[Federal Register Volume 80, Number 199 (Thursday, October 15, 2015)]
[Proposed Rules]
[Pages 62273-62388]
[FR Doc No: 2015-24507]

Vol. 80

Thursday,

No. 199

October 15, 2015

Part III

Securities and Exchange Commission

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17 CFR Parts 210, 270, 274

Open-End Fund Liquidity Risk Management Programs; Swing Pricing; Re-
Opening of Comment Period for Investment Company Reporting
Modernization Release; Proposed Rule

Federal Register / Vol. 80 , No. 199 / Thursday, October 15, 2015 /
Proposed Rules

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SECURITIES AND EXCHANGE COMMISSION

17 CFR Parts 210, 270, 274

[Release Nos. 33-9922; IC-31835; File Nos. S7-16-15; S7-08-15]
RIN 3235-AL61; 3235-AL42

Open-End Fund Liquidity Risk Management Programs; Swing Pricing;
Re-Opening of Comment Period for Investment Company Reporting
Modernization Release

AGENCY: Securities and Exchange Commission.

ACTION: Proposed rule; re-opening of comment period.

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SUMMARY: The Securities and Exchange Commission is proposing a new rule
and amendments to its rules and forms designed to promote effective
liquidity risk management throughout the open-end fund industry,
thereby reducing the risk that funds will be unable to meet redemption
obligations and mitigating dilution of the interests of fund
shareholders in accordance with section 22(e) and rule 22c-1 under the
Investment Company Act. The proposed amendments also seek to enhance
disclosure regarding fund liquidity and redemption practices. The
Commission is proposing new rule 22e-4, which would require each
registered open-end fund, including open-end exchange-traded funds
(``ETFs'') but not including money market funds, to establish a
liquidity risk management program. The Commission also is proposing
amendments to rule 22c-1 to permit a fund, under certain circumstances,
to use ``swing pricing,'' the process of adjusting the net asset value
of a fund's shares to effectively pass on the costs stemming from
shareholder purchase or redemption activity to the shareholders
associated with that activity, and amendments to rule 31a-2 to require
funds to preserve certain records related to swing pricing. With
respect to reporting and disclosure, the Commission is proposing
amendments to Form N-1A regarding the disclosure of fund policies
concerning the redemption of fund shares, and the use of swing pricing.
The Commission also is proposing amendments to proposed Form N-PORT and
proposed Form N-CEN that would require disclosure of certain
information regarding the liquidity of a fund's holdings and the fund's
liquidity risk management practices. In connection with these proposed
amendments, the Commission is re-opening the comment period for
Investment Company Reporting Modernization, Investment Company Act
Release No. 31610 (May 20, 2015).

DATES: The comment period for the proposed rule published June 12, 2015
(80 FR 33589) is reopened. Comments on this release (Investment Company
Act Release No. 31835) and Investment Company Act Release No. 31610
should be received on or before January 13, 2016.

ADDRESSES: Comments may be submitted by any of the following methods:

Electronic Comments

     Use the Commission's Internet comment form (http://www.sec.gov/rules/proposed.shtml); or
     Send an email to<EMAIL_ADDRESS>Please include
File Number S7-16-15 or S7-08-15 on the subject line; or
     Use the Federal Rulemaking Portal (http://www.regulations.gov). Follow the instructions for submitting comments.

Paper Comments

     Send paper comments to Secretary, Securities and Exchange
Commission, 100 F Street NE., Washington, DC 20549-1090.

All submissions should refer to File Number S7-16-15 or S7-08-15. The
file number should be included on the subject line if email is used. To
help the Commission process and review your comments more efficiently,
please use only one method. The Commission will post all comments on
the Commission's Internet Web site (http://www.sec.gov/rules/proposed.shtml). Comments are also available for Web site viewing and
printing in the Commission's Public Reference Room, 100 F Street NE.,
Washington, DC 20549, on official business days between the hours of 10
a.m. and 3 p.m. All comments received will be posted without change;
the Commission does not edit personal identifying information from
submissions. You should submit only information that you wish to make
available publicly.
    Studies, memoranda, or other substantive items may be added by the
Commission or staff to the comment file during this rulemaking. A
notification of the inclusion in the comment file of any such materials
will be made available on the Commission's Web site. To ensure direct
electronic receipt of such notifications, sign up through the ``Stay
Connected'' option at www.sec.gov to receive notifications by email.

FOR FURTHER INFORMATION CONTACT: Melissa S. Gainor, Senior Special
Counsel; Naseem Nixon, Senior Counsel; Amanda Hollander Wagner, Senior
Counsel; Sarah A. Buescher, Branch Chief; or Sarah G. ten Siethoff,
Assistant Director, Investment Company Rulemaking Office, at (202) 551-
6792, Division of Investment Management, Securities and Exchange
Commission, 100 F Street NE., Washington, DC 20549-8549.

SUPPLEMENTARY INFORMATION: The Securities and Exchange Commission (the
``Commission'') is proposing for public comment amendments to rules
22c-1 [17 CFR 270.22c-1] and 31a-2 [17 CFR 270.31a-2], and new rule
22e-4 [17 CFR 270.22e-4], under the Investment Company Act of 1940 [15
U.S.C. 80a-1 et seq.] (``Investment Company Act'' or ``Act'');
amendments to Form N-1A [referenced in 17 CFR 274.11A] under the
Investment Company Act and the Securities Act of 1933 (``Securities
Act'') [15 U.S.C. 77a et seq.]; amendments to Article 6 [17 CFR 210.6-
01 et seq.] of Regulation S-X [17 CFR 210]; and amendments to proposed
Form N-PORT [referenced in 17 CFR 274.150] and proposed Form N-CEN
[referenced in 17 CFR 274.101] under the Investment Company Act.\1\
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    \1\ Unless otherwise noted, all references to statutory sections
are to the Investment Company Act, and all references to rules under
the Investment Company Act will be to Title 17, Part 270 of the Code
of Federal Regulations [17 CFR 270].
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Table of Contents

I. Introduction
II. Background
    A. Open-End Funds
    B. The Role of Liquidity in Open-End Funds
    1. Introduction
    2. Liquidity Management by Open-End Funds
    C. Recent Developments in the Open-End Fund Industry
    1. Fixed Income Funds and Alternative Funds
    2. Evolution of Settlement Periods and Redemption Practices
    D. Current Regulatory Framework
    1. Statutory and Regulatory Requirements
    2. 15% Guideline
    3. Overview of Current Practices
    E. Rulemaking Proposal Overview
III. Discussion
    A. Program Requirements and Scope of Proposed Rule 22e-4
    1. Proposed Program Elements
    2. Scope of Proposed Rule 22e-4 and Related Disclosure and
Reporting Requirements
    3. Request for Comment
    B. Classifying the Liquidity of a Fund's Portfolio Positions
Under Proposed Rule 22e-4
    1. Proposed Relative Liquidity Classification Categories
    2. Factors to Consider in Classifying the Liquidity of a
Portfolio Position

    3. Ongoing Review of the Liquidity of a Fund's Portfolio
Positions
    C. Assessing and Managing a Fund's Liquidity Risk
    1. Assessing a Fund's Liquidity Risk
    2. Periodic Review of a Fund's Liquidity Risk
    3. Portfolio Liquidity: Minimum Investments in Three-Day Liquid
Assets
    4. Portfolio Liquidity: Limitation on Funds' Investments in 15%
Standard Assets
    5. Policies and Procedures Regarding Redemptions in Kind
    6. Discussion of Additional Liquidity Risk Management Tools
    7. Cross-Trades
    D. Board Approval and Designation of Program Administrative
Responsibilities
    1. Initial Approval of Liquidity Risk Management Program
    2. Approval of Material Changes to Liquidity Risk Management
Program and Oversight of the Three-Day Liquid Asset Minimum
    3. Designation of Administrative Responsibilities to Fund
Investment Adviser or Officers
    4. Request for Comment
    E. Liquidity Risk Management Program Recordkeeping Requirements
    F. Swing Pricing
    1. Proposed Rule 22c-1(a)(3)
    2. Guidance on Operational Considerations Relating to Swing
Pricing
    3. Master-Feeder Funds
    4. Financial Statement Disclosure Regarding Swing Pricing
    G. Disclosure and Reporting Requirements Regarding Liquidity
Risk and Liquidity Risk Management
    1. Proposed Amendments to Form N-1A
    2. Proposed Amendments to Proposed Form N-PORT
    3. Proposed Amendments to Proposed Form N-CEN
    H. Compliance Dates
    1. Liquidity Risk Management Program
    2. Swing Pricing
    3. Amendments to Form N-1A
    4. Amendments to Form N-PORT
    5. Amendments to Form N-CEN
    6. Request for Comment
IV. Economic Analysis
    A. Introduction and Primary Goals of Proposed Regulation
    B. Economic Baseline
    1. Funds' Current Practices Regarding Liquidity Risk Management,
Swing Pricing, and Liquidity Risk Disclosure
    2. Economic Trends Regarding Funds' Liquidity and Liquidity Risk
Management
    3. Fund Industry Developments Highlighting the Importance of
Funds' Liquidity Risk Management
    C. Benefits and Costs, and Effects on Efficiency, Competition,
and Capital Formation
    1. Proposed Rule 22e-4
    2. Swing Pricing
    3. Disclosure and Reporting Requirements Regarding Liquidity
Risk and Liquidity Risk Management
    D. Request for Comment
V. Paperwork Reduction Act Analysis
    A. Introduction
    B. Rule 22e-4
    C. Rule 22c-1
    D. Rule 31a-2
    E. Form N-PORT
    F. Form N-CEN
    G. Form N-1A
    H. Request for Comments
VI. Initial Regulatory Flexibility Act Analysis
    A. Reasons for and Objectives of the Proposed Actions
    B. Legal Basis
    C. Small Entities Subject to the Proposed Liquidity Regulations
    D. Projected Reporting, Recordkeeping, and Other Compliance
Requirements
    1. Proposed Rule 22e-4
    2. Swing Pricing
    3. Disclosure and Reporting Requirements Regarding Liquidity
Risk and Liquidity Risk Management
    E. Duplicative, Overlapping, or Conflicting Federal Rules
    F. Significant Alternatives
    G. General Request for Comment
VII. Consideration of Impact on the Economy
VIII. Statutory Authority and Text of Proposed Amendments
Text of Rules and Forms

I. Introduction

    Daily redeemability is a defining feature of open-end management
investment companies (``open-end funds'' or ``funds'') such as mutual
funds.\2\ As millions of Americans have come to rely on open-end funds
as an investment vehicle of choice, the role of fund liquidity
management in reducing the risk that a fund will be unable to meet its
obligations to redeeming shareholders while also minimizing the impact
of those redemptions on the fund (i.e., mitigating investor dilution)
is becoming more important than ever. The U.S. fund industry has
experienced significant growth in the last 20 years,\3\ markets have
grown more complex, and funds pursue more complex investment
strategies, including fixed income and alternative investment
strategies that are focused on less liquid asset classes. Yet, it has
been over twenty years since we have provided guidance regarding the
liquidity of open-end funds other than money market funds.\4\
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    \2\ An open-end fund is required by law to redeem its securities
on demand from shareholders at a price approximating their
proportionate share of the fund's net asset value at the time of
redemption. Section 22(d) of the Act prohibits a dealer from selling
a redeemable security that is being offered to the public by or
through an underwriter other than at a current public offering price
described in the fund's prospectus. Rule 22c-1 under the Act
requires open-end funds, their principal underwriters, and dealers
in fund shares (and certain others) to sell and redeem fund shares
at a price determined at least daily based on the current net asset
value next computed after receipt of an order to buy or redeem.
Together, these provisions require that fund shareholders be treated
equitably when buying and selling their fund shares. While a money
market fund is an open-end management investment company, money
market funds generally are not subject to the amendments we are
proposing (except certain amendments to proposed Form N-CEN) and
thus are not included when we refer to ``funds'' or ``open-end
funds'' in this release except where specified. The term ``mutual
fund'' is not defined in the 1940 Act.
    \3\ As of the end of 2014, there were 8,734 open-end funds
(excluding money market funds, but including ETFs), as compared to
2,960 at the end of 1992. See Investment Company Institute, 2015
Investment Company Fact Book (2015), available at http://www.ici.org/pdf/2015_factbook.pdf (``2015 ICI Fact Book''), at 177
and 184.
    \4\ Revisions of Guidelines to Form N-1A, Investment Company Act
Release No. 18612 (Mar. 12, 1992) [57 FR 9828 (Mar. 20, 1992)]
(``Guidelines Release'').
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    We remain committed, as the primary regulator of open-end funds, to
designing regulatory programs that respond to the risks associated with
the increasingly complex portfolio composition and operations of the
asset management industry. Commission staff engaged with large and
small fund complexes to better understand funds' management of
liquidity risk. Through these outreach efforts our staff has learned
that, while some funds and their managers have developed comprehensive
liquidity risk management programs, others have dedicated significantly
fewer resources to managing liquidity risk in a formalized way. We
believe proposing to address these variations in practices is
appropriate and that it is in the interest of funds and fund investors
to create a regulatory framework that would reduce the risk that a fund
will be unable to meet its redemption obligations and minimize dilution
of shareholder interests by promoting stronger and more effective
liquidity risk management across open-end funds.
    We are proposing a set of comprehensive reforms that would provide
for: (i) Liquidity risk management standards that address issues
arising from modern portfolio construction; (ii) a new pricing method
that, if funds choose to use it, could better allocate costs to
shareholders entering or exiting the fund; and (iii) fuller disclosure
of information regarding the liquidity of fund portfolios and how funds
manage liquidity risk and redemption obligations. To accomplish this,
first, we are proposing new rule 22e-4 under the Act, which would
require funds to establish liquidity risk management programs. Under
the proposed rule, the principal components of a liquidity risk
management program would include a fund's classification and monitoring
of each portfolio asset's level of liquidity, as well as designation of
a minimum amount of portfolio liquidity, which funds would tailor to
their particular

