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

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

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

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

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.
---------------------------------------------------------------------------

    \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.
---------------------------------------------------------------------------

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).
---------------------------------------------------------------------------

    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\

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.
---------------------------------------------------------------------------

    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\
---------------------------------------------------------------------------

    \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

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).

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.
---------------------------------------------------------------------------

    \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.
---------------------------------------------------------------------------

    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\
---------------------------------------------------------------------------

    \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

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\

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

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

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.

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

    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

by the investor (e.g., check, wire, automated clearing house).\919\
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    \919\ See Item 11(c)(7) of Form N-1A.
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    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\
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    \920\ See id. (emphasis added).
    \921\ See Proposing Release, supra footnote 9, section
III.G.1.a.
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    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\
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    \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.
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    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).
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    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\
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    \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.
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    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

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.
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    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.
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    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\
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    \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

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