the ability of a UIT to issue 
redeemable securities, much as an open-end fund will be required to 
evaluate whether its investment strategy and the securities it holds is 
appropriate for an open-end fund under the final liquidity risk 
management program.\891\ Though UITs are not actively managed and do 
not have a board of directors, corporate officers, or an investment 
adviser to render advice during the life of the trust, making active 
liquidity risk management inapposite to the management structure of a 
UIT, we believe that this requirement of a tailored, one-time, initial 
liquidity risk management requirement for UITs is in line with the 
unmanaged structure of a UIT and its liquidity risk.\892\
---------------------------------------------------------------------------

    \890\ See supra footnote 885 and accompanying text.
    \891\ As noted above, all UITs are subject to the requirements 
of section 22(e) and therefore must meet redemptions within seven 
days. See also section 4(2).
    \892\ With regard to UITs structured as ETFs in particular, we 
agree with commenters' concerns that UIT ETFs' liquidity risks may 
be comparable to those faced by other ETFs and that the relatively 
large size of certain UIT ETFs could lead to significant market 
consequences if these UIT ETFs were to encounter liquidity issues. 
However, because UIT ETFs are unmanaged and must fully replicate 
their underlying indices, we believe that a one-time determination 
regarding liquidity concerns at the commencement of the offering of 
a registered UIT is the appropriate manner to mitigate such 
concerns.
---------------------------------------------------------------------------

    We expect that this initial review requirement would in many 
respects be similar to the process for determining whether a fund's 
holding of illiquid investments is consistent with rule 22e-4's 15% 
limitation on illiquid investments, taking into account the unique 
structure and purpose of UITs. If a UIT were to hold or planned to hold 
more than 15% of its investments in illiquid investments at the time of 
initial deposit, such a level of illiquid investments is unlikely to be 
consistent with the nature of the redeemable securities it issues. 
Thus, if a UIT planned to hold significant amounts of illiquid 
securities (in excess of 15%), its principal underwriter or depositor 
would be unlikely to be able to make the determination that its 
investment's liquidity is consistent with its issuance of redeemable 
securities.
    Due to the unmanaged structure of UITs and the fixed nature of 
their portfolios, it would be inconsistent with their structure and 
portfolios to require UITs to re-evaluate the securities they hold 
based on their liquidity characteristics and change their investments 
accordingly over time. Therefore, the requirement only applies at the 
time of the UIT's creation. Although this is a one-time determination 
at the time of the UIT's initial deposit, it should take into

[[Page 82222]]

account the planned structure of the UIT's holdings. In particular, if 
the UIT tracks an index, the determination should consider the index 
design and whether the index design is likely to lead to the UIT 
holding an amount of illiquid assets that is inconsistent with the 
redeemable nature of the securities it issues.
    As discussed above, because of the unmanaged nature of an UIT, we 
recognize that depending on its particular circumstances, after initial 
deposit, an UIT might potentially hold a higher level of illiquid 
investments due to redemptions or changes in the liquidity of the 
investments it holds. Nonetheless, we expect that the requirement for 
the depositor or principal underwriter to determine that the liquidity 
of the investments the UIT holds is consistent with the nature of the 
redeemable securities it issues at the time of initial deposit should 
help enhance UIT liquidity.

L. Disclosure and Reporting Requirements Regarding Liquidity Risk and 
Liquidity Risk Management

    Receiving relevant information about the operations of a fund and 
its principal investment risks is important to investors in choosing 
the appropriate fund 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. Currently, funds are not 
expressly required to disclose how they manage the liquidity of their 
investments, and limited information is available regarding fund 
liquidity and whether the liquidity of a fund's portfolio securities 
corresponds with its anticipated liquidity needs.
    We are adopting, substantially as proposed with some modifications 
in response to comment, amendments to Form N-1A that will require a 
fund to further describe its procedures for redeeming the fund's shares 
including the number of days following receipt of shareholder 
redemption requests in which the fund typically expects to pay 
redemption proceeds to redeeming shareholders and the methods the fund 
typically uses to meet redemption requests, including whether those 
methods are used regularly or only in stressed market conditions.\893\ 
We also are adopting an amendment to General Instruction A of Form N-1A 
to conform the definition of ``exchange-traded fund'' to the definition 
of ETF adopted today in connection with rule 22e-4 and the adoption of 
Form N-CEN in the Investment Company Reporting Modernization Adopting 
Release.\894\
---------------------------------------------------------------------------

    \893\ See Items 11(c)(7) and (c)(8) of Form N-1A.
    \894\ See infra footnote 906.
---------------------------------------------------------------------------

    In addition, we are adopting new Form N-LIQUID to incorporate 
information that would have previously been reported on Form N-PORT 
under the proposal concerning a fund's investments in illiquid 
investments, but with some modifications in response to comments. Under 
this new reporting form, a fund is required to notify the Commission 
when more than 15% of the fund's net assets are, or become, illiquid 
investments that are assets as defined in rule 22e-4 and report 
information about the investments affected.\895\ A fund also is 
required to report on Form N-LIQUID if the fund's illiquid investments 
that are assets previously exceeded 15% of net assets and the fund 
determines that its illiquid investments that are assets have changed 
to be less than or equal to 15% of net assets.\896\ In addition, under 
the new form, a fund is required to notify the Commission if the fund's 
holdings in highly liquid investments that are assets fall below the 
fund's highly liquid investment minimum for more than 7 consecutive 
calendar days.\897\ Information reported on Form N-LIQUID will be non-
public.
---------------------------------------------------------------------------

    \895\ See Part A and Part B of Form N-LIQUID.
    \896\ See Part C of Form N-LIQUID.
    \897\ See Part D of Form N-LIQUID.
---------------------------------------------------------------------------

    We are adopting, as proposed, the requirement that a fund report on 
Form N-CEN information regarding the use of lines of credit, interfund 
lending, and interfund borrowing.\898\ In addition, we are adopting a 
new requirement that a fund report on Form N-CEN whether the fund is an 
``In-Kind Exchange-Traded Fund'' as defined in rule 22e-4.\899\
---------------------------------------------------------------------------

    \898\ See Item C.20 of Form N-CEN. In the Proposing Release, we 
also proposed to add to Form N-CEN a requirement for funds to report 
whether the fund required that an authorized participant post 
collateral to the fund or any of its designated service providers in 
connection with the purchase or redemption of fund shares during the 
reporting period. See Proposing Release, supra footnote 9, at 
section III.G.3.a. We are adopting this requirement in the 
Investment Company Reporting Modernization Adopting Release. See 
Investment Company Reporting Modernization Adopting Release, supra 
footnote 120.
    \899\ Item E.5 of Form N-CEN.
---------------------------------------------------------------------------

    Many commenters expressed general support for enhanced disclosures 
regarding fund liquidity risk management practices.\900\ Some 
commenters noted that understanding the liquidity dynamics of an 
investment strategy employed by a fund would be beneficial to investors 
\901\ and that enhanced information could assist the Commission in its 
role as the primary regulator of investment companies and help 
investors make more informed investing decisions by providing more 
transparency into fund investment practices.\902\ Other commenters 
expressed concerns with specific disclosure and reporting requirements 
outlined in the proposal, which are discussed in detail below.
---------------------------------------------------------------------------

    \900\ See, e.g., BlackRock Comment Letter; J.P. Morgan Comment 
Letter; LPL Comment Letter (supporting increased disclosure about 
liquidity); SIFMA Comment Letter I (expressing general support for 
the proposed amendments to Form N-1A and proposed Form N-CEN).
    \901\ See BlackRock Comment Letter.
    \902\ See Charles Schwab Comment Letter.
---------------------------------------------------------------------------

1. Amendments to Form N-1A
    Form N-1A is used by open-end funds, including money market funds 
and ETFs, to register under the Investment Company Act and to register 
offerings of their securities under the Securities Act. We are 
adopting, substantially as proposed, amendments to Form N-1A that will 
require a fund to further describe its procedures for redeeming the 
fund's shares including the number of days following receipt of 
shareholder redemption requests in which the fund typically expects to 
pay redemption proceeds to redeeming shareholders.\903\ A fund also 
will be required to describe the methods the fund typically expects to 
use to meet redemption requests in stressed and non-stressed market 
conditions.\904\ Funds will not be required, however, to file as 
exhibits to their registration statements credit agreements as we 
proposed. We note that these amendments will apply to all open-end 
funds, including money market funds and ETFs.\905\
---------------------------------------------------------------------------

    \903\ See Item 11(c)(7) of Form N-1A.
    \904\ See Item 11(c)(8) of Form N-1A.
    \905\ See supra footnote 4; see also infra section V.H.; and 
Proposing Release, supra footnote 9, at section V.G.
---------------------------------------------------------------------------

    In addition, we are adopting an amendment to General Instruction A 
of Form N-1A to conform the definition of ``exchange-traded fund,'' 
which currently defines an ETF to mean, in part, a fund or class, ``the 
shares of which are traded on a national securities exchange'' to the 
definition of ETF adopted today in connection with rule /-4 and the 
adoption of Form N-PORT and Form N-CEN in the Investment Company 
Reporting Modernization Adopting Release, which both define an ETF, in 
part, to mean a fund or class, ``the shares of which are listed and 
traded on a national securities exchange.'' \906\
---------------------------------------------------------------------------

    \906\ See General Instructions A of Form N-1A (emphasis added) 
and General Instruction E of Form N-CEN. See also Investment Company 
Reporting Modernization Adopting Release, supra footnote 120. For 
purposes of reporting on proposed Form N-CEN, we proposed to define 
(i) ``exchange-traded fund'' as an open-end management investment 
company (or series or class thereof) or UIT, the shares of which are 
listed and traded on a national securities exchange at market 
prices, and that has formed and operates under an exemptive order 
under the Investment Company Act granted by the Commission or in 
reliance on an exemptive rule under the Act adopted by the 
Commission and (ii) ``exchange-traded managed fund'' as an open-end 
management investment company (or series or class thereof) or UIT, 
the shares of which are listed and traded on a national securities 
exchange at NAV-based prices, and that has formed and operates under 
an exemptive order under the Investment Company Act granted by the 
Commission or in reliance on an exemptive rule under the Act adopted 
by the Commission. See Investment Company Reporting Modernization, 
Investment Company Act Release No. 31610 (May 20, 2015) [80 FR 33590 
(June 12, 2015)] (``Investment Company Reporting Modernization 
Proposing Release''), at n.446 and accompanying text. In the 
Investment Company Reporting Modernization Proposing Release, we 
requested comment on whether the definitions of the type of funds 
listed in proposed Form N-CEN were appropriate and if any different 
definitions should be used. We did not receive any comments on the 
proposed definitions of ETF and ETMF in proposed Form N-CEN, and are 
adopting the definitions of ETF and ETMF, as proposed. See 
Investment Company Reporting Modernization Adopting Release, supra 
footnote 120.

---------------------------------------------------------------------------

[[Page 82223]]

    Many commenters generally supported enhancing prospectus disclosure 
requirements,\907\ noting, for example, that enhanced disclosures will 
improve shareholder and market participant knowledge regarding fund 
redemption procedures and liquidity risk management.\908\ Several 
commenters expressed concerns with the proposed requirements to 
disclose the number of days or the methods in which a fund will pay 
redemption proceeds \909\ and include lines of credit agreements as 
exhibits to the fund registration statement.\910\ We discuss the 
comments received in response to the proposal, as well as the 
amendments to Form N-1A and modifications to the proposal, in more 
detail below.
---------------------------------------------------------------------------

    \907\ See, e.g., CFA Comment Letter; LPL Comment Letter; Charles 
Schwab Comment Letter; Vanguard Comment Letter.
    \908\ See J.P. Morgan Comment Letter.
    \909\ See, e.g., Fidelity Comment Letter; Federated Comment 
Letter; NYC Bar Comment Letter; Vanguard Comment Letter.
    \910\ See, e.g., Fidelity Comment Letter; Invesco Comment 
Letter; T. Rowe Comment Letter; Voya Comment Letter.
---------------------------------------------------------------------------

a. Timing of the Redemption of Fund Shares
    Form N-1A requires funds to describe their procedures for redeeming 
fund shares.\911\ 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 at a price based on the next calculation 
of net asset value after the order is placed but may delay payment for 
up to seven days (consistent with section 22(e) of the Act), and others 
provide no specific time periods for the payment. Some funds disclose 
differences in the timing of payment of redemption proceeds based on 
the distribution channel or payment method through which the fund 
shares are redeemed, while others do not.
---------------------------------------------------------------------------

    \911\ See Item 11(c) of Form N-1A, which requires a fund to 
describe procedures for redeeming fund shares, including (1) any 
restrictions on redemptions; (2) any redemption charges; (3) if the 
fund has reserved the right to redeem in kind; (4) any procedure 
that a shareholder can use to sell fund shares to the fund or its 
underwriter through a broker-dealer (noting any charges that may be 
imposed for such service); (5) the circumstances under which the 
fund may redeem shares automatically without action by the 
shareholder in accounts below a certain number or value of shares; 
(6) the circumstances under which the fund may delay honoring a 
request for redemption for a certain time after a shareholder's 
investment; and (7) any restrictions on, or costs associated with, 
transferring shares held in street name accounts.
---------------------------------------------------------------------------

    We proposed amendments to Item 11 of Form N-1A that would require a 
fund to disclose the number of days in which the fund would pay 
redemption proceeds to redeeming shareholders.\912\ Under the proposal, 
if the number of days in which the fund would pay redemption proceeds 
differed by distribution channel, the fund also would be required to 
disclose the number of days for each distribution channel.\913\ We also 
proposed amendments to Item 11 that would require a fund to disclose 
the methods that the fund uses to meet redemption requests.\914\ Under 
the proposal, funds would have been required to disclose whether they 
use the methods regularly to meet redemptions or only in stressed 
market conditions.
---------------------------------------------------------------------------

    \912\ See proposed Item 11(c)(7) of Form N-1A; see also 
Proposing Release, supra footnote 9, section III.G.1.
    \913\ Id.
    \914\ See proposed Item 11(c)(8) of Form N-1A.
---------------------------------------------------------------------------

    Some commenters expressed general support for these new disclosure 
requirements under the proposal, stating that this information will 
improve shareholder and market participant knowledge regarding fund 
redemption procedures and liquidity risk management \915\ and provide 
meaningful information about the general time taken to meet redemptions 
and the fund's approaches to liquidity risk management.\916\
---------------------------------------------------------------------------

    \915\ See J.P. Morgan Comment Letter.
    \916\ See ICI Comment Letter I.
---------------------------------------------------------------------------

    Some commenters also expressed concerns with the proposed 
requirement that funds disclose the number of days in which a fund will 
pay redemption proceeds for each distribution channel, stating that the 
disclosure could present undue complexity to the prospectus and may 
lead to shareholder confusion.\917\ In addition, commenters argued that 
a fund does not always have a direct contractual relationship with the 
ultimate beneficial owners of its shares, as there are often multiple 
intermediaries between the mutual fund and its shareholder, and that a 
fund is not in the best position to disclose to its shareholders a 
precise timeframe in which an intermediary will transmit the proceeds 
of a shareholder's redemption.\918\
---------------------------------------------------------------------------

    \917\ See, e.g., Fidelity Comment Letter. See also e.g., 
Federated Comment Letter (stating that distribution channel level 
disclosure is unnecessary and could present undue complexity in 
prospectus if there are minor deviations).
    \918\ See Fidelity Comment Letter.
---------------------------------------------------------------------------

    We understand that in most cases, the distribution channel through 
which a shareholder transacts in fund shares is unlikely to have a 
material effect on the timing of the payment of redemption proceeds, 
but instead that the choice of method of payment of redemption proceeds 
will have the most significant effect on when an investor receives 
proceeds. For example, we understand that the industry's central fund 
transaction processing utility (the NSCC), typically debits or credits 
the cash accounts of users of the utility (such as funds or their 
transfer agents on one side of the transaction, and intermediaries on 
behalf of beneficial owners, on the other side of the transaction) 
regarding net purchase or redemption activities in shares of a fund on 
T+1 (and to a lesser extent with respect to certain funds on T+3). Such 
intermediary users of the utility would in turn update their account 
records, including the beneficial owner's activity, on that date 
regardless of the type of book entry securities, account structure, or 
intermediary that the beneficial owner holds through. However, if the 
beneficial owner wishes to receive remittance of redemption proceeds 
via check (for example, instead of reinvesting them in another 
investment), it may take a certain number of days for the intermediary 
(or fund, as applicable) to process and mail the check to the customer. 
Accordingly, in a change from the proposal, the final form amendments 
do not require disclosure on timing of redemption proceeds based on 
distribution channel, but instead only require a fund to disclose 
typical expected payout times based on the payment method chosen

[[Page 82224]]

by the investor (e.g., check, wire, automated clearing house).\919\
---------------------------------------------------------------------------

    \919\ See Item 11(c)(7) of Form N-1A.
---------------------------------------------------------------------------

    Thus, under the final amendments, if the number of days a fund 
expects to pay redemption proceeds differs by method of payment (e.g., 
check, wire, automated clearing house), then the fund is required to 
disclose the typical number of days or estimated range of days that the 
fund expects it will take to pay out redemption proceeds for each 
method used.\920\ This requirement focuses on disclosing when the fund 
expects to make the payment, not when the shareholder should expect to 
receive the proceeds, because receipt of proceeds is unlikely to be in 
the fund's control (for example, a fund cannot predict how long a 
mailed check will take to arrive). We believe narrowing the disclosure 
requirement to the effects of payment methods rather than the effects 
of all types of distribution channels addresses comments. We also 
believe that this modification will increase the quality of information 
provided to fund shareholders about the timing of their redemption 
proceeds and, at the same time, reduce the likelihood that disclosures 
regarding such timing will be overly granular and complex for investors 
and overly burdensome for registrants.\921\
---------------------------------------------------------------------------

    \920\ See id. (emphasis added).
    \921\ See Proposing Release, supra footnote 9, section 
III.G.1.a.
---------------------------------------------------------------------------

    Other commenters expressed concerns about specific aspects of the 
proposed disclosure amendments. For example, some commenters stated 
that requiring funds to disclose the number of days in which the fund 
will pay redemption proceeds to redeeming shareholders would pressure 
funds to disclose shorter redemption payment periods, thereby limiting 
funds from exercising discretion in stressed markets.\922\ Other 
commenters opposed a requirement to disclose the number of days or 
methods used to pay redemption proceeds,\923\ arguing, for example, 
that the disclosure requirement would inappropriately limit the 
flexibility of a fund to meet redemptions to timing and methods 
previously disclosed in its prospectus \924\ or would cause generic 
disclosures because of the variety of methods available to funds to 
meet redemptions.\925\ One commenter recommended that the Commission 
narrow the scope of the amendments to only the ``typical'' number of 
days, methods, and funding sources used for meeting redemption 
requests.\926\
---------------------------------------------------------------------------

    \922\ See FSR Comment Letter; NYC Bar Comment Letter.
    \923\ See, e.g., Fidelity Comment Letter; Federated Comment 
Letter; Invesco Comment Letter; Vanguard Comment Letter.
    \924\ See, e.g., Invesco Comment Letter; NYC Bar Comment Letter; 
Vanguard Comment Letter.
    \925\ See Federated Comment Letter.
    \926\ See ICI Comment Letter I.
---------------------------------------------------------------------------

    In consideration of these comments, and in a modification to the 
proposal, we are adopting amendments to Item 11 of Form N-1A to require 
a fund to disclose the number of days following receipt of shareholder 
redemption requests in which the fund typically expects to pay 
redemption proceeds to redeeming shareholders,\927\ rather than the 
number of days in which the fund will pay redemption proceeds as 
proposed. Funds may wish to consider also disclosing whether payment of 
redemption proceeds may take longer than the number of days that the 
fund typically expects and may take up to seven days as provided in the 
Investment Company Act.
---------------------------------------------------------------------------

    \927\ See Item 11(c)(7) of Form N-1A (emphasis added).
---------------------------------------------------------------------------

    We appreciate commenters' concerns, and believe that this 
adjustment to the language in Form N-1A will give funds flexibility to 
provide disclosures about redemption procedures that do not 
inappropriately limit a fund's ability to meet redemptions to the exact 
timing previously disclosed in its prospectus. We continue to believe 
that requiring this disclosure will inform the public about a critical 
aspect of a shareholder's relationship with a fund--when the 
shareholder can expect redemption proceeds. Funds generally should 
disclose timing that reflects their actual operational procedures for 
meeting redemption rather than generic disclosures about fund 
redemptions, regardless of what other funds in the industry may 
disclose. We continue to believe that it is in the public interest to 
inform investors on the timing of when fund shareholders should expect 
redemption proceeds. We believe that this disclosure requirement will 
also enhance consistency in fund disclosures regarding the timing in 
which a fund will pay redemption proceeds, thereby improving the 
information provided to shareholders and the ability of investors to 
compare redemption procedures across funds.
b. Methods Used To Meet Shareholder Redemption Obligations
    As noted above, some commenters opposed a requirement to disclose 
the methods used (and number of days) to pay redemption proceeds, 
arguing, for example, that the disclosure requirement would 
inappropriately limit the flexibility of a fund to meet redemptions to 
timing and methods previously disclosed in its prospectus or would 
cause generic disclosures because of the variety of methods available 
to funds to meet redemptions.\928\ Some commenters generally opposed 
requirements for funds to disclose the methods used to meet redemption 
requests, stating, for example, that it does not serve a purpose for 
investors to know precisely how the fund meets their redemption 
requests--so long as they receive their redemption proceeds within the 
period prescribed by regulation.\929\ As noted above, one commenter 
suggested that we narrow the scope of the disclosure requirement to 
only the ``typical'' methods funds use for meeting redemption 
requests.\930\
---------------------------------------------------------------------------

    \928\ See, e.g., Federated Comment Letter; Invesco Comment 
Letter; NYC Bar Comment Letter; Vanguard Comment Letter.
    \929\ See Invesco Comment Letter.
    \930\ See ICI Comment Letter I; see also footnote 926 and 
accompanying text.
---------------------------------------------------------------------------

    In light of these comments, in a modification to the proposal, we 
are adopting amendments to Item 11 of Form N-1A to require a fund to 
disclose the methods that the fund typically expects to use to meet 
redemption requests, and whether those methods are used regularly, or 
only in stressed market conditions.\931\ We believe requiring that the 
description of the procedures for redeeming fund shares include a 
description of the methods a fund typically expects to use to meet 
redemption requests will improve disclosure about another critical 
aspect of a shareholder's relationship with a fund--how a shareholder 
can expect to receive redemption proceeds. We appreciate the concerns 
expressed by commenters and believe that the modified language in the 
form provides some needed flexibility for funds while at the same time 
providing investors with improved information concerning redemption 
procedures. Furthermore, this disclosure requirement will increase 
consistency in fund disclosure documents regarding fund redemption 
practices and improve the comparability of such information across 
funds. Absent this amendment, disclosures concerning the methods funds 
use to pay redemption proceeds will continue to vary across funds.
---------------------------------------------------------------------------

    \931\ See Item 11(c)(8) of Form N-1A (emphasis added).
---------------------------------------------------------------------------

    We believe that requiring specific disclosure on the methods a fund 
uses to pay redemption proceeds could improve investor knowledge on how 
a fund manages liquidity and its redemption obligations to 
shareholders. At the foundation of the prospectus

[[Page 82225]]

disclosure framework is the provision to all investors of user-friendly 
information that is key to an investment decision.\932\ Additionally, 
given the increase in open-end funds pursuing alternative and fixed 
income strategies with varied liquidity risks,\933\ the sources of 
liquidity and methods used to meet shareholder redemptions are key 
information that investors need.
---------------------------------------------------------------------------

    \932\ See Enhanced Disclosure and New Prospectus Delivery Option 
for Registered Open-End Management Investment Companies, Investment 
Company Act Release No. 28584 (Jan. 13, 2009) [74 FR 4546 (Jan. 26, 
2009)] (``N-1A Release''), at section I.
    \933\ See supra section II.C.1.
---------------------------------------------------------------------------

    Methods to meet redemption obligations may include, for example, 
sales of portfolio assets, holdings of cash or cash equivalents, the 
use of lines of credit and/or interfund lending, and in-kind 
redemptions.\934\ Funds may also use redemption fees to help mitigate 
dilution and address transaction costs associated with shareholder 
activity. We also believe that requiring this disclosure could 
encourage funds to consider their operations and ensure that the 
methods they may use to meet shareholder redemption obligations in 
normal and reasonably foreseeable stressed markets are viable.
---------------------------------------------------------------------------

    \934\ See supra footnote 686 and accompanying text.
---------------------------------------------------------------------------

    As noted above, Form N-1A requires funds to disclose whether they 
reserve the right to redeem their shares in kind instead of in cash and 
to describe the procedures for such redemptions.\935\ As proposed, we 
are amending Form N-1A to incorporate this disclosure requirement into 
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.\936\ 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. A fund should consider 
whether adding relevant detail to its disclosure regarding in-kind 
redemptions, including, for example, whether redemptions in kind will 
be pro-rata slices of the fund's portfolio or individual securities or 
a representative basket of securities, 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.
---------------------------------------------------------------------------

    \935\ See Item 11(c)(3) of Form N-1A.
    \936\ See supra section III.J. We note that funds also have the 
ability to redeem in kind, subject to the limitations under rule 
18f-1 under the Act for funds that have made an election under the 
rule. An 18f-1 election commits a fund to pay in cash all requests 
for redemption by any shareholder of record, limited in amount with 
respect to each shareholder during any 90-day period to the lesser 
of $250,000 or 1% of the fund's net asset value at the beginning of 
the period.
---------------------------------------------------------------------------

    One commenter expressed concerns that the proposed additional 
disclosure requirements in Form N-1A runs against the Commission's goal 
of clear and concise, user-friendly disclosures.\937\ We believe that 
the amendments adopted today in this Release, including specific 
modifications in response to commenters, respond appropriately to this 
commenter's concern and are designed to provide disclosures to 
investors with key information in a clear, concise, and understandable 
manner. We believe that investors in an open-end fund should have 
information on how the fund expects to meet redemptions and in what 
time period they expect to pay redemption proceeds.
---------------------------------------------------------------------------

    \937\ See Federated Comment Letter.
---------------------------------------------------------------------------

c. Credit Agreements Exhibit
    We also proposed 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 to 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.\938\ In light of concerns expressed by 
commenters, we are not adopting amendments to Form N-1A to require the 
filing of credit agreements as exhibits to a fund's registration 
agreement.
---------------------------------------------------------------------------

    \938\ See Proposing Release, supra footnote 9, at section 
III.G.1 (where we also proposed to include an instruction related to 
credit agreements noting that the specific fees paid in connection 
with the credit agreements need not be disclosed in the exhibit 
filed with the Commission to preserve the confidentiality of this 
information).
---------------------------------------------------------------------------

    Many commenters objected to the credit agreements exhibit 
requirement,\939\ with some arguing, for example, that credit 
agreements are often extremely lengthy documents that are not user-
friendly,\940\ the disclosure of which would be unnecessary in light of 
the lines of credit reporting requirements in Form N-CEN as well as 
information concerning lines of credit disclosed in a fund's statement 
of additional information and financial statements.\941\ Other 
commenters expressed concern that public disclosure of line of credit 
agreements in a fund's registration statement could ultimately harm 
fund shareholders, noting that public disclosure could (1) disrupt and 
weaken a fund's ability to negotiate credit terms; \942\ (2) make 
public proprietary and competitive information (e.g., certain 
representations and warranties) that lenders and funds may wish to keep 
confidential and are not easily redacted; \943\ and (3) ultimately 
discourage lending banks from granting lending terms to funds out of a 
concern that terms granted would become standard in other lending 
agreements.\944\
---------------------------------------------------------------------------

    \939\ See, e.g., Fidelity Comment Letter; CRMC Comment Letter; 
Oppenheimer Comment Letter; Voya Comment Letter.
    \940\ See CRMC Comment Letter; T. Rowe Comment Letter.
    \941\ See, e.g., Oppenheimer Comment Letter; T. Rowe Comment 
Letter; Voya Comment Letter.
    \942\ See Oppenheimer Comment Letter; Fidelity Comment Letter.
    \943\ See CRMC Comment Letter; Invesco Comment Letter; 
Oppenheimer Comment Letter; Voya Comment Letter.
    \944\ See Fidelity Comment Letter.
---------------------------------------------------------------------------

    Rather than include line of credit agreements as exhibits, other 
commenters suggested including a narrative discussion of lines of 
credit information, similar to the data required to be disclosed in 
Form N-CEN, in a fund's statement of additional information.\945\ Some 
commenters did not oppose requiring the filing of line of credit 
agreements as an exhibit to a fund's registration statement if, in 
addition to redacting fees as proposed, certain other portions of the 
agreement were permitted to be redacted.\946\
---------------------------------------------------------------------------

    \945\ See ICI Comment Letter I; CRMC Comment Letter.
    \946\ See FSR Comment Letter (requesting redaction of the 
identity of the counterparty); Federated Comment Letter (requesting 
redaction of the rate payable by the fund on any drawdowns).
---------------------------------------------------------------------------

    We find the concerns expressed by commenters persuasive and have 
determined to not adopt this amendment to Form N-1A. We acknowledge 
that credit agreements can be lengthy, complex documents that may be of 
limited value to retail investors and that the information provided in 
the proposed exhibits could be, in part, duplicative of information 
provided in a fund's statement of additional information and financial 
statements. We believe that requiring funds to report the use of lines 
of credit in response to reporting requirements in Form N-CEN is an 
appropriate means to increase Commission, investor, and market 
participant knowledge concerning the arrangements funds have made in 
order to strengthen their ability to meet shareholder redemption

[[Page 82226]]

requests and manage liquidity risk and the terms of those arrangements.
d. Additional Disclosure Requirements
    Some commenters recommended that the Commission require additional 
disclosures in a fund's registration statement about a fund's specific 
liquidity risk management policies and procedures \947\ and the market 
impact costs associated with redemption activity.\948\ For example, one 
commenter recommended requiring a fund to disclose a narrative of its 
liquidity risk management program in its statement of additional 
information as well as a statement in the fund prospectus about the 
liquidity risk appetite of each fund.\949\ Another commenter expressed 
support for the Commission requiring funds to include a discussion of 
their liquidity risk management policies and procedures, similar to 
what is currently required on Form N-1A for policies and procedures 
regarding proxy voting (Items 17 and 27) and valuation procedures (Item 
23), among others.\950\ In addition, one commenter recommended that we 
consider requiring a fund to also disclose the level of ``position 
concentration'' that is appropriate for the fund in terms of portfolio 
liquidity in light of the fund's investment strategy and investor 
profile.\951\ While another commenter recommended that, at a minimum, 
funds be required to provide disclosures noting the possibility of 
suspending redemptions and how the fund will handle redemption requests 
in that situation.\952\
---------------------------------------------------------------------------