circumstances after consideration of a set of market-related factors
established by the Commission.
    Second, in order to provide funds with an additional tool to
mitigate potential dilution and to manage fund liquidity, we are
proposing amendments to rule 22c-1 under the Act to permit funds
(except money market funds and ETFs) to use ``swing pricing,'' a
process of adjusting the net asset value of a fund's shares to pass on
to purchasing or redeeming shareholders more of the costs associated
with their trading activity. Lastly, in order to give investors, market
participants, and Commission staff improved information on fund
liquidity and redemption practices, we are proposing amendments to our
disclosure requirements and recently proposed data reporting forms. We
discuss these proposals as well as why liquidity management is so vital
to investors in open-end funds and the developments that have led us to
this proposal further below. Taken together, these reforms are designed
to provide investors with increased protections regarding how liquidity
in their open-end funds is managed, thereby reducing the risk that
funds will be unable to meet redemption obligations and mitigating
dilution of the interests of fund shareholders. These reforms are also
intended to give investors better information with which to make
investment decisions, and to give the Commission better information
with which to conduct comprehensive monitoring and oversight of an
ever-evolving fund industry.

II. Background

A. Open-End Funds

    Over the past few decades, investors increasingly have come to rely
on investments in open-end funds to meet their financial needs and
access the capital markets. Individuals invest in these funds for a
variety of reasons, from investing for retirement and their children's
college education to providing a source of financial security for
emergencies and other lifetime events. Institutions also invest
significantly in open-end funds as part of basic or sophisticated
trading and hedging strategies or to manage cash flows.
    There are currently two kinds of open-end funds: Mutual funds and
ETFs.\5\ At the end of 2014, 53.2 million households, or 43.3 percent
of all U.S. households owned mutual funds.\6\ Mutual funds allow
investors to pool their investments with those of other investors so
that they may together benefit from fund features such as professional
investment management, diversification, and liquidity. Fund
shareholders share the gains and losses of the fund, and also share its
costs. Investors in mutual funds can redeem their shares on each
business day and, by law, must receive their pro rata share of the
fund's net assets (or its cash value) within seven calendar days after
delivery of a redemption notice.\7\
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    \5\ ETFs registered with the Commission are organized either as
open-end management investment companies or unit investment trusts.
See section 4(2) of the Act (defining ``unit investment trust'' as
an investment company which (i) is organized under a trust
indenture, contract of custodianship or agency, or similar
instrument, (ii) does not have a board of directors, and (iii)
issues only redeemable securities, each of which represents an
undivided interest in a unit of specified securities, but does not
include a voting trust). Most ETFs are organized as open-end
management investment companies and, except where specified, when we
refer to ETFs in this release, we are referring to ETFs that are
organized as open-end management investment companies.
    \6\ See 2015 ICI Fact Book, supra note 3, at 114.
    \7\ See section 2(a)(32) of the Act (defining a ``redeemable
security'' as any security, other than short-term paper, that
entitles its holder to receive approximately his proportionate share
of the issuer's current net assets, or the cash equivalent thereof),
and section 22(e) of the Act (providing, in part, that no open-end
fund 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).
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    ETFs also offer investors an undivided interest in a pool of
assets. Since 2003, the number of ETFs traded in U.S. markets has
increased by more than 1,200 funds, and the assets held by ETFs have
increased from $151 billion at the end of 2003 to $1.9 trillion at the
end of 2014.\8\ ETF shares, similar to stocks, are bought and sold
throughout the day by investors on an exchange through a broker-
dealer.\9\ In addition, like mutual funds, ETFs provide redemption
rights on a daily basis, but, pursuant to exemptive orders, such
redemption rights may only be exercised by certain large market
participants--typically broker-dealers--called ``authorized
participants.'' Authorized participants may purchase and redeem ETF
shares at the ETF's net asset value per share (``NAV'') from the
ETF.\10\ When an authorized participant transacts with an ETF to
purchase and sell ETF shares, these share transactions are structured
in large blocks called ``creation units.'' Most ETFs are structured so
that an authorized participant will purchase a creation unit with a
``portfolio deposit,'' which is a basket of assets (and sometimes cash)
that generally reflects the composition of the ETF's portfolio.\11\ The
ETF makes public the contents of the portfolio deposit before the
beginning of the trading day.\12\ After purchasing a creation unit, an
authorized participant may hold the ETF shares or sell (or lend) some
or all of them to investors in the secondary market.
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    \8\ See 2015 ICI Fact Book, supra note 3, at 60.
    \9\ See Exchange-Traded Funds, Investment Company Act Release
No. 28193 (Mar. 11, 2008) [73 FR 14618 (Mar. 18, 2008)] (``ETF
Proposing Release'').
    \10\ Authorized participants purchase ETF shares at the ETF's
NAV through the ETF's underwriter or other service provider.
    \11\ See Request for Comment on Exchange-Traded Products,
Securities Exchange Act Release No. 75165 (June 12, 2015) [80 FR
34729 (June 17, 2015)] (``2015 ETP Request for Comment''), at n.19
and accompanying text.
    \12\ See id. at n.20 and accompanying text.
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    Similarly, for most ETFs, when an authorized participant wishes to
redeem ETF shares, it presents a creation unit of ETF shares to the ETF
for redemption and receives in return a ``redemption basket,'' the
contents of which are made public by the ETF before the beginning of
the trading day. The redemption basket (which is usually, but not
always, the same as the portfolio deposit) typically consists of
securities and a small amount of cash.\13\ In addition, while less
common, some ETFs represent to the Commission that they ordinarily
intend to conduct all purchase and redemption transactions with
authorized participants in cash instead of an in-kind basket of assets,
and all ETFs reserve the right to transact with authorized participants
in cash. The ability of these authorized participants to purchase and
redeem creation units at each day's NAV enables authorized participants
(or market makers that trade through authorized participants) to
exercise arbitrage opportunities that are generally expected to have
the effect of keeping the market price of ETF shares at or close to the
NAV of the ETF.\14\
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    \13\ See id. at n.21 and accompanying text.
    \14\ For example, if ETF shares begin trading on national
securities exchanges at a price below the ETF's NAV, authorized
participants can purchase ETF shares in secondary market
transactions and, after accumulating enough shares to comprise a
creation unit, redeem them from the ETF in exchange for the more
valuable securities in the ETF's redemption basket. Those purchases
create greater market demand for the ETF shares, and thus tend to
drive up the market price of the shares to a level closer to NAV.
Conversely, and again by way of example, if the market price for ETF
shares exceeds the NAV of the ETF itself, an authorized participant
can deposit a basket of securities in exchange for the more valuable
creation unit of ETF shares, and then sell the individual shares in
the market to realize its profit. These sales would increase the
supply of ETF shares in the secondary market, and thus tend to drive
down the price of the ETF shares to a level closer to the NAV of the
ETF share. In each case, the authorized participant (or its market
maker customer) may hedge its exposure to cover the risk from the
time the arbitrage opportunity is exercised through the time it can
deliver shares or assets to the ETF, at which time it will unwind
its hedge. See ETF Proposing Release, supra note 9, at nn.25-30 and
accompanying text; see also 2015 ETP Request for Comment, supra note
11, at section I.C.2.

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    Recently, the Commission has also approved exchange-traded managed
funds (``ETMFs'').\15\ ETMFs are a hybrid between a traditional mutual
fund and an ETF. Like ETFs, ETMFs would have shares listed and traded
on a national securities exchange; directly issue and redeem shares in
creation units only; impose fees on creation units issued and redeemed
to authorized participants to offset the related costs to the ETMFs;
and primarily utilize in-kind transfers of portfolio deposits in
issuing and redeeming creation units. Like mutual funds, ETMFs would be
bought and sold at prices linked to NAV and would seek to maintain the
confidentiality of their current portfolio positions. While no ETMF has
been launched yet, the proposed rule and amendments (except the
proposed amendments to rule 22c-1) would also apply to ETMFs to the
same extent as to other open-end funds whose shares are redeemable on a
daily basis.
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    \15\ See Eaton Vance Management, et al., Investment Company Act
Release Nos. 31333 (Nov. 6, 2014) (notice) (``ETMF Notice'') and
31361 (Dec. 2, 2014) (order). For the purposes of the proposed
amendments to rule 22c-1, the definition of ``exchange-traded fund''
shall include ETMFs.
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    Open-end funds are an attractive investment option for many
different types of investors because they provide diversification,
economies of scale, and professional management. They also facilitate
retail investors' access to certain investment strategies or markets
that might be difficult (if not impossible) or time consuming for
investors to replicate on their own.\16\ Additionally, open-end funds
have become a popular investment vehicle because they may provide a
cost-efficient way for investors to track a benchmark index or
strategy.\17\
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    \16\ For example, many retail investors would have difficulty
investing in certain foreign and emerging market securities given
local requirements for purchasing and holding such securities. In
addition, some securities may only be sold in large blocks that
retail investors would be unlikely to be able to purchase. Many
retail investors also may not have the expertise to construct
investment strategies followed by, for example, alternative funds on
their own. See also Notice Seeking Comment on Asset Management
Products and Activities, Docket No. FSOC-2014-0001 (``FSOC
Notice''); Comment Letter of the Asset Management Group of SIFMA and
the Investment Adviser Association on the FSOC Notice (Mar. 25,
2015) (``SIFMA IAA FSOC Notice Comment Letter''), at 12 (``Pooled
funds provide many individual investors exposure to asset classes
that they could not reach without investing collectively.'');
Comment Letter of the Investment Company Institute on the FSOC
Notice (Mar. 25, 2015) (``ICI FSOC Notice Comment Letter''), at 11
(``The vast majority of [mutual fund] investors would be unable to
replicate such investment exposure by directly holding securities
themselves.'').
    \17\ See e.g., Rick Ferri, Index Funds Gain Momentum (Part 1 of
2), FORBES (July 29, 2013), available at http://www.forbes.com/sites/rickferri/2013/07/29/index-funds-gain-momentum-part-1-of-2/
(discussing the growth of passively managed index funds and ETFs
that follow indexes).
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B. The Role of Liquidity in Open-End Funds

