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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

    We are adopting, as proposed, the requirement that a fund report
whether it engaged in interfund lending or interfund borrowing during
the reporting period, and, if so, the average amount of the interfund
loan when the loan was outstanding and the number of days that the
interfund loan was outstanding.\986\ This information will provide some
transparency regarding the extent to which funds use interfund lending
or interfund borrowing. We understand that one reason that funds have
sought exemptive relief to engage in interfund lending and borrowing is
to meet redemption obligations if necessary.\987\
---------------------------------------------------------------------------

    \986\ See Items C.20.b and c of Form N-CEN.
    \987\ For example, we understand that funds may engage in
interfund lending and borrowing to pay out redemption proceeds same-
day or T+1 while the fund awaits proceeds from sales of non-traded
securities.
---------------------------------------------------------------------------

b. Additional Information Concerning ETFs
    In a modification to the proposal, we are requiring that each ETF
that complies with rule 22e-4 as an ``In-Kind ETF'' under the rule,
identify itself accordingly in reports on Form N-CEN.\988\ As discussed
above, we are adopting certain tailored liquidity risk management
program requirements for ETFs, and certain ETFs that qualify as In-Kind
ETFs will not be required to classify their portfolio investments or
comply with the highly liquid investment minimum requirement of rule
22e-4.\989\ We believe that the In-Kind ETF information reported on
Form N-CEN will be helpful in understanding the volume of ETFs that
identify as In-Kind ETFs and thus are not required to classify their
portfolio investments or comply with the highly liquid investment
minimum requirement of rule 22e-4.\990\
---------------------------------------------------------------------------

    \988\ See Item E.5 of Form N-CEN; see also supra section III.J
regarding the definition and treatment of ``In-Kind ETFs'' under
rule 22e-4.
    \989\ Id.
    \990\ ETFs that redeem in cash, or that do not qualify otherwise
as ``In-Kind ETFs'' (as defined in rule 22e-4(a)(9)) will be subject
to the full set of liquidity risk management program elements,
including the classification and highly liquid investment minimum
requirements. See rule 22e-4(b)(1)(i)-(iii).
---------------------------------------------------------------------------

4. Safe Harbors
    Some commenters suggested that the Commission should include a safe
harbor and/or protection from liability as part of the final rule for
proposed liquidity-related disclosures.\991\ One commenter recommended
that the Commission provide a safe harbor for ``forward-looking
statements'' given the speculative nature of the proposed
disclosures.\992\ Another commenter recommended that the Commission
implement measures to shield from liability funds that in good faith
make forward-looking assessments of liquidity at either the asset or
portfolio level that subsequently turn out to materially differ from
actual liquidity.\993\ One commenter further suggested that the
Commission should include a provision stating that funds and their
affiliates will not face liability for errors in classification or
otherwise in implementing their liquidity risk management programs, and
related reports and (if applicable) disclosures, unless (i) the error
is material and (ii) the fund or affiliate acted knowingly or
recklessly. Commenters argued that any safe harbor provision should
also make clear that funds and managers would not face liability for
violation of rule 22e-4 based on second-guessing, either by the
Commission or by fund shareholders, of the design of the liquidity risk
management program.\994\ One commenter expressed concern that, even if
a safe harbor provision were established that protected funds and
directors from Commission enforcement actions, funds and directors
could still be subject to private litigation.\995\ We decline to
provide such a safe harbor.
---------------------------------------------------------------------------

    \991\ See, e.g., ICI Comment Letter I; LSTA Comment Letter;
SIFMA Comment Letter II; T. Rowe Comment Letter.
    \992\ See FSR Comment Letter.
    \993\ See ICI Comment Letter I (noting that the Commission has
precedent for using its authority to shield from potential liability
certain forward-looking information that registrants are required to
provide (see, e.g., rule 175 under the Securities Act; rule 3b-6
under the Exchange Act; Item 303(c) of Reg. S-K; and Disclosure in
Management's Discussion and Analysis about Off-Balance Sheet
Arrangements and Aggregate Contractual Obligations, Securities Act
Release No. 33-8182 (Feb. 5, 2003) (regarding MD&A disclosures)).
    \994\ See SIFMA Comment Letter II.
    \995\ See Federated Comment Letter.
---------------------------------------------------------------------------

M. Effective and Compliance Dates

    We are adopting the following effective and compliance dates, as
set forth below.
1. Liquidity Risk Management Program
    The compliance date for our liquidity risk management program
requirement is December 1, 2018 for larger entities, and June 1, 2019
for smaller entities. Thus all registered open-end management
investment companies, including open-end ETFs, that are not smaller
entities, will be required to adopt and implement a written liquidity
risk management program, approved by a fund's board of directors on
December 1, 2018, while smaller entities will be required to do so six
months later, on June 1, 2019.\996\
---------------------------------------------------------------------------

    \996\ The compliance date in the section applies to rule 22e-4,
rule 30b1-10, and Form N-LIQUID.
---------------------------------------------------------------------------

    In the Proposing Release, the Commission stated that it expected to
provide a tiered set of compliance dates based on asset size.\997\ The
Commission expected that 18 months after the effective date would
provide an adequate period of time for larger entities to prepare
internal processes, policies, and procedures and implement liquidity
risk management programs that would meet the requirements of the
rule.\998\ We believed that smaller entities would benefit from having
an additional 12 months to establish and implement a written liquidity
risk management program.\999\
---------------------------------------------------------------------------

    \997\ See Proposing Release, supra footnote 9, at section III.H.
Specifically, for larger entities--namely, funds that together with
other investment companies in the same ``group of related investment
companies'' have net assets of $1 billion or more as of the end of
the most recent fiscal year--the Commission proposed a compliance
date of 18 months after the effective date to comply with the
Proposed Rule. For smaller entities (i.e., funds that together with
other investment companies in the same ``group of related investment
companies'' have net assets of less than $1 billion as of the end of
the most recent fiscal year), the proposal provided for an extra 12
months (or 30 months after the effective date) to comply with
proposed rule 22e-4.
    \998\ Id.
    \999\ Id.
---------------------------------------------------------------------------

    Most of the commenters who discussed the proposed liquidity risk
management program compliance

date(s) opposed tiered compliance and requested at least 30 months to
comply. Some argued larger funds would need at least 30 months to
comply because of their size: More funds and a greater number and
variety of investments to classify would require more time.\1000\
Others cited operational limitations: A need of adequate time for (1)
all funds to properly prepare processes, policies and procedures; (2)
managers to adjust operations and develop reporting capabilities; and
(3) mutual fund boards to review, approve, and implement the
program.\1001\ The only commenter that supported tiered compliance
requested lengthier compliance dates for both larger and smaller
entities.\1002\
---------------------------------------------------------------------------

    \1000\ See, e.g., Fidelity Comment Letter; FSR Comment Letter;
ICI Comment Letter I; Invesco Comment Letter.
    \1001\ See, e.g., BlackRock Comment Letter; CRMC Comment Letter;
T. Rowe Comment Letter; Vanguard Comment Letter.
    \1002\ See Dechert Comment Letter.
---------------------------------------------------------------------------

    After evaluating the comments received, we believe that larger
entities would benefit from an additional period of time to come into
compliance with the rules over the 18 months that was proposed.
Therefore, we are providing an additional 6 months for these entities,
for a total of 24 months (i.e., December 1, 2018) to come into
compliance. We continue to believe that smaller entities may face
additional or different challenges in coming into compliance with the
rules quickly, and are therefore providing an extended compliance
period of a total of 30 months (i.e., June 1, 2019) for such smaller
entities.
2. Amendments to Form N-1A, Form N-PORT, and Form N-CEN
    In the Proposing Release, the Commission expected to require all
initial registration statements on Form N-1A, and all post-effective
amendments that are annual updates to effective registration statements
on Form N-1A, filed six months or more after the effective date, to
comply with the proposed amendments to Form N-1A.\1003\ Few commenters
discussed the Form N-1A amendments. One commenter agreed that 6 months
was sufficient to comply with the amendments;\1004\ another commenter
requested 30 months to comply.\1005\ Because we do not expect that
funds will require significant amounts of time to prepare these
additional disclosures,\1006\ we are adopting a compliance date for our
amendments to Form N-1A of June 1, 2017. This will provide a six month
compliance period for these amendments, as proposed.
---------------------------------------------------------------------------

    \1003\ See Proposing Release, supra footnote 9, at section
III.H.
    \1004\ See ICI Comment Letter I.
    \1005\ See Vanguard Comment Letter.
    \1006\ See Proposing Release, supra footnote 9, at section
III.H.
---------------------------------------------------------------------------

    Similar to the tiered compliance dates for the liquidity
classification requirements (discussed above), we are providing a
tiered set of compliance dates based on asset size for the additions to
Form N-PORT and Form N-CEN.\1007\ In the Proposing Release, for larger
entities, we expected that 18 months would provide an adequate period
of time for funds, intermediaries, and other service providers to
conduct the requisite operational changes to their systems and to
establish internal processes to prepare, validate, and file reports
containing the additional information requested by the proposed
amendments to Form N-PORT. Further, we believed that smaller entities
would benefit from extra time to comply and from the lessons learned by
larger investment companies during the adoption period for Form N-PORT.
For Form N-CEN, we proposed a compliance date of 18 months after the
effective date to comply with the new reporting requirements.\1008\ We
expected that 18 months would provide an adequate period of time for
funds, intermediaries, and other service providers to conduct the
requisite operational changes to their systems and to establish
internal processes to prepare, validate, and file reports containing
the additional information requested by the proposed amendments to Form
N-CEN. Multiple commenters, restating their concerns about operational
limitations, requested 30 months for all entities to comply with the
Form N-PORT and Form N-CEN amendments.\1009\
---------------------------------------------------------------------------

    \1007\ Id.
    \1008\ Id.
    \1009\ See Cohen & Steers Comment Letter; Fidelity Comment
Letter; ICI Comment Letter I; Vanguard Comment Letter.
---------------------------------------------------------------------------

    As discussed above, we are persuaded that larger entities would
benefit from extra time to comply and are therefore providing a
compliance date of December 1, 2018 for larger entities to come into
compliance with the additional liquidity-related reporting requirements
of Form N-PORT and Form N-CEN. This will result in larger funds filing
their first reports with additional liquidity-related information on
Form N-PORT, reflecting data as of December 31, no later than January
31. For smaller entities, the compliance date will be June 1, 2019.
This will provide smaller entities an additional six months to comply
with the new liquidity-related reporting requirements.

