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

Federal RegisterOct 15, 2015

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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.

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

rule-comments@sec.gov

. 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.

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].

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.

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,

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.

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.

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.

Revisions of Guidelines to Form N-1A, Investment Company Act Release No. 18612 (Mar. 12, 1992) [57 FR 9828 (Mar. 20, 1992)] (“Guidelines Release”).

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.

At the end of 2014, 53.2 million households, or 43.3 percent of all U.S. households owned mutual funds.

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.

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.

See

2015 ICI Fact Book,

supra

note 3, at 114.

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).

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.

ETF shares, similar to stocks, are bought and sold throughout the day by investors on an exchange through a broker-dealer.

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.

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.

The ETF makes public the contents of the portfolio deposit before the beginning of the trading day.

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.

See

2015 ICI Fact Book,

supra

note 3, at 60.

See

Exchange-Traded Funds, Investment Company Act Release No. 28193 (Mar. 11, 2008) [73 FR 14618 (Mar. 18, 2008)] (“ETF Proposing Release”).

Authorized participants purchase ETF shares at the ETF's NAV through the ETF's underwriter or other service provider.

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.

See id.

at n.20 and accompanying text.

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.

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.

See id.

at n.21 and accompanying text.

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.

Recently, the Commission has also approved exchange-traded managed funds (“ETMFs”).

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.

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.

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.

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.

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.”).

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).

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,

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.

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.

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.

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.

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.

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.

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.”).

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.”).

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.”).

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.

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.

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).

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.

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.

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.

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.”).

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.

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.

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.

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.

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.”).

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).

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.

Further, as ETMF market makers would not engage in the same arbitrage as ETF market makers,

the liquidity of an ETMF's portfolio might have a limited relevance beyond the ETMF's ability to meet redemptions.

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.

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.

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.

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,

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.

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.

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.

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).

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”

) 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).

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.”).

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.

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”).

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).

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.

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.

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.

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.

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.

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.

Rule 22c-1(a).

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

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)

invest substantial amounts of their assets in bank loans and loan participations, which typically have long settlement times compared to other investments.

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.

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.

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.

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.”).

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.

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.

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.

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.

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.

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.

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

Restricted Securities Release,

supra

note 86 (discussing valuation difficulties that may be associated with restricted securities).

Guidelines Release,

supra

note 4.

Rule 144A Release,

supra

note 86, at n.61.

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.

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.

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).

See supra

note 81 and accompanying text.

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”).

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.

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

as well as certain

instruments or transactions not maturing in seven days or less, including term repurchase agreements.

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).”

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.

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.

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.

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).

See

Interval Fund Proposing Release,

supra

note 83.

See

Rule 144A Release,

supra

note 86.

Id.

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.

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).

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.

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

Repurchase Offers by Closed-End Management Investment Companies, Investment Company Act Release No. 19399 (Apr. 7, 1993) [58 FR 19330 (Apr. 14, 1993)] (“Repurchase Offers Release”), at n.7 and accompanying text.

134

Specifically, rule 23c-3 requires that: (i) A specified percentage of the investment company's portfolio consists of assets that can be sold or disposed of in the ordinary course of business, at approximately the price at which the investment company has valued the investment, within the period within which the investment company pays repurchase proceeds; and (ii) the investment company's board of directors adopts written procedures reasonably designed, taking into account current market conditions and the company's investment objectives, to ensure that the company's portfolio assets are sufficiently liquid so that the company can comply with its fundamental policy on repurchases.

See

rule 23c-3(b)(10)(i), (iii).

Based on staff analysis, there were 26 closed-end interval funds, representing approximately $5.7 billion in assets, in 2014.

135

See

Interval Fund Proposing Release,

supra

note 83, at text following n.35 (“Closed-end companies are not subject to a liquidity standard.”).

UITs, including ETFs structured as UITs, also would not be covered within the scope of proposed rule 22e-4. A UIT issues redeemable securities, like a traditional open-end fund, which represent undivided interests in an essentially fixed portfolio of securities.

136

As units of a UIT series

137

are redeemable, UITs are subject to the requirements of section 22(e).

