cause funds to carefully monitor liquidity considerations
surrounding loan investments . . . . [In making such determinations,
funds] typically consider factors common to general liquidity
determinations, as well as factors specific to the loan markets,
which can include: (i) the legal limitations on the transferability
or sale of a loan including the requirement to obtain consents from
borrowers or syndicate agents and members prior to assignment; (ii)
the existence of a trading market for the loans and the estimated
depth of the market; (iii) the frequency of trades or quotes for the
loan; (iv) the estimated length of the settlement period; and (v)
the borrower's health.'').
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h. Size of Position in an Asset Relative to the Asset's Average Daily
Trading Volume and, as Applicable, Number of Units of the Asset
Outstanding
    Under proposed rule 22e-4, a fund's liquidity analysis regarding a
particular portfolio asset would be required to take into consideration
the ability to sell and receive cash for the entire position (or, as
applicable, portions of a position in a particular asset), not only its
ability to convert a single trading lot of that asset to cash.\234\
Because the size of a fund's portfolio position in a particular asset
is a key element in determining a fund's ability to convert the entire
position (or portions of a position in a particular asset) to cash, the
proposed rule would require a fund assessing the liquidity of a
portfolio asset to consider the size of the fund's position in that
asset.\235\ Staff outreach has shown that many funds currently consider
this factor in evaluating the liquidity of their portfolio positions. A
fund would be required to consider the size of its position in a
particular portfolio asset relative to the asset's average daily
trading volume and, as applicable, the number of units of the asset
outstanding.\236\ Small-capitalization securities are generally less
liquid than large-capitalization securities\237\ and, as discussed
above, securities with lower trading volume are generally less liquid
than securities whose trading volume is higher.\238\ The size of a
fund's position in a particular portfolio asset could augment the
effects of these two liquidity factors. For example, if a fund holds a
significant position in a small-capitalization security, this could
indicate that its position is relatively illiquid.\239\ Likewise,
holding a large position in a thinly traded security diminishes the
possibility that a fund would be able to convert a significant portion
of that position to cash in order to meet redemptions. In considering
the number of units of an asset that are currently outstanding, a fund
may wish to take into account the extent to which units of an asset may
be technically outstanding, but cannot be purchased by a member of the
public (e.g., shares of a company that the company has repurchased from
the public, but not cancelled because the company plans to later
reissue the shares, for example to cover employee stock grants).
Because units of an asset that cannot be purchased by a member of the
public are not able to be actively traded, this consideration could be
relevant to a fund's assessment of how the size of a portfolio position
relative to the number of outstanding units may affect that position's
liquidity.
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    \234\ See proposed rule 22e-4(b)(2)(i); supra paragraph
accompanying note 177.
    \235\ See proposed rule 22e-4(b)(2)(ii)(H).
    \236\ Proposed rule 22e-4(b)(2)(ii)(H).
    \237\ See, e.g., DERA Study, supra note 39, at p. 27; cf. also
Amy K. Edwards, Lawrence E. Harris & Michael S. Piwowar, Corporate
Bond Market Transaction Costs and Transparency, 62 J. Fin. 1421,
1444 (June 2007) (``Large issues have significantly lower
transaction costs than do small issues.'').
    \238\ See supra section III.B.2.b.
    \239\ See, e.g., Marshall E. Blume & Donald B. Keim,
Institutional Investors and Stock Market Liquidity: Trends and
Relationships (Aug. 21, 2012), available at http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2147757 (examining the relation between
illiquidity and two measures of institutional stock ownership--the
percentage of a stock owned by institutions and the number of
institutions that own the stock--and finding that the number of
institutions that own and trade a stock is more important than the
percentage of institutional ownership in explaining the cross-
sectional variability of illiquidity (``an increase in the number of
institutional holders of a stock decreases the average number of
shares of the stock held by individual institutions and, thereby,
reduces the potential size of a trade and its accompanying
liquidity-induced impact'')).
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    When a fund is evaluating the size of its position in a particular
asset as a factor in assessing that position's liquidity, it would be
required to consider the extent to which the timing of disposing of the
position could create any market value impact.\240\ Selling a large
position in a particular asset into the market over a short time period
could entail a negative price impact on the asset, which in turn could
cause losses to the fund and its shareholders. Therefore, this
consideration is relevant to determining the period in which a fund
would be able to convert a particular portfolio position (or portion
thereof) to cash, without affecting the value of that asset by virtue
of the transaction.
---------------------------------------------------------------------------

    \240\ Proposed rule 22e-4(b)(2)(ii)(H).
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i. Relationship of Asset to Another Portfolio Asset
    Under proposed rule 22e-4(b)(2)(ii)(I), a fund would be required to
consider, in assessing the liquidity of a position in a particular
portfolio asset, whether the fund invests in the asset because it is
connected with an investment in another portfolio asset. This may arise
in connection with a derivatives transaction, or if the fund uses an
asset for hedging or risk mitigation purposes.
    When funds enter into certain transactions that implicate section
18 of the Investment Company Act, they generally will maintain in a
segregated account certain liquid assets in order to ``cover'' the
fund's obligation under the transactions. We applied this framework to
certain financing transactions in Investment Company Act Release No.
10666 (``Release 10666''), issued in 1979,\241\ and also understand
that funds today apply this framework to certain derivatives, based on
the guidance we provided in Release 10666 and on no-action letters
issued by our staff.\242\ We explained in Release 10666 that ``[a]
segregated account freezes certain assets of the investment company and
renders

such assets unavailable for sale or other disposition.''\243\ We also
stated in Release 10666 that only liquid assets should be placed in a
segregated account. Thus, although we expect that assets used by a fund
to cover derivatives and other transactions would be liquid when
considered in isolation, when evaluating their liquidity for purposes
of the proposed rule, the fund would have to consider that they are
being used to cover other transactions and, consistent with our
position in Release 10666, are ``frozen'' and ``unavailable for sale or
other disposition.'' Because these assets are only available for sale
to meet redemptions once the related derivatives position is disposed
of or unwound, a fund should classify the liquidity of these segregated
assets using the liquidity of the derivative instruments they are
covering. Release 10666 notes that segregated assets may be ``replaced
by other appropriate non-segregated assets of equal value,'' and when
they are so replaced, formerly segregated assets would no longer be
considered unavailable for sale or other disposition.\244\ When a
formerly segregated asset is no longer segregated, a fund generally
should assess, as part of its ongoing review of the liquidity
classifications assigned to each portfolio position, whether the
liquidity classification given to the portfolio asset when it was
segregated continues to be appropriate.\245\
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    \241\ Securities Trading Practices of Registered Investment
Companies, Investment Company Act Release No. 10666 (Apr. 18, 1979)
[44 FR 25128 (Apr. 27, 1979)] (``Release 10666'').
    \242\ See generally Use of Derivatives by Investment Companies
Under the Investment Company Act of 1940, Investment Company Act
Release No. 29776 (Aug. 31, 2011) [76 FR 55237 (Sept. 7, 2011)]
(``Investment Company Derivatives Use Concept Release'') (providing
background information on the application of section 18 to
derivatives and certain other transactions).
    \243\ See also Dear Chief Financial Officer Letter from Lawrence
A. Friend, Chief Accountant, Division of Investment Management (Nov.
7, 1997) (staff letter taking the position that a fund could
segregate assets by designating such assets on its books, rather
than establishing a segregated account at its custodian).
    \244\ See Release 10666, supra note 241.
    \245\ See infra section III.B.3.a.
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    A fund may purchase an asset in connection with its holding of
another asset for other reasons, such as hedging. For example, a fund
might purchase a debt security denominated in a foreign currency and
attempt to hedge the currency risks associated with the debt security
by entering into a currency future. When evaluating the liquidity of
the currency future, the fund should consider the way the currency
future is being used in the fund's portfolio. In situations where a
fund purchases a more liquid asset in connection with a less liquid
asset, and it plans to transact in the more liquid asset only in
connection with the less liquid asset, then the liquidity of the two
assets is linked by the fund and, in this case, the fund should
consider the liquidity classification of the foreign debt security when
determining the liquidity of the currency future.
j. Request for Comment
    We request comment on the proposed factors that a fund would be
required to consider, as applicable, in classifying the liquidity of
each portfolio position in a particular asset.
     What factors do funds currently use to assess and classify
the liquidity of portfolio assets, and do the proposed factors reflect
factors that funds already consider when evaluating portfolio assets'
liquidity? Do commenters agree that requiring a fund to consider
certain factors would encourage effective liquidity assessment across
the fund industry? Would considering certain factors improve funds'
ability to meet their redemption obligations and to reduce potential
dilution of non-redeeming shareholders? Would classification generally
enhance funds' liquidity risk management, including funds' ability to
meet their redemption obligations and to reduce potential dilution of
non-redeeming shareholders?
     Should any of the proposed factors not be required to be
considered by a fund in making liquidity determinations? Should any of
the proposed factors be modified? Are there any additional factors,
besides the proposed factors, that a fund should be required to
consider in evaluating the liquidity of a portfolio position in a
particular asset? Should the proposed rule text be modified to
explicitly exempt certain types of funds from considering certain
factors? Or are there additional factors, besides the proposed factors,
that should be required to be considered by certain types of funds?
Should funds be required to consider correlations between asset classes
more generally, outside the derivatives and hedging contexts? Should
certain factors be given more weight than others? Should proposed rule
22e-4 explicitly require a fund to classify the liquidity of a position
(or portions of a position in a particular asset) used to cover a
derivative position using the same liquidity classification category as
it assigned to the derivative? Should the Commission provide additional
guidance regarding the circumstances in which a fund should consider
the liquidity of a particular portfolio asset in relation to the
liquidity of another asset? What types of operational challenges would
arise in connection with considering the liquidity of a particular
portfolio asset in relation to the liquidity of another asset?
     Instead of codifying the factors as part of proposed rule
22e-4, should the Commission solely provide guidance as to what would
be appropriate for a fund to consider in assessing its portfolio
assets' liquidity? Why or why not? Would the failure to codify the
factors diminish how consistently they are applied across the industry?
     Would a more principles-based approach, in lieu of
codified factors or guidance, be more appropriate? For example, would
it be less costly to implement and allow more flexible use of factors
that might be more pertinent in analyzing the liquidity of a particular
asset? Or would a more principles-based approach not materially advance
portfolio asset liquidity assessments beyond those conducted today
under the 15% guidelines, and thus be subject to similar limitations as
discussed above as a stand-alone method for liquidity assessment?
     To the extent that a fund lacks pertinent information
about a particular portfolio asset, should the fund be required to
consider the proposed rule 22e-4(b)(2)(ii) factors with respect to
appropriate comparable assets? What characteristics of the portfolio
asset and the comparable asset would a fund generally compare in
determining the weight to ascribe to the comparable asset's liquidity
in evaluating the portfolio asset's liquidity?
     Should ETFs and ETMFs be governed by the same, a subset
of, or different factors? If so, which factors and why?
    We seek comment on the Commission's guidance regarding each of the
proposed factors.
     Besides the guidance, are there any other specific issues
associated with any of the proposed factors that a fund may wish to
consider in evaluating the liquidity of a portfolio position in a
particular asset?
     Do commenters generally agree with the guidance that we
have proposed regarding the ways that each of the proposed factors
could indicate relative liquidity or illiquidity of a portfolio asset?
Should we add a note to rule 22e-4 indicating that the release includes
additional guidance regarding the proposed factors?
3. Ongoing Review of the Liquidity of a Fund's Portfolio Positions
a. Proposed Ongoing Review Requirement
    Proposed rule 22e-4(b)(2)(i) would require a fund to review the
liquidity classification of each of the fund's portfolio positions on
an ongoing basis. As appropriate, a fund could determine to revise its
liquidity classification of a portfolio position based on this ongoing