1. Introduction
    A hallmark of open-end funds is that they must be able to convert
some portion of their portfolio holdings into cash on a frequent basis
because they issue redeemable securities,\18\ and are required by
section 22(e) of the Investment Company Act to make payment to
shareholders for securities tendered for redemption within seven days
of their tender.\19\ As a practical matter, many investors expect to
receive redemption proceeds in less than seven days as some mutual
funds disclose in their prospectuses that they will generally pay
redemption proceeds on a next-business day basis.\20\ Furthermore,
open-end funds that are redeemed through broker-dealers must meet
redemption requests within three business days because broker-dealers
are subject to rule 15c6-1 under the Securities Exchange Act of 1934
(the ``Exchange Act''), which establishes a three-day (T+3) settlement
period for security trades effected by a broker or a dealer.\21\ Given
the statutory and regulatory requirements for meeting redemption
requests, as well as any disclosure made to investors regarding payment
of redemption proceeds, a mutual fund must adequately manage the
liquidity of its portfolio so that redemption requests can be satisfied
in a timely manner.\22\
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    \18\ See sections 5(a)(1) and 2(a)(32) of the Act. All other
management companies are closed-end (``closed-end funds''). Closed-
end fund shareholders do not have redemption rights and closed-end
funds are usually traded on secondary markets, either on exchanges
or over the counter, at prices that may be at a premium or a
discount to the fund's NAV.
    \19\ 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.
    \20\ See Comment Letter of Fidelity Investments on the FSOC
Notice (Mar. 25, 2015) (``Fidelity FSOC Notice Comment Letter''), at
6 (``mutual funds normally process redemption requests by the next
business day''); see also ICI FSOC Notice Comment Letter, supra note
16, at 17 (``For example, a mutual fund has by law up to seven days
to pay proceeds to redeeming investors, although as a matter of
practice funds typically pay proceeds within one to two days of a
redemption request.'').
    \21\ 17 CFR 240.15c6-1. In a 1995 staff no-action letter, the
Division of Investment Management expressed the view that because
rule 15c6-1 under the Exchange Act applies to broker-dealers and
does not apply directly to funds, the implementation of T+3 pursuant
to rule 15c6-1 did not change the standards for determining
liquidity, which were based on the requirements of section 22(e) of
the Investment Company Act. The Division noted, however, that as a
practical matter, many funds have to meet redemption requests within
three business days because a broker-dealer is often involved in the
redemption process. See Letter from Jack W. Murphy, Associate
Director and Chief Counsel, Division of Investment Management, SEC,
to Paul Schott Stevens, General Counsel, Investment Company
Institute (May 26, 1995), available at http://www.sec.gov/divisions/investment/noaction/1995/ici052695.pdf, (``May 1995 Staff No-Action
Letter''); see also Fidelity FSOC Notice Comment Letter, supra note
20, at 6 (``As a practical matter, three-day settlement requirements
under Exchange Act Rule 15c6-1 . . . effectively take most fund
investments to a T+3 settlement timeline.'').
    \22\ See ICI FSOC Notice Comment Letter, supra note 16, at 6-7
(``Daily redeemability is a defining feature of mutual funds. This
means that liquidity management is not only a regulatory compliance
matter, but also a major element of investment risk management, an
intrinsic part of portfolio management, and a constant area of focus
for fund managers.'').
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    Sufficient liquidity of ETF portfolio positions also is important.
ETFs typically make in-kind redemptions of creation units, which can
mitigate liquidity concerns for ETFs compared to mutual funds, if the
in-kind redemptions are of a representative basket of the ETF's
portfolio assets that do not alter the ETF's liquidity profile.\23\
However, transferring illiquid instruments to the redeeming authorized
participants could result in a liquidity cost to the authorized
participant or any of its clients, which would then be reflected in the
bid-ask spread and ultimately impact investors. Moreover, declining
liquidity in an ETF's basket assets could affect the ability of an
authorized participant or any of its clients to readily assemble the
basket for purchases of creation units and to sell securities received
upon redemption of creation units.\24\
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    \23\ ETFs have some discretion in determining their basket
composition. See, e.g., New York Alaska ETF Management LLC, et al.,
Investment Company Act Release Nos. 31667 (June 12, 2015) (notice)
and 31709 (July 8, 2015) (order).
    \24\ ETF Proposing Release, supra note 9 at section III.A.1. But
see, e.g., Shelly Antoniewicz, Investment Company Institute, Plenty
of Players Provide Liquidity for ETFs (Dec. 2, 2014), available at
http://www.ici.org/viewpoints/view_14_ft_etf_liquidity
(``Antoniewicz'') (stating that most of the trading activity in bond
ETF shares is done in the secondary market and not through creations
and redemptions with authorized participants).
---------------------------------------------------------------------------

    In addition, a significant amount of illiquid securities in an
ETF's portfolio can make arbitrage opportunities more difficult to
evaluate because it would be difficult for market makers to price,
trade, and hedge their exposure to, the

ETF.\25\ The effective functioning of this arbitrage mechanism has been
pivotal to the operation of ETFs and to the Commission's approval of
exemptions that allow their operation.\26\ The liquidity of the ETF's
portfolio positions is a factor that contributes to the effective
functioning of the ETF's arbitrage mechanism and the ETF shares trading
at a price that is at or close to the NAV of the ETF.\27\
---------------------------------------------------------------------------

    \25\ See Comment Letter of the Investment Company Institute on
Exchange-Traded Funds, File No. S7-07-08 (May 19, 2008) (discussing
the impact of the inclusion of illiquid assets in an ETF's
portfolio). See also Comment Letter of The American Stock Exchange
LLC on the Concept Release: Actively Managed Exchange-Traded Funds,
File No. S7-20-01 (Mar. 5, 2002) (``Ultimately it is in the interest
of the sponsor and investment adviser to provide for effective
arbitrage opportunities. It is unlikely that an . . . ETF sponsor
would be able to convince the critical market participants such as
specialists, market makers, arbitragers and other Authorized
Participants to support a product that contained illiquid securities
to a degree that would affect the liquidity of the ETF, making it
difficult to price, trade and hedge, ultimately leading to its
failure in the marketplace.'').
    \26\ ETFs exist today only through exemptive orders issued by
the Commission providing relief from a number of provisions of the
Investment Company Act, including the requirement that they sell and
redeem their individual shares at NAV.
    \27\ See 2015 ETP Request for Comment, supra note 11, at n.102
and accompanying text (requesting comment on the trading of
exchange-traded product securities that invest in less liquid assets
and the effective functioning of the arbitrage mechanism in these
products). See, e.g., Comment Letter of BlackRock, Inc. on the 2015
ETP Request for Comment (Aug. 11, 2015) (discussing the arbitrage
mechanism with respect to less liquid assets); Comment Letter of KCG
Holdings, Inc. on the 2015 ETP Request for Comment (Aug. 17, 2015)
(``While ETF pricing closely tracks NAV for most ETFs, certain types
of ETFs exhibit less close alignment between ETF prices and NAV. . .
Price discovery difficulties in the bond market makes it much more
difficult and expensive to perform arbitrage in bond ETFs, and this
difficultly may be exacerbated during stressed market
environments.''); Comment Letter of State Street Global Advisors on
the 2015 ETP Request for Comment (Aug. 17, 2015) (discussing the
arbitrage mechanism with respect to fixed-income based ETFs).
---------------------------------------------------------------------------

    If authorized participants are unwilling or unable to trade ETF
shares in the primary market, and the majority of trading takes place
among investors in the secondary market, the ETF's shares may trade at
a significant premium or a discount to the value of the ETF's
underlying portfolio securities.\28\ As a result, the ETF's arbitrage
mechanism that keeps the secondary price at or close to NAV would not
function effectively. In a period of significant decline in market
liquidity, this could cause the ETF, in effect, to function more like a
closed-end investment company, potentially frustrating the expectations
of secondary market investors.\29\ In addition, all ETFs permit
authorized participants to redeem in cash, rather than in kind, and
some ETFs ordinarily redeem authorized participants in cash. ETFs that
elect to redeem authorized participants in cash, like mutual funds,
would need to ensure that they have adequate portfolio liquidity (in
conjunction with any other liquidity sources) to meet shareholder
redemptions.\30\
---------------------------------------------------------------------------

    \28\ See, e.g., Bradley Hope et al., Stock-Market Tumult Exposes
Flaws in Modern Markets, The Wall Street Journal (Aug. 25, 2015),
available at http://www.wsj.com/articles/stock-market-tumult-exposes-flaws-in-modern-markets-1440547138 (noting that ``[d]ozens
of ETFs traded at sharp discounts'' to NAV during a market sell-off,
``leading to outsize losses for investors who entered sell orders at
the depth of the panic''). We recognize that not all changes in
market liquidity can lead to such extreme results. In many cases of
day-to-day price volatility and fluctuations in liquidity, market
participants will simply demand greater compensation for purchasing
less liquid or more volatile assets. However, declining liquidity
can become so acute that market makers and investors begin to
refrain from conducting transactions. See, e.g., Carrie Driebusch et
al., The Problem with ETFs, The Wall Street Journal (Sept. 14, 2015)
(stating that the ``trading turmoil of Aug. 24 disrupted the
arbitrage activity in which traders buy and sell ETFs and their
components to take advantage of price discrepancies.'').
    \29\ See, e.g., Matthew Tucker & Stephen Laipply, ``Fixed Income
ETFs and the Corporate Bond Liquidity Challenge'' (2014), available
at http://www.ishares.com/us/literature/brochure/blackrock-ish-fixed-income-etfs-wp-prd-814.pdf, at 9 (``It should be noted that,
although fixed income ETFs have created an incremental source of
bond market liquidity for investors, the ETF structure itself
remains dependent on the liquidity of the underlying bond market.
ETFs serve as efficient risk transfer vehicles because the value at
which they trade is reflective of the value of the underlying bonds
held within the ETF. If a true and actionable value discrepancy
between the ETF and its underlying bond portfolio develops, market
participants can trade one versus the other to take advantage of the
arbitrage opportunity. This mechanism is premised upon a functioning
OTC bond market that can be accessed to buy and sell the underlying
securities. Ultimately, if the underlying bond market liquidity
becomes impaired then the ETF creation/redemption process would
become impaired as well. In such a scenario the ETF would continue
to provide price discovery, but would mechanically begin to function
more like a closed-end fund (which is unable to grow or shrink in
size in order to balance supply and demand). While ETFs provide
liquidity enhancement for the bond market, they remain structurally
dependent upon the same market.'').
     Market stresses have demonstrated how declines in market
liquidity may cause an ETF's shares to trade at a significant
premium or discount to the shares of the ETF's underlying portfolio
assets. See, e.g., Eleanor Laise, Risks Lurk for ETF Investors, The
Wall Street Journal (Feb. 1, 2010), available at http://www.wsj.com/articles/SB10001424052748703837004575012772071656484 (``A lack of
liquidity also may cause the ETF to trade at a large premium or
discount to net asset value. . . . This means an investor buying the
fund may overpay for that portfolio, or an investor selling could
get less than that basket of securities is worth.''); Bradley Kay,
Has the ETF Arbitrage Mechanism Failed?, Morningstar (Mar. 11,
2009), available at http://news.morningstar.com/articlenet/article.aspx?id=283302 (stating that during periods of market
stress, market prices for ETFs may deviate significantly from NAV);
ETF Trends, While Athens Exchange is Closed, the Greece ETF Show
Goes On (July 6, 2015), available at http://www.etftrends.com/2015/07/while-athens-exchange-is-closed-the-greece-etf-show-goes-on/
(reporting that the Global X FTSE Greece 20 ETF was trading at a
significant discount compared to the net asset value of its
underlying portfolio assets because of the closure of the Athens
Stock Exchange); ETF Trends, China A-Shares ETFs Trading at Steep
Discount to NAV (July 9, 2015), available at http://www.etftrends.com/2015/07/china-a-shares-etfs-trading-at-steep-discount-to-nav/ (reporting that U.S.-listed China A-shares ETFs
were trading at a steep discount to the underlying market because of
the fact that a significant number of companies stopped trading on
China's mainland stock exchanges).
    \30\ When an ETF does permit an authorized participant to redeem
in cash, it typically requires the authorized participant to pay a
fee covering the costs of the liquidity it receives. See BlackRock,
Viewpoint, Fund Structures as Systemic Risk Mitigants (Sept. 2014),
available at http://www.blackrock.com/corporate/en-us/literature/whitepaper/viewpoint-fund-structures-as-systemic-risk-mitigants-september-2014.pdf (``BlackRock Fund Structures Paper''), at 7.
---------------------------------------------------------------------------

    As noted above, ETMFs have features of both mutual funds and ETFs.
As ETMFs would redeem their shares on a daily basis from authorized
participants, the ETMF would need to hold sufficiently liquid assets to
meet such redemptions to the extent that authorized participants redeem
in cash. Like ETFs, however, the ETMF's ability to make in-kind
redemptions could mitigate liquidity concerns.\31\ Further, as ETMF
market makers would not engage in the same arbitrage as ETF market
makers,\32\ the liquidity of an ETMF's portfolio might have a limited
relevance beyond the ETMF's ability to meet redemptions.
---------------------------------------------------------------------------

    \31\ However, an ETMF's transferring illiquid instruments to the
redeeming authorized participants would likely affect the premium/
discount over NAV at which ETMF shares trade. See ETMF Notice, supra
note 15, at n.17.
    \32\ ETMF market makers would assume no intraday market risk in
their ETMF share inventory positions because all trading prices are
linked to NAV. See id. at paragraphs 13 and 24.
---------------------------------------------------------------------------

2. Liquidity Management by Open-End Funds
    Portfolio managers consider a variety of factors in addition to
liquidity when constructing a fund's portfolio, including the fund's
investment strategies, economic and market trends, portfolio asset
credit quality, and tax considerations. Nevertheless, meeting daily
redemption obligations is fundamental for open-end funds, and funds
must manage liquidity in order to meet these obligations.\33\ Several
factors influence how liquidity management by open-end funds affects
the equitable treatment of investors in a fund, investor incentives,
and potentially the orderly operation of the markets when fulfilling
redemption obligations.
---------------------------------------------------------------------------

    \33\ See supra note 2.