IV. Economic Analysis

A. Introduction and Primary Goals of Regulation

1. Introduction
    As discussed above, the Commission is adopting regulatory changes
to require a liquidity risk management program, and to require new
disclosures regarding liquidity risk and liquidity risk management
(collectively, the ``final liquidity regulations''). Because of the
significant diversity in liquidity risk management practices that we
have observed in the fund industry, there exists the need for enhanced
comprehensive baseline regulations instead of only guidance for fund
liquidity risk management. In summary, and as discussed in greater
detail in section III above, the final liquidity regulations include
the following:
     New rule 22e-4 will require that each fund stablish a
written liquidity risk management program. A fund's liquidity risk
management program broadly requires a fund to assess, manage and review
the fund's liquidity risk; to classify the liquidity of each of the
fund's portfolio investments; to determine a highly liquid investment
minimum (except for funds that hold primarily highly liquid
investments); and to limit illiquid investments to 15% of fund
investments. The final rule also provides for a tailored program for
all ETFs, but offers some exemptions for In-Kind ETFs. Finally, the
rule requires for board oversight of the liquidity risk management
program.
     Amendments to Form N-1A and additional elements of new
Form N-PORT and Form N-CEN will require enhanced fund disclosure and
reporting regarding position liquidity and shareholder redemption
practices. New Form N-LIQUID will require more prompt, non-public
notification to the Commission when a fund's holdings of assets that
are illiquid investments exceed 15% of net assets, or when a fund's
holdings of highly liquid investments that are assets fall below the
fund's highly liquid investment minimum for more than 7 consecutive
calendar days.
    The Commission is sensitive to the economic effects of the final
liquidity regulations, including the benefits and costs as well as the
effects on efficiency, competition, and capital formation. The economic
effects are discussed below in the context of the primary goals of the
final liquidity regulations.
2. Primary Goals
    The primary goals of the final liquidity regulations are to promote

investor protection by reducing the risk that funds will be unable to
meet their redemption obligations, elevate the overall quality of
liquidity risk management across the fund industry, increase
transparency of funds' liquidity risks and risk management practices,
and mitigate potential dilution of non-transacting shareholders'
interests. Funds are not currently subject to requirements under the
federal securities laws or Commission rules that specifically require
them to maintain a minimum level of portfolio liquidity (with the
exception of money market funds), and follow Commission guidelines (not
rules) that generally limit their investment in illiquid assets.\1010\
Additionally, a fund today is only subject to limited disclosure
requirements concerning the fund's liquidity risk and risk
management.\1011\ As discussed in the Proposing Release, staff outreach
has shown that funds today engage in a variety of different practices--
ranging from comprehensive and rigorous to minimal and basic--for
assessing the liquidity of their portfolios, managing liquidity risk,
and disclosing information about their liquidity risk, redemption
practices, and liquidity risk management practices to investors.\1012\
We believe that the enhanced requirements for funds' assessment,
management, and disclosure of liquidity risk and enhanced limits on
illiquid investment holdings could decrease the chance that funds would
be unable to meet their redemption obligations and mitigate potential
dilution of non-redeeming shareholders' interests.
---------------------------------------------------------------------------

    \1010\ See supra section II.D; infra section IV.B.1.a.
    \1011\ See supra section II.D; infra section IV.B.1.c.
    \1012\ See supra section II.D; infra sections IV.B.1.a,
IV.B.1.c.
---------------------------------------------------------------------------

    The final liquidity regulations are also intended to lessen the
possibility of early redemption incentives (and investor dilution)
created by insufficient liquidity risk management, as well as the
possibility that investors' share value will be diluted by costs
incurred by a fund as a result of other investors' purchase or
redemption activity. When a fund experiences significant redemption
requests, it may sell portfolio securities or borrow funds in order to
obtain sufficient cash to meet redemptions.\1013\ However, sales of a
fund's portfolio investments conducted in order to meet shareholder
redemptions could result in significant adverse consequences to non-
redeeming shareholders when a fund fails to adequately manage
liquidity. For example, if a fund sells portfolio investments under
unfavorable circumstances, this could create dilution for non-redeeming
shareholders.\1014\ Funds also may borrow from a bank or use interfund
lending facilities to meet redemption requests, but there are costs
(such as interest rates) associated with such borrowings. Both selling
of portfolio investments and borrowing to meet redemption requests
could cause funds to incur costs that would be borne mainly by non-
redeeming shareholders.\1015\ These factors could result in dilution of
the value of non-redeeming shareholders' interests in a fund,\1016\
which could create incentives for early redemptions in times of
liquidity stress, and result in further dilution of non-redeeming
shareholders' interests.\1017\ There also is a potential for adverse
effects on the markets when open-end funds fail to adequately manage
liquidity. For example, the sale of less liquid portfolio investments
at discounted or even fire sale prices when a fund is facing redemption
pressures can produce significant negative price pressure on those
investments and correlated investments, which can impact other
investors holding these investments and may transmit stress to other
funds or portions of the markets.\1018\ For reasons discussed in detail
below, we believe that the liquidity risk management program
requirement, including the enhanced restrictions on holdings of assets
that are illiquid investments, should mitigate the risk of potential
shareholder dilution and decrease the incentive for early redemption in
times of liquidity stress.
---------------------------------------------------------------------------

    \1013\ See supra section II.B.2; infra sections IV.C.1, IV.C.2.
    \1014\ See supra footnotes 79-80 and accompanying text.
    \1015\ See supra footnote 259 and accompanying text.
    \1016\ See supra footnotes 79-80 and accompanying text; infra
sections IV.C.1, IV.C.2.
    \1017\ See supra footnote 85 and accompanying text; infra
sections IV.C.1, IV.C.2.
    \1018\ See supra footnote 89 and accompanying text.
---------------------------------------------------------------------------

    Finally, the final liquidity regulations are meant to address
recent industry developments that have underscored the significance of
funds' liquidity risk management practices. In recent years, there has
been significant growth in the assets managed by funds with strategies
that focus on holding relatively less liquid investments, such as fixed
income funds (including emerging market debt funds), open-end funds
with alternative strategies, and emerging market equity funds.\1019\
There also has been considerable growth in assets managed by funds that
exhibit characteristics that could give rise to increased liquidity
risk, such as relatively high investor flow volatility.\1020\
Additionally, as discussed in detail above, standard fund redemption
and securities settlement periods have tended to become significantly
shorter over the last several decades, which has caused funds to
satisfy redemption requests within relatively short time periods (e.g.,
within T + 3, T + 2, and next-day periods).\1021\ But while fund
redemption periods have become shorter, certain funds, for example,
certain bank loan funds and emerging market debt funds, have increased
their holdings of portfolio securities with relatively long settlement
periods, which could result in a liquidity mismatch between when a fund
plans or is required to pay redeeming shareholders, and when any asset
sales that the fund has executed in order to pay redemptions will
settle.\1022\ Collectively, these industry trends have emphasized the
importance of effective liquidity risk management among funds and
enhanced disclosure regarding liquidity risk and risk management.
---------------------------------------------------------------------------

    \1019\ See supra section II.C.1; infra section IV.B.3; see also
DERA Study, supra footnote 95, at 6-9. Relevant statistics from the
DERA Study were updated through 2015 using the CRSP US Mutual Fund
Database.
    \1020\ See infra section IV.B.3.
    \1021\ See supra footnotes 102 and 103 and accompanying text.
    \1022\ See supra footnotes 104, 105, 377, and 378 and
accompanying text.
---------------------------------------------------------------------------

B. Economic Baseline

    The final liquidity regulations will affect all funds and their
investors, investment advisers and other service providers, all issuers
of the portfolio securities in which funds invest, and other market
participants potentially affected by fund and investor behavior. The
economic baseline of the final liquidity regulations includes funds'
current practices regarding liquidity risk management and liquidity
risk disclosure, as well as the economic attributes of funds that
affect their portfolio liquidity and liquidity risk. These economic
attributes include industry-wide trends regarding funds' liquidity and
liquidity risk management, as well as industry developments
highlighting the importance of robust liquidity risk management by
funds.

1. Funds' Current Practices Regarding Liquidity Risk Management and
Liquidity Risk Disclosure
a. Funds' Current Liquidity Risk Management Requirements and Practices
    Under section 22(e) of the Investment Company Act, a registered
investment company is required to make payment to shareholders for
redeemable securities tendered for redemption within seven days of
their tender.\1023\ In addition to the seven-day redemption requirement
in section 22(e), registered investment companies that are sold through
broker-dealers are required as a practical matter to meet redemption
requests within three business days because broker-dealers are subject
to rule 15c6-1 under the Exchange Act, which establishes a three-day (T
+ 3) settlement period for purchases and sales of securities (other
than certain types of securities exempted by the rule) effected by a
broker or a dealer, unless a different settlement period is expressly
agreed to by the parties at the time of the transaction. Furthermore,
rule 22c-1 under the Act, the ``forward pricing'' rule, requires funds,
their principal underwriters, and dealers to sell and redeem fund
shares at a price based on the current NAV next computed after receipt
of an order to purchase or redeem fund shares, even though cash
proceeds from purchases may be invested or fund investments may be sold
in subsequent days in order to satisfy purchase requests or meet
redemption obligations.
---------------------------------------------------------------------------

    \1023\ See section 22(e) of the Act. Section 22(e) of the Act
provides, in part, that no registered investment company shall
suspend the right of redemption or postpone the date of payment upon
redemption of any redeemable security in accordance with its terms
for more than seven days after tender of the security absent
specified unusual circumstances.
---------------------------------------------------------------------------

    With the exception of money market funds subject to rule 2a-7 under
the Act, the Commission has not promulgated rules requiring open-end
funds to hold a minimum level of liquid investments.\1024\ The
Commission historically has taken the position that open-end funds
should maintain a high degree of portfolio liquidity to ensure that
their portfolio securities and other assets can be sold and the
proceeds used to satisfy redemptions in a timely manner in order to
comply with section 22(e) and their other obligations.\1025\ The
Commission also has stated that open-end funds have a ``general
responsibility to maintain a level of portfolio liquidity that is
appropriate under the circumstances,'' and to engage in ongoing
portfolio liquidity monitoring to determine whether an adequate level
of portfolio liquidity is being maintained in light of the fund's
redemption obligations.\1026\ Open-end funds are also required by rule
38a-1 under the Act to adopt and implement written compliance policies
and procedures reasonably designed to prevent violations of the federal
securities laws, including policies and procedures that provide for the
oversight of compliance by certain of the fund's service providers, and
such policies and procedures should be appropriately tailored to
reflect each fund's particular compliance risks; the rule also requires
board approval and review of the service providers' compliance policies
and procedures.\1027\ An open-end fund that holds a significant portion
of its assets in securities with long settlement periods or with
infrequent trading, or an open-end fund that represents it will pay
redemptions in fewer than seven days, for instance, may be subject to
relatively greater liquidity risks than other open-end funds.
---------------------------------------------------------------------------