138

136

Securities and Exchange Commission, Office of Investor Education and Advocacy, Unit Investment Trusts (UITs),

available at http://www.sec.gov/answers/uit.htm

(“UIT Answers”).

137

UITs typically consist of a number of consecutive series, with each series representing units in a specific, separate portfolio of securities. Unlike traditional open-end investment companies, UITs have no corporate management structure, and their portfolios are not managed.

138

With respect to UITs that are not ETFs, and that do not serve as separate account vehicles that are used to fund variable annuity and variable life insurance products, sponsors have historically maintained a secondary market in UIT units, rather than having the series liquidate portfolio securities to meet redemptions, because a large number of redemptions could necessitate premature termination of the series.

See

Form N-7 for Registration of Unit Investment Trusts under the Securities Act of 1933 and the Investment Company Act of 1940, Investment Company Act Release No. 15612 (Mar. 9, 1987) [52 FR 8268 (Mar. 17, 1987)] (“Form N-7 Re-Proposing Release”), at text following n.1;

see also

UIT Answers,

supra

note 136.

At present, however, the majority of UIT assets are attributable to separate account vehicles that are used to fund variable annuity and variable life insurance products, and the sponsors of these UITs do not typically maintain a secondary market in UIT units.

See infra

note 139 and accompanying text.

We are not proposing to include UITs within the scope of the proposed rule for a number of reasons. First, we understand based on staff analysis that approximately 75% of the assets held in UITs currently serve as separate account vehicles that are used to fund variable annuity and variable life insurance products.

139

These UITs essentially function as pass-through vehicles, investing principally in securities of one or more open-end investment companies, which as discussed above would be subject to the scope of proposed rule 22e-4.

140

Thus, we believe that the liquidity risk of these UITs would be even more limited if proposed rule 22e-4 were adopted, because their underlying holdings are funds that would be required to adopt their own liquidity risk management programs under the proposed rule.

139

Based on data as of December 2014.

140

Jeffrey K. Dellinger, The Handbook of Variable Income Annuities 448-450 (2006).

Second, UITs are not actively managed, and their portfolios are not actively traded. A UIT buys a relatively fixed portfolio of securities, and generally holds them with little change for the life of the UIT.

141

A UIT does not have a board of directors, corporate officers, or an investment adviser to render advice during the life of the trust.

142

Accordingly, the provisions of proposed rule 22e-4, which require a fund's board to approve and oversee a liquidity risk management program and the fund's adviser or officers to administer the program, are thus inapposite to the management structure of a UIT.

143

141

See

UIT Answers,

supra

note 136.

142

See id.

Because of this lack of management, some UIT trust documents provide that its administrator must redeem a pro rata share of the trust's holdings when an investor redeems from a UIT, subject to practical constraints such as securities with transfer restrictions.

143

See infra

section III.D.

Finally, we also are not including UIT ETFs within the scope of proposed rule 22e-4 because UIT ETFs generally track established and widely recognized indices.

144

Moreover, they fully replicate their underlying indices including with respect to their basket assets. Therefore, we do not view a liquidity risk management program as necessary or beneficial for UIT ETFs.

144

Based on information from Morningstar as of July 22, 2015, the following ETFs are structured as UITs, and each ETF tracks the index in its name unless otherwise noted: SPDR Dow Jones Industrial Average ETF Trust, SPDR S&P 500 ETF Trust, SPDR S&P Midcap 400 ETF Trust, Invesco Powershares QQQ Trust Series 1 (which tracks the NASDAQ 100 Index), and the Invesco BLDRS Index Funds Trust (which has ETFs tracking the BNY Mellon Asia 50 ADR Index, the BNY Mellon Developed Markets 100 ADR Index, the BNY Mellon Emerging Markets 50 ADR Index, and the BNY Mellon Europe Select ADR Index).

We also propose to exclude from the scope of rule 22e-4 all money market funds subject to the requirements of rule 2a-7 under the Investment Company Act. Money market funds are subject to extensive requirements concerning the liquidity of their portfolio assets. As described below, these requirements are more stringent than the liquidity-related requirements applicable to funds that are not money market funds (and that would be applicable to funds that are not money market funds under proposed rule 22e-4), on account of the historical redemption patterns of money market fund investors and the assets held by money market funds.