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

    First, it is important to consider how a mutual fund (or ETF
redeeming shares by using significant amounts of cash) meets
redemptions. When a fund receives redemption requests from
shareholders, and the fund does not have cash on hand to meet those
redemptions,\34\ the fund has discretion to determine whether to sell
portfolio assets to generate cash to meet the redemptions and which
assets will be sold, or to obtain cash by other available means such as
bank lines of credit.\35\ A fund may choose to sell its most liquid
assets first. This method of selling is limited to some degree by the
investment strategies of the fund, and a fund pursuing this method of
meeting redemptions to any significant degree may in the near term need
to rebalance its portfolio so that the fund continues to follow its
investment strategies.\36\ A fund that chooses to sell its most liquid
assets to meet fund redemptions may minimize the effect of the
redemptions on short-term fund performance for redeeming and remaining
shareholders, but may leave remaining shareholders in a potentially
less liquid and riskier fund until the fund rebalances.\37\ In contrast
to meeting redemptions by selling its most liquid assets first, a fund
alternatively could choose to meet redemptions by selling, to the best
of its ability, a ``strip'' of the fund's portfolio (i.e., a cross-
section or representative selection of the fund's portfolio
assets).\38\ Funds also could choose to meet redemptions by selling a
range of assets in between its most liquid, on one end of the spectrum,
and a perfect pro rata strip of assets, on the other end of the
spectrum. Additionally, funds could choose to opportunistically pare
back or eliminate holdings in a particular asset or sector to meet
redemptions. As discussed further in section IV.B.2, analysis conducted
by staff in the Division of Economic and Risk Analysis (the ``DERA
Study'' \39\) suggests that the typical U.S. equity fund appears to
sell relatively more liquid assets (as opposed to a strip of the fund's
portfolio) to meet redemptions, and that as a fund's liquidity
decreases, a fund will become even more likely to sell its relatively
more liquid assets (rather than a strip of its portfolio) to meet
redemptions (thus resulting in decreased liquidity in the fund's
portfolio).
---------------------------------------------------------------------------

    \34\ A fund can have cash on hand to meet redemptions from cash
held in the fund's portfolio, cash received from investor purchases
of fund shares, interest payments and dividends on portfolio
securities, or maturing bonds. See, e.g., Fidelity FSOC Notice
Comment Letter, supra note 20, at n.17 (``[S]ecurities do not need
to be sold every time a redemption order is placed. Sale of fund
assets is necessary only when gross redemptions significantly exceed
net inflows.'').
    \35\ See, e.g., id., at 21 (``When facing stressed markets and
shareholder redemptions, a portfolio manager must decide whether to:
(i) maintain current portfolio composition and sell a cross section
of holdings; (ii) meet redemptions with cash and/or index futures if
held, with the result being increased concentrations in non-cash
positions; or (iii) reposition a portfolio's composition by selling
a mixture of holdings and cash and/or index futures, thereby
realigning holdings in response to shifting market prices and
expectations.'').
     A fund could also use a line of credit to meet redemptions
instead of selling assets, but using a line of credit leverages the
fund, and thus many funds only do so infrequently. See infra section
III.C.5.a (discussing the extent to which drawing on a credit line
to meet redemptions could result in negative impacts on the fund,
and providing guidance on borrowing arrangements entered into by
funds); see also Fidelity FSOC Notice Comment Letter, supra note 20,
at 21 (``Fully substituting cash liquidation for security sales is a
very short-term strategy if redemptions are persistent.''); Comment
Letter of Invesco Ltd. on the FSOC Notice (Mar. 25, 2015) (``Invesco
FSOC Notice Comment Letter''), at 10 (stating that Invesco portfolio
managers do not automatically sell the most liquid assets when there
is a need to raise cash for redemptions or other purposes and that
they may seek to rebalance portfolios in falling markets in a manner
that cushions the impact of redemptions). But see infra note 371
(noting that other funds rely on lines of credit more frequently).
     A fund also may reserve the right to redeem its shares in kind
instead of in cash. However, there are often logistical issues
associated with paying in-kind redemptions, which limit the
availability of in-kind redemptions under many circumstances. See
infra section III.C.5.c.
    \36\ Some mutual funds disclose that they may temporarily depart
from their investment strategies in order to take a ``temporary
defensive position'' to avoid losses in response to adverse market,
economic, political or other conditions. See Investment Company
Names, Investment Company Act Release No. 24828 (Jan. 17, 2001) [66
FR 8509 (Feb. 1, 2001)] (``Investment Company Names Rule Release'').
    \37\ See, e.g., Matt Wirz, Waddell Fund's Sales Leave Investors
With Riskier Securities, The Wall Street Journal (June 16, 2015),
available at http://www.wsj.com/articles/waddell-funds-sales-leave-investors-with-riskier-securities-1434482621 (noting that from July
2014 through June 2015, a high-yield bond fund experienced heavy
redemptions that caused its net assets to shrink 33% in this period,
and during this same period, the fund's holdings of bonds rated
triple-C or below grew to 47% of assets, from 35% before the
redemptions).
    \38\ There are practical limitations on a fund's ability to sell
a pro rata slice of its portfolio, such as minimum trade sizes,
transfer restrictions, illiquid assets, tax complications from
certain sales, and avoidance of odd lot positions.
    \39\ Paul Hanouna, Jon Novak, Tim Riley, Christof Stahel,
``Liquidity and Flows of U.S. Mutual Funds,'' Division of Economic
and Risk Analysis White Paper, September 2015, available at http://wcm.sec.gov/dera/staff-papers/white-papers/liquidity-white-paper-09-2015.pdf.
---------------------------------------------------------------------------

    Second, the effect of redemptions on shareholders is determined by
how and when those redemptions affect the price of the fund's shares.
Under rule 22c-1, all investors who redeem from an open-end fund on any
particular day must receive the NAV next calculated by the fund after
receipt of such redemption request.\40\ As most funds, with the
exception of money market funds, only calculate their NAV once a day,
this means that redemption requests received during the day receive the
end of day NAV, typically calculated as of 4 p.m. Eastern time.\41\
When calculating a fund's NAV, however, rule 2a-4 requires funds to
reflect changes in holdings of portfolio securities and changes in the
number of outstanding shares resulting from distributions, redemptions,
and repurchases no later than the first business day following the
trade date.\42\ We allow this calculation method to provide funds with
additional time and flexibility to incorporate last-minute portfolio
transactions into their NAV calculations on the business day following
the trade date, rather than the trade date.\43\ As a practical matter,
this calculation method also gives broker-dealers, retirement plan
administrators, and other intermediaries additional time to process
transactions received by 4 p.m. on the trade date, which then may be
reflected in the fund's NAV on the business day following the trade
date. Given that under many circumstances reflecting these changes on
the trade date would not materially affect the fund's price, we have
allowed and continue to allow such changes to be reflected no later
than the first business day following the trade date.
---------------------------------------------------------------------------

    \40\ Rule 22c-1(a). See also supra note 2.
    \41\ Commission rules do not require that a fund calculate its
NAV at a specific time of day. Rule 22c-1 generally requires that
the purchase and redemption of a redeemable security be effected at
the current NAV next computed after receipt of a purchase or
redemption request. See rule 22c-1(a). Current NAV must be computed
at least once daily, subject to limited exceptions, Monday through
Friday, at the specific time or times set by the board of directors.
See rule 22c-1(b)(1).
    \42\ Rule 2a-4(a)(2)-(3).
    \43\ See Adoption of Rule 2a-4 Defining the Term ``Current Net
Asset Value'' in Reference to Redeemable Securities Issued by a
Registered Investment Company, Investment Company Act Release No.
4105 (Dec. 22, 1964) [29 FR 19100 (Dec. 30, 1964)].
---------------------------------------------------------------------------

    Nevertheless, we recognize that trading activity and other changes
in portfolio holdings associated with meeting redemptions may occur
over multiple business days following the redemption request. Such
activities associated with meeting redemptions may include, for
example, selling assets and, if the fund's most liquid assets are sold
to meet redemptions, rebalancing the portfolio to avoid departing from
the fund's investment strategies. If these activities occur (and their
associated costs are incurred) in days following redemption requests,
the costs of providing liquidity to redeeming investors could be borne
at least partially by the remaining investors in the fund, thus
potentially diluting the

interests of non-redeeming shareholders.\44\ The less liquid the fund's
portfolio holdings, the greater these liquidity costs can become.\45\
---------------------------------------------------------------------------

    \44\ See, e.g., Comment Letter of Mutual Fund Directors Forum on
the FSOC Notice (Mar. 25, 2015), at 5 (stating that ``there could be
severe outlier situations in which sudden and extensive redemptions
might impose costs on non-redeeming shareholders, either because of
increases in transaction costs associated with selling portfolio
securities in stressful circumstances or because portfolio managers
are forced to sell securities into falling markets at a price less
than what they believe the security's fundamental value to be.'').
We note that ETFs either conduct redemptions with authorized
participants in kind or, if in cash, typically require the
authorized participant to pay a fee covering the costs of the
liquidity it receives. See supra note 30 and accompanying text.
Accordingly, ETFs do not necessarily create the same dilution
concerns as mutual funds.
    \45\ See Comment Letter of Nuveen Investments on the FSOC Notice
(Mar. 25, 2015) (``Nuveen FSOC Notice Comment Letter''), at 10
(stating that ``to the extent that the prices of portfolio
securities do not reflect the most current market conditions, which
is more likely to occur with less liquid asset classes in stressed
markets, a fund with net redemptions may be paying more to redeeming
shareholders than it should (giving such redeemers a `first mover
advantage'), thereby harming remaining shareholders and the long-
term performance of the fund'' but noting that there is no evidence
that shareholders are actually motivated by this advantage); Comment
Letter of Occupy the SEC on the FSOC Notice (Mar. 25, 2015)
(``Occupy the SEC FSOC Notice Comment Letter''), at 13 (stating that
many funds that hold securities traded over-the-counter cannot
observe market prices so they base their NAVs on price estimates and
that these ``estimates are surely lagging, particularly in turbulent
times'').
---------------------------------------------------------------------------

    Thus, with respect to redemptions, there can be significant adverse
consequences to remaining investors in a fund when it fails to
adequately manage liquidity.\46\ For example, portfolio assets held by
a fund can become increasingly illiquid as its more liquid portfolio
assets are sold to meet redemptions and thus could have a compounding
effect of causing the fund's entire portfolio to become increasingly
illiquid for purposes of meeting future shareholder redemptions, which
could adversely affect the fund's risk profile.\47\ Furthermore, if a
fund finds that it can only sell portfolio assets (or portions of a
position in a particular asset) that are less liquid at prices that
incorporate a significant discount from fair value, the discounted sale
price can materially affect the fund's NAV.\48\
---------------------------------------------------------------------------

    \46\ See, e.g., Jason Greene & Charles Hodges, The Dilution
Impact of Daily Fund Flows on Open-end Mutual Funds, 65 J. of Fin.
Econ. 131 (2002) (``Greene & Hodges'') (``Active trading of open-end
funds has a meaningful economic impact on the returns of passive,
nontrading shareholders, particularly in U.S.-based international
funds. The overall sample of domestic equity funds shows no dilution
impact, but we find an annualized negative impact of 0.48% in
international funds (and nearly 1% for a subsample of funds whose
daily flows are particularly large).'').
    \47\ See, e.g., In re Heartland Advisors, Inc., et al.,
Investment Company Act Release No. 28136 (Jan. 25, 2008)
(``Heartland Release'') (settled enforcement action against advisory
firm alleging that certain high-yield bond funds experienced
liquidity problems (caused in part by adviser's unwillingness to
sell bond holdings at prices below which the funds had valued them)
and, as a result, the funds borrowed heavily against a line of
credit to meet fund redemption requests, and investors redeemed fund
shares at prices that benefited redeeming shareholders at the
expense of remaining and new investors).
    \48\ Id.
---------------------------------------------------------------------------

    These factors in fund redemptions--either individually or in
combination--can create incentives in times of liquidity stress in the
markets for early redemptions (or a ``first-mover advantage'').\49\ If
investor redemptions are motivated by this first-mover advantage,\50\
they can lead to increasing levels of redemptions, and as the level of
outflows from a fund increases, the incentive to redeem also
increases.\51\ Regardless of whether investor redemptions are motivated
by a first-mover advantage or other factors, there can be significant
adverse consequences to remaining investors in a fund when it fails to
adequately manage liquidity.\52\ This underlines the importance of fund
liquidity management for advancing investor protection by reducing the
risk that a fund would be unable to meet redemption obligations without
materially affecting the fund's NAV.\53\
---------------------------------------------------------------------------