    \1024\ See supra footnotes 61-62 and accompanying text.
    \1025\ See Restricted Securities Release, supra footnote 37.
    \1026\ See supra footnote 64 and accompanying text.
    \1027\ See Rule 38a-1 Adopting Release, supra footnote 65.
---------------------------------------------------------------------------

    Additionally, long-standing Commission guidelines generally limit
an open-end fund's aggregate investment in ``illiquid assets'' to no
more than 15% of the fund's net assets (the ``15% guideline'').\1028\
Under the 15% guideline, a portfolio security or other asset is
considered illiquid if it cannot be sold or disposed of in the ordinary
course of business within seven days at approximately the value at
which the fund has valued the investment.\1029\ The 15% guideline has
generally limited funds' exposure to particular types of securities
that cannot be sold within seven days and that the Commission and staff
have indicated may be illiquid, depending on the facts and
circumstances. Depositors of UITs are currently required to consider
which of their restricted securities are illiquid.\1030\
---------------------------------------------------------------------------

    \1028\ See supra footnote 38 and accompanying text.
    \1029\ See supra footnote 39 and accompanying text.
    \1030\ See Rule 144A Release, supra footnote 37 at n.61
(discussing liquidity requirements for UITs prior to the adoption of
rule 22e-4).
---------------------------------------------------------------------------

    As noted in the Proposing Release, staff outreach has shown that
funds currently employ a diversity of practices with respect to
assessing portfolio investments' liquidity, as well as managing
liquidity risk. Section II.D.3 above provides an overview of these
practices, which include, among others: Assessing the ability to sell
particular investments within various time periods, taking into account
relevant market, trading, and other factors; monitoring initial
liquidity determinations for portfolio investments (and modifying these
determinations, as appropriate); holding certain amounts of the fund's
portfolio in highly liquid investments or cash equivalents;
establishing committed back-up lines of credit or interfund lending
facilities; and conducting stress testing relating to the extent the
fund has liquid investments to cover possible levels of
redemptions.\1031\ Some commenters indicated that they view in-kind
redemptions as an important liquidity risk management tool.\1032\
Another commenter noted that ETFs are often used to help manage
liquidity risk because they can allow funds to maintain market exposure
while ensuring sufficient liquidity.\1033\ As noted in the Proposing
Release, the staff has observed that some of the funds with relatively
more thorough liquidity risk management practices have appeared to be
able to meet periods of high redemptions without significantly altering
the risk profile of the fund or materially affecting the fund's
performance, and thus with few dilutive impacts. It therefore appears
that these funds have generally aligned their portfolio liquidity with
their liquidity needs, and that their liquidity risk management permits
them to efficiently meet redemption requests. Other funds, however,
employ portfolio investment liquidity assessment and liquidity risk
management practices that are substantially less rigorous.\1034\ As
discussed above in section II.D.3, some funds do not take different
market conditions into account when

evaluating portfolio investment liquidity, and do not conduct ongoing
liquidity monitoring. Likewise, some funds do not have independent
oversight of their liquidity risk management outside of the portfolio
management process. As a result, funds' procedures for assessing the
liquidity of their portfolio securities, as well as the
comprehensiveness and independence of their liquidity risk management,
vary significantly.
---------------------------------------------------------------------------

    \1031\ See also, e.g., Nuveen FSOC Notice Comment Letter, supra
footnote 85 (discussing stress tests of a fund's ability to meet
redemptions over certain periods); BlackRock FSOC Notice Comment
Letter, supra footnote 85 (discussing several overarching principles
that provide the foundation for a prudent market liquidity risk
management framework for collective investment vehicles, including
an independent risk management function, compliance checks to ensure
portfolio holdings do not exceed regulatory limits, a risk
management function that is independent from portfolio management,
and measuring levels of liquid assets into ``tiers of liquidity'');
Invesco FSOC Notice Comment Letter, supra footnote 248, at 11
(discussing liquidity analysis).
    \1032\ See BlackRock Comment Letter; Invesco Comment Letter.
    \1033\ See BlackRock Comment Letter.
    \1034\ See infra section IV.C.1.b, where the potential
consequences of less rigorous liquidity risk management are
discussed in the context of risk management program benefits.
---------------------------------------------------------------------------

    A fund may meet redemption requests in a variety of ways, including
by using cash, borrowing under a line of credit, or by selling
portfolio investments. The fund's portfolio liquidity as well as its
value will be affected by the choice of which investments are sold.
Subsequent portfolio transactions after redemptions are met will also
affect portfolio liquidity and value. For example, a fund facing a
large redemption request might lessen the impact on portfolio value of
selling investments by selling the most liquid portion of the portfolio
or using some of its cash or a line of credit.\1035\ That choice
benefits non-redeeming investors by minimizing transaction costs and
the loss in fund value due to the price impact of selling, but it also
could increase the liquidity risk of the fund portfolio and the fund
may incur transaction costs if it subsequently engages in portfolio
transactions such as rebalancing towards its previous portfolio
allocation.\1036\ If the fund instead were to sell a ``strip'' of the
portfolio (i.e., a cross-section or representative selection of the
fund's portfolio investments), the immediate impact on fund value may
be greater, but the liquidity of the fund portfolio would be unchanged
as a result of the sale. Funds also could choose to meet redemptions by
selling a range of investments in between their most liquid, on one end
of the spectrum, and a perfect pro rata strip of investments, on the
other end of the spectrum.\1037\ All of the above ways by which a fund
may meet redemptions potentially occur in conjunction with other
strategic portfolio management decisions, such as opportunistically
paring back or eliminating holdings in a particular investment or
sector while meeting redemptions.
---------------------------------------------------------------------------

    \1035\ We note that in some instances, selling only the most
liquid investments to meet a large redemption could be inconsistent
with the fund's investment mandate. For example, if a fund's
investment mandate required it to hold a certain percentage of its
portfolio in equities, the fund might not be able to sell a large
portion of its equity holdings to meet redemption requests and still
hold the required percentage of its portfolio in equities.
    \1036\ See, e.g., supra footnote 71 (discussing recent
circumstances in which, during a year of heavy redemptions that
caused a high yield bond fund's assets to shrink 33% in this period,
the fund's holdings of lower quality bonds grew to 47% of assets,
from 35% before the redemptions).
    \1037\ See, e.g., Hao Jiang, Dan Li, and Ashley Wang, Dynamic
Liquidity Management by Corporate Bond Mutual Funds (May 6, 2016)
(unpublished working paper), available at http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2776829. The study presents preliminary
evidence consistent with the notion that corporate bond funds tend
to sell proportional ``strips'' of their portfolios during periods
of high market volatility and disproportionately sell more liquid
assets during periods of lower market volatility.
---------------------------------------------------------------------------

    Staff analysis of the impact of large redemptions on U.S. equity
fund portfolio liquidity is consistent with the hypothesis that the
average U.S. equity fund does not sell a strip of its portfolio
investments to meet large redemptions, but instead appears--based on
changes in funds' portfolio liquidity following net outflows--to
disproportionately sell the more liquid portion of its portfolio for
this purpose.\1038\ Similarly, staff analysis shows that after a U.S.
municipal bond fund encounters net outflows, the typical U.S. municipal
bond fund will experience an increase in its holdings of municipal
bonds (and a decrease in its holdings of cash and cash equivalents),
potentially decreasing the fund's overall portfolio liquidity.\1039\
---------------------------------------------------------------------------

    \1038\ DERA Study, supra footnote 95, at 43-46. The DERA Study
analyzes U.S. equity mutual fund liquidity management trends using
the Amihud liquidity measure. See Proposing Release, supra footnote
9, at n.621. We respond to comments on this result and other aspects
of the DERA study in section IV.C.1.f.
    \1039\ DERA Study, supra footnote 95, at 47-49.
---------------------------------------------------------------------------

b. Funds' Current Liquidity Risk Disclosure Requirements and Practices
    Items 4 and 9 of Form N-1A require a fund to disclose the principal
risks of investing in the fund.\1040\ A fund currently must disclose
the risks to which the fund's portfolio as a whole is expected to be
subject and the circumstances reasonably likely to adversely affect the
fund's NAV, yield, or total return.\1041\ Some funds currently disclose
that liquidity risk is a principal risk of investing in the fund, but
often do so in a generic way.
---------------------------------------------------------------------------

    \1040\ Item 4(b)(1)(i) and Item 9(c) of Form N-1A.
    \1041\ Id.
---------------------------------------------------------------------------

    Item 11 of Form N-1A requires a fund to describe its procedure for
redeeming fund shares, including restrictions on redemptions, any
redemption charges, and whether the fund has reserved the right to
redeem in kind.\1042\ Disclosure regarding other redemption
information, such as the timing of payment of redemption proceeds to
fund shareholders, varies across funds as there are currently no
specific requirements for this disclosure. Some funds disclose that
they will redeem shares within a specific number of days after
receiving a redemption request, other funds disclose that they will
honor such requests within seven days (as required by section 22(e) of
the Act), and others provide no specific time periods. Additionally,
some funds disclose differences in the timing of payment of redemption
proceeds based on the payment method by which the fund shares are
redeemed, while others do not.
---------------------------------------------------------------------------

    \1042\ Item 11(c) of Form N-1A.
---------------------------------------------------------------------------

    Funds are not currently required to disclose information about the
liquidity of their portfolio investments. However, some funds
voluntarily disclose in their registration statements any specific
limitations applicable to the fund's investment in 15% guideline
assets, as well as types of assets considered by the fund to be subject
to the 15% guideline.
    Form N-1A does not currently require funds to disclose information
about liquidity risk management practices such as the establishment (or
use) of committed back-up lines of credit. A fund is, however, required
to disclose information regarding the amount and terms of unused lines
of credit for short-term financing, as well as information regarding
related party transactions in its financial statements or notes
thereto.\1043\
---------------------------------------------------------------------------

    \1043\ See Sec. Sec.  210.5-02.19(b) and 210.4-08(k) of
Regulation S-X.
---------------------------------------------------------------------------

