ad-hoc basis as conditions demand.\350\ As discussed below, the fund's
investment adviser or officers administering the fund's liquidity risk
management program would be required to submit written reports to the
fund's board concerning the adequacy of the fund's liquidity risk
management program, including the fund's three-day liquid asset
minimum, and the effectiveness of its implementation. Board approval
would be required for any changes to the fund's three-day liquid asset
minimum.\351\ Each fund would be required to maintain a copy of the
written reports provided to the board, as well as a written record of
the fund's assessment of the factors set forth in rule 22e-
4(b)(2)(iii)(A) through (D) and the determination of the three-day
liquid asset minimum, and any reviews and adjustments to the fund's
three-day liquid asset minimum.\352\
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    \349\ Proposed rule 22e-4(b)(2)(iv)(B).
    \350\ See infra paragraph following note 352.
    \351\ See infra section III.D (discussing the board's role in
approving and overseeing a fund's liquidity risk management
program); see also proposed rule 22e-4(b)(3)(i) and (ii). We note
that a fund may hold more three-day liquid assets than required by
the three-day liquid asset minimum. Thus, a fund may determine it is
appropriate to increase its minimum holdings in three-day liquid
assets without waiting for the next board meeting (or calling a
special meeting) to formally approve an increase in the minimum.
    \352\ See supra note 331.
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    Because we anticipate that a fund would rely significantly on its
three-day liquid assets in meeting fund redemptions, we view the three-
day liquid asset minimum determination as a cornerstone of a fund's
liquidity risk management, and we believe it is important for a fund to
periodically reassess whether its three-day liquid asset minimum
effectively assists the fund in managing its liquidity risk. We
envision the determination of a fund's three-day liquid asset minimum
as a dynamic process, incorporating new or updated information into the
fund's assessment of factors, reflecting shareholder-related, fund-
management-oriented, or market changes that could affect the fund's
ability to meet redemptions. A fund's three-day liquid asset minimum
could become outdated for multiple reasons. For example, a fund's
shareholder ownership concentration could change or market events could
reveal that shareholder redemption patterns are different than
anticipated under certain circumstances. Additionally, market events or
national regulatory, monetary, and fiscal policies could affect the
liquidity of a fund's portfolio assets. Any of these events, or similar
events influencing a fund's cash flows, portfolio liquidity, or the
other liquidity risk factors included in proposed rule 22e-
4(b)(2)(iii), could alter the level of three-day liquid assets that a
fund would determine appropriate to manage its liquidity risk.
    Like the proposed requirements to perform an ongoing review of the
liquidity of portfolio assets and to review periodically the fund's
liquidity risk,\353\ the proposed three-day liquid

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

    \353\ See supra note 323 and accompanying text.
---------------------------------------------------------------------------

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

with this requirement? Should we limit the extent to which a fund can
fall below its three-day liquid asset minimum? If so, what extent
should be the limit?
     Should the board be required to approve the fund's three-
day liquid asset minimum and any changes to the three-day liquid asset
minimum? Why or why not?
    We request comment on how the three-day liquid asset minimum
requirement (or a similar requirement) could affect the management of a
fund's liquidity risk, decrease the probability that the fund will be
able to meet redemption obligations only through activities that could
materially affect the fund's NAV or risk profile, and mitigate
dilution.
     What range of levels of three-day liquid assets do
commenters anticipate different funds would determine to be
appropriate, based on the factors the proposed rule would require a
fund to consider? What types of securities do commenters anticipate
that different funds would determine are or are not appropriate as
three-day liquid asset minimum holdings?
     How many funds today target a minimum level of more liquid
assets? If some funds indeed aim to invest a certain portion of their
assets in more liquid assets for purposes of liquidity risk management,
what types of assets do funds hold for these purposes, and how do funds
determine what portion of their net assets they intend to invest in
these assets? What burdens and other difficulties, if any, would funds
have in initially complying with the three-day liquid asset minimum
requirement?
     What are the processes that commenters anticipate a fund
would use for determining and reviewing its three-day liquid asset
minimum under the proposed rule? Do commenters generally agree with the
guidance that the Commission has provided regarding the processes a
fund could use to determine and review its three-day liquid asset
minimum? Should the minimum frequency of the fund's review of the
adequacy of its three-day liquid asset minimum be shorter than semi-
annually (such as quarterly) or longer (such as annually)?
     Should the Commission specify certain procedures that a
fund must use in determining its three-day liquid asset minimum, such
as requiring a fund to consider specific historical redemption
scenarios? Should we require that the minimum not be less than, for
example, a fund's highest historical level of net redemptions, its
average level of net redemptions over some time period, or a multiple
(e.g., two times) of those levels?
    We request comment on the proposed factors that each fund would be
required to consider in determining and reviewing its three-day liquid
asset minimum.
     To what extent do funds already consider the proposed
factors when determining the portion of fund assets that should be
invested in more liquid assets for purposes of liquidity risk
management? Do commenters believe it is appropriate for a fund to
consider the same set of factors in determining and reviewing its
three-day liquid asset minimum as it considers in assessing and
reviewing its liquidity risk? Are there other factors that would be
preferable?
     Should any of the proposed factors not be required to be
considered by a fund in determining and reviewing its three-day liquid
asset minimum? Should any of the proposed factors be modified? Are
there any additional factors, besides the proposed factors, that a fund
should be required to consider?
     Instead of codifying the proposed factors as part of
proposed rule 22e-4, should the Commission provide guidance on factors
that may be appropriate for a fund to consider in determining and
reviewing its three-day liquid asset minimum? Should the Commission
provide additional guidance on the proposed factors?
4. Portfolio Liquidity: Limitation on Funds' Investments in 15%
Standard Assets
a. 15% Standard Assets
    Included in proposed rule 22e-4 is a limit on a fund's ability to
acquire ``15% standard assets.'' Specifically, proposed rule 22e-
4(b)(2)(iv)(D) would prohibit a fund from acquiring any 15% standard
asset if, immediately after the acquisition, the fund would have
invested more than 15% of its net assets in 15% standard assets. The
provision would not require a fund to divest any holdings if 15%
standard assets rise above 15% of its net assets.\354\
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    \354\ A fund's investments in 15% standard assets could rise
above 15% of the fund's net assets for a variety of reasons. For
instance, the fund could sell its most liquid assets in order to
obtain cash to meet redemption requests, thereby increasing its
holdings of 15% standard assets relative to its total holdings. Or,
if the market value of a fund's 15% standard assets rises relative
to the market value of the fund's other assets, the percentage of a
fund's assets invested in 15% standard assets could increase. Assets
that are not 15% standard assets also could become 15% standard
assets if market conditions deteriorate. See supra note 345
(discussing similar considerations with respect to a fund's holdings
of three-day liquid assets).
---------------------------------------------------------------------------

    Under proposed rule 22e-4(a)(4), a 15% standard asset would be
defined as any asset that may not be sold or disposed of in the
ordinary course of business within seven calendar days at approximately
the value ascribed to it by the fund.\355\ For purposes of the proposed
definition, a fund would not be required to take into account the size
of the fund's position in the asset or the time period associated with
receipt of proceeds of sale or disposition of the asset. We believe
that assets included in the definition of 15% standard asset would be
consistent with those currently classified as illiquid by funds under
the 15% guideline, and that such a limit would be an important
limitation on certain relatively illiquid holdings in funds'
portfolios, such as private equity investments, securities acquired in
an initial public offering, and real estate assets. As noted above, we
believe that the 15% guideline has generally caused funds to limit
their exposure to particular types of securities that cannot be sold
within seven days and the proposed limit on 15% standard assets would
continue to limit these exposures.
---------------------------------------------------------------------------

    \355\ As discussed above, under the 15% guideline, a portfolio
security or other asset is considered illiquid if it cannot ``be
sold or disposed of in the ordinary course of business within seven
days at approximately the value at which the mutual fund has valued
the investment.'' See supra note 93. Rule 2a-7(a)(20) defines the
term ``illiquid security'' to mean ``a security that cannot be sold
or disposed of in the ordinary course of business within seven
calendar days at approximately the value ascribed to it by the
fund.'' We understand the terms ``approximately the value at which
the . . . fund has valued the investment'' and ``approximately the
value ascribed to it by the fund'' to have identical meanings. For
the sake of consistency with the language of current rule 2a-7, the
definition of 15% standard asset incorporates the ``approximately
the value ascribed to it by the fund'' formulation.
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    As discussed above, the Commission and staff have in the past
provided guidance in connection with the 15% guideline.\356\ We propose
to withdraw this guidance because we believe this proposal provides a
more comprehensive framework for funds to evaluate the liquidity of
their assets. We request comment below on whether additional guidance
is needed in connection with the definition of 15% standard asset.
---------------------------------------------------------------------------

    \356\ See supra section II.D.2.
---------------------------------------------------------------------------

    We believe that the proposed limit on 15% standard assets and the
proposed three-day liquid asset minimum each serve distinctly
important, but interrelated, roles in managing liquidity risk. We
therefore propose to require each fund to comply with the limit on 15%
standard assets as well as the three-day liquid asset minimum
requirement. While the three-day liquid

asset minimum requirement would increase the likelihood that each fund
holds adequate liquid assets to meet redemption requests without
materially affecting the fund's NAV, the limit on 15% standard assets
would increase the likelihood that a fund's portfolio is not
concentrated in assets whose liquidity is limited and thus may serve as
a limit on certain cases of fund illiquidity. While we considered
requiring a different percentage-based ceiling on relatively illiquid
holdings, we ultimately decided that proposing the 15% standard would
effectively accomplish our intended goals while disrupting funds'
existing practices to the least extent possible.
    While this definition is similar to the definition of an asset that
cannot be converted to cash within seven days under the proposed
liquidity classification framework, we note several key differences
between the definitions. When determining whether an asset may be sold
or disposed of within seven calendar days for purposes of assessing
whether the asset is a 15% standard asset, a fund need not consider
whether it can receive the proceeds of such sale or disposition within
the same seven-day time period. In contrast, the classification
framework takes into consideration whether a fund could convert an
asset to cash--that is, sell the asset and receive cash for the sale
within this period. Also, the definition of 15% standard asset does not
require a fund to consider any specific factors in determining the
circumstances under which an asset may be sold or disposed of. The
definition of less liquid asset, on the other hand, requires a fund to
consider, as applicable, certain market, trading, and asset-specific
factors set forth in proposed rule 22e-4(b)(2)(ii).\357\ These factors
include the size of a fund's position in a particular portfolio asset
relative to the asset's average daily trading volume and (as
applicable) the number of units of the asset outstanding, which a fund
is not required to assess in determining whether an asset is a 15%
standard asset.\358\
---------------------------------------------------------------------------

    \357\ Proposed rule 22e-4(a)(6).
    \358\ See supra section II.D.2.
---------------------------------------------------------------------------