review requirement. The Commission has previously stated that it
``expects funds to monitor portfolio liquidity on an ongoing basis to
determine whether, in light of current circumstances, an adequate level
of liquidity is being maintained.''\246\ Some have interpreted this
statement to mean that the Commission does not intend for a fund to
reassess the liquidity status of individual securities on an ongoing
basis, but instead to monitor whether a fund portfolio's overall
liquidity profile is appropriate in light of its redemption obligations
under section 22(e).\247\ We agree that a fund should monitor the
liquidity of its portfolio holistically, in light of shareholder flows,
to determine the fund's capacity to meet its redemption
obligations.\248\ However, decreased liquidity of individual portfolio
components can directly affect the ability of a fund to meet its
redemption obligations, or to meet obligations in a manner that does
not dilute the interests of non-redeeming shareholders.\249\ We thus
believe that requiring a fund to review position-level liquidity
classifications made under proposed rule 22e-4 on an ongoing basis
would reduce the risk that the fund will be unable to meet its
redemption obligations and reduce potential dilution of shareholders'
interests.
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    \246\ Guidelines Release, supra note 4, at section II.
    \247\ See ICI Valuation and Liquidity Issues White Paper, supra
note 177, at 45.
    \248\ See Guidelines Release, supra note 4, at section II.
(stating, with respect to the Commission's expectation that a fund
would monitor its portfolio liquidity, ``For example, an equity fund
that begins to experience a net outflow of assets because investors
increasingly shift their moneys from equity to income funds should
consider reducing its holdings of illiquid securities in an orderly
fashion in order to maintain liquidity.'').
    \249\ See, e.g., Heartland Release, supra note 47.
---------------------------------------------------------------------------

    As discussed above, Commission staff understands, based on outreach
to the fund industry and information provided by industry participants,
that different funds employ varying approaches to monitoring the
liquidity of individual assets and positions. We understand that some
funds may not normally review the liquidity of individual portfolio
assets on a continuing basis after they are acquired. On the other
hand, our staff learned through outreach efforts across the fund
industry that certain funds periodically reassess the liquidity of each
portfolio security based on market-wide developments, as well as events
affecting particular securities or asset classes.\250\
---------------------------------------------------------------------------

    \250\ See also, e.g., ICI FSOC Notice Comment Letter, supra note
16, at 23-25 (``A mutual fund manager's liquidity management
practices typically will include active monitoring of the liquidity
profile of individual portfolio holdings.'').
---------------------------------------------------------------------------

    Pursuant to the proposed ongoing review requirement, each fund
would be required to consider the rule 22e-4(b)(2)(ii) factors, as
applicable, in reviewing its portfolio positions' liquidity on an
ongoing basis.\251\ However, beyond this, rule 22e-4 does not include
prescribed review procedures, nor does it incorporate specific
developments that a fund must monitor. A fund may wish to determine the
frequency of its ongoing review of portfolio positions' liquidity
classifications based in part on the liquidity of its portfolio
holdings, as well as the timing of its portfolio acquisitions and
turnover, in order to evaluate whether its portfolio acquisitions are
in compliance with the three-day liquid asset minimum requirement.\252\
For example, a fund whose portfolio assets' liquidity could depend
significantly on current market conditions should generally review the
liquidity classifications of its portfolio assets relatively often (up
to daily, or even hourly, depending on facts and circumstances). On the
other end of the spectrum, it may be appropriate for a fund whose
portfolio holdings' liquidity tends to be more stable (for example, a
large-cap equity fund) to consider reviewing the liquidity
classifications of its portfolio assets less frequently.\253\
---------------------------------------------------------------------------

    \251\ See proposed rule 22e-4(b)(2)(i)-(ii).
    \252\ See infra section III.C.3 (discussion of three-day liquid
asset minimum requirement).
    \253\ We note that at a minimum, a fund would review its
liquidity classification at least monthly in order to accurately
report this information on proposed Form N-PORT.
---------------------------------------------------------------------------

    In adopting ongoing review policies and procedures, a fund
generally should include policies and procedures for identifying
market-wide developments, as well as security- and asset-class-specific
developments, that could demonstrate a need to change the liquidity
classification of a portfolio position. For instance, relevant market-
wide developments could include changes in interest rates or other
macroeconomic events, market-wide volatility, market-wide flow changes,
dealer inventory or capacity changes, and extraordinary events such as
natural disasters or political upheaval.\254\ Security- and asset-class
specific developments that a fund may wish to consider include
corporate events (such as bankruptcy, default, or delisting, as well as
reputational events) and regulatory changes affecting certain asset
classes. Any of these developments could cause changes, for example, in
the frequency of trades or quotes for a particular asset, as well as
changes to that asset's trading volume, price volatility, and bid-ask
spreads.
---------------------------------------------------------------------------

    \254\ See, e.g., 2014 Fixed Income Guidance Update, supra note
62.
---------------------------------------------------------------------------

b. Request for Comment
    We request comment on the proposed ongoing review requirement.
     How do funds currently monitor the liquidity of portfolio
assets, and how frequently do they do so? To what extent do funds
anticipate that the ongoing review procedures that would be required
under proposed rule 22e-4 would replicate the procedures funds
currently use to monitor whether portfolio assets are limited by the
15% guideline? Are current processes largely automated? Do funds
believe that systems could be used to automate the monitoring that
would be required under proposed rule 22e-4? What trade-offs or risks
does automated monitoring pose vis-[agrave]-vis manual monitoring, and
how do firms currently manage those risks? Are there circumstances in
which automated monitoring is inappropriate, and, if so, why?
     Is the ongoing review requirement, as proposed,
sufficiently clear? Are there certain approaches to ongoing review that
we should require and/or on which we should provide guidance? Should we
specify a minimum time period for funds to review their liquidity
classifications under proposed rule 22e-4? Should we require that a
fund monitor for certain specified developments or events, and/or
expand our guidance on the market-wide and security- and asset-class-
specific developments that a fund could consider?

C. Assessing and Managing a Fund's Liquidity Risk

    We believe that assessing and managing liquidity risk in a
comprehensive manner is critical to a fund's ability to honor
redemption requests within the seven-day period required under section
22(e) of the Investment Company Act, as well as within any shorter time
period disclosed in the fund's prospectus or advertising materials or
required for purposes of rule 15c6-1. Proposed rule 22e-4(a)(7) would
define liquidity risk as the risk that the fund could not meet requests
to redeem shares issued by the fund that are expected under normal
conditions, or are reasonably foreseeable under stressed conditions,
without materially affecting the fund's net asset value. This proposed
definition contemplates that a fund consider both expected requests to
redeem (e.g., shareholder flows relating to seasonality or shareholder
tax considerations), as well as requests to redeem that may not be
expected, but are reasonably

foreseeable under stressed conditions (e.g., shareholder outflows
related to stressed market conditions or increased volatility, or
outflows that are reasonable to expect in light of a reputational event
affecting the fund or the departure of a fund's portfolio
manager).\255\
---------------------------------------------------------------------------

    \255\ See, e.g., infra section IV.C.1.e (discussing why we do
not believe that a general stress testing requirement would be an
adequate substitute for the proposed three-day liquid asset
requirement).
---------------------------------------------------------------------------

    A fund's liquidity risk depends on a variety of factors, including,
among others, its cash flows, investment strategy, portfolio liquidity,
use of borrowings and derivatives, cash (and cash equivalents) on hand,
and borrowing arrangements.\256\ Staff outreach has shown that funds
consider these types of factors in assessing their liquidity risk, and
some funds conduct stress tests (incorporating these factors) to
analyze various redemption scenarios to determine whether the fund has
sufficient liquid assets to cover different levels of redemptions.\257\
Likewise, we understand that a fund may employ many different policies
and procedures for managing its liquidity risk, including adjusting
portfolio composition to withstand potential liquidity stresses,
maintaining bank lines of credit or other borrowing arrangements,
requesting notification from large shareholders about possible upcoming
redemptions, and other similar risk management techniques. In addition,
some fund complexes have established a dedicated risk management
function, with independent risk oversight. Other funds, however, employ
substantially less comprehensive liquidity risk assessment and
management practices and procedures. These funds, for example, may have
little coordination between the compliance personnel who monitor the
fund's adherence to the 15% guideline, and the portfolio and risk
management personnel who assess the liquidity profile of portfolio
assets. Staff outreach has shown that it is fairly common for a fund
not to have adopted a specific liquidity risk management program, but
instead to rely primarily on the portfolio management process to
consider liquidity risk when making portfolio management decisions.
While a fund's portfolio management function has access to a great deal
of information relevant to the liquidity of the fund's portfolio
assets, and thus pertinent to the fund's liquidity risk, portfolio
managers may have competing interests that could potentially impede
effective liquidity risk management. For example, depending on the
circumstances, a fund's portfolio manager could be reluctant to invest
a portion of the fund's assets in highly liquid assets, which may be
appropriate for liquidity risk management purposes, but that the
manager believes could cause a fund's performance to lag compared to
similar funds or the fund's benchmark.\258\ In sum, our staff has found
that the comprehensiveness as well as the independence of funds'
liquidity risk management vary significantly.
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    \256\ See infra section III.C.1; see also Nuveen FSOC Notice
Comment Letter, supra note 45, at 10-11 (stating that mutual funds
that could have liquidity challenges in difficult markets include
those that invest not only in less liquid asset classes, but also
those with larger investor concentrations, with fund flows
particularly sensitive to changes in the returns of the markets in
which they invest, that hold a large amount of a single issuance or
a high percentage of its average daily trading volume, with
meaningful use of effective leverage, and that invest in assets that
do not have contractual settlement periods and tend to settle over
longer periods than ordinary securities).
    \257\ See supra text following note 100; see also supra note 104
(discussing Commission initiative to require large investment
companies and investment advisers to engage in annual stress tests
as required by section 165(i) of the Dodd-Frank Act); BlackRock FSOC
Notice Comment Letter, supra note 50, at 6 (stating that among
several overarching principles that provide the foundation for a
prudent market liquidity risk management framework for collective
investment vehicles is estimating ``potential fund redemptions based
on (a) historical behavior under normal as well as under adverse
market conditions, and (b) monitoring investor profiles and related
redemption behaviors to help identify potential liquidity needs,
recognizing the differences between institutional and retail
investors, large and small investors, categories of assets (e.g.,
retirement versus non-retirement assets), and the platforms on which
funds are sold (e.g., self-directed versus through an
intermediary''); AII FSOC Notice Comment Letter, supra note 50, at
15 (``investment advisers to mutual funds continually review a broad
series of metrics to evaluate the current adequacy of the fund's
liquidity position. These include historic data regarding redemption
request levels, stressing the historic redemption levels, assessing
levels of liquidity of categories of assets held by the fund based
on industry standards, assessing current and expected market
conditions of the types of asset held by the fund and then assessing
liquidity in those various market conditions.'').
    \258\ But see Mikhail Simutin, Cash Holdings and Mutual Fund
Performance, 18 Rev. of Fin. 1425 (2013) (``Simutin'') (``Cash
holdings of equity mutual funds impose a drag on fund performance
but also allow managers to make quick investments in attractive
stocks and satisfy outflows without costly fire sales. This article
shows that actively managed equity funds with high abnormal cash--
that is, with cash holdings in excess of the level predicted by fund
attributes--outperform their low abnormal cash peers by over 2% per
year.'').
---------------------------------------------------------------------------