2. Fund Industry Developments Regarding Funds' Liquidity Risk
Management
a. Overview
    Below we discuss the size and growth of the U.S. fund industry
generally, as well as the growth of various investment strategies
within the industry. We show that the fund industry has grown
significantly in the past two decades, and during this period, funds
with international strategies, fixed income funds, and funds with
alternative strategies have grown particularly quickly. We also
determine the types of funds that demonstrate notably volatile and
unpredictable flows. Because volatility and predictability in a fund's
flows can affect the extent to which the fund is able to meet expected
and reasonably foreseeable redemption requests without diluting the
interests of fund shareholders, assessing trends regarding these
factors can provide information about sectors of the fund industry that
could be particularly susceptible to liquidity risk.
    While we believe that these trends are relevant from the
perspective of addressing potential liquidity risk in the fund industry
(and in funds' underlying portfolio investments), we emphasize

that liquidity risk is not confined to certain types of funds or
investment strategies. Although we recognize that certain fund
characteristics could make a fund relatively more prone to liquidity
risk, we believe that all types of funds entail liquidity risk to some
extent.\1044\ Thus, while in this section we discuss certain types of
funds and strategies that are generally considered to exhibit increased
liquidity risk, we are not asserting that only these types of funds and
strategies involve liquidity risk, or that a fund of the type and with
the strategy discussed below necessarily demonstrates greater liquidity
risk than a fund that does not have these same characteristics.
---------------------------------------------------------------------------

    \1044\ See supra section III.A.2.
---------------------------------------------------------------------------

b. Size and Growth of the U.S. Fund Industry and Various Investment
Strategies Within the Industry
    Open-end funds and ETFs manage a significant and growing amount of
assets in U.S. financial markets. As of the end of 2015, there were
10,633 open-end funds (excluding money market funds, but including
ETFs), as compared to 5,279 at the end of 1996.\1045\ The assets of
these funds were approximately $15.0 trillion in 2015, having grown
from about $2.63 trillion in 1996.\1046\ Within these figures, the
number of ETFs and ETFs' assets have increased notably in the past
decade. There were 1,594 ETFs in 2015, as opposed to a mere 119 in
2003, and ETFs' assets have increased from $151 billion in 2003 to $2.1
trillion in 2015.\1047\
---------------------------------------------------------------------------

    \1045\ See 2016 ICI Fact Book, supra footnote 11, at 22, 176,
183. Specifically, as of the end of 2015, there were 9,039 open-end
mutual funds (including funds that invest in other funds) and 1,594
ETFs. There were approximately 50 ETFs that invest in other ETFs,
which are not included in our figures.
    \1046\ See 2016 ICI Fact Book, supra footnote 11, at 174, 182.
    \1047\ See 2016 ICI Fact Book, supra footnote 11, at 182, 183.
---------------------------------------------------------------------------

    U.S. equity funds represent the greatest percentage of U.S. open-
end fund industry assets.\1048\ Open-end U.S. equity funds, excluding
ETFs, money market funds and variable annuities, held 44.7% of U.S.
fund industry assets as of the end of 2015. The investment strategies
with the next-highest percentages of U.S. fund industry assets are
foreign equity funds (16.7%), general bond funds (13.2%), and mixed
strategy funds (12.3%).\1049\ Funds with alternative strategies \1050\
only represent a small percentage of the U.S. fund industry assets, but
as discussed below, the number of alternative strategy funds and the
assets of this sector have grown considerably in recent years.\1051\
---------------------------------------------------------------------------

    \1048\ DERA Study, supra footnote 95, at Table 1.
    \1049\ Id. The figure for general bond funds does not include
assets attributable to foreign bond funds (1.9%), U.S. corporate
bond funds (0.8%), U.S. government bond funds (1.4%), and U.S.
municipal bond funds (4.7%). The figure for mixed strategy funds
includes assets of, among others, target date funds, convertible
securities funds, and flexible portfolio funds.
    \1050\ Alternative funds are funds that seek total returns
through the use of alternative investment strategies, including but
not limited to equity market neutral, long/short equity, global
macro, event driven, credit focus strategies.
    \1051\ DERA Study, supra footnote 95, at 7-8.
---------------------------------------------------------------------------

    While the overall growth rate of funds' assets has been generally
high (about 7.2% per year, between the years 2000 and 2015 \1052\), it
has varied significantly by investment strategy.\1053\ U.S. equity
funds' assets grew substantially in terms of dollars from the end of
2000 to 2015,\1054\ but this sector's assets as a percentage of total
U.S. fund industry assets decreased from about 65% to about 45% during
that same period.\1055\ Like U.S. equity funds, the assets of U.S.
corporate bond funds, government bond funds, and municipal bond funds
also increased in terms of dollars from 2000 to 2015, but each of these
sectors' assets as a percentage of the fund industry decreased during
this period.\1056\ On the other hand, the assets of foreign equity
funds, general bond funds, and foreign bond funds increased steadily
and substantially as a percentage of the fund industry over the same
period.\1057\ For example, foreign equity funds increased steadily from
10.6% of total industry assets in 2000 to 16.7% in 2015. And within
these three investment strategies, certain investment subclasses
(emerging market debt and emerging market equity) have grown
particularly quickly from 2000 to 2015.\1058\ The overall growth rate
of funds' assets between the years 2000 and 2015 was greater for index
funds (12.3%) than actively managed funds (4.9%).\1059\
---------------------------------------------------------------------------

    \1052\ DERA Study, supra footnote 95, at Table 2.
    \1053\ The figures in this paragraph and the following
paragraph, discussing the variance in growth rate of funds' assets
by investment strategy, exclude ETF assets.
    \1054\ U.S. equity funds held about $5.6 trillion as the end of
2015, compared to about $2.9 trillion at the end of 2000. DERA
Study, supra footnote 95, at Table 2.
    \1055\ DERA Study, supra footnote 95, at Table 2.
    \1056\ Id. U.S. corporate bond funds held about $95 billion at
the end of 2015, as opposed to $66 billion in 2000; these funds'
assets as a percentage of the U.S. fund industry decreased from 1.5%
in 2000 to 0.8% in 2015. U.S. government bond funds held about $174
billion at the end of 2015, as opposed to $91 billion in 2000; these
funds' assets as a percentage of the U.S. fund industry decreased
from 2.1% in 2000 to 1.4% in 2015. U.S. municipal bond funds held
about $592 billion at the end of 2015, as opposed to $278 billion in
2000; these funds' assets as a percentage of the U.S. fund industry
decreased from 6.3% in 2000 to 4.7% in 2015.
    \1057\ Id. Foreign equity funds held about $2.1 trillion in
2015, as opposed to $465 billion in 2000. U.S. general bond funds
held about $1.7 trillion at the end of 2015, as opposed to $240
billion in 2000; these funds' assets as a percentage of the U.S.
fund industry increased from 5.4% in 2000 to 13.2% in 2015. Foreign
bond funds held about $244 billion at the end of 2015, as opposed to
$19 billion in 2000; these funds' assets as a percentage of the U.S.
fund industry increased from 0.4% in 2000 to 1.9% in 2015.
    \1058\ DERA Study, supra footnote 95, at 9. Emerging market debt
and emerging market equity funds held about $289 billion at the end
of 2015, as opposed to $20 billion in 2000. The assets of emerging
market debt funds and emerging market equity funds grew by an
average of 18.1% and 19.8%, respectively, each year from 2000
through 2015.
     These investment subclasses represent a small portion of the
U.S. mutual fund industry (the combined assets of these investment
subclasses as a percentage of the U.S. fund industry was 2.3% at the
end of 2015).
    \1059\ See 2016 ICI Fact Book, supra footnote 11, at 174, 218.
---------------------------------------------------------------------------

    The assets of funds with alternative strategies \1060\ also have
grown rapidly in recent years. From 2005 to 2015, the assets of
alternative strategy funds grew from $366 million to $310 billion, and
from the end of 2011 to the end of 2013, the assets of alternative
strategy funds grew by an average rate of almost 80% each year.
However, as discussed above, funds with alternative strategies remain a
relatively small portion of the U.S. fund industry as a percentage of
total assets.\1061\
---------------------------------------------------------------------------

    \1060\ See supra footnote 95 for a discussion of the primary
investment strategies practiced by ``alternative strategy'' funds.
    \1061\ See supra footnote 1051 and accompanying text.
---------------------------------------------------------------------------

c. Significance of Fund Industry Developments
    The industry developments discussed above are notable for several
reasons. The growth of funds generally over the past few decades
demonstrates that investors have increasingly come to rely on
investments in funds to meet their financial needs.\1062\ These trends
also demonstrate growth in particular types of funds that may entail
increased liquidity risk. In particular, there has been significant
growth in high-yield bond funds, emerging market debt funds, and funds
with alternative strategies. Commissioners and Commission staff have
previously spoken about the need to focus on potential liquidity risks
relating to fixed income assets and fixed income funds,\1063\ and
within this sector, funds that invest in high-yield bonds could be
subject to greater liquidity risk as they invest in lower-rated bonds
that tend to be less liquid than investment grade

fixed income securities.\1064\ Emerging market debt funds may invest in
relatively illiquid securities with lengthy settlement periods.\1065\
Likewise, funds with alternative strategies may hold portfolio
investments that are relatively illiquid.\1066\ Moreover, Commission
staff economists have found that both foreign bond funds (including
emerging market debt funds) and alternative strategy funds have
historically experienced relatively more volatile and unpredictable
flows than the average mutual fund,\1067\ which could increase these
funds' liquidity risks by making it more likely that a fund may need to
sell portfolio investments in a manner that creates a market impact in
order to pay redeeming shareholders.
---------------------------------------------------------------------------

    \1062\ See supra footnote 21 and accompanying text.
    \1063\ See supra footnote 93 and accompanying text.
    \1064\ The Commission and Commission staff have cautioned that
high yield securities may be considered to be illiquid, depending on
the facts and circumstances. See Interval Fund Proposing Release,
supra footnote 41; see also SEC Investor Bulletin, What Are High-
Yield Corporate Bonds?, SEC Pub. No. 150 (June 2013), available at
http://www.sec.gov/investor/alerts/ib_high-yield.pdf (noting that
high-yield bonds may be subject to more liquidity risk than, for
example, investment-grade bonds). But see Who Owns the Assets?,
supra footnote 378 (discussing the liquidity characteristics of
high-yield bond funds in depth, and noting that these funds have
weathered multiple market environments, and are generally managed
with multiple sources of liquidity).
    \1065\ See, e.g., supra footnote 377 and accompanying text
(discussing the settlement cycles associated with transactions in
certain foreign securities); see also Reuters, Fitch: Close Look at
EM Corporate Bond Trading Reveals Liquidity Risks (Apr. 16, 2015),
available at http://www.reuters.com/article/2015/04/16/idUSFit91829620150416. But see Who Owns the Assets?, supra footnote
378 (discussing the liquidity characteristics of emerging market
debt funds in depth, and noting that these funds tend to hold a
portion of their assets in developed market government bonds
(providing further liquidity), generally establish limits on less
liquid issuers, and generally maintain allocations to cash for
liquidity and rebalancing purposes).
    \1066\ See supra footnotes 99-100 and accompanying text.
    \1067\ DERA Study, supra footnote 95, at 16-24.
---------------------------------------------------------------------------