    To provide an example of the distinctions between the proposed 15%
standard and the proposed three-day liquid asset minimum, consider a
fund that holds a very large block of a particular security ``X''.
Because the fund holds a large block of the issue, it may determine,
based on the liquidity classification factors required to be considered
under the proposed rule, that it could convert a certain percentage
(e.g., 70%) of its position to cash in fewer than three business days,
but that it would take more than three business days to convert the
remainder of its position to cash. Under the proposed rule, 70% of the
fund's position in security ``X'' would be considered three-day liquid
assets, and the other 30% would be considered to be less liquid assets.
The fund would take these classifications into account when considering
whether the further acquisition of less liquid assets would cause the
fund to not be in compliance with its three-day liquid asset minimum.
However, even though 30% of the fund's position in security ``X'' would
be considered to be less liquid assets, the fund's position in security
``X'' would not also be considered to be 15% standard assets. This is
because, as discussed above, a fund is not required to assess position
size in determining whether a particular portfolio asset is a 15%
standard asset. Thus, if a fund can sell a standard size lot of its
holdings in that position within seven days at approximately the value
ascribed to it by the fund, the entire position would be deemed not to
be a 15% standard asset.
    Consider as well a scenario in which a fund holds shares of
security ``Y,'' and the fund determines, based on the liquidity
classification factors required to be considered under the proposed
rule, that it can sell security ``Y'' within seven days at
approximately the value ascribed to it by the fund, but whose sale(s)
will not also settle until the tenth day. Security ``Y'' would fall
into the 8-15 day liquidity classification category and would be
considered a less liquid asset because it would not be able to be
converted to cash within three business days. However, because the fund
would be able to sell its shares of security ``Y'' within seven days at
approximately the value ascribed to it by the fund, security ``Y''
would not be considered to be a 15% standard asset. This is because a
fund is required to consider whether it would be able to sell an asset
within seven days, but not also whether those asset sales would settle
within this period, in determining whether a particular portfolio asset
is a 15% standard asset.\359\
---------------------------------------------------------------------------

    \359\ See proposed rule 22e-4(a)(4).
---------------------------------------------------------------------------

    Conversely, consider a fund that holds shares of security ``Z,'' a
privately placed security that the fund determines cannot be sold
within seven days at approximately the value ascribed to it by the
fund. Under the proposed rule, security ``Z'' would be considered a
less liquid asset, because it would not be able to be converted to cash
(that is, sold, with the sale settled) within three business days.
Security ``Z'' also would be considered to be a 15% standard asset,
because it would not be able to be sold within seven days at
approximately the value ascribed to it by the fund. The fund would take
these classifications into account when it is considering whether the
further acquisition of less liquid assets or 15% standard assets would
cause the fund to not be in compliance with its three-day liquid asset
minimum or the 15% standard.
    The scenarios depicted in the preceding paragraphs demonstrate that
the same asset could be deemed to be a less liquid asset but not also
deemed to be a 15% standard asset, and also illustrate the different
roles that the proposed three-day liquid asset minimum and the 15%
standard play in liquidity risk management. The proposed 15% standard
would provide an across-the-board limitation on the acquisition of
certain relatively illiquid holdings. The proposed definition of less
liquid asset, on the other hand, is meant to identify those assets that
would generally not be able to be converted to cash to meet redemption
requests, and the proposed three-day liquid asset minimum is meant to
tailor a fund's acquisition of these holdings to correspond with its
particular liquidity needs. Thus, the proposed 15% standard acts as a
cap on the amount of relatively illiquid assets that a fund may hold,
while the proposed three-day liquid asset minimum acts as a floor on
the amount of three-day liquid assets that a fund must hold.
b. Request for Comment
    We request comment on the proposed 15% standard.
     Do commenters agree that the Commission should include the
15% standard in proposed rule 22e-4? Would the 15% standard enhance
funds' ability to manage liquidity risk?
     Do commenters agree that the three-day liquid asset
minimum requirement and the 15% standard serve distinct roles in
managing liquidity risk? Is there a single alternative standard that
would be an effective substitute for the three-day liquid asset minimum
requirement and the 15% standard?
     Should the Commission instead adopt a different
restriction on funds' investments in assets whose liquidity is
extremely limited, and if so, what should this restriction be? For
example, should we adopt a different percentage limit on funds'
investments in 15% standard assets? Should we instead limit funds'
investments in some other subset of assets with extremely limited
liquidity, such as assets that can only be converted to cash in over 7
days, over

15 days, over 30 days, or over 90 days at a price that does not
materially affect the value of that asset immediately prior to sale? If
we did the latter, what should the limit be? Should it be a set
percentage of fund assets established by the Commission (e.g., 5%, 10%,
20%, 30%), or should a fund be required to set its own limit, using the
factors it would be required to consider in determining its three-day
liquid asset minimum (or some other set of factors)? Should this limit
apply to all funds, or only a subset of funds (e.g., only funds with
certain investment strategies, or whose three-day liquid asset minimums
are below a certain threshold)?
     As noted above, the 15% standard would be tested each time
the fund acquires new assets, and a fund would be permitted to hold
more than 15% of its net assets in 15% standard assets if it does so
due to redemptions or market events. Once a fund rises above the 15%
limit, any acquisition of new assets must be of non-15% standard assets
until the fund is at or below the 15% standard. Would a requirement
mandating that a fund divest excess 15% standard assets if its holdings
of these assets rise above 15% of its net assets better facilitate
funds' liquidity risk management and promote investor protection? Or
should we limit the time period (e.g., to 30 days, 60 days, or 90 days)
in which a fund holds more than 15% of its net assets in 15% standard
assets so that a fund cannot persistently be above the 15% standard?
Alternatively, we note that certain Canadian mutual funds are subject
to illiquid asset restrictions that provide that a fund: (i) Must not
acquire illiquid assets if more than 10% of the fund's net assets would
be made up of illiquid assets; (ii) must not have invested more than
15% of the fund's net assets in illiquid assets for a period of 90 days
or more; and (iii) must, as quickly as is commercially reasonable, take
all necessary steps to reduce the percentage of its net assets made up
of illiquid assets to 15% or less if more than 15% of the fund's net
assets is made up of illiquid assets.\360\ Should we adopt similar
requirements? Would such requirements better promote investor
protection?
---------------------------------------------------------------------------

    \360\ See Canadian Securities Administrators, National
Instrument 81-102--Investment Funds at section 2.4.
---------------------------------------------------------------------------

     Should the Commission modify the proposed definition of
15% standard assets to require that funds take into account the time
period associated with receipt of proceeds of sale or disposition of an
asset?
     Do commenters agree with the proposal to withdraw current
guidance associated with the 15% guideline? Do commenters believe
additional guidance is needed in connection with the proposed
definition of 15% standard asset? If so, what guidance should the
Commission provide?
     What assets do funds currently consider to be limited by
the 15% guideline? Do commenters believe that assets that would meet
the proposed definition of 15% standard asset are consistent with
assets that funds currently classify as illiquid under the 15%
guideline? If not, what types of assets would be classified
differently?
     What are funds' current practices for determining whether
a portfolio asset is limited by the 15% guideline, and what factors do
funds currently use to make this determination? Who at the fund and/or
the adviser is tasked with determining whether a portfolio asset is
limited by the 15% guideline, and how often is each asset reviewed? Do
funds expect to engage in the same practices for determining whether an
asset is a 15% standard asset?
     Would it be beneficial to funds for the Commission to
include as part of the rule certain types of securities whose
acquisition would be limited by the 15% standard, or other factors for
funds to consider in determining whether an asset is a 15% standard
asset? Do commenters believe that confusion could arise between the
definition of a 15% standard asset and the definition of a less liquid
asset under the proposed rule, and if so, how could this confusion be
reduced?
     Rule 2a-7 currently defines the term ``illiquid security''
to mean ``a security that cannot be sold or disposed of in the ordinary
course of business within seven calendar days at approximately the
value ascribed to it by the fund.'' \361\ Should we amend rule 2a-7 to
clarify that ``illiquid security'' has the same definition as ``15%
standard asset?''
---------------------------------------------------------------------------

    \361\ Rule 2a-7(a)(20).
---------------------------------------------------------------------------

5. Policies and Procedures Regarding Redemptions in Kind
a. Use of Redemptions in Kind
    Along with ETFs, which commonly redeem shares in kind, many mutual
funds reserve the right to redeem their shares in kind instead of in
cash.\362\ Mutual funds that reserve the right to redeem in kind may
use in-kind redemptions to manage liquidity risk under exceptional
circumstances.\363\ A fund, for example, could choose to redeem in kind
when faced with significant redemptions, because this would result in
the redeeming shareholder (and not the fund and its remaining
shareholders) bearing any liquidity costs associated with dispositions
of portfolio assets. We understand that many funds also use in-kind
redemptions if a large shareholder is redeeming to transition to a
separately managed account with a similar investment strategy.
---------------------------------------------------------------------------

    \362\ See, e.g., Adoption of (1) Rule 18f-1 Under the Investment
Company Act of 1940 to Permit Registered Open-End Investment
Companies Which Have the Right to Redeem In Kind to Elect to Make
Only Cash Redemptions and (2) Form N-18F-1, Investment Company Act
Release No. 6561 (June 14, 1971) [36 FR 11919 (June 23, 1971)]
(``Rule 18f-1 and Form N-18F-1 Adopting Release'') (stating that the
definition of ``redeemable security'' in section 2(a)(32) of the
Investment Company Act ``has traditionally been interpreted as
giving the issuer the option of redeeming its securities in cash or
in kind.'').
    \363\ See Karen Damato, `Redemptions in Kind' Become Effective
for Tax Management, Wall Street Journal (Mar. 10, 1999), available
at http://www.wsj.com/articles/SB921028092685519084 (`` `Redemptions
in kind' are typically viewed by fund managers as an emergency
measure, a step they could take to meet massive redemptions in the
midst of a market meltdown.'').
     Besides using in-kind redemptions as an emergency measure to
manage liquidity risk, funds may also use in-kind redemptions for
other reasons. For example, funds may wish to redeem certain
investors (particularly, large, institutional investors) in kind,
because in-kind redemptions could have a lower tax impact on the
fund than selling portfolio securities in order to pay redemptions
in cash. This, in turn, could benefit the remaining shareholders in
the fund. See, e.g., id. (``If a fund has to sell appreciated stocks
to pay a redeeming shareholder, it realizes capital gains. Unless
the fund has offsetting capital losses, those gains are distributed
as taxable income to all remaining fund holders. By contrast, when
funds distribute stocks from their portfolios, there is no tax event
for the continuing holders.'').
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    There are often logistical issues associated with paying in-kind
redemptions, and this limits the availability of in-kind redemptions
under many circumstances.\364\ For instance, in-kind redemptions could
entail complex operational issues that would be imposed on both the
fund and on investors receiving portfolio securities.\365\ Moreover,
some shareholders are generally unable or unwilling to receive in-kind
redemptions.\366\ Some funds also have