    Because we are concerned with funds' ability to meet their
redemption obligations and to mitigate shareholder dilution associated
with redemptions, we are proposing new requirements for assessing and
managing funds' liquidity risk. Proposed rule 22e-4(b)(2)(iii) would
require a fund to assess and periodically review its liquidity risk,
taking into account certain factors. Proposed rule 22e-4(b)(2)(iv)
would require a fund to manage its liquidity risk based on this
assessment, including: (i) Requiring the fund to determine (and
periodically review) a minimum percentage of the fund's net assets that
must be invested in three-day liquid assets (the fund's ``three-day
liquid asset minimum''); \259\ (ii) prohibiting a fund from acquiring
any less liquid asset if the fund would have invested less than its
three-day liquid asset minimum in three-day liquid assets; \260\ and
(iii) prohibiting a fund from acquiring any 15% standard asset if the
fund would have invested more than 15% of its net assets in 15%
standard assets.\261\
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    \259\ Proposed rule 22e-4(b)(2)(iv)(A)-(B).
    \260\ Proposed rule 22e-4(b)(2)(iv)(C).
    \261\ Proposed rule 22e-4(b)(2)(iv)(D). In addition, proposed
rule 22e-4(b)(2)(iv)(E) would require a fund to establish policies
and procedures regarding redemptions in kind, to the extent that the
fund engages in or reserves the right to engage in redemptions in
kind.
---------------------------------------------------------------------------

    We are proposing these new requirements with the goal of providing
funds with the flexibility to adopt policies and procedures that would
be most appropriate to assess and manage their liquidity risk, while at
the same time reducing the risk that funds will be unable to meet
redemption obligations, minimizing dilution, and elevating the overall
quality of liquidity risk assessment and management across the fund
industry. Given that a fund's liquidity risk arises from the
interaction of multiple discrete and overlapping factors, we believe
that the most effective liquidity risk management programs would be
multi-faceted and customized to reflect the sources of the fund's
liquidity risk. The requirements that we are proposing are therefore
intended to be largely principles-based and would permit a fund to
tailor its risk assessment and management procedures to respond to the
fund's particular risks and circumstances. On the other hand, we also
believe that requiring each fund to consider, as a baseline, a standard
set of factors for assessing liquidity risk, requiring each fund to
keep a minimum portion of net assets in cash and assets that the fund
believes are convertible to cash within three business days without
materially affecting the value of the asset (which minimum each fund
would determine based on standard factors), and limiting a fund's
holdings of 15% standard assets would create an overall framework that
we believe would assist the development of effective and thorough
liquidity risk assessment and management across the fund industry,
thereby strengthening the ability of funds to meet redemption
obligations

and mitigating dilution of the interests of fund shareholders.
1. Assessing a Fund's Liquidity Risk
    Proposed rule 22e-4 envisions a two-pronged liquidity risk
assessment and risk management process, whereby a fund would be
required to assess its liquidity risk, based on certain specified
factors, and then develop a liquidity risk management program tailored
to the fund's liquidity risk.\262\ Here we discuss the liquidity risk
assessment portion of this process. The requirements we are proposing
for the fund's management of the risks identified by this assessment
are discussed in a later section of the release.\263\ Proposed rule
22e-4(b)(2)(iii) would require each fund to assess the fund's liquidity
risk, considering certain specified factors that are discussed in more
detail below. We compiled these factors based, in part, on staff
outreach to funds and third-party service providers who assess
liquidity risk on behalf of funds. To the extent that funds currently
conduct liquidity stress tests, we understand that these stress tests
commonly incorporate many of the proposed factors (or functionally
similar factors).\264\ The proposed liquidity risk factors also
incorporate considerations that we believe have historically
contributed to liquidity risk in open-end funds.\265\
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    \262\ To the extent that liquidity risk differs among each
series of an investment company, each series would be required to
adopt a liquidity risk management program whose liquidity risk
assessment and management elements are distinct from other series'
programs. See supra paragraph accompanying notes 114-115.
    \263\ See infra sections III.C.3-III.C.5.
    \264\ See supra notes 101, 257 and accompanying text.
    \265\ See Guidelines Release, supra note 4 (noting that funds
should consider cash flows into specific investment strategies in
determining whether the fund is maintaining an adequate level of
liquidity).
---------------------------------------------------------------------------

    The proposed rule would require each fund to take the following
factors into account, as applicable, in assessing the fund's liquidity
risk:
    [cir] Short-term and long-term cash flow projections, taking into
account the following considerations:
    [ssquf] Size, frequency, and volatility of historical purchases and
redemptions of fund shares during normal and stressed periods;
    [ssquf] The fund's redemption policies;
    [ssquf] The fund's shareholder ownership concentration;
    [ssquf] The fund's distribution channels; and
    [ssquf] The degree of certainty associated with the fund's short-
term and long-term cash flow projections
    [cir] The fund's investment strategy and liquidity of portfolio
assets;
    [cir] Use of borrowings and derivatives for investment purposes;
and
    [cir] Holdings of cash and cash equivalents, as well as borrowing
arrangements and other funding sources.
    This list is not meant to be exhaustive. In assessing its liquidity
risk, a fund may take into account considerations in addition to the
factors set forth in proposed rule 22e-4(b)(2)(iii). For example, if a
fund elects to conduct stress testing \266\ to determine whether it has
sufficient liquid assets to cover different levels of redemptions, a
fund should consider incorporating the results of this stress testing
into its liquidity risk assessment. However, a fund would be required
to consider, as applicable, the proposed rule 22e-4(b)(2)(iii) factors
as a minimum set of considerations to be used in assessing its
liquidity risk. For this reason, a fund that elects to conduct stress
tests may wish to review the factors and parameters it uses to
construct scenario analyses concerning the adequacy of the fund's
portfolio liquidity, and update these factors and parameters to reflect
the proposed liquidity risk assessment factors. We believe that stress
tests that incorporate the proposed factors, though not required, could
be particularly useful to a fund in assessing its liquidity risk.
---------------------------------------------------------------------------

    \266\ See supra notes 101, 257 and accompanying text.
---------------------------------------------------------------------------

    We recognize that some of the proposed factors may not be
applicable in assessing the liquidity risk of certain funds or types of
funds. For example, we recognize that certain considerations that the
proposed rule would require a fund to consider in assessing its cash
flow projections (e.g., shareholder ownership concentration, and the
fund's distribution channels) would generally be more applicable to
mutual funds than to ETFs. To the extent that a proposed factor is not
applicable to a particular fund, the fund would not be required to
consider that factor in assessing its liquidity risk.
    Below we provide guidance on specific issues associated with each
of the proposed liquidity risk assessment factors. We also request
comment below with respect to each of the proposed factors, as well as
guidance regarding each factor.
a. Cash Flow Projections
    A fund's cash flow (the amount of cash flowing either into or out
of the fund) is important in determining whether the fund will have
sufficient cash to satisfy redemption requests.\267\ Cash flow
projections thus directly affect a fund's liquidity risk.\268\ As
discussed below, we believe that several factors influence the extent
to which a fund's cash flow profile could indicate or contribute to the
fund's liquidity risk. Proposed rule 22e-4(b)(2)(iii)(A) thus would
require a fund to consider these factors when evaluating its liquidity
risk. In general, we believe that the better a fund's portfolio and
risk managers are able to predict the fund's net flows, the better they
will be able to measure and manage the fund's liquidity risk.\269\
Predictability about whether periods of market stress or declines in
fund performance generally lead to increased redemptions of fund shares
is particularly significant, as careful liquidity risk management
during these periods could prevent the need to sell less-liquid
portfolio assets under unfavorable circumstances, which in turn could
create significant negative price pressure on the assets and, to the
extent the fund continues to hold a portion of those assets, decrease
the value of the assets still held by the fund at least
temporarily.\270\
---------------------------------------------------------------------------

    \267\ See, e.g., Invesco FSOC Notice Comment Letter, supra note
35, at 11(``Cash inflows from sources such as gross subscriptions
(including reinvested dividends on fund shares), dividend and
interest payments on portfolio securities and maturities of debt
securities held in portfolios do help manage fund level liquidity
and are taken into account by portfolio managers as part of their
liquidity management.''); ICI FSOC Notice Comment Letter, supra note
16, at 18 (``Managing liquidity as part of overall portfolio
management is a dynamic process requiring fund managers to make
daily adjustments to accommodate cash inflows and outflows. . .
Portfolio managers and traders typically receive data on cash flows
at least daily and thus have a strong sense of whether additional
actions (including the sale of portfolio holdings) would be needed
to meet redemption requests or otherwise adjust a fund's liquidity
profile.'').
    \268\ Proposed rule 22e-4(a)(7).
    \269\ See, e.g., Gordon J. Alexander, Gjergi Cici & Scott
Gibson, Does Motivation Matter When Assessing Trade Performance? An
Analysis of Mutual Funds, 20 Rev. of Fin. Stud. 125 (Jan. 2007)
(noting that unexpected investor flows may force managers to
rebalance their portfolios to control liquidity, and that these
liquidity-related trades should underperform trades motivated by
valuation beliefs).
    \270\ See, e.g., supra note 54 and accompanying paragraph; Coval
& Stafford, supra note 51 (noting that fire sales can be anticipated
based on past flows and returns); Peter Fortune, Mutual Funds, Part
I: Reshaping the American Financial System, New England Econ. Rev.
(July/Aug. 1997), at 66-67, (``Fortune''), available at http://www.bostonfed.org/economic/neer/neer1997/neer497d.htm (positing that
funds with insufficient liquidity to meet redemption requests
following a significant decline in stock prices will need to sell
securities in a declining market, making the funds more sensitive to
price fluctuations); 1987 Market Crash Report, supra note 54, at
III-16--III-26, IV-1--IV-8 (discussing mutual fund selling behavior
during the October 1987 stock market crash, and in particular the
selling of three mutual fund companies, whose heavy selling of
assets to meet significant redemptions ``accounted for approximately
one quarter of all trading on the NYSE for the first 30 minutes that
the Exchange was open'' on October 19, 1987 and that such selling
had ``a significant impact on the downward direction of the
market'').