    \947\ See, e.g., Invesco Comment Letter; J.P. Morgan Comment 
Letter.
    \948\ See BlackRock Comment Letter.
    \949\ See Invesco Comment Letter.
    \950\ See J.P. Morgan Comment Letter.
    \951\ See BlackRock Comment Letter.
    \952\ See CFA Comment Letter.
---------------------------------------------------------------------------

    We support commenters' goals of providing useful information about 
a fund's liquidity risk management practices to investors but also 
remain committed to encouraging statutory prospectuses that are simple, 
clear, and useful to investors \953\ and registration statements that 
provide useful information, rather than boilerplate legal 
representations. In the interest of balancing these two goals, we are 
adopting the proposed amendments to Form N-1A substantially as proposed 
without including these specific additional disclosure requirements 
suggested by commenters in the text of the form. We note, however, that 
nothing in Form N-1A prohibits disclosures about the features of a 
fund's liquidity risk management program where relevant to 
understanding disclosures under existing reporting requirements.
---------------------------------------------------------------------------

    \953\ See N-1A Release, supra footnote 932.
---------------------------------------------------------------------------

2. New Form N-LIQUID
    We are also adopting a new requirement that open-end investment 
companies, including In-Kind ETFs to the extent applicable \954\ but 
not including money market funds (i.e., registrants), file on a non-
public basis a current report to the Commission on new Form N-LIQUID 
when certain significant events related to a fund's liquidity 
occur.\955\ This requirement will be implemented through our adoption 
of new rule 30b1-10, which requires funds to file a report on new Form 
N-LIQUID in certain circumstances. The content of this report is 
similar to the information that we proposed to be reported on Form N-
PORT under the proposal concerning a fund's investments in illiquid 
assets, but with some modifications in response to comments. A report 
on Form N-LIQUID is required to be filed, as applicable, within one 
business day of the occurrence of one or more of the events specified 
in the form.\956\ Form N-LIQUID will be non-public. For the same 
reasons discussed previously regarding our determination to keep 
information regarding a fund's highly liquid investment minimum and 
specific position level disclosure of illiquid investments non-public, 
we find that it is neither necessary nor appropriate in the public 
interest or for the protection of investors to make the information 
filed on Form N-LIQUID publicly available.\957\
---------------------------------------------------------------------------

    \954\ As discussed below, some of the events required to be 
reported on Form N-LIQUID are in connection with the breach of a 
fund's highly liquid investment minimum. See Part D of Form N-
LIQUID. Because In-Kind ETFs are not subject to the highly liquid 
investment minimum requirement under rule 22e-4(b)(1)(iii), they 
would not be subject to this Part D reporting requirement on Form N-
LIQUID.
    \955\ See rule 30b1-10.
    \956\ Form N-LIQUID will also require a fund to report the 
following general information: (1) The date of the report; (2) the 
registrant's central index key (``CIK'') number; (3) the EDGAR 
series identifier; (4) the Securities Act file number; and (v) the 
name, email address, and telephone number of the person authorized 
to receive information and respond to questions about the filing. 
See Part A of Form N-LIQUID.
    \957\ See supra footnote 615 and accompanying text and footnote 
743 and accompanying text. Section 45(a) of the Investment Company 
Act requires information in reports filed with the Commission 
pursuant to the Investment Company Act to be made available to the 
public, unless we find that public disclosure is neither necessary 
nor appropriate in the public interest or for the protection of 
investors.
---------------------------------------------------------------------------

    First, a registrant is required to file Form N-LIQUID within one 
business day when more than 15% of its net assets are, or become, 
illiquid investments that are assets as defined in rule 22e-4.\958\ If 
this occurs, the registrant will be required to report on Form N-LIQUID 
general information about the registrant as well as (1) the date(s) of 
the event, (2) the current percentage of the registrant's net assets 
that are illiquid investments that are assets, and (3) identification 
information about the illiquid investments.\959\
---------------------------------------------------------------------------

    \958\ See Part A and Part B of Form N-LIQUID.
    \959\ See Items A.1--A.5 and Items B.1--B.3 of Form N-LIQUID.
---------------------------------------------------------------------------

    Second, if a registrant whose illiquid investments that are assets 
previously exceeded 15% of net assets determines that its holdings in 
illiquid investments that are assets have changed to be less than or 
equal to 15% of the registrant's net assets, then the registrant also 
is required to report within one business day (1) the date(s) on which 
its illiquid investments that are assets fell to or below 15% of net 
assets and (2) the current percentage of the registrant's net assets 
that are illiquid investments that are assets.\960\
---------------------------------------------------------------------------

    \960\ See Item C.1 and Item C.2 of Form N-LIQUID.
---------------------------------------------------------------------------

    Lastly, a registrant also is required to notify the Commission on 
Form N-LIQUID within one business day if its holdings in highly liquid 
investments that are assets fall to or below the registrant's highly 
liquid investment minimum for more than 7 consecutive calendar 
days.\961\ If this occurs, a fund is required to report the date(s) on 
which the fund's holdings in liquid investments that are assets fell 
below the fund's highly liquid investment minimum.\962\
---------------------------------------------------------------------------

    \961\ See Part D of Form N-LIQUID.
    \962\ See Item D.1 of Form N-LIQUID.
---------------------------------------------------------------------------

    As discussed above, we are modifying the 15% standard asset-
reporting requirement originally proposed by incorporating this 
information into the fourth ``illiquid investment'' classification 
category reported on Form N-PORT.\963\ Under the proposal, Form N-PORT 
would have required a fund to report, for each portfolio asset, whether 
the asset is a 15% standard asset in order to allow our staff and other 
interested parties to track the extent that funds are holding 15% 
standard assets and to discern the nature of those holdings and assist 
these groups in tracking the fund's exposure to liquidity risk.\964\
---------------------------------------------------------------------------

    \963\ See Item C.7 Form N-PORT; see also supra section III.C.6.
    \964\ See Proposing Release, supra footnote 9, at section 
II.G.2.b.
---------------------------------------------------------------------------

    Some commenters recommended that the Commission require more 
detailed reporting data from funds that hold a larger percentage of 
securities that are

[[Page 82227]]

less liquid or illiquid and that funds should notify the Commission 
more promptly than the Form N-PORT filing deadline when a fund's 
illiquid assets exceed 15% of net assets, or if the fund otherwise 
encounters indications of increased liquidity risk.\965\ Other 
commenters expressed support for the addition of an early warning 
notification provision, under which funds would be required to notify 
the Commission when illiquid assets held at the end of a business day 
exceed 15% of net assets and continue to exceed 15% of net assets three 
business days after the threshold was first exceeded.\966\ Another 
commenter expressed the belief that the sheer scale of Americans' 
reliance on open-end funds as an investment instrument and the 
potential for systemic contagion that arises when funds confront 
liquidity challenges must inform any consideration of the Commission's 
proposal.\967\ In the commenter's view, the reporting requirements 
under the proposal with underlying factor-based analysis was largely 
discretionary and lacked mandatory requirements, and thereby failed to 
adequately account for the potential systemic threat to the nation's 
financial stability posed by liquidity risk.\968\
---------------------------------------------------------------------------

    \965\ See, e.g., Charles Schwab Comment Letter (noting that this 
proposed approach could be similar to the Commission's 2015 
Derivatives Proposing Release, which has proposed to enhance 
requirements for funds whose aggregate exposure to derivatives 
exceeds 50% of its net assets); see also, e.g., SIFMA Comment Letter 
III.
    \966\ See, e.g., SIFMA Comment Letter III (noting that this 
early warning notification could respond to concerns raised by the 
Third Avenue Fund liquidation); see also Third Avenue Temporary 
Order, supra footnote 12.
    \967\ See Better Markets Comment Letter.
    \968\ See id.
---------------------------------------------------------------------------

    We appreciate the concerns and suggestions raised by commenters and 
agree that the Commission should be notified promptly when a fund 
encounters indications of increased liquidity risk and believe that new 
Form N-LIQUID addresses some concerns expressed by commenters that 
certain liquidity events that could affect the liquidity of a 
particular fund and/or indicate potential liquidity risks across the 
fund industry require particular attention by Commission staff. 
Pursuant to Part B of Form N-LIQUID, registrants will now be required 
to report to the Commission within one business day of when their 
percentage of illiquid investments that are assets exceeds (and 
subsequently falls to or below) 15% of their net assets.\969\ Providing 
this information more promptly than monthly reporting on Form N-PORT, 
as proposed, will be the ``early warning notification'' that some 
commenters recommended \970\ and will inform the Commission of 
potential liquidity stress events at the earliest possible juncture. 
Similarly, requiring a registrant to report when its holdings in highly 
liquid investments that are assets fall below the registrant's highly 
liquid investment minimum will add to this early warning system and 
ensure the Commission is made aware of such breaches promptly, rather 
than later in reports filed on Form N-PORT.\971\ We believe that the 
information reported on Form N-LIQUID will assist Commission staff in 
its monitoring efforts of liquidity, including monitoring of not only 
the reporting fund but also funds that may have comparable 
characteristics to the reporting fund and could be similarly affected 
by market events.
---------------------------------------------------------------------------

    \969\ See Part B and Part C of Form N-LIQUID; see also General 
Instruction A of Form N-LIQUID.
    \970\ See SIFMA Comment Letter III.
    \971\ See Part D of Form N-LIQUID.
---------------------------------------------------------------------------

    Form N-LIQUID also includes general filing and reporting 
instructions, as well as definitions of specific terms referenced in 
the form.\972\ These instructions and definitions are intended to 
provide clarity to funds and to assist them in filing reports on Form 
N-LIQUID.
---------------------------------------------------------------------------

    \972\ See General Instructions A (Rule as to Use of Form N-
LIQUID), B (Application of General Rules and Regulations), C 
(Information to Be Included in Report Filed on Form N-LIQUID), D 
(Filing of Form N-LIQUID), E (Paperwork Reduction Act Information), 
and F (Definitions) of Form N-LIQUID.
---------------------------------------------------------------------------

3. Amendments to Form N-CEN
    We proposed several reporting items under Part C of Form N-CEN to 
allow the Commission and other users to track certain liquidity risk 
management practices that we expect funds to use on a less frequent 
basis than the day-to-day portfolio construction techniques captured by 
Form N-PORT.\973\ We are adopting these reporting requirements 
substantially as proposed. Where we have received comments on specific 
reporting requirements, we discuss them in more detail below.
---------------------------------------------------------------------------

    \973\ See Proposing Release, supra footnote 9, at section 
III.G.3.
---------------------------------------------------------------------------

a. Lines of Credit, Interfund Lending, and Interfund Borrowing
    We are adopting, largely as proposed, but with a modification in 
response to comment, the requirement in Form N-CEN that a management 
company report information regarding the use of lines of credit, 
interfund lending, and interfund borrowing.\974\ Several commenters 
expressed general support for these reporting requirements on Form N-
CEN.\975\ In a modification to the proposal, if a fund reports that it 
has access to a line of credit, for each line of credit the fund will 
be required to report whether the line of credit is a committed or 
uncommitted line of credit.\976\ The fund will be required to report 
information concerning the size of the line of credit in U.S. dollars, 
the name of the institution(s) with which the fund has the line of 
credit, and whether the line of credit is for that fund alone or is 
shared among multiple funds.\977\ If the line of credit is shared among 
multiple funds, the fund is required to disclose the names and SEC File 
numbers of the other funds (including any series) that may use the line 
of credit.\978\ If the fund responds affirmatively to having available 
a line of credit, the fund is required to disclose whether it drew on 
the line of credit during the reporting period.\979\ If the fund drew 
on that line of credit during the reporting period, the fund is 
required to disclose the average dollar amount outstanding when the 
line of credit was in use and the number of days that line of credit 
was in use.\980\
---------------------------------------------------------------------------

    \974\ See Item C.20 of Form N-CEN. We have modified the 
numbering convention for items within Form N-CEN from the proposal 
to be consistent with Form N-CEN as adopted in the Investment 
Company Reporting Modernization Adopting Release and to clarify that 
responses regarding lines of credit, interfund lending, and 
interfund borrowing should apply to each line of credit or loan, as 
applicable.
    \975\ See, e.g., CFA Comment Letter; Federated Comment Letter; 
Vanguard Comment Letter.
    \976\ See Item C.20.a.i of Form N-CEN (emphasis added).
    \977\ See Item C.20.a.ii-iv. of Form N-CEN.
    \978\ See Item C.20.a.iv.1 of Form N-CEN. Under Form N-CEN, 
``SEC File number'' means the number assigned to an entity by the 
Commission when that entity registered with the Commission in the 
capacity in which it is named in Form N-CEN. See General Instruction 
E to Form N-CEN.
    \979\ See Item C.20.a.v of Form N-CEN.
    \980\ See Item C.20.a.vi. and vii of Form N-CEN.
---------------------------------------------------------------------------

    The Proposing Release included a request for comment on whether 
funds should be required to report information on uncommitted lines of 
credit on Form N-CEN.\981\ In general, a 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. For uncommitted or standby 
lines of credit, however, a bank indicates a willingness, but no 
obligation, to lend to a fund.\982\ As one commenter noted, funds may 
have certain tools like lines of credit from banks for temporary 
liquidity management purposes ``when more typical means (e.g., use of 
new or existing cash or sales of portfolio holdings) are unavailable or 
otherwise

[[Page 82228]]

sub-optimal.'' \983\ One commenter suggested that funds report the 
availability of uncommitted lines of credit in addition to committed 
lines of credit in Form N-CEN.\984\
---------------------------------------------------------------------------

    \981\ See Proposing Release, supra footnote 9, at section 
III.G.3.c.
    \982\ See Fortune, supra footnote 781 at 47.
    \983\ ICI Comment Letter I.
    \984\ See Federated Comment Letter.
---------------------------------------------------------------------------

    In consideration of these comments, we are including in Form N-CEN 
a requirement for funds to report the availability and use of committed 
and uncommitted lines of credit.\985\ We believe that this information 
will allow our staff and other potential users to assess what sources 
of external liquidity are available to funds and to what extent funds 
rely on dedicated external sources of liquidity, rather than relying on 
the liquidity of fund portfolio investments alone, for liquidity risk 
management. In addition, we believe that if funds make substantial use 
of uncommitted lines of credit, the reporting of that reliance could 
flag potential vulnerabilities in a fund or the fund industry, 
particularly in the event of a market crisis when uncommitted lines of 
credit might become unavailable. Furthermore, having funds report 
information on lines of credit will also allow monitoring of whether 
lines of credit are concentrated in particular financial institutions.
---------------------------------------------------------------------------

    \985\ See Item C.20.a.(i) of Form N-CEN.
---------------------------------------------------------------------------

    We are adopting, as proposed, the requirement that a fund report 
whether it engaged in interfund lending or interfund borrowing during 
the reporting period, and, if so, the average amount of the interfund 
loan when the loan was outstanding and the number of days that the 
interfund loan was outstanding.\986\ This information will provide some 
transparency regarding the extent to which funds use interfund lending 
or interfund borrowing. We understand that one reason that funds have 
sought exemptive relief to engage in interfund lending and borrowing is 
to meet redemption obligations if necessary.\987\
---------------------------------------------------------------------------

    \986\ See Items C.20.b and c of Form N-CEN.
    \987\ For example, we understand that funds may engage in 
interfund lending and borrowing to pay out redemption proceeds same-
day or T+1 while the fund awaits proceeds from sales of non-traded 
securities.
---------------------------------------------------------------------------

b. Additional Information Concerning ETFs
    In a modification to the proposal, we are requiring that each ETF 
that complies with rule 22e-4 as an ``In-Kind ETF'' under the rule, 
identify itself accordingly in reports on Form N-CEN.\988\ As discussed 
above, we are adopting certain tailored liquidity risk management 
program requirements for ETFs, and certain ETFs that qualify as In-Kind 
ETFs will not be required to classify their portfolio investments or 
comply with the highly liquid investment minimum requirement of rule 
22e-4.\989\ We believe that the In-Kind ETF information reported on 
Form N-CEN will be helpful in understanding the volume of ETFs that 
identify as In-Kind ETFs and thus are not required to classify their 
portfolio investments or comply with the highly liquid investment 
minimum requirement of rule 22e-4.\990\
---------------------------------------------------------------------------

    \988\ See Item E.5 of Form N-CEN; see also supra section III.J 
regarding the definition and treatment of ``In-Kind ETFs'' under 
rule 22e-4.
    \989\ Id.
    \990\ ETFs that redeem in cash, or that do not qualify otherwise 
as ``In-Kind ETFs'' (as defined in rule 22e-4(a)(9)) will be subject 
to the full set of liquidity risk management program elements, 
including the classification and highly liquid investment minimum 
requirements. See rule 22e-4(b)(1)(i)-(iii).
---------------------------------------------------------------------------

4. Safe Harbors
    Some commenters suggested that the Commission should include a safe 
harbor and/or protection from liability as part of the final rule for 
proposed liquidity-related disclosures.\991\ One commenter recommended 
that the Commission provide a safe harbor for ``forward-looking 
statements'' given the speculative nature of the proposed 
disclosures.\992\ Another commenter recommended that the Commission 
implement measures to shield from liability funds that in good faith 
make forward-looking assessments of liquidity at either the asset or 
portfolio level that subsequently turn out to materially differ from 
actual liquidity.\993\ One commenter further suggested that the 
Commission should include a provision stating that funds and their 
affiliates will not face liability for errors in classification or 
otherwise in implementing their liquidity risk management programs, and 
related reports and (if applicable) disclosures, unless (i) the error 
is material and (ii) the fund or affiliate acted knowingly or 
recklessly. Commenters argued that any safe harbor provision should 
also make clear that funds and managers would not face liability for 
violation of rule 22e-4 based on second-guessing, either by the 
Commission or by fund shareholders, of the design of the liquidity risk 
management program.\994\ One commenter expressed concern that, even if 
a safe harbor provision were established that protected funds and 
directors from Commission enforcement actions, funds and directors 
could still be subject to private litigation.\995\ We decline to 
provide such a safe harbor.
---------------------------------------------------------------------------

    \991\ See, e.g., ICI Comment Letter I; LSTA Comment Letter; 
SIFMA Comment Letter II; T. Rowe Comment Letter.
    \992\ See FSR Comment Letter.
    \993\ See ICI Comment Letter I (noting that the Commission has 
precedent for using its authority to shield from potential liability 
certain forward-looking information that registrants are required to 
provide (see, e.g., rule 175 under the Securities Act; rule 3b-6 
under the Exchange Act; Item 303(c) of Reg. S-K; and Disclosure in 
Management's Discussion and Analysis about Off-Balance Sheet 
Arrangements and Aggregate Contractual Obligations, Securities Act 
Release No. 33-8182 (Feb. 5, 2003) (regarding MD&A disclosures)).
    \994\ See SIFMA Comment Letter II.
    \995\ See Federated Comment Letter.
---------------------------------------------------------------------------

M. Effective and Compliance Dates

    We are adopting the following effective and compliance dates, as 
set forth below.
1. Liquidity Risk Management Program
    The compliance date for our liquidity risk management program 
requirement is December 1, 2018 for larger entities, and June 1, 2019 
for smaller entities. Thus all registered open-end management 
investment companies, including open-end ETFs, that are not smaller 
entities, will be required to adopt and implement a written liquidity 
risk management program, approved by a fund's board of directors on 
December 1, 2018, while smaller entities will be required to do so six 
months later, on June 1, 2019.\996\
---------------------------------------------------------------------------

    \996\ The compliance date in the section applies to rule 22e-4, 
rule 30b1-10, and Form N-LIQUID.
---------------------------------------------------------------------------

    In the Proposing Release, the Commission stated that it expected to 
provide a tiered set of compliance dates based on asset size.\997\ The 
Commission expected that 18 months after the effective date would 
provide an adequate period of time for larger entities to prepare 
internal processes, policies, and procedures and implement liquidity 
risk management programs that would meet the requirements of the 
rule.\998\ We believed that smaller entities would benefit from having 
an additional 12 months to establish and implement a written liquidity 
risk management program.\999\
---------------------------------------------------------------------------

    \997\ See Proposing Release, supra footnote 9, at section III.H. 
Specifically, for larger entities--namely, funds that together with 
other investment companies in the same ``group of related investment 
companies'' have net assets of $1 billion or more as of the end of 
the most recent fiscal year--the Commission proposed a compliance 
date of 18 months after the effective date to comply with the 
Proposed Rule. For smaller entities (i.e., funds that together with 
other investment companies in the same ``group of related investment 
companies'' have net assets of less than $1 billion as of the end of 
the most recent fiscal year), the proposal provided for an extra 12 
months (or 30 months after the effective date) to comply with 
proposed rule 22e-4.
    \998\ Id.
    \999\ Id.
---------------------------------------------------------------------------

    Most of the commenters who discussed the proposed liquidity risk 
management program compliance

[[Page 82229]]

date(s) opposed tiered compliance and requested at least 30 months to 
comply. Some argued larger funds would need at least 30 months to 
comply because of their size: More funds and a greater number and 
variety of investments to classify would require more time.\1000\ 
Others cited operational limitations: A need of adequate time for (1) 
all funds to properly prepare processes, policies and procedures; (2) 
managers to adjust operations and develop reporting capabilities; and 
(3) mutual fund boards to review, approve, and implement the 
program.\1001\ The only commenter that supported tiered compliance 
requested lengthier compliance dates for both larger and smaller 
entities.\1002\
---------------------------------------------------------------------------

    \1000\ See, e.g., Fidelity Comment Letter; FSR Comment Letter; 
ICI Comment Letter I; Invesco Comment Letter.
    \1001\ See, e.g., BlackRock Comment Letter; CRMC Comment Letter; 
T. Rowe Comment Letter; Vanguard Comment Letter.
    \1002\ See Dechert Comment Letter.
---------------------------------------------------------------------------

    After evaluating the comments received, we believe that larger 
entities would benefit from an additional period of time to come into 
compliance with the rules over the 18 months that was proposed. 
Therefore, we are providing an additional 6 months for these entities, 
for a total of 24 months (i.e., December 1, 2018) to come into 
compliance. We continue to believe that smaller entities may face 
additional or different challenges in coming into compliance with the 
rules quickly, and are therefore providing an extended compliance 
period of a total of 30 months (i.e., June 1, 2019) for such smaller 
entities.
2. Amendments to Form N-1A, Form N-PORT, and Form N-CEN
    In the Proposing Release, the Commission expected to require all 
initial registration statements on Form N-1A, and all post-effective 
amendments that are annual updates to effective registration statements 
on Form N-1A, filed six months or more after the effective date, to 
comply with the proposed amendments to Form N-1A.\1003\ Few commenters 
discussed the Form N-1A amendments. One commenter agreed that 6 months 
was sufficient to comply with the amendments;\1004\ another commenter 
requested 30 months to comply.\1005\ Because we do not expect that 
funds will require significant amounts of time to prepare these 
additional disclosures,\1006\ we are adopting a compliance date for our 
amendments to Form N-1A of June 1, 2017. This will provide a six month 
compliance period for these amendments, as proposed.
---------------------------------------------------------------------------

    \1003\ See Proposing Release, supra footnote 9, at section 
III.H.
    \1004\ See ICI Comment Letter I.
    \1005\ See Vanguard Comment Letter.
    \1006\ See Proposing Release, supra footnote 9, at section 
III.H.
---------------------------------------------------------------------------

    Similar to the tiered compliance dates for the liquidity 
classification requirements (discussed above), we are providing a 
tiered set of compliance dates based on asset size for the additions to 
Form N-PORT and Form N-CEN.\1007\ In the Proposing Release, for larger 
entities, we expected that 18 months would provide an adequate period 
of time for funds, intermediaries, and other service providers to 
conduct the requisite operational changes to their systems and to 
establish internal processes to prepare, validate, and file reports 
containing the additional information requested by the proposed 
amendments to Form N-PORT. Further, we believed that smaller entities 
would benefit from extra time to comply and from the lessons learned by 
larger investment companies during the adoption period for Form N-PORT. 
For Form N-CEN, we proposed a compliance date of 18 months after the 
effective date to comply with the new reporting requirements.\1008\ We 
expected that 18 months would provide an adequate period of time for 
funds, intermediaries, and other service providers to conduct the 
requisite operational changes to their systems and to establish 
internal processes to prepare, validate, and file reports containing 
the additional information requested by the proposed amendments to Form 
N-CEN. Multiple commenters, restating their concerns about operational 
limitations, requested 30 months for all entities to comply with the 
Form N-PORT and Form N-CEN amendments.\1009\
---------------------------------------------------------------------------

    \1007\ Id.
    \1008\ Id.
    \1009\ See Cohen & Steers Comment Letter; Fidelity Comment 
Letter; ICI Comment Letter I; Vanguard Comment Letter.
---------------------------------------------------------------------------

    As discussed above, we are persuaded that larger entities would 
benefit from extra time to comply and are therefore providing a 
compliance date of December 1, 2018 for larger entities to come into 
compliance with the additional liquidity-related reporting requirements 
of Form N-PORT and Form N-CEN. This will result in larger funds filing 
their first reports with additional liquidity-related information on 
Form N-PORT, reflecting data as of December 31, no later than January 
31. For smaller entities, the compliance date will be June 1, 2019. 
This will provide smaller entities an additional six months to comply 
with the new liquidity-related reporting requirements.

IV. Economic Analysis

A. Introduction and Primary Goals of Regulation

1. Introduction
    As discussed above, the Commission is adopting regulatory changes 
to require a liquidity risk management program, and to require new 
disclosures regarding liquidity risk and liquidity risk management 
(collectively, the ``final liquidity regulations''). Because of the 
significant diversity in liquidity risk management practices that we 
have observed in the fund industry, there exists the need for enhanced 
comprehensive baseline regulations instead of only guidance for fund 
liquidity risk management. In summary, and as discussed in greater 
detail in section III above, the final liquidity regulations include 
the following:
     New rule 22e-4 will require that each fund stablish a 
written liquidity risk management program. A fund's liquidity risk 
management program broadly requires a fund to assess, manage and review 
the fund's liquidity risk; to classify the liquidity of each of the 
fund's portfolio investments; to determine a highly liquid investment 
minimum (except for funds that hold primarily highly liquid 
investments); and to limit illiquid investments to 15% of fund 
investments. The final rule also provides for a tailored program for 
all ETFs, but offers some exemptions for In-Kind ETFs. Finally, the 
rule requires for board oversight of the liquidity risk management 
program.
     Amendments to Form N-1A and additional elements of new 
Form N-PORT and Form N-CEN will require enhanced fund disclosure and 
reporting regarding position liquidity and shareholder redemption 
practices. New Form N-LIQUID will require more prompt, non-public 
notification to the Commission when a fund's holdings of assets that 
are illiquid investments exceed 15% of net assets, or when a fund's 
holdings of highly liquid investments that are assets fall below the 
fund's highly liquid investment minimum for more than 7 consecutive 
calendar days.
    The Commission is sensitive to the economic effects of the final 
liquidity regulations, including the benefits and costs as well as the 
effects on efficiency, competition, and capital formation. The economic 
effects are discussed below in the context of the primary goals of the 
final liquidity regulations.
2. Primary Goals
    The primary goals of the final liquidity regulations are to promote

[[Page 82230]]

investor protection by reducing the risk that funds will be unable to 
meet their redemption obligations, elevate the overall quality of 
liquidity risk management across the fund industry, increase 
transparency of funds' liquidity risks and risk management practices, 
and mitigate potential dilution of non-transacting shareholders' 
interests. Funds are not currently subject to requirements under the 
federal securities laws or Commission rules that specifically require 
them to maintain a minimum level of portfolio liquidity (with the 
exception of money market funds), and follow Commission guidelines (not 
rules) that generally limit their investment in illiquid assets.\1010\ 
Additionally, a fund today is only subject to limited disclosure 
requirements concerning the fund's liquidity risk and risk 
management.\1011\ As discussed in the Proposing Release, staff outreach 
has shown that funds today engage in a variety of different practices--
ranging from comprehensive and rigorous to minimal and basic--for 
assessing the liquidity of their portfolios, managing liquidity risk, 
and disclosing information about their liquidity risk, redemption 
practices, and liquidity risk management practices to investors.\1012\ 
We believe that the enhanced requirements for funds' assessment, 
management, and disclosure of liquidity risk and enhanced limits on 
illiquid investment holdings could decrease the chance that funds would 
be unable to meet their redemption obligations and mitigate potential 
dilution of non-redeeming shareholders' interests.
---------------------------------------------------------------------------

    \1010\ See supra section II.D; infra section IV.B.1.a.
    \1011\ See supra section II.D; infra section IV.B.1.c.
    \1012\ See supra section II.D; infra sections IV.B.1.a, 
IV.B.1.c.
---------------------------------------------------------------------------

    The final liquidity regulations are also intended to lessen the 
possibility of early redemption incentives (and investor dilution) 
created by insufficient liquidity risk management, as well as the 
possibility that investors' share value will be diluted by costs 
incurred by a fund as a result of other investors' purchase or 
redemption activity. When a fund experiences significant redemption 
requests, it may sell portfolio securities or borrow funds in order to 
obtain sufficient cash to meet redemptions.\1013\ However, sales of a 
fund's portfolio investments conducted in order to meet shareholder 
redemptions could result in significant adverse consequences to non-
redeeming shareholders when a fund fails to adequately manage 
liquidity. For example, if a fund sells portfolio investments under 
unfavorable circumstances, this could create dilution for non-redeeming 
shareholders.\1014\ Funds also may borrow from a bank or use interfund 
lending facilities to meet redemption requests, but there are costs 
(such as interest rates) associated with such borrowings. Both selling 
of portfolio investments and borrowing to meet redemption requests 
could cause funds to incur costs that would be borne mainly by non-
redeeming shareholders.\1015\ These factors could result in dilution of 
the value of non-redeeming shareholders' interests in a fund,\1016\ 
which could create incentives for early redemptions in times of 
liquidity stress, and result in further dilution of non-redeeming 
shareholders' interests.\1017\ There also is a potential for adverse 
effects on the markets when open-end funds fail to adequately manage 
liquidity. For example, the sale of less liquid portfolio investments 
at discounted or even fire sale prices when a fund is facing redemption 
pressures can produce significant negative price pressure on those 
investments and correlated investments, which can impact other 
investors holding these investments and may transmit stress to other 
funds or portions of the markets.\1018\ For reasons discussed in detail 
below, we believe that the liquidity risk management program 
requirement, including the enhanced restrictions on holdings of assets 
that are illiquid investments, should mitigate the risk of potential 
shareholder dilution and decrease the incentive for early redemption in 
times of liquidity stress.
---------------------------------------------------------------------------

    \1013\ See supra section II.B.2; infra sections IV.C.1, IV.C.2.
    \1014\ See supra footnotes 79-80 and accompanying text.
    \1015\ See supra footnote 259 and accompanying text.
    \1016\ See supra footnotes 79-80 and accompanying text; infra 
sections IV.C.1, IV.C.2.
    \1017\ See supra footnote 85 and accompanying text; infra 
sections IV.C.1, IV.C.2.
    \1018\ See supra footnote 89 and accompanying text.
---------------------------------------------------------------------------

    Finally, the final liquidity regulations are meant to address 
recent industry developments that have underscored the significance of 
funds' liquidity risk management practices. In recent years, there has 
been significant growth in the assets managed by funds with strategies 
that focus on holding relatively less liquid investments, such as fixed 
income funds (including emerging market debt funds), open-end funds 
with alternative strategies, and emerging market equity funds.\1019\ 
There also has been considerable growth in assets managed by funds that 
exhibit characteristics that could give rise to increased liquidity 
risk, such as relatively high investor flow volatility.\1020\ 
Additionally, as discussed in detail above, standard fund redemption 
and securities settlement periods have tended to become significantly 
shorter over the last several decades, which has caused funds to 
satisfy redemption requests within relatively short time periods (e.g., 
within T + 3, T + 2, and next-day periods).\1021\ But while fund 
redemption periods have become shorter, certain funds, for example, 
certain bank loan funds and emerging market debt funds, have increased 
their holdings of portfolio securities with relatively long settlement 
periods, which could result in a liquidity mismatch between when a fund 
plans or is required to pay redeeming shareholders, and when any asset 
sales that the fund has executed in order to pay redemptions will 
settle.\1022\ Collectively, these industry trends have emphasized the 
importance of effective liquidity risk management among funds and 
enhanced disclosure regarding liquidity risk and risk management.
---------------------------------------------------------------------------

    \1019\ See supra section II.C.1; infra section IV.B.3; see also 
DERA Study, supra footnote 95, at 6-9. Relevant statistics from the 
DERA Study were updated through 2015 using the CRSP US Mutual Fund 
Database.
    \1020\ See infra section IV.B.3.
    \1021\ See supra footnotes 102 and 103 and accompanying text.
    \1022\ See supra footnotes 104, 105, 377, and 378 and 
accompanying text.
---------------------------------------------------------------------------

B. Economic Baseline

    The final liquidity regulations will affect all funds and their 
investors, investment advisers and other service providers, all issuers 
of the portfolio securities in which funds invest, and other market 
participants potentially affected by fund and investor behavior. The 
economic baseline of the final liquidity regulations includes funds' 
current practices regarding liquidity risk management and liquidity 
risk disclosure, as well as the economic attributes of funds that 
affect their portfolio liquidity and liquidity risk. These economic 
attributes include industry-wide trends regarding funds' liquidity and 
liquidity risk management, as well as industry developments 
highlighting the importance of robust liquidity risk management by 
funds.