145

Rule 2a-7 includes a general portfolio liquidity standard, which requires that each money market fund hold securities that are sufficiently liquid to meet reasonably foreseeable shareholder redemptions in light of its obligations under section 22(e) of the Act and any commitments the fund has made to shareholders.

146

Money market funds are also subject to a specific limitation on the acquisition of illiquid securities. Namely, a money market fund cannot acquire illiquid securities if, immediately after the acquisition, the fund would have invested more than 5% of its total assets in illiquid securities.

147

This limit on illiquid asset holdings is more stringent than the corollary 15% guideline for open-end funds that are not money market funds, which as discussed above, limits a fund's aggregate holdings of illiquid assets to 15% of the fund's net assets.

148

In addition to the 5% limit on money market funds' illiquid asset holdings, all taxable money market funds must invest at least 10% of their total assets in “daily liquid assets,”

149

and all money

market funds must invest at least 30% of their total assets in “weekly liquid assets.”

150

There is no current or proposed corollary requirement for open-end funds that are not money market funds to invest certain portions of their assets in daily liquid assets or weekly liquid assets.

145

See infra

notes 722-725 and accompanying text.

146

Rule 2a-7(d)(4).

147

Rule 2a-7(d)(4)(i).

148

See supra

section II.D.2.

149

Rule 2a-7(d)(4)(ii).

150

Rule 2a-7(d)(4)(iii).

Money market funds are also subject to liquidity-related disclosure and reporting requirements.

151

These disclosure and reporting requirements do not currently extend to funds that are not money market funds, although under the proposed amendments to Form N-PORT, funds that are not money market funds would be required to report information about each portfolio asset's liquidity classification under rule 22e-4 and whether it is a 15% standard asset.

152

151

On the compliance date for the disclosure-related money market fund reforms adopted in 2014 (Apr. 14, 2016), money market funds will be required to disclose each day the percentage of their total assets invested in daily liquid assets and weekly liquid assets on their Web sites.

See

rule 2a-7(h)(10)(ii) (a money market fund must maintain a schedule, chart, graph, or other depiction on its Web site showing historical information about its investments in daily liquid assets and weekly liquid assets for the previous six months, and must update this historical information each business day, as of the end of the preceding business day). As of the compliance date, they also will be required to report information about the liquidity of their portfolio securities on Form N-MFP.

See

Form N-MFP Items C.21, C.22, and C.23.

152

See infra

section III.G.2; proposed Item C.7 of proposed Form N-PORT (requiring a fund to disclose whether a portfolio investment is a 15% Standard Asset); Form N-MFP Item 44 (requiring a money market fund to disclose whether each portfolio security is an illiquid security).

Money market funds also have certain tools at their disposal to manage heavy redemptions that are not available to other open-end funds.

153

A money market fund is permitted to impose a liquidity fee on redemptions or temporarily suspend redemptions if its weekly liquid assets fall below 30% of its total assets and the fund's board determines that imposing a fee or gate is in the fund's best interests; if a fund's weekly liquid asset falls below 10% of total assets, the fund is required to impose a liquidity fee on redemptions unless the fund's board determines that imposing such a fee would not be in the fund's best interests.

154

Additionally, rule 22e-3 permits a money market fund to suspend redemptions and postpone payment of redemption proceeds in an orderly liquidation of the fund if, subject to other requirements, the fund's board makes certain findings.

155

Because money market funds are required to maintain a liquidity risk management program, we propose that these funds be excluded from the scope of rule 22e-4.

153

See infra

notes 722-725 and accompanying text for a discussion of why we are not proposing a liquidity fee regime similar to that for money market funds for other types of open-end management investment companies.

154

See

rule 2a-7(c)(2);

see also

2014 Money Market Fund Reform Adopting Release,

supra

note 85, at section III.A. The compliance date for the amendments to rule 2a-7 related to liquidity fees and gates is October 14, 2016.