    One commenter has argued that flow volatility, which staff
economists have used as a measure of liquidity risk, does not
necessarily translate into liquidity risk.\1068\ In this commenter's
view, for example, a fund with volatile but predictable flows may have
less liquidity risk than a fund with less volatile but less predictable
flows. Likewise, a U.S. equity fund could have much greater flow
volatility than a foreign bond mutual fund without having greater
liquidity risk because the equity fund's assets are more liquid.
However, differences in average flow volatility between fund categories
persist after accounting for predictability, and the analysis suggests
that changes in flow volatility may influence the management of fund
liquidity.\1069\ Flow volatility is not the sole determinant of
liquidity risk for a fund, but it is an important determinant, which
makes it useful in helping understand differences in potential
liquidity risk within and between fund categories.
---------------------------------------------------------------------------

    \1068\ ICI Comment Letter II.
    \1069\ DERA Study, supra footnote 95, at 23-24, 37.
---------------------------------------------------------------------------

    The same commenter has also suggested that the same approach of
measuring liquidity risk does not consider the usage of derivatives in
managing volatile flows, noting that they are often more liquid than
their underlying assets.\1070\ We acknowledge that derivatives could
play a role in managing fund flows. As is the case for corporate bond
holding data, data on fund holdings of derivatives is limited so our
analysis of holdings level data was necessarily limited to U.S. equity
funds.
---------------------------------------------------------------------------

    \1070\ ICI Comment Letter II.
---------------------------------------------------------------------------

C. Benefits and Costs, and Effects on Efficiency, Competition, and
Capital Formation

    Taking into account the goals of the final liquidity regulations
and the economic baseline, as discussed above, this section discusses
the benefits and costs of the final liquidity regulations, as well as
the potential effects of the final liquidity regulations on efficiency,
competition, and capital formation. This section also discusses
reasonable alternatives to rule 22e-4 and the disclosure and reporting
requirements regarding funds' liquidity risk and liquidity risk
management.
1. Rule 22e-4
a. Summary of Rule 22e-4's Requirements
    Rule 22e-4 will require each fund to establish a written liquidity
risk management program. The rule specifies that a fund's liquidity
risk management program shall include the following required program
elements: (i) Assessment, management, and periodic review of the fund's
liquidity risk; (ii) classification of the liquidity of each of the
fund's portfolio investments based on asset class, so long as the fund
or its adviser does not have information about any market, trading, or
investment-specific considerations that are reasonably expected to
significantly affect the liquidity characteristics of an investment
that would suggest a different classification for that investment;
\1071\ (iii) determining and periodically reviewing a highly liquid
investment minimum and adopting and implementing policies and
procedures for responding to a shortfall of the fund's assets that are
highly liquid investments below its highly liquid investment minimum;
(iv) prohibiting the fund's acquisition of ``illiquid investments''
(that is, any investment that the fund reasonably expects cannot be
sold or disposed of in current market conditions in seven calendar days
or less without the sale or disposition significantly changing the
market value of the investment) if, following the acquisition, the fund
would hold more than 15% of its net assets in assets that are illiquid
investments; (v) requiring a fund whose illiquid investments that are
assets exceed 15% of its net assets to conduct certain board reporting;
and (vi) for funds that engage in, or reserve the right to engage in,
redemptions in kind, establishing policies and procedures regarding how
and when it will engage in such redemptions in kind.\1072\ A fund's
board, including a majority of the fund's independent directors, will
be required to provide general oversight of the fund's liquidity risk
management program, but the board would not have to approve the fund's
highly liquid investment minimum.\1073\ The fund will be required to
designate the fund's adviser or officer(s) responsible for
administering the program, and such designation is required to be
approved by the fund's board of directors.\1074\ The fund's board will
also be required to review, at least annually, a written report
prepared by the fund's investment adviser or officer(s) administering
the liquidity risk management program reviewing the adequacy and
effectiveness of the implementation of the fund's liquidity risk
management program, including the fund's highly liquid investment
minimum, and the effectiveness of its implementation.\1075\
---------------------------------------------------------------------------

    \1071\ Rule 22e-4 (b)(1)(ii).
    \1072\ Proposed rule 22e-4(b)(2)(iv).
    \1073\ Proposed rule 22e-4(b)(3)(i).
    \1074\ Proposed rule 22e-4(b)(3)(iii).
    \1075\ Rule 22e-4(b)(3)(ii).
---------------------------------------------------------------------------

    Rule 22e-4 also includes certain recordkeeping requirements. A fund
will be required to keep a written copy of its liquidity risk
management policies and procedures, as well as copies of any materials
provided to the fund's board in connection with the approval of the
initial liquidity risk management program and annual board reporting
requirement.\1076\ A fund will also be required to keep a written
record of how its highly liquid investment minimum, and any adjustments
thereto, were determined.\1077\
---------------------------------------------------------------------------

    \1076\ Rule 22e-4(c)(1) and (2).
    \1077\ Rule 22e-4(c)(3).

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

    In addition, two types of funds are subject to tailored
requirements by the final rule. First, funds that primarily hold highly
liquid assets do not have to establish a highly liquid investment
minimum as part of their liquidity risk management programs.\1078\
Second, ETFs are required to assess and manage liquidity risk with
respect to certain additional factors tailored to the specific risks of
ETFs.\1079\ However, an ETF that meets the final rule's definition of
an ``In-Kind ETF'' is not required to establish a highly liquid
investment minimum or to classify its individual portfolio
holdings.\1080\
---------------------------------------------------------------------------

    \1078\ Rule 22e-4(b)(1)(iii)(A).
    \1079\ Rule 22e-4(b)(1)(iii)(D)-(E).
    \1080\ See infra footnote 846 and accompanying text for the
definition of ``In-Kind ETF.''
---------------------------------------------------------------------------

    In addition to the special treatment of In-Kind ETFs and primarily
highly liquid funds, the final rules differ from the proposed version
in several ways that may have economic consequences: (1) It integrates
the definition of illiquid investments subject to the 15% illiquid
investment limit as a part of the portfolio classification process,
requiring the consideration of market, trading, and investment-specific
factors and market depth in determining whether an investment is
illiquid, as well as the periodic review of this assessment at least
monthly; (2) it reduces the number of categories used to classify
portfolio investment liquidity from six to four and requires fewer
long-term liquidity projections; (3) it simplifies portfolio position
classification by allowing them to be based on asset classes, with
customized exceptions for individual positions where necessary; \1081\
(4) it does not prohibit the acquisition of less liquid investments if
a fund goes below its highly liquid investment minimum, but instead
requires that a fund report to its board if it goes below its highly
liquid investment minimum, and, if the shortfall lasts more than 7
consecutive calendar days, also requires reporting to the Commission;
(5) it requires that a fund's board approve and annually review a
report concerning its liquidity risk management program, but generally
does not require the board to approve the highly liquid investment
minimum (except in some circumstances) or material changes to these
programs; (6) it requires that a fund assess its liquidity risk with
respect to several factors, where applicable, in both stressed and
normal market conditions, whether its strategy is appropriate for an
open-ended fund, and whether its strategy involves a concentrated
portfolio or large positions in particular issuers; \1082\ (7) it
requires that principal underwriters or depositors of UITs to
determine, on or before the date of the initial deposit of portfolio
securities into a UIT, that the portion of the illiquid investments
that the UIT holds or will hold at the date of deposit that are assets
is consistent with the redeemable nature of the securities that it
issues; and (8) requires that In-Kind ETFs offer daily transparency by
posting on the ETF's Web site on each day that the national securities
exchange on which the fund's shares are listed is open for business,
before commencement of trading of fund shares on the exchange, the
identities and quantities of the securities, assets or other positions
held by the fund, or its respective master fund, that will form the
basis for the fund's calculation of net asset value at the end of the
business day.
---------------------------------------------------------------------------

    \1081\ See supra footnote 408 and accompanying text.
    \1082\ Rule 22e-4(b)(1)(iii)(A)-(C).
---------------------------------------------------------------------------

b. Benefits
    Rule 22e-4, as adopted, should produce the same broad benefits for
current and potential fund investors as discussed in the proposal.
Where appropriate, we discuss below any changes in these benefits due
to differences between the proposed and final rules. Specifically, the
liquidity risk management program requirements are likely to improve
investor protection by decreasing the chance that some funds may be
unable to meet their redemption obligations, would meet such
obligations by diluting the fund's shares, or would meet such
obligations through methods that would have other adverse impacts on
non-redeeming investors (e.g., increased risk exposure and decreased
liquidity). To the extent that some funds do not currently meet the
liquidity risk management standards required by the rule--either by
meeting the rule's minimum baseline requirements for fund assessment
and management of liquidity risk or via alternative liquidity risk
management approaches--investor protection will be enhanced by imposing
these minimum requirements on funds.
    We believe that the liquidity risk management program requirement
should promote improved alignment of the liquidity of the fund's
portfolio with the fund's expected (and reasonably foreseeable) levels
of redemptions. As discussed above, rule 22e-4 will require each fund
to classify the liquidity of its portfolio investments in assessing its
liquidity risk, and to determine a highly liquid investment minimum to
increase the likelihood that the fund will hold adequate liquid
investments to meet redemption requests without significant dilution.
Each fund will have flexibility to determine the particular investments
that it holds in connection with its highly liquid investment minimum.
Assets eligible for inclusion in a fund's highly liquid investment
minimum could include a broad variety of securities, as well as cash
and cash equivalents. While one fund may conclude that it is
appropriate to hold a significant portion of its assets that are highly
liquid investments in cash and cash equivalents, another could decide
it is appropriate to hold assets that are convertible to cash within
longer periods (but not exceeding three business days) as the majority
of its highly liquid investments. The highly liquid investment minimum
requirement should allow funds to continue to meet a wide variety of
investors' investment needs by obliging funds to maintain appropriate
liquidity in their portfolios. The proposed rule would have required
funds to set a firm three-day liquid asset minimum, prohibiting the
acquisition of relatively less liquid assets until a fund was back
above its minimum, instead of allowing them to operate below the
minimum with board notification, so the final rule should mitigate any
unfavorable market effects related to the systematic purchase or sale
of investments once a strict minimum was exceeded. In extreme cases--
for example, if investments that the fund sought to purchase were
trading at fire sale prices due to a market event--a fund could go
below its minimum to trade opportunistically. However, that might cause
the fund to operate below its highly liquid investment minimum for more
than 7 consecutive calendar days, requiring reporting to the fund's
board and the Commission within one business day, so funds may be
hesitant to take advantage of attractive market prices when they are
close to their minimum under the final rule. The ability to deviate
from the minimum for up to 7 consecutive calendar days with required
reporting at the next regular board meeting, or for longer periods
provided the fund reports to the board and the Commission, could also
reduce the likelihood that funds set artificially low minimums, which
would be less protective of investors than a minimum with some
flexibility built in such as the one we are adopting. The limitation on
the acquisition of assets that are illiquid investments to no more than
15% of net assets, along with the corresponding enhancements to how
investment illiquidity is assessed, complements the