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

    A fund would be required to consider the size, frequency, and
volatility of historical purchases and redemptions of fund shares,
during both normal and stressed periods, when considering its cash flow
projections.\271\ A fund whose inflows generally correspond to its
outflows in terms of timing, size, frequency, and response to market
events will likely be able to use cash received from purchases to pay
redeeming shareholders, which decreases the fund's liquidity risk.
Funds whose net flows are relatively less volatile in terms of size and
frequency will likely entail less liquidity risk than similar funds
with more volatile net flows, because funds with less flow volatility
can better plan how to meet fund redemptions and thus will be less
likely to need to sell portfolio assets in a manner that creates a
market impact in order to pay redeeming shareholders.\272\ A fund
should generally review historical purchases and redemptions of fund
shares across a variety of market conditions in order to determine how
the fund's flows may differ during stressed and normal periods (keeping
in mind that historical experience may not necessarily be indicative of
future outcomes, depending on changes in market conditions and the
fund's particular circumstances). In particular, if outflows are
greater, more frequent, or more volatile during stressed periods, this
could exacerbate the fund's liquidity risk.\273\ A fund may find it
instructive to understand when its highest, lowest, most frequent, and
most volatile purchases and redemptions occurred within various time
horizons, such as the past one, five, ten, and twenty years (as
applicable, considering the fund's operating history). In addition to
considering its own historical flow data, a fund, particularly a fund
without a substantial operating history, may wish to consider purchase
and redemption activity in funds with similar investment strategies.
Consideration of similar funds' purchases and redemptions could show
whether the fund's historical flows are typical or aberrant compared to
those seen in similar funds and assist new funds in predicting flow
patterns.
---------------------------------------------------------------------------

    \271\ Proposed rule 22e-4(b)(2)(iii)(A)(1).
    \272\ See, e.g., Thomas M. Idzorek, James X. Xiong & Roger G.
Ibbotson, The Liquidity Style of Mutual Funds, 68 Fin. Analysts J.
38 (2012), at n.4, available at http://corporate.morningstar.com/us/documents/MethodologyDocuments/ResearchPapers/LiquidityStyleOfMutualFunds.pdf (noting that funds with less
volatile fund flows can afford to hold more illiquid stocks because
they can accommodate redemptions with the liquid portion of their
portfolios).
    \273\ See, e.g., supra note 270.
---------------------------------------------------------------------------

    A fund may wish to evaluate whether the size, frequency, and
volatility of its shareholder flows follow any discernable pattern. For
example, patterns in shareholder flows have been observed relating to
seasonality,\274\ shareholder tax considerations,\275\ fund
advertising,\276\ and changes in fund performance ratings provided by
third-party rating agencies.\277\ A fund's investment strategy also
could contribute to its shareholder flows: for instance, we understand
that certain investors tend to trade in and out of ETFs with index-
based strategies frequently because they invest in these ETFs for
hedging and/or short-term trading purposes.\278\ Furthermore, a fund
may wish to take into account its assets in assessing historical flow
data, since smaller funds may experience greater flow volatility.\279\
---------------------------------------------------------------------------

    \274\ See, e.g., Mark J Kamstra, et al., Seasonal Asset
Allocation: Evidence from Mutual Fund Flows (Dec. 2013), available
at http://www.bus.umich.edu/ConferenceFiles/2014-Mitsui-Finance-Symposium/files/Kramer_Seasonal_Asset_Allocation.pdf (``[W]e find
that aggregate investor flow data reveals a preference for U.S.
money market and government bond mutual funds in the autumn, and
equity funds in the spring, controlling for the influence of
seasonality in past performance, advertising, liquidity needs, and
capital gains overhang on fund flow. This movement of large amounts
of money between fund categories is correlated with a proxy for
variation in risk aversion across the seasons, consistent with
households' revealed preferences for safer investments in the fall,
and riskier investments in the spring.''); Hyung-Suk Choi,
Seasonality in Mutual Fund Flows, 31 J. of Applied Bus. Research 715
(Mar./Apr. 2015), available at http://www.cluteinstitute.com/ojs/index.php/JABR/article/viewFile/9162/9156 (``January is the month
when equity funds experience the largest net cash flows and December
is the month with the smallest cash flows.'').
    \275\ See, e.g., Woodrow T. Johnson & James M. Poterba, Taxes
and Mutual Fund Inflows around Distribution Dates, NBER Working
Paper 13884 (Mar. 2006, rev'd Mar. 2008), available at http://economics.mit.edu/files/2512 (``Johnson & Poterba'') (finding a
``modest'' decline in inflows into mutual funds by taxable investors
prior to a capital gains distribution date); Brad M. Barger &
Terrance Odean, Are Individual Investors Tax Savvy? Evidence from
Retail and Discount Brokerage Accounts, 88 J. of Pub. Econ. 419
(Jan. 2004), available at http://faculty.haas.berkeley.edu/odean/papers%20current%20versions/areindividualinvestorstaxsavvy_2003.pdf
(observing tax losses being related at greater rates than gains only
in the month of December).
    \276\ See, e.g., Murat Aydogdu & Jay W. Wellman, The Effects of
Advertising on Mutual Fund Flows: Results from a New Database,
Financial Management (Fall 2011), available at http://onlinelibrary.wiley.com/doi/10.1111/j.1755-053X.2011.01161.x/epdf
(finding significant differences in the effectiveness of mutual fund
advertising to attract inflows (e.g., smaller funds received
significant inflows due to advertising, while ``flagship'' funds did
not attract inflows as a result of their advertisements)).
    \277\ See, e.g., Diane Del Guercio & Paula A. Tkac, Star Power:
The Effect of Morningstar Ratings on Mutual Fund Flow, 43 J. of Fin.
and Quantitative Analysis 907 (Dec. 2008), available at http://www.jstor.org/stable/27647379?seq=1#page_scan_tab_contents (finding
that certain changes in performance ratings (rather than changes in
the underlying fund performance) have a substantial influence on
retail investors inflows into and outflows from mutual funds).
    \278\ See, e.g., 2015 ICI Fact Book, supra note 3, at 13
(``Investment managers, including mutual funds and pension funds,
use ETFs to manage liquidity--helping them manage their investor
flows and remain fully invested in the market. Asset managers also
use ETFs as part of their investment strategies, including as a
hedge against their exposure to equity markets.''); see also Izhak
Ben-David, Francesco A. Franzoni & Rabih Moussawi, Do ETFs Increase
Volatility?, NBER Working Paper No. 20071, at 12, available at
http://www.nber.org/papers/w20071.pdf (``Theoretical support for
this conjecture comes from Amihud and Mendelson (1986) and
Constantinides (1986), who propose that investors with shorter
holding periods self-select into assets with lower trading costs.
Atkins and Dyl (1997) find support for this conjecture by showing
that securities with lower bid-ask spread have higher trading
volume. These theories and empirical evidence suggest that, due to
the low trading costs of ETFs, a new clientele of high-frequency
investors can materialize around the newly created securities. This
clientele would not trade the less-liquid underlying assets if ETFs
were not present.'').
    \279\ See infra notes 726 and 727.
---------------------------------------------------------------------------

    While historical redemption patterns are an important factor in
assessing cash flows, a fund should be cognizant of the limitations of
using past flow history to assess future cash flow needs. Therefore, a
fund would be required to take into account other factors when
considering cash flow projections, including its redemption
policies.\280\ Specifically, we believe a fund should generally
consider the disclosures in its prospectus or advertising materials
regarding the time period in which it will pay redemption proceeds (or
endeavor to pay redemption proceeds),\281\ and whether its redemption
policies vary based on the distribution channels the fund employs. A
fund whose policies require it to pay redeeming shareholders on a next-
day basis could find itself with fewer options for managing high levels
of redemptions than a fund that is bound only by the redemption timing
requirements of rule 15c6-1. To illustrate, when a fund that pays
redemption proceeds within one day receives a large redemption request
and a fund that pays redemption proceeds within three business days
pursuant to the timing requirements of rule 15c6-1

receives a redemption request of the same size, the first fund must
satisfy the full request within one day, whereas the second fund has
more time to space out the sale of portfolio assets in order to satisfy
the redemption request. Even though the shareholder flows of the first
and second fund are identical, the redemption policies of the first
fund magnify its liquidity risks by requiring that the fund pay
redemptions quickly.\282\ An ETF that typically pays redemption
proceeds in kind should generally also consider that it has reserved
the right to transact with authorized participants in cash, the
circumstances in which it anticipates that it would pay redemption
proceeds in cash, and how these policies impact its cash flow
projections.
---------------------------------------------------------------------------

    \280\ Proposed rule 22e-4(b)(2)(iii)(A)(2).
    \281\ See Item 6(b) of Form N-1A (requiring a fund to briefly
identify the procedures for redeeming shares); proposed amendments
to Item 11 of Form N-1A (requiring funds to disclose the number of
days in which a fund will pay redemption proceeds to redeeming
shareholders, and explain if the number of days differs by
distribution channel); infra section III.G.1.a (discussing proposed
amendments to Item 11 of Form N-1A).
    \282\ See supra note 270.
---------------------------------------------------------------------------

    A mutual fund also would be required to consider its shareholder
ownership concentration as a factor affecting its cash flow
projections.\283\ If a mutual fund's shares are concentrated in a
relatively small group of shareholders, one shareholder's redemptions
of fund shares could result in considerable cash outflows from the
fund.\284\ This in turn could increase the mutual fund's liquidity risk
if the fund does not have procedures in place to manage large
redemptions, particularly if the fund were to encounter unexpected
redemptions from a large shareholder. For these reasons, we believe a
mutual fund should consider the extent to which its shareholder
concentration affects its liquidity risk, particularly taking into
account other factors that could magnify shareholder concentration-
related liquidity risk (e.g., if a fund has an investment strategy that
attracts shareholders who trade based on short-term price movements,
shareholders could be more likely to redeem precipitously, and
resulting unexpected redemptions by a shareholder with a large
ownership stake could cause significant liquidity stresses to the
fund).
---------------------------------------------------------------------------

    \283\ Proposed rule 22e-4(b)(2)(iii)(A)(3).
    \284\ We note that a relatively concentrated fund shareholder
base may make it easier for funds to communicate with those
shareholders about their anticipated future redemptions, and thus
plan liquidity demands. However, those shareholders are under no
legal obligation to forewarn the fund of their redemptions and so,
particularly in times of stress, may not do so.
---------------------------------------------------------------------------

    There are multiple ways that a mutual fund's distribution channels
could affect its cash flows (including the predictability of the fund's
cash flows), and the proposed rule would require a mutual fund to
consider this factor in evaluating its cash flows and related liquidity
risk.\285\ First, a mutual fund's redemption practices could depend on
its distribution channels. For example, mutual funds that are sold
through broker-dealers will have to meet redemption requests within
three business days, because rule 15c6-1 under the Exchange Act
establishes a T+3 settlement period for securities trades effected by a
broker or dealer. Second, to the extent that mutual fund shares are
held through omnibus accounts, it could be difficult for a mutual fund
to be fully aware of the composition of the underlying investor
base,\286\ including investor characteristics that could affect the
mutual fund's short-term and long-term flows (e.g., whether ownership
in the mutual fund is relatively concentrated,\287\ and whether the
mutual fund's underlying investors share any common investment goals
affecting redemption frequency and timing). Finally, a mutual fund's
distribution channels could affect its cash flow predictions insofar as
certain distribution channels are generally correlated with particular
purchase and redemption patterns. For instance, investors in mutual
funds distributed through a retirement plan channel or other planned
savings channel (e.g., funds underlying a 529 plan) \288\ may be more
likely to be long-term investors who do not trade based on short-term
price movements, and their purchase and redemption patterns thus may be
relatively predictable compared to those of other investors. Investors
in mutual funds distributed through certain channels also may have
similar purchase and redemption characteristics relating to their
financial and tax-related needs. For example, taxable investors who are
considering purchasing mutual fund shares around capital gains
distribution dates have an incentive to delay their purchases until
after the distribution, but non-taxable shareholders (such as those who
invest through IRAs and other tax-deferred accounts) face no such
incentive for delaying purchases.\289\
---------------------------------------------------------------------------

    \285\ Proposed rule 22e-4(b)(2)(iii)(A)(4).
    \286\ See, e.g., Board of the IOSCO, Principles of Liquidity
Risk Management for Collective Investment Schemes (Mar. 2013), at 5,
available at http://www.iosco.org/library/pubdocs/pdf/IOSCOPD405.pdf
(``The responsible entity should consider liquidity aspects related
to its proposed distribution channels.'').
    \287\ See supra notes 283-284 and accompanying text.
    \288\ A 529 plan is a tax-advantaged plan designed to encourage
saving for future college costs that is sponsored by a state, state
agency, or educational institution and is authorized by section 529
of the Internal Revenue Code.
    \289\ See Johnson & Poterba, supra note 275; see also supra note
274 and accompanying text (discussing seasonality in mutual fund
flows).
---------------------------------------------------------------------------