    \49\ See, e.g., Qi Chen, Itay Goldstein & Wei Jiang, Payoff
Complementarities and Financial Fragility: Evidence from Mutual Fund
Outflows, 97 J. Fin. Econ. 239 (2010), at 240 (``Because mutual
funds conduct most of the resulting trades after the day of
redemption, most of the costs are not reflected in the NAV paid out
to redeeming investors, but rather are borne by the remaining
investors. This leads to strategic complementarities--the
expectation that other investors will withdraw their money reduces
the expected return for staying in the fund and increases the
incentive for each individual investor to withdraw as well--and
amplifies the damage to the fund.''); Comment Letter of State Street
Corporation on the FSOC Notice (Mar. 25, 2015), at 3 (``Anticipation
of other investors' activity could be a powerful motivator for
selling units by a fund holder, particularly if the structure of the
fund was such that continuing investors were concerned in some way
of being disadvantaged by earlier generations of exiting
investors.''). But see Fidelity FSOC Notice Comment Letter, supra
note 20, at 9-10 (stating that there are several limitations in the
Chen, Goldstein, & Jiang academic paper, including that its analysis
excluded retirement shares, analyzed only equity and not bond funds,
and did not examine recent data (it examined data from 1995 to
2005); Nuveen FSOC Notice Comment Letter, supra note 45, at 10
(stating that there is no evidence that shareholders are actually
motivated by a first-mover advantage). We also note that any first-
mover advantage may be further mitigated in ETFs to the extent that
they conduct in-kind redemptions of authorized participants or
charge liquidity fees for cash redemptions. See supra note 30 and
accompanying text.
    \50\ See, e.g., Comment Letter of BlackRock on the FSOC Notice
(Mar. 25, 2015) (``BlackRock FSOC Notice Comment Letter''), at 17
(stating that although incentives to redeem may exist, this does not
necessarily imply that investors will in fact redeem en masse in
times of market stress, but also noting that a well-structured fund
``should seek to avoid features that could create a `first-mover
advantage' in which one investor has an incentive to leave'' before
others); Comment Letter of Association of Institutional Investors on
the FSOC Notice (Mar. 25, 2015) (``AII FSOC Notice Comment
Letter''), at 10-11 (``The empirical evidence of historical
redemption activity, even during times of market stress, supports
the view that either (i) there are not `incentives to redeem' that
are sufficient to overcome the asset owner's asset allocation
decision or (ii) that there are disincentives, such as not
triggering a taxable event, that outweigh the hypothesized
`incentives to redeem.' ''); Comment Letter of The Capital Group
Companies on the FSOC Notice (Mar. 25, 2015), at 8 (``We also do not
believe that the mutualization of fund trading costs creates any
first mover advantage.''); ICI FSOC Notice Comment Letter, supra
note 16, at 7 (``Investor behavior provides evidence that any
mutualized trading costs must not be sufficiently large to drive
investor flows. We consistently observe that investor outflows are
modest and investors continue to purchase shares in most funds even
during periods of market stress.'').
    \51\ See, e.g., Joshua Coval & Erik Stafford, Asset Fire Sales
(and Purchases) in Equity Markets, 86 J. Fin. Econ. 479 (2007)
(``Coval & Stafford'') (``Funds experiencing large outflows tend to
decrease existing positions, which creates price pressure in the
securities held in common by distressed funds. Similarly, the
tendency among funds experiencing large inflows to expand existing
positions creates positive price pressure in overlapping holdings.
Investors who trade against constrained mutual funds earn
significant returns for providing liquidity. In addition, future
flow-driven transactions are predictable, creating an incentive to
front-run the anticipated forced trades by funds experiencing
extreme capital flows.''); Teodor Dyakov & Marno Verbeek, Front-
Running of Mutual Fund Fire-Sales, 37 J. of Bank. and Fin. 4931
(2013) (``Dyakov & Verbeek'') (``We show that a real-time trading
strategy which front-runs the anticipated forced sales by mutual
funds experiencing extreme capital outflows generates an alpha of
0.5% per month during the 1990-2010 period . . . Our results suggest
that publicly available information of fund flows and holdings
exposes mutual funds in distress to predatory trading.''). See infra
notes 805-809 and accompanying text for a discussion of predatory
trading concerns.
    \52\ See, e.g., Greene & Hodges, supra note 46.
    \53\ See, e.g., Fidelity FSOC Notice Comment Letter, supra note
20, at 18 (``Managing liquidity levels to fulfill [a fund adviser's]
fiduciary obligations benefits [redeeming and remaining]
shareholders as well as the broader financial markets.'').
---------------------------------------------------------------------------

    There also is a potential for adverse effects on the markets when
open-end funds fail to adequately manage liquidity. For example, if
liquid asset levels are insufficient to meet redemptions, funds may
sell less-liquid portfolio assets at discounted or even fire sale
prices. These sales can produce significant negative price pressure on
those assets and correlated assets. Accordingly, redemptions and funds'
liquidity risk management can affect not just the remaining investors
in the fund, but any other investors holding these assets. Such
liquidity stress on the assets held in the fund may transmit

stress to other funds or portions of the market as well.\54\
---------------------------------------------------------------------------

    \54\ See, e.g., Francis A. Longstaff, The Subprime Credit Crisis
and Contagion in Financial Markets, 97 J. Fin. Econ. No. 3 436
(2010) (finding that financial contagion during the financial crisis
from the subprime asset-backed securities market was propagated to
other markets primarily through liquidity and risk-premium channels,
rather than through a correlated-information channel); U.S.
Presidential Task Force on Market Mechanisms & U.S. Dept. of the
Treasury, Report of the Presidential Task Force on Market Mechanisms
(Jan. 1988), available at https://archive.org/details/reportofpresiden01unit (``1987 Market Crash Report''), at III-16--
III-26, IV-1--IV-8 (discussing mutual fund selling behavior during
the October 1987 stock market crash, and in particular the selling
of three mutual fund companies, whose heavy selling of assets to
meet significant redemptions ``accounted for approximately one
quarter of all trading on the NYSE for the first 30 minutes that the
Exchange was open'' on October 19, 1987 and that such selling had
``a significant impact on the downward direction of the market'').
---------------------------------------------------------------------------

    In December 2014, the Financial Stability Oversight Council
(``FSOC'') issued a notice seeking public comment on the potential
risks to the U.S. financial system that may be posed by asset
management products and activities in the areas of liquidity and
redemptions among others.\55\ Although our rulemaking proposal is
independent of FSOC, several commenters responding to the FSOC notice
discussed issues concerning liquidity and redemptions, and we have
considered and cited to the relevant comments throughout the
release.\56\ As the primary regulator of the U.S. securities markets,
we are proposing rules today that focus on mitigating the adverse
effects that liquidity risk in funds can have on investors and the
fair, efficient and orderly operation of the markets. To the extent
there are any potential financial stability risks from poor fund
liquidity management,\57\ our proposal may mitigate those risks as
well.
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    \55\ FSOC Notice, supra note 16.
    \56\ Comments submitted in response to the FSOC Notice are
available at http://www.regulations.gov/#!docketDetail;D=FSOC-2014-
0001.
    \57\ See, e.g., Itay Goldstein, Hao Jiang & David T. Ng,
Investor Flows and Fragility in Corporate Bond Funds, unpublished
working paper (June 25, 2015), available at http://
finance.wharton.upenn.edu/~itayg/Files/bondfunds.pdf (finding that
``corporate bond funds tend to have more concave flow-performance
relationships when they have more illiquid assets and when the
overall market illiquidity is high'' and that these results ``point
to the possibility of fragility'').
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C. Recent Developments in the Open-End Fund Industry

    Recent industry developments have underlined our focus on the
importance of liquidity risk management practices in open-end funds.
These developments include significant growth in assets of, and
shareholder inflows into, open-end funds with fixed income strategies
and alternative strategies since 2008 and the evolution of settlement
periods and redemption practices utilized by open-end funds. While
mutual funds holding U.S. equities continue to make up the largest
category of funds in terms of fund assets, their share of the total
industry assets has declined from 65.2% in 2000 to 44.5% in 2014.\58\
Assets of foreign bond and foreign equity funds have grown during the
same period from 11% to 17.4%,\59\ and there has been significant
growth in fixed income and alternative strategy funds, as discussed
below.
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    \58\ DERA Study, supra note 39, at Table 2.
    \59\ Id.
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1. Fixed Income Funds and Alternative Funds
    We have observed significant growth in cash flows into, and assets
of, fixed income mutual funds and fixed income ETFs. Assets in these
funds grew from $1.5 trillion at the end of 2008 to $3.5 trillion at
the end of 2014, with net inflows exceeding $1.3 trillion during that
period.\60\ As growth in fixed income fund assets was occurring, we
increased our focus on fixed income market structure, holding a
roundtable focused on the fixed income markets in 2013 and publishing a
report on the municipal securities markets in 2012.\61\ In addition,
both Commissioners and Commission staff have spoken about the need to
focus on potential risks relating to the fixed income markets and their
underlying liquidity.\62\ Commission staff also has focused on the
nature of liquidity risk management in fixed income funds, including by
selecting fixed income funds as an examination priority in 2014 and
2015.\63\
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    \60\ These figures were obtained from staff analysis of
Morningstar Direct data, and are based on fund categories defined by
Morningstar.
    \61\ See Transcript, Roundtable on Fixed Income Markets (Apr.
16, 2013), available at https://www.sec.gov/spotlight/fixed-income-markets/2013-04-16-fixed-income-markets-transcript.txt (discussing,
among other topics, liquidity characteristics and risks in the
municipal bond and corporate bond markets); Report on the Municipal
Securities Market (July 31, 2012), available at https://www.sec.gov/news/studies/2012/munireport073112.pdf (discussing, among other
topics, the low liquidity, opacity and fragmentation of the
municipal securities market).
    \62\ See, e.g., Chair Mary Jo White, Speech, Intermediation in
the Modern Securities Markets: Putting Technology and Competition to
Work for Investors, (June 20, 2014), available at http://www.sec.gov/News/Speech/Detail/Speech/1370542122012; Commissioner
Luis A. Aguilar, Speech, Advocating for Investors Saving for
Retirement, (Feb. 5, 2015), available at http://www.sec.gov/news/speech/advocating-for-investors-saving-for-retirement.html;
Commissioner Daniel M. Gallagher, Speech, A Watched Pot Never Boils:
the Need for SEC Supervision of Fixed Income Liquidity, Market
Structure, and Pension Accounting, (Mar. 10, 2015), available at
http://www.sec.gov/news/speech/031015-spch-cdmg.html and Remarks
Regarding the Fixed Income Markets at the Conference on Financial
Markets Quality, (Sept. 19, 2012), available at http://www.sec.gov/News/Speech/Detail/Speech/1365171491192; Commissioner Michael S.
Piwowar, Speech, Remarks at the 2014 Municipal Finance Conference
presented by The Bond Buyer and Brandeis International Business
School, (Aug. 1, 2014), available at http://www.sec.gov/News/Speech/Detail/Speech/1370542588006; Commissioner Kara M. Stein, Speech,
Mutual Funds--The Next 75 Years, (June 15, 2015), available at
http://www.sec.gov/news/speech/mutual-funds-the-next-75-years-stein.html; Norm Champ, former Director of the Division of
Investment Management, Speech, Remarks to the ICI 2014 Securities
Law Developments Conference, (Dec. 10, 2014), available at http://www.sec.gov/News/Speech/Detail/Speech/1370543675348; IM Guidance
Update No. 2014-01, Risk Management in Changing Fixed Income Market
Conditions (Jan. 2014), available at http://www.sec.gov/divisions/investment/guidance/im-guidance-2014-1.pdf (``2014 Fixed Income
Guidance Update'').
    \63\ See, e.g., 2014 Fixed Income Guidance Update, supra note
62; Office of Compliance Inspections and Examinations, National Exam
Program 2015 Examination Priorities, available at http://www.sec.gov/about/offices/ocie/national-examination-program-priorities-2015.pdf (``National Exam Program 2015 Examination
Priorities'') (``With interest rates expected to rise at some point
in the future, we will review whether mutual funds with significant
exposure to interest rate increases have implemented compliance
policies and procedures and investment and trading controls
sufficient to ensure that their funds' disclosures are not
misleading and that their investments and liquidity profiles are
consistent with those disclosures.''); Office of Compliance
Inspections and Examinations, National Exam Program 2014 Examination
Priorities, available at http://www.sec.gov/about/offices/ocie/national-examination-program-priorities-2014.pdf (``The staff will
monitor the risks associated with a changing interest rate
environment and the impact this may have on bond funds and related
disclosures of risks to investors.'').
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    We also have observed recent growth in alternative mutual funds.
Since 2005, the assets of open-end funds with alternative strategies
have grown significantly, from approximately $365 million at the end of
2005 to approximately $334 billion at the end of 2014.\64\ Although the
assets of open-end funds pursuing alternative strategies accounted for
a relatively small percentage (approximately 3%) of the mutual fund
market as of December 2014, the growth of assets in these funds has
been substantial, with asset growth of approximately 58% each year from