waived the right to redeem in kind with respect to certain relatively
small redemption requests under rule 18f-1 under the Investment Company
Act, which allows a fund to abide by different in-kind redemption
policies for different shareholders without being deemed to create a
class of senior securities prohibited by section 18(f)(1) of the
Act.\367\
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    \364\ See, e.g., Invesco FSOC Notice Comment Letter, supra note
35, at 11 (noting that while ``Invesco has on occasion exercised
rights to redeem in kind, in practice such rights are exercised
infrequently'').
    \365\ Money Market Fund Reform; Amendments to Form PF,
Investment Company Act Release No. 30551 (June 5, 2013) [78 FR 36834
(June 19, 2013)] (``2013 Money Market Fund Reform Proposing
Release''), at n.473.
    \366\ See, e.g., Fortune, supra note 270, at 47 (``A fund
redeeming in kind does so at the risk of its reputation and future
business . . .''). In the context of money market funds, we
requested comment on whether we should require redemptions in kind
for redemptions in excess of a certain size threshold, to ease
liquidity strains on the fund and reduce the risks and unfairness
posed by significant sudden redemptions. See Money Market Fund
Reform; Proposed Rule, Investment Company Act Release No. 28807
(June 30, 2009) [74 FR 32688 (July 8, 2009)] (``2009 Money Market
Fund Reform Proposing Release''), at section III.B. Commenters
generally opposed this type of reform for a variety of reasons, all
of which likely would apply equally to funds other than money market
funds. For example, most commenters stated that in-kind redemptions
would be technically unworkable due to complex valuation and
operational issues that would be imposed on both the fund and on
investors receiving the in-kind distribution. See 2013 Money Market
Fund Reform Proposing Release, supra note 365, at section III.B.9.c.
    \367\ Under rule 18f-1, any registered open-end fund that has
the right to redeem in kind could file with the Commission, on Form
N-18F-1, a notification of election committing itself to pay in cash
all requests for redemptions by any shareholder of record, limited
in amount during any ninety-day period to the lesser of $250,000 or
1 percent of the net asset value of the fund at the beginning of the
period. See Rule 18f-1 and Form N-18F-1 Adopting Release, supra note
362.
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    We believe that, as part of a fund's management of its liquidity
risk, a fund that engages in or reserves the right to engage in in-kind
redemptions should adopt and implement written policies and procedures
regarding in-kind redemptions, and we have included this requirement in
proposed rule 22e-4.\368\ We expect these policies and procedures would
address the process for redeeming in kind, as well as the circumstances
under which the fund would consider redeeming in kind. Through staff
outreach to funds, we understand that while many funds disclose that
they have reserved the right to redeem in kind, most of these funds
consider redemptions in kind to be a last resort or emergency measure,
and many do not have policies or procedures in place that would govern
in-kind redemptions. Because the management and personnel capacity of
funds facing heavy redemptions and other liquidity stresses would
likely be strained as funds attempt to manage these pressures, policies
and procedures that dictate the fund's in-kind redemption procedures
(which, as discussed above, could be quite complicated and could apply
differently to different types of shareholders) would increase the
likelihood that in-kind redemptions would be a feasible risk management
tool.\369\
---------------------------------------------------------------------------

    \368\ See proposed rule 22e-4(b)(2)(iv)(E).
    \369\ See infra notes 552-554 and accompanying text.
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b. Requests for Comment
     Our understanding is that redemptions in kind are not used
extensively outside ETFs. Is this assumption correct? Do funds that
engage in redemptions in kind have policies and procedures regarding
those redemptions? Are there steps that funds can take to make
redemptions in kind easier to implement?
     Under rule 18f-1, any registered open-end fund that has
the right to redeem in kind could file with the Commission a
notification of election committing itself to pay in cash all requests
for redemptions by any shareholder of record, limited in amount during
any ninety-day period to the lesser of $250,000 or 1 percent of the net
asset value of the fund at the beginning of the period.\370\ Would re-
visiting and eliminating funds' ability to limit in-kind redemptions
clarify that the Investment Company Act permits funds to redeem shares
in kind as well as in cash?
---------------------------------------------------------------------------

    \370\ See supra note 362 and accompanying text.
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6. Discussion of Additional Liquidity Risk Management Tools
    While proposed rule 22e-4 specifies that each fund would be
required to adopt a liquidity risk management program incorporating
certain specified elements, a fund's program could incorporate
liquidity risk management tools beyond the requirements of the proposed
rule. We understand that many funds currently engage in certain
practices that would not be required by proposed rule 22e-4, but which
could enhance funds' ability--in conjunction with the policies and
procedures required to be adopted under the proposed rule--to manage
liquidity risk. Specifically, we understand based on staff outreach
that it is relatively common for funds to establish lines of credit to
manage liquidity risk, and that funds may use borrowed money or draw on
other funding sources to meet shareholder redemptions, typically during
periods of significantly limited market liquidity. We also understand
that it is relatively common for certain funds (particularly, funds
with strategies involving investment in relatively less liquid
portfolio securities) to invest in ETFs to enhance the liquidity of the
fund's portfolio. Below we provide guidance funds may wish to consider
in using these tools and their role in a fund's liquidity risk
management program. We note that the liquidity risk management tools
discussed below do not comprise an exhaustive list of liquidity risk
management controls or procedures that a fund could consider
implementing, nor are we currently proposing to mandate that a fund use
these tools as part of its liquidity risk management program.
    In addition, there are currently several tools that a fund could
use, generally under emergency circumstances, to pay redeeming
shareholders during periods in which the fund encounters limited
liquidity. As discussed above, many funds reserve the right to redeem
their shares in kind instead of in cash, although we understand that
many funds that do so consider in-kind redemptions to be a last resort
or emergency measure. As a separate emergency measure, money market
funds (but not other funds) are currently permitted, under certain
circumstances, to permanently suspend shareholder redemptions and
liquidate the fund. Below we request comment on whether this tool would
be useful and appropriate for the Commission to make available to funds
besides money market funds.
a. Borrowing Arrangements and Other Funding Sources
    As discussed above, entering into borrowing arrangements and
agreements with other potential funding sources could strengthen a
fund's management of liquidity risk, as they could be used to pay
redeeming shareholders without the need to sell portfolio securities at
significantly discounted prices. For example, a fund could establish a
committed or uncommitted line of credit with a commercial bank, engage
in interfund lending within a family of funds, or use repurchase
transactions to generate liquidity.\371\ Proposed rule

22e-4(b)(2)(iii)(D) would require a fund to consider its borrowing
arrangements and other funding sources in assessing its liquidity risk,
and above we provide guidance on particular aspects of these activities
that could affect a fund's liquidity risk.\372\ We anticipate that a
fund could consider this guidance in assessing whether entering into
borrowing or other funding arrangements would assist the fund in
managing its liquidity risk, as well as determining the terms under
which such arrangements would best help the fund to manage its
liquidity risk. We also anticipate that this guidance could be used in
reviewing existing borrowing arrangements and the use of other funding
sources to assess whether these activities would continue to help the
fund effectively manage its liquidity risk. In evaluating borrowing
arrangements or other funding sources for purposes of managing
liquidity risk, a fund should take into account restrictions on
affiliated transactions and leverage under the Investment Company Act
and rules under the Act.\373\ A fund also may wish to consider any
negative impact on the fund resulting from borrowing funds for
liquidity risk management purposes, as opposed to managing liquidity
through the fund's portfolio construction.\374\
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    \371\ See, e.g., SIFMA IAA FSOC Notice Comment Letter, supra
note 16, at nn.73-75 (stating that 79% of SIFMA AMG survey
respondents report having access to a line of credit to manage
outflows from their mutual funds, that 64% have drawn on that line
of credit at some point within the last five years, and that 8% of
SIMFA AMG members surveyed state that they engage in interfund
lending to address liquidity issues); BlackRock FSOC Notice Comment
Letter, supra note 50, at 6 (statement that among several
overarching principles that provide the foundation for a prudent
market liquidity risk management framework for collective investment
vehicles is identifying backup sources of liquidity such as
temporary borrowings). But see Fidelity FSOC Notice Comment Letter,
supra note 20, at 20 (``During the time period since its inception
in 2001, the committed bank line of credit has never been used.'');
Comment Letter of PIMCO on the FSOC Notice (Mar. 25, 2015), at
Appendix-2 (``In practice, it is rare for funds to . . . draw on
these lines of credit.''); Invesco FSOC Notice Comment Letter, supra
note 35, at 12 (stating that it has a line of credit for its
floating rate fund and senior loan portfolio ETF, but that it has
been used on a very infrequent basis).
    \372\ See supra notes 315-318 and accompanying and following
text.
    \373\ See supra notes 320-322 and accompany and following text.
    \374\ See, e.g., Nuveen FSOC Notice Comment Letter, supra note
45, at 9-10 (``Funds without credit lines face the possibility of
not being able to sell sufficient assets to raise cash to fund
redemption requests, or having to sell assets at significantly
discounted values. To the extent that a fund draws on a credit line
to meet net redemptions (and thus temporarily leverages itself), it
increases its market risk at a time when markets are stressed. While
this can be potentially beneficial to long-term performance if the
asset class recovers, it increases the risk of loss to remaining
shareholders if markets continue to weaken.'').
---------------------------------------------------------------------------

b. Use of ETF Portfolio Holdings as a Liquidity Risk Management Tool
    We understand that certain funds, particularly funds with
investment strategies involving relatively less liquid portfolio
securities (such as micro-cap equity funds, high-yield bond funds and
bank loan funds), may invest a portion of their assets in ETFs with
strategies similar to the fund's investment strategy because they view
ETF shares as having characteristics that enhance the liquidity of the
fund's portfolio.\375\ Specifically, funds that invest in ETF shares
have stated to Commission staff that they find that these shares are
more readily tradable, are less expensive to trade, and have shorter
settlement periods than other types of portfolio investments.\376\ And
unlike investments in cash, cash equivalents, and other highly liquid
instruments, funds have suggested that investing in ETFs with the same
(or a similar) strategy as the fund's investment strategy permits the
fund to remain fully invested in assets that reflect the fund's
investment concentrations, risks, and performance potential.
---------------------------------------------------------------------------

    \375\ See, e.g., Katy Burne, Institutions Pour Cash Into Bond
ETFs, Wall Street Journal (Mar. 1, 2015), available at http://www.wsj.com/articles/institutions-pour-cash-into-bond-etfs-1425250969. Funds' investments in ETFs are subject to the Investment
Company Act's limitations on investments in shares issued by other
registered investment companies. See section 12(d)(1)(A) of the
Investment Company Act.
    \376\ The Commission's 2015 Request for Comment on Exchange-
Traded Products requested comment on whether investors' expectations
of the nature of the liquidity of an exchange-traded product
(including an ETF) holding relatively less liquid portfolio
securities differ from their expectations of the liquidity of the
underlying portfolio securities. See 2015 ETP Request for Comment,
supra note 11, at Question #49. See e.g., Comment Letter of Vanguard
on the 2015 ETP Request for Comment (Aug. 17, 2015) (stating that
the disclosures made by ETFs in prospectuses, shareholder reports,
and Web sites ``ensures that investors and market participants have
the necessary information to make informed investment decisions'');
Comment Letter of ETF Radar on the 2015 ETP Request for Comment
(Aug. 8, 2015) (stating that investor expectations of liquidity
depend on the skill of the investor); Comment Letter of Danny Reich
on the 2015 ETP Request for Comment (July 2, 2015) (stating that
there is a ``false assumption'' that underlying assets have the same
liquidity as the ETP, particularly with respect to bond ETPs).
---------------------------------------------------------------------------

    While we appreciate that ETFs' exchange-traded nature could make
these instruments useful to funds in managing purchases and redemptions
(for example, ETFs' settlement times could more closely reflect the
time in which a fund has disclosed that it will typically redeem fund
shares), funds should consider the extent to which relying
substantially on ETFs to manage liquidity risk is appropriate. As
discussed above, the liquidity of an ETF, particularly in times of
declining market liquidity, may be limited by the liquidity of the
market for the ETF's underlying securities.\377\ Thus, shares of an ETF
whose underlying securities are relatively less liquid (taking into
account the factors discussed in proposed rule 22e-4(b)(2)(ii)) may not
be able to be counted on as an effective liquidity risk management tool
during times of liquidity stress. In the case of a significant decline
in market liquidity, if authorized participants were unwilling or
unable to trade ETF shares in the primary market, and the majority of
trading took place among investors in the secondary market, the ETF's
shares could trade continuously at a premium or a discount to the value
of the ETF's underlying portfolio securities. This could frustrate the
expectations of secondary market investors who count on the creation
and redemption process to align the prices of ETF shares and their
underlying portfolio securities.\378\ We therefore encourage funds to
assess the liquidity characteristics of an ETF's underlying securities,
as well as the characteristics of the ETF shares themselves, in
classifying an ETF's liquidity under proposed rule 22e-4(b)(2)(i). We
also encourage funds to consider the portion of a fund's three-day
liquid assets that is invested in ETF shares, taking into account the
foregoing concerns.
---------------------------------------------------------------------------