[[Page 82231]]

1. Funds' Current Practices Regarding Liquidity Risk Management and 
Liquidity Risk Disclosure
a. Funds' Current Liquidity Risk Management Requirements and Practices
    Under section 22(e) of the Investment Company Act, a registered 
investment company is required to make payment to shareholders for 
redeemable securities tendered for redemption within seven days of 
their tender.\1023\ In addition to the seven-day redemption requirement 
in section 22(e), registered investment companies that are sold through 
broker-dealers are required as a practical matter to meet redemption 
requests within three business days because broker-dealers are subject 
to rule 15c6-1 under the Exchange Act, which establishes a three-day (T 
+ 3) settlement period for purchases and sales of securities (other 
than certain types of securities exempted by the rule) effected by a 
broker or a dealer, unless a different settlement period is expressly 
agreed to by the parties at the time of the transaction. 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 cash 
proceeds from purchases may be invested or fund investments may be sold 
in subsequent days in order to satisfy purchase requests or meet 
redemption obligations.
---------------------------------------------------------------------------

    \1023\ See section 22(e) of the Act. Section 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.
---------------------------------------------------------------------------

    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 hold a minimum level of liquid investments.\1024\ 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) and their other obligations.\1025\ 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.\1026\ Open-end funds are also required by rule 
38a-1 under the Act to adopt and implement written compliance policies 
and procedures reasonably designed to prevent violations of the federal 
securities laws, including policies and procedures that provide for the 
oversight of compliance by certain of the fund's service providers, and 
such policies and procedures should be appropriately tailored to 
reflect each fund's particular compliance risks; the rule also requires 
board approval and review of the service providers' compliance policies 
and procedures.\1027\ An open-end fund that holds a significant portion 
of its assets in securities with long settlement periods or with 
infrequent trading, or an open-end fund that represents it will pay 
redemptions in fewer than seven days, for instance, may be subject to 
relatively greater liquidity risks than other open-end funds.
---------------------------------------------------------------------------

    \1024\ See supra footnotes 61-62 and accompanying text.
    \1025\ See Restricted Securities Release, supra footnote 37.
    \1026\ See supra footnote 64 and accompanying text.
    \1027\ See Rule 38a-1 Adopting Release, supra footnote 65.
---------------------------------------------------------------------------

    Additionally, long-standing Commission guidelines generally limit 
an open-end fund's aggregate investment in ``illiquid assets'' to no 
more than 15% of the fund's net assets (the ``15% guideline'').\1028\ 
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.\1029\ The 15% guideline has 
generally limited funds' exposure 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. Depositors of UITs are currently required to consider 
which of their restricted securities are illiquid.\1030\
---------------------------------------------------------------------------

    \1028\ See supra footnote 38 and accompanying text.
    \1029\ See supra footnote 39 and accompanying text.
    \1030\ See Rule 144A Release, supra footnote 37 at n.61 
(discussing liquidity requirements for UITs prior to the adoption of 
rule 22e-4).
---------------------------------------------------------------------------

    As noted in the Proposing Release, staff outreach has shown that 
funds currently employ a diversity of practices with respect to 
assessing portfolio investments' liquidity, as well as managing 
liquidity risk. Section II.D.3 above provides an overview of these 
practices, which include, among others: Assessing the ability to sell 
particular investments within various time periods, taking into account 
relevant market, trading, and other factors; monitoring initial 
liquidity determinations for portfolio investments (and modifying these 
determinations, as appropriate); holding certain amounts of the fund's 
portfolio in highly liquid investments or cash equivalents; 
establishing committed back-up lines of credit or interfund lending 
facilities; and conducting stress testing relating to the extent the 
fund has liquid investments to cover possible levels of 
redemptions.\1031\ Some commenters indicated that they view in-kind 
redemptions as an important liquidity risk management tool.\1032\ 
Another commenter noted that ETFs are often used to help manage 
liquidity risk because they can allow funds to maintain market exposure 
while ensuring sufficient liquidity.\1033\ As noted in the Proposing 
Release, the staff has observed that some of the funds with relatively 
more thorough liquidity risk management practices have appeared to be 
able to meet periods of high redemptions without significantly altering 
the risk profile of the fund or materially affecting the fund's 
performance, and thus with few dilutive impacts. It therefore appears 
that these funds have generally aligned their portfolio liquidity with 
their liquidity needs, and that their liquidity risk management permits 
them to efficiently meet redemption requests. Other funds, however, 
employ portfolio investment liquidity assessment and liquidity risk 
management practices that are substantially less rigorous.\1034\ As 
discussed above in section II.D.3, some funds do not take different 
market conditions into account when

[[Page 82232]]

evaluating portfolio investment liquidity, and do not conduct ongoing 
liquidity monitoring. Likewise, some funds do not have independent 
oversight of their liquidity risk management outside of the portfolio 
management process. As a result, funds' procedures for assessing the 
liquidity of their portfolio securities, as well as the 
comprehensiveness and independence of their liquidity risk management, 
vary significantly.
---------------------------------------------------------------------------

    \1031\ See also, e.g., Nuveen FSOC Notice Comment Letter, supra 
footnote 85 (discussing stress tests of a fund's ability to meet 
redemptions over certain periods); BlackRock FSOC Notice Comment 
Letter, supra footnote 85 (discussing several overarching principles 
that provide the foundation for a prudent market liquidity risk 
management framework for collective investment vehicles, including 
an independent risk management function, compliance checks to ensure 
portfolio holdings do not exceed regulatory limits, a risk 
management function that is independent from portfolio management, 
and measuring levels of liquid assets into ``tiers of liquidity''); 
Invesco FSOC Notice Comment Letter, supra footnote 248, at 11 
(discussing liquidity analysis).
    \1032\ See BlackRock Comment Letter; Invesco Comment Letter.
    \1033\ See BlackRock Comment Letter.
    \1034\ See infra section IV.C.1.b, where the potential 
consequences of less rigorous liquidity risk management are 
discussed in the context of risk management program benefits.
---------------------------------------------------------------------------

    A fund may meet redemption requests in a variety of ways, including 
by using cash, borrowing under a line of credit, or by selling 
portfolio investments. The fund's portfolio liquidity as well as its 
value will be affected by the choice of which investments are sold. 
Subsequent portfolio transactions after redemptions are met will also 
affect portfolio liquidity and value. For example, a fund facing a 
large redemption request might lessen the impact on portfolio value of 
selling investments by selling the most liquid portion of the portfolio 
or using some of its cash or a line of credit.\1035\ That choice 
benefits non-redeeming investors by minimizing transaction costs and 
the loss in fund value due to the price impact of selling, but it also 
could increase the liquidity risk of the fund portfolio and the fund 
may incur transaction costs if it subsequently engages in portfolio 
transactions such as rebalancing towards its previous portfolio 
allocation.\1036\ If the fund instead were to sell a ``strip'' of the 
portfolio (i.e., a cross-section or representative selection of the 
fund's portfolio investments), the immediate impact on fund value may 
be greater, but the liquidity of the fund portfolio would be unchanged 
as a result of the sale. Funds also could choose to meet redemptions by 
selling a range of investments in between their most liquid, on one end 
of the spectrum, and a perfect pro rata strip of investments, on the 
other end of the spectrum.\1037\ All of the above ways by which a fund 
may meet redemptions potentially occur in conjunction with other 
strategic portfolio management decisions, such as opportunistically 
paring back or eliminating holdings in a particular investment or 
sector while meeting redemptions.
---------------------------------------------------------------------------

    \1035\ We note that in some instances, selling only the most 
liquid investments to meet a large redemption could be inconsistent 
with the fund's investment mandate. For example, if a fund's 
investment mandate required it to hold a certain percentage of its 
portfolio in equities, the fund might not be able to sell a large 
portion of its equity holdings to meet redemption requests and still 
hold the required percentage of its portfolio in equities.
    \1036\ See, e.g., supra footnote 71 (discussing recent 
circumstances in which, during a year of heavy redemptions that 
caused a high yield bond fund's assets to shrink 33% in this period, 
the fund's holdings of lower quality bonds grew to 47% of assets, 
from 35% before the redemptions).
    \1037\ See, e.g., Hao Jiang, Dan Li, and Ashley Wang, Dynamic 
Liquidity Management by Corporate Bond Mutual Funds (May 6, 2016) 
(unpublished working paper), available at http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2776829. The study presents preliminary 
evidence consistent with the notion that corporate bond funds tend 
to sell proportional ``strips'' of their portfolios during periods 
of high market volatility and disproportionately sell more liquid 
assets during periods of lower market volatility.
---------------------------------------------------------------------------

    Staff analysis of the impact of large redemptions on U.S. equity 
fund portfolio liquidity is consistent with the hypothesis that the 
average U.S. equity fund does not sell a strip of its portfolio 
investments to meet large redemptions, but instead appears--based on 
changes in funds' portfolio liquidity following net outflows--to 
disproportionately sell the more liquid portion of its portfolio for 
this purpose.\1038\ Similarly, staff analysis shows that after a U.S. 
municipal bond fund encounters net outflows, the typical U.S. municipal 
bond fund will experience an increase in its holdings of municipal 
bonds (and a decrease in its holdings of cash and cash equivalents), 
potentially decreasing the fund's overall portfolio liquidity.\1039\
---------------------------------------------------------------------------

    \1038\ DERA Study, supra footnote 95, at 43-46. The DERA Study 
analyzes U.S. equity mutual fund liquidity management trends using 
the Amihud liquidity measure. See Proposing Release, supra footnote 
9, at n.621. We respond to comments on this result and other aspects 
of the DERA study in section IV.C.1.f.
    \1039\ DERA Study, supra footnote 95, at 47-49.
---------------------------------------------------------------------------

b. Funds' Current Liquidity Risk Disclosure Requirements and Practices
    Items 4 and 9 of Form N-1A require a fund to disclose the principal 
risks of investing in the fund.\1040\ A fund currently must disclose 
the risks to which the fund's portfolio as a whole is expected to be 
subject and the circumstances reasonably likely to adversely affect the 
fund's NAV, yield, or total return.\1041\ Some funds currently disclose 
that liquidity risk is a principal risk of investing in the fund, but 
often do so in a generic way.
---------------------------------------------------------------------------

    \1040\ Item 4(b)(1)(i) and Item 9(c) of Form N-1A.
    \1041\ Id.
---------------------------------------------------------------------------

    Item 11 of Form N-1A requires a fund to describe its procedure for 
redeeming fund shares, including restrictions on redemptions, any 
redemption charges, and whether the fund has reserved the right to 
redeem in kind.\1042\ Disclosure regarding other redemption 
information, such as the timing of payment of redemption proceeds to 
fund shareholders, varies across funds as there are currently no 
specific requirements for this disclosure. 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. Additionally, 
some funds disclose differences in the timing of payment of redemption 
proceeds based on the payment method by which the fund shares are 
redeemed, while others do not.
---------------------------------------------------------------------------

    \1042\ Item 11(c) of Form N-1A.
---------------------------------------------------------------------------

    Funds are not currently required to disclose information about the 
liquidity of their portfolio investments. However, some funds 
voluntarily disclose in their registration statements any specific 
limitations applicable to the fund's investment in 15% guideline 
assets, as well as types of assets considered by the fund to be subject 
to the 15% guideline.
    Form N-1A does not currently require funds to disclose information 
about liquidity risk management practices such as the establishment (or 
use) of committed back-up lines of credit. A fund is, however, required 
to disclose information regarding the amount and terms of unused lines 
of credit for short-term financing, as well as information regarding 
related party transactions in its financial statements or notes 
thereto.\1043\
---------------------------------------------------------------------------

    \1043\ See Sec. Sec.  210.5-02.19(b) and 210.4-08(k) of 
Regulation S-X.
---------------------------------------------------------------------------

2. Fund Industry Developments Regarding Funds' Liquidity Risk 
Management
a. Overview
    Below we discuss the size and growth of the U.S. fund industry 
generally, as well as the growth of various investment strategies 
within the industry. We show that the fund industry has grown 
significantly in the past two decades, and during this period, funds 
with international strategies, fixed income funds, and funds with 
alternative strategies have grown particularly quickly. We also 
determine the types of funds that demonstrate notably volatile and 
unpredictable flows. Because volatility and predictability in a fund's 
flows can affect the extent to which the fund is able to meet expected 
and reasonably foreseeable redemption requests without diluting the 
interests of fund shareholders, assessing trends regarding these 
factors can provide information about sectors of the fund industry that 
could be particularly susceptible to liquidity risk.
    While we believe that these trends are relevant from the 
perspective of addressing potential liquidity risk in the fund industry 
(and in funds' underlying portfolio investments), we emphasize

[[Page 82233]]

that liquidity risk is not confined to certain types of funds or 
investment strategies. Although we recognize that certain fund 
characteristics could make a fund relatively more prone to liquidity 
risk, we believe that all types of funds entail liquidity risk to some 
extent.\1044\ Thus, while in this section we discuss certain types of 
funds and strategies that are generally considered to exhibit increased 
liquidity risk, we are not asserting that only these types of funds and 
strategies involve liquidity risk, or that a fund of the type and with 
the strategy discussed below necessarily demonstrates greater liquidity 
risk than a fund that does not have these same characteristics.
---------------------------------------------------------------------------

    \1044\ See supra section III.A.2.
---------------------------------------------------------------------------

b. Size and Growth of the U.S. Fund Industry and Various Investment 
Strategies Within the Industry
    Open-end funds and ETFs manage a significant and growing amount of 
assets in U.S. financial markets. As of the end of 2015, there were 
10,633 open-end funds (excluding money market funds, but including 
ETFs), as compared to 5,279 at the end of 1996.\1045\ The assets of 
these funds were approximately $15.0 trillion in 2015, having grown 
from about $2.63 trillion in 1996.\1046\ Within these figures, the 
number of ETFs and ETFs' assets have increased notably in the past 
decade. There were 1,594 ETFs in 2015, as opposed to a mere 119 in 
2003, and ETFs' assets have increased from $151 billion in 2003 to $2.1 
trillion in 2015.\1047\
---------------------------------------------------------------------------

    \1045\ See 2016 ICI Fact Book, supra footnote 11, at 22, 176, 
183. Specifically, as of the end of 2015, there were 9,039 open-end 
mutual funds (including funds that invest in other funds) and 1,594 
ETFs. There were approximately 50 ETFs that invest in other ETFs, 
which are not included in our figures.
    \1046\ See 2016 ICI Fact Book, supra footnote 11, at 174, 182.
    \1047\ See 2016 ICI Fact Book, supra footnote 11, at 182, 183.
---------------------------------------------------------------------------

    U.S. equity funds represent the greatest percentage of U.S. open-
end fund industry assets.\1048\ Open-end U.S. equity funds, excluding 
ETFs, money market funds and variable annuities, held 44.7% of U.S. 
fund industry assets as of the end of 2015. The investment strategies 
with the next-highest percentages of U.S. fund industry assets are 
foreign equity funds (16.7%), general bond funds (13.2%), and mixed 
strategy funds (12.3%).\1049\ Funds with alternative strategies \1050\ 
only represent a small percentage of the U.S. fund industry assets, but 
as discussed below, the number of alternative strategy funds and the 
assets of this sector have grown considerably in recent years.\1051\
---------------------------------------------------------------------------

    \1048\ DERA Study, supra footnote 95, at Table 1.
    \1049\ Id. The figure for general bond funds does not include 
assets attributable to foreign bond funds (1.9%), U.S. corporate 
bond funds (0.8%), U.S. government bond funds (1.4%), and U.S. 
municipal bond funds (4.7%). The figure for mixed strategy funds 
includes assets of, among others, target date funds, convertible 
securities funds, and flexible portfolio funds.
    \1050\ Alternative funds are funds that seek total returns 
through the use of alternative investment strategies, including but 
not limited to equity market neutral, long/short equity, global 
macro, event driven, credit focus strategies.
    \1051\ DERA Study, supra footnote 95, at 7-8.
---------------------------------------------------------------------------

    While the overall growth rate of funds' assets has been generally 
high (about 7.2% per year, between the years 2000 and 2015 \1052\), it 
has varied significantly by investment strategy.\1053\ U.S. equity 
funds' assets grew substantially in terms of dollars from the end of 
2000 to 2015,\1054\ but this sector's assets as a percentage of total 
U.S. fund industry assets decreased from about 65% to about 45% during 
that same period.\1055\ Like U.S. equity funds, the assets of U.S. 
corporate bond funds, government bond funds, and municipal bond funds 
also increased in terms of dollars from 2000 to 2015, but each of these 
sectors' assets as a percentage of the fund industry decreased during 
this period.\1056\ On the other hand, the assets of foreign equity 
funds, general bond funds, and foreign bond funds increased steadily 
and substantially as a percentage of the fund industry over the same 
period.\1057\ For example, foreign equity funds increased steadily from 
10.6% of total industry assets in 2000 to 16.7% in 2015. And within 
these three investment strategies, certain investment subclasses 
(emerging market debt and emerging market equity) have grown 
particularly quickly from 2000 to 2015.\1058\ The overall growth rate 
of funds' assets between the years 2000 and 2015 was greater for index 
funds (12.3%) than actively managed funds (4.9%).\1059\
---------------------------------------------------------------------------

    \1052\ DERA Study, supra footnote 95, at Table 2.
    \1053\ The figures in this paragraph and the following 
paragraph, discussing the variance in growth rate of funds' assets 
by investment strategy, exclude ETF assets.
    \1054\ U.S. equity funds held about $5.6 trillion as the end of 
2015, compared to about $2.9 trillion at the end of 2000. DERA 
Study, supra footnote 95, at Table 2.
    \1055\ DERA Study, supra footnote 95, at Table 2.
    \1056\ Id. U.S. corporate bond funds held about $95 billion at 
the end of 2015, as opposed to $66 billion in 2000; these funds' 
assets as a percentage of the U.S. fund industry decreased from 1.5% 
in 2000 to 0.8% in 2015. U.S. government bond funds held about $174 
billion at the end of 2015, as opposed to $91 billion in 2000; these 
funds' assets as a percentage of the U.S. fund industry decreased 
from 2.1% in 2000 to 1.4% in 2015. U.S. municipal bond funds held 
about $592 billion at the end of 2015, as opposed to $278 billion in 
2000; these funds' assets as a percentage of the U.S. fund industry 
decreased from 6.3% in 2000 to 4.7% in 2015.
    \1057\ Id. Foreign equity funds held about $2.1 trillion in 
2015, as opposed to $465 billion in 2000. U.S. general bond funds 
held about $1.7 trillion at the end of 2015, as opposed to $240 
billion in 2000; these funds' assets as a percentage of the U.S. 
fund industry increased from 5.4% in 2000 to 13.2% in 2015. Foreign 
bond funds held about $244 billion at the end of 2015, as opposed to 
$19 billion in 2000; these funds' assets as a percentage of the U.S. 
fund industry increased from 0.4% in 2000 to 1.9% in 2015.
    \1058\ DERA Study, supra footnote 95, at 9. Emerging market debt 
and emerging market equity funds held about $289 billion at the end 
of 2015, as opposed to $20 billion in 2000. The assets of emerging 
market debt funds and emerging market equity funds grew by an 
average of 18.1% and 19.8%, respectively, each year from 2000 
through 2015.
     These investment subclasses represent a small portion of the 
U.S. mutual fund industry (the combined assets of these investment 
subclasses as a percentage of the U.S. fund industry was 2.3% at the 
end of 2015).
    \1059\ See 2016 ICI Fact Book, supra footnote 11, at 174, 218.
---------------------------------------------------------------------------

    The assets of funds with alternative strategies \1060\ also have 
grown rapidly in recent years. From 2005 to 2015, the assets of 
alternative strategy funds grew from $366 million to $310 billion, and 
from the end of 2011 to the end of 2013, the assets of alternative 
strategy funds grew by an average rate of almost 80% each year. 
However, as discussed above, funds with alternative strategies remain a 
relatively small portion of the U.S. fund industry as a percentage of 
total assets.\1061\
---------------------------------------------------------------------------

    \1060\ See supra footnote 95 for a discussion of the primary 
investment strategies practiced by ``alternative strategy'' funds.
    \1061\ See supra footnote 1051 and accompanying text.
---------------------------------------------------------------------------

c. Significance of Fund Industry Developments
    The industry developments discussed above are notable for several 
reasons. The growth of funds generally over the past few decades 
demonstrates that investors have increasingly come to rely on 
investments in funds to meet their financial needs.\1062\ These trends 
also demonstrate growth in particular types of funds that may entail 
increased liquidity risk. In particular, there has been significant 
growth in high-yield bond funds, emerging market debt funds, and funds 
with alternative strategies. Commissioners and Commission staff have 
previously spoken about the need to focus on potential liquidity risks 
relating to fixed income assets and fixed income funds,\1063\ and 
within this sector, funds that invest in high-yield bonds could be 
subject to greater liquidity risk as they invest in lower-rated bonds 
that tend to be less liquid than investment grade

[[Page 82234]]

fixed income securities.\1064\ Emerging market debt funds may invest in 
relatively illiquid securities with lengthy settlement periods.\1065\ 
Likewise, funds with alternative strategies may hold portfolio 
investments that are relatively illiquid.\1066\ Moreover, Commission 
staff economists have found that both foreign bond funds (including 
emerging market debt funds) and alternative strategy funds have 
historically experienced relatively more volatile and unpredictable 
flows than the average mutual fund,\1067\ which could increase these 
funds' liquidity risks by making it more likely that a fund may need to 
sell portfolio investments in a manner that creates a market impact in 
order to pay redeeming shareholders.
---------------------------------------------------------------------------

    \1062\ See supra footnote 21 and accompanying text.
    \1063\ See supra footnote 93 and accompanying text.
    \1064\ The Commission and Commission staff have cautioned that 
high yield securities may be considered to be illiquid, depending on 
the facts and circumstances. See Interval Fund Proposing Release, 
supra footnote 41; see also SEC Investor Bulletin, What Are High-
Yield Corporate Bonds?, SEC Pub. No. 150 (June 2013), available at 
http://www.sec.gov/investor/alerts/ib_high-yield.pdf (noting that 
high-yield bonds may be subject to more liquidity risk than, for 
example, investment-grade bonds). But see Who Owns the Assets?, 
supra footnote 378 (discussing the liquidity characteristics of 
high-yield bond funds in depth, and noting that these funds have 
weathered multiple market environments, and are generally managed 
with multiple sources of liquidity).
    \1065\ See, e.g., supra footnote 377 and accompanying text 
(discussing the settlement cycles associated with transactions in 
certain foreign securities); see also Reuters, Fitch: Close Look at 
EM Corporate Bond Trading Reveals Liquidity Risks (Apr. 16, 2015), 
available at http://www.reuters.com/article/2015/04/16/idUSFit91829620150416. But see Who Owns the Assets?, supra footnote 
378 (discussing the liquidity characteristics of emerging market 
debt funds in depth, and noting that these funds tend to hold a 
portion of their assets in developed market government bonds 
(providing further liquidity), generally establish limits on less 
liquid issuers, and generally maintain allocations to cash for 
liquidity and rebalancing purposes).
    \1066\ See supra footnotes 99-100 and accompanying text.
    \1067\ DERA Study, supra footnote 95, at 16-24.
---------------------------------------------------------------------------

    One commenter has argued that flow volatility, which staff 
economists have used as a measure of liquidity risk, does not 
necessarily translate into liquidity risk.\1068\ In this commenter's 
view, for example, a fund with volatile but predictable flows may have 
less liquidity risk than a fund with less volatile but less predictable 
flows. Likewise, a U.S. equity fund could have much greater flow 
volatility than a foreign bond mutual fund without having greater 
liquidity risk because the equity fund's assets are more liquid. 
However, differences in average flow volatility between fund categories 
persist after accounting for predictability, and the analysis suggests 
that changes in flow volatility may influence the management of fund 
liquidity.\1069\ Flow volatility is not the sole determinant of 
liquidity risk for a fund, but it is an important determinant, which 
makes it useful in helping understand differences in potential 
liquidity risk within and between fund categories.
---------------------------------------------------------------------------

    \1068\ ICI Comment Letter II.
    \1069\ DERA Study, supra footnote 95, at 23-24, 37.
---------------------------------------------------------------------------

    The same commenter has also suggested that the same approach of 
measuring liquidity risk does not consider the usage of derivatives in 
managing volatile flows, noting that they are often more liquid than 
their underlying assets.\1070\ We acknowledge that derivatives could 
play a role in managing fund flows. As is the case for corporate bond 
holding data, data on fund holdings of derivatives is limited so our 
analysis of holdings level data was necessarily limited to U.S. equity 
funds.
---------------------------------------------------------------------------

    \1070\ ICI Comment Letter II.
---------------------------------------------------------------------------

C. Benefits and Costs, and Effects on Efficiency, Competition, and 
Capital Formation

    Taking into account the goals of the final liquidity regulations 
and the economic baseline, as discussed above, this section discusses 
the benefits and costs of the final liquidity regulations, as well as 
the potential effects of the final liquidity regulations on efficiency, 
competition, and capital formation. This section also discusses 
reasonable alternatives to rule 22e-4 and the disclosure and reporting 
requirements regarding funds' liquidity risk and liquidity risk 
management.
1. Rule 22e-4
a. Summary of Rule 22e-4's Requirements
    Rule 22e-4 will require each fund to establish a written liquidity 
risk management program. The rule specifies that a fund's liquidity 
risk management program shall include the following required program 
elements: (i) Assessment, management, and periodic review of the fund's 
liquidity risk; (ii) classification of the liquidity of each of the 
fund's portfolio investments based on asset class, so long as the fund 
or its adviser does not have information about any market, trading, or 
investment-specific considerations that are reasonably expected to 
significantly affect the liquidity characteristics of an investment 
that would suggest a different classification for that investment; 
\1071\ (iii) determining and periodically reviewing a highly liquid 
investment minimum and adopting and implementing policies and 
procedures for responding to a shortfall of the fund's assets that are 
highly liquid investments below its highly liquid investment minimum; 
(iv) prohibiting the fund's acquisition of ``illiquid investments'' 
(that is, any investment that the fund reasonably expects cannot be 
sold or disposed of in current market conditions in seven calendar days 
or less without the sale or disposition significantly changing the 
market value of the investment) if, following the acquisition, the fund 
would hold more than 15% of its net assets in assets that are illiquid 
investments; (v) requiring a fund whose illiquid investments that are 
assets exceed 15% of its net assets to conduct certain board reporting; 
and (vi) for funds that engage in, or reserve the right to engage in, 
redemptions in kind, establishing policies and procedures regarding how 
and when it will engage in such redemptions in kind.\1072\ A fund's 
board, including a majority of the fund's independent directors, will 
be required to provide general oversight of the fund's liquidity risk 
management program, but the board would not have to approve the fund's 
highly liquid investment minimum.\1073\ The fund will be required to 
designate the fund's adviser or officer(s) responsible for 
administering the program, and such designation is required to be 
approved by the fund's board of directors.\1074\ The fund's board will 
also be required to review, at least annually, a written report 
prepared by the fund's investment adviser or officer(s) administering 
the liquidity risk management program reviewing the adequacy and 
effectiveness of the implementation of the fund's liquidity risk 
management program, including the fund's highly liquid investment 
minimum, and the effectiveness of its implementation.\1075\
---------------------------------------------------------------------------

    \1071\ Rule 22e-4 (b)(1)(ii).
    \1072\ Proposed rule 22e-4(b)(2)(iv).
    \1073\ Proposed rule 22e-4(b)(3)(i).
    \1074\ Proposed rule 22e-4(b)(3)(iii).
    \1075\ Rule 22e-4(b)(3)(ii).
---------------------------------------------------------------------------

    Rule 22e-4 also includes certain recordkeeping requirements. A fund 
will be required to keep a written copy of its liquidity risk 
management policies and procedures, as well as copies of any materials 
provided to the fund's board in connection with the approval of the 
initial liquidity risk management program and annual board reporting 
requirement.\1076\ A fund will also be required to keep a written 
record of how its highly liquid investment minimum, and any adjustments 
thereto, were determined.\1077\
---------------------------------------------------------------------------

    \1076\ Rule 22e-4(c)(1) and (2).
    \1077\ Rule 22e-4(c)(3).