the end of 2011 to the end of 2014.\65\ While growth in alternative
mutual funds and ETFs has slowed over the past year, a rising interest
rate environment could cause inflows to these funds to increase once
again, as investors look to reduce their interest rate risk and/or
increase income by investing in alternative strategies.\66\
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    \64\ DERA Study, supra note 39, at pp. 7-8. While there is no
clear definition of ``alternative'' in the mutual fund space, an
alternative mutual fund is generally understood to be a fund whose
primary investment strategy falls into one or more of the three
following buckets: (i) non-traditional asset classes (for example,
currencies or managed futures funds), (ii) non-traditional
strategies (such as long/short equity, event driven), and/or (iii)
less liquid assets (such as private debt). Their investment
strategies often seek to produce positive risk-adjusted returns that
are not closely correlated to traditional investments or benchmarks,
in contrast to traditional mutual funds that historically have
pursued long-only strategies in traditional asset classes.
    \65\ Id.
    \66\ See, e.g., Brian Haskin, Flows to Liquid Alts Drop in
December, End 2014 Up 10%, DailyAlts.com, (Feb. 16, 2015), available
at http://dailyalts.com/flows-liquid-alts-drop-december-end-2014-10
(``Going into 2014, investors held the view that interest rates
would rise and, thus, they looked to reduce interest rate risk and/
or increase income with the more flexible non-traditional bond
funds. This all came to a halt as interest rates actually declined
and flows to the category nearly dried up in the second half. This
also impacted market neutral strategies which are often used as a
substitute for fixed income portfolios.'').
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    Unlike alternative mutual funds and ETFs, private funds (such as
hedge funds and private equity funds) pursuing similar alternative
strategies can invest in portfolio assets that are relatively illiquid
without generating the same degree of redemption risk for the fund
because investor redemption rights are often limited.\67\ In addition,
investor expectations of private funds' redemption rights differ from
the redemption expectations of typical retail investors in open-end
funds. For example, investors in private equity funds typically commit
their capital for the life of the fund.\68\ Hedge funds often contain
``lock-up'' provisions (in which an investor only can redeem after a
specified period of time has elapsed since its initial investment),
typically impose limitations on the frequency of redemptions (e.g.,
allowing redemptions only once a quarter or once a year), and require
advance notice periods for redemptions.\69\ They also are often able to
impose gates, suspensions of redemptions, and side pockets to manage
liquidity stress. As a result these funds can, and often do, restrict
investor redemption rights as the liquidity of the funds' portfolio
assets declines. Data reported on Form PF show that at December 31,
2014, only 16.5% of qualifying hedge funds allowed investors to
withdraw any of their investment in seven days or less and for almost
60% of reporting qualifying hedge funds, the liquidity of the fund's
portfolio was greater than the withdrawal rights provided to investors
for all time frames reported on the form.\70\ As of that date, 88% of
qualifying hedge funds may suspend investor withdrawals and 62% may
impose gates on investor withdrawals.\71\
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    \67\ A private fund is an issuer that would be an investment
company, as defined in section 3 of the Investment Company Act, but
for the exclusion from the definition of ``investment company'' in
section 3(c)(1) or 3(c)(7) of the Act. Section 202(a)(29) of the
Investment Advisers Act of 1940 (the ``Investment Advisers Act'').
    \68\ See Comment Letter of Private Equity Growth Capital Council
on the FSOC Notice (Mar. 25, 2015).
    \69\ See Comment Letter of Managed Funds Association on the FSOC
Notice (Mar. 25, 2015).
    \70\ Based on data reported in response to questions 32 and 50
of Form PF. Reports filed on Form PF are submitted by advisers
registered with the Commission with at least $150 million in private
fund assets under management. For a definition of which funds are
treated as ``qualifying hedge funds'' for purposes of Form PF that
must complete these questions, see General Instructions to Form PF,
available at http://www.sec.gov/about/forms/formpf.pdf.
    \71\ Based on data reported in response to question 49 of Form
PF.
---------------------------------------------------------------------------

    In contrast, alternative strategy mutual funds and ETFs have no
such ability to tailor investor redemption rights based on the
liquidity profile of the funds' portfolios. Yet some of these funds
seek to pursue similar investment strategies as hedge funds and other
private funds, while still being bound by the redemption obligations
applicable to open-end funds. Accordingly, our staff has been focused
on the liquidity of alternative strategy mutual funds and ETFs, the
nature of liquidity and redemption risks faced by investors in these
funds given their legal right to be paid the proceeds of any redemption
request within seven days.\72\ The findings in the DERA Study have lent
further support to our focus on liquidity risk management practices in
this industry segment, as the study found that alternative strategy
mutual funds had cash flows that were significantly more volatile than
other strategies, indicating that these funds may face higher levels of
redemption risk. Volatility in flows places additional importance on
liquidity risk management to prevent some of the consequences from a
failure to adequately manage liquidity discussed in section II.B.2
above. The proposed rule and rule amendments build off of many of the
observations we and our staff have made through efforts examining the
growth in funds and ETFs with fixed income strategies and alternative
strategies that are discussed below.
---------------------------------------------------------------------------

    \72\ Norm Champ, former Director of the Division of Investment
Management, Speech, Remarks to the Practicing Law Institute, Private
Equity Forum, (June 30, 2014), available at http://www.sec.gov/News/Speech/Detail/Speech/1370542253660. (noting that alternative mutual
funds should consider setting criteria for assessing the liquidity
of a security and consider including those criteria in written
policies and procedures for registered fund compliance programs
under rule 38a-1 under the Act); National Exam Program 2015
Examination Priorities, supra note 63 (``We will continue to assess
funds offering alternative investments and using alternative
investment strategies, with a particular focus on: (i) leverage,
liquidity, and valuation policies and practices; (ii) factors
relevant to the adequacy of the funds' internal controls, including
staffing, funding, and empowerment of boards, compliance personnel,
and back-offices; and (iii) the manner in which such funds are
marketed to investors.'').
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 2. Evolution of Settlement Periods and Redemption Practices
    Practices relating to securities trade settlement periods and the
timing of the payment of redemption proceeds to investors also have
evolved considerably over the decades since the Commission last
addressed liquidity needs in open-end funds.\73\ Prior to the adoption
of rule 15c6-1 under the Exchange Act in 1993, which established three
business days (T+3) as the standard settlement timeframe for broker-
dealer trades, there was no federal rule that mandated a specific
settlement cycle for securities transactions.\74\ Before the adoption
of rule 15c6-1, trades settled on a T+5 basis based on industry
practice, and the decline in the securities trading settlement period
from T+5 to T+3 prompted funds that were sold through broker-dealers to
satisfy redemption requests within three business days.\75\ In recent
years, market participants have explored the possibility of further
reducing this T+3 settlement period.\76\

We also have observed that some open-end funds disclose in their
prospectuses that they generally will satisfy redemption requests in
even shorter periods of time than T+3, including on a next-business-day
basis.\77\
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    \73\ See, e.g., Invesco FSOC Notice Comment Letter, supra note
35, at 14 (noting that it ``was not long ago that equity securities
settled on a T+7 basis rather than today's T+3 standard and
initiatives are underway to shorten that time to T+2'').
    \74\ See Securities Transactions Settlement, Exchange Act
Release No. 33023 (Oct. 6, 1993) [58 FR 52891 (Oct. 13, 1993)]
(``Securities Transactions Settlement Release'') (adopting rule
15c6-1 under the Exchange Act).
    \75\ See May 1995 Staff No-Action Letter, supra note 21 (noting
that funds that are sold through brokers or dealers and that hold
portfolio securities that do not settle within three business days
``should assess the mix of their portfolio holdings to determine
whether, under normal circumstances, they will be able to facilitate
compliance with the T+3 standard by brokers and dealers,'' taking
into account the ``percentage of the portfolio that would settle in
three days or less, the level of cash reserves, and the availability
of lines of credit or interfund lending facilities.'').
    \76\ See PricewaterhouseCoopers LLP (in conjunction with the
Depositary Trust Clearing Corporation (``DTCC'') Industry Steering
Committee), Shortening the Settlement Cycle: The Move to T+2 (2015),
available at http://www.ust2.com/pdfs/ssc.pdf; DTCC, DTCC Recommends
Shortening the U.S. Trade Settlement Cycle (Apr. 2014), available at
http://www.dtcc.com/~/media/Files/Downloads/WhitePapers/T2-
Shortened-Cycle-WP.pdf; see also Recommendation of the Investor
Advisory Committee: Shortening the Trade Settlement Cycle in U.S.
Financial Markets (Feb. 12, 2015), available at https://www.sec.gov/spotlight/investor-advisory-committee-2012/settlement-cycle-recommendation-final.pdf. See also Letter from Mary Jo White, Chair,
SEC, to Kenneth E. Bentsen, Jr., President & CEO, Securities
Industry and Financial Markets Association, and Paul Schott Stevens,
President & CEO, Investment Company Institute (Sept. 16, 2015),
available at http://www.sec.gov/divisions/marketreg/chair-white-letter-to-sifma-ici-t2.pdf; Commissioner Luis A. Aguilar, Public
Statement, The Benefits of Shortening the Securities Settlement
Cycle, (July 16, 2015), available at http://www.sec.gov/news/statement/benefits-of-shortening-the-securities-settlement-cycle.html; Commissioner Michael S. Piwowar and Commissioner Kara M.
Stein, Public Statement, Statement Regarding Proposals to Shorten
the Trade Settlement Cycle, (June 29, 2015), available at http://www.sec.gov/news/statement/statement-on-proposals-to-shorten-the-trade-settlement-cycle.html.
    \77\ Disclosures by open-end funds are subject to the antifraud
provisions of the federal securities laws. Therefore there may be
liability under these provisions if a fund fails to meet redemptions
within seven days or any shorter time disclosed in the fund's
prospectus or advertising materials. See section 17(a) of the
Securities Act, section 10(b) of the Exchange Act and rule 10b-5
under the Exchange Act, and section 34(b) of the Exchange Act; see
also Fidelity FSOC Notice Comment Letter, supra note 20, at 6
(``mutual funds normally process redemption requests by the next
business day''); Nuveen FSOC Notice Comment Letter, supra note 45,
at 9 (noting settlement periods for trades of fund portfolio
securities as a relevant factor in assessing liquidity risk,
particularly with securities that ``do not trade with enforceable
settlement rights and tend to settle over longer settlement periods
than the T+1 or T+3 periods over which mutual fund share redemptions
themselves settle'').
---------------------------------------------------------------------------

    While standard settlement periods for securities trades in the
markets have tended to fall significantly over the last several
decades--and investor expectations that redemption proceeds will be
paid promptly after redemption requests have risen--settlement periods
for other securities held in large amounts by certain funds have not
fallen correspondingly. For example, some bank loan funds (an asset
class that has grown in recent years) \78\ invest substantial amounts
of their assets in bank loans and loan participations, which typically
have long settlement times compared to other investments.\79\ Based on
our review of fund filings, many funds that invest in these assets do
not consider most of their portfolio holdings to be illiquid and
generally represent in their disclosures that they comply with the
Commission's current guidelines, which state that an open-end fund
should invest no more than 15% of its net assets in ``illiquid''
assets.\80\ However, the settlement periods associated with some bank
loans and loan participations may extend beyond the period of time the
fund would be required to meet shareholder redemptions, creating a
potential mismatch between the timing of the receipt of cash upon sale
of these assets and the payment of cash for shareholder
redemptions.\81\
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    \78\ Based on staff analysis of Morningstar Direct Data, net
assets of bank loan mutual funds and ETFs grew from $14.6 billion in
December 2008 to $123.5 billion in December 2014.
    \79\ See, e.g., BlackRock, Viewpoint, Who Owns the Assets? A
Closer Look at Bank Loans, High Yield Bonds and Emerging Markets
Debt (Sept. 2014) (``BlackRock, Viewpoint, Who Owns the Assets?''),
available at https://www.blackrock.com/corporate/en-fi/literature/whitepaper/viewpoint-closer-look-selected-asset-classes-sept2014.pdf
(``[T]he settlement periods for bank loans are longer than the
settlement periods for fixed income securities such as high yield
bonds, which typically settle in three days. This delayed settlement
period may cause a potential liquidity mismatch for mutual funds
offering daily liquidity, requiring fund managers to ensure that a
fund has sufficient liquidity over settlement windows to meet
potential redemptions.''); Comment Letter of OppenheimerFunds on the
FSOC Notice (Mar. 25, 2015) (``OppenheimerFunds FSOC Notice Comment
Letter'') at 3-4 (stating that ``loans still take longer to settle
than other securities. Median settlement times for buy-side loan
sales are 12 days'' and noting that an ``important tool in managing
settlement times is the establishment of a credit line dedicated to
bank loan funds.'').
    \80\ See infra note 92 and accompanying text. Under current
Commission guidelines, a portfolio security or other asset is
considered illiquid if it cannot be sold or disposed of (rather than
settled) in the ordinary course of business within seven days at
approximately the value at which the fund has valued the investment.
    \81\ Mutual funds and ETFs investing in foreign securities can
also have such settlement mismatches. See, e.g., Investment Company
Institute, Understanding Exchange-Traded Funds: How ETFs Work,
(Sept. 2014), at n.34, available at https://www.ici.org/pdf/per20-05.pdf (noting that internationally focused ETFs generally require
authorized participants to post collateral ``because the timing of
clearing and settlement in another country may not coincide with the
T+3 settlement cycle in the United States''). There has been
significant growth in emerging market funds since the year 2000. See
infra note 664 and accompanying text.
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    Overall, the evolution of the market towards shorter settlement
periods--and corresponding investor expectations--combined with open-
end funds holding certain securities with longer settlement periods
have raised concerns for us about whether fund portfolios are
sufficiently liquid to support a fund's ability to meet its redemption
obligations.