    \377\ See supra note 24 and accompanying text; see also Tyler
Durden, What Would Happen if ETF Holders Sold All at Once?, ETF
Daily News (Mar. 26, 2015), available at http://etfdailynews.com/2015/03/26/what-would-happen-if-etf-holders-sold-all-at-once/2/
(``Thus we can't get away from depending on the liquidity of the
underlying high yield bonds. The ETF can't be more liquid than the
underlying, and we know the underlying can become highly
illiquid.'').
    \378\ See supra note 29 and accompanying text.
---------------------------------------------------------------------------

c. Suspension of Redemptions
    Section 22(e) of the Investment Company Act permits a fund to
suspend redemptions in specified unusual circumstances, including for
any period during which an emergency exists (only as determined by
Commission rules and regulations) as a result of which it is not
reasonably practicable for the fund to liquidate its portfolio
securities, or fairly determine the value of its net assets.\379\ Rule
22e-3 exempts money market funds from section 22(e), permitting a money
market fund to suspend redemptions and postpone payment of redemption
proceeds in an orderly liquidation of the fund if, subject to other
requirements, the fund's board makes certain findings.\380\ The
Commission has previously requested comment on whether the relief
provided by rule 22e-3 should be available to types of open-end funds
besides money market funds.\381\ The Commission received only limited
comments addressing the topic, with a few commenters generally
supportive of extending the rule to all open-end funds,\382\ and one
commenter arguing that open-end funds should be required

to seek individual exemptive orders from the Commission to obtain the
relief provided by rule 22e-3.\383\ We request specific comment below
on whether proposing a rule similar to rule 22e-3, which would permit
open-end funds other than money market funds to suspend redemptions and
postpone payment of redemption proceeds in an orderly liquidation of
the fund under certain circumstances, would protect the interests of
its investors if the fund were to liquidate.
---------------------------------------------------------------------------

    \379\ See supra note 82.
    \380\ See supra note 155 and accompanying text.
    \381\ See 2009 Money Market Fund Reform Proposing Release, supra
note 366.
    \382\ See Comment Letter of the Committee on Federal Regulation
of Securities, Section of Business Law of the American Bar
Association on Money Market Fund Reform (Sept. 9, 2009); Comment
Letter of Bankers Trust Company, N.A. on Money Market Fund Reform
(Aug. 28, 2009).
    \383\ See Comment Letter of Federated Investors, Inc. on Money
Market Fund Reform (Sept. 8, 2009).
---------------------------------------------------------------------------

    We also request comment below on whether the Commission should
consider proposing rules that would permit funds to suspend redemptions
under other circumstances not involving the liquidation of the
fund.\384\ As discussed above, private funds are often able to impose
gates and suspend redemptions to manage liquidity stress,\385\ and rule
2a-7 likewise permits money market funds to temporarily suspend
redemptions under certain circumstances.\386\ Registered funds that are
not money market funds, however, are significantly more limited in
their current ability to suspend redemptions under the Investment
Company Act.\387\ Specifically, open-end funds may suspend redemptions
for any period during which the NYSE is closed (other than customary
weekend and holiday closings) and in three additional situations only
if the Commission has made certain determinations.\388\ These limited
suspension rights are aimed at preventing funds and their advisers from
interfering with shareholders' redemption rights for improper
purposes,\389\ and recognize the importance that shareholders place on
daily redeemability of fund shares.
---------------------------------------------------------------------------

    \384\ See, e.g., BlackRock FSOC Notice Comment Letter, supra
note 50, at 40 (stating that the Commission should ``extend the
authority to suspend redemptions under extraordinary redemptions,
including an unmanageable spike in redemptions, to fund boards.'').
    \385\ See supra note 71 and accompanying text.
    \386\ See supra note 154 and accompanying text.
    \387\ See supra text accompanying note 379.
    \388\ See supra note 82.
    \389\ See 2014 Money Market Fund Reform Adopting Release, supra
note 85, at section III.A.1.
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d. Request for Comment
    We request comment on the above discussion and guidance regarding
certain tools that a fund could use to manage liquidity risk beyond the
requirements specified in proposed rule 22e-4.
     Are there any specific liquidity risk management policies
or procedures, beyond those that would be required by proposed rule
22e-4(b)(2)(iv)(A)-(E), that funds should be required to implement?
What procedures, separate from any that resemble those required by
proposed rule 22e-4(b)(2)(iv)(A)-(E), do funds currently use to manage
liquidity risk?
     Do commenters generally agree with our guidance discussed
above on the use of borrowing arrangements and other funding sources,
the use of ETFs to manage portfolio liquidity, and the use of
redemptions in kind? Is any additional guidance needed on the liquidity
risk management tools described in this section? Are there any other
issues associated with specific liquidity risk management tools or
techniques about which we should provide guidance? To the extent that
funds use liquidity risk management tools outside those mentioned in
this section, what guidance, if any, is needed regarding those tools?
     Regarding borrowing arrangements and other funding
sources, would additional guidance be useful regarding specific types
of borrowing arrangements?
     When using ETFs to manage liquidity, do funds consider the
liquidity of the ETFs' portfolio securities? Why or why not?
    We also request specific comment on several current rules that
touch on liquidity risk management issues and the suspension of
shareholder redemptions.
     Would proposing a rule similar to rule 22e-3 for funds
other than money market funds protect the interests of fund investors
if the fund were to liquidate? If so, under what circumstances should
funds be permitted to suspend redemptions and postpone payment of
redemption proceeds, and should a fund's board be required to make any
finding in connection with a fund's suspension of redemptions?
     Should we consider proposing rules that would permit funds
to suspend redemptions under other circumstances, such as rules that
would specify certain emergency circumstances that would permit funds
to suspend redemptions under section 22(e)? How could we define such
emergency circumstances? For example, should we define emergency
circumstances to include situations where redemptions exceeded a high
level over a certain period of time or where asset price volatility in
the markets exceeded a certain level making it difficult for the fund
to accurately price?
7. Cross-Trades
    Funds, subject to the requirements of the Investment Company Act,
are permitted to engage in ``cross-trading,'' that is, securities
transactions with certain of their affiliated persons, including other
funds within the fund family. Some funds may seek to use cross-trading
as an additional liquidity risk management tool. Rule 17a-7, however,
includes conditions that limit the portfolio assets that may be cross-
traded, and as discussed below, cross-trades that involve certain less
liquid assets may not be eligible to rely on the rule. We propose below
guidance relating to the use of cross-trading in response to investor
redemptions.
    Section 17 of the Investment Company Act restricts transactions
between an ``affiliated person of a registered investment company or an
affiliated person of such affiliated person'' and that investment
company--for example, transactions between a fund and another fund
managed by the same adviser.\390\ A fund must therefore obtain
exemptive relief from the Commission before entering into purchase or
sale transactions with an affiliated fund, or execute such transactions
subject to the provisions of rule 17a-7 under the Investment Company
Act (permitting purchase and sale transactions among affiliated funds
and other accounts, under certain circumstances).\391\
---------------------------------------------------------------------------

    \390\ See supra note 320 and accompanying text.
    \391\ Rule 17a-7 under the Investment Company Act provides an
exemption from section 17(a)'s prohibitions so long as certain
conditions are met. In summary, rule 17a-7 requires, among other
things, that: (i) The transaction at issue is a purchase or sale,
for no consideration other than cash, for a security for which
market quotations are readily available; (ii) the transaction be
effected at the independent current market price for the security at
issue; (iii) the transaction must be consistent with the policy of
each fund participating in the transaction as set forth in its
registration statement and reports filed under the Investment
Company Act; (iv) no brokerage commission, fee (except for customary
transfer fees) or other remuneration be paid in connection with the
transaction; and (v) the fund's board, including a majority of the
independent directors, adopts procedures that are reasonably
designed to provide that the rule 17a-7 transactions comply with the
conditions of the rule, approve changes to the procedures as the
board deems necessary, and determines no less frequently than
quarterly that all rule 17a-7 transactions made during the preceding
quarter were effected in compliance with the approved procedures.
---------------------------------------------------------------------------

    Cross-trading can benefit funds and their shareholders, for example
by allowing funds that are mutually interested in a securities
transaction that is consistent with the investment strategies of each
fund to conduct such a transaction without incurring transaction costs
and without generating a market impact.\392\ However, cross-

trades also have the potential for abuse. As the Commission has said,
``[f]or example, an unscrupulous investment adviser might ``dump''
undesirable securities on a registered investment company or transfer
desirable securities from a registered investment company to another
more favored advisory client in the complex. Moreover the transaction
could be effected at a price which is disadvantageous to the registered
investment company.'' \393\ Accordingly, rule 17a-7 requires that any
cross-trades satisfy certain conditions designed to prevent such
abuses, including the requirement that market quotations be readily
available for each traded security and that if the security is only
traded over the counter, the cross-trade be conducted at the average of
the highest current independent bid and lowest current independent
offer determined on the basis of reasonable inquiry.\394\ In requiring
market quotations for cross-traded securities, the Commission has
stated that ``[r]eliance upon such market quotations provides an
independent basis for determining that the terms of the transaction are
fair and reasonable to each participating investment company and do not
involve overreaching.'' \395\
---------------------------------------------------------------------------

    \392\ As noted above, rule 17a-7 requires that each cross-trade
be consistent with the policy of each fund participating in the
transaction and that no brokerage commissions, fees or other
remuneration be paid in connection with the transaction. Because
cross-trades are conducted privately between funds, they are not
transparent to market trading reporting systems and thus are
unlikely to generate a market impact.
    \393\ Exemption of Certain Purchase or Sale Transactions Between
a Registered Investment Company and Certain Affiliated Persons
Thereof, Investment Company Act Release No. 11136 (Apr. 21, 1980)
[45 FR 29067 (May 1, 1980)].
    \394\ See rule 17a-7(b).
    \395\ Exemption of Certain Purchase or Sale Transactions Between
a Registered Investment Company and Certain Affiliated Persons
Thereof, Investment Company Act Release No. 11676 (Mar. 10, 1981)
[45 FR 17011 (Mar. 17, 1981)]. The Commission historically declined
to expand rule 17a-7 to cross-trades for which market quotations
were not readily available and where independent current market
prices were not available because these conditions increase the
potential for abuse through cross-trades. See id.
---------------------------------------------------------------------------

    Certain less liquid assets may be ineligible to trade under rule
17a-7 due to this requirement. Indeed, the less liquid an asset is, the
more likely it may not satisfy rule 17a-7.\396\ Accordingly, for assets
that do not trade in active secondary markets, a fund should consider
whether ``market quotations are readily available'' and a ``current
market price'' is available and thus whether the asset may be cross-
traded in accordance with rule 17a-7.
---------------------------------------------------------------------------

    \396\ See supra section III.B.2 (discussing proposed factors for
classifying the liquidity of a portfolio position).
---------------------------------------------------------------------------

    In addition, when considering whether cross-trading would be an
effective and appropriate liquidity risk management tool, a fund's
adviser should consider its duty to seek best execution for each fund
potentially involved in the cross-trading transaction, as well as its
duty of loyalty to each fund.\397\ An adviser should not cause funds to
enter into a cross-trade unless doing so would be in the best interests
of each fund participating in the transaction. In assessing these
factors, a fund should consider any negative impact on the fund
resulting from the purchase of assets by one fund from an affiliated
fund (that is, whether any risk-shifting between funds that results
from trading assets is appropriate, considering the funds' strategies,
risk profile, and liquidity needs before the transaction takes place)
given the policy of each fund as recited in its registration statement
and reports under the Act. We request comment on our guidance relating
to cross-trading.
---------------------------------------------------------------------------