    Finally, a fund would be required to consider the degree of
certainty surrounding its short-term and long-term cash flow
projections.\290\ A fund could consider the length of its operating
history (including the fund's experience during points of market
instability, illiquidity, or volatility), any observed purchase and
redemption patterns, and the applicable other factors set forth in
proposed rule 22e-4(b)(2)(iii)(A) in determining the level of certainty
the fund has regarding its cash flows. A fund may find it instructive
to employ ranges in considering cash flow projections and their
relationship to liquidity risk. For instance, a fund that could
reasonably project that its cash flows will fall within a relatively
narrow range could more precisely assess its liquidity risk than a fund
that could reasonably project a broader range of projected cash flows.
If a fund has implemented policies to encourage certain shareholders
(e.g., large shareholders, or certain types of shareholders such as
institutional shareholders) to provide advance notification of their
intent to redeem a significant number of shares of the fund, this could
increase the degree of certainty surrounding its cash flow
projections.\291\
---------------------------------------------------------------------------

    \290\ Proposed rule 22e-4(b)(2)(iii)(A)(5).
    \291\ We understand, based on staff outreach, that advance
notification procedures are a relatively common liquidity risk
management tool that funds currently employ. See also Invesco FSOC
Notice Comment Letter, supra note 35, at 11 (noting that Invesco has
advance notification arrangements regarding anticipated redemptions
above certain levels in place with certain distribution partners).
---------------------------------------------------------------------------

b. Investment Strategy and Liquidity of Portfolio Assets
    Under proposed rule 22e-4, a fund's procedures for assessing its
liquidity risk must take into account the effects that the fund's
investment strategy and the liquidity of its portfolio assets could
have on the fund's liquidity risk.\292\ A fund's investment strategy
could increase or decrease the fund's liquidity risk in various ways.
For example, whether a fund is actively or passively managed could have
ramifications on the fund's liquidity. On one hand, a fund with a
passive investment strategy could have less liquidity risk relative to
an actively managed fund that invests in a similar portfolio, to the
extent that the portfolio of the passively managed fund is built around
a widely followed market index (securities that are

components of such an index are generally more liquid than securities
that are not).\293\ An index-tracking fund also may be more likely to
sell a ``strip'' of the portfolio (i.e., a cross-section or
representative selection of the fund's portfolio assets) to meet net
redemptions, which minimizes the outcome that the fund would sell its
most liquid assets first, in order to continue to closely track the
applicable benchmark. On the other hand, index-based strategies could
exhibit increased liquidity risk during periods when an index is being
reconstituted, if the index reconstitution results in multiple funds
simultaneously attempting to get into or out of the same portfolio
position.\294\ Index-based strategies also could experience increased
liquidity risk when the assets in the index become less liquid due to
market events, because the fund's manager will have less discretion to
move the fund's strategy away from the index's assets. In addition,
index-based strategies that track less-liquid market indices may
exhibit more liquidity risk than passively managed funds built around
widely-followed market indices.\295\
---------------------------------------------------------------------------

    \292\ Proposed rule 22e-4(b)(2)(iii)(B).
    \293\ See supra paragraph accompanying notes 215-216.
    \294\ See, e.g., Antti Petajisto, The Index Premium and Its
Hidden Cost for Index Funds, 18 J. of Empirical Fin. 271, 288
(2011), available at http://citeseerx.ist.psu.edu/viewdoc/download?doi=<IP_ADDRESS>2.3301&rep=rep1&type=pdf (``The annual index
turnover cost from 1990 to 2005 is about 21-28 bp for the S&P 500
and 38-77 bp for the Russell 2000. This is the cost of mechanically
tracking the index rather than holding an essentially similar index-
neutral portfolio.'').
    \295\ See also Jonathan Wheatley & Joel Lewin, Emerging Market
ETFs: Solving the Liquidity Problem or Storing it Up?, Financial
Times (Apr. 20, 2015), available at http://www.ft.com/cms/s/0/43c52f1e-e75e-11e4-a01c-00144feab7de.html (discussing ETFs built
around emerging market corporate bond indexes).
---------------------------------------------------------------------------

    The extent to which a fund's portfolio is diversified (or,
relatedly, a fund's concentration in certain types of portfolio assets)
could have ramifications on the fund's potential liquidity risk as
well. A fund's status as a diversified investment company under the
Investment Company Act,\296\ its status as a regulated investment
company under Subchapter M of the Internal Revenue Code,\297\ and its
principal investment strategies as disclosed in its prospectus all
could affect the fund's liquidity risk.\298\ For example, a fund
constrained by various diversification requirements that needs to sell
portfolio securities in order to meet redemption requests could be
limited by its diversification obligations in determining which
portfolio securities it will sell. Such a fund might need to unwind
certain portfolio positions under unfavorable circumstances. A fund
whose investment strategy requires it to invest a certain percentage of
its assets in a particular asset class, industry segment, or securities
associated with a particular geographic region could encounter similar
limitations, if selling certain portfolio securities would cause the
fund to not be in compliance with its investment strategies. On the
other hand, a fund with a relatively more-diversified portfolio needing
to sell portfolio assets to build liquidity would possibly be able to
select assets for sale based on whether the markets for those assets
are favorable. A relatively less-diversified fund may have fewer
options (i.e., because the markets for its portfolio assets are uniform
or correlated) and could thus be compelled to transact in unfavorable
markets. Such fund also may need to trade larger dollar amounts of each
asset, which may increase the price impact of the trades.
---------------------------------------------------------------------------

    \296\ See section 5(b)(1) of the Investment Company Act.
    \297\ 26 U.S.C. 851. To qualify as a regulated investment
company, a fund must meet several diversification requirements at
the close of each fiscal quarter of the taxable year. See id.
    \298\ See Items 4(a), 9 of Form N-1A.
---------------------------------------------------------------------------

    In addition to diversification or concentration issues, a fund's
portfolio management decisions that are meant, in part, to decrease an
undesirable tax impact on the fund could affect the fund's liquidity
risk. For example, a fund whose portfolio includes foreign securities
might manage its portfolio to avoid securities transaction taxes
imposed by other jurisdictions.\299\ Similarly, a fund could be managed
using an active tax loss harvesting strategy to opportunistically
realize losses that may be used to offset future gains.\300\ The sale
of certain portfolio assets to meet liquidity needs might adversely
affect these, and comparable, management practices. Consequently, a
fund whose tax management strategy makes its portfolio managers
unwilling to sell certain portfolio assets in order to meet redemptions
could face increased liquidity risk compared to a similarly situated
fund, because it could have fewer desirable options to generate cash to
pay redemptions (and thus could have increased risk that it would need
to sell portfolio assets under unfavorable circumstances in order to
meet redemptions) than another, similar fund.
---------------------------------------------------------------------------

    \299\ See, e.g., Karl Habermeier & Andrei Kirilenko, Securities
Transaction Taxes and Financial Markets, IMF Working Paper (May
2001), available at http://www.imf.org/external/pubs/ft/wp/2001/wp0151.pdf (discussing, among other things, the effects of
transaction taxes on liquidity).
    \300\ See, e.g., Scott J. Donaldson & Francis M. Kinniry Jr.,
Tax-Efficient Equity Investing: Solutions for Maximizing After-Tax
Returns, Vanguard Investment Counseling & Research (2008), available
at https://personal.vanguard.com/pdf/flgtei.pdf.
---------------------------------------------------------------------------

    While we believe consideration of a fund's investment strategy is
an important factor in assessing a fund's liquidity risk, we caution
that different types of funds within the same broad investment strategy
may demonstrate different levels of liquidity (and thus, presumably,
different levels of liquidity risk).\301\ The liquidity of a fund's
portfolio assets directly affects the amount of liquidity risk
associated with the fund. A fund should consider the portions of the
fund's net assets that are invested in each of the six liquidity
categories set forth in proposed rule 22e-4(b)(2)(i). All else being
equal, funds with relatively greater portions of their assets invested
in less liquid assets would tend to have greater liquidity risk than
funds holding relatively fewer less liquid assets.
---------------------------------------------------------------------------

    \301\ See infra note 627 and accompanying text.
---------------------------------------------------------------------------

c. Use of Borrowings and Derivatives for Investment Purposes
    Proposed rule 22e-4 would require a fund to take into account the
potential effects of the use of borrowings and derivatives for
investment purposes (for example, to enhance returns) on its liquidity
risk.\302\ Funds may borrow from a bank under section 18 of the
Investment Company Act. In addition to the asset coverage limitations
imposed by section 18,\303\ any such borrowing would be subject to the
terms agreed between a fund and the bank, including terms relating to
the maturity date of the borrowing and any circumstances under which
the borrowing may be required to be repaid. In addition, as noted
above, funds that borrow for investment purposes, for example through
financing transactions such as reverse repurchase agreements and short
sales, generally do so in reliance on the guidance we provided in
Release 10666, under which funds cover their obligations under such
transactions by segregating certain liquid assets.\304\ Segregated
assets are considered to be unavailable for sale or disposition,
including for redemptions, unless replaced by other appropriate non-
segregated assets of equal value.\305\ This means that a fund that
receives significant redemption requests may

need to unwind a portion of its financing transactions in order make
more liquid assets available for sale to fulfill such requests.
Furthermore, if a fund seeks to unwind its financing transactions in a
declining market, it may need to dispose of a greater amount of its
more liquid holdings in order to repay its borrowings, thereby reducing
the amount of liquid assets it has available to meet redemptions.
Consequently, a fund's assessment of its liquidity risk should include
an evaluation of the nature and extent of its borrowings and the
potential impact of borrowings on the fund's overall liquidity profile.
---------------------------------------------------------------------------

    \302\ Proposed rule 22e-4(b)(2)(iii)(C). Although the use of
borrowings and derivatives is a distinct factor under proposed rule
22e-4(b)(2)(iii), a fund should also consider the potential impact
of borrowings and derivatives in its assessment of other factors set
forth in proposed rule 22e-4(b)(2)(iii), such as the fund's cash
flow projections and its investment strategy and liquidity of
portfolio assets.
    \303\ See infra note 321.
    \304\ See supra section III.B.2.i.
    \305\ See Release 10666, supra note 241.
---------------------------------------------------------------------------

    The use of derivatives, such as futures, forwards, swaps and
written options, may also affect a fund's liquidity risk. Funds use
derivatives for a wide range of purposes, including hedging or risk
mitigation, but also to obtain leverage or investment exposures.\306\
As noted above, funds that use derivatives under which they have an
obligation to pay typically do so in reliance on the guidance we
provided in Release 10666 and in related no-action letters issued by
our staff, and therefore segregate liquid assets in respect of their
obligations under derivatives transactions.\307\ Derivatives may
therefore raise concerns that are similar to those discussed above in
the context of borrowings. Funds also may be required to dispose of
assets in order to post required margins with respect to their short
sale transactions. In addition, some derivatives transactions--
particularly those that are complex or entered into OTC--may be less
liquid, have longer settlement periods, or be more difficult to price
than other types of investments, which potentially increases the amount
of time required to unwind such transactions.
---------------------------------------------------------------------------

    \306\ See generally Investment Company Derivatives Use Concept
Release, supra note 242, at 13-17.
    \307\ See supra section III.B.2.i.
---------------------------------------------------------------------------

    Even highly liquid derivatives may present liquidity risk for some
funds. For example, some funds use derivatives for cash and liquidity
management purposes. A large-cap equity fund with a temporary cash
position may purchase equity index futures that have lower transaction
costs, shorter settlement periods and greater liquidity than a direct
investment in equity securities, in order to obtain a degree of
exposure to large-cap equities. While ``equitizing'' its temporary cash
position in this manner may mitigate the potential performance lag
associated with a cash holding, it also exposes the fund to market
risk.\308\ Accordingly, a fund's assessment of liquidity risk should
take into account the manner and extent of its derivatives use and the
structure and terms of its derivatives transactions.
---------------------------------------------------------------------------