---------------------------------------------------------------------------

[[Page 82235]]

    In addition, two types of funds are subject to tailored 
requirements by the final rule. First, funds that primarily hold highly 
liquid assets do not have to establish a highly liquid investment 
minimum as part of their liquidity risk management programs.\1078\ 
Second, ETFs are required to assess and manage liquidity risk with 
respect to certain additional factors tailored to the specific risks of 
ETFs.\1079\ However, an ETF that meets the final rule's definition of 
an ``In-Kind ETF'' is not required to establish a highly liquid 
investment minimum or to classify its individual portfolio 
holdings.\1080\
---------------------------------------------------------------------------

    \1078\ Rule 22e-4(b)(1)(iii)(A).
    \1079\ Rule 22e-4(b)(1)(iii)(D)-(E).
    \1080\ See infra footnote 846 and accompanying text for the 
definition of ``In-Kind ETF.''
---------------------------------------------------------------------------

    In addition to the special treatment of In-Kind ETFs and primarily 
highly liquid funds, the final rules differ from the proposed version 
in several ways that may have economic consequences: (1) It integrates 
the definition of illiquid investments subject to the 15% illiquid 
investment limit as a part of the portfolio classification process, 
requiring the consideration of market, trading, and investment-specific 
factors and market depth in determining whether an investment is 
illiquid, as well as the periodic review of this assessment at least 
monthly; (2) it reduces the number of categories used to classify 
portfolio investment liquidity from six to four and requires fewer 
long-term liquidity projections; (3) it simplifies portfolio position 
classification by allowing them to be based on asset classes, with 
customized exceptions for individual positions where necessary; \1081\ 
(4) it does not prohibit the acquisition of less liquid investments if 
a fund goes below its highly liquid investment minimum, but instead 
requires that a fund report to its board if it goes below its highly 
liquid investment minimum, and, if the shortfall lasts more than 7 
consecutive calendar days, also requires reporting to the Commission; 
(5) it requires that a fund's board approve and annually review a 
report concerning its liquidity risk management program, but generally 
does not require the board to approve the highly liquid investment 
minimum (except in some circumstances) or material changes to these 
programs; (6) it requires that a fund assess its liquidity risk with 
respect to several factors, where applicable, in both stressed and 
normal market conditions, whether its strategy is appropriate for an 
open-ended fund, and whether its strategy involves a concentrated 
portfolio or large positions in particular issuers; \1082\ (7) it 
requires that principal underwriters or depositors of UITs to 
determine, on or before the date of the initial deposit of portfolio 
securities into a UIT, that the portion of the illiquid investments 
that the UIT holds or will hold at the date of deposit that are assets 
is consistent with the redeemable nature of the securities that it 
issues; and (8) requires that In-Kind ETFs offer daily transparency by 
posting on the ETF's Web site on each day that the national securities 
exchange on which the fund's shares are listed is open for business, 
before commencement of trading of fund shares on the exchange, the 
identities and quantities of the securities, assets or other positions 
held by the fund, or its respective master fund, that will form the 
basis for the fund's calculation of net asset value at the end of the 
business day.
---------------------------------------------------------------------------

    \1081\ See supra footnote 408 and accompanying text.
    \1082\ Rule 22e-4(b)(1)(iii)(A)-(C).
---------------------------------------------------------------------------

b. Benefits
    Rule 22e-4, as adopted, should produce the same broad benefits for 
current and potential fund investors as discussed in the proposal. 
Where appropriate, we discuss below any changes in these benefits due 
to differences between the proposed and final rules. Specifically, the 
liquidity risk management program requirements are likely to improve 
investor protection by decreasing the chance that some funds may be 
unable to meet their redemption obligations, would meet such 
obligations by diluting the fund's shares, or would meet such 
obligations through methods that would have other adverse impacts on 
non-redeeming investors (e.g., increased risk exposure and decreased 
liquidity). To the extent that some funds do not currently meet the 
liquidity risk management standards required by the rule--either by 
meeting the rule's minimum baseline requirements for fund assessment 
and management of liquidity risk or via alternative liquidity risk 
management approaches--investor protection will be enhanced by imposing 
these minimum requirements on funds.
    We believe that the liquidity risk management program requirement 
should promote improved alignment of the liquidity of the fund's 
portfolio with the fund's expected (and reasonably foreseeable) levels 
of redemptions. As discussed above, rule 22e-4 will require each fund 
to classify the liquidity of its portfolio investments in assessing its 
liquidity risk, and to determine a highly liquid investment minimum to 
increase the likelihood that the fund will hold adequate liquid 
investments to meet redemption requests without significant dilution. 
Each fund will have flexibility to determine the particular investments 
that it holds in connection with its highly liquid investment minimum. 
Assets eligible for inclusion in a fund's highly liquid investment 
minimum 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 assets that are highly 
liquid investments in cash and cash equivalents, another could decide 
it is appropriate to hold assets that are convertible to cash within 
longer periods (but not exceeding three business days) as the majority 
of its highly liquid investments. The highly liquid investment minimum 
requirement should allow funds to continue to meet a wide variety of 
investors' investment needs by obliging funds to maintain appropriate 
liquidity in their portfolios. The proposed rule would have required 
funds to set a firm three-day liquid asset minimum, prohibiting the 
acquisition of relatively less liquid assets until a fund was back 
above its minimum, instead of allowing them to operate below the 
minimum with board notification, so the final rule should mitigate any 
unfavorable market effects related to the systematic purchase or sale 
of investments once a strict minimum was exceeded. In extreme cases--
for example, if investments that the fund sought to purchase were 
trading at fire sale prices due to a market event--a fund could go 
below its minimum to trade opportunistically. However, that might cause 
the fund to operate below its highly liquid investment minimum for more 
than 7 consecutive calendar days, requiring reporting to the fund's 
board and the Commission within one business day, so funds may be 
hesitant to take advantage of attractive market prices when they are 
close to their minimum under the final rule. The ability to deviate 
from the minimum for up to 7 consecutive calendar days with required 
reporting at the next regular board meeting, or for longer periods 
provided the fund reports to the board and the Commission, could also 
reduce the likelihood that funds set artificially low minimums, which 
would be less protective of investors than a minimum with some 
flexibility built in such as the one we are adopting. The limitation on 
the acquisition of assets that are illiquid investments to no more than 
15% of net assets, along with the corresponding enhancements to how 
investment illiquidity is assessed, complements the

[[Page 82236]]

highly liquid investment minimum requirement by increasing the 
likelihood that a fund's portfolio is not overly concentrated in 
investments whose liquidity is limited. Furthermore, the additional 
board reporting requirements triggered when a fund's illiquid 
investments that are assets exceed 15% of net assets decreases the 
likelihood that a fund's portfolio is overly concentrated in 
investments classified as illiquid for an extended period of time 
without board oversight.
    We believe that the rule also will decrease the probability that a 
fund will need to meet redemption requests through activities that can 
materially affect the fund's NAV or risk profile or dilute the 
interests of fund shareholders. For example, when a fund is 
insufficiently liquid or does not effectively manage liquidity and is 
faced with significant redemptions, or both, it may be forced to sell 
portfolio investments under unfavorable circumstances, which could 
create significant negative price pressure on those investments.\1083\ 
This, in turn, could disadvantage non-redeeming shareholders by 
decreasing the value of those shareholders' interests in the 
fund.\1084\ Even if a fund were to sell the most liquid portion of its 
portfolio to meet redemption requests, which would minimize the loss in 
fund value due to the price impact of selling, these asset sales could 
decrease the liquidity of the fund portfolio, potentially creating 
increased liquidity risk for non-redeeming shareholders. As discussed 
above, staff analysis is consistent with the hypothesis that U.S. 
equity funds may disproportionally sell more liquid assets, especially 
when facing significant outflows, as opposed to selling a pro rata 
``strip'' of the fund's portfolio assets, which minimizes price impact 
on a fund in the short term, but ultimately decreases the liquidity of 
the fund's portfolio.\1085\ Short-term borrowings by a fund to meet 
redemption requests could also disadvantage non-redeeming shareholders 
by leveraging the fund, which requires the fund to pay interest on the 
borrowed funds (although, in some instances, the costs of borrowing may 
be less than the costs of selling assets to meet redemptions) and 
magnifies any gains or losses to non-redeeming shareholders. Moreover, 
the costs of borrowing (that is, the costs associated with maintaining 
a committed line of credit, as well as interest expenses associated 
with drawing on a credit line) could be passed on to fund shareholders 
in the form of fund operating expenses, which adversely affect a fund's 
NAV. To the extent that the program requirement results in liquidity 
risk assessment and management that enhance funds' ability to meet 
redemption obligations, it will be less likely that a fund takes 
actions to pay redemptions that cause dilution or have other adverse 
impacts on non-redeeming shareholders.
---------------------------------------------------------------------------

    \1083\ See Coval & Stafford, supra footnote 86 (discussing how 
mutual fund fire sales impact asset prices).
    \1084\ While the impact of fire sales on asset prices may be 
short lived in some instances, Coval and Stafford show that the 
impact of fire sales can often take many months to dissipate. Id.
    \1085\ See supra footnote 1038 and accompanying text.
---------------------------------------------------------------------------

    The potential negative consequences of asset sales undertaken to 
pay fund redemptions could create early redemption incentives in times 
of liquidity stress, or a ``first-mover advantage.'' \1086\ For 
example, academic studies have suggested that an incentive exists for 
market participants to front-run trades conducted by a fund in response 
to significant changes in fund flows.\1087\ This suggests that 
sophisticated fund investors could anticipate that significant fund 
outflows could lead a fund to conduct trades that would disadvantage 
non-redeeming shareholders, which could create an incentive to redeem 
ahead of such trades. If investors' redemptions are motivated by a 
first-mover advantage, this could lead to increasing levels of 
redemptions, and as the level of outflows from a fund increases, the 
incentive to redeem also increases. Any negative effects on non-
redeeming shareholders thus could be magnified by a first-mover 
advantage to the extent that this dynamic produces growing redemptions 
and decreasing portfolio liquidity. The first-mover advantage is more 
commonly discussed with respect to money market funds, especially 
institutional prime money market funds that operated under a fixed NAV 
prior to the 2014 reform (that will become effective October 14, 2016), 
but the incentives that have been argued to create the first-mover 
advantage among those funds could in theory exist (in possibly weaker 
form) among other open-end funds. We agree with commenters that the 
empirical support for the existence of a first-mover advantage is not 
conclusive and that the mutual fund industry has been able to 
successfully navigate periods of historical market stress.\1088\ While 
we understand that fund investors may not have historically been 
motivated to redeem on account of a perceived (or actual) first-mover 
advantage during previous periods of stress, we cannot predict how 
investors may behave in the future. To the extent that economic 
incentives exist to redeem fund shares prematurely, such redemptions 
could lead to investor dilution as discussed above, and the possibility 
of protecting against this potential dilution could be one benefit of 
rule 22e-4.
---------------------------------------------------------------------------

    \1086\ See supra footnote 85 and accompanying text (discussing 
the possibility of a first-mover advantage with respect to the 
timing of shareholder redemption from funds, but also arguments that 
such a first-mover advantage does not exist in funds, as well as 
arguments that even if incentives to redeem ahead of other 
shareholders do exist, this does not necessarily imply that 
investors will in fact redeem en masse in times of market stress).
    \1087\ See Coval & Stafford, supra footnote 86; Dyakov & 
Verbeek, supra footnote 86.
    \1088\ See, e.g., Comment Letter of Wellington Management Group 
LLP on the Notice Seeking Comment on Asset Management Products and 
Activities, Docket No. FSOC-2014-0001 (Mar. 25, 2015), at 4; ICI 
FSOC Notice Comment Letter, supra footnote 68, at 7; Nuveen FSOC 
Notice Comment Letter, supra footnote 85, at 10; Dechert Comment 
Letter; Vanguard Comment Letter; Comment Letter of the Independent 
Trustees of Fidelity Fixed Income and Asset Allocation Funds (Jan. 
13, 2016) (all arguing that evidence shows that fund shareholders' 
redemptions are largely driven by other concerns rather than a 
theoretical first-mover advantage).
---------------------------------------------------------------------------

    The program requirement aims to promote a minimum baseline for 
liquidity risk management in the fund industry. This should promote 
investor protection by elevating the overall quality of liquidity risk 
management across the fund industry, reducing the likelihood that funds 
will meet redemption obligations only through activities that could 
significantly dilute shareholders or adversely affect fund risk 
profiles. Shareholders in funds that already engage in strong liquidity 
risk management practices may be less likely to benefit from the 
program requirement, or may benefit less, than shareholders in funds 
that do not employ equally rigorous practices. We cannot quantify the 
total benefits to fund operations and investor protection that we 
discuss above, but to the extent that staff outreach has noted that 
some funds currently have no (or very limited) formal liquidity risk 
management programs in place, rule 22e-4 would enhance current 
liquidity risk management practices.
    Finally, to the extent that the program requirement results in 
funds less frequently needing to sell portfolio investments in 
unfavorable market conditions in order to meet redemptions, the 
requirement also could lower potential spillover risks that funds could 
pose to the financial markets generally. If, as a result of the program 
requirement, a fund was prepared to meet redemption requests in other 
ways, the rule could decrease the

[[Page 82237]]

risk that the fund might indirectly transmit stress to other market 
sectors and participants. The rule should help ensure that all funds, 
not just those with liquidity risk management practices currently in 
place, operate in a manner that lessens the chance of spillover risks. 
We are unable to quantify this potential benefit because we cannot 
predict the extent to which funds would enhance their current liquidity 
risk management practices as a result of rule 22e-4, or predict the 
precise circumstances that could entail negative spillover effects in 
light of less-comprehensive liquidity risk management by funds.\1089\
---------------------------------------------------------------------------

    \1089\ The ability of the Commission to perform such analysis is 
limited by difficulties in both gathering data about funds' 
liquidity risk management practices and quantifying such data.
---------------------------------------------------------------------------

    Commenters generally did not disagree with the benefits of the 
proposed rule, with any exceptions noted in the above discussion of 
rule 22e-4's benefits. As discussed above, the final rule differs from 
the proposal in several key respects, but it largely preserves the 
proposed rule's benefits. First, funds that primarily hold assets that 
are highly liquid investments are not required to establish a highly 
liquid investment minimum, so any benefits that might have accrued to 
shareholders of these funds under the proposed rule may be diminished. 
However, these funds are less likely to be exposed to the liquidity 
risks discussed above to the same degree as other funds, so any loss in 
benefits should be negligible and is likely to be less than the costs 
of establishing a minimum. Similarly, In-Kind ETFs are exempt from 
certain aspects of the final rule, because the benefits of those 
aspects of the final rule would have been insignificant for In-Kind 
ETFs. The final rule instead achieves benefits with respect to ETFs by 
replacing these less-apposite requirements with new tailored 
requirements for ETFs that are designed to promote the proper 
management of ETF liquidity, focused on preventing the arbitrage 
mechanism that keeps ETFs priced properly from being adversely impacted 
by a lack of liquidity. In addition, the new requirement for daily 
transparency will permit the sophisticated authorized participants that 
directly interact with the ETF to effectively evaluate the liquidity of 
the ETF's holdings. Since nearly all In-Kind ETFs already provide daily 
transparency as a matter of course, we believe no additional costs 
arise for In-Kind ETFs.\1090\
---------------------------------------------------------------------------

    \1090\ We note that ETMFs are not required to provide such daily 
transparency under their orders, and thus would need to choose to 
provide such daily transparency if they wished to take advantage if 
this provision. Choosing to take advantage of this provision is 
within the discretion of ETFs that could potentially qualify as In-
Kind. As discussed in the PRA section below, we estimate that not 
all ETFs would qualify as In-kind, either because of their use of 
cash for redemptions or because of their choice not to provide daily 
transparency of holdings.
---------------------------------------------------------------------------

    Second, modifications to the proposal allow funds to classify 
portfolio investments via assignments to asset classes as a default, 
but require them to classify specific investments separately if they 
merit special attention,\1091\ which preserves the benefits of 
investment liquidity classification without imposing the additional 
cost of individually classifying each portfolio position in all cases. 
Third, the rule's simplification of classification categories from six 
to four, with shorter-term horizons, still provides a reasonably 
nuanced view of a fund portfolio's position-level liquidity while 
responding to commenters' concerns that the proposed rule's more 
detailed classification would have required too much precision at long-
term horizons and would not accurately reflect a fund's actual 
liquidity profile. Fourth, the final rule should preserve the benefits 
of board oversight of a fund's liquidity risk management program 
without requiring that board members approve the highly liquid 
investment minimum (except in certain circumstances). The modifications 
to the board's role make the board's involvement in the liquidity risk 
management more consistent with the board's historical duty to provide 
oversight (instead of day-to-day management).
---------------------------------------------------------------------------

    \1091\ See supra footnote 1064 and accompanying text.
---------------------------------------------------------------------------

    Changes to the final rule could also provide additional benefits 
relative to the proposal. While the final rule clarifies that the 
factors a fund should consider in devising a liquidity risk management 
program may be considered as appropriate, it also requires that funds 
consider two additional factors--whether a given strategy is 
appropriate in an open-ended fund or involves a concentrated portfolio 
or concentrated positions in particular issuers--which could improve 
the risk management program's effectiveness for funds that do not 
already consider these factors. The final rule also more precisely 
specifies criteria for both the initial and ongoing assessment of 
whether investments should be classified as illiquid under the 15% 
illiquid investment limit by tying it to the same criteria used in 
assigning investments to other liquidity categories (including 
considering relevant market, trading, and investment-specific 
considerations, and market depth), which should reduce a firm's 
compliance burdens relative to the proposed rule while at the same time 
providing a more precise picture of how exposed to illiquid investments 
a given fund is. Finally, while UITs were not subject to rule 22e-4 
under the proposal, the final rule requires that the principal 
underwriter or depositor of a UIT will be required to determine, on or 
before the date of the initial deposit of portfolio securities into the 
UIT, that the portion of illiquid investments the UIT holds or will 
hold at the date of deposit that are assets is consistent with the 
redeemable nature of the securities it issues. This enhancement of the 
final rule over the proposal could benefit investors by reducing the 
likelihood that a UIT could be created that holds an excessive amount 
of illiquid securities, which in turn would reduce the liquidity risk 
associated with UITs.
c. Costs
One-Time and Ongoing Costs Associated With Program Establishment and 
Implementation
    Funds will incur one-time costs to establish and implement a 
liquidity risk management program in compliance with rule 22e-4, as 
well as ongoing program-related costs. As discussed above, funds today 
employ a range of different practices, with varying levels of quality, 
for assessing the liquidity of their portfolio investments and managing 
fund liquidity risk. Accordingly, funds whose practices regarding 
portfolio investment liquidity classification and liquidity risk 
assessment and management most closely align with the liquidity risk 
management program requirements would incur relatively lower costs to 
comply with rule 22e-4. Funds whose practices for classifying the 
liquidity of their portfolio investments and for assessing and managing 
liquidity risk are less thorough or not closely aligned with the rule, 
on the other hand, may incur relatively higher initial compliance 
costs.
    Some commenters suggested that the estimates of costs in the rule 
proposal were significantly understated and that the true costs of 
compliance with the rule requirements would likely exceed the expected 
benefits.\1092\ Another

[[Page 82238]]

commenter suggested that costs were underestimated because other fund 
systems would also have to be modified to ensure compliance with the 
entirety of the requirements of the rule.\1093\ For example, if funds 
are required to maintain or target a certain level of fund liquidity, 
then the trade order management system would have to be modified to 
ensure accurate monitoring of such limitations. We have revised the 
discussion of costs to both reflect new information on the potential 
costs of compliance and changes in the rule that are designed to lessen 
the potential costs. Specifically, we use estimates provided by 
commenters to approximate costs for each fund complex under the 
proposed rule and then qualitatively discuss how changes to the 
proposed rule affect these estimates. Because most changes to the final 
rule reduce requirements for some segment of funds relative to the 
proposal, the estimates below can generally be considered an upper 
bound on fund costs except where explicitly noted.
---------------------------------------------------------------------------

    \1092\ See CFA Comment Letter; Cohen & Steers Comment Letter; 
Dechert Comment Letter; Dodge & Cox Comment Letter; Federated 
Comment Letter; FSR Comment Letter; ICI Comment Letter I; Invesco 
Comment Letter; LSTA Comment Letter; MFDF Comment Letter; SIFMA 
Comment Letter I; T. Rowe Comment Letter; Vanguard Comment Letter; 
Voya Comment Letter.
    \1093\ See Federated Comment Letter.
---------------------------------------------------------------------------

    Staff estimates of the one-time costs in the proposal, which ranged 
from $1.3 million to $2.25 million per fund complex, were partly based 
on estimates from another Commission rulemaking.\1094\ Some commenters 
expressed concern about the calculation of this estimate because it was 
based on assumptions driven by analysis performed with respect to money 
market fund reform.\1095\ While some of the large scale system 
modifications required by rule 22e-4 will be similar to those required 
for money market funds due to regulatory reform, and we attempted to 
adjust our estimates for differences between the two rules, one 
commenter suggested that the process of classifying portfolio assets 
was more akin to a fund's costs in analyzing the value of its 
assets.\1096\ We acknowledge that could be an informative approach to 
estimating costs, but absent concrete estimates associated with that 
approach, which the commenter did not provide, we have updated our 
estimates based on the limited quantitative information available from 
commenters.\1097\ One commenter estimated that there would be $2 
million in initial implementation costs and more than $650,000 in 
annual recurring costs for automating a classification process that 
would have to manage 63,000 different portfolio positions.\1098\ 
Another commenter estimated the costs of building a system to classify 
the liquidity of its investments, which is not currently commercially 
available, in the millions of dollars to manage their 44,000 different 
portfolio positions.\1099\ We use the former as a basis for our 
analysis because it is comparable in magnitude to the latter.\1100\ 
Because there are likely to be economies of scale in developing the 
policies, procedures, and systems required to comply with rule 22e-4, 
we approximate the cost per fund complex by assuming fixed costs 
constitute 30% of the commenter's estimates, and extrapolate using the 
number of funds per complex to scale variable costs up or down.\1101\ 
In addition, because the process of classifying assets under the 
proposal would likely constitute a majority of a fund's costs, we 
assume the classification process constitutes approximately 75% of a 
fund's cost of complying with proposed rule 22e-4. This method results 
in one-time costs for funds under the proposed rule that range from 
approximately $0.8 million to $10.2 million, that the average cost per 
fund complex is $1 million, and the aggregate cost is approximately 
$855 million. The estimated range of costs using this approach is wider 
than our approach in the proposal, but the estimated aggregate cost is 
lower than our initial estimate of $1.3 billion. While these estimates 
would change if we varied our assumption that fixed costs comprise 30% 
of the commenter's estimate--for example, increasing this percentage 
would compress the range of costs and the aggregate may increase or 
decrease--they are of the same order of magnitude as our estimates in 
the proposal.
---------------------------------------------------------------------------

    \1094\ See Proposing Release, supra footnote 9, at n.702 and 
accompanying text.
    \1095\ See FSR Comment Letter; SIFMA Comment Letter I.
    \1096\ See Dechert Comment Letter.
    \1097\ As in the proposal, the estimates assume that each fund 
would not bear all of the costs (particularly, the costs of systems 
modification) on an individual basis, but instead that these costs 
would likely be allocated among the multiple users of the systems, 
that is, each of the members of a fund complex. Accordingly, we 
expect that, in general, funds within large fund complexes would 
incur fewer costs on a per fund basis than funds within smaller fund 
complexes, due to economies of scale in allocating costs among a 
group of users.
    \1098\ See Invesco Comment Letter.
    \1099\ See T. Rowe Comment Letter.
    \1100\ We estimate that there were 146 funds in the second 
commenter's fund complex as of December 31, 2015, which implies an 
estimated cost of approximately $4 million using our estimation 
procedure, in line with the commenter's statement that its cost 
would be ``in the millions.'' See supra footnote 1094 for discussion 
of the estimation procedure.
    \1101\ We use CRSP U.S. Mutual Fund Database to obtain the 
number of funds for each complex. As of December 31, 2015, there 
were 7551 mutual funds (excluding money market funds and annuities), 
1484 ETFs (excluding non-40-act ETFs, ETNs, and Commodity ETFs), and 
847 fund complexes (334 of them with only one fund). The commenter, 
Invesco, consisted of 87 funds as of that date, and we assume the 
fixed cost component of their estimate is $0.6 million (30% of $2 
million). The remaining $1.4 million is assumed to be a variable 
cost that scales linearly with the number of funds. To arrive at a 
total cost of 22e-4, each of these estimates is scaled so that the 
classification process constitutes 75% of the total costs of 
proposed rule 22e-4.
---------------------------------------------------------------------------

    These estimated one-time costs are attributable to the following 
activities, as applicable to each of the funds within the complex: (i) 
Developing policies and procedures relating to each of the required 
program elements,\1102\ and the related recordkeeping requirements of 
the rule; (ii) planning, coding, testing, and installing any system 
modifications relating to each of the required program elements; (iii) 
integrating and implementing policies and procedures relating to each 
of the required program elements (including classifying the liquidity 
of each of the fund's portfolio investments pursuant to rule 22e-
4(b)(1)(ii)), as well as the recordkeeping requirements of the rule; 
(iv) preparing training materials and administering training sessions 
for staff in affected areas; and (v) costs associated with educating 
the fund's board and obtaining approval of the program. These 
activities are likely to cut across many different functional groups 
within a fund or fund complex, including legal, compliance, risk, 
portfolio management, accounting, and technology staff. To the extent 
that some of the systems needed to support the required program 
elements are developed by third parties, fund complexes may be able to 
implement their liquidity risk management programs for less than our 
estimated cost of developing these

[[Page 82239]]

programs themselves, but the final rule emphasizes that it is 
ultimately each fund's responsibility to classify its positions, so 
these potential cost reductions may be limited. For example, we 
understand that third parties have already developed programs that 
include certain market, trading, and investment-specific factors which 
could be useful in classifying the liquidity of portfolio investments, 
and are currently available for purchase.\1103\
---------------------------------------------------------------------------

    \1102\ Specifically, a fund would be required, where applicable, 
to establish policies and procedures relating to: (i) Assessment, 
management, and periodic review of the fund's liquidity risk; (ii) 
classification of the liquidity of each of the fund's portfolio 
investments, as well as at-least-monthly reviews of the fund's 
liquidity classifications; (iii) the requirements to determine and 
periodically review a highly liquid investment minimum, and to adopt 
and implement policies and procedures for responding to a shortfall 
of the fund's highly liquid investments below its highly liquid 
investment minimum; (iv) the requirement to limit the fund's 
acquisition of illiquid investments over 15% of the fund's net 
assets; and (v) for funds that engage in, or reserve the right to 
engage in, redemptions in kind, the requirement to establish 
policies and procedures regarding how it will engage in such 
redemptions in kind. The final rule also provides for a tailored 
program for ETFs that redeem in kind, excluding them from the 
classification and highly liquid investment minimum requirements, 
but requiring them to consider additional factors as part of their 
liquidity risk assessment and management that reflect potential 
liquidity-related concerns that could arise from the structure and 
operation of ETFs. The final rule also provides an exclusion from 
the highly-liquid investment minimum requirement for funds that 
primarily hold highly liquid investments. The rule also provides for 
board oversight of the liquidity risk management program.
    \1103\ See supra footnote 323 and accompanying text (discussing 
Commission guidance on a fund's use of third-party service providers 
to obtain data to inform or supplement its consideration of the 
liquidity classification factors). We understand, based on staff 
outreach, that annual costs to subscribe to the liquidity 
classification services provided by third-party data and analytics 
providers currently range from $50,000-$500,000.
---------------------------------------------------------------------------

    We have also revised our estimates of the ongoing costs of 
complying with rule 22e-4 using the same approach and based on the same 
commenter's estimate as above for one-time costs. While our analysis in 
the proposal assumed ongoing costs ranged from 10% to 25% of the one-
time costs resulting from the rule, we've reduced the low end of the 
range to 5% to reflect changes from the Proposing Release, discussed 
below, that should lower some funds' compliance burdens, and increased 
the high end of the range to 32.5% to reflect the commenter's estimate 
that ongoing costs for their fund under the proposed rule would be 
$0.65 million (compared to one-time costs of $2 million). We again 
extrapolate from the commenter's estimate as above to arrive at a 
minimum and maximum cost estimate for each fund, which implies a range 
of ongoing costs across all funds of $40,000 to $3.3 million per fund 
complex. These costs are attributable to the following activities, as 
applicable to each of the funds within the complex: (i) Classification 
of the liquidity of each of the fund's portfolio investments, as well 
as at-least-monthly reviews of the fund's liquidity classifications 
(rule 22e-4(b)(1)(ii)); (ii) periodic review of the fund's liquidity 
risk (rule 22e-4(b)(1)(i)); (iii) periodic review of the adequacy of 
the fund's highly liquid investment minimum (rule 22e-
4(b)(1)(iii)(A)(2)); (iv) systems maintenance; (v) additional staff 
training; (vi) approval, annual review, and general oversight by the 
board of the fund's liquidity risk management program (rule 22e-
4(b)(2)); and (viii) recordkeeping relating to the fund's liquidity 
risk management program (rule 22e-4(b)(3)).\1104\ Relative to the 
proposed rule, the final rule reduces the responsibilities of a fund's 
board, which is not required to approve the fund's highly liquid 
investment minimum or material changes to the fund's liquidity risk 
management program, which should reduce the board-related costs 
embedded in the above estimates of rule 22e-4's one-time and ongoing 
costs.
---------------------------------------------------------------------------

    \1104\ As discussed in greater detail below, we anticipate that, 
depending on the personnel (and/or third-party service providers) 
involved in the activities associated with administering a liquidity 
risk management program, certain of the estimated ongoing costs 
associated with these activities could be borne by the fund, and 
others could be borne by the adviser.
---------------------------------------------------------------------------