    \397\ See, e.g., In the Matter of Western Asset Management Co.,
Investment Company Act Release No. 30893 (Jan. 27, 2014) (settled
action) (the adviser to funds engaging in cross-trading ``has a
fiduciary duty of loyalty to its clients and also must seek to
obtain best execution for both its buying and selling clients'').
---------------------------------------------------------------------------

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

D. Board Approval and Designation of Program Administrative
Responsibilities

1. Initial Approval of Liquidity Risk Management Program
    Proposed rule 22e-4(b)(3)(i) would require each fund to obtain
initial approval of its written liquidity risk management program from
the fund's board of directors, including a majority of independent
directors.\398\ The proposed rule specifies that this approval is
required to include the fund's three-day liquid asset minimum.
Directors, and particularly independent directors, play a critical role
in overseeing fund operations, although they may delegate day-to-day
management to a fund's adviser.\399\ Given the board's historical
oversight role, we believe it is appropriate to require a fund's board
to approve the fund's liquidity risk management program. This
requirement is designed to facilitate independent scrutiny by the board
of directors of the liquidity risk management program--an area where
there may be a conflict of interest between the investment adviser and
the fund. For example, an adviser might have an incentive to set a low
three-day liquid asset minimum in order to permit the fund to invest in
additional less liquid assets (because such assets may result in higher
total returns for a fund), even though a low minimum may not reflect an
appropriate alignment between the fund's portfolio liquidity profile
and the fund's liquidity needs.
---------------------------------------------------------------------------

    \398\ In this release, we refer to directors who are not
``interested persons'' of the fund as ``independent directors.''
Section 2(a)(19) of the Investment Company Act identifies persons
who are ``interested persons'' of a fund.
    \399\ 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 (1979) (citing Tannenbaum v. Zeller, 552 F.2d
402, 406 (2d. Cir. 1979)) (describing independent directors as
``independent watchdogs''). See also Comment Letter of the
Independent Directors Council on the FSOC Notice (Mar. 25, 2015), at
5 (``A fund board oversees the adviser's management of the
portfolio's liquidity as part of its oversight of the fund's
compliance program and portfolio management more generally.'').
---------------------------------------------------------------------------

    Directors may satisfy their obligations with respect to this
initial approval by reviewing summaries of the liquidity risk
management program prepared by the fund's investment adviser or
officers administering the program, legal counsel, or other persons
familiar with the liquidity risk management program. The summaries
should familiarize directors with the salient features of the program
and provide them with an understanding of how the liquidity risk
management program addresses the required assessment of the fund's
liquidity risk, including how the fund's investment adviser or officers
administering the program determined the fund's three-day liquid asset
minimum. In considering whether to approve a fund's liquidity risk
management program, the board may wish to consider the nature of the
fund's liquidity risk exposure. A board also may wish to consider the
adequacy of the fund's liquidity risk management program in light of
recent experiences regarding the fund's liquidity, including any
redemption pressures experienced by the fund.
2. Approval of Material Changes to Liquidity Risk Management Program
and Oversight of the Three-Day Liquid Asset Minimum
    Proposed rule 22e-4(b)(3)(i) also would require each fund to obtain
approval of any material changes to the fund's liquidity risk
management program, including changes to the

fund's three-day liquid asset minimum, from the fund's board of
directors, including a majority of independent directors. As with the
initial approval of a fund's liquidity risk management program, the
requirement to obtain approval of any material changes to the fund's
liquidity risk management program from the board is designed to
facilitate independent scrutiny of material changes to the liquidity
risk management program by the board of directors. We note that our
proposal to require directors to approve material changes to the fund's
liquidity risk management program differs from the requirements under
rule 38a-1 under the Act, which does not require a fund board to
approve changes to a fund's compliance policies and procedures.\400\
Given that the fund's liquidity risk management program will be
administered by a fund's investment adviser or officers (rather than a
chief compliance officer),\401\ we believe that board approval of
material changes in this context will provide an important independent
check on such administration.
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    \400\ Rule 38a-1 requires that the fund's chief compliance
officer provide a written annual report to the fund's board
addressing, among other things, any material changes made to the
fund's compliance policies and procedures since the date of the last
report and any material changes to the fund's compliance policies
and procedures recommended as a result of the fund's annual review
of the adequacy of such policies and procedures and the
effectiveness of their implementation.
    \401\ Rule 38a-1 contains several provisions ``designed to
promote the independence of the chief compliance officer from the
management of the fund.'' See Rule 38a-1 Adopting Release, supra
note 90. These include: Rule 38a-1(a)(4)(i) (designation and
compensation of the chief compliance officer must be approved by the
fund's board, including a majority of the fund's independent
directors); rule 38a-1(a)(4)(ii) (the chief compliance officer can
only be discharged from his or her responsibilities with the
approval of the fund's board, including a majority of the fund's
independent directors); rule 38a-1(a)(4)(iii) (the chief compliance
officer must provide an annual report to the board addressing: (i)
The operation of the policies and procedures of the fund and certain
service providers since the last report; (ii) any material changes
to the policies and procedures since the last report; (iii) any
recommendations for material changes to the policies and procedures
as a result of the annual review; and (iv) any material compliance
matters since the date of the last report); and rule 38a-1(a)(4)(iv)
(requiring the chief compliance officer to meet separately with the
fund's independent directors at least once a year).
---------------------------------------------------------------------------

    The fund's board would be responsible under the proposed rule for
reviewing a written report from the fund's investment adviser or
officers administering the fund's liquidity risk management program,
provided no less frequently than annually, that reviews the adequacy of
the fund's liquidity risk management program, including the fund's
three-day liquid asset minimum, and the effectiveness of its
implementation.\402\ This aspect of the proposed rule is designed to
facilitate board oversight over the adequacy and effectiveness of the
fund's liquidity risk management program, including the three-day
liquid asset minimum and whether the three-day liquid asset minimum is
providing an appropriate level of minimum liquidity to the fund in
light of changes in the markets, the fund, and its shareholder base
over time. To the extent that the board is being asked to approve a
change in a fund's three-day liquid asset minimum, the written report
should also provide directors with an understanding of how a change to
the fund's three-day liquid asset minimum was determined to be
appropriate. We believe that this review and its related report will
provide the board with sufficient information to provide oversight over
the adequacy and effective implementation of the fund's liquidity risk
management program. As with the initial approval of each fund's
liquidity risk management program, directors may also wish to consider
the nature of the fund's liquidity risk exposure in approving any
material changes, particularly with respect to the fund's three-day
liquid asset minimum.
---------------------------------------------------------------------------

    \402\ Proposed rule 22e-4(b)(3)(ii).
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3. Designation of Administrative Responsibilities to Fund Investment
Adviser or Officers
    Proposed rule 22e-4(b)(3)(iii) would expressly require a fund to
designate the fund's investment adviser or officers (which may not be
solely portfolio managers of the fund) responsible for administering
the fund's liquidity risk management program, which designation must be
approved by the fund's board of directors. Designating the fund's
investment adviser or officers responsible for the administration of
the fund's liquidity risk management program, subject to board
oversight, is consistent with the way we understand most funds
currently manage liquidity.\403\ The proposed designation also tasks
the persons who are in a position to manage the fund's liquidity risks
on a real-time basis with responsibility for administration of the
liquidity risk management program. In administering a fund's liquidity
risk management program, the fund's investment adviser or officers may
wish to consult with the fund's portfolio manager, traders, risk
managers, and others as necessary or appropriate (e.g., to obtain
information used in classifying the liquidity of a new portfolio
position), but we note that the fund's portfolio managers may not be
solely responsible for administering the program.
---------------------------------------------------------------------------

    \403\ See Federal Regulation Of Securities Committee, American
Bar Association, Fund Director's Guidebook (4th ed. 2015), at p. 82
(``Determining the liquidity of a security is primarily an
investment decision that is delegated to the investment adviser, but
directors may establish guidelines and standards for determining
liquidity.'').
---------------------------------------------------------------------------

    We understand, based on staff outreach, that some funds employ a
dedicated risk management officer and task liquidity risk management to
this officer, in consultation with the fund's portfolio management
function. The board of a fund that employs a dedicated risk management
officer (or an officer whose role includes risk management among other
duties) may find it appropriate to designate administration of the
fund's liquidity risk management program to this officer. We request
comment below on whether a fund should be required to specifically task
administration of the fund's liquidity risk management program to a
dedicated risk officer, or whether we should otherwise specify the
officer who must administer the fund's liquidity risk management
program.
    Because the administration of a fund's liquidity risk management
program would be designated to a fund's investment adviser or officers,
the investment adviser or officers should provide the board with enough
information to oversee such administration. As discussed above, the
fund's investment adviser or officers would therefore be required to
provide the board with a written report on the adequacy of the fund's
liquidity risk management program, including the three-day liquid asset
minimum, and the effectiveness of its implementation, at least
annually. To the extent that a serious compliance issue arises under
the program, it may be appropriate to consider whether the event should
be brought to the board's attention promptly.\404\
---------------------------------------------------------------------------

    \404\ See Rule 38a-1 Adopting Release, supra note 90 (noting, in
the case of a rule 38a-1 compliance program, that ``[s]erious
compliance issues must, of course, always be brought to the board's
attention promptly'').
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    We understand that, in certain circumstances, a fund's service
providers may assist a fund and its investment adviser in monitoring
factors relevant to a fund's liquidity risk and managing the fund's
liquidity risk. For example, third parties could provide data relevant
to assessing fund flows. Also, a sub-adviser's portfolio management
responsibilities would involve investing a fund's assets in accordance
with the fund's three-day

liquid asset minimum and any other liquidity-related portfolio
requirements adopted by the fund.\405\ While we understand that such
actions could provide useful assistance to a fund in assessing,
monitoring, and managing liquidity risk, we note that the primary
parties responsible for a fund's liquidity risk management are the fund
itself and any parties to whom the fund has designated responsibility
for administering the fund's liquidity risk management program. A fund
(or its investment adviser, to the extent the investment adviser has
been given liquidity risk management responsibility) should thus
oversee any liquidity risk monitoring or risk management activities
undertaken by the fund's service providers, and we encourage a fund (or
its investment adviser, as appropriate) to communicate regularly with
its service providers as a part of its oversight and to coordinate the
liquidity risk management efforts undertaken by various parties.
---------------------------------------------------------------------------

    \405\ A fund could also formally designate a fund's sub-adviser
as responsible for the fund's liquidity risk management program.
---------------------------------------------------------------------------

4. Request for Comment
    We request comment on the proposed board approval and oversight
requirements.
     Do fund boards currently approve procedures for
classifying the liquidity of portfolio assets? Do fund boards take any
additional steps to oversee the liquidity of portfolio assets? Should
the Commission require boards, including a majority of independent
directors, to approve the initial liquidity risk management program,
including the three-day liquid asset minimum?
     Should the Commission require boards to approve material
changes to a fund's liquidity risk management program, including any
changes to a fund's three-day liquid asset minimum? Should the
Commission define what would constitute a ``material change'' to a
fund's liquidity risk management program or provide additional guidance
regarding what changes would constitute material changes?
Alternatively, should the Commission require boards to approve all
changes to a fund's liquidity risk management program? Or, similar to
rule 38a-1 regarding a fund's compliance program, should there be no
requirement for board approval of changes to the liquidity risk
management program?
     Does the release provide adequate guidance to fund boards
regarding their approval of the liquidity risk management program?
Should we provide any additional guidance in this regard?
     Do commenters agree that it would be appropriate to
require a fund to designate the fund's adviser or officers responsible
for administering a fund's liquidity risk management program, subject
to board approval? Is it appropriate to specify that those
administering the program may not be solely the fund's portfolio
managers? Would any small fund complexes have difficulty meeting the
proposed requirement that the program may not be solely administered by
the fund's portfolio manager? Is it appropriate to allow a fund to
designate a fund sub-adviser responsible for administering a fund's
liquidity risk management program? Should the Commission require a fund
to task administration of the fund's liquidity risk management program
to a specific officer of the fund? Should the Commission require that a
fund have a chief risk officer or risk committee administer the fund's
liquidity risk management program?
     Should the Commission specify a shorter or longer
frequency for review of a report on the fund's liquidity risk
management program? Should the report to the board cover both the
adequacy and effectiveness of the fund's liquidity risk management
program as well as the adequacy of the fund's three-day liquid asset
minimum? Alternatively, would a report reviewing the adequacy of the
fund's three-day liquid asset minimum likely provide a review of the
fund's liquidity risk management program overall given the factors that
must be assessed in setting the three-day liquid asset minimum?
     Are there other aspects of the fund's liquidity risk
management program about which the fund's investment adviser or
officers responsible for administering the program should report to the
board? Should we provide any additional guidance to fund boards in
connection with the approval and oversight of a fund's liquidity risk
management program?