highly liquid investment minimum requirement by increasing the
likelihood that a fund's portfolio is not overly concentrated in
investments whose liquidity is limited. Furthermore, the additional
board reporting requirements triggered when a fund's illiquid
investments that are assets exceed 15% of net assets decreases the
likelihood that a fund's portfolio is overly concentrated in
investments classified as illiquid for an extended period of time
without board oversight.
    We believe that the rule also will decrease the probability that a
fund will need to meet redemption requests through activities that can
materially affect the fund's NAV or risk profile or dilute the
interests of fund shareholders. For example, when a fund is
insufficiently liquid or does not effectively manage liquidity and is
faced with significant redemptions, or both, it may be forced to sell
portfolio investments under unfavorable circumstances, which could
create significant negative price pressure on those investments.\1083\
This, in turn, could disadvantage non-redeeming shareholders by
decreasing the value of those shareholders' interests in the
fund.\1084\ Even if a fund were to sell the most liquid portion of its
portfolio to meet redemption requests, which would minimize the loss in
fund value due to the price impact of selling, these asset sales could
decrease the liquidity of the fund portfolio, potentially creating
increased liquidity risk for non-redeeming shareholders. As discussed
above, staff analysis is consistent with the hypothesis that U.S.
equity funds may disproportionally sell more liquid assets, especially
when facing significant outflows, as opposed to selling a pro rata
``strip'' of the fund's portfolio assets, which minimizes price impact
on a fund in the short term, but ultimately decreases the liquidity of
the fund's portfolio.\1085\ Short-term borrowings by a fund to meet
redemption requests could also disadvantage non-redeeming shareholders
by leveraging the fund, which requires the fund to pay interest on the
borrowed funds (although, in some instances, the costs of borrowing may
be less than the costs of selling assets to meet redemptions) and
magnifies any gains or losses to non-redeeming shareholders. Moreover,
the costs of borrowing (that is, the costs associated with maintaining
a committed line of credit, as well as interest expenses associated
with drawing on a credit line) could be passed on to fund shareholders
in the form of fund operating expenses, which adversely affect a fund's
NAV. To the extent that the program requirement results in liquidity
risk assessment and management that enhance funds' ability to meet
redemption obligations, it will be less likely that a fund takes
actions to pay redemptions that cause dilution or have other adverse
impacts on non-redeeming shareholders.
---------------------------------------------------------------------------

    \1083\ See Coval & Stafford, supra footnote 86 (discussing how
mutual fund fire sales impact asset prices).
    \1084\ While the impact of fire sales on asset prices may be
short lived in some instances, Coval and Stafford show that the
impact of fire sales can often take many months to dissipate. Id.
    \1085\ See supra footnote 1038 and accompanying text.
---------------------------------------------------------------------------

    The potential negative consequences of asset sales undertaken to
pay fund redemptions could create early redemption incentives in times
of liquidity stress, or a ``first-mover advantage.'' \1086\ For
example, academic studies have suggested that an incentive exists for
market participants to front-run trades conducted by a fund in response
to significant changes in fund flows.\1087\ This suggests that
sophisticated fund investors could anticipate that significant fund
outflows could lead a fund to conduct trades that would disadvantage
non-redeeming shareholders, which could create an incentive to redeem
ahead of such trades. If investors' redemptions are motivated by a
first-mover advantage, this could lead to increasing levels of
redemptions, and as the level of outflows from a fund increases, the
incentive to redeem also increases. Any negative effects on non-
redeeming shareholders thus could be magnified by a first-mover
advantage to the extent that this dynamic produces growing redemptions
and decreasing portfolio liquidity. The first-mover advantage is more
commonly discussed with respect to money market funds, especially
institutional prime money market funds that operated under a fixed NAV
prior to the 2014 reform (that will become effective October 14, 2016),
but the incentives that have been argued to create the first-mover
advantage among those funds could in theory exist (in possibly weaker
form) among other open-end funds. We agree with commenters that the
empirical support for the existence of a first-mover advantage is not
conclusive and that the mutual fund industry has been able to
successfully navigate periods of historical market stress.\1088\ While
we understand that fund investors may not have historically been
motivated to redeem on account of a perceived (or actual) first-mover
advantage during previous periods of stress, we cannot predict how
investors may behave in the future. To the extent that economic
incentives exist to redeem fund shares prematurely, such redemptions
could lead to investor dilution as discussed above, and the possibility
of protecting against this potential dilution could be one benefit of
rule 22e-4.
---------------------------------------------------------------------------

    \1086\ See supra footnote 85 and accompanying text (discussing
the possibility of a first-mover advantage with respect to the
timing of shareholder redemption from funds, but also arguments that
such a first-mover advantage does not exist in funds, as well as
arguments that even if incentives to redeem ahead of other
shareholders do exist, this does not necessarily imply that
investors will in fact redeem en masse in times of market stress).
    \1087\ See Coval & Stafford, supra footnote 86; Dyakov &
Verbeek, supra footnote 86.
    \1088\ See, e.g., Comment Letter of Wellington Management Group
LLP on the Notice Seeking Comment on Asset Management Products and
Activities, Docket No. FSOC-2014-0001 (Mar. 25, 2015), at 4; ICI
FSOC Notice Comment Letter, supra footnote 68, at 7; Nuveen FSOC
Notice Comment Letter, supra footnote 85, at 10; Dechert Comment
Letter; Vanguard Comment Letter; Comment Letter of the Independent
Trustees of Fidelity Fixed Income and Asset Allocation Funds (Jan.
13, 2016) (all arguing that evidence shows that fund shareholders'
redemptions are largely driven by other concerns rather than a
theoretical first-mover advantage).
---------------------------------------------------------------------------

    The program requirement aims to promote a minimum baseline for
liquidity risk management in the fund industry. This should promote
investor protection by elevating the overall quality of liquidity risk
management across the fund industry, reducing the likelihood that funds
will meet redemption obligations only through activities that could
significantly dilute shareholders or adversely affect fund risk
profiles. Shareholders in funds that already engage in strong liquidity
risk management practices may be less likely to benefit from the
program requirement, or may benefit less, than shareholders in funds
that do not employ equally rigorous practices. We cannot quantify the
total benefits to fund operations and investor protection that we
discuss above, but to the extent that staff outreach has noted that
some funds currently have no (or very limited) formal liquidity risk
management programs in place, rule 22e-4 would enhance current
liquidity risk management practices.
    Finally, to the extent that the program requirement results in
funds less frequently needing to sell portfolio investments in
unfavorable market conditions in order to meet redemptions, the
requirement also could lower potential spillover risks that funds could
pose to the financial markets generally. If, as a result of the program
requirement, a fund was prepared to meet redemption requests in other
ways, the rule could decrease the

risk that the fund might indirectly transmit stress to other market
sectors and participants. The rule should help ensure that all funds,
not just those with liquidity risk management practices currently in
place, operate in a manner that lessens the chance of spillover risks.
We are unable to quantify this potential benefit because we cannot
predict the extent to which funds would enhance their current liquidity
risk management practices as a result of rule 22e-4, or predict the
precise circumstances that could entail negative spillover effects in
light of less-comprehensive liquidity risk management by funds.\1089\
---------------------------------------------------------------------------

    \1089\ The ability of the Commission to perform such analysis is
limited by difficulties in both gathering data about funds'
liquidity risk management practices and quantifying such data.
---------------------------------------------------------------------------

    Commenters generally did not disagree with the benefits of the
proposed rule, with any exceptions noted in the above discussion of
rule 22e-4's benefits. As discussed above, the final rule differs from
the proposal in several key respects, but it largely preserves the
proposed rule's benefits. First, funds that primarily hold assets that
are highly liquid investments are not required to establish a highly
liquid investment minimum, so any benefits that might have accrued to
shareholders of these funds under the proposed rule may be diminished.
However, these funds are less likely to be exposed to the liquidity
risks discussed above to the same degree as other funds, so any loss in
benefits should be negligible and is likely to be less than the costs
of establishing a minimum. Similarly, In-Kind ETFs are exempt from
certain aspects of the final rule, because the benefits of those
aspects of the final rule would have been insignificant for In-Kind
ETFs. The final rule instead achieves benefits with respect to ETFs by
replacing these less-apposite requirements with new tailored
requirements for ETFs that are designed to promote the proper
management of ETF liquidity, focused on preventing the arbitrage
mechanism that keeps ETFs priced properly from being adversely impacted
by a lack of liquidity. In addition, the new requirement for daily
transparency will permit the sophisticated authorized participants that
directly interact with the ETF to effectively evaluate the liquidity of
the ETF's holdings. Since nearly all In-Kind ETFs already provide daily
transparency as a matter of course, we believe no additional costs
arise for In-Kind ETFs.\1090\
---------------------------------------------------------------------------

    \1090\ We note that ETMFs are not required to provide such daily
transparency under their orders, and thus would need to choose to
provide such daily transparency if they wished to take advantage if
this provision. Choosing to take advantage of this provision is
within the discretion of ETFs that could potentially qualify as In-
Kind. As discussed in the PRA section below, we estimate that not
all ETFs would qualify as In-kind, either because of their use of
cash for redemptions or because of their choice not to provide daily
transparency of holdings.
---------------------------------------------------------------------------

    Second, modifications to the proposal allow funds to classify
portfolio investments via assignments to asset classes as a default,
but require them to classify specific investments separately if they
merit special attention,\1091\ which preserves the benefits of
investment liquidity classification without imposing the additional
cost of individually classifying each portfolio position in all cases.
Third, the rule's simplification of classification categories from six
to four, with shorter-term horizons, still provides a reasonably
nuanced view of a fund portfolio's position-level liquidity while
responding to commenters' concerns that the proposed rule's more
detailed classification would have required too much precision at long-
term horizons and would not accurately reflect a fund's actual
liquidity profile. Fourth, the final rule should preserve the benefits
of board oversight of a fund's liquidity risk management program
without requiring that board members approve the highly liquid
investment minimum (except in certain circumstances). The modifications
to the board's role make the board's involvement in the liquidity risk
management more consistent with the board's historical duty to provide
oversight (instead of day-to-day management).
---------------------------------------------------------------------------