    The original classification scheme would have mandated significant 
micro-level analysis of instruments not currently conducted by fund 
advisers according to many commenters.\1105\ Such an analysis would 
have required entirely new systems for many fund complexes and would 
have required funds to incur significant expenses (especially for 
smaller fund complexes).\1106\ The new classification system lowers the 
potential costs of compliance with the liquidity classification 
requirement by (i) reducing the number of classification categories 
reduced from six to four, (ii) only requiring ``days-to-cash'' 
estimates out to 7 days, (iii) allowing funds to generally classify 
based on asset class (subject to an exception process), (iv) changing 
the process for considering position size to reduce complexity, and (v) 
simplifying the classification factors to be considered into a single 
requirement that funds consider market, trading, and investment-
specific data when classifying an investment. As a whole, these changes 
should lower the potential costs of compliance with the classification 
requirement relative to the proposal estimates above without 
significantly reducing the potential benefits of the requirement.
---------------------------------------------------------------------------

    \1105\ See Credit Suisse Comment Letter; Dechert Comment Letter; 
Federated Comment Letter; Fidelity Comment Letter; Oppenheimer 
Comment Letter; SIFMA Comment Letter I; Wellington Comment Letter.
    \1106\ See Dechert Comment Letter; ICI Comment Letter I; SIFMA 
Comment Letter I; T. Rowe Comment Letter.
---------------------------------------------------------------------------

    Specifically with respect to position size, commenters argued that 
evaluating ``days-to-cash'' was inherently biased against large funds 
and could lead to ``plain vanilla'' funds that generally invest in only 
highly-liquid securities (e.g., S&P 500 funds) being classified as 
highly illiquid if they manage a large amount of assets.\1107\ The rule 
now only requires a fund to determine whether trading varying portions 
of a position in a particular portfolio investment or asset class, in 
sizes that the fund reasonably anticipates trading, is reasonably 
expected to significantly affect its liquidity. This change should 
prevent large ``plain vanilla'' funds from appearing to be very 
illiquid under the classification scheme while still maintaining the 
idea that position size is an important consideration in the evaluation 
of liquidity. Relative to the proposed rule, this should reduce the 
costs associated with determining how position size affects the number 
of days required to liquidate an investment and eliminate the cost of 
classifying separate portions of a position into separate liquidity 
buckets.
---------------------------------------------------------------------------

    \1107\ See Dodge & Cox Comment Letter; Oppenheimer Comment 
Letter; Vanguard Comment Letter; ICI Comment Letter I; ICI Comment 
Letter II; Invesco Comment Letter.
---------------------------------------------------------------------------

    The classification process has also been revised in response to 
commenter concerns about the need to evaluate whether an investment can 
be sold for cash without materially affecting the security's price, 
which investors could interpret as an indication that they can redeem 
out of funds at a known or protected NAV.\1108\ One commenter expressed 
concern that if investors were given estimates of liquidity that are 
speculative or stale, or both, which might fail to predict liquidity 
with accuracy during periods of market stress, then funds could be 
potentially subject to significant litigation costs.\1109\ The value 
impact component of the rule has been modified so that determinations 
of market impact can be based on a reasonable expectation that an 
investment can be converted to cash (or in some cases, sold or disposed 
of) without the conversion (or in some cases, sale or disposition) 
significantly changing the market value, rather than a price ``that 
does not materially affect the value of that asset immediately prior to 
sale.'' This modification in the definition should relieve funds of the 
need to develop precise security-by-security expectations of forward 
looking liquidity while still emphasizing the need to consider the 
potential market impact of buying or selling an investment, reducing 
compliance costs relative to the proposed rule.
---------------------------------------------------------------------------

    \1108\ See ICI Comment Letter II.
    \1109\ See Dodge & Cox Comment Letter.
---------------------------------------------------------------------------

    Commenters also expressed concern about the use of third-party 
vendors in the process of liquidity classification.\1110\ If only a few 
vendors were able to provide the necessary data, such data would likely 
cause significant expenses for the funds, and those expenses would 
likely be passed on, at least in part, to fund investors through

[[Page 82240]]

higher fees. Another commenter suggested that the cost of third-party 
liquidity data should be included in any estimate of the potential 
costs of the classification system because of the strong likelihood 
that all funds would need to subscribe to a third-party vendor to 
ensure compliance with the rule.\1111\ As discussed in the proposal, we 
believe outsourcing program functions to vendors should, if anything, 
reduce compliance costs, and we noted that liquidity classification 
services already exist.\1112\ In addition, our updated estimate of 
costs above is based on a large investment manager's estimate of 
constructing an internal system from scratch, so we would expect the 
cost of a vendor-based solution, which would be partially amortized 
across all of its clients, to be lower. The changes made to the 
classification system from the proposal could also lessen the costs 
associated with third-party vendors relative to the proposed rule. In 
particular, to the extent that requiring less precision via fewer 
classification categories and shorter time horizons, allowing funds to 
generally classify according to asset class (subject to an exception 
process), and requiring a simpler position size evaluation criterion 
reduce the scope and intensity of the investment classification 
process, funds may not rely as much on vendors to comply with the rule, 
and vendors themselves may experience reduced costs in developing 
programs, leading to lower prices if they pass on some of the savings 
to funds.
---------------------------------------------------------------------------

    \1110\ See Dechert Comment Letter; Federated Comment Letter; ICI 
Comment Letter I; ICI Comment Letter II; MFDF Comment Letter; Nuveen 
Comment Letter; SIFMA Comment Letter I; T. Rowe Comment Letter; 
Wells Fargo Comment Letter.
    \1111\ See Interactive Data Comment Letter.
    \1112\ See Proposing Release, supra footnote 9, at n.705 and 
accompanying text.
---------------------------------------------------------------------------

    If all funds use a small number of third-party vendors, there could 
be other indirect, but potentially large, costs. According to one 
commenter, the vendors could become de facto liquidity ``rating 
agencies'' and their ``upgrades'' and ``downgrades'' of asset liquidity 
could have systemic effects on the market.\1113\ For example, if a 
vendor were to remove a widely-held investment from the highly liquid 
investment category, then many funds could simultaneously attempt to 
sell that investment, which could harm both fund investors and the 
wider market. Given the data limitations and difficulties in estimating 
liquidity for many less liquid investments, that potential effect might 
be driven by error-prone modeling instead of true changes in liquidity. 
We emphasize above that while third-party products can serve as a 
useful input to the classification process, it is the fund's 
responsibility to determine the liquidity of each investment, which 
should lessen the potential for systemic issues by reducing fund 
reliance on third-party vendors and allowing more of the necessary 
liquidity analysis to be performed within each fund complex.\1114\
---------------------------------------------------------------------------

    \1113\ See ICI Comment Letter II.
    \1114\ See supra section III.C.1.b. (providing guidance on the 
appropriate use of data vendors).
---------------------------------------------------------------------------

    Several additional components of the final rule will affect costs 
relative to the proposal. First, by excluding any fund that primarily 
holds assets that are highly liquid investments from the requirement to 
have a highly liquid investment minimum, the final rule avoids imposing 
any potential costs related to the minimum on some funds that would 
benefit less from having a minimum. It is possible that some funds that 
do not qualify as primarily highly liquid funds will incur the costs of 
establishing a minimum without a significant benefit. Second, whereas 
funds may currently use back-office operations to limit their 
acquisition of illiquid assets under exiting Commission guidelines, the 
final rule's enhanced illiquid investment standard may require funds to 
incur direct costs associated with a shift of these operations to other 
business functions (we also discuss indirect costs associated with the 
enhanced illiquid investment limit below).\1115\ Third, the final rule 
does not require In-Kind ETFs to establish a highly liquid investment 
minimum or classify the liquidity of their portfolios, which will 
reduce their costs relative to other funds, but it also requires them--
as it does all ETFs--to consider several additional factors as part of 
their liquidity risk programs, which may increase their implementation 
costs. Finally, principal underwriters or depositors of UITs, which had 
no liquidity risk requirements under the proposed rule, will now have 
to incur a one-time cost on or before the date of the initial deposit 
of the portfolio securities into the UITs to assess whether the amount 
of illiquid investments they expect the UITs to hold is compatible with 
the redeemable nature of the securities they issue. This cost should be 
comparable in magnitude to incurring a fraction of the ongoing costs of 
an open-ended fund under rule 22e-4 because it involves an analysis 
that is similar to complying with the rule's 15% illiquid investment 
limit without having to establish all of the systems and processes that 
are required to perform that task on a continuing basis. Assuming that 
this activity accounts for 20% of an open-ended fund's ongoing costs, 
we estimate that it would cost a UIT $8,000 to $52,000, and note that 
it will only be incurred by UITs that are launched after the rule's 
compliance date.\1116\ UITs are already required to consider which of 
their restricted securities are illiquid, so this estimate should be 
considered an upper bound on the costs imposed on UITs by the rule. 
Finally, the rule's provision requiring board oversight when a fund's 
holding of illiquid assets exceed 15% of its net assets may impose 
additional costs on the fund to hold a special board meeting, including 
the cost of preparing materials for the board's deliberation, the cost 
of board members' time, as well as the cost of consultations with 
outside counsel.
---------------------------------------------------------------------------

    \1115\ See supra section III.C.4.a.
    \1116\ These figures are based on the same comment letter used 
to estimate one-time and ongoing costs for open-ended funds. We 
assume the costs associated with launching a UIT under rule 22e-4 
are equivalent to 20% of the ongoing costs of a one fund complex. 
Under the assumptions above that ongoing costs for open-ended funds 
are 5% to 32.5% of their initial costs, fund complexes with one fund 
have estimated ongoing costs of approximately $40,000 to $260,000. 
Multiplying that range by 20% produces the UIT estimate.
---------------------------------------------------------------------------

    Depending on the personnel (and/or third-party service providers) 
involved with respect to the activities associated with establishing 
and implementing a liquidity risk management program, certain of the 
estimated one-time costs could be borne by the fund, and others could 
be borne by the fund's adviser or other service providers. This cost 
allocation would be dependent on the facts and circumstances of a 
particular fund's liquidity risk management program, and thus we cannot 
specify the extent to which the estimated costs would typically be 
allocated to the fund as opposed to the adviser. Estimated costs that 
are allocated to the fund would likely be borne by fund shareholders in 
the form of fund operating expenses.
    Certain elements of the program requirement may entail marked 
variability in related compliance costs, depending on a fund's 
particular circumstances and sources of potential liquidity risk. The 
process of classifying the liquidity of each of a fund's portfolio 
investments could give rise to varying costs depending on the fund's 
particular investment strategy. For example, a U.S. large cap equity 
fund would likely incur relatively few costs to obtain the data 
necessary to classify its portfolio positions, specifically given that, 
relative to the proposed rule, the final rule allows such a fund to 
generally classify its positions based on asset classes (subject to an 
exception process). On the other hand, funds that hold investments for 
which relevant market,

[[Page 82241]]

trading, and other investment-specific data is less readily available, 
for which a general asset-class-based classification is more difficult 
to apply, or funds that require more exceptions to their asset-class-
based classification would incur relatively greater costs associated 
with the classification of their portfolio positions' liquidity. In 
addition, funds with multiple sub-advisers may incur relatively more 
costs to coordinate the process of classifying position liquidity as 
well as monitoring whether the fund is compliant with its highly liquid 
investment minimum and the 15% illiquid investment limit.
    Certain factors that the rule's guidance suggests a fund should 
consider in assessing its liquidity risk also could entail relatively 
greater costs, depending on the fund's circumstances. For instance, a 
fund with a relatively short operating history could incur greater 
costs in assessing the fund's cash flow projections than a similarly 
situated fund with a relatively long operating history. This is because 
the newer fund could find it appropriate to assess redemption activity 
in similar funds during normal and stressed periods (to predict its 
future cash flow patterns), which could entail additional costs to 
gather and analyze relevant data about these comparison funds. Also, a 
fund whose shares are held largely through omnibus accounts may wish to 
periodically request shareholder information from financial 
intermediaries in order to determine how the fund's ownership 
concentration may affect its cash flow projections. These data 
requests, and related analyses, could cause a fund to incur costs that 
another fund, whose shares are largely held directly, would not. A fund 
that deems it appropriate to establish and implement additional 
liquidity risk management policies and procedures beyond those 
specifically required under the rule also would incur additional 
related costs. While we recognize that, as described above, the costs 
to establish and implement a liquidity risk management program in 
compliance with rule 22e-4 will depend to some degree on the level of 
liquidity risk facing the fund, we are unable to quantify the various 
ways in which a fund's individual risks and circumstances could affect 
the costs associated with establishing a liquidity risk management 
program.
    Commenters suggested that the proposed three-day liquid asset 
minimum requirement could have had a number of unintended consequences. 
As discussed above, if third-party vendors become de facto ``rating 
agencies'' for liquidity, then a liquidity minimum could force many 
funds to sell the same investments simultaneously after a liquidity 
``downgrade,'' which could have a systemic impact on funds and the 
overall market.\1117\ Similarly, if a fund were forced into predictable 
trading behavior during a market downturn because of the highly liquid 
investment minimum requirement, the liquidity and performance of that 
fund would be negatively impacted.\1118\ It is possible that the 
proposed three-day liquid asset minimum requirements could have created 
these types of unintended consequences by prohibiting a fund from 
acquiring less liquid assets if it was below its three-day liquid asset 
minimum, but the final rule does not include this prohibition. Instead, 
as discussed above, a fund is only required to report to its board and, 
possibly, the Commission when it is below its highly liquid investment 
minimum. This requirement should provide fund management the 
flexibility to avoid forced, predictable trading behavior while 
maintaining the emphasis on effective liquidity risk management the 
minimum is designed to provide. While fund liquidity may vary more 
under this approach, the reporting requirements surrounding any 
shortfall, including a requirement to provide the fund's board with an 
explanation of how the fund plans to restore its minimum if a shortfall 
lasts more than 7 consecutive calendar days, should help provide 
oversight to prevent a fund from continually failing to meet its 
liquidity minimum. As a whole, this approach should result in lower 
costs for funds compared to the proposed three-day liquid asset minimum 
and, because we anticipate that lengthy breaches of the minimum will be 
relatively rare, it should not significantly decrease the benefits of 
having a highly liquid investment minimum.
---------------------------------------------------------------------------

    \1117\ ICI Comment Letter II.
    \1118\ ICI Comment Letter II.
---------------------------------------------------------------------------

    One commenter suggested that investor choice could be negatively 
impacted because of the implementation and on-going costs of the 
liquidity risk management program.\1119\ The commenter asserted that 
the costs could overwhelm small fund complexes and force them to either 
cease operations or consolidate with a larger complex.\1120\ Most of 
the changes made to the rule since its proposal--exclusions for funds 
that primarily hold assets that are highly liquid investments and In-
Kind ETFs, a reduction in the number of investment classification 
categories, and the ability to generally classify investments based on 
asset classes (subject to an exception process)--should decrease the 
estimated implementation and on-going costs compared to the proposal. 
Yet it remains possible that some fund complexes will still find the 
costs burdensome. While investor choice may be harmed if a fund is 
closed because the costs of the rule are burdensome, remaining funds 
will be better positioned to avoid the negative consequences of 
inadequate liquidity management if that fund exited because it was 
unable to provide a minimum acceptable baseline of liquidity. To the 
extent that there are funds that are currently able to provide 
effective liquidity risk management, but would be forced to cease 
operations because of the costs of complying with the rule (even after 
changes from the proposal that increase flexibility and decrease 
implementation and on-going costs), investor choice may be negatively 
affected.
---------------------------------------------------------------------------

    \1119\ Charles Schwab Comment Letter.
    \1120\ Id.
---------------------------------------------------------------------------

    A fund may incur costs if it reallocates its portfolio to 
correspond with its initial or subsequently modified highly liquid 
investment minimum, or if the rule's definition of an illiquid 
investment results in the fund holding more than 15% of its net assets 
in assets that are illiquid investments. While we are unable to 
anticipate how many funds may reallocate their portfolios for these two 
reasons, or the extent of such reallocation by any fund that does so, 
we anticipate that the transaction-related costs of any such 
reallocation will not be significant for most funds. This is because 
some funds may not need to reallocate their portfolios at all to 
correspond with their highly liquid investment minimum or the 15% 
illiquid investment limit, and those that do so would be able to 
gradually adjust their portfolios in order to buy and sell portfolio 
positions during times that are financially advantageous given the 
delayed compliance date. Thus, while a fund may reallocate its 
portfolio to comply with its highly liquid investment minimum and the 
15% illiquid investment limit by the time of the compliance date, a 
fund would not be required to conduct transactions in portfolio 
investments in any particular timeframe prior to the compliance date. 
If a fund wishes to reallocate its portfolio by the compliance date, we 
anticipate that the compliance date would provide sufficient time to do 
so with relatively few associated transaction costs. Along with the 
transaction-related costs associated with any portfolio reallocation, 
we recognize that this reallocation in turn could affect

[[Page 82242]]

the performance and/or risk profiles of funds that modify their 
composition, which in turn could result in costs associated with 
decreased investment options available to investors and any changes to 
the market for relatively less liquid investments; these costs are 
discussed below. Finally, it is worth noting that, because the rule 
excludes both In-Kind ETFs and funds that primarily hold assets that 
are highly liquid investments from the requirement of having a highly 
liquid investment minimum, these funds will not incur any of the costs 
associated with transactions, reduced fund performance, or altered risk 
profiles associated with a minimum, though they will still incur these 
costs as they apply to the rule's 15% illiquid investment limit.
Potential for Decreased Investment Options and Adverse Effects
    We recognize that the rule requires a fund to determine the 
liquidity profile of its current portfolio and evaluate its potential 
liquidity needs, which could result in a fund concluding that its 
current portfolio lacks sufficient liquidity. This could lead a fund to 
modify its portfolio composition to meet its appropriate highly liquid 
investment minimum (e.g., one commenter stated that funds may decrease 
their holdings of long-term municipal bonds) or to comply with the more 
specific 15% illiquid investment limit.\1121\ The rule could therefore 
result in certain funds increasing their investments in relatively more 
liquid investments or altering the way in which their portfolios are 
managed, which in turn could affect the performance, tracking error, 
and/or risk profiles of these funds.\1122\ This is most likely to 
affect funds that currently hold investments with relatively lower 
liquidity. Such modifications to funds' portfolio compositions could in 
turn decrease certain investment options available to investors or 
reduce investor returns. However, because these portfolio composition 
shifts are most likely to occur if a fund needs to adjust its existing 
liquidity level to comply with the rule, we anticipate that the 
potential for decreased yield is most likely to affect funds currently 
holding portfolios whose liquidity levels have the potential to create 
redemption-related liquidity risk for fund investors. Thus, the 
potential for decreased investment options for certain investors, and 
any related decrease in investment yield, has the potential offsetting 
benefit of decreased liquidity risk in the funds in which these 
investors hold shares. However, there could be other reasons funds may 
choose to invest in more liquid investments as a result of the rule 
even if this reallocation is not required, including the possibility 
that they do not want to appear less liquid than their peer funds in 
their publicly disclosed liquidity profile, or because increased 
disclosure requirements regarding the timing of a fund's redemption 
payments may result in funds holding more liquid investments.\1123\
---------------------------------------------------------------------------

    \1121\ GFOA Comment Letter.
    \1122\ See, e.g., supra footnote 767 (discussing how index funds 
that use full replication strategies might need to move towards 
other techniques for tracking an index if full replication requires 
them to exceed the 15% illiquid asset limit).
    \1123\ See infra section IV.c.2.a (discussing the effects of the 
rule's disclosure requirements).
---------------------------------------------------------------------------

    We cannot quantify the number of funds that would need to 
significantly modify their portfolios' risk profile as a result of the 
rule because we lack the information necessary to provide a reasonable 
estimate. Such an estimate would depend on the number of funds that 
might need to modify their current portfolio composition as a result of 
the rule, as well as the availability of relatively liquid investments 
that can act as adequate substitutes to existing investments for those 
affected funds. We are unable to quantify the total potential costs 
discussed in this section because: (1) We cannot anticipate the highly 
liquid investment minimum that each fund would determine to be 
appropriate based on its liquidity risk or the extent to which fund 
holdings exceed the rule's more specific 15% illiquid investment limit 
relative to the current 15% guideline; (2) we cannot determine what 
relatively more liquid investments funds would purchase as substitutes; 
(3) we are unable to estimate the resulting changes to funds' yields 
and risk profiles, nor how investors would react to these changes. In-
Kind ETFs and funds that primarily hold assets that are highly liquid 
investments will not be subject to the highly liquid investment 
minimum, so this may reduce the aggregate costs associated with 
decreased investment options relative to the proposed rule. Commenters 
did not specifically object to our assessment of the rule's impact on 
investment options in the proposed rule.
Market for Relatively Less Liquid Investments
    As discussed above, the rule could result in certain funds 
increasing their investments in relatively more liquid investments, 
which would effectively mean that these funds would decrease their 
investments in relatively less liquid investments. If funds decrease 
their investments in relatively less liquid investments, the market for 
those investments could become even less liquid. This could discourage 
new issuances of similar investments and decrease the liquidity of 
relatively less liquid investments that are still outstanding. The 
impact of decreased investment by funds in relatively less liquid 
markets will depend on how much current investment in those markets is 
driven by the funds, which varies between markets. Further, these 
market effects could be partially offset if other opportunistic 
investors with greater capacity to hold less liquid investments are 
attracted to the market by any lower prices for these investments that 
result if funds decrease their holdings of less liquid 
investments.\1124\ In addition, if the rule leads funds to better 
assess the liquidity risk associated with certain investments, any 
decrease in the prices of these investments could reflect more 
efficient pricing of the investments (that is, risk would be better 
reflected in asset prices than it is currently). Because funds 
currently are not required to report or disclose information concerning 
the liquidity of their investments, and because we cannot anticipate 
the highly liquid investment minimum that each fund would determine to 
be appropriate based on its liquidity risk or the extent to which the 
more specific 15% illiquid investment limit will apply to current fund 
holdings, it is difficult to predict the extent to which the rule could 
lead funds to modify their portfolio holdings, or whether such 
modifications would discourage the issuance of certain investment. As a 
result, we cannot quantify the potential costs discussed in this 
section. Commenters did not specifically object to our assessment of 
the costs related to decreased investment in illiquid assets in the 
proposed rule.
---------------------------------------------------------------------------

    \1124\ Relatively less liquid investments have a higher expected 
return compared to relatively more liquid investments, thereby 
compensating longer-term investors for holding relatively less 
liquid investments. See Yakov Amihud & Haim Mendelson, Asset Pricing 
and the Bid-Ask Spread, 17 J. Fin. Econ. 223 (1986), available at 
http://pages.stern.nyu.edu/~lpederse/courses/LAP/papers/
TransactionCosts/AmihudMendelson86.pdf.
---------------------------------------------------------------------------

d. Effects on Efficiency, Competition, and Capital Formation
    The liquidity risk management program requirement would require a 
fund to assess its liquidity risk and to determine its highly liquid 
investment minimum based on this risk assessment. For funds that do not 
already engage in liquidity risk management practices that meet the 
rule's requirements, the requirements should improve the

[[Page 82243]]

alignment between fund portfolio liquidity and fund liquidity needs. 
This improved alignment could enhance funds' ability to meet 
redemptions in a manner that mitigates potential dilution of 
shareholders' interests, and thus this improved alignment could be 
viewed as increasing efficiency to the extent that dilution is 
perceived as a drag on the ability of a fund's NAV to reflect the 
performance of its portfolio. Additionally, the requirement for each 
fund to classify the liquidity of its portfolio investments and 
publicly report the aggregated percentage of its portfolio assigned to 
each of the four classifications categories could increase allocative 
efficiency by assisting investors in making investment choices that 
better match their risk tolerances. However, this potential efficiency 
gain will only hold to the extent that these portfolio-level 
classification aggregates, which are based on non-public subjective 
assessments of investment liquidity, are comparable across funds. 
Furthermore, this potential efficiency gain will only be achieved if 
this classification sufficiently contrasts the tradeoff between 
portfolio liquidity and performance across funds.
    By enhancing funds' liquidity risk assessment and risk management, 
the program requirement also could promote pricing efficiency in the 
sense that it could decrease the likelihood that a fund would be forced 
to sell portfolio investments under unfavorable circumstances in order 
to meet redemptions, potentially creating significant negative price 
pressure on those investments. If a fund's asset sales were to cause 
temporary changes in market prices unrelated to an investment's 
fundamentals, this could create a temporary pricing inefficiency. By 
decreasing the likelihood that these types of price movements would 
occur, the program requirement could decrease pricing inefficiency. 
However, the program requirement could negatively affect the efficient 
pricing of investments with lower liquidity if it indirectly 
discourages funds from investing in them (for example, if a fund were 
to decrease its holdings in investments that have lower liquidity if it 
determines, as a result of the fund's liquidity risk assessment, that 
its appropriate highly liquid investment minimum or the more specific 
15% illiquid investment limit do not correspond with the fund's current 
portfolio composition). But as discussed above, this market effect 
could be partially offset if other investors are incentivized to buy 
relatively less liquid investments on account of any lower prices for 
these investments that result if funds decrease their holdings of these 
investments.\1125\ Alternatively, any price decreases experienced as a 
result of decreased mutual fund investment could be considered 
efficient price adjustments given the reduction in liquidity of the 
investments.
---------------------------------------------------------------------------

    \1125\ See supra section IV.C.1.c.
---------------------------------------------------------------------------

    If the liquidity risk management program requirement results in a 
material decrease in funds' investment in relatively less liquid 
investments, competition for these investments would initially be 
negatively affected. Under this scenario, the relatively less liquid 
investments in which funds formerly would have invested may become less 
liquid, since the number of current or potential market participants 
would be reduced. However, because this reduction in demand and 
liquidity results in larger illiquidity discounts and higher expected 
returns, some investors might become willing to invest in these assets, 
which in turn would partially offset the initial reduction in 
competition. As a corollary, if the liquidity risk management program 
requirement results in a material increase in funds' investment in 
highly liquid investments, competition for these investments would be 
positively affected. However, as funds increase their investments, the 
liquidity of those investments should increase and their liquidity 
premium decrease, which in turn could lead some investors to reduce 
their demand for these investments, partially offsetting the initial 
increase in competition. Relative to the proposal, the competitive 
effects of fund demand for highly liquid investments relative to lower 
liquidity investments should, if anything, be reduced because the rule 
only requires a fund to consider stressed conditions that are 
reasonably foreseeable in determining its minimum.
    The size of a fund, or the family of funds to which a fund belongs, 
could have certain competitive effects with respect to the fund's 
implementation of its liquidity risk management program. If there are 
economies of scale in creating and administering multiple liquidity 
risk management programs, funds in large families would have a 
competitive advantage. For a fund in a smaller complex, however, a 
greater portion of the fund's (and/or adviser's \1126\) resources may 
be needed to create and administer a liquidity risk management program, 
which may increase barriers to entry in the fund industry, and lead to 
an adverse effect on competition. The size of a fund family also could 
produce competitive advantages or disadvantages with respect to a 
fund's use of products developed by third parties to assist in 
classifying the liquidity of their portfolio investments, or to assess 
the fund's liquidity risk. Funds in a large complex also could receive 
relatively more favorable pricing for third-party liquidity risk 
management tools, if the fund complex were to purchase discounted bulk 
services from the developer or receive relationship-based pricing 
discounts. To the extent that they choose to use liquidity risk 
management tools such as committed lines of credit and interfund 
lending,\1127\ funds in larger complexes likewise could receive more 
favorable rates on committed lines of credit than funds in smaller 
complexes, and could have opportunities to establish interfund lending 
arrangements more easily than funds in smaller complexes.
---------------------------------------------------------------------------

    \1126\ See supra footnote 446 and accompanying text.
    \1127\ See supra footnote 258 and accompanying text (discussing 
and providing guidance on the use of these tools).
---------------------------------------------------------------------------

    Any changes in certain investments' or asset classes' liquidity 
that could indirectly result from the liquidity risk management program 
requirement (for example, as discussed above, if the number of buyers 
and sellers for certain investments becomes significantly reduced as a 
result of the program requirement) could also affect capital formation 
among issuers of these investments. Because lower asset liquidity 
implies higher illiquidity premiums and larger asset price discounts 
some firms and other issuers of securities could be discouraged from 
issuing new securities in asset classes that are associated with lower 
liquidity. If changes in liquidity are not equal across all asset 
classes, firms and other entities may begin to shift their capital 
structure (e.g., begin to issue equity instead of debt) or to change 
the terms of certain securities that they issue in order to increase 
their liquidity (e.g., by standardizing the terms of certain debt 
securities, or modifying the securities' terms to promote electronic 
trading).\1128\
---------------------------------------------------------------------------

    \1128\ See GFOA Comment Letter (discussing these types of 
effects on municipal bond issuers).
---------------------------------------------------------------------------

    Commenters did not specifically object to our assessment of the 
proposed rule's effects on efficiency, competition, and capital 
formation. With the exception of the potential efficiency changes due 
to modifications reflected in the adoption of a highly liquid 
investment minimum and the more specific 15% illiquid investment limit 
discussed above, our assessment of the

[[Page 82244]]

final rule's effects largely corresponds with those of the proposed 
rule.
e. Reasonable Alternatives
    The Commission considered various alternatives to the individual 
elements of rule 22e-4. Those alternatives are outlined above in the 
sections discussing the rule elements.\1129\ The following discussion 
addresses economically significant alternatives to rule 22e-4, which 
involve broader issues than the more granular alternatives to the 
individual rule elements discussed above.
---------------------------------------------------------------------------

    \1129\ See supra sections III.A.3, III.B.1.b, III.B.2.j, 
III.B.3.b, III.C.1.c, III.C.1.d, III.C.2.a, III.C.2.b, III.C.3.a, 
III.C.3.a, III.C.6.a, III.C.6.b, II.C.5.c, III.D.4, and III.E.
---------------------------------------------------------------------------

Liquidity Risk Management Program and Scope
    The Commission considered, but ultimately decided against, 
excluding certain types of funds from rule 22e-4.\1130\ For example, 
the rule could have carved out funds with investment strategies that 
historically have entailed relatively little liquidity risk, or funds 
with relatively low asset levels. We are not excluding any subset of 
open-end funds, other than money market funds, from the scope of the 
rule, although we have tailored the rule for certain kinds of 
investment companies that present different liquidity risks (In-Kind 
ETFs, funds that primarily hold assets that are highly liquid 
investments, and UITs). Some funds with investment strategies that 
historically have involved little liquidity risk invest in assets that 
have lower liquidity, or in more liquid assets that can experience 
episodes of lower liquidity.\1131\ To the extent that these types of 
investments create potential liquidity risk for a fund, excluding funds 
with investment strategies that have historically involved little 
liquidity risk could expose investors to more potential liquidity risk 
than they would face under the rule. Furthermore, investors in small 
funds could suffer from insufficient liquidity risk management just as 
investors in larger funds could. Indeed, staff analysis suggests that 
funds with relatively low total assets can experience greater flow 
volatility, including more volatility in unexpected flows, than funds 
with higher assets, which could indicate increased liquidity 
risk.\1132\ The program requirement permits a fund to customize and 
calibrate its liquidity risk management program to reflect the 
liquidity risks that it typically faces (and that it could face in 
stressed market conditions). This flexibility is meant to result in 
programs whose scope, and related costs and burdens beyond the fixed 
cost of establishing a minimum liquidity risk management program, are 
appropriate to manage the actual liquidity risks facing a particular 
fund. For example, funds that primarily hold assets that are highly 
liquid investments are not required to adopt a highly liquid investment 
minimum because any benefits associated with this requirement as 
applied to these funds are less likely to justify the associated 
burdens.
---------------------------------------------------------------------------