E. Liquidity Risk Management Program Recordkeeping Requirements

    We are proposing to require that each fund maintain a written copy
of the policies and procedures adopted as part of its liquidity risk
management program for five years, in an easily accessible place.\406\
Each fund also would be required to maintain copies of any materials
provided to its board in connection with the board's initial approval
of the fund's liquidity risk management program and approvals of any
subsequent material changes to the program, including any changes to
the fund's three-day liquid asset minimum, and copies of written
reports provided to the board that review the adequacy of the fund's
liquidity risk management program, including the fund's three-day
liquid asset minimum, and the effectiveness of its implementation.\407\
Funds would have to maintain such records for at least five years after
the end of the fiscal year in which the documents were provided to the
board, the first two years in an easily accessible place.
---------------------------------------------------------------------------

    \406\ Proposed rule 22e-4(c)(1).
    \407\ Proposed rule 22e-4(c)(2); see also proposed rule 22e-
4(b)(3)(i)-(ii).
---------------------------------------------------------------------------

    Finally, we are proposing to require that each fund keep a written
record of how its three-day liquid asset minimum, and any adjustments
thereto, were determined, including the fund's assessment and periodic
review of its liquidity risk in light of the factors incorporated in
paragraphs (b)(2)(iii)(A) through (D) of proposed rule 22e-4.\408\
Funds would have to maintain such records for a period of not less than
five years, the first two years in an easily accessible place,
following the determination of, and each change to, the fund's three-
day liquid asset minimum.
---------------------------------------------------------------------------

    \408\ Proposed rule 22e-4(c)(3).
---------------------------------------------------------------------------

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

has been in compliance) with the liquidity risk management program
requirements of the rule and anticipate that such information would
become less relevant if extended beyond a five-year retention period.
Furthermore, we believe that the proposed five-year retention period
appropriately balances recordkeeping-related burdens on funds.
    We request comment on the proposed liquidity risk management
program recordkeeping requirements.
    [ssquf] Do commenters agree that the proposed recordkeeping
requirements are appropriate? Specifically, are there any additional
records associated with a fund's liquidity risk management program that
a fund should be required to keep? Should a fund be required to keep a
written record of how the liquidity classifications of each of the
fund's positions in a portfolio asset were determined, including
assessment of the factors set forth in proposed rule 22e-4(b)(2)(ii)?
Should a fund be required to keep a written record of what liquidity
classifications were determined for each of the fund's positions in a
portfolio asset? Do commenters anticipate that, to the extent that data
regarding certain factors that a fund would be required to consider in
classifying its portfolio positions' liquidity could be obtained
largely through automated systems, it would be possible to easily re-
create a record of how past liquidity classifications assigned to a
fund's portfolio positions were determined? Are there feasible
alternatives to the proposed rule that would minimize recordkeeping
burdens, including the costs of maintaining the required records?
    [ssquf] Do commenters agree that the five-year retention period for
records that would be required to be kept pursuant to proposed rule
22e-4(c) is appropriate? If not, what retention period would commenters
recommend? Would commenters recommend a six-year retention period? Why
or why not?
    [ssquf] We specifically request comment on any alternatives to the
proposed recordkeeping requirements that would minimize recordkeeping
burdens on funds, the utility and necessity of the proposed
recordkeeping requirements in relation to the associated costs and in
view of the public benefits derived, and the effects that additional
recordkeeping requirements would have on funds' internal compliance
policies and procedures.\409\
---------------------------------------------------------------------------

    \409\ See sections 30(c)(2)(A), 30(c)(2)(B), and 31(a)(2) of the
Investment Company Act.
---------------------------------------------------------------------------

F. Swing Pricing

    Rule 22c-1 under the Investment Company Act, the ``forward
pricing'' rule, requires funds, their principal underwriters, dealers
in fund shares, and other persons designated in a fund's prospectus, to
sell and redeem fund shares at a price based on the current NAV next
computed after receipt of an order to purchase or redeem.\410\ When a
fund trades portfolio assets as a result of purchase or redemption
requests, costs associated with this trading activity can dilute the
value of the existing shareholders' interests in the fund. This
dilution occurs because the price at which shareholders transact in
fund shares reflects the shares' current NAV that is next computed
after the fund's receipt of the shareholders' purchase and redemption
requests (generally, the fund's NAV calculated as of the close of the
fund's primary underlying market, which is typically 4 p.m. Eastern
Time),\411\ but the fund's NAV will not generally reflect changes in
holdings of the fund's portfolio assets and changes in the number of
the fund's outstanding shares until the first business day following
the fund's receipt of the shareholders' purchase and redemption
requests.\412\ Thus, the price that a purchasing shareholder pays for
fund shares customarily does not take into account the market impact
costs and trading costs that arise when the fund buys portfolio assets
in order to invest proceeds of shareholder purchases. Likewise, the
price that a redeeming shareholder receives for fund shares customarily
does not take into account the market impact costs and trading costs
that arise when the fund sells portfolio assets in order to meet
shareholder redemptions. Going forward, however, the NAV of the fund
shares held by existing shareholders does reflect these costs, and thus
these costs are borne not by the purchasing or redeeming shareholders
but by all existing fund shareholders.\413\
---------------------------------------------------------------------------

    \410\ See rule 22c-1(a). Prior to adoption of rule 22c-1,
investor orders to purchase and redeem could be executed at a price
computed before receipt of the order, allowing investors to lock-in
a low price in a rising market and a higher price in a falling
market. The forward pricing provision of rule 22c-1 was designed to
eliminate these trading practices and the dilution to fund
shareholders which occurred as a result of backward pricing. Pricing
of Redeemable Securities for Distribution, Redemption, and
Repurchase, Investment Company Act Release No. 14244 (Nov. 21, 1984)
[49 FR 46558 (Nov. 27, 1984)], at text following n.2.
    \411\ See supra note 41 and accompanying text.
    \412\ See rule 2a-4(a)(2) (providing that changes in holdings of
portfolio securities shall be reflected in the fund's current NAV no
later than in the first calculation on the first business day
following the trade date); rule 2a-4(a)(3) (providing that changes
in the number of outstanding shares of the registered company
resulting from distributions, redemptions, and repurchases shall be
reflected in the fund's current NAV no later than in the first
calculation on the first business day following such change); see
also BlackRock, Swing Pricing: The Dilution Effects of Trading
Activity (Dec. 2011), available at http://www2.blackrock.com/content/groups/internationalsite/documents/literature/1111157589.pdf
(``BlackRock Swing Pricing Paper'').
    \413\ See Association of the Luxembourg Fund Industry, Swing
Pricing: Survey, Reports & Guidelines (Feb. 2011), available at
http://www.alfi.lu/sites/alfi.lu/files/ALFI_Swing_Pricing.pdf
(``Luxembourg Swing Pricing Survey, Reports & Guidelines''), at 13
(``[T]he single price at which investors buy and sell the fund's
shares only reflects the value of its net assets. It does not take
into account the dealing costs that arise when the portfolio manager
trades as a result of capital activity incurring a spread on the
underlying securities. In other words, the charges incurred fall not
on the client who has just traded, but on all investors in the
fund.'').
     To the extent that a fund were to apply a purchase fee or
redemption fee, shareholders would, at least to a certain extent,
bear the transaction-related costs associated with their purchase
and redemption requests. See infra notes 421-422 and accompanying
text; see also Securities and Exchange Commission, Mutual Fund Fees
and Expenses, available at http://www.sec.gov/answers/mffees.htm.
---------------------------------------------------------------------------

    While forward pricing captures the changes in portfolio assets'
value that arise as a result of market-wide trading, it does not
necessarily reflect any disparity between the market price of a
portfolio asset at the end of the day (as determined for purposes of
striking a fund's NAV) and the price that a fund receives for trading
that asset. This scenario could arise, for example, in situations in
which an asset's value changes throughout the day, and the price that a
fund receives when trading that asset differs from the market value of
the asset at the end of the day. It also could arise if a fund were
forced to sell a relatively less liquid asset at an inopportune time,
and thus had to accept a price for that asset that incorporates a
significant discount to the asset's stated value.
    To provide an illustration of a situation in which forward pricing
may not result in a fund's NAV reflecting the price that a fund
actually received when it sold portfolio assets, consider the following
example. If a fund has valued portfolio asset X at $10 at the beginning
of day 1, and market activity on day 1 (including the fund's sale of
portfolio asset X) decreases the market value of portfolio asset X to
$9 at the end of day 1, the fund's remaining holdings of portfolio
asset X at the end of day 1 would be valued at $9 to reflect the
asset's market value on that day. However, staff outreach has shown
that it is common industry practice, as permitted by rule 2a-4, for the
fund's current NAV to not reflect the actual price at which the fund
has sold the

portfolio assets until the next business day following the sale.\414\
In the example above, if the fund selling portfolio asset X sold the
asset during the day at $8 on day 1, the price that the fund received
for these asset sales would not be reflected in the fund's NAV until
day 2. Thus, redeeming shareholders would have received an exit price
that would reflect portfolio asset X being valued at the close of the
market at $9 on day 1, whereas remaining shareholders would hold shares
on day 2 whose value reflects portfolio asset X being sold at $8 (the
actual price that the fund received when it sold the asset on day one).
---------------------------------------------------------------------------

    \414\ See 2a-4(a)(2) (providing that changes in holdings of
portfolio securities shall be reflected in the fund's current NAV no
later than in the first calculation on the first business day
following the trade date). The next day's NAV would generally
reflect the cash receivable from the sale instead of the value of
the shares that were sold (although if the shares were sold and
settled within a T+0 or T+1 timeframe, the next day's NAV would
reflect the value of the shares that were sold).
---------------------------------------------------------------------------