    \1091\ See supra footnote 1064 and accompanying text.
---------------------------------------------------------------------------

    Changes to the final rule could also provide additional benefits
relative to the proposal. While the final rule clarifies that the
factors a fund should consider in devising a liquidity risk management
program may be considered as appropriate, it also requires that funds
consider two additional factors--whether a given strategy is
appropriate in an open-ended fund or involves a concentrated portfolio
or concentrated positions in particular issuers--which could improve
the risk management program's effectiveness for funds that do not
already consider these factors. The final rule also more precisely
specifies criteria for both the initial and ongoing assessment of
whether investments should be classified as illiquid under the 15%
illiquid investment limit by tying it to the same criteria used in
assigning investments to other liquidity categories (including
considering relevant market, trading, and investment-specific
considerations, and market depth), which should reduce a firm's
compliance burdens relative to the proposed rule while at the same time
providing a more precise picture of how exposed to illiquid investments
a given fund is. Finally, while UITs were not subject to rule 22e-4
under the proposal, the final rule requires that the principal
underwriter or depositor of a UIT will be required to determine, on or
before the date of the initial deposit of portfolio securities into the
UIT, that the portion of illiquid investments the UIT holds or will
hold at the date of deposit that are assets is consistent with the
redeemable nature of the securities it issues. This enhancement of the
final rule over the proposal could benefit investors by reducing the
likelihood that a UIT could be created that holds an excessive amount
of illiquid securities, which in turn would reduce the liquidity risk
associated with UITs.
c. Costs
One-Time and Ongoing Costs Associated With Program Establishment and
Implementation
    Funds will incur one-time costs to establish and implement a
liquidity risk management program in compliance with rule 22e-4, as
well as ongoing program-related costs. As discussed above, funds today
employ a range of different practices, with varying levels of quality,
for assessing the liquidity of their portfolio investments and managing
fund liquidity risk. Accordingly, funds whose practices regarding
portfolio investment liquidity classification and liquidity risk
assessment and management most closely align with the liquidity risk
management program requirements would incur relatively lower costs to
comply with rule 22e-4. Funds whose practices for classifying the
liquidity of their portfolio investments and for assessing and managing
liquidity risk are less thorough or not closely aligned with the rule,
on the other hand, may incur relatively higher initial compliance
costs.
    Some commenters suggested that the estimates of costs in the rule
proposal were significantly understated and that the true costs of
compliance with the rule requirements would likely exceed the expected
benefits.\1092\ Another

commenter suggested that costs were underestimated because other fund
systems would also have to be modified to ensure compliance with the
entirety of the requirements of the rule.\1093\ For example, if funds
are required to maintain or target a certain level of fund liquidity,
then the trade order management system would have to be modified to
ensure accurate monitoring of such limitations. We have revised the
discussion of costs to both reflect new information on the potential
costs of compliance and changes in the rule that are designed to lessen
the potential costs. Specifically, we use estimates provided by
commenters to approximate costs for each fund complex under the
proposed rule and then qualitatively discuss how changes to the
proposed rule affect these estimates. Because most changes to the final
rule reduce requirements for some segment of funds relative to the
proposal, the estimates below can generally be considered an upper
bound on fund costs except where explicitly noted.
---------------------------------------------------------------------------

    \1092\ See CFA Comment Letter; Cohen & Steers Comment Letter;
Dechert Comment Letter; Dodge & Cox Comment Letter; Federated
Comment Letter; FSR Comment Letter; ICI Comment Letter I; Invesco
Comment Letter; LSTA Comment Letter; MFDF Comment Letter; SIFMA
Comment Letter I; T. Rowe Comment Letter; Vanguard Comment Letter;
Voya Comment Letter.
    \1093\ See Federated Comment Letter.
---------------------------------------------------------------------------

    Staff estimates of the one-time costs in the proposal, which ranged
from $1.3 million to $2.25 million per fund complex, were partly based
on estimates from another Commission rulemaking.\1094\ Some commenters
expressed concern about the calculation of this estimate because it was
based on assumptions driven by analysis performed with respect to money
market fund reform.\1095\ While some of the large scale system
modifications required by rule 22e-4 will be similar to those required
for money market funds due to regulatory reform, and we attempted to
adjust our estimates for differences between the two rules, one
commenter suggested that the process of classifying portfolio assets
was more akin to a fund's costs in analyzing the value of its
assets.\1096\ We acknowledge that could be an informative approach to
estimating costs, but absent concrete estimates associated with that
approach, which the commenter did not provide, we have updated our
estimates based on the limited quantitative information available from
commenters.\1097\ One commenter estimated that there would be $2
million in initial implementation costs and more than $650,000 in
annual recurring costs for automating a classification process that
would have to manage 63,000 different portfolio positions.\1098\
Another commenter estimated the costs of building a system to classify
the liquidity of its investments, which is not currently commercially
available, in the millions of dollars to manage their 44,000 different
portfolio positions.\1099\ We use the former as a basis for our
analysis because it is comparable in magnitude to the latter.\1100\
Because there are likely to be economies of scale in developing the
policies, procedures, and systems required to comply with rule 22e-4,
we approximate the cost per fund complex by assuming fixed costs
constitute 30% of the commenter's estimates, and extrapolate using the
number of funds per complex to scale variable costs up or down.\1101\
In addition, because the process of classifying assets under the
proposal would likely constitute a majority of a fund's costs, we
assume the classification process constitutes approximately 75% of a
fund's cost of complying with proposed rule 22e-4. This method results
in one-time costs for funds under the proposed rule that range from
approximately $0.8 million to $10.2 million, that the average cost per
fund complex is $1 million, and the aggregate cost is approximately
$855 million. The estimated range of costs using this approach is wider
than our approach in the proposal, but the estimated aggregate cost is
lower than our initial estimate of $1.3 billion. While these estimates
would change if we varied our assumption that fixed costs comprise 30%
of the commenter's estimate--for example, increasing this percentage
would compress the range of costs and the aggregate may increase or
decrease--they are of the same order of magnitude as our estimates in
the proposal.
---------------------------------------------------------------------------

    \1094\ See Proposing Release, supra footnote 9, at n.702 and
accompanying text.
    \1095\ See FSR Comment Letter; SIFMA Comment Letter I.
    \1096\ See Dechert Comment Letter.
    \1097\ As in the proposal, the estimates assume that each fund
would not bear all of the costs (particularly, the costs of systems
modification) on an individual basis, but instead that these costs
would likely be allocated among the multiple users of the systems,
that is, each of the members of a fund complex. Accordingly, we
expect that, in general, funds within large fund complexes would
incur fewer costs on a per fund basis than funds within smaller fund
complexes, due to economies of scale in allocating costs among a
group of users.
    \1098\ See Invesco Comment Letter.
    \1099\ See T. Rowe Comment Letter.
    \1100\ We estimate that there were 146 funds in the second
commenter's fund complex as of December 31, 2015, which implies an
estimated cost of approximately $4 million using our estimation
procedure, in line with the commenter's statement that its cost
would be ``in the millions.'' See supra footnote 1094 for discussion
of the estimation procedure.
    \1101\ We use CRSP U.S. Mutual Fund Database to obtain the
number of funds for each complex. As of December 31, 2015, there
were 7551 mutual funds (excluding money market funds and annuities),
1484 ETFs (excluding non-40-act ETFs, ETNs, and Commodity ETFs), and
847 fund complexes (334 of them with only one fund). The commenter,
Invesco, consisted of 87 funds as of that date, and we assume the
fixed cost component of their estimate is $0.6 million (30% of $2
million). The remaining $1.4 million is assumed to be a variable
cost that scales linearly with the number of funds. To arrive at a
total cost of 22e-4, each of these estimates is scaled so that the
classification process constitutes 75% of the total costs of
proposed rule 22e-4.
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    These estimated one-time costs are attributable to the following
activities, as applicable to each of the funds within the complex: (i)
Developing policies and procedures relating to each of the required
program elements,\1102\ and the related recordkeeping requirements of
the rule; (ii) planning, coding, testing, and installing any system
modifications relating to each of the required program elements; (iii)
integrating and implementing policies and procedures relating to each
of the required program elements (including classifying the liquidity
of each of the fund's portfolio investments pursuant to rule 22e-
4(b)(1)(ii)), as well as the recordkeeping requirements of the rule;
(iv) preparing training materials and administering training sessions
for staff in affected areas; and (v) costs associated with educating
the fund's board and obtaining approval of the program. These
activities are likely to cut across many different functional groups
within a fund or fund complex, including legal, compliance, risk,
portfolio management, accounting, and technology staff. To the extent
that some of the systems needed to support the required program
elements are developed by third parties, fund complexes may be able to
implement their liquidity risk management programs for less than our
estimated cost of developing these