D. Current Regulatory Framework

1. Statutory and Regulatory Requirements
    Section 22(e) of the Act provides that no open-end fund shall
suspend the right of redemption or postpone the date of payment of
redemption proceeds for more than seven days after tender of the
security absent specified unusual circumstances.\82\ This statutory
requirement was enacted ``in response to abusive practices of early
open-end companies that claimed that their securities were redeemable,
but then instituted barriers to redemption'' to prevent net redemptions
or to prevent shareholders from switching to other funds.\83\ As
previously discussed, in addition to the seven-day redemption
requirement in section 22(e), rule 15c6-1 under the Exchange Act also
impacts the timing of open-end fund redemptions because the rule
requires broker-dealers to settle securities transactions, including
transactions in open-end fund shares, within three business days after
the trade date. Furthermore, rule 22c-1 under the Act, the ``forward
pricing'' rule, requires funds, their principal underwriters, and
dealers to sell and redeem fund shares at a price based on the current
NAV next computed after receipt of an order to purchase or redeem fund
shares, even though fund assets may be sold in subsequent days in order
to meet redemption obligations.\84\ Thus, there

are a number of statutory and regulatory provisions that must be
considered in assessing a fund's ability to meet redemptions and
mitigate potential dilution of shareholders' interests.
---------------------------------------------------------------------------

    \82\ Section 22(e) permits open-end funds to suspend redemptions
and postpone payment for redemptions already tendered for any period
during which the New York Stock Exchange (``NYSE'') is closed (other
than customary weekend and holiday closings) and in three additional
situations if the Commission has made certain determinations. First,
a fund may suspend redemptions for any period during which trading
on the NYSE is restricted, as determined by the Commission. Second,
a fund may suspend redemptions for any period during which an
emergency exists, as determined by the Commission, as a result of
which it is not reasonably practicable for the fund to: (i)
liquidate its portfolio securities, or (ii) fairly determine the
value of its net assets. Third, a fund may suspend redemptions for
such other periods as the Commission may by order permit for the
protection of fund shareholders. See also Letter from Douglas
Scheidt, Associate Director and Chief Counsel, Division of
Investment Management, SEC, to Craig S. Tyle, General Counsel,
Investment Company Institute (Dec. 8, 1999) available at http://www.sec.gov/divisions/investment/guidance/tyle120899.htm, at n.2 and
accompanying text. The Commission has rarely issued orders
permitting the suspension of redemptions for periods of restricted
trading or emergency circumstances but has done so on a few
occasions. See, e.g., In the Matter of The Reserve Fund, on behalf
of two of its series, the Primary Fund and the U.S. Government Fund,
Investment Company Act Release No. 28386 (Sept. 22, 2008) [73 FR
55572 (Sept. 25, 2008)]; see also, e.g., In the Matter of Municipal
Lease Securities Fund, Inc., Investment Company Act Release No.
17245 (Nov. 29, 1989). Money market funds are able to suspend
redemptions in certain limited circumstances. See rule 22e-3 under
the Act; see also infra note 155 and accompanying text.
    \83\ Periodic Repurchases by Closed-End Management Investment
Companies; Redemptions by Open-End Management Investment Companies
and Registered Separate Accounts at Periodic Intervals or with
Extended Payment, Investment Company Act Release No. 18869 (July 28,
1992) [57 FR 34701 (Aug. 6, 1992)] at nn.16-18 and accompanying text
(``Interval Fund Proposing Release'') (citing Investment Trusts and
Investment Companies: Hearings on S. 3580 before a Subcomm. of the
Senate Comm. on Banking and Currency, 76th Cong., 3d Sess. 291-92
(1940) (statement of David Schenker, Chief Counsel, SEC Investment
Trust Study)).
    \84\ See supra notes 41-43 and accompanying text for a
discussion of why this calculation method is permitted under rule
22c-1 and rule 2a-4.
---------------------------------------------------------------------------

    With the exception of money market funds subject to rule 2a-7 under
the Act, the Commission has not promulgated rules requiring open-end
funds to invest in a minimum level of liquid assets.\85\ 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).\86\ 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.\87\ As noted in this guidance, a fund
experiencing net outflows due to shifts in market sentiment may wish to
consider reducing its illiquid asset holdings to maintain adequate
liquidity.\88\ Similarly, a fund may need to determine whether it is
appropriate to take certain actions when it has determined that a
previously liquid holding has become illiquid due to changed
circumstances.\89\
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    \85\ Under rule 2a-7, money market funds must maintain
sufficient liquidity to meet reasonably foreseeable redemptions,
generally must invest at least 10% of their portfolios in assets
that can provide daily liquidity and at least 30% of their
portfolios in assets that can provide weekly liquidity, and may not
acquire any illiquid security if, immediately after the acquisition,
the money market fund would have invested more than 5% of its total
assets in illiquid securities. Rule 2a-7. Additionally, the
Commission recently adopted amendments to rule 2a-7 that, among
other things: (i) give boards of directors of money market funds
discretion to impose a liquidity fee or temporarily suspend the
right of redemption if a fund's weekly liquidity level falls below
the required regulatory threshold; and (ii) require all non-
government money market funds to impose a liquidity fee if the
fund's weekly liquidity level falls below a designated threshold of
10%, unless the fund's board determines that imposing such a fee is
not in the best interests of the fund. Money Market Fund Reform;
Amendments to Form PF, Investment Company Act Release No. 31166
(July 23, 2014) [79 FR 47736 (Aug. 14, 2014)] (``2014 Money Market
Fund Reform Adopting Release'').
    \86\ Statement Regarding ``Restricted Securities,'' Investment
Company Act Release No. 5847 (Oct. 21, 1969) [35 FR 19989 (Dec. 31,
1970)] (``Restricted Securities Release'') (``Because open-end
companies hold themselves out at all times as being prepared to meet
redemptions within seven days, it is essential that such companies
maintain a portfolio of investments that enable them to fulfill that
obligation. This requires a high degree of liquidity in the assets
of open-end companies because the extent of redemption demands or
other exigencies are not always predictable.''); Resale of
Restricted Securities; Changes to Method of Determining Holding
Period of Restricted Securities Under Rules 144 and 145, Investment
Company Act Release No. 17452 (Apr. 23, 1990) [55 FR 17933 (Apr. 30,
1990)] (``Rule 144A Release'') (adopting rule 144A under the
Securities Act).
    \87\ Guidelines Release, supra note 4, at section I (``[A]
mutual fund must compute its net asset value each business day and
give purchase and redemption orders the price next computed after
receipt of an order. Moreover, most mutual funds allow shareholders
easily to exchange their fund shares for shares of another mutual
fund managed by the same investment adviser, in transactions which
generally can include only nominal costs. Shareholders thus easily
may move their money among equity, income, and money market funds as
they choose, increasing the need for liquidity of mutual fund
assets.''); see also Restricted Securities Release, supra note 86
(discussing valuation difficulties that may be associated with
restricted securities).
    \88\ Guidelines Release, supra note 4.
    \89\ Rule 144A Release, supra note 86, at n.61.
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    Open-end funds also are required by rule 38a-1 under the Act to
adopt and implement written policies and procedures reasonably designed
to prevent violations of the federal securities laws. A fund's
compliance policies and procedures should be appropriately tailored to
reflect each fund's particular compliance risks.\90\ An open-end fund
holding a significant portion of its assets in securities with long
settlement periods or with infrequent trading, for instance, may be
subject to relatively greater liquidity risks than other open-end
funds, and should appropriately tailor its policies and procedures to
comply with its redemption obligations.\91\
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    \90\ In the rule 38a-1 adopting release, the Commission stated
that funds should adopt policies and procedures regarding the
pricing of portfolio securities and fund shares. See Compliance
Programs of Investment Companies and Investment Advisers, Investment
Company Act Release No. 26299 (Dec. 17, 2003) [68 FR 74714 (Dec. 24,
2003)] (``Rule 38a-1 Adopting Release'') (``These pricing
requirements are critical to ensuring fund shares are purchased and
redeemed at fair prices and that shareholder interests are not
diluted.''). The Commission also identifies ``portfolio management
processes'' as an issue that should be covered in the compliance
policies and procedures of a fund or its adviser and indicates that
each fund should tailor its policies and procedures to address the
fund's particular compliance risks. See id., at n.82 (noting that
the chief compliance officer's annual report should discuss the
fund's particular compliance risks and any changes that were made to
the policies and procedures to address newly identified risks).
    \91\ See supra note 81 and accompanying text.
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 2. 15% Guideline
    In addition to the Commission's historical statements regarding the
importance of adequate liquidity in open-end fund portfolios pursuant
to section 22(e) of the Act, long-standing Commission guidelines
generally limit an open-end fund's aggregate holdings of ``illiquid
assets'' to 15% of the fund's net assets (the ``15% guideline'').\92\
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.\93\ The 15% guideline has
generally caused funds to limit their exposures to particular types of
securities that cannot be sold within seven days and that the
Commission and staff have indicated may be illiquid, depending on the
facts and circumstances, such as private equity securities, securities
purchased in an initial public offering, and certain other privately
placed or other restricted securities \94\ as well as certain

instruments or transactions not maturing in seven days or less,
including term repurchase agreements.\95\ The Commission has not
established a set of required factors that must be considered when
assessing the liquidity of these or other types of securities, but
rather has provided ``examples of factors that would be reasonable for
a board of directors to take into account with respect to a rule 144A
security (but which would not necessarily be determinative).'' \96\
These factors include: the frequency of trades and quotations for the
security; the number of dealers willing to purchase or sell the
security and the number of other potential purchasers; dealer
undertakings to make a market in the security; and the nature of the
security and the nature of the marketplace in which it trades,
including the time needed to dispose of the security, the method of
soliciting offers, and the mechanics of transfer.\97\
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    \92\ Guidelines Release, supra note 4, at section III. (``If an
open-end company holds a material percentage of its assets in
securities or other assets for which there is no established market,
there may be a question concerning the ability of the fund to make
payment within seven days of the date its shares are tendered for
redemption. The usual limit on aggregate holdings by an open-end
investment company of illiquid assets is 15% of its net assets. An
illiquid asset is any asset which may not be sold or disposed of in
the ordinary course of business within seven days at approximately
the value at which the mutual fund has valued the investment.'').
The Guidelines Release modified prior Commission guidance that set a
10% limit on illiquid assets for open-end funds. See Restricted
Securities Release, supra note 86.
     While the wording of the Guidelines Release limits holdings of
illiquid assets above 15% of a fund's net assets, the Guidelines
Release cites a prior Commission statement regarding the ``prudent
limit on mutual fund holdings of illiquid securities'' that limits a
fund from acquiring any illiquid asset if, immediately after such
acquisition, the fund's holdings of illiquid assets would exceed a
certain percentage of the fund's net assets. See Guidelines Release,
supra note 4, at n.8 (citing Restricted Securities Release, supra
note 86). The latter interpretation (that is, the interpretation
that the 15% standard is a limit on the acquisition of illiquid
assets, not a limit on the holdings of illiquid assets) is
consistent with approaches that Congress and the Commission have
historically taken in other parts of the Investment Company Act and
the rules thereunder. See infra note 348.
    \93\ Guidelines Release, supra note 4; see also ETF Proposing
Release, supra note 9; Valuation of Debt Instruments and Computation
of Current Price Per Share by Certain Open-End Investment Companies
(Money Market Funds), Investment Company Act Release No. 13380 (July
11, 1983) [48 FR 32555 (July 18, 1983)]; Rule 144A Release, supra
note 86.
    \94\ See Restricted Securities Release, supra note 86.
Securities offered pursuant to rule 144A under the Securities Act
may be considered liquid depending on certain factors. See Rule 144A
Release, supra note 86. The Commission stated that ``determination
of the liquidity of Rule 144A securities in the portfolio of an
investment company issuing redeemable securities is a question of
fact for the board of directors to determine, based upon the trading
markets for the specific security'' and noted that the board should
consider the unregistered nature of a rule 144A security as one of
the factors it evaluates in determining its liquidity. Id. The
Division of Investment Management has also stated that an open-end
fund's board of directors may determine that an issue of commercial
paper in reliance on section 4(a)(2) of the Securities Act is
liquid, even if it may not be resold under rule 144A in certain
circumstances. Merrill Lynch Money Markets Inc., SEC Staff No-Action
Letter (Jan. 14, 1994).
    \95\ See Interval Fund Proposing Release, supra note 83.
    \96\ See Rule 144A Release, supra note 86.
    \97\ Id.
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3. Overview of Current Practices
    Over the last two years, Commission staff has had the occasion to
observe through a variety of different events the current liquidity
risk management practices at a cross-section of different fund
complexes with varied investment strategies. The staff has observed
that liquidity risk management techniques may vary across funds,
including funds within the same fund complex, in light of unique fund
characteristics, including, for example, the nature of a fund's
investment objectives or strategies, the composition of the fund's
investor base, and historical fund flows. These observations
collectively have shown the staff that, even with various unique
characteristics, many open-end funds and fund complexes have
implemented procedures for assessing, classifying, and managing the
liquidity of their portfolio assets.\98\
---------------------------------------------------------------------------

    \98\ There are varying degrees of formality in the adoption and
implementation of these procedures.
---------------------------------------------------------------------------