    \1130\ See section III.A.2 for more detailed discussion of rule 
22e-4's scope.
    \1131\ See Proposing Release, supra footnote 9, at n.123-124 
(discussing liquidity issues in microcap stocks as well as treasury 
bonds during the ``Flash Crash'').
    \1132\ DERA Study, supra footnote 95, at 16-24. See infra 
footnote 1159 and accompanying paragraph regarding comments on small 
funds.
---------------------------------------------------------------------------

    Instead of adopting rule 22e-4, the Commission could issue guidance 
surrounding the assessment and management of liquidity risk, which 
would give funds more flexibility in managing liquidity risk and could 
reduce costs relative to the requirements of the rule. However, on 
account of the significant diversity in liquidity risk management 
practices that we have observed in the fund industry, we believe that 
the need exists for an enhanced comprehensive baseline requirement 
instead of only guidance for fund liquidity risk management.
    Commenters suggested the rule could have also taken a purely 
principles-based approach instead of a prescriptive approach.\1133\ The 
final rule is not a purely prescriptive rule; while it does specify 
certain standards, it provides funds with a substantial degree of 
flexibility in implementing those standards. That said, a purely 
principles-based approach that specified few or no requirements could 
give funds more flexibility in tailoring risk management programs to 
their needs and could reduce compliance costs, but it would be less 
certain to create a comprehensive baseline for fund liquidity risk 
management, which in turn would diminish the comparability (and thus 
the value) of information reported to the Commission and to the public 
about funds' liquidity. Under a purely principles-based approach, an 
investor with investments in multiple funds would be aware that those 
funds are all generally required to manage liquidity risk, but may not 
have sufficient clarity about how each of the funds may have chosen to 
interpret and implement general principles so as to permit the investor 
to understand how this variation across funds affects the liquidity 
risk to which the investor is exposed. Finally, funds are not 
prohibited from developing or maintaining their own, tailored risk 
management programs to the extent that they are supplemental to the 
baseline that the Commission's program requires.
---------------------------------------------------------------------------

    \1133\ AIMA Comment Letter; CFA Comment Letter; Cohen & Steers 
Comment Letter; Dodge & Cox Comment Letter; Eaton Vance Comment 
Letter I; FSR Comment Letter; ICI Comment Letter I; ICI Comment 
Letter III; LSTA Comment Letter; MFDF Comment Letter; Nuveen Comment 
Letter; NYC Bar Comment Letter; Oppenheimer Comment Letter; State 
Street Comment Letter; Vanguard Comment Letter; Wellington Comment 
Letter; Wells Fargo Comment Letter; Dechert Comment Letter.
---------------------------------------------------------------------------

    The Commission considered proposing liquidity requirements similar 
to those imposed on money market funds--that is, the requirement to 
hold a specified minimum level of highly liquid investment holdings, 
and the ability to impose redemption fees and gates.\1134\ The 
requirements imposed on money market funds, and the tools available to 
these funds to manage heavy redemptions, are specifically tailored to 
the assets held by money market funds and the behavior of money market 
fund investors.\1135\ Imposing similar regulatory requirements on funds 
that are not money market funds would ignore significant differences 
between money market funds and other funds. We discuss the costs and 
benefits of requiring funds to hold a specified minimum level of highly 
liquid investments below (similar to the portfolio liquidity 
requirements applicable to money market funds). With respect to 
redemption fees, funds are already permitted to use them under existing 
regulations (up to a maximum fee of two percent), although those fees 
are largely used by certain funds to recoup costs incurred as a result 
of excessive short-term trading of mutual fund shares, rather than 
mitigating dilution arising from shareholder transaction activity 
generally, and are viewed as unpopular with investors and 
intermediaries. Redemption gates would allow funds to limit the 
potential dilution shareholders face in circumstances where they face 
extreme redemptions, but they would also impose constraints on 
shareholders' access to their assets in those situations, and 
commenters were not in favor of extending rule 22e-3 to permit funds to 
make broader use of suspensions of redemptions.\1136\ In addition, 
funds that are not money market funds have not demonstrated the same 
risk of significant redemptions during times of

[[Page 82245]]

market stress that money market funds may face and which redemption 
gates are meant to prevent, implying that the benefits of gates are 
less applicable to funds that are not money market funds.\1137\
---------------------------------------------------------------------------

    \1134\ See supra footnotes 153-155 and accompanying text.
    \1135\ See 2014 Money Market Fund Reform Adopting Release, supra 
footnote 43, at section II.
    \1136\ See ICI Comment Letter I.
    \1137\ See 2014 Money Market Fund Reform Adopting Release, supra 
footnote 43, at section III.A.1.
---------------------------------------------------------------------------

Classifying Portfolio Investment Liquidity
    The Commission considered multiple alternatives to the rule's 
requirement that funds classify the liquidity of their portfolio 
investments, which establishes one component of a uniform baseline for 
fund liquidity risk management. As discussed above, commenters raised 
three primary structural alternatives to the proposed classification 
requirement: (i) A ``principles-based'' liquidity classification 
approach, where each fund would have to classify the liquidity of its 
portfolio assets, but the Commission would not require any specific 
classification scheme; \1138\ (ii) a simplified version of the proposed 
classification system, with fewer classification categories based on 
shorter time projections than the proposal; \1139\ and (iii) an 
approach with new classification categories based on qualitative 
distinctions in the market- and trading-related characteristics of 
different asset classes under different market conditions, which 
generally would rely on the Commission mapping different asset classes 
to each of these new classification categories.\1140\
---------------------------------------------------------------------------

    \1138\ See, e.g., AIMA Comment Letter; LSTA Comment Letter; 
Street Comment Letter; Wellington Comment Letter.
    \1139\ See, e.g., Eaton Vance Comment Letter I; Interactive Data 
Comment Letter; Markit Comment Letter; Wells Fargo Comment Letter. 
Commenters generally suggested three, four, or five classification 
categories.
    \1140\ See, e.g., BlackRock Comment Letter; MFS Comment Letter; 
Nuveen Comment Letter; CSRC Comment Letter.
---------------------------------------------------------------------------

    A purely principles-based approach to classifying assets, as 
suggested by several commenters, would have the benefit of allowing 
each fund to tailor its classification scheme to the liquidity factors 
most relevant to the assets it invests in rather than imposing a one-
size-fits-all approach that may be less applicable to some funds. 
However, as discussed above, this approach would not provide a uniform 
methodology for funds' liquidity assessment procedures and would not 
promote reasonably comparable reporting to the Commission and 
disclosure to the public about funds' portfolio liquidity.\1141\ 
Instead, also as discussed above, we are largely adopting commenters' 
suggested approach of reducing the number of liquidity classifications 
from six to four.\1142\
---------------------------------------------------------------------------

    \1141\ See supra section III.C.6.
    \1142\ The Commission also could have, as described in the 
Proposing Release, required funds to classify each portfolio 
position as ``liquid'' or ``illiquid,'' but commenters did not 
support such an alternative, and we continue to believe that a two-
category approach would be insufficiently nuanced to capture the 
full spectrum of portfolio position liquidity. See also supra 
section III.C.1.a for a more detailed discussion of commenter 
suggestions with respect to the number of liquidity classification 
categories.
---------------------------------------------------------------------------

    The Commission considered but is not adopting commenters' 
alternative of having the Commission establish a fixed classification 
schema to which all funds must adhere--for example, an enumeration of 
asset classes and a mapping of those classes to a liquidity 
classification.\1143\ This approach would have the benefit of producing 
liquidity classifications that are objectively comparable across funds, 
but the Commission may not be able to respond as quickly as market 
participants to dynamic market conditions that might necessitate 
changes to asset class liquidity classifications, and would be unable 
to account for determinants of investment liquidity that are fund-
specific.
---------------------------------------------------------------------------

    \1143\ For examples suggesting this approach see, e.g., AFR 
Comment Letter; BlackRock Comment Letter; SRC Comment Letter.
---------------------------------------------------------------------------

    Relatedly, some commenters also suggested classification categories 
based on alternatives to the ``days-to-cash'' criterion of the proposed 
and final rule, including, in whole or in part, on the fraction of 
average daily trading volume (``ADTV'') that each position size 
corresponds to, the expected behavior of bid-ask spreads in a given 
asset, or more qualitative liquidity buckets (e.g., ``converted to cash 
quickly under most circumstances'').\1144\ Some of these more specific 
criteria may be appropriate for particular assets (e.g., ADTV is a 
reasonable measure for exchange-traded securities), but do not apply to 
all assets (e.g., bid-ask spreads are not readily available for some 
asset classes). Also, more qualitative criteria make it more difficult 
to compare classifications across funds relative to the ``days-to-
cash'' approach in the final rule.
---------------------------------------------------------------------------

    \1144\ See Nuveen Comment Letter; BlackRock Comment Letter; 
Dodge & Cox Comment Letter; SIFMA Comment Letter I.
---------------------------------------------------------------------------

Highly Liquid Investment Minimum
    The final rules require funds that do not primarily hold assets 
that are highly liquid investments to establish a highly liquid 
investment minimum as part of their liquidity risk management program 
and provides some flexibility by not prohibiting the acquisition of 
less liquid investments, but instead requiring a fund to report to the 
board and, in some cases, the Commission if it goes below its minimum. 
The first type of alternative the Commission considered with respect to 
this requirement concerns which investments satisfy a minimum, which 
could have varied along a spectrum from more liquid (e.g., only cash 
would qualify as a highly liquid investment) to less liquid (e.g., 
investments reasonably expected to convert to cash in the 7-day 
timeframe associated with open-ended fund redemption and settlement 
requirements would qualify). While there are various marginal benefits 
and costs associated with defining investments that satisfy the minimum 
at points along that spectrum--for example, cash is more liquid but 
does not provide any yield--the final rule aligns the definition of 
what investments are subject to the minimum with the definition of the 
first (most liquid) category of investments in the liquidity risk 
management program's liquidity classification requirement.\1145\ This 
consistency in treatment means that fund advisers, investors, and the 
Commission can focus on a smaller number of clearly-defined concepts 
when broadly evaluating fund liquidity.
---------------------------------------------------------------------------

    \1145\ See the Proposing Release, supra footnote 9 at n.730 and 
associated text for a further discussion of cash and ``seven day 
liquid assets'' as alternatives for a minimum. We did not receive 
explicit comments on the merits of which types of investments should 
satisfy a minimum.
---------------------------------------------------------------------------

    The Commission also considered whether to make the highly liquid 
investment minimum purely a target instead of a minimum. The proposed 
rule would have precluded funds from acquiring less liquid investments 
anytime they were below their highly liquid investment minimum. 
Commenters suggested this could lead to several potential costs, as 
discussed above regarding the rule's costs and benefits, including the 
possibility that it could lead to herding behavior among funds.\1146\ 
Some commenters instead suggested that a target or range be used 
instead of a minimum, which could provide funds more flexibility in 
returning to their target without incurring unnecessary trading costs, 
as well as the ability to trade more opportunistically during periods 
of market stress.\1147\ However, a target

[[Page 82246]]

might have been interpreted as an ``average'' level of highly liquid 
investments funds should hold and, without further requirements such as 
board reporting, may not have provided a sufficient incentive to fund 
managers to ensure that the percentage of a fund's investments invested 
in relatively liquid investments is at (or above) the level deemed 
appropriate by the fund. The final rules strike a balance: Funds are 
not prohibited from acquiring less liquid investments if they go below 
their highly liquid investment minimum, but they must report any 
shortfall to their boards (and the Commission where required). This 
should reduce concerns regarding herding behavior,\1148\ but does make 
it more burdensome for a fund to buy any assets that are not highly 
liquid investments opportunistically if the fund is at or below its 
highly liquid investment minimum, insofar as funds may not want to 
trigger their reporting obligation to their board, the Commission, or 
both.
---------------------------------------------------------------------------

    \1146\ For example, any market event that increases the value of 
the less liquid portion of many funds' portfolios could place them 
below the minimum, and could indirectly result in some funds selling 
less liquid investments at the same time to bring their allocations 
back in line with their minimums.
    \1147\ For comments discussing the costs and benefits of a 
target vs. a minimum, see, e.g., Blackrock Comment Letter; Federated 
Comment Letter; Invesco Comment Letter; PIMCO Comment Letter.
    \1148\ For example, if an asset ceased to be a highly liquid 
investment, it could indirectly lead funds to sell that asset in 
order to meet their minimum. Coordinated selling could produce 
further downward pressure on the value of the investment. Some funds 
could be interested in purchasing such an investment if they viewed 
it to be undervalued and thus good for fund investors--which could 
also help counteract the downward pricing pressure caused by funds 
exiting their positions--but if such a purchase would cause them to 
violate their minimum, it would have been prohibited under the 
proposed rule.
---------------------------------------------------------------------------

    Some commenters were generally opposed to a highly liquid 
investment minimum,\1149\ and the final rule could have excluded this 
requirement altogether. Doing so would still require that funds manage 
liquidity risk appropriately but would provide even more flexibility in 
how that is achieved. However, the highly liquid investment minimum 
requires funds to directly consider the assets they need to have on 
hand to meet redemptions in a flexible manner to reduce dilution that 
may result from forced sales, and funds have flexibility in setting a 
minimum that is appropriate to the needs of their fund as well as 
adjusting the minimum dynamically to adapt to changing market 
conditions.\1150\ We note that the final rule does not require funds 
that primarily hold assets that are highly liquid investments to 
establish a minimum.
---------------------------------------------------------------------------

    \1149\ See, e.g., Invesco Comment Letter; Blackrock Comment 
Letter.
    \1150\ See supra footnote 638 and accompanying text.
---------------------------------------------------------------------------

    The Commission also considered requiring a uniform highly liquid 
investment minimum for all funds. This alternative approach would have 
the advantage of being simple for investors to understand, easy for 
funds to apply, and simple for our examination staff to verify. 
However, this alternative would fail to account for notable differences 
between funds with respect to investment strategy, fund flow patterns, 
and other characteristics that contribute to funds' liquidity risk, 
which in turn would make it reasonable for funds' portfolios to have 
varying liquidity profiles. We believe that the fund-specific highly 
liquid investment minimum requirement will promote alignment of a 
fund's liquidity needs with the liquidity of fund investments, while 
still permitting funds reasonable flexibility in implementation. In 
light of the significant diversity within the fund industry, we believe 
that flexibility is appropriate to help minimize the potential costs to 
investors of the requirement. This approach still includes elements 
that will help our staff to assess whether funds are holding an 
appropriate level of assets that are highly liquid investments. Each 
fund will be required to maintain a written record of how its highly 
liquid investment minimum was determined, as well as copies of 
materials submitted to the fund's board in connection with the highly 
liquid investment minimum.\1151\ One benefit of a Commission-determined 
uniform highly liquid investment minimum would be to ensure that funds 
do not set their minimum at an artificially low level (e.g., 0) that is 
divorced from their liquidity risk. We believe that the requirement for 
a fund to consider certain specified factors in determining its 
minimum, as well as the recordkeeping and board review requirements 
discussed above, will help promote funds' establishing realistic 
minimums, and discourage inappropriately low or zero minimums.
---------------------------------------------------------------------------

    \1151\ See proposed rule 22e-4(c)(2)-(3).
---------------------------------------------------------------------------

    Instead of requiring funds to determine and invest their assets in 
compliance with a highly liquid investment minimum, we could require 
funds to conduct stress tests of their own design assessing the extent 
to which the fund has a level of highly liquid investments necessary to 
cover possible levels of redemptions. This would have the benefit of 
granting a fund flexibility in determining whether its portfolio 
liquidity profile is appropriate given its liquidity needs. However, 
because the quality and comprehensiveness of funds' liquidity risk 
management currently varies significantly, we believe that requiring 
funds to have a highly liquid investment minimum is important in 
reducing the risk that funds will be unable to meet their redemption 
obligations, in minimizing dilution, and in elevating the overall 
quality of liquidity risk management across the fund industry. Also, we 
believe that it would be difficult to determine, depending on the level 
of discretion a fund would have in developing stress scenarios, whether 
these scenarios would accurately depict liquidity risk and lead funds 
to determine the appropriate level of portfolio liquidity they should 
hold. For example, if a fund's liquidity needs were generally high 
during normal periods, but were not correspondingly extreme during 
stress events, basing this fund's portfolio liquidity on the results of 
stress testing alone could cause a fund to hold too little liquidity 
during non-stressed periods. Therefore, we do not believe that a 
general stress testing requirement would be an adequate substitute for 
the highly liquid investment minimum requirement.
15% Illiquid Investment Limit
    Instead of the adopted illiquid investment definition, the 
Commission could have codified a definition of illiquid investments 
that reflects the current 15% guideline. This approach would have had 
the benefit of already being accepted and understood by the industry, 
and would have entailed few additional implementation costs for funds. 
However, it would not have been harmonized with the rule's requirements 
with respect to other liquidity classifications, particularly the 
requirement that funds review at least monthly whether their 
investments are illiquid with respect to relevant market, trading, and 
investment-specific factors, and also incorporate market depth 
considerations into this process.\1152\ To the extent that the rule's 
liquidity classification requirement results in funds more accurately 
assessing the amount of illiquid investments in their portfolios, funds 
may improve on their liquidity risk management under the rule as 
adopted than under a codification of the 15% guideline.
---------------------------------------------------------------------------

    \1152\ See supra sections III.C.1.b and III.C.3.b.
---------------------------------------------------------------------------

f. Comments on the DERA Study
    We received substantial comments on the DERA Study from one 
commenter. The Commission has carefully considered these comments and 
adjusted our analysis where appropriate. In terms of broader concerns, 
the commenter suggested that the analysis in the DERA Study does not 
provide a strong basis for the specifics

[[Page 82247]]

of the rule.\1153\ For example, the commenter asserts that the DERA 
Study's analysis does not provide a justification for funds sorting 
their assets into six liquidity categories and does not apply this 
classification in the DERA Study. The DERA Study's analysis was not 
designed to justify each policy choice made in the rule. Rather, the 
analysis in the DERA Study makes certain findings and reports certain 
empirical results designed to inform the Commission more generally 
about the current state of fund liquidity.
---------------------------------------------------------------------------

    \1153\ ICI Comment Letter II.
---------------------------------------------------------------------------

    With respect to the proposal's interpretation of the DERA Study's 
results, the commenter expressed the concern that the results in the 
DERA Study provide only indirect evidence on the selling behavior of 
funds in response to redemptions. While a direct test would be 
preferable, such a test would require data on both daily fund flows and 
fund daily transactions, neither of which are available in sufficient 
detail for analysis. The commenter states that the DERA Study itself 
only shows that fund liquidity tends to decrease following outflows and 
that other endogenous factors, such as broad changes in market 
conditions due to macroeconomic events, could be causing changes in 
both fund liquidity and fund flows.\1154\ To demonstrate its concerns 
about endogeneity, the commenter uses a vector autoregression (VAR) to 
present evidence that a proxy for market returns causes changes to both 
the Amihud liquidity of the S&P 500 and net U.S. equity mutual fund 
flows in a manner consistent with its alternative hypothesis that a 
fund's average Amihud liquidity may decrease due to an increase in 
market volatility rather than because of fund managers' trading 
behavior.\1155\ The analysis performed in the DERA Study does control 
for broad changes in market liquidity at the fund class-level.\1156\ To 
the extent that broad market effects drive variation in fund liquidity 
within a fund class in a way that is also correlated with fund flows, 
we acknowledge the commenter's concern about endogeneity and have 
modified our interpretation in the discussion above, but we also note 
that there is anecdotal evidence that supports this 
interpretation.\1157\ With respect to the Amihud liquidity measure used 
in the study, the commenter states that the DERA Study's conclusion 
that a ``10% outflow increases the impact of selling $10 million of the 
asset-weighted average equity portfolio holding by 11 basis points'' is 
a key result supporting the proposal's hypothesis that funds sell their 
more liquid assets first to meet redemptions. We disagree that the 
specific economic interpretation of the Amihud measure cited by the 
commenter is necessary to support the hypothesis that funds tend to 
sell their more liquid assets: To the extent that the Amihud measure 
reflects the liquidity of underlying fund assets, a decline in the 
average Amihud liquidity of a fund's portfolio is consistent with the 
fund disproportionately selling its more liquid assets.
---------------------------------------------------------------------------

    \1154\ ICI Comment Letter II.
    \1155\ ICI Comment Letter II.
    \1156\ DERA Study, supra footnote 95, at 43-44. The model 
includes Lipper class fixed effects, year-quarter fixed effects, and 
interactions of those fixed effects. The year-quarter and 
interaction fixed effects should capture any broad changes in 
liquidity within different fund styles over time, which could be 
related to macroeconomic events.
    \1157\ See, e.g., supra footnote 71.
---------------------------------------------------------------------------

    The commenter concludes that the analysis in the DERA Study does 
not demonstrate that funds are managing portfolios and redemptions in a 
manner that harms the interests of non-redeeming shareholders.\1158\ We 
acknowledge that the analysis does not establish a direct link between 
redemptions and quantifiable harm to non-redeeming shareholders; as 
discussed above, it was designed to inform the Commission more 
generally about the current state of fund liquidity. The commenter also 
states the DERA Study's finding that municipal bond funds hold less 
cash following redemptions implies that a 40% outflow would be required 
to deplete the average municipal bond fund's cash holdings. We 
acknowledge the commenter's interpretation of the analysis, but note 
that the results do not imply that all municipal bond funds would 
necessarily require outflows of a similar magnitude to deplete a 
significant portion of their cash holdings.
---------------------------------------------------------------------------

    \1158\ ICI Comment Letter II.
---------------------------------------------------------------------------

    The commenter makes several statements regarding results related to 
the volatility of fund flows. First, the commenter provides evidence 
that flow volatility declines with fund size, notes that the DERA 
Study's use of simple averages to calculate average flow volatility in 
a given fund category overstates the highly volatile flows of small 
funds, and shows that asset-weighted flow volatility measures are 
significantly smaller for all fund categories.\1159\ We acknowledge 
that the simple average will overstate smaller funds relative to an 
asset-weighted average, but the opposite view holds too: Asset-weighted 
averages will understate flow volatility for small funds, and the rule 
is concerned with the potential liquidity risk problems at all funds. 
The commenter also states that the relatively higher flow volatility of 
alternative funds may simply be attributable to the fact that they are 
generally smaller in size (because small funds generally tend to have 
more volatile flows as a percentage of their assets) and that, as they 
have grown, the volatility of their flows has, if anything, decreased. 
We acknowledge that the flow volatility of alternative funds may be a 
function of their smaller size, but also note that small funds are also 
subject to the rule and that other fund categories, such as foreign 
bond funds, exhibit higher flow volatility despite being relatively 
larger in size. The commenter also notes that, as the DERA Study 
acknowledged, the predictability of fund flows is likely understated. 
The purpose of analyzing the predictability of flows in the analysis 
was to determine, using a simple model of fund flows, the extent which 
flow volatility was predictable and whether, after accounting for 
predictability, the unexpected component of flow volatility varied 
across fund types in the same way as total flow volatility. While fund 
managers may be able to predict a larger fraction of flow volatility, 
the evidence in the DERA Study supports the notion that unexpected flow 
volatility varies proportionally with total flow volatility, and the 
relative ranking of unexpected flow volatility by fund type is not 
likely to change with a better model of flows. The commenter also 
states that the DERA Study provides evidence that funds already 
successfully manage volatile flows.\1160\ The proposal acknowledged 
that this evidence supports the view that funds do manage volatile 
flows by holding larger amounts of cash and liquid assets, and this 
evidence provides support for the rule's inclusion of flow volatility 
as a factor for funds to consider when managing risk.\1161\ Finally, 
the commenter points out that, while the DERA Study finds smaller funds 
have more volatile flows, small funds may find it easier to trade 
assets with minimal price effects. We agree that small funds may have 
less price impact, but note that any fixed trading costs incurred via 
smaller trades will involve larger proportional trading costs.
---------------------------------------------------------------------------

    \1159\ ICI Comment Letter II.
    \1160\ ICI Comment Letter II.
    \1161\ See Proposing Release, supra footnote 9, at n.631 and 
accompanying discussion.
---------------------------------------------------------------------------

    The commenter also provides evidence on the relationship between 
fund flows and holdings of short-term

[[Page 82248]]

assets for alternative strategy and high-yield bond funds. It finds no 
relationship between the two, asserting that the lack of a relationship 
shows funds are not systematically selling short-term assets to meet 
redemptions. However, this result is at the aggregate level, and does 
not necessarily preclude a relationship between the two quantities at 
the fund level for some funds. It also provides a fund-level analysis 
across high-yield bond funds in 5 separate months and also does not 
find a relationship between the two in four of the months. In one of 
the months, it does find statistically significant evidence that a 
decrease in short-term assets is associated with outflows, consistent 
with the DERA Study's finding. The commenter's inability to find a 
relationship is not evidence that there is no relationship per se: It 
is possible the commenter's test simply had low statistical power. To 
the extent that the commenter's evidence does support the claim that 
funds do not sell short-term assets in response to fund flows, the DERA 
Study used a different measure of liquidity and did not claim any 
evidence found using another measure, such as the short-term asset 
ratio used by the commenter, would produce the same result. More 
specifically, while funds may not sell their most liquid investments 
(which would be reflected in the short-term asset ratio used by the 
commenter), they could still be disproportionately selling their more 
liquid investments.
    With respect to the liquidity measure used in the DERA Study, the 
commenter points out that it only uses a single measure of market 
liquidity (Amihud illiquidity) and claims that the measure is not 
sufficient to support the interpretations the proposal draws from the 
study.\1162\ We acknowledge that the use of alternative measures could 
alter some of the results and interpretations in the DERA Study, but 
also emphasize that the DERA Study was intended to generally inform the 
Commission about the current state of fund liquidity, not to justify 
each policy choice made in the rule.
---------------------------------------------------------------------------

    \1162\ ICI Comment Letter II.
---------------------------------------------------------------------------

    The commenter stated that the academic studies used in support of 
the DERA Study and the proposal are either (1) theoretical and ignore 
important institutional details or (2) based on empirical fund-level 
results which by their design cannot provide any commentary on market-
wide concerns. With respect to the theoretical study cited in the 
proposal, it shows one mechanism by which mutual fund shareholders may 
have a first-mover incentive using a simplified model of the world for 
tractability; it is possible that in a model which captures more 
institutional details as proposed by the commenter--taxes, longer 
investor horizons, and reinvestment risk--this incentive is reduced or 
eliminated, but we are not aware of any other studies that reach such a 
conclusion. With respect to any empirical studies, the primary goal of 
the rule is to improve the fund-level management of liquidity and 
redemptions, which makes the cited fund-level academic studies relevant 
for the discussion. The commenter also points out that one of the 
empirical studies (Coval and Stafford), which provides evidence of 
negative price pressure due to forced selling by mutual funds, also 
states that the ex-ante probability of an equity mutual fund being 
affected by this risk is small because less than one percent of stocks 
are affected in a given quarter. The proposal did not claim that forced 
selling by mutual funds was a pervasive phenomenon, but did highlight 
that it is a possible risk that funds and their shareholders face.
2. Disclosure and Reporting Requirements Regarding Liquidity Risk and 
Liquidity Risk Management
a. Disclosure and Reporting Requirements
    We are adopting amendments to Form N-1A as well as adopting new 
items to Form N-PORT, Form N-CEN, and adopting Form N-LIQUID, to 
enhance fund disclosure and reporting regarding liquidity and 
redemption practices. Specifically, amendments to Form N-1A will 
require a fund to disclose: (i) The number of days in which the fund 
typically expects to pay redemption proceeds to redeeming shareholders 
\1163\ and (ii) the methods the fund typically expects to use to meet 
redemption requests in stressed and non-stressed market 
conditions.\1164\
---------------------------------------------------------------------------

    \1163\ Item 11(c)(7) of Form N-1A.
    \1164\ Item 11(c)(8) of Form N-1A.
---------------------------------------------------------------------------

    New items on Form N-PORT will require a fund to confidentially 
disclose monthly: (i) The fund's highly liquid investment minimum and 
the number of days a fund's holdings in assets that are highly liquid 
investments fell below that minimum during a given reporting period; 
\1165\ (ii) the liquidity classification of each investment as 
determined pursuant to rule 22e-4(b)(2)(i) including the determination 
of whether the investment qualifies as an illiquid investment, and 
(iii) the percentage of the fund's highly liquid investments that the 
fund has segregated to cover, or pledged to satisfy margin requirements 
in connection with, derivatives transactions in each of the other 
liquidity classification categories.\1166\ Once per quarter, funds will 
be required to publicly disclose (with a 60-day delay): (i) The 
aggregated percentage of their portfolios invested in each of the four 
liquidity classification categories, but funds will not be required to 
publicly disclose the liquidity classification of each individual 
position; \1167\ and (ii) the percentage of the fund's highly liquid 
investments that it has segregated to cover, or pledged to satisfy 
margin requirements in connection with, derivatives transactions in 
each of other liquidity classification categories.\1168\
---------------------------------------------------------------------------

    \1165\ Item B.7 of Form N-PORT.
    \1166\ Item C.7 of Form N-PORT.
    \1167\ Item B.8 of Form N-PORT.
    \1168\ Item B.8.b of Form N-PORT.
---------------------------------------------------------------------------

    New items on Form N-CEN will require a fund to disclose certain 
information regarding the use of committed lines of credit and 
interfund borrowing and lending.\1169\ We have also adopted a new item 
on Form N-CEN that will require an ETF to report whether it qualifies 
as an In-Kind ETF.\1170\
---------------------------------------------------------------------------

    \1169\ Item C.20 of Form N-CEN.
    \1170\ Item E.5 of Form N-CEN.
---------------------------------------------------------------------------