155

See

rule 22e-3(a) (permitting a money market fund to permanently suspend redemptions and liquidate if the fund's level of weekly liquid assets falls below 10% of its total assets or, in the case of a fund that is a government money market fund or a retail money market fund, the fund's board determines that the deviation between the fund's amortized cost price per share and its market-based NAV may result in material dilution or other unfair results to investors or existing shareholders);

see also

2014 Money Market Fund Reform Adopting Release,

supra

note 85, at section III.A.4 (discussing amendments to rule 22e-3 adopted as part of the 2014 money market fund reforms); Division of Investment Management, 2014 Money Market Fund Reform Frequently Asked Questions (Aug. 4, 2015),

available at http://www.sec.gov/divisions/investment/guidance/2014-money-market-fund-reform-frequently-asked-questions.shtml.

3. Request for Comment

While we request detailed comment on each of the specific elements of proposed rule 22e-4 below, here we request comment on the general program requirement of the proposed rule, as well as the extent to which the proposed program requirement would promote effective liquidity risk management.

• As proposed, rule 22e-4 would require that a fund's liquidity risk management program include certain general elements. Do commenters believe that the general elements of the program would enhance a fund's ability to assess and manage its liquidity risk? Are there any elements that should be excluded from the program requirement, or are there any additional elements that should be included in the program requirement? Should any of the proposed elements be modified? Do commenters believe that the program would enhance funds' management of liquidity risk better than they already do in practice? Do commenters believe that the program would materially strengthen a fund's ability to meet its redemption obligations and would materially reduce potential dilution? Should the rule focus not just on the liquidity of the fund's assets but also more specifically and prominently on its liabilities, such as derivatives obligations, that may affect the liquidity of the fund?

• Should the Commission be more prescriptive in requiring a fund to adopt certain specific policies and procedures for classifying and monitoring the liquidity of portfolio assets, assessing and periodically reviewing liquidity risk, and/or managing the fund's liquidity risk, beyond the proposed requirements of rule 22e-4? If so, what other procedures should the Commission require? Are there operational challenges associated with any of the other procedures the Commission could require? To what extent do funds currently have policies and procedures resembling the proposed program requirements? Have funds' current policies and procedures proven effective at managing liquidity risk, and how have they evolved in recent years? Are these policies and procedures primarily overseen by a fund's chief compliance officer, chief risk officer (if any), or someone else?

We also request comment on the scope of proposed rule 22e-4.

• Do commenters agree that all open-end funds, including open-end ETFs but excluding money market funds, should be subject to the program requirement of the proposed rule? If not, why not? Do commenters agree that the proposed program requirement gives enough flexibility for a fund to adopt a program whose scope, and related costs and benefits, are adequately tailored for that fund to manage its actual and potential liquidity risk?

• Should certain funds or types of funds be excluded from the proposed program requirement, or subject to a different or less stringent requirement, because their investment strategies, ownership concentrations, redemption policies, or some other factor makes them less prone to liquidity risk? If so, which funds or types of funds, and why? Should smaller funds and smaller fund complexes be excluded from the proposed program requirement, or subject to a different or less stringent requirement? Why or why not? How should we distinguish between funds that should be subject to liquidity risk management program requirements and those that should not? Conversely, are there particular types of funds (or investment strategies) that are subject to heightened liquidity risk and should be subject to more prescriptive or stringent requirements under a liquidity risk management program or otherwise? If so, what types of funds should be considered to have higher liquidity risk and why? Can these types of funds be easily categorized or defined? What enhanced liquidity risk management program requirements should be considered for such funds and why? Are there any types of funds (or investment strategies) with such limited liquidity that we should consider limiting their ability to be structured as open-end funds?

• Do commenters agree that open-end ETFs and ETMFs should be included? If not, why not? Do commenters believe that ETFs and/or ETMFs incur additional liquidity risk if they permit redeeming authorized participants to receive cash, rather than an in-kind basket of securities, in exchange for redeemed shares?

• Should any of the requirements of the proposed rule be modified for ETFs or ETMFs on account of the relief from section 22(e) some of these funds receive under their exemptive orders? Should any of the requirements apply differently when an ETF or an ETMF is organized as a class of an open-end fund or as a feeder fund in a master-feeder structure where other classes or feeder funds operate as traditional mutual funds?