    \308\ Investment Company Derivatives Use Concept Release, supra
note 242, at n.46 and accompanying text.
---------------------------------------------------------------------------

    In addition to the liquidity of the derivatives positions
themselves, assessing liquidity risk generally may include an
evaluation of the potential liquidity demands that may be imposed on
the fund in connection with its use of derivatives, including any
variation margin or collateral calls the fund may be required to
meet.\309\ To the extent the fund is required to make payments to a
derivatives counterparty, those assets would not be available to meet
shareholder redemptions.
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    \309\ See In re OppenheimerFunds, Inc., et al., Investment
Company Act Release No. 30099 (June 6, 2012) (``OppenheimerFunds
Release'') (settled action) (alleging the adviser made misleading
statements regarding two fixed income mutual funds that suffered
significant losses during the 2008 financial crisis primarily due to
their use of total return swaps to obtain exposure to commercial
mortgage-backed securities and noting that the funds ``had to raise
cash for anticipated [total return swap] contract payments by
selling depressed bonds into an increasingly illiquid market.'').
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d. Holdings of Cash and Cash Equivalents, as Well as Borrowing
Arrangements and Other Funding Sources
    Proposed rule 22e-4 would require a fund to consider its cash and
cash equivalent holdings, as well as its borrowing arrangements and
other funding sources, in assessing its liquidity risk.\310\ Current
U.S. generally accepted accounting principles define cash equivalents
as short-term, highly liquid investments that are readily convertible
to known amounts of cash and that are so near their maturity that they
present insignificant risk of changes in value because of changes in
interest rates.\311\ Examples of items commonly considered to be cash
equivalents include certain Treasury bills, agency securities, bank
deposits, commercial paper, and shares of money market funds.\312\ Cash
and cash equivalents are extremely liquid (in that they either are
cash, or could be easily and nearly immediately converted to known
amounts of cash without a loss in value), and significant holdings of
these instruments generally decrease a fund's liquidity risk because
the fund could use them to meet redemption requests without materially
affecting the fund's NAV.\313\
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    \310\ Proposed rule 22e-4(b)(2)(iii)(D).
    \311\ FASB Accounting Standards Codification paragraph 305-10-
20l.
    \312\ See 2014 Money Market Fund Reform Adopting Release, supra
note 85, at sections III.A.7 and III.B.6 (clarifying that the
reforms to the regulation of money market funds adopted by the
Commission in 2014 should not preclude an investment in a money
market fund from being classified as a cash equivalent under U.S.
GAAP under normal circumstances); Form PF: Glossary of Terms
(defining ``cash and cash equivalents'').
    \313\ However, a substantial investment in cash and cash
equivalents could decrease a fund's total return and/or cause a fund
to diverge from its investment strategy, and thus a fund may wish to
calibrate its holdings of these instruments to manage the fund's
liquidity risk while taking these concerns into consideration. But
see Simutin, supra note 258 (observing that actively managed equity
funds with cash holdings in excess of the level predicted by fund
attributes outperform their low abnormal cash peers by over 2% per
year).
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    Entering into borrowing arrangements and agreements with other
potential funding sources also could affect a fund's liquidity risk, as
they could assist the fund in paying redeeming shareholders without the
need to sell portfolio securities under circumstances that could impair
the fund's NAV.\314\ For example, in the past several decades, it has
become increasingly common for fixed income funds to establish lines of
credit with commercial banks.\315\ When considering the extent to which
a bank credit facility could affect a fund's liquidity risk, we believe
a fund may find it instructive to evaluate the terms of the credit
facility (e.g., associated fees, the borrowing rate, and the time frame
for repaying borrowed funds), the amount of the credit facility,
whether the credit facility is committed or uncommitted,\316\ and the
financial health of the institution(s) providing the facility
(especially to the extent that the fund also holds bonds or other
securities issued by such institution(s), as a decrease in these
securities' liquidity--caused, for example, by increased volatility of
their trading prices--could contribute to an increased need to borrow
from the institution). If a credit facility is shared among multiple
funds within a fund family, a fund may wish to consider that the
ability of that facility to mitigate the

liquidity risk of one fund within the family hinges in part on the
degree of liquidity risk associated with the other funds sharing the
facility. A fund also may wish to consider any negative impact on the
fund resulting from borrowing funds for liquidity risk management
purposes, as opposed to managing liquidity through the fund's portfolio
construction. For example, borrowing funds to pay redeeming
shareholders (for example, to avoid making sales of assets into
distressed markets) could be beneficial to redeeming shareholders but
could ultimately disadvantage non-redeeming shareholders who would
effectively bear the costs of borrowing.\317\ In assessing the effects
of the fund's borrowing arrangements on the fund's liquidity risk, a
fund may find it useful to assess the purposes for which the fund has
historically borrowed funds to pay redemption proceeds. Finally, if a
fund holds bonds or other securities issued by a bank, the fund may
wish to consider whether entering into a borrowing arrangement with the
same bank that issued such securities increases correlated exposure to
the bank.
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    \314\ See supra note 35 (noting that most funds do not
frequently draw on their lines of credit).
    \315\ See, e.g., Miles Weiss, BlackRock Leads Funds Raising
Credit Lines Amid Review, Bloomberg (Jan. 21, 2015), available at
http://www.bloomberg.com/news/articles/2015-01-21/blackrock-leads-funds-raising-credit-lines-amid-review (discussing an uptick in
demand by funds for bank lines of credit); see also Fortune, supra
note 270, at 64 (noting that lines of credit with banks were rarely
available to funds prior to the mid-1980s); infra section III.C.5.a
(Commission guidance on use of borrowing arrangements and other
funding sources as a liquidity risk management control).
    \316\ A committed line of credit represents a bank's obligation,
in exchange for a fee, to make a loan to a fund subject to specified
conditions. A bank can also provide an uncommitted or standby line
of credit, in which the bank indicates a willingness, but no
obligation, to lend to a fund. See Fortune, supra note 270, at 47.
    \317\ See Heartland Release, supra note 47.
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    A fund also could engage in interfund lending within a family of
funds if the fund has obtained exemptive relief from the Commission
permitting the arrangement.\318\ When considering the extent to which
an interfund lending arrangement could affect a fund's liquidity risk,
we believe a fund may find it instructive to evaluate the terms of the
arrangement (e.g., the lending rate and the time frame for repaying
borrowed funds), as well as any conditions required under exemptive
relief, including limitations on the circumstances in which interfund
lending may be used. For example, it is common for exemptive orders to
permit interfund lending in circumstances in which there is a timing
mismatch between when a fund is required to pay redeeming shareholders
and when any asset sales that the fund has executed in order to pay
redemptions will settle (e.g., a fund may be required to pay redeeming
shareholders within three business days, but the portfolio transactions
the fund has executed in order to pay these shareholders may not settle
for seven days). A fund can reasonably predict that it will repay
borrowed money relatively quickly and reliably under these
circumstances. Therefore this type of borrowing would tend to be very
low risk, and thus entail less liquidity risk,\319\ than borrowing
money to pay redemptions without already having secured a price at
which the assets used to cover the borrowing will be sold.
---------------------------------------------------------------------------

    \318\ See infra note 320 and accompanying and following text.
    \319\ See supra section III.C.1.c (discussing circumstances in
which a fund's use of leverage and derivatives could increase the
fund's liquidity risk).
---------------------------------------------------------------------------

    Finally, a fund could generate liquidity through repurchase
transactions, whereby the fund could agree to sell securities to
another party at a specified price with a commitment to buy the
securities back at a later date for another specified price. A
repurchase agreement is structurally similar to a short-term loan, and
thus a fund could use repurchase agreements to temporarily borrow cash
to repay redeeming shareholders. A fund may find it instructive to
consider how factors such as market conditions, supply and demand
factors, whether the repurchase agreement is on a bilateral or tri-
party basis, and counterparty credit risk could affect the ability of
repurchase transactions to mitigate liquidity risk.
    A fund's borrowing and other funding arrangements are subject to
restrictions on affiliated transactions and leverage under the
Investment Company Act and rules under the Act. For example, funds must
obtain exemptive relief from the Commission before executing
transactions that implicate section 17 of the Investment Company Act,
which restricts transactions between an ``affiliated person of a
registered investment company or an affiliated person of such
affiliated person'' and that investment company.\320\ Thus, as noted
above, a fund must obtain exemptive relief before executing interfund
lending arrangements. Additionally, funds' borrowing arrangements must
be conducted in compliance with section 18 of the Investment Company
Act, which limits a fund's ability to issue or sell ``senior
securities.'' For instance, section 18(f) of the Investment Company Act
limits funds to bank borrowing with 300% asset coverage.\321\ The
Commission and its staff have also taken the position that reverse
repurchase agreements may involve the issuance of a senior security
subject to the requirements of section 18 and, under certain
circumstances, a fund could need to ``cover'' the senior security by
maintaining ``segregated accounts.'' \322\ These statutory and
regulatory restrictions could constrain a fund's ability to use
borrowing and other funding sources to meet redemption requests, and
these limitations should be considered in assessing a fund's liquidity
risk.
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    \320\ See Investment Company Act sections 17(a) (prohibiting
first- and second-tier affiliates of a fund from borrowing money or
other property from, or selling or buying securities or other
property to or from the fund, or any company that the fund controls;
17(b) (permitting the Commission to grant an exemptive order
permitting transactions that would otherwise be prohibited under
section 17(a) if certain conditions of fairness are met); see also
Investment Company Act section 17(d) (making it unlawful for first-
and second-tier affiliates of a fund, the fund's principal
underwriters, and affiliated persons of the fund's principal
underwriters, acting as principal, to effect any transaction in
which the fund or a company controlled by the fund is a joint or a
joint and several participant in contravention of Commission rules);
rule 17d-1(a) under the Investment Company Act (prohibiting first-
and second-tier affiliates of a fund, the fund's principal
underwriters, and affiliated persons of the fund's principal
underwriters, acting as principal, from participating in or
effecting any transaction in connection with any joint enterprise or
other joint arrangement or profit-sharing plan in which any such
fund or company controlled by a fund is a participant unless an
application regarding such enterprise, arrangement or plan has been
filed with the Commission and has been granted).
    \321\ See Investment Company Act section 18(f) (prohibiting an
open-end fund from issuing any senior security, except that a fund
may borrow from any bank so long as immediately after the borrowing
there is asset coverage of at least 300% for all borrowings of the
fund).
    \322\ See, e.g., Release 10666 supra note 241. In Release 10666,
the Commission considered the application of section 18's
restrictions on the issuance of senior securities to reverse
repurchase agreements (among other types of agreements). The
Commission concluded that such agreements may involve the issuance
of senior securities subject to the prohibitions and asset coverage
requirements of section 18. The Commission further stated that,
although reverse repurchase agreements (among other types of
agreements) are functionally equivalent to senior securities, these
and similar arrangements nonetheless could be used by funds in a
manner that would not warrant application of the section 18
restrictions. The Commission noted that in circumstances involving
similar economic effects, such as short sales of securities by
funds, Commission staff had determined that the issue of section 18
compliance would not be raised if funds ``cover'' senior securities
by maintaining ``segregated accounts.'' The Commission also
discussed the specific attributes of segregated accounts, board
obligations, and other related matters in Release 10666.
---------------------------------------------------------------------------