    The final form amendments differ from the proposal in several ways 
that may have potential economic consequences. In response to 
commenters' suggestions, the rule does not require funds to file credit 
agreements as part of Form N-1A. While Form N-PORT requires funds to 
report position-level liquidity classifications to the Commission, 
these classifications will not be publicly released. Instead, a fund 
will only be required to publicly disclose the aggregate percentage of 
the fund's holdings invested in each of the four liquidity 
classification categories and the percentage in each of the four 
liquidity classification categories of the fund's highly liquid 
investments that are segregated to cover derivatives transactions. The 
adopted rule also incorporates commenters' suggestions that the 
Commission be notified more quickly if a fund's assets that are 
illiquid investments exceed 15% of its net assets by requiring funds to 
file Form N-LIQUID indicating such a breach immediately after it 
occurs. With respect to the highly liquid investment minimum, a fund is 
required to report any decline below the minimum that lasts more than 7 
consecutive calendar days to the Commission by filing Form N-LIQUID, 
whereas the proposal would have required that a fund not purchase

[[Page 82249]]

less liquid investments while below its minimum. Any significant 
economic effects of these changes are discussed below.
b. Benefits
    The disclosure and reporting requirements will promote investor 
protection by improving the availability of information regarding 
funds' liquidity risks and risk management practices, as well as funds' 
redemption practices. As discussed above, funds' disclosures to 
shareholders regarding their redemption practices are currently varied 
in content and comprehensiveness.\1171\ To the extent that the 
requirement for funds to disclose the number of days in which the fund 
will pay redemption proceeds to redeeming shareholders fosters 
competition among funds to minimize the timing of redemptions, and 
assuming funds are able to meet redemptions in the time advertised, 
such competition could potentially be to the benefit of investors. 
Relative to the proposal, final Form N-1A requires that funds disclose 
estimated payment times for each payment method, which should reduce 
any potential investor confusion associated with the complexity of 
estimates based on funds' distribution channels under the 
proposal.\1172\
---------------------------------------------------------------------------

    \1171\ See supra section III.G.1.a.
    \1172\ See Fidelity Comment Letter.
---------------------------------------------------------------------------

    While some funds voluntarily include disclosure regarding fund 
limitations on illiquid asset holdings that track the 15% guideline, a 
fund is not currently required to disclose information about the 
liquidity of its portfolio investments. In light of the relatively few 
disclosure requirements regarding funds' liquidity risks, liquidity 
risk management practices, and redemption practices, as well as the 
current inconsistency in funds' liquidity-related disclosures, we 
believe that the disclosure and reporting requirements would increase 
shareholders' and the Commission's understanding of particular funds' 
liquidity-related risks and redemption policies. This in turn should 
assist investors in making investment choices that better match their 
risk tolerances.
    We note that, while Form N-PORT and Form N-CEN are designed 
primarily to assist the Commission and its staff, we believe that the 
information in these forms (including the liquidity-related information 
to be included in these forms) also will be valuable to investors and 
other potential users.\1173\ In particular, we believe that both 
sophisticated institutional investors and third-party users that 
provide services to retail investors may find the publically disclosed 
liquidity-related information to be useful. And we believe that 
individual investors could benefit indirectly from the information 
collected on reports on Form N-PORT through analyses prepared by third-
party service providers.
---------------------------------------------------------------------------

    \1173\ See Investment Company Reporting Modernization Adopting 
Release, supra footnote 120.
---------------------------------------------------------------------------

    The liquidity-related information that funds will be required to 
provide on Form N-PORT and Form N-CEN will enhance investor protection 
by improving the Commission's ability to monitor funds' liquidity using 
relevant and targeted data. This monitoring will permit us to analyze 
liquidity trends in individual funds, and, to the extent that liquidity 
profiles are comparable across funds, among certain types of funds and 
the fund industry as a whole, as well as to better understand funds' 
liquidity risk management practices. As discussed in our release 
adopting rules and forms to modernize investment company reporting, the 
information we receive on these reports will facilitate the oversight 
of funds and will assist the Commission, as the primary regulator of 
such funds, to better effectuate its mission to protect investors, 
maintain fair, orderly, and efficient markets, and facilitate capital 
formation.\1174\ Some commenters supported the reporting of asset-level 
liquidity classifications if such information was only provided to the 
Commission (i.e., made non-public),\1175\ although some did object to 
the disclosure regardless of whether or not it was made public.\1176\
---------------------------------------------------------------------------

    \1174\ See id.
    \1175\ See CFA Comment Letter; Dechert Comment Letter; State 
Street Comment Letter; Interactive Data Comment Letter; Nuveen 
Comment Letter; Oppenheimer Comment Letter; Charles Schwab Comment 
Letter; T. Rowe Comment Letter; Voya Comment Letter; Wellington 
Comment Letter.
    \1176\ See Federated Comment Letter; Fidelity Comment Letter; 
Invesco Comment Letter; SIFMA Comment Letter I.
---------------------------------------------------------------------------

    Form N-LIQUID will complement rule 22e-4's enhanced focus on the 
limits on illiquid investments and the highly liquid investment minimum 
discussed above by requiring reporting to the SEC every time: (1) A 
fund's assets that are illiquid investments exceed 15% of its net 
assets (as well as additional reporting when the fund's assets that are 
illiquid investments fall back to or below 15% of its net assets); and 
(2) a fund's investments in highly liquid investments that are assets 
fall below its highly liquid investment minimum for more than 7 
consecutive calendar days. This enhanced reporting could produce 
significant benefits. For example, the SEC's market monitoring capacity 
could be enhanced, in that multiple close-in-time filings by similar 
types of funds may be an indication of market stress in a market 
segment. Similarly, multiple close-in-time filings by the same fund may 
be an indication that the fund is failing to adequately manage its 
liquidity.
    Form N-PORT as adopted does not require that the asset-level 
liquidity classifications be publicly disclosed in order to address 
commenter concerns about the potential costs of such disclosure (which 
are discussed in the costs section below). This change reduces some of 
the proposal's potential public disclosure benefits. Under the 
proposal, investors--by their own efforts or via third-party products--
could have compared how assets were classified according to different 
funds' subjective approaches and resolved discrepancies across funds to 
arrive at more directly comparable fund liquidity profiles. Under the 
form as adopted, a fund will publicly disclose a new aggregate 
liquidity profile by reporting the percentage of its portfolio assigned 
to each of the four liquidity classification categories on Form N-PORT. 
This will provide a useful snapshot of fund liquidity to investors and 
will increase the amount of information available to investors about 
fund liquidity, but this snapshot may not be as informative as 
liquidity profiles under the proposed rule. The final form requires 
funds to confidentially report their investment liquidity 
classifications to the Commission via Form N-PORT. This maintains a 
major benefit of the proposal, allowing the Commission to monitor 
funds' liquidity levels and take action when significant aberrations 
are discovered.
    Similarly, the final form amendments do not require the public 
disclosure of a fund's highly liquid investment minimum in order to 
address commenter concerns, but it is not likely that this change will 
significantly reduce the benefits of reporting this minimum: The 
primary investor protection benefit of reporting the minimum via Form 
N-PORT is to encourage funds' holding of highly liquid investments that 
correspond to the liquidity risks of their strategies. By 
confidentially reporting the minimum, a fund will give the Commission 
the capability to monitor whether the minimum is an outlier relative to 
other funds with similar investment strategies. The oversight role of 
the fund's board under rule 22e-4 is yet another safeguard in this 
respect.
    Finally, Form N-PORT's requirement that funds disclose the 
percentage of the fund's highly liquid investments that it

[[Page 82250]]

has segregated to cover or pledged to satisfy margin requirements in 
connection with derivatives transactions that are classified as 
moderately liquid investments, less liquid investments, and illiquid 
investments, should more accurately reflect the amount of highly liquid 
investments that are available to manage a fund's liquidity risk. For 
example, without such a disclosure, investors might assume a fund whose 
highly liquid investments are all segregated to cover derivatives 
positions that are not highly liquid is better prepared to handle 
redemption requests than it actually is.
    Because we cannot predict the extent to which the requirements will 
enhance investors' awareness of funds' portfolio liquidity and 
liquidity risk, influence investors' investments in certain funds, or 
increase the Commission's ability to protect investors, we are unable 
to quantify the potential benefits discussed in this section.
c. Costs
    Funds will incur one-time and ongoing annual costs to comply with 
the disclosure and reporting requirements regarding liquidity and 
shareholder redemption practices. Commenters' responses to the 
estimates of these costs are discussed in the PRA discussion below, and 
we have updated all estimates in this section to reflect changes in the 
PRA.\1177\
---------------------------------------------------------------------------

    \1177\ See infra section V.
---------------------------------------------------------------------------

    We estimate that the one-time costs to comply with the amendments 
to Form N-1A will be approximately $324 per fund (plus printing 
costs).\1178\ We estimate that each fund will incur an ongoing cost 
associated with compliance with the amendments to Form N-1A of 
approximately $81 each year to review and update the disclosure 
regarding redemptions.
---------------------------------------------------------------------------

    \1178\ This estimate is based on the following calculation: 1 (1 
hour to update registration statement disclosure about redemption 
procedures) x $324 (blended rate for a compliance attorney ($340) 
and a senior programmer ($308)) = $324. This figure incorporates the 
costs we estimated for each fund to update its registration 
statement to include the required disclosure about: (i) The number 
of days in which the fund will pay redemption proceeds to redeeming 
shareholders; and (ii) the methods the fund uses to meet redemption 
requests in stressed and non-stressed market conditions. The costs 
associated with these activities are all paperwork-related costs and 
are discussed in more detail infra at section V.F.
---------------------------------------------------------------------------

    The amendments to Form N-PORT will require funds to report on Form 
N-PORT the liquidity classification of each portfolio investment, and 
we estimate that the average one-time compliance costs associated with 
this reporting will be $15,576 per fund.\1179\ Furthermore, we estimate 
that 9,347 funds will be required to file, on a monthly basis, 
additional information on Form N-PORT as a result of the 
amendments.\1180\ Assuming that 35% of funds (3,271 funds) will choose 
to license a software solution to file reports on Form N-PORT in 
house,\1181\ we estimate an upper bound on the initial annual costs to 
file the additional information associated with the amendments for 
funds choosing this option of $783 per fund \1182\ with annual ongoing 
costs of $261 per fund.\1183\ We further assume that 65% of funds 
(6,076 funds) will choose to retain a third-party service provider to 
provide data aggregation and validation services as part of the 
preparation and filing of reports on Form N-PORT,\1184\ and we estimate 
an upper bound on the initial costs to file the additional information 
associated with the amendments for funds choosing this option of $1,044 
per fund \1185\ with annual ongoing costs of $131 per fund.\1186\
---------------------------------------------------------------------------

    \1179\ This estimate is based on the following calculation: (i) 
Project planning and systems design (24 hours x $264 (hourly rate 
for a senior systems analyst) = $6,336) and (ii) systems 
modification integration, testing, installation and deployment (30 
hours x $308 (hourly rate for a senior programmer) = $9,240). $6,336 
+ $9,240 = $15,576. Estimates for drafting, integrating, 
implementing policies and procedures are addressed in the discussion 
of rule 22e-4. This figure incorporates the costs that we estimated 
associated with preparing the section of the fund's report on Form 
N-PORT that will incorporate the information that will be required 
under Item C.7. The costs associated with these activities are all 
paperwork-related costs and are discussed in more detail infra at 
section V.E. As discussed in section V.E infra, we believe that any 
external annual costs associated with filing Form N-PORT will be 
only incrementally affected by compliance with Item C.7 of Form N-
PORT, and thus Item C.7 does not affect our previous estimates of 
these costs.
    \1180\ There were 10,633 open-end funds (excluding money market 
funds, and including ETFs) as of the end of 2015. See 2016 ICI Fact 
Book, supra footnote 11, at 22, 176, 183. As discussed in note 1253, 
infra, we assume that 75% of ETFs, or 1,196 ETFs, will identify as 
In-Kind ETFs, which are exempt from the classification requirement, 
thereby reducing the total number of funds filing classification 
information to 9,347.
    \1181\ This assumption tracks the assumption made in the 
Investment Company Reporting Modernization Adopting Release that 35% 
of funds will choose to license a software solution to file reports 
on Form N-PORT. See Investment Company Reporting Modernization 
Adopting Release, supra footnote 120.
    \1182\ This estimate is based upon the following calculations: 
$783 in internal costs = ($783 = 3 hours x $261 (blended hourly rate 
for senior programmer ($308), senior database administrator ($312), 
financial reporting manager ($266), senior accountant ($192), 
intermediate accountant ($157), senior portfolio manager ($306), and 
compliance manager ($283)). We do not anticipate any change to 
external annual costs as a result of the amendments. See infra at 
section V.E. The hourly wage figures in this and subsequent 
footnotes are from SIFMA's Management & Professional Earnings in the 
Securities Industry 2013, modified by Commission staff to account 
for an 1800-hour work-year and multiplied by 5.35 to account for 
bonuses, firm size, employee benefits, and overhead.
    \1183\ This estimate is based upon the following calculations: 
$261 in internal costs ($261 = 1 hour x $261 (blended hourly rate 
for senior programmer ($308), senior database administrator ($312), 
financial reporting manager ($266), senior accountant ($192), 
intermediate accountant ($157), senior portfolio manager ($306), and 
compliance manager ($283)). We do not anticipate any change to 
external annual costs as a result of the amendments. See infra at 
section V.E.
    \1184\ This assumption tracks the assumptions made in the 
Investment Company Reporting Modernization Adopting Release that 65% 
of funds will choose to retain a third-party service provider to 
provide data aggregation and validation services as part of the 
preparation and filing of reports on Form N-PORT. See Investment 
Company Reporting Modernization Adopting Release, supra footnote 
120.
    \1185\ This estimate is based upon the following calculations: 
$1,044 in internal costs ($1,044 = 4 hours x $261 (blended hourly 
rate for senior programmer ($308), senior database administrator 
($312), financial reporting manager ($266), senior accountant 
($192), intermediate accountant ($157), senior portfolio manager 
($306), and compliance manager ($283)). We do not anticipate any 
change to external annual costs as a result of the amendments.
    \1186\ This estimate is based upon the following calculations: 
$130.5 in internal costs ($130.5 = (0.5 hours x $261 (blended hourly 
rate for senior programmer ($308), senior database administrator 
($312), financial reporting manager ($266), senior accountant 
($192), intermediate accountant ($157), senior portfolio manager 
($306), and compliance manager ($283)). We do not anticipate any 
change to external annual costs as a result of the amendments.
---------------------------------------------------------------------------

    Likewise, compliance with the amendments to Form N-CEN will involve 
ongoing costs as well as one-time costs. We estimate that 10,633 funds 
will be required to file responses on Form N-CEN as a result of the 
amendments to the form. We estimate that the one-time and ongoing 
annual compliance costs associated with providing additional responses 
to Form N-CEN as a result of the amendments will be approximately $162 
per fund.\1187\
---------------------------------------------------------------------------

    \1187\ This estimate is based on the following calculation: 0.5 
hour x $324 (blended hourly rate for a compliance attorney ($340) 
and a senior programmer ($308)) = $162. This figure incorporates the 
costs that we estimated associated with preparing the section of the 
fund's report on Form N-CEN that will incorporate the information 
that will be required under Item C.20. We do not estimate any 
additional costs in connection with proposed Item E.5 of Form N-CEN 
because the new item only requires a yes or no response. We do not 
estimate any change to the external costs associated with Form N-
CEN. The costs associated with these activities are all paperwork-
related costs and are discussed in more detail infra at section V.E.
---------------------------------------------------------------------------

    Based on these estimates, staff further estimates that the total 
one-time costs to comply with the disclosure and reporting requirements 
will be approximately $55 million for all funds that would file reports 
on Form N-PORT in house \1188\ and approximately

[[Page 82251]]

$103 million for all funds that will use a third-party service provider 
to prepare and file reports on Form N-PORT.\1189\ In addition, staff 
estimates that the total ongoing annual costs associated with the 
disclosure and reporting requirements would be approximately $1.6 
million for all funds that file reports on Form N-PORT in house \1190\ 
and approximately $2.3 million for all funds that use a third-party 
service provider to prepare and file reports on Form N-PORT.\1191\
---------------------------------------------------------------------------

    \1188\ This estimate assumes that 35% of funds (3,271 funds) 
would choose to file reports on proposed Form N-PORT in house (see 
infra section V.D) and is based on the following calculation: 3,271 
funds x $16,845 ($324 + $15,576 + $783 + $162) = $55,099,995.
    \1189\ This estimate assumes that 65% of funds (6,076) would 
choose to file reports on proposed Form N-PORT with the assistance 
of third-party service providers (see infra section V.D) and is 
based on the following calculation: 6,076 funds x $17,106 ($324 + 
$15,576 + $1,044 + $ 162) = $103,850,526.
    \1190\ This estimate is based on the following calculation: 
3,271 funds x $502.63 ($79.63 + $261 + $162) = $1,644,102.73.
    \1191\ This estimate is based on the following calculation: 
6,071 funds x $372.63 ($79.63 + $131 + $162) = $2,262,236.73
---------------------------------------------------------------------------

    Commenters expressed concern that it was not appropriate to require 
public disclosure of liquidity classifications by position via Form N-
PORT, arguing that reporting position-level liquidity classifications 
creates significant costs which outweigh the potential benefits. For 
example, they suggested this disclosure could create potential 
litigation exposures, create investor confusion surrounding the 
perceived precision of the classifications, stifle innovation in 
liquidity risk management, or facilitate predatory trading and/or 
first-mover incentives, particularly during times of stress.\1192\ We 
agree that funds could have encountered costs related to the above 
concerns if they were required to follow the disclosure regime 
contemplated in the original proposal. While investors already have 
access to fund portfolio positions, to the extent that position-level 
liquidity classifications could have been valuable to professional 
traders, predatory trading opportunities could have increased under the 
proposal. The final form mitigates these costs by requiring that a 
fund's most competitively-sensitive information--its individual 
position liquidity classifications--be filed confidentially with the 
Commission.
---------------------------------------------------------------------------

    \1192\ See, e.g., Federated Comment Letter; Dodge & Cox Comment 
Letter; PIMCO Comment Letter; Invesco Comment Letter.
---------------------------------------------------------------------------

    The costs of the adopted form amendments differ from the proposal 
in several ways. First, as discussed above, the Form N-PORT only 
requires that funds publicly disclose an aggregate liquidity profile, 
which should significantly mitigate many of the potential costs 
associated with the potential front running of mutual funds by 
sophisticated investors. Second, Form N-PORT requires a fund to 
disclose the percentage of the fund's highly liquid investments that it 
has segregated to cover or pledged to satisfy margin requirements in 
connection with derivatives transactions that are classified as 
moderately liquid investments, less liquid investments, and illiquid 
investments. By contrast, the proposed rules required a fund to pair 
each segregated asset with the derivative it was covering. The final 
rule's approach should lower costs relative to the proposal. We also 
are not requiring funds to file credit agreements as exhibits to Form 
N-1A. Many commenters objected to the proposed requirement to file line 
of credit agreements \1193\ with some arguing that such filings would 
be unnecessary because lines of credit are often already disclosed 
under existing requirements of Form N-1A, in a fund's statement of 
additional information, in footnotes to fund financial statements, and 
potentially in Form N-CEN.\1194\ In addition, commenters stated that 
public disclosure of line of credit agreements could (1) weaken their 
ability to negotiate credit terms; \1195\ (2) make public proprietary 
and competitive information; \1196\ and (3) discourage lending banks 
from granting certain lending terms to funds (out of a concern that 
terms granted would become standard in other lending agreements).\1197\ 
Removing the requirement to file credit agreements as exhibits to Form 
N-1A should, if anything, lead to a reduction in the costs associated 
with filing that form, vis-[agrave]-vis the proposed rule.
---------------------------------------------------------------------------

    \1193\ Fidelity Comment Letter; CRMC Comment Letter; Invesco 
Comment Letter; Oppenheimer Comment Letter; T. Rowe Comment Letter; 
Voya Comment Letter.
    \1194\ Oppenheimer Comment Letter; T. Rowe Comment Letter; Voya 
Comment Letter.
    \1195\ Oppenheimer Comment Letter; Fidelity Comment Letter.
    \1196\ CRMC Comment Letter; Invesco Comment Letter; Oppenheimer 
Comment Letter; Voya Comment Letter.
    \1197\ Fidelity Comment Letter.
---------------------------------------------------------------------------

    The requirement to file Form N-LIQUID in three circumstances--if 
more than 15% of a fund's net assets are, or become, illiquid 
investments that are assets; if the fund's illiquid investments that 
are assets previously exceeded 15% of net assets and the fund 
determines that its illiquid investments that are assets have changed 
to be less than or equal to 15% of net assets; or if a fund's holdings 
in highly liquid investments that are assets fall below the fund's 
highly liquid investment minimum for more than 7 consecutive calendar 
days--may impose small incremental costs on funds. The adopted rule's 
liquidity risk management framework should help encourage funds to 
avoid exceeding the 15% illiquid investment limit, but in cases where 
they must file Form N-LIQUID, there will be incidental costs associated 
with filing the form itself. There will be similar incidental costs 
associated with filing Form N-LIQUID should a fund breach its highly 
liquid investment minimum for more than 7 consecutive calendar days. We 
estimate these costs as $1,745 per filing, and estimate the total 
number of filings to be roughly 90 per year, for an aggregate cost of 
$157,050.\1198\ Finally, any potential indirect costs associated with 
filing the form, such as spillover effects or investor flight due to a 
breach, should be limited because Form N-LIQUID filings will not be 
publicly disclosed. Because Form N-LIQUID filings will be triggered by 
events that are part of a fund's periodic review of its investment 
classifications under rule 22e-4, the monitoring costs associated with 
Form N-LIQUID are included in our estimates of the compliance costs for 
rule 22e-4 above.
---------------------------------------------------------------------------

    \1198\ See infra footnotes 1280-1287 and surrounding discussion 
for more details on these estimates.
---------------------------------------------------------------------------

d. Effects on Efficiency, Competition, and Capital Formation
    We believe the final rules' disclosure requirements could increase 
informational efficiency by providing additional information about the 
aggregate liquidity profile of funds' portfolios to investors and 
third-party service providers. To the extent that aggregate liquidity 
profiles--the percentages a fund holds in each of the four liquidity 
classification categories--are comparable across funds, this could 
assist investors in evaluating the risks associated with certain funds, 
which could increase allocative efficiency by assisting investors in 
making more informed investment choices that better match their risk 
tolerances. However, because each fund has discretion in how it defines 
both the asset type and liquidity classification of its portfolio 
positions, the publicly disclosed aggregation of these classifications 
may not be directly comparable across funds; in this case, allocative 
efficiency may not be enhanced, and, if fund liquidity profiles are 
misinterpreted as being comparable, efficiency could be reduced. 
Enhanced disclosure regarding funds' liquidity and liquidity risk

[[Page 82252]]

management practices could positively affect competition by permitting 
investors to choose whether to invest in certain funds based on this 
information. However, if investors were to move their assets among 
funds as a result of the disclosure requirements (for example, if the 
disclosure made clear that a certain fund was able to generate higher 
returns than its peers only because of high exposures to relatively 
less liquid positions, which then led investors with limited risk 
tolerance to move assets out of this fund), this could negatively 
affect the competitive stance of certain funds.
    Increased investor awareness of funds' portfolio liquidity and 
liquidity risk management practices also could promote capital 
formation if investors find certain funds' liquidity profiles or risk 
management practices, or both, attractive, and this awareness promotes 
increased investment in these funds (assuming these investments consist 
of assets that were not otherwise invested in the capital markets) and 
in turn in the assets in which the funds invest. On the other hand, 
disclosure which reveals liquidity risk could negatively impact capital 
formation if the disclosure causes investors to perceive that some 
funds pose too great an investment risk. Investors could consequently 
decide not to invest in these funds or to decrease their investment in 
these funds. If these foregone investments are not reinvested elsewhere 
in capital markets, capital formation would be negatively affected. 
Conversely, to the extent that investors assume that funds investing in 
relatively less liquid investments could obtain a liquidity risk 
premium in the form of higher returns over some period of time, the 
potential for higher returns could draw certain investors to funds 
investing in relatively less liquid asset classes, which could 
positively affect capital formation. If investors shift their invested 
investments between funds based on liquidity, there could be capital 
formation effects stemming from increased (or decreased) investment in 
the funds' portfolio investments, even if the total capital invested in 
funds remains constant. For example, if fund investors move assets from 
an investment strategy that entails relatively high liquidity risk to 
one whose investment strategy involves relatively low liquidity risk, 
less liquid portfolio asset classes could experience an adverse impact 
on capital formation while the more liquid portfolio asset classes 
could experience a positive impact on capital formation, although the 
total capital invested in funds would remain constant.
    Relative to the proposal, the final disclosure and reporting 
requirements do not significantly alter our assessment of the 
requirements' impact on efficiency, competition, and capital formation. 
The exclusion of individual portfolio position classification from 
public disclosure requirements reduces the potential efficiency and 
capital formation gains that might accrue from better informed 
investors: position-level data could have been used (directly or via 
third-party vendor applications) to construct a detailed breakdown of a 
fund's liquidity profile, but any public analysis is now limited to an 
aggregate liquidity profile for each fund to address the concerns of 
commenters regarding the potential costs of disclosing position-level 
liquidity data publicly. At the same time, to the extent position-level 
liquidity classifications could be valuable to professional traders, 
requiring less public disclosure may reduce any potential 
inefficiencies that could have resulted from predatory trading or front 
running associated with the disclosure of individual investment 
classifications.
    In addition, while we are also imposing a new filing requirement 
via Form N-LIQUID, this form will be filed confidentially with the 
Commission and will only be necessary when a fund breaches the 15% 
illiquid investment limit, returns to compliance with the 15% illiquid 
investment limit, or breaches its highly liquid investment minimum for 
longer than 7 consecutive calendar days. Requiring notice to the 
Commission of these events may itself provide an incentive for funds to 
manage their liquidity in such a way as to avoid triggering the 
reporting obligation; where a reporting obligation is triggered, Form 
N-LIQUID will provide the Commission with timely information that may 
prompt the Commission to inquire further into the circumstances that 
gave rise to the requirement to file Form N-LIQUID. As discussed above, 
for example, if a number of similarly-situated funds each file a report 
in close temporal proximity to one another, or if a single fund files a 
series of reports, such information is likely to be of value to the 
Commission in taking appropriate action to protect investors, if 
required. If Form N-LIQUID provides an early warning of potential fund 
liquidity issues that is sufficiently timely and clear to permit 
Commission involvement when needed to respond to the potential for 
disruptive fund closures and associated negative consequences, 
including fund shareholder dilution and any spillover effects, Form N-
LIQUID could enhance efficiency to the extent that negative price 
pressure on investments due to fire sales is avoided and, to the extent 
mutual fund investors associate this with lower liquidity risk in the 
mutual fund industry, Form N-LIQUID may promote capital formation.
e. Reasonable Alternatives
    The following discussion addresses significant alternatives to the 
disclosure and reporting requirements. More detailed alternatives to 
the individual elements of the requirements are discussed in detail 
above.\1199\
---------------------------------------------------------------------------

    \1199\ See supra sections III.G.1.a, III.G.1.b, III.G.2.d, and 
III.G.3.c.
---------------------------------------------------------------------------

    The Commission considered requiring each fund to disclose 
information about the liquidity of its portfolio positions in the 
fund's prospectus or on the fund's Web site, in addition to in reports 
filed on Form N-PORT. For example, we could have required a fund to 
disclose its highly liquid investment minimum, or the percentage of the 
fund's portfolio invested in each of the liquidity categories specified 
under rule 22e-4(b)(2)(i), in its prospectus or on its Web site. This 
additional disclosure could further increase transparency with respect 
to funds' portfolio liquidity and liquidity-related risks. But this 
additional disclosure could inappropriately emphasize risks relating to 
a fund's portfolio liquidity over other significant risks associated 
with an investment in the fund. In addition, funds are not precluded 
from voluntarily disclosing any of the information contained in the 
rule's required disclosure forms on their Web sites, so it is likely 
more efficient to allow investor demand for this information to drive 
whether or not funds publicly disclose this information of their own 
volition.
    Conversely, the Commission also considered both limiting and 
expanding the enhancements to funds' liquidity-related disclosures on 
Form N-PORT. As discussed above, we are sensitive to the possibility 
that any amendments to the form could facilitate front-running, 
predatory trading, and other activities that could be detrimental to a 
fund and its investors. We likewise carefully considered costs and 
benefits with respect to the new liquidity-related disclosures required 
under Form N-PORT and concluded that these disclosures appropriately 
balance related costs with the benefits that could arise from the 
ability of the Commission, and members of the public, to monitor and 
analyze the liquidity of individual funds, as well as liquidity trends 
within the fund industry.

[[Page 82253]]

    In response to the proposal, which would have required that certain 
position-level data be reported publicly (albeit with a 60 day delay) 
commenters suggested that the Commission require (1) no reporting of 
any kind, or (2) no public disclosure, in light of potential negative 
competitive effects of public reporting and the limited benefits of 
stale data in understanding current fund liquidity levels.\1200\ The 
Commission considered these alternatives, but rejected the first 
alternative because it would have provided no useful information to 
investors to permit them to better understand their funds' liquidity 
profiles, and no useful information to the Commission to enable the 
Commission to better monitor funds' liquidity. With regard to the 
second alternative, providing no information to investors would have 
the same defect of not permitting investors the opportunity to assess 
and make investment decisions based on better information about funds' 
liquidity. However, recognizing commenters' concern about voluminous, 
stale data, the final form provides investors with aggregated 
information--the percentage of the funds' portfolio falling into each 
of the four liquidity categories--and reserves the more detailed data 
for confidential submission to the Commission. We believe the approach 
in the final form strikes an appropriate balance, by mitigating many of 
the concerns expressed by commenters while preserving significant 
benefits for investors (both directly, and through the Commission's 
improved ability to monitor funds).
---------------------------------------------------------------------------

    \1200\ See supra section III.C.6.
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V. Paperwork Reduction Act Analysis

A. Introduction

    New rule 22e-4 contains ``collections of information'' within the 
meaning of the Paperwork Reduction Act of 1995 (``PRA'').\1201\ In 
addition, the amendments to Form N-1A will impact the collections of 
information burden under those rules and form. The new reporting 
requirements on Form N-CEN and Form N-PORT will impact the collections 
of information burdens associated with these forms described in the 
Investment Company Reporting Modernization Adopting Release.\1202\ New 
rule 30b1-10 and new Form N-LIQUID also contain a collection of 
information within the meaning of the PRA.\1203\
---------------------------------------------------------------------------

    \1201\ 44 U.S.C. 3501 through 3521.
    \1202\ See Investment Company Reporting Modernization Adopting 
Release, supra footnote 120.
    \1203\ See rule 30b1-10 requiring certain funds to file Form N-
LIQUID.
---------------------------------------------------------------------------

    The titles for the existing collections of information are: ``Form 
N-1A under the Securities Act of 1933 and under the Investment Company 
Act of 1940, Registration Statement of Open-End Management Investment 
Companies'' (OMB Control No. 3235-0307). In the Investment Company 
Reporting Modernization Adopting Release, we submitted new collections 
of information for Form N-CEN and Form N-PORT.\1204\ The titles for 
these new collections of information are: ``Form N-CEN Under the 
Investment Company Act, Annual Report for Registered Investment 
Companies'' and ``Form N-PORT Under the Investment Company Act, Monthly 
Portfolio Investments Report.''
---------------------------------------------------------------------------

    \1204\ See Investment Company Reporting Modernization Adopting 
Release, supra footnote 120.
---------------------------------------------------------------------------

    We are submitting new collections of information for new rule 22e-
4, new rule 30b1-10, and new Form N-LIQUID under the Investment Company 
Act of 1940. The titles for these new collections of information will 
be: ``Rule 22e-4 Under the Investment Company Act of 1940, Liquidity 
risk management programs,'' ``Rule 30b1-10 Under the Investment Company 
Act of 1940, Current report for open-end management investment 
companies,'' and ``Form N-LIQUID, Current Report, Open-end Management 
Investment Company Liquidity.'' The Commission is submitting these 
collections of information to the OMB for review in accordance with 44 
U.S.C. 3507(d) and 5 CFR 1320.11. An agency may not conduct or sponsor, 
and a person is not required to respond to, a collection of information 
unless it displays a currently valid control number.
    The Commission is adopting new rule 22e-4, new rule 30b1-10, new 
Form N-LIQUID, and amendments to Form N-1A. The Commission also is 
adopting new items to Form N-CEN and Form N-PORT. The new rules and 
amendments are designed to promote effective liquidity risk management 
throughout the open-end fund industry and enhance disclosure and 
Commission oversight of fund liquidity and shareholder redemption 
practices. We discuss below the collection of information burdens 
associated with these reforms. In the Proposing Release, the Commission 
solicited comment on the collection of information requirements and the 
accuracy of the Commission's statements in the Proposing Release.