Exemptive orders for ETF relief include provisions that govern the composition of portfolio deposits and redemption baskets. In general, portfolio deposits and redemption baskets must represent pro rata slices of the ETF's portfolio and must be the same for all purchasers and redeemers that transact with the ETF on the same day. In recent years, ETF sponsors have requested increased flexibility in determining the composition of portfolio deposits and redemption baskets.

156

See, e.g.,

Comment Letter of Charles Schwab & Co., Inc. on the 2015 ETP Request for Comment (Aug. 17, 2015) (“At a minimum, we believe it is important that ETF managers have the ability to construct non-pro rata baskets, subject to compliance and board oversight to help identify and address instances where the use of such baskets may conflict with the interests of the ETF and its shareholders.”).

• We request comments on whether such flexibility would result in favorable or unfavorable changes in how ETFs manage the liquidity of their holdings. For example, would ETFs benefit from reduced cash drag? Would the flexibility enable or encourage ETFs to reduce the overall liquidity of their portfolios or to hold a greater amount of relatively illiquid assets? Does the existing 15% guideline adequately address any concerns regarding liquidity that could result from greater basket flexibility? Would the requirements we are proposing adequately address any concerns regarding liquidity that could result from greater basket flexibility? If not, could other requirements adequately address any concerns?

We request comment on the types of investment products that the Commission proposes not to include, or to specifically exclude, from the scope of proposed rule 22e-4.

• Do commenters agree that closed-end funds, including closed-end interval funds, should not be included within the scope of the proposed rule? Should we make any changes to the liquidity requirements for closed-end interval funds?

• Do commenters agree that UITs should not be included within the proposed rule's scope? Is there any subset of UITs that should be considered for inclusion, if only for some aspects of the rule? Is there a significant risk that UITs (or a certain subset of UITs) may not be able to meet redemption requests? With respect to UITs that are not ETFs, and that do not serve as separate account vehicles that are used to fund variable annuity and variable life insurance products, is it reasonable to expect that UIT sponsors would maintain a secondary market in UIT units to the same extent and in the same manner as they have historically?

• Alternatively, should we require UITs to meet certain minimum liquidity requirements at the time of deposit of the securities, such as requiring a UIT to maintain a prescribed minimum portion of its net assets in assets that it 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? Why or why not? What specific requirements of proposed rule 22e-4 should be modified for UITs to account for the facts that UITs are not actively managed, UITs' portfolios are not actively traded, and UITs do not have a board of directors, corporate officers, or an investment adviser to render advice during the life of the trust?

• Is it appropriate that we include ETFs organized as open-end funds but not ETFs organized as UITs within the rule? Should we exclude from the scope of the rule ETFs organized as open-end funds that, similar to UIT ETFs, fully track established and widely recognized indices? Why or why not? Do commenters believe that ETFs organized as open-end funds would reorganize as UITs in response to the rule? Why or why not?

• Do commenters agree that we should specifically exclude money market funds from the scope of proposed rule 22e-4? Is there any subset of money market funds that should be considered for inclusion, if only for some aspects of the rule?

B. Classifying the Liquidity of a Fund's Portfolio Positions Under Proposed Rule 22e-4

We have not updated the liquidity guidelines applicable to funds and fund portfolio assets in over two decades, and we believe that developments in the fund industry as well as staff observations of funds' current liquidity risk management practices warrant proposing requirements for classifying the liquidity of funds' portfolio positions.

157

We are aware based on staff experience that many fund managers engage in analysis of the liquidity of portfolio assets, beyond considering whether the fund's portfolio construction is consistent with the 15% guideline, and we believe that all open-end funds and their shareholders would benefit from a comprehensive review of the liquidity of funds' portfolio positions. Staff outreach has shown that funds today employ notably different procedures for assessing and classifying the liquidity of their portfolio assets.

158

Some funds have implemented procedures that analyze multiple aspects relating to an asset's liquidity, including relevant market, trading, and asset-specific factors, and monitor whether their initial liquidity determinations should be amended based on changed conditions. While the 15% guideline requires a binary determination of whether an asset is liquid or illiquid, funds with relatively comprehensive liquidity classification procedures tend to view the liquidity of their portfolio assets in terms of a more-liquid to less-liquid spectrum.

159

This “spectrum”-based approach to liqu

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