programs themselves, but the final rule emphasizes that it is
ultimately each fund's responsibility to classify its positions, so
these potential cost reductions may be limited. For example, we
understand that third parties have already developed programs that
include certain market, trading, and investment-specific factors which
could be useful in classifying the liquidity of portfolio investments,
and are currently available for purchase.\1103\
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    \1102\ Specifically, a fund would be required, where applicable,
to establish policies and procedures relating to: (i) Assessment,
management, and periodic review of the fund's liquidity risk; (ii)
classification of the liquidity of each of the fund's portfolio
investments, as well as at-least-monthly reviews of the fund's
liquidity classifications; (iii) the requirements to determine and
periodically review a highly liquid investment minimum, and to adopt
and implement policies and procedures for responding to a shortfall
of the fund's highly liquid investments below its highly liquid
investment minimum; (iv) the requirement to limit the fund's
acquisition of illiquid investments over 15% of the fund's net
assets; and (v) for funds that engage in, or reserve the right to
engage in, redemptions in kind, the requirement to establish
policies and procedures regarding how it will engage in such
redemptions in kind. The final rule also provides for a tailored
program for ETFs that redeem in kind, excluding them from the
classification and highly liquid investment minimum requirements,
but requiring them to consider additional factors as part of their
liquidity risk assessment and management that reflect potential
liquidity-related concerns that could arise from the structure and
operation of ETFs. The final rule also provides an exclusion from
the highly-liquid investment minimum requirement for funds that
primarily hold highly liquid investments. The rule also provides for
board oversight of the liquidity risk management program.
    \1103\ See supra footnote 323 and accompanying text (discussing
Commission guidance on a fund's use of third-party service providers
to obtain data to inform or supplement its consideration of the
liquidity classification factors). We understand, based on staff
outreach, that annual costs to subscribe to the liquidity
classification services provided by third-party data and analytics
providers currently range from $50,000-$500,000.
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    We have also revised our estimates of the ongoing costs of
complying with rule 22e-4 using the same approach and based on the same
commenter's estimate as above for one-time costs. While our analysis in
the proposal assumed ongoing costs ranged from 10% to 25% of the one-
time costs resulting from the rule, we've reduced the low end of the
range to 5% to reflect changes from the Proposing Release, discussed
below, that should lower some funds' compliance burdens, and increased
the high end of the range to 32.5% to reflect the commenter's estimate
that ongoing costs for their fund under the proposed rule would be
$0.65 million (compared to one-time costs of $2 million). We again
extrapolate from the commenter's estimate as above to arrive at a
minimum and maximum cost estimate for each fund, which implies a range
of ongoing costs across all funds of $40,000 to $3.3 million per fund
complex. These costs are attributable to the following activities, as
applicable to each of the funds within the complex: (i) Classification
of the liquidity of each of the fund's portfolio investments, as well
as at-least-monthly reviews of the fund's liquidity classifications
(rule 22e-4(b)(1)(ii)); (ii) periodic review of the fund's liquidity
risk (rule 22e-4(b)(1)(i)); (iii) periodic review of the adequacy of
the fund's highly liquid investment minimum (rule 22e-
4(b)(1)(iii)(A)(2)); (iv) systems maintenance; (v) additional staff
training; (vi) approval, annual review, and general oversight by the
board of the fund's liquidity risk management program (rule 22e-
4(b)(2)); and (viii) recordkeeping relating to the fund's liquidity
risk management program (rule 22e-4(b)(3)).\1104\ Relative to the
proposed rule, the final rule reduces the responsibilities of a fund's
board, which is not required to approve the fund's highly liquid
investment minimum or material changes to the fund's liquidity risk
management program, which should reduce the board-related costs
embedded in the above estimates of rule 22e-4's one-time and ongoing
costs.
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    \1104\ As discussed in greater detail below, we anticipate that,
depending on the personnel (and/or third-party service providers)
involved in the activities associated with administering a liquidity
risk management program, certain of the estimated ongoing costs
associated with these activities could be borne by the fund, and
others could be borne by the adviser.
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    The original classification scheme would have mandated significant
micro-level analysis of instruments not currently conducted by fund
advisers according to many commenters.\1105\ Such an analysis would
have required entirely new systems for many fund complexes and would
have required funds to incur significant expenses (especially for
smaller fund complexes).\1106\ The new classification system lowers the
potential costs of compliance with the liquidity classification
requirement by (i) reducing the number of classification categories
reduced from six to four, (ii) only requiring ``days-to-cash''
estimates out to 7 days, (iii) allowing funds to generally classify
based on asset class (subject to an exception process), (iv) changing
the process for considering position size to reduce complexity, and (v)
simplifying the classification factors to be considered into a single
requirement that funds consider market, trading, and investment-
specific data when classifying an investment. As a whole, these changes
should lower the potential costs of compliance with the classification
requirement relative to the proposal estimates above without
significantly reducing the potential benefits of the requirement.
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    \1105\ See Credit Suisse Comment Letter; Dechert Comment Letter;
Federated Comment Letter; Fidelity Comment Letter; Oppenheimer
Comment Letter; SIFMA Comment Letter I; Wellington Comment Letter.
    \1106\ See Dechert Comment Letter; ICI Comment Letter I; SIFMA
Comment Letter I; T. Rowe Comment Letter.
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    Specifically with respect to position size, commenters argued that
evaluating ``days-to-cash'' was inherently biased against large funds
and could lead to ``plain vanilla'' funds that generally invest in only
highly-liquid securities (e.g., S&P 500 funds) being classified as
highly illiquid if they manage a large amount of assets.\1107\ The rule
now only requires a fund to determine whether trading varying portions
of a position in a particular portfolio investment or asset class, in
sizes that the fund reasonably anticipates trading, is reasonably
expected to significantly affect its liquidity. This change should
prevent large ``plain vanilla'' funds from appearing to be very
illiquid under the classification scheme while still maintaining the
idea that position size is an important consideration in the evaluation
of liquidity. Relative to the proposed rule, this should reduce the
costs associated with determining how position size affects the number
of days required to liquidate an investment and eliminate the cost of
classifying separate portions of a position into separate liquidity
buckets.
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    \1107\ See Dodge & Cox Comment Letter; Oppenheimer Comment
Letter; Vanguard Comment Letter; ICI Comment Letter I; ICI Comment
Letter II; Invesco Comment Letter.
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    The classification process has also been revised in response to
commenter concerns about the need to evaluate whether an investment can
be sold for cash without materially affecting the security's price,
which investors could interpret as an indication that they can redeem
out of funds at a known or protected NAV.\1108\ One commenter expressed
concern that if investors were given estimates of liquidity that are
speculative or stale, or both, which might fail to predict liquidity
with accuracy during periods of market stress, then funds could be
potentially subject to significant litigation costs.\1109\ The value
impact component of the rule has been modified so that determinations
of market impact can be based on a reasonable expectation that an
investment can be converted to cash (or in some cases, sold or disposed
of) without the conversion (or in some cases, sale or disposition)
significantly changing the market value, rather than a price ``that
does not materially affect the value of that asset immediately prior to
sale.'' This modification in the definition should relieve funds of the
need to develop precise security-by-security expectations of forward
looking liquidity while still emphasizing the need to consider the
potential market impact of buying or selling an investment, reducing
compliance costs relative to the proposed rule.
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    \1108\ See ICI Comment Letter II.
    \1109\ See Dodge & Cox Comment Letter.
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    Commenters also expressed concern about the use of third-party
vendors in the process of liquidity classification.\1110\ If only a few
vendors were able to provide the necessary data, such data would likely
cause significant expenses for the funds, and those expenses would
likely be passed on, at least in part, to fund investors through

higher fees. Another commenter suggested that the cost of third-party
liquidity data should be included in any estimate of the potential
costs of the classification system because of the strong likelihood
that all funds would need to subscribe to a third-party vendor to
ensure compliance with the rule.\1111\ As discussed in the proposal, we
believe outsourcing program functions to vendors should, if anything,
reduce compliance costs, and we noted that liquidity classification
services already exist.\1112\ In addition, our updated estimate of
costs above is based on a large investment manager's estimate of
constructing an internal system from scratch, so we would expect the
cost of a vendor-based solution, which would be partially amortized
across all of its clients, to be lower. The changes made to the
classification system from the proposal could also lessen the costs
associated with third-party vendors relative to the proposed rule. In
particular, to the extent that requiring less precision via fewer
classification categories and shorter time horizons, allowing funds to
generally classify according to asset class (subject to an exception
process), and requiring a simpler position size evaluation criterion
reduce the scope and intensity of the investment classification
process, funds may not rely as much on vendors to comply with the rule,
and vendors themselves may experience reduced costs in developing
programs, leading to lower prices if they pass on some of the savings
to funds.
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    \1110\ See Dechert Comment Letter; Federated Comment Letter; ICI
Comment Letter I; ICI Comment Letter II; MFDF Comment Letter; Nuveen
Comment Letter; SIFMA Comment Letter I; T. Rowe Comment Letter;
Wells Fargo Comment Letter.
    \1111\ See Interactive Data Comment Letter.
    \1112\ See Proposing Release, supra footnote 9, at n.705 and
accompanying text.
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    If all funds use a small number of third-party vendors, there could
be other indirect, but potentially large, costs. According to one
commenter, the vendors could become de facto liquidity ``rating
agencies'' and their ``upgrades'' and ``downgrades'' of asset liquidity
could have systemic effects on the market.\1113\ For example, if a
vendor were to remove a widely-held investment from the highly liquid
investment category, then many funds could simultaneously attempt to
sell that investment, which could harm both fund investors and the
wider market. Given the data limitations and difficulties in estimating
liquidity for many less liquid investments, that potential effect might
be driven by error-prone modeling instead of true changes in liquidity.
We emphasize above that while third-party products can serve as a
useful input to the classification process, it is the fund's
responsibility to determine the liquidity of each investment, which
should lessen the potential for systemic issues by reducing fund
reliance on third-party vendors and allowing more of the necessary
liquidity analysis to be performed within each fund complex.\1114\
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    \1113\ See ICI Comment Letter II.
    \1114\ See supra section III.C.1.b. (providing guidance on the
appropriate use of data vendors).
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    Several additional components of the final rule will affect costs
relative to the proposal. First, by excluding any fund that primarily
holds assets that are highly liquid investments from the requirement to
have a highly liquid investment minimum, the final rule avoids imposing
any potential costs related to the minimum on some funds that would
benefit less from having a minimum. It is possible that some funds that
do not qualify as primarily highly liquid funds will incur the costs of
establishing a minimum without a significant benefit. Second, whereas
funds may currently use back-office operations to limit their
acquisition of illiquid assets under exiting Commission guidelines, the
final rule's enhanced illiquid investment standard may require funds to
incur direct costs associated with a shift of these operations to other
business functions (we also discuss indirect costs associated with the
enhanced illiquid investment limit below).\1115\ Third, the final rule
does not require In-Kind ETFs to establish a highly liquid investment
minimum or classify the liquidity of their portfolios, which will
reduce their costs relative to other funds, but it also requires them--
as it does all ETFs--to consider several additional factors as part of
their liquidity risk programs, which may increase their implementation
costs. Finally, principal underwriters or depositors of UITs, which had
no liquidity risk requirements under the proposed rule, will now have
to incur a one-time cost on or before the date of the initial deposit
of the portfolio securities into the UITs to assess whether the amount
of illiquid investments they expect the UITs to hold is compatible with
the redeemable nature of the securities they issue. This cost should be
comparable in magnitude to incurring a fraction of the ongoing costs of
an open-ended fund under rule 22e-4 because it involves an analysis
that is similar to complying with the rule's 15% illiquid investment
limit without having to establish all of the systems and processes that
are required to perform that task on a continuing basis. Assuming that
this activity accounts for 20% of an open-ended fund's ongoing costs,
we estimate that it would cost a UIT $8,000 to $52,000, and note that
it will only be incurred by UITs that are launched after the rule's
compliance date.\1116\ UITs are already required to consider which of
their restricted securities are illiquid, so this estimate should be
considered an upper bound on the costs imposed on UITs by the rule.
Finally, the rule's provision requiring board oversight when a fund's
holding of illiquid assets exceed 15% of its net assets may impose
additional costs on the fund to hold a special board meeting, including