    Similarly, as noted above, the price that a purchasing shareholder
pays for fund shares normally does not take into account trading and
market impact costs that arise when the fund buys portfolio assets to
invest the proceeds received from shareholder purchases. For example,
when a fund experiences net inflows, it may invest the proceeds of
shareholder purchases over several days following the purchase of fund
shares. Thus, the purchase price that shareholders receive on day 1
would not reflect any transaction fees associated with investing the
proceeds of shareholder purchases on subsequent days, or any market
activity (including the fund's purchase of portfolio assets) that
increases the value of the fund's portfolio assets. To illustrate, if
the fund's NAV on day 1 (and the purchase price an incoming shareholder
were to receive on day 1) reflects portfolio asset X being valued at
$10, but the fund were to purchase additional shares of portfolio asset
X on day 2 at $11, the price that a purchasing shareholder pays on day
1 would not reflect the costs of investing the proceeds of the
shareholder's purchases of fund shares. These costs instead would be
reflected in the fund's NAV on days following the shareholder's
purchase, and thus would be borne by all of the investors in the fund,
not only the shareholders who purchased on day 1.
    Certain foreign funds currently use ``swing pricing,'' the process
of adjusting the fund's NAV to effectively pass on the market impact
costs,\415\ spread costs,\416\ and transaction fees and charges
stemming from net capital activity (i.e., flows into or out of the
fund) to the shareholders associated with that activity, in order to
protect other shareholders from dilution arising from these costs.
Investment management industry representative associations operating in
certain European jurisdictions have adopted guidelines on swing pricing
procedures in recent years,\417\ and a survey conducted by the
Association of the Luxembourg Fund Industry (``ALFI'') several years
ago confirmed a strong directional trend towards the adoption of swing
pricing among major market participants in that jurisdiction, which is
a significant jurisdiction for the organization of UCITS funds in
Europe.\418\ Likewise, several comments from asset managers received in
response to the FSOC Notice \419\ noted favorably that funds regulated
under the UCITS Directive use swing pricing to allocate transaction
costs to purchasing and redeeming shareholders.\420\
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    \415\ Market impact costs are incurred when the price of a
security changes as a result of the effort to purchase or sell the
security. Stated formally, market impacts are the price concessions
(amounts added to the purchase price or subtracted from the selling
price) that are required to find the opposite side of the trade and
complete the transaction. Market impact cost cannot be calculated
directly. It can be roughly estimated by comparing the actual price
at which a trade was executed to prices that were present in the
market at or near the time of the trade. See Concept Release:
Request for Comments on Measures to Improve Disclosure of Mutual
Fund Transaction Costs, Investment Company Act Release No. 26313
(Dec. 18, 2003) [68 FR 74819 (Dec. 24, 2003)] (``Transaction Cost
Concept Release'').
    \416\ Spread costs are incurred indirectly when a fund buys a
security from a dealer at the ``asked'' price (slightly above
current value) or sells a security to a dealer at the ``bid'' price
(slightly below current value). The difference between the bid price
and the asked price is known as the ``spread.'' See Transaction Cost
Concept Release, supra note 415. For equity securities listed on an
exchange, the costs associated with trading the security typically
take the form of brokerage commissions, as opposed to spread costs.
    \417\ See, e.g., Luxembourg Swing Pricing Survey, Reports &
Guidelines, supra note 413; Association Francaise de la Gestion
Financi[egrave]re, Charte de bonne conduit pour le Swing Pricing et
les droits d'entr[eacute]e et de sortie ajustables acquis aux fonds
(2014), available at http://www.afg.asso.fr/index.php?option=com_content&view=article&id=5459%3Acharte-de-bonne-conduite-pour-le-swing-pricing-et-les-droits-dentree-et-de-sortie-ajustables-acquis-aux-fonds&catid=527%3A2014⟨=fr.
     The European Commission's 2009 revised Undertakings for
Collective Investment in Transferable Securities (``UCITS'')
Directive does not specifically provide for swing pricing, but does
provide that ``[t]he rules for the valuation of assets and the rules
for calculating the sale or issue price and the repurchase or
redemption price of the units of a UCITS shall be laid down in the
applicable national law, in the fund rules or in the instruments of
incorporation of the investment company.'' Directive 2009/65/EC of
the European Parliament and of the Council of 13 July 2009 on the
coordination of laws, regulations, and administrative provisions
relating to undertakings for collective investment in transferable
securities, Official J. of the European Union (Nov. 2009), available
at http://eur-lex.europa.eu/LexUriServ/LexUriServ.do?uri=OJ:L:2009:302:0032:0096:en:PDF, at Article 85.
    \418\ See Luxembourg Swing Pricing Survey, Reports & Guidelines,
supra note 413; see also BlackRock Swing Pricing Paper, supra note
412 (discussing the results of the ALFI survey). The results of the
ALFI survey indicated that the majority of respondents were already
using swing pricing, and the number of fund managers using swing
pricing had tripled over the previous five years.
    \419\ See supra note 16.
    \420\ See Comment Letter of AllianceBernstein L.P. on the FSOC
Notice (Mar. 25, 2015) (noting that UCITS funds may utilize swing
pricing to ``accurately reflect the costs borne by other
shareholders stemming from transaction costs''); BlackRock FSOC
Notice Comment Letter, supra note 50, at 5 and 39 (recommending that
policy makers consider a ``mechanism to allocate transaction costs
to redeeming shareholders as a way to provide a price signal for the
price of market liquidity and to reimburse or buffer a fund's
remaining shareholders''); see also Nuveen FSOC Notice Comment
Letter, supra note 45, at n.26 (``The SEC could also study proposals
to change the pricing mechanisms for mutual fund subscriptions and
redemptions in such a way that, under certain pre-specified
circumstances, subscribing and redeeming shareholders would bear the
cost of portfolio transactions necessary to invest cash for new
subscriptions and to fund redemptions.''); Occupy the SEC FSOC
Notice Comment Letter, supra note 45, at 13 (stating that investors
buying or selling large amounts of fund shares impose costs on the
fund that results in inequitable outcomes as long-term investors
subsidize those who trade more actively and that for funds that hold
illiquid assets these externalities can become quite material).
---------------------------------------------------------------------------

    Commission rules and guidance do not currently address the ability
of a fund to use swing pricing to mitigate potential dilution of fund
shareholders. The Commission has previously recognized that excessive
trading of mutual fund shares could dilute the value of long-term
investors' shares,\421\ however, and in response to this, the
Commission adopted rule 22c-2 under the Investment Company Act. Rule
22c-2, among other things, permits a fund to impose a fee of up to two
percent on shareholders' redemptions and requires fund boards to
consider imposing redemption fees under certain circumstances.\422\
While redemption

fees (or purchase fees) could mitigate dilution arising from
shareholder transaction activity, implementing a fee requires
coordination with the fund's service providers, which could entail
operational complexity. On the other hand, adjusting a fund's NAV, like
imposing a fee, could pass on transaction-related costs to purchasing
and redeeming shareholders, but could be simpler to implement because
this adjustment would occur pursuant to the fund's own procedures (as
opposed to involving the intermediaries' systems) and would be factored
into the process by which a fund strikes its NAV. However, the
Commission has not addressed whether a fund might adjust its current
NAV to lessen dilution of the value of a fund's outstanding securities,
and the Commission's current valuation guidance could raise questions
about making such a NAV adjustment.\423\
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    \421\ See, e.g., Mutual Fund Redemption Fees, Investment Company
Act Release No. 26782 (Mar. 11, 2005) [70 FR 13328 (Mar. 18, 2005)]
(``Rule 22c-2 Adopting Release'') at n.7 and accompanying text.
    \422\ Rule 22c-2 prohibits a fund from redeeming shares within
seven days after the share purchase unless the fund meets three
conditions. See rule 22c-2(a). First, the board of directors must
either: (i) Approve a redemption fee (in an amount not to exceed two
percent of the value of shares redeemed), or (ii) determine that
imposition of a redemption fee is either not necessary or not
appropriate. Second, the fund (or its principal underwriter or
transfer agent) must enter into a written agreement with each
financial intermediary under which the intermediary agrees to, among
other things: (i) Provide, at the fund's request, identity and
transaction information about shareholders who hold their shares
through an account with the intermediary; and (ii) execute
instructions from the fund to restrict or prohibit future purchases
or exchanges. Third, the fund must maintain a copy of each written
agreement with a financial intermediary for six years.
    \423\ For example, adjusting a fund's NAV in order to
effectively require shareholders who are purchasing or redeeming
shares of the fund to bear the costs associated with their purchases
or redemptions could be viewed as a temporary change in a fund's
valuation policies that might conflict with long-standing Commission
guidance that a fund's valuation policies be ``consistently
applied.'' See Accounting for Investment Securities by Registered
Investment Companies, Investment Company Act Release No. 6295 (Dec.
23, 1970) [35 FR 19986 (Dec. 31, 1970)] (``ASR 118'').
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    Because we believe that swing pricing could be a useful tool in
mitigating potential dilution of fund shareholders, we are proposing
rule 22c-1(a)(3), which would permit certain mutual funds (but not ETFs
or money market funds) to use swing pricing under certain
circumstances. Proposed rule 22c-1(a)(3) specifies the conditions under
which we believe swing pricing would be appropriately used. Below we
describe in detail the proposed requirements that a fund using swing
pricing would be obliged to follow, the objectives of the proposed
rule, and certain considerations that a fund should generally assess in
determining whether swing pricing would be an effective tool to prevent
fund dilution and promote fairness among all its shareholders. The
proposed rule is designed to promote all shareholders' interests and
promote practices that seek to ensure that a fund's shares are
purchased and redeemed at a fair price.\424\ We also believe that the
proposed rule would provide a set of operational standards that would
allow U.S. funds to gain comfort using swing pricing as a new means of
mitigating potential dilution. We recognize that implementing swing
pricing could give rise to a number of operational issues and
questions, and we provide guidance and request comment on relevant
operational considerations below.
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    \424\ See Rule 38a-1 Adopting Release, supra note 90, at text
following n.40 (noting that the pricing requirements of the
Investment Company Act are ``critical to ensuring fund shares are
purchased and redeemed at fair prices and that shareholder interests
are not diluted.'').
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1. Proposed Rule 22c-1(a)(3)
a. Overview and Objectives of Proposed Rule
    Under proposed rule 22c-1(a)(3), a registered open-end investment
company (but not a registered investment company that is regulated as a
money market fund,\425\ and not including an exchange-traded fund
\426\) would be permitted to establish and implement policies and
procedures providing for the fund to adjust its current NAV to mitigate
dilution of the value of its outstanding redeemable securities as a
result of shareholder purchase and redemption activity.\427\
Specifically, a fund \428\ would be permitted to establish and
implement swing pricing policies and procedures that would require a
fund to adjust its NAV under certain circumstances, provided that the
fund's board (including a majority of directors who are not interested
persons of the fund) \429\ must approve these policies and procedures,
and the policies and procedures must include certain specified
elements.\430\ A fund's swing pricing policies and procedures must
provide that the fund will adjust its NAV by an amount designated as
the ``swing factor'' once the level of net purchases into or net
redemptions from the fund has exceeded a specified percentage of the
fund's net asset value known as the ``swing threshold.'' \431\ A fund
would be required to adopt policies and procedures for determining and
periodically reviewing its swing threshold. A fund's swing pricing
policies and procedures also would be required to include policies and
procedures for determining a swing factor that would be used to adjust
the fund's NAV when the fund's swing threshold is breached. While the
swing factor could vary depending on the facts and circumstances, a
fund's policies and procedures for determining its swing factor must
take certain specified factors into account.\432\ A fund's board must
approve the swing pricing policies and procedures (including the fund's
swing threshold), as well as any material change thereto,\433\ and the
board would be required to designate the fund's adviser or officers
responsible for administering the policies and procedures.\434\ A fund
would be required to abide by certain recordkeeping requirements
relating to its swing pricing policies and procedures and any NAV
adjustments made pursuant to these policies and procedures.\435\
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    \425\ See rule 2a-7.
    \426\ Proposed rule 22c-1(a)(3)(v)(A) would define ``exchange-
traded fund'' as ``an open-end management investment company or a
class thereof, the shares of which are traded on a national
securities exchange, and that operates pursuant to an exemptive
order granted by the Commission or in reliance on an exemptive rule
adopted by the Commission.''
    \427\ Proposed rule 22c-1(a)(3). Under the proposed rule,
``swing pricing'' would be defined as ``the process of adjusting a
fund's current net asset value per share to mitigate dilution of the
value of its outstanding redeemable securities as a result of
shareholder purchase and redemption activity, pursuant to the
requirements set forth in [proposed rule 22c-1(a)(3)].'' See
proposed rule 22c-1(a)(3)(v)(C).
    \428\ For purposes of this section III.F and the discussions of
proposed rule 22c-1(a)(3) in this document, the term ``fund''
denotes a fund as defined in proposed rule 22c-1(a)(3), that is, ``a
registered open-end management investment company (but not a
registered open-end management investment company that is regulated
as a money market fund under Sec.  270.2a-7 or an exchange traded
fund as defined in [proposed rule 22c-1(a)(3)(v)(A)]).''
    \429\ Proposed rule 22c-1(a)(3)(ii)(A).
    \430\ Proposed rule 22c-1(a)(3)(i).
    \431\ Proposed rule 22c-1(a)(3)(i)(A). Under the proposed rule,
``swing factor'' would be defined as ``the amount, expressed as a
percentage of the fund's net asset value and determined pursuant to
the fund's swing pricing procedures, by which a fund adjusts its net
asset value per share when the level of net purchases or net
redemptions from the fund has exceeded the fund's swing threshold.''
Proposed rule 22c-1(a)(3)(v)(B). We request comment on this
definition in section III.F.1.e below.
    ``Swing threshold'' would be defined as ``the amount of net
purchases into or net redemptions from a fund, expressed as a
percentage of the fund's net asset value, that triggers the
initiation of swing pricing.'' Proposed rule 22c-1(a)(3)(v)(D). We
request comment on this definition in section III.F.1.c below.
    \432\ Proposed rule 22c-1(a)(3)(i)(D).
    \433\ Proposed rule 22c-1(a)(3)(ii)(A).
    \434\ Proposed rule 22c-1(a)(3)(ii)(B).
    \435\ See infra section III.F.1.g; proposed rule 22c-
1(a)(3)(iii); proposed amendment to rule 31a-2(a)(2).
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    In determining whether the fund's level of net purchases or net
redemptions has exceeded the fund's swing threshold, the person(s)
responsible for administering the fund's swing pricing policies and
procedures \436\ would be permitted to make such determination on the
basis of information obtained after reasonable inquiry.\437\ As
discussed below, swing pricing requires the net cash flows for a fund
to be known, or reasonably estimated, before determining whether to
adjust the fund's NAV on a particular