B. Rule 22e-4

    Rule 22e-4 requires a ``fund'' and an In-Kind ETF, each within the 
meaning of rule 22e-4,\1205\ to establish a written liquidity risk 
management program that is reasonably designed to assess and manage the 
fund's or In-Kind ETF's liquidity risk. This program includes policies 
and procedures that incorporate certain program elements, including: 
(i) For funds, the classification of the liquidity of a fund's 
portfolio positions; (ii) for funds and In-Kind ETFs, the assessment, 
management, and periodic review of liquidity risk (with such review 
occurring no less frequently than annually); (iii) for funds that do 
not primarily hold assets that are highly liquid investments, the 
determination of and periodic review of the fund's highly liquid 
investment minimum and establishment of policies and procedures for 
responding to a shortfall of the fund's highly liquid investment 
minimum, which includes reporting to the fund's board of directors; and 
(iv) for funds and In-Kind ETFs, the establishment of 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. The 
rule also requires board approval and oversight of a fund's or In-Kind 
ETF's liquidity risk management program and recordkeeping. Rule 22e-4 
also requires a limited liquidity review, under which a UIT's principal 
underwriter or depositor determines, on or before the date of the 
initial deposit of portfolio securities into the UIT, that the portion 
of the illiquid investments that the UIT holds or will hold at the date 
of deposit that are assets is consistent with the redeemable nature of 
the securities it issues and retains a record of such determination for 
the life of the UIT and for five years thereafter.
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    \1205\ The term ``funds'' is defined under rule 22e-4(a)(4) to 
mean an open-end management investment company that is registered or 
required to be registered under section 8 of the Act and includes a 
separate series of such an investment company, but does not include 
a registered open-end management investment company that is 
regulated as a money market fund under Sec.  270.2a-7 or an In-Kind 
ETF, as defined under rule 22e-4(a)(9).
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    The requirements under rule 22e-4 that a fund and In-Kind ETF adopt 
a written liquidity risk management program, report to the board, 
maintain a written record of how the highly liquid investment minimum 
was determined and written policies and procedures for responding to a 
shortfall of the fund's highly liquid investment

[[Page 82254]]

minimum, which includes reporting to the fund's board of directors (for 
funds that do not primarily hold highly liquid investments), establish 
written policies and procedures regarding how the fund will engage in 
redemptions in kind, and retain certain other records are all 
collections of information under the PRA. In addition, the requirement 
under rule 22e-4 that the principal underwriter or depositor of a UIT 
assess the liquidity of the UIT on or before the date of the initial 
deposit of portfolio securities into the UIT and retain a record of 
such determination for the life of the UIT, and for five years 
thereafter, is also a collection of information under the PRA. The 
respondents to rule 22e-4 will be open-end management investment 
companies (including, under certain circumstances, In-Kind ETFs but 
excluding money market funds), and the principal underwriters or 
depositors of UITs under certain circumstances.
1. Preparation of Written Liquidity Risk Management Program
    We believe that some open-end funds regularly monitor the liquidity 
of their portfolios as part of the portfolio management function, but 
they may not have written policies and procedures regarding liquidity 
management. Rule 22e-4 requires funds and In-Kind ETFs to have a 
written liquidity risk management program. We believe such a program 
will minimize dilution of shareholder interests by promoting stronger 
and more effective liquidity risk management across open-end funds and 
will reduce the risk that a fund or In-Kind ETF will be unable to meet 
redemption obligations.
    In the Proposing Release, we estimated that funds within 867 fund 
complexes would be subject to rule 22e-4.\1206\ Compliance with rule 
22e-4 would have been mandatory for all such funds. We further 
estimated that a fund complex would incur a one-time average burden of 
40 hours associated with documenting the liquidity risk management 
programs adopted by each fund within the complex. Under the proposal, 
rule 22e-4 would have required fund boards to approve the liquidity 
risk management program and any material changes to the program, and we 
estimated a one-time burden of nine hours per fund complex associated 
with fund boards' review and approval of the funds' liquidity risk 
management programs and preparation of board materials. Amortized over 
a 3-year period, we estimated this would be an annual burden per fund 
complex of about 16 hours. Accordingly, we estimated that the total 
burden for initial documentation and review of funds' written liquidity 
risk management program would be 42,483 hours.\1207\ We also estimated 
that it would cost a fund complex approximately $38,791 to document, 
review and initially approve these policies and procedures, for a total 
cost of approximately $33,631,797.\1208\
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    \1206\ See Proposing Release, supra footnote 9, at n.819 and 
accompanying text. This estimate excluded ETFs and UITs. See also 
2016 ICI Fact Book, supra footnote 11, at Fig. 1.8.
    \1207\ This estimate was based on the following calculation: (40 
+ 9) hours x 867 fund complexes = 42,483 hours.
    \1208\ These estimates were based on the following calculations: 
20 hours x $301 (hourly rate for a senior portfolio manager) = 
$6,020; 20 hours x $455.5 (blended hourly rate for assistant general 
counsel ($426) and chief compliance officer ($485)) = $9,110; 5 
hours x $4,465 (hourly rate for a board of 8 directors) = $22,325; 4 
hours (for a fund attorney's time to prepare materials for the 
board's determinations) x $334 (hourly rate for a compliance 
attorney) = $1,336. $6,020 + $9,110 + $22,325 + $1,336 = $38,791; 
$38,791 x 867 fund complexes = $33,631,797. The hourly wages used 
are from SIFMA's Management & Professional Earnings in the 
Securities Industry 2013, modified to account for an 1800-hour work-
year and multiplied by 5.35 to account for bonuses, firm size, 
employee benefits, and overhead. The staff previously estimated in 
2009 that the average cost of board of director time was $4,000 per 
hour for the board as a whole, based on information received from 
funds and their counsel. Adjusting for inflation, the staff 
estimates that the current average cost of board of director time is 
approximately $4,465.
---------------------------------------------------------------------------

    We did not receive any comments on the estimated hour and costs 
burdens associated with the overall preparation of written liquidity 
risk management programs under rule 22e-4 discussed above. We did, 
however, receive comments on the costs associated with the 
classification of the liquidity of a fund's portfolio positions, which 
we address below in connection with Form N-PORT. The Commission has 
modified the estimated increase in annual burden hours and total time 
costs that will result from the new written liquidity risk management 
requirements of rule 22e-4 based on certain modifications made to rule 
22e-4 and updates to the industry data figures that were utilized in 
the Proposing Release. Based upon our review of industry data, we 
estimate that funds within 873 fund complexes would be subject to rule 
22e-4,\1209\ updated from 867 in our proposal. Compliance with rule 
22e-4 will be mandatory for all such funds and In-Kind ETFs, with 
certain program elements applicable to certain funds within a fund 
complex based upon whether the fund is an In-Kind ETF or does not 
primarily hold assets that are highly liquid investments, as noted 
above. We discuss mandatory compliance with rule 22e-4 with respect to 
principal underwriters and depositors of UITs in section V.B.5. below.
---------------------------------------------------------------------------

    \1209\ See 2016 ICI Fact Book, supra footnote 11, at Fig. 1.8.
---------------------------------------------------------------------------

    The Commission continues to estimate that a fund complex will incur 
a one-time average burden of 40 hours associated with documenting the 
liquidity risk management programs adopted by each fund within a fund 
complex. In light of the requirement that a fund subject to the highly 
liquid investment minimum requirement adopt and implement policies and 
procedures for responding to a shortfall of the fund's highly liquid 
investment minimum, and responding to any potential excesses of the 15% 
illiquid asset limit, both of which include reporting to the fund's 
board of directors, we estimate a one-time burden of 10 hours, rather 
than 9 hours, per fund complex associated with fund boards' review and 
approval of the funds' liquidity risk management programs and 
preparation of board materials. Amortized over a 3-year period, we 
estimate this will be an annual burden per fund complex of about 16.67 
hours. Accordingly, we estimate that the total burden for initial 
documentation and review of funds' written liquidity risk management 
program will be 43,650 hours.\1210\ We also estimate that it will cost 
a fund complex approximately $41,467.5 to document, review, and 
initially approve these policies and procedures, for a total cost of 
approximately $36,201,127.5.\1211\
---------------------------------------------------------------------------

    \1210\ This estimate is based on the following calculation: (40 
+10) hours x 873 fund complexes = 43,650 hours.
    \1211\ These estimates are based on the following calculations: 
20 hours x $306 (hourly rate for a senior portfolio manager) = 
$6,120; 20 hours x $463 (blended hourly rate for assistant general 
counsel ($433) and chief compliance officer ($493)) = $9,260; 5.5 
hours x $4,465 (hourly rate for a board of 8 directors) = $24,557.5; 
4.5 hours (for a fund attorney's time to prepare materials for the 
board's determinations) x $340 (hourly rate for a compliance 
attorney) = $1,530. $6,120 + $9,260 + $24,557.5 + $1,530 = 
$41,467.5; $41,467.5 x 873 fund complexes = $36,201,127.5. The 
hourly wages used are from SIFMA's Management & Professional 
Earnings in the Securities Industry 2013, modified by Commission 
staff to account for an 1800-hour work-year and inflation, and 
multiplied by 5.35 to account for bonuses, firm size, employee 
benefits, and overhead. The staff previously estimated in 2009 that 
the average cost of board of director time was $4,000 per hour for 
the board as a whole, based on information received from funds and 
their counsel. Adjusting for inflation, the staff estimates that the 
current average cost of board of director time is approximately 
$4,465.
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2. Reporting Regarding the Highly Liquid Investment Minimum
    Rule 22e-4 requires any fund that does not primarily hold assets 
that are highly liquid investments to determine

[[Page 82255]]

a highly liquid investment minimum for the fund, which must be reviewed 
at least annually, and may not be changed during any period of time 
that a fund's assets that are highly liquid investments are below the 
determined minimum without approval from the fund's board of 
directors.\1212\ The fund's investment adviser or officers designated 
to administer the liquidity risk management program must provide a 
written report to the fund's board at least annually that describes a 
review of the adequacy and effectiveness of the fund's liquidity risk 
management program, including, if applicable, the operation of the 
highly liquid investment minimum.\1213\ In addition, the fund must 
adopt and implement policies and procedures for responding to a 
shortfall of the fund's assets that are highly liquid investments below 
its highly liquid investment minimum, which must include reporting to 
the fund's board of directors with a brief explanation of the causes of 
the shortfall, the extent of the shortfall, and any actions taken in 
response, and, if the shortfall lasts more than 7 consecutive calendar 
days, an explanation of how the fund plans to come back into compliance 
with its minimum within a reasonable period of time.\1214\
---------------------------------------------------------------------------

    \1212\ See rule 22e-4(b)(1)(iii)(A).
    \1213\ See rule 22e-4(b)(3)(iii).
    \1214\ See rule 22e-4(b)(1)(iii)(A)(3).
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    Similar to the highly liquid investment minimum, in the Proposing 
Release, we proposed that funds be required to establish a three-day 
liquid asset minimum as part of a fund's liquidity risk management 
program, subject to board review, and we estimated that, for each fund 
complex, compliance with this reporting requirement would entail: (i) 
Five hours of portfolio management time, (ii) five hours of compliance 
time, (iii) five hours of professional legal time and (iv) 2.5 hours of 
support staff time, requiring an additional 17.5 burden hours at a time 
cost of approximately $5,193 per fund complex to draft the required 
report to the board.\1215\ We estimated that the total burden for 
preparation of the board report would be 15,173 hours, at an aggregate 
cost of $4,502,331.\1216\
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    \1215\ This estimate was based on the following calculation: 5 
hours x $301 (hourly rate for a senior portfolio manager) = $1,505; 
5 hours x $283 (hourly rate for compliance manager) = $1,415; 5 
hours x $426 (hourly rate for assistant general counsel) = $2,130; 
and 2.5 hours x $57 (hourly rate for general clerk) = $143. $1,505 + 
$1,415 + $2,130 + $143 = $5,193. The hourly wages used were from 
SIFMA's Management & Professional Earnings in the Securities 
Industry 2013, modified to account for an 1800-hour work-year and 
multiplied by 5.35 to account for bonuses, firm size, employee 
benefits, and overhead. The hourly wage used for the general clerk 
was from SIFMA's Office Salaries in the Securities Industry 2013, 
modified to account for an 1800-hour work-year and multiplied by 
2.93 to account for bonuses, firm size, employee benefits, and 
overhead.
    Because, under the proposal, each fund within a fund complex 
would be required to determine its own three-day liquid asset 
minimum, this estimate assumed that the report at issue would 
incorporate an assessment of the three-day liquid asset minimum for 
each fund within the fund complex.
    \1216\ These estimates were based on the following calculations: 
867 fund complexes x 17.5 hours = 15,173 hours; and $5,193 x 867 
fund complexes = $4,502,331.
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    We received several comments addressing, in general, the potential 
costs associated with a fund establishing and implementing a liquid 
asset minimum. To minimize the costs of implementing a liquid asset 
minimum, one commenter recommended that funds that have demonstrated a 
history of investing in only three-day liquid assets be excluded from 
the proposed three-day liquid asset minimum requirements and thus not 
incur the costs of related board reporting requirements.\1217\ Other 
commenters characterized the program requirements under the proposal as 
a one-size-fits-all approach to liquidity risk management and expressed 
the belief that such requirements were expensive and unsuitable for 
many funds.\1218\
---------------------------------------------------------------------------

    \1217\ See CFA Comment Letter.
    \1218\ See, e.g., Dechert Comment Letter; Federated Comment 
Letter.
---------------------------------------------------------------------------

    As discussed above, the Commission has modified the proposed three-
day liquid asset minimum requirement to a highly liquid investment 
minimum requirement that is tailored to apply only to funds that do not 
primarily hold highly liquid investments, thereby potentially reducing 
the number of funds required to establish, maintain, and report a 
highly liquid investment minimum. In addition, the final rule retains a 
role for the board in overseeing the fund's liquidity risk management 
program, but eliminates certain of the more specific and detailed 
approval requirements originally proposed.\1219\ Unlike the proposal, 
however, rule 22e-4 requires a fund that is subject to the highly 
liquid investment minimum requirement to also adopt and implement 
policies and procedures to respond to a shortfall of assets that are 
highly liquid investments below the fund's highly liquid investment 
minimum, which includes reporting to the fund's board of directors.
---------------------------------------------------------------------------

    \1219\ See supra section III.H.3.
---------------------------------------------------------------------------

    In light of these modifications, we estimate that the burdens 
associated with board reporting will decrease overall in comparison to 
the proposal due to the elimination of certain board oversight 
requirements originally proposed and the potential reduction in the 
number of funds that would require board oversight of a highly liquid 
investment minimum. Therefore, we have modified the estimated annual 
burden hours and total costs that will result from the highly liquid 
investment minimum requirement under rule 22e-4.\1220\ We estimate 
that, for each fund complex, compliance with the reporting requirement 
would entail: (i) 4 Hours, rather than five hours, of portfolio 
management time; (ii) 4 hours, rather than five hours, of compliance 
time; (iii) 4 hours, rather than five hours, of professional legal 
time; and (iv) 2 hours, rather than 2.5 hours, of support staff time, 
requiring an additional 14 burden hours at a time cost of approximately 
$4,224 per fund complex to draft the required report to the 
board.\1221\ We estimate that fund complexes will have at least one 
fund that will be subject to the highly liquid investment minimum 
requirement. Thus, we estimate that 873 fund complexes will be subject 
to this requirement under rule 22e-4 and that the total burden for 
preparation of the board report associated will be 12,222 hours, at an 
aggregate cost of $3,687,552.\1222\
---------------------------------------------------------------------------

    \1220\ Under the proposal, because each fund within a fund 
complex would have been required to determine its own three-day 
liquid asset minimum, the estimate under the proposal assumed that 
the report at issue would incorporate an assessment of the three-day 
liquid asset minimum for each fund within the fund complex. As 
adopted, rule 22e-4 only requires the assessment of the highly 
liquid investment minimum for funds that do not primarily hold 
assets that are highly liquid investments.
    \1221\ The estimate is based on the following calculation: 4 
hours x $306 (hourly rate for a senior portfolio manager) = $1,224; 
4 hours x $288 (hourly rate for compliance manager) = $1,152; 4 
hours x $433 (hourly rate for assistant general counsel) = $1,732; 
and 2 hours x $58 (hourly rate for general clerk) = $116. $1,224 + 
$1,152 + $1,732 + $116 = $4,224. The hourly wages used are from 
SIFMA's Management & Professional Earnings in the Securities 
Industry 2013, modified by Commission staff to account for an 1800-
hour work-year and inflation, and multiplied by 5.35 to account for 
bonuses, firm size, employee benefits, and overhead. The hourly wage 
used for the general clerk is from SIFMA's Office Salaries in the 
Securities Industry 2013, modified by Commission staff to account 
for an 1800-hour work-year and inflation, and multiplied by 5.35 to 
account for bonuses, firm size, employee benefits, and overhead.
    \1222\ These estimates are based on the following calculations: 
873 fund complexes x 14 hours =12,222 hours; and $4,224 x 873 fund 
complexes = $3,687,552.
---------------------------------------------------------------------------

3. Recordkeeping
    Final rule 22e-4 requires a fund or In-Kind ETF to maintain a 
written copy of the policies and procedures adopted pursuant to its 
liquidity risk management program for five years in

[[Page 82256]]

an easily accessible place.\1223\ The rule also requires a fund to 
maintain copies of materials provided to the board in connection with 
its initial approval of the liquidity risk management program and any 
written reports provided to the board, for at least five years, the 
first two years in an easily accessible place.\1224\ If applicable, a 
fund must also maintain a written record of how its highly liquid 
investment minimum and any adjustments to the minimum were determined, 
as well as any reports to the board regarding a shortfall in the fund's 
highly liquid investment minimum, for five years, the first two years 
in an easily accessible place.\1225\ The retention of these records 
would be necessary to allow the staff during examinations of funds to 
determine whether a fund is in compliance with the liquidity risk 
management program requirements.
---------------------------------------------------------------------------

    \1223\ See rule 22e-4(b)(4)(i).
    \1224\ See rule 22e-4(b)(4)(ii).
    \1225\ See rule 22e-4(b)(4)(iii).
---------------------------------------------------------------------------

    Under the proposal, the recordkeeping requirements were 
substantially similar to those being adopted. In the Proposing Release, 
we estimated that the burden to retain these records would be five 
hours per fund complex, with 2.5 hours spent by a general clerk and 2.5 
hours spent by a senior computer operator, with an estimated time cost 
per fund complex of $361.\1226\ We also estimated that the total burden 
for recordkeeping related to the liquidity risk management program 
would be 4,335 hours, at an aggregate cost of $312,987.\1227\
---------------------------------------------------------------------------

    \1226\ This estimate was based on the following calculations: 
2.5 hours x $57 (hourly rate for a general clerk) = $143; 2.5 hours 
x $87 (hour rate for a senior computer operator) = $218. $143 + $218 
= $361.
    \1227\ This estimate was based on the following calculations: 
867 fund complexes x 5 hours = 4,335 hours. 867 fund complexes x 
$361 = $312,987.
---------------------------------------------------------------------------

    We did not receive any comments on the estimated hour and cost 
burdens associated with the recordkeeping requirements of rule 22e-4. 
The Commission has modified the estimated increase in annual burden 
hours and total time costs that will result from these requirements in 
light of modifications to change those subject to the requirements to 
funds and In-Kind ETFs and to require them to maintain reports to 
boards concerning a shortfall of the fund's highly liquid investment 
minimum and the new requirement to retain records submitted to the 
board related to shortfalls of the minimum. We believe that, on an 
annual basis, the burden to retain records in connection with rule 22e-
4 will be four hours, rather than five hours per fund complex, with 2 
hours, rather than 2.5 hours, spent by a general clerk, and 2 hours, 
rather than 2.5 hours, spent by a senior computer operator, with an 
estimated time cost per fund complex of $292, rather than $361, based 
on updated data concerning funds and fund personnel salaries.\1228\ In 
addition, we estimate that the total burden for recordkeeping related 
to the liquidity risk management program requirement of rule 22e-4 will 
be 3,492 hours, rather than 4,335 hours, at an aggregate cost of 
$254,916, rather than $312,987.\1229\
---------------------------------------------------------------------------

    \1228\ This estimate is based on the following calculations: 2 
hours x $58 (hourly rate for a general clerk) = $116; 2 hours x $88 
(hour rate for a senior computer operator) = $176. $116 + $176 = 
$292.
    \1229\ This estimate is based on the following calculations: 873 
fund complexes x 4 hours = 3,492 hours. 873 fund complexes x $292 = 
$254,916.
---------------------------------------------------------------------------

4. Estimated Total Burden for Open-End Funds
    Amortized over a three-year period, we estimate that the hour 
burdens and time costs associated with rule 22e-4 for open-end funds, 
including the burden associated with (1) funds' initial documentation 
and review of the required written liquidity risk management program, 
(2) reporting to a fund's board regarding the fund's highly liquid 
investment minimum, and (3) recordkeeping requirements will result in 
an average aggregate annual burden of 26,190 hours, rather than 28,611 
hours as proposed, and average aggregate time costs of $14,780,326.5, 
rather than $14,431,215 as proposed.\1230\ We continue to estimate that 
there are no external costs associated with this collection of 
information.
---------------------------------------------------------------------------

    \1230\ These estimates are based on the following calculations: 
43,650 hours (year 1) + (2 x 12,222 hours) (years 2 and 3) + (3 x 
3,492 hours) (years 1, 2 and 3) / 3 = 26,190 hours; $36,201,127.5 
(year 1) + (2 x $3,687,552) (years 2 and 3) + (3 x $254,916) (years 
1, 2 and 3) / 3 = $14,780,326.5.
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5. UIT Liquidity Determination
    As discussed above, we recognize that UITs may in some 
circumstances be subject to liquidity risk (particularly where the UIT 
is not a pass-through vehicle and the sponsor does not maintain an 
active secondary market for UIT shares). We believe that UITs may not 
have written policies and procedures regarding liquidity management and 
are adopting a new requirement under rule 22e-4 with respect to UITs. 
On or before the date of initial deposit of portfolio securities into a 
registered UIT, the UIT's principal underwriter or depositor is 
required to determine that the portion of the illiquid investments that 
the UIT holds or will hold at the date of deposit that are assets is 
consistent with the redeemable nature of the securities it issues, and 
maintain a record of that determination for the life of the UIT and for 
five years thereafter. The retention of these records would be 
necessary to allow the staff during examinations to determine whether a 
UIT is in compliance with the liquidity risk assessment required under 
rule 22e-4. This assessment would occur on or before the initial 
deposit of portfolio securities of a new UIT and thus would only need 
to occur once. Maintenance of the records would be required for the 
life of the UIT and for five years thereafter.
    We estimate that 1615 newly registered UITs will be subject to the 
UIT liquidity determination requirement under rule 22e-4 each 
year.\1231\ Compliance with rule 22e-4(c) will be mandatory for all 
principal underwriters or depositors of such UITs. We estimate that the 
principal underwriter or depositor of a UIT will incur a one-time 
average burden of 10 hours to document its determination that the 
portion of the illiquid investments that the UIT holds or will hold at 
the date of deposit that are assets is consistent with the redeemable 
nature of the securities it issues. Amortized over a 3 year period, we 
estimate this would be an annual burden per UIT of about 3 hours. 
Accordingly, we estimate that the total burden for the initial 
documentation and review of funds' written liquidity risk management 
program would be 16,150 hours.\1232\ We also estimate that it will cost 
the principal underwriter or depositor of a UIT approximately $2,466 to 
perform and document this review, for a total cost of approximately 
$3,982,590.\1233\
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    \1231\ This estimate is based upon staff review of new UIT 
registration statements and semi-annual reporting on Form N-SAR 
filed with the Commission and Monthly Unit Investment Trust Data 
released by the Investment Company Institute, available at https://www.ici.org/research/stats, for the months of January through 
December of 2015.
    \1232\ This estimate is based on the following calculation: 10 
hours x 1615 new UITs = 16,150 hours.
    \1233\ These estimates are based on the following calculations: 
5 hours x $308 (hourly rate for a senior programmer) = $1540; 2 
hours x $463 (blended hourly rate for assistant general counsel 
($433) and chief compliance officer ($493)) = $926. $1,540 + $926 = 
$2,466; $2,466 x 1615 estimated new UITs = $3,982,590. The hourly 
wages used are from SIFMA's Management & Professional Earnings in 
the Securities Industry 2013, modified by Commission staff to 
account for an 1800-hour work-year and inflation, and multiplied by 
5.35 to account for bonuses, firm size, employee benefits, and 
overhead.
---------------------------------------------------------------------------

    We estimate that the burden to retain these records will be two 
hours per UIT, with 1 hour spent by a general clerk and 1 hour spent by 
a senior computer operator, with an estimated time cost

[[Page 82257]]

per UIT of $146.\1234\ We also estimate that the total burden for 
recordkeeping related to the liquidity risk management program will be 
3,230 hours, at an aggregate cost of $235,790.\1235\ We estimate that 
there are no external costs associated with this collection of 
information.
---------------------------------------------------------------------------

    \1234\ This estimate is based on the following calculations: 1 
hour x $58 (hourly rate for a general clerk) = $58; 1 hours x $88 
(hour rate for a senior computer operator) = $88. $58 + 88 = $146.
    \1235\ This estimate is based on the following calculations: 
1615 UITs x 2 hours = 3,230 hours. 1615 UITs x $146 = $235,790.
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C. Form N-PORT

    Today, the Commission is adopting Form N-PORT, which will require 
funds to report information within thirty days after the end of each 
month about their monthly portfolio holdings to the Commission in a 
structured data format.\1236\ Preparing a report on Form N-PORT is 
mandatory and a collection of information under the PRA, and the 
information required by Form N-PORT will be data-tagged in XML format. 
Except for certain reporting items specified in the form, responses to 
the reporting requirements will be kept confidential for reports filed 
with respect to the first two months of each quarter; the third month 
of the quarter will not be kept confidential, but made public sixty 
days after the quarter end.
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    \1236\ See Investment Company Reporting Modernization Adopting 
Release, supra footnote 120.
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    In the Investment Company Reporting Modernization Adopting Release, 
we estimate that, for the 35% of funds that would file reports on Form 
N-PORT in house, the per fund average aggregate annual hour burden will 
be 144 hours per fund, and the average cost to license a third-party 
software solution will be $4,805 per fund per year.\1237\ For the 
remaining 65% of funds that would retain the services of a third party 
to prepare and file reports on Form N-PORT on the fund's behalf, we 
estimate that the average aggregate annual hour burden will be 125 
hours per fund, and each fund will pay an average fee of $11,440 per 
fund per year for the services of third-party service provider. In sum, 
we estimate that filing reports on Form N-PORT will impose an average 
total annual hour burden of 144 hours on applicable funds, and all 
applicable funds will incur on average, in the aggregate, external 
annual costs of $103,787,680, or $9,118 per fund.\1238\
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    \1237\ See id. at n. 1426 and accompanying text.
    \1238\ See id. at n. 1499 and accompanying text.
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    Today, we are also adopting amendments to Form N-PORT concerning 
liquidity information that require a fund to report information about 
the fund's highly liquid investment minimum (if applicable),\1239\ the 
liquidity classification for each portfolio investment among four 
liquidity categories (with the fourth category covering investments 
that qualify as ``illiquid investments'' under the 15% illiquid 
investment limit),\1240\ certain information on the percentage of the 
fund's highly liquid investments that is segregated to cover, or 
pledged to satisfy margin requirements in connection with, fund's 
derivatives transactions in each of the other liquidity 
categories,\1241\ and the aggregate percentage of the fund representing 
each of the four liquidity categories.\1242\ Unlike the proposal, the 
amendments adopted today will not require funds to indicate the dollar 
amount attributable to different classifications for different portions 
within a given holding.\1243\ We believe that requiring funds to report 
information about the liquidity of portfolio investments will enhance 
the Commission's ability to assess liquidity risk in the open-end fund 
industry and assist in our regulatory oversight efforts. Moreover, we 
believe that this information will help investors and other potential 
users of information on Form N-PORT better understand the liquidity 
risks in funds.
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    \1239\ See Item B.7 of Form N-PORT.
    \1240\ See Item C.7.a of Form N-PORT.
    \1241\ See Item C.7.b of Form N-PORT. The fourth classification 
category incorporates data that, under the proposal, would have been 
reported as a 15% standard asset in response to proposed Item C.7 of 
proposed Form N-PORT.
    \1242\ See Item C.7.c of Form N-PORT.
    \1243\ See supra section III.C
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1. Liquidity Classification
    Under rule 22e-4(b)(1)(ii), an open-end management investment 
company (other than a money market fund or an In-Kind ETF) is required 
as part of its liquidity risk management program to clas