e. Request for Comment
    We request comment on the proposed liquidity risk assessment
requirement.
     Do commenters believe that the definition of ``liquidity
risk'' in proposed rule 22e-4 is appropriate? Within the proposed
definition, are the terms ``reasonably foreseeable'' and ``without
materially affecting the fund's NAV'' clear? If not, how could the
definition of ``liquidity risk,'' and terms within the proposed
definition, be made more appropriate and/or clear?
     How do funds currently assess their liquidity risk? Who at
the fund and/or the adviser is tasked with assessing the fund's
liquidity risk? Who should be tasked with assessing the fund's
liquidity risk? Should the proposed rule specify the officers or
functional areas

that should be tasked with assessing a fund's liquidity risk?
    We also request comment on each of the proposed factors that each
fund would be required to consider in assessing its liquidity risk.
     What factors do funds currently use to assess their
liquidity risk, and do the proposed factors reflect factors that funds
(and/or the adviser, as applicable) already consider when evaluating
liquidity risk? Should any of the proposed factors not be required to
be considered by a fund in assessing its liquidity risk? Should any of
the proposed factors be modified? Are there any additional factors,
besides the proposed factors, that a fund should be required to
consider in assessing liquidity risk? Should any of the proposed
factors be given additional weight and, if so, under what
circumstances?
     Instead of codifying the proposed factors as part of
proposed rule 22e-4, should we provide guidance on factors that might
be appropriate for a fund to consider in assessing its liquidity risk?
    We seek comment on the Commission's guidance discussed above
regarding each of the proposed factors.
     Besides the guidance, are there any other specific issues
associated with any of the proposed factors that a fund may wish to
consider in assessing the fund's liquidity risk? Do commenters
generally agree with the guidance that the Commission has proposed
regarding the ways in which each of the proposed factors could
contribute to a fund's liquidity risk? Should the staff provide
additional guidance about the factors? Should we add a note to rule
22e-4 indicating that the release includes additional guidance
regarding the proposed factors?
     Are there any factors or procedures that would be of
particular use to a fund without a substantial operating history in
assessing liquidity risk? Would a new fund look to purchase and
redemption activity in similar funds to predict its flow patterns?
2. Periodic Review of a Fund's Liquidity Risk
a. Proposed Liquidity Risk Review Requirement
    Proposed rule 22e-4(b)(2)(iii) would require a fund to periodically
review the fund's liquidity risk, taking into account each of the
factors of proposed rule 22e-4(b)(2)(iii)(A)-(D) (discussed above in
sections III.C.1.a-III.C.1.d). We believe that the periodic review of a
fund's liquidity risk is necessary to determine whether, in light of
current circumstances, an adequate level of liquidity is being
maintained. Like the proposed requirement to monitor the liquidity of
portfolio assets,\323\ the proposed liquidity risk review requirement
would permit each fund to develop and adopt effective and
individualized procedures to review the fund's liquidity risk, tailored
as appropriate to reflect the fund's particular facts and
circumstances. A fund would be required to consider each of the
proposed rule 22e-4(b)(2)(iii)(A)-(D) factors in reviewing its
liquidity risk. However, beyond this, rule 22e-4 does not include
prescribed review procedures, nor does it specify the required risk
review period or incorporate specific developments that a fund should
consider as part of its review. A fund might generally consider whether
its periodic review procedures should include procedures for evaluating
regulatory, market-wide, and fund-specific developments affecting each
of the proposed rule 22e-4(b)(2)(iii) risk factors. Because a fund's
liquidity risk is directly related to the liquidity of the fund's
portfolio assets (as reflected by proposed rule 22e-4(b)(2)(iii)(B),
which requires consideration of the liquidity of a fund's portfolio
assets as an element of the fund's liquidity risk assessment), a fund
may wish to adopt liquidity risk review procedures that reference the
fund's procedures for monitoring portfolio assets' liquidity. For
example, a fund's liquidity risk review procedures could specify that
certain circumstances giving rise to a revision of a portfolio asset's
liquidity classification \324\ could necessitate a review of the fund's
liquidity risk.
---------------------------------------------------------------------------

    \323\ See proposed rule 22e-4(b)(2)(i).
    \324\ See, e.g., supra paragraph accompanying notes 251-254.
---------------------------------------------------------------------------

b. Request for Comment
    We request comment on the proposed liquidity risk review
requirement.
     How do funds currently review liquidity risk? How often do
funds currently review this risk? To what extent do funds anticipate
that the periodic review procedures that would be required under
proposed rule 22e-4 would replicate procedures funds currently use to
periodically evaluate liquidity risks facing the fund?
     Are there certain review procedures that the Commission
should require and/or on which the Commission should provide guidance?
Should the Commission specify how frequently a fund must review its
liquidity risk? Should funds review liquidity risk at least as
frequently as they conduct ongoing liquidity reviews? Should the
Commission expand its guidance on regulatory, market-wide, and fund-
specific developments that a fund's review procedures should cover?
3. Portfolio Liquidity: Minimum Investments in Three-Day Liquid Assets
a. Proposed Three-Day Liquid Asset Minimum Requirement
    Proposed rule 22e-4(b)(2)(iv)(A) would require each fund to
determine the fund's ``three-day liquid asset minimum'' as part of its
liquidity risk management program.\325\ As proposed, the fund's three-
day liquid asset minimum would be defined as the percentage of the
fund's net assets to be invested in three-day liquid assets.\326\ In
determining its three-day liquid asset minimum, a fund would be
required to consider the factors a fund would be required to consider
in assessing its liquidity risk under proposed rule 22e-
4(b)(2)(iii).\327\ These factors include an assessment of short-term
and long-term cash flow projections, taking into account certain
specified considerations discussed further below; the investment
strategy and liquidity of the fund's portfolio assets; the use of
borrowings and derivatives for investment purposes (for example, to
enhance returns),\328\ and holdings of cash and cash equivalents, as
well as borrowing arrangements and other funding sources. These factors
are based, in part, on staff outreach to funds and third-party service
providers that assess liquidity risk on behalf of funds, and they also
incorporate considerations that we believe have historically
contributed to liquidity risk in open-end funds.\329\
---------------------------------------------------------------------------

    \325\ Under proposed rule 22e-4(b)(2)(iv)(C), a fund would be
prohibited from acquiring any less liquid asset if, immediately
after the acquisition, the fund would have invested less than its
three-day liquid asset minimum in three-day liquid assets.
    \326\ We propose to define three-day liquid asset as any cash
held by a fund and any position of a fund in an asset (or portion of
the fund's position in an asset) that the fund believes is
convertible into cash within three business days at a price that
does not materially affect the value of that asset immediately prior
to sale. See proposed rule 22e-4(a)(8).
    \327\ See proposed rule 22e-4(b)(2)(iv)(A).
    \328\ See Investment Company Names Rule Release, supra note 36,
at n.36 (``Whether a particular transaction is considered borrowing
for investment purposes would depend on all facts and
circumstances.'').
    \329\ See supra section III.C.1.
---------------------------------------------------------------------------

    A fund's board would be required to approve the fund's three-day
liquid asset minimum (including any changes to the fund's three-day
liquid asset minimum),\330\ and a fund would be required to maintain a
written record of how the fund's three-day liquid asset minimum was
determined (including an

assessment of each of the factors proposed rule 22e-4 would require a
fund to assess in making this determination).\331\
---------------------------------------------------------------------------

    \330\ See proposed rule 22e-4(b)(3)(i).
    \331\ See proposed rule 22e-4(c)(3) (each fund must maintain a
written record of how the three-day liquid asset minimum, and any
adjustments thereto, were determined, including assessment of the
factors specified in proposed rule 22e-4(b)(2)(iii)(A)-(D), for a
period of not less than five years (the first two years in an easily
accessible place) following the determination of and each change to
the three-day liquid asset minimum).
---------------------------------------------------------------------------

    We are proposing the requirement for each fund to determine a
three-day liquid asset minimum to increase the likelihood that the fund
will hold adequate liquid assets to meet redemption requests without
materially affecting the fund's NAV. Although the Commission has stated
that open-end funds have a general responsibility to maintain an
appropriate level of portfolio liquidity, no requirements under the
federal securities laws or Commission rules specifically oblige open-
end funds (with the exception of money market funds) to maintain a
minimum level of portfolio liquidity.\332\ We believe that codifying a
three-day liquid asset minimum requirement would result in a portfolio
liquidity standard that fosters consistency in funds' consideration of
the factors relevant to their liquidity risk management, while
simultaneously permitting flexibility in implementation, which we
believe is appropriate in light of the significant diversity of
holdings and strategies within the fund industry.
---------------------------------------------------------------------------

    \332\ See supra section II.D.1.
---------------------------------------------------------------------------

    We believe setting the minimum amount of liquid assets in the fund
based on three-day liquid assets is appropriate for a number of
reasons. Most funds sell at least some of their shares through broker-
dealers, and thus, as a practical matter, are required as a result of
rule 15c6-1 under the Exchange Act to meet redemptions within three
business days.\333\ While some mutual funds disclose in their
prospectuses that they will generally pay redemption proceeds on a
next-business day basis and many others do so as a matter of
practice,\334\ we are not proposing that funds maintain a minimum
amount of assets that may be converted to cash within one day, given
the impact such a minimum could have on investment strategies. Staff
outreach has shown that, for the funds that typically do target a
minimum amount of liquidity in the fund, they typically target either
cash and cash equivalents or assets similar to our definition of three-
day liquid assets. Accordingly, targeting such a minimum appears to be
a common practice for those funds that do establish a target.
---------------------------------------------------------------------------

    \333\ See, e.g., Fidelity FSOC Notice Comment Letter, supra note
20, at 6 (``As a practical matter, three-day settlement requirements
under Exchange Act Rule 15c6-1 . . . effectively take most fund
investments to a T+3 settlement timeline.'').
    \334\ See id. at 6 (``mutual funds normally process redemption
requests by the next business day''); see also ICI FSOC Notice
Comment Letter, supra note 16, at 17 (``For example, a mutual fund
has by law up to seven days to pay proceeds to redeeming investors,
although as a matter of practice funds typically pay proceeds within
one to two days of a redemption request.'').
---------------------------------------------------------------------------

    Consistent with the time period referenced in section 22(e) of the
Act, we considered requiring that a fund determine a minimum amount of
liquid assets based on assets convertible to cash within seven calendar
days at a price that does not materially affect the value of that asset
immediately prior to sale (``seven-day liquid assets''). Determining a
minimum amount of seven-day liquid assets would require that a fund
have a certain amount of liquidity to meet redemptions within the
seven-day period required under the Act. However, we were concerned
that requiring a minimum amount of seven-day liquid assets would not as
well match regulatory requirements and disclosures that require most
funds to meet redemption requests in shorter time periods and market
practices and investor expectations that effectively require all funds
to meet redemption requests in shorter time periods. We thus believe
that a three-day liquid asset minimum more effectively advances our
goals of reducing the risk that funds will be unable to meet
redemptions and mitigating dilution.
    We anticipate that the proposed requirement for a fund to consider
certain factors, including the factors required in assessing the fund's
liquidity risk, in determining its three-day liquid asset minimum would
promote investor protection by reducing the risk funds will be unable
to meet their redemption obligations, mitigating dilution, and
elevating the overall quality of liquidity risk management across the
fund industry. The consideration of certain factors also would require
every fund to consider multiple aspects of its history, policies,
strategy, and operations that could give rise to liquidity risk.
    When determining its three-day liquid asset minimum, a fund must
consider short-term and long-term cash flow projections, taking into
account the following factors, which we discussed previously in
connection with the assessment of a fund's liquidity risk: \335\
---------------------------------------------------------------------------