day.\438\ Because the deadline by which a fund must strike its NAV may
precede the time that a fund receives final information concerning
daily net flows from the fund's transfer agent or principal
underwriter, we believe it is appropriate to permit the person
responsible for administering swing pricing policies and procedures to
determine whether net purchases or net redemptions have exceeded the
fund's swing threshold on the basis of information obtained after
reasonable inquiry. The operational processes associated with swing
pricing are discussed in more detail below at section III.F.2.a.
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    \436\ See infra section III.F.1.f.
    \437\ Proposed rule 22c-1(a)(3)(i)(A).
    \438\ See infra section III.F.2.a.
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    Under the proposed rule, in-kind purchases and in-kind redemptions
would be excluded from the calculation of net purchases and net
redemptions for purposes of determining whether a fund's net purchases
or net redemptions exceed its swing threshold.\439\ When a fund
investor purchases or redeems shares of a fund in kind as opposed to in
cash, this does not necessarily cause the fund to trade any of its
portfolio assets. We therefore believe that the risk of dilution as a
result of shareholder purchase and redemption activity is lower with
respect to in-kind purchases and in-kind redemptions, and thus swing
pricing would not be permitted unless a fund's net purchases or net
redemptions that are made in cash (and not in kind) exceed the fund's
swing threshold.
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    \439\ Proposed rule 22c-1(a)(3)(i)(A).
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    We are proposing rule 22c-1(a)(3) to provide funds with a tool to
mitigate the potentially dilutive effects of shareholder purchase and
redemption activity. Funds would be able to adopt swing pricing
policies and procedures in their discretion (although, once these
policies and procedures are adopted, a fund would be required to adjust
its NAV when net purchases or net redemptions cross the swing
threshold, unless the fund's board approves a change to the fund's
swing threshold). When a fund that has adopted swing pricing
experiences net purchases exceeding the swing threshold, it would
adjust its NAV upward, which would effectively require purchasing
shareholders to cover near-term costs associated with the fund
investing in additional portfolio assets. Conversely, when a fund that
has adopted swing pricing experiences net redemptions exceeding the
swing threshold, it would adjust its NAV downward, which would
effectively require redeeming shareholders to cover near-term costs
associated with the fund selling portfolio assets. In both cases, swing
pricing would result in the costs of trading portfolio assets (along
with transaction fees and charges relating to these trades) being
passed on to purchasing and redeeming shareholders.
    As discussed above, some foreign funds currently use swing pricing,
which suggests that these funds consider swing pricing to be a valuable
and effective means of decreasing dilution. Indeed, one investment
manager conducted a study of its funds whose prices swung over a one-
year period (over fifty funds) and found that the performance of each
of these funds would have been impaired, in some cases quite
considerably, had the manager not implemented a swing pricing
policy.\440\ Likewise, ALFI has noted that studies have shown that
``[f]unds that apply swing pricing show superior performance over time
compared to funds (with identical investment strategies and trading
patterns) that do not employ anti-dilution measures,'' and that
``[s]wing pricing helps preserve investment returns as the value to
long-term investors normally exceeds the value of the swing factor
applied on entry to or exit from the fund.'' \441\ We believe that the
swing pricing policies contemplated by the proposed rule, which are
similar to those used by some foreign funds, could mitigate dilution
arising from shareholders' purchase and redemption activity.\442\ As
opposed to purchase and redemption fees or liquidity fees, which could
also prevent fund dilution arising from purchase or redemption
activity,\443\ swing pricing would occur pursuant to the fund's own
procedures and would not require coordination with the fund's service
providers because the swing pricing adjustment would be factored into
the process by which a fund strikes its NAV.\444\ In addition to
mitigating potential dilution arising from purchase and redemption
activity, swing pricing also could help deter redemptions motivated by
any first-mover advantage. That is, if remaining shareholders
understood that redeeming shareholders would bear the estimated costs
of their redemption activity, it would reduce their incentive to redeem
quickly because there would be less risk that they would bear the costs
of other shareholders' redemption activity.
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    \440\ See BlackRock Swing Pricing Paper, supra note 412.
    \441\ See Luxembourg Swing Pricing Survey, Reports & Guidelines,
supra note 413, at 12. But see infra paragraph following note 447
(noting that swing pricing could increase the volatility of a fund's
NAV in the short term, which could increase tracking error and could
make a fund's performance deviate from the fund's benchmark during
the period of volatility to a greater degree than if swing pricing
had not been used).
    \442\ See Luxembourg Swing Pricing Survey, Reports & Guidelines,
supra note 413, at 12. The Commission has previously recognized that
costs arising from certain types of redemption activity (namely,
short-term trading strategies, such as market timing) could dilute
the value of long-term investors' shares. See Rule 22c-2 Adopting
Release, supra note 421.
    \443\ As discussed above, the Commission has previously
recognized that excessive trading of fund shares could dilute the
value of long-term investors' shares, and in response to this,
adopted rule 22c-2, which permits a fund to impose redemption fees,
and requires fund boards to consider imposing redemption fees, under
certain circumstances. See supra notes 421-422.
     In addition, money market funds are permitted to use liquidity
fees under rule 2a-7. See 2014 Money Market Fund Reform Adopting
Release, supra note 85, at section III.A.5; see also discussion of
money market fund liquidity fees in section III.F.1.b infra.
Liquidity fees (including ``dilution levies'' used by certain UCITS)
are also used in some foreign jurisdictions, as a distinct liquidity
risk management tool separate from swing pricing. See infra notes
467-468 and accompanying text.
    \444\ See supra note 422 and accompanying and following text.
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    In considering the swing pricing proposal, we considered proposing
a rule that would permit ``dual pricing'' as opposed to swing pricing.
We understand that certain foreign funds use dual pricing as an
alternative means of mitigating potential dilution arising from
shareholder transaction activity. A fund using dual pricing would not
adjust the fund's NAV by a swing factor when it faces high levels of
net purchases or net redemptions, but instead would quote two prices--
one for incoming shareholders (reflecting the cost of buying portfolio
securities at the ask price in the market), and one for outgoing
shareholders (reflecting the proceeds the fund would receive from
selling portfolio securities at the bid price in the market).\445\
While we believe that dual pricing also could mitigate potential
dilution, we believe that swing pricing is a preferable alternative
because we believe it would be simpler to implement and for investors
to understand. Swing pricing would permit a fund to continue to
transact using one price, as they do today (instead of transacting
using separate prices for purchasing and redeeming shareholders), and
also would permit a fund to price its shares without adjustment unless
the level of net purchases or net redemptions were to cross the fund's
swing threshold.
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    \445\ See, e.g., supra note 423 for a discussion of different
methods of valuing portfolio assets, as considered in ASR 118.
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    We recognize that swing pricing may involve potential disadvantages
to funds as well as potential advantages, and the provisions of
proposed rule 22c-1(a)(3) are designed to maximize the relative

advantages and respond to potential concerns associated with swing
pricing. While swing pricing protects against dilution at the fund
level and could act as a deterrent against redemptions motivated by any
first-mover advantage, the potential disadvantages of swing pricing
(described in more detail below) include increased performance
volatility and the fact that the precise impact of swing pricing on
particular purchase and redemption requests would not be known in
advance and thus may not be fully transparent to investors. Under
proposed rule 22c-1(a)(3), swing pricing would be a voluntary tool for
funds, and thus a fund would be able to weigh the potential advantages
and disadvantages of swing pricing in relation to the fund's particular
circumstances and risks, as well as the other tools the fund uses to
manage risks relating to dilution and liquidity.
    The swing pricing requirements in proposed rule 22c-1(a)(3) aim to
minimize NAV volatility (and related tracking error) associated with
swing pricing to the extent possible. Swing pricing could increase the
volatility of a fund's NAV in the short term, because NAV adjustments
would occur when the fund's net purchases or net redemptions pass the
fund's swing threshold. Thus, the fund's NAV would show greater
fluctuation than would be the case in the absence of swing pricing.
This volatility might increase tracking error (i.e., the difference in
return based on the swung NAV compared to the fund's benchmark) during
the period of NAV adjustment, and could make a fund's short-term
performance deviate from the fund's benchmark to a greater degree than
if swing pricing had not been used.\446\ Volatility and tracking error
related to swing pricing could, therefore, result in investors
incorrectly perceiving the short-term relative performance of a fund.
This could potentially cause market distortions if investors were to
incorrectly rate the performance of funds that use swing pricing
compared to funds that do not, and shifted their invested assets from
funds that use swing pricing to funds that do not as a result of this
perception. Volatility and tracking error related to swing pricing also