    Specifically, some of the funds observed by the staff assess their
ability to sell particular assets within various time periods
(typically focusing on one-, three-, and/or seven-day periods).\99\ In
conducting this analysis, these funds may take into account relevant
market, trading, and other factors, and monitor whether their initial
liquidity determination should be changed based on changed market
conditions. This process helps open-end funds determine their ability
to meet redemption requests in various market conditions within the
disclosed period for payment of redemption proceeds.
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    \99\ See 2014 Fixed Income Guidance Update, supra note 62
(noting that fund advisers ``generally assess overall fund liquidity
and funds' ability to meet potential redemptions over a number of
periods'' and discussing certain steps that fund advisers may
consider taking given potential fixed income market volatility); see
also infra note 151 and accompanying text.
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    Funds observed by the staff that have implemented procedures for
assessing and classifying the liquidity of their portfolio assets also
often have developed controls to manage fund portfolio liquidity risk
and the risk of changing levels of shareholder redemptions, such as
holding certain amounts of the fund's portfolio in highly liquid
assets, setting minimum cash reserves, and establishing committed back-
up lines of credit or interfund lending facilities.\100\ A few of the
funds observed by staff conduct stress testing relating to the
availability of liquid assets to cover possible levels of
redemptions.\101\ Some of these funds' advisers also have periodic
discussions with their boards of directors about how the fund
approaches liquidity risk management and what emerging risks they are
observing relating to liquidity risk. We have observed that some of the
funds with the more thorough liquidity risk management practices have
appeared to be able to better meet periods of higher than typical
redemptions without significantly altering the risk profile of the fund
or materially affecting the fund's performance, and thus with less
dilutive impacts.
---------------------------------------------------------------------------

    \100\ Press coverage has detailed steps some funds and their
advisers have taken to manage liquidity in light of changing market
conditions as well. See, e.g., Jessica Toonkel, Fund Boards,
Management Go on High Alert Around Bond Liquidity, Reuters (Nov. 24,
2014), available at http://www.reuters.com/article/2014/11/24/us-funds-bondholders-alert-idUSKCN0J80AD20141124 (reporting that
investment advisers ``have been testing their funds against various
market scenarios, building cushions of cash, shorter-duration bonds
and other liquid securities, and regularly discussing risks with
their boards''); Katy Burne, Bond Funds Loan Up on Cash, The Wall
Street Journal (Nov. 30, 2014), available at http://www.wsj.com/articles/bond-funds-load-up-on-cash-1417394534 (discussing cash
buffers and use of certain derivatives to manage liquidity
concerns); Cordell Eddings, Bond Liquidity Risk in $3.5 Trillion
Funds Defused by Cash, Bloomberg (Aug. 18, 2014), available at
http://www.bloomberg.com/news/articles/2014-08-17/bond-liquidity-risk-in-3-5-trillion-funds-defused-by-cash-pile (discussing cash
holdings in U.S. fixed income funds that are at historically
significant levels).
    \101\ See, e.g., Nuveen FSOC Notice Comment Letter, supra note
45, at 12 (``We stress test a fund's ability to meet redemptions
over a one-month period in a badly stressed market by hypothetically
assuming a large increase in net redemptions, cash outflows for
derivatives cash collateral and cash outlay requirements imposed by
various leverage structures, and comparing the level of cash needed
to meet that hypothetical scenario against the amount of cash the
fund could reasonably expect to raise from various sources
(including selling assets in a hypothetically stressed market or
drawing on a credit facility) in that same time frame.''); ICI FSOC
Notice Comment Letter, supra note 16, at 24 (stating that some asset
managers conduct forms of stress testing to determine the impact of
certain changes on portfolio liquidity).
---------------------------------------------------------------------------

    Conversely, the Commission is concerned that some funds employ
liquidity risk management practices that are substantially less
rigorous. Some funds observed by the staff do not take different market
conditions into account when evaluating portfolio asset liquidity, and
do not conduct any ongoing liquidity monitoring. Some funds do not
incorporate any independent oversight of fund liquidity risk management
outside of the portfolio management process.\102\ Staff has observed
that some of these funds, when faced with higher than normal
redemptions, experienced particularly poor performance compared with
their benchmark and some even experienced an adverse change in the
fund's risk profile, each of which can increase the risk of investor
dilution.
---------------------------------------------------------------------------

    \102\ See, e.g., BlackRock FSOC Notice Comment Letter, at 6
(stating that among several overarching principles that provide the
foundation for a prudent market liquidity risk management framework
for collective investment vehicles is having ``a risk management
function that is independent from portfolio management, with direct
reporting lines to senior leadership and a regular role in
communication with the asset manager's board of directors'').
---------------------------------------------------------------------------

    Finally, the Commission learned through staff outreach that many
funds treat their risk management process for assessing the liquidity
profile of portfolio assets, and the incorporation of market and
trading information, as entirely separate from their assessment of
assets under the 15% guideline. The former process is typically
conducted on an ongoing basis through the fund's risk management
function, through the fund's portfolio management function, or through
the fund's trading function (or a combination of the foregoing), while
assessment of assets under the 15% guideline is more typically
conducted upon purchase of an asset through the fund's compliance or
``back-office'' functions, with little indication that information
generated from the risk management or trading functions informs the
compliance determinations. This functional divide may be a by-product
of the limitations of the 15% guideline as a stand-alone method for
comprehensive liquidity risk management, a situation that our

proposed framework is meant to address.\103\
---------------------------------------------------------------------------

    \103\ See infra section III.C.4 for a discussion of the
limitations of the 15% guideline.
---------------------------------------------------------------------------

    Overall, our staff outreach has increased our understanding of some
of the valuable liquidity risk management practices employed by some
firms as a matter of prudent risk management. This outreach also has
shown us the great diversity in liquidity risk management practices
that raises concerns regarding various funds' ability to meet their
redemption obligations and minimize the effects of dilution under
certain conditions. Collectively, these observations have informed our
understanding of the need for an enhanced minimum baseline requirement
for fund management of liquidity risk.

E. Rulemaking Proposal Overview

    Against this background, today we are proposing a multi-layered set
of reforms designed to promote effective liquidity risk management
throughout the open-end fund industry and thereby reduce the risk that
funds will not be able to meet redemption obligations and mitigate
potential dilution of the interests of fund shareholders in accordance
with section 22(e) of, and rule 22c-1 under, the Investment Company
Act. The proposed amendments also seek to enhance disclosure regarding
fund liquidity and redemption practices. In addition, these proposed
reforms are intended to address the liquidity-related developments in
the open-end fund industry discussed above and are a part of a broader
set of initiatives to address the impact of open-end fund investment
activities on investors and the financial markets, and the risks
associated with the increasingly complex portfolio composition and
operations of the asset management industry.\104\
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    \104\ Such other initiatives include modernizing investment
company reporting and disclosure, addressing the risks of
derivatives use, and requiring large investment companies and
investment advisers to engage in annual stress tests as required by
section 165(i) of the Dodd-Frank Wall Street Reform and Consumer
Protection Act (``Dodd-Frank Act''). See Chair Mary Jo White,
Speech, Remarks to the New York Times DealBook Opportunities for
Tomorrow Conference (Dec. 11, 2014), available at http://www.sec.gov/News/Speech/Detail/Speech/1370543677722; Investment
Company Reporting Modernization, Investment Company Act Release No.
31610 (May 20, 2015) [80 FR 33590 (June 12, 2015)] (``Investment
Company Reporting Modernization Release'').
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    First, we are proposing new rule 22e-4, which would require each
registered open-end fund, including open-end ETFs but not including
money market funds, to establish a liquidity risk management program.
The proposed rule would require a fund's liquidity risk management
program to incorporate certain specified elements. One primary element
of this program is a new requirement for funds to classify and monitor
the liquidity of portfolio assets, reflecting that liquidity may be
viewed as falling on a spectrum rather than a binary conclusion that an
asset is either ``liquid'' or ``illiquid.'' Another principal feature
is a new requirement that funds establish a minimum amount of their
assets that would be held in cash and assets that the fund believes are
convertible to cash within three business days at a price that does not
materially affect the value of that asset immediately prior to the
sale.\105\ This proposed requirement is aimed at decreasing the
likelihood that funds would be unable to meet their redemption
obligations and promote effective liquidity risk management industry-
wide. We also anticipate that the proposed program requirement would
result in investor protection benefits, as improved liquidity risk
management could decrease the chance that a fund could meet its
redemption obligations only with material effects on the fund's NAV or
changes to the fund's risk profile.
---------------------------------------------------------------------------

    \105\ Proposed rule 22e-4(a)(8) defines ``Three-Day Liquid
Asset'' to mean ``any cash held by a fund and any position of a fund
in an asset (or portion of the fund's position in an asset) that the
fund believes is convertible into cash within three business days at
a price that does not materially affect the value of that asset
immediately prior to sale. In determining whether a position or
portion of a position in an asset is a three-day liquid asset, a
fund must take into account the factors set forth in paragraph
(b)(2)(ii) of this section, to the extent applicable.'' Proposed
rule 22e-4(a)(9) defines ``Three-Day Liquid Asset Minimum'' to mean
``the percentage of the fund's net assets to be invested in three-
day liquid assets,'' in accordance with rule 22e-4(b)(2)(iv)(A) and
(C).
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    Even with improved liquidity risk management, circumstances could
arise in which shareholder purchase and redemption activity could
dilute the value of existing shareholders' interests in the fund. For
this reason, we are also proposing amendments to rule 22c-1 under the
Act to permit a fund (except a money market fund or ETF) to use ``swing
pricing,'' the process of adjusting a fund's NAV to effectively pass on
to purchasing or redeeming shareholders more of the costs stemming from
their trading activity. Swing pricing could protect existing
shareholders from dilution associated with such purchase and redemption
activity and could be another tool to manage liquidity risks. Pooled
investment vehicles in certain foreign jurisdictions currently use
various forms of swing pricing to mitigate shareholder dilution
associated with other shareholders' capital activity, and we believe
swing pricing could be an effective tool to assist U.S. registered
funds in mitigating potential shareholder dilution.
    Finally, we are proposing disclosure- and reporting-related
amendments to provide greater transparency with respect to funds'
liquidity risks and risk management. Specifically, we are proposing
amendments to Form N-1A to require disclosure regarding swing pricing,
if applicable, and to improve disclosure regarding how funds meet
redemptions of fund shares. We also are proposing amendments to
proposed Form N-PORT and proposed Form N-CEN to provide detailed
information, both to the Commission and the public, regarding a fund's
liquidity-related holdings data and liquidity risk management
practices. We note that while these disclosure- and reporting-related
amendments are primarily applicable to mutual funds that are not money
market funds, as well as ETFs, certain of the proposed amendments are
applicable to money market funds as well.
    We anticipate that these proposed requirements will facilitate the
Commission's risk monitoring efforts by providing greater transparency
regarding the liquidity characteristics of fund portfolio holdings, as
well as to monitor and assess compliance with rule 22e-4 if adopted.
While proposed Form N-PORT and proposed Form N-CEN are primarily
designed to assist the Commission, we believe that the proposed
requirements also would increase investor understanding of particular
funds' liquidity-related risks and redemption policies, which in turn
would assist investors in making investment choices that better match
their risk tolerances.\106\ We note that many investors, particularly
institutional investors, as well as academic researchers, financial
analysts, and economic research firms, could use the information
regarding a fund's liquidity-related holdings data and liquidity risk
management practices reported on Form N-PORT to evaluate fund
portfolios.\107\ Finally, we are

proposing to require that ETFs report on proposed Form N-CEN
information regarding any requirement to post collateral by authorized
participants that are purchasing or redeeming shares. Such collateral
requirements could affect authorized participants' capacity and
willingness to serve as authorized participants for ETFs, and, in turn,
the effective functioning of the ETF's arbitrage mechanism and the ETF
shares trading at a market price that approximates the NAV of the ETF.
---------------------------------------------------------------------------

    \106\ See, e.g., Comment Letter of Markit on the FSOC Notice
(Mar. 25, 2015), at 2 (``we believe that liquidity and redemption
risk contained in asset management products can be mitigated by
providing risk managers or investors of pooled investment vehicles
better information about the liquidity risk associated with pool
investments so that they can price it more accurately. This could be
done through, among other things, disclosures of the `prudent
valuation' (accounting for pricing uncertainty) of the fund's
investments and the implementation of appropriate liquidity risk
management policies and procedures'').
    \107\ See infra section IV.C.3.
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III. Discussion

A. Program Requirements and Scope of Proposed Rule 22e-4

    Today we are proposing new rule 22e-4 under the Investment Company
Act, which would require that each registered open-end management
investment company, including open-end ETFs but not including money
market funds,\108\ establish a written liquidity risk management
program. We expect that the proposed rule 22e-4 program requirements
would reduce the risk that funds will be unable to timely meet their
redemption obligations under section 22(e) of the Investment Company
Act and other statutory and regulatory provisions,\109\ mitigate
potential investor dilution, and provide for more effective liquidity
risk management among funds. We believe that this, in turn, would
result in significant investor protection benefits and enhance the fair
and orderly operation of the markets.\110\
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    \108\ Under proposed rule 22e-4(a)(5), ``fund'' means ``an open-
end management investment company that is registered or required to
register under section 8 of the Act (15 U.S.C. 80a-8) and includes a
separate series of such an investment company, but does not include
a registered open-end management investment company that is
regulated as a money market fund under Sec.  270.2a-7.''
    \109\ In addition to the seven-day redemption requirement in
section 22(e), rule 15c6-1 under the Exchange Act also impacts the
timing of open-end fund redemptions because the rule requires
broker-dealers to settle securities transactions, including