    \335\ See supra section III.C.1.a.
---------------------------------------------------------------------------

    1. the size, frequency, and volatility of historical purchases and
redemptions of fund shares during normal and stressed periods;
    2. the fund's redemption policies;
    3. the fund's shareholder ownership concentration;
    4. the fund's distribution channels; and
    5. the degree of certainty associated with the fund's short-term
and long-term cash flow projections.\336\
---------------------------------------------------------------------------

    \336\ See proposed rule 22e-4(b)(2)(iii)(A).
---------------------------------------------------------------------------

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

    \337\ See supra text following note 100; see also supra note 104
(discussing Commission initiative to require large investment
companies and investment advisers to engage in annual stress tests
as required by section 165(i) of the Dodd-Frank Act).
---------------------------------------------------------------------------

    In formulating the fund's cash flow projections, a fund also must
consider the fund's redemption policies, shareholder ownership
concentration, and distribution channels. These are

important structural features of a fund that can materially affect the
risk of significant redemptions--and thus may cause a fund to set a
higher three-day liquid asset minimum than one based on its redemption
history alone. For example, a fund with a concentrated shareholder base
has a high risk that only one or two shareholders deciding to redeem
can cause the fund to sell a significant amount of assets, which
depending on the liquidity of the fund's portfolio and how it meets
those redemptions, can dilute remaining shareholders. Similarly, a fund
whose redemption policy is to satisfy all redemptions on a next
business day basis (T+1) or that is sold through distribution channels
that historically attract investors with more volatile and/or
unpredictable flows also should consider setting a higher three-day
liquid asset minimum than a fund that--all else equal--does not face
these risks. Finally, in setting a three-day liquid asset minimum it is
critical that a fund consider the degree of certainty associated with
the fund's short-term and long-term cash flow projections. Projections
may only be as good as the extent and quality of information that
informs them. For example, if a fund does not have great visibility
into its shareholder base (e.g., because the fund's shares are
principally sold through intermediaries that do not provide shareholder
transparency) or if a fund is uncertain about changing market
conditions which are likely to materially affect the fund's level of
net redemptions, it may make projections but be quite uncertain about
those projections. In these circumstances, we would expect a fund to
set its three-day liquid asset minimum to reflect this uncertainty, for
example, by providing a cushion or multiple of its cash flow
projections in the event realized net redemptions are significantly
higher. A fund should have a three-day liquid asset minimum that will
allow it to meet its net redemption projections.
    In setting its three-day liquid asset minimum, a fund also must
consider its investment strategy and the liquidity of portfolio assets.
A finding of the DERA Study is that certain investment strategies
typically have greater volatility of flows than other investment
strategies. For example, the DERA Study indicates that the mean
standard deviation of monthly net flows for alternative funds is 13.6%
and for emerging market debt funds is 9.4%, but is only 2.7% for
municipal bond funds and 4.9% for U.S. corporate bond funds.\338\
Accordingly, all else equal, we generally would expect that an emerging
market debt fund would have a higher three-day liquid asset minimum
than a municipal bond fund. Similarly, the less liquid a fund's overall
portfolio assets are, the more a fund may want to establish a higher
three-day liquid asset minimum to avoid dilution when meeting investor
redemptions.
---------------------------------------------------------------------------

    \338\ DERA Study, supra note 39, at Table 6.
---------------------------------------------------------------------------

    A fund also must consider its use of borrowings and derivatives in
setting its three-day liquid asset minimum. A leveraged fund has an
increased risk that it will be unable to meet redemptions and an
increased risk of investor dilution compared to an equivalent fund with
no leverage. For example, a fund with leverage through bank borrowings
may have to meet margin calls if a security the fund provided to the
bank to secure the loan declines in value. Such margin calls can render
highly liquid portfolio assets unavailable to meet investor
redemptions, which can increase dilution and the risk the fund will be
unable to meet redemptions. Similarly, a fund that has significant
fixed obligations to derivatives counterparties (for example, from a
total return swap or writing credit default swaps) must pay out on
these obligations when due, even if it means selling the fund's more
liquid, high quality assets to raise cash.\339\ A fund with a leveraged
strategy thus, all else equal, should have a higher three-day liquid
asset minimum than a fund that does not.
---------------------------------------------------------------------------

    \339\ See, e.g., OppenheimerFunds Release, supra note 309.
---------------------------------------------------------------------------

    Finally, a fund must consider its holdings of cash and cash
equivalents, as well as borrowing arrangements and other funding
sources when determining its three-day liquid asset minimum.
Unencumbered cash and cash equivalents are assets that the fund can
typically readily deploy, in normal and stressed conditions, to meet
redemptions. A fund can have cash on hand to meet redemptions from cash
held in the fund's portfolio, cash received from investor purchases of
fund shares, interest payments and dividends on portfolio securities,
or maturing bonds. Our staff observed that several fund complexes
targeted a minimum amount of cash or cash equivalent holdings in the
fund because they assumed such holdings would allow the fund to meet
redemptions in a stressed period without realizing significant
discounts to fair value when the asset was sold. Accordingly, higher
cash and cash equivalent holdings may make a fund more comfortable that
it can meet redemptions under stressed conditions with a lower three-
day asset minimum than an equivalent fund whose three-day asset minimum
was comprised primarily of non-cash equivalent assets. A fund also
should consider whether it has a line of credit or other funding
sources available to it to meet redemptions. As discussed further
below, while we believe that liquidity risk management is best
conducted primarily through portfolio construction, we recognize a line
of credit can facilitate a fund's ability to meet unexpected
redemptions.
    Because each fund would be required to maintain a written record of
how its three-day liquid asset minimum was determined, including an
assessment of each of the factors discussed above,\340\ our examination
staff would be able to ascertain that funds are indeed considering the
required factors. We expect that a board approving a fund's three-day
liquid asset minimum would consider how the specified factors inform
that minimum, and thus we believe that the proposed rule would cause
fund boards to consider a comprehensive set of issues surrounding the
fund's liquidity risk and risk management. Moreover, we believe that
the board approval requirement associated with the three-day liquid
asset minimum determination would add independent oversight over funds'
liquidity risk management.
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    \340\ See supra note 331.
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    Although a fund would be permitted to determine its three-day
liquid asset minimum under the analysis required by the proposed rule,
we generally believe that it would be extremely difficult to conclude,
based on the factors it would be required to consider, that a zero
three-day liquid asset minimum would be appropriate. Under the proposed
rule, a fund's three-day liquid asset minimum would be a control to
manage the fund's liquidity risk, and as discussed above the fund's
three-day liquid asset minimum would be required to be determined based
on the consideration of certain specified factors.\341\ We believe that
it would be extremely difficult to conclude, based on factors such as
the fund's cash flow projections and redemption policies, that zero
holdings of three-day liquid assets would allow the fund to manage its
liquidity risk (in conjunction with any other liquidity risk management
policies and procedures the fund adopts as part of its liquidity risk
management program).
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    \341\ See proposed rule 22e-4(b)(iv)(A).
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    By way of example, consider a bank loan fund with a ten-year track
record. The fund has a history of volatile cash

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

proposed rule 22e-4(b)(2)(iv)(C) would require the fund to acquire only
three-day liquid assets until its investments in three-day liquid
assets reach the fund's three-day liquid asset minimum, but the
proposed rule would not require the fund to divest less liquid assets
and reinvest the proceeds in three-day liquid assets.\345\
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    \344\ A fund's three-day liquid asset minimum would apply at the
series level, not at the class level.
    \345\ A fund's investments in three-day liquid assets could drop
below the fund's three-day liquid asset minimum for a variety of
reasons. For instance, the fund could sell its most liquid assets in
order to obtain cash to meet redemption requests, thereby reducing
its holdings of three-day liquid assets. Or, if the market value of
a fund's three-day liquid assets falls relative to the market value
of the fund's less liquid assets, the percentage of a fund's assets
invested in three-day liquid assets could decrease. A fund's three-
day liquid assets also could become less liquid if market conditions
deteriorate.
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    While we believe that fund shareholders' interests are generally
best served when the percentage of a fund's assets invested in three-
day liquid assets is at (or above) the fund's three-day liquid asset
minimum,\346\ we believe that requiring a fund to maintain this
percentage at all times could adversely affect shareholders and could
potentially negate the liquidity risk management benefits of the
proposed three-day liquid asset minimum requirement. For instance, if a
fund were forced to sell less liquid assets at an inopportune time in
order to reinvest the proceeds in three-day liquid assets, the fund
might need to sell the less liquid assets at prices that incorporate a
significant discount to the assets' stated value, or even at fire sale
prices. These forced sales could produce significant negative price
pressure on those assets and decrease the value of the assets still
held by the fund, thereby decreasing the value of fund shares held by
remaining investors, and possibly creating a first-mover advantage that
harms investors who choose not to redeem their shares as quickly as
others.\347\ Also, if a fund needed to rebalance its portfolio
frequently to maintain a specified percentage of the fund's net assets
invested in three-day liquid assets, this could produce unnecessary
transaction costs adversely affecting the fund's NAV, and could cause a
fund to sell portfolio assets when it is not advantageous to do so
(e.g., when an asset's price is low, or when sales of an asset would
have an undesirable tax impact). For these reasons, we are proposing a
requirement that limits the acquisition of less liquid assets when such
acquisition would result in a fund investing less than its three-day
liquid asset minimum in three-day liquid assets, but we are not
proposing to require that funds always maintain a certain portion of
their portfolio assets in three-day liquid assets.\348\
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    \346\ See supra text preceding and following note 332.
    \347\ See infra notes 690-698 and accompanying text.
    \348\ This proposed acquisition test (in contrast to a
maintenance test) reflects approaches that Congress and the
Commission have historically taken in other parts of the Investment
Company Act and the rules thereunder. See, e.g., Investment Company
Act section 5(c) (a registered diversified company that at the time
of its qualification meets the diversification requirements
specified in Investment Company Act section 5(b)(1) shall not lose
its status as a diversified company because of any subsequent
discrepancy between the value of its various investments and the
requirements of section 5(b)(1), so long as any such discrepancy
existing immediately after its acquisition of any security or other
property is neither wholly nor partly the result of such
acquisition); rule 2a-7(d)(3) (portfolio diversification
requirements of rule 2a-7 are determined at the time of portfolio
securities' acquisition); rule 2a-7(d)(4)(i) (limit on a money
market fund's acquisition of illiquid securities if, immediately
after the acquisition, the money market fund would have invested
more than 5% of its total assets in illiquid securities); rule 2a-
7(d)(4)(ii)-(iii) (minimum daily liquidity requirement and minimum
weekly liquidity requirement of rule 2a-7 are determined at the time
of portfolio securities' acquisition).
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c. Periodic Review of a Fund's Three-Day Liquid Asset Minimum
    Under proposed rule 22e-4(b)(2)(iv)(B), each fund would be required
to periodically review the adequacy of the fund's three-day liquid
asset minimum, and in conducting such review would be required to take
into account the factors a fund would be required to consider in
determining its three-day liquid asset minimum. We believe the factors
used to determine a fund's three-day liquid asset minimum also provide
an appropriate framework for reviewing the adequacy of a fund's three-
day liquid asset minimum because, as discussed below, changes in the
assessment of the factors could provide a basis for adjusting the
three-day liquid asset minimum. A fund would be required to complete
this review no less frequently than semi-annually,\349\ but could
establish a more frequent periodic review period, and in addition could
review the three-day liquid asset minimum even more frequently on an