# Open-End Fund Liquidity Risk Management Programs; Swing Pricing; Re-Opening of Comment Period for Investment Company Reporting Modernization Release > Briefs, arguments, decisions, and more. URL: https://www.frixlaw.com/law-library/documents/fr%3A2015-24507 ## Record - **Collection:** Federal Register - **Document type:** Proposed Rule - **Published:** October 15, 2015 - **Citation:** 80 FR 62274 ## Text 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. 1 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]. 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 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”). 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 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). 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. 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. 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 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. 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. 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. 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 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). 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 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.”). 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 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. 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”). 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. 58 DERA Study, supra note 39, at Table 2. 59 Id. 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 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.”). 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 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.”). 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 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.”). 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 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 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. 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 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. 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 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. 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 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. 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. 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. 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. 104 104 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”). 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). 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. 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. 110 108 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 § 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 transactions in open-end fund shares, within three business days after the trade date. See supra note 21 and accompanying text. Furthermore, funds' redemption obligations are also governed by any disclosure to shareholders that a fund has made about the time within which it will meet redemption requests, as disclosures by open-end funds are subject to the antifraud provisions of the federal securities laws. See supra note 77 and accompanying text. 110 See infra section IV.C.1. 1. Proposed Program Elements Proposed rule 22e-4 would require each fund to adopt and implement a written liquidity risk management program that is designed to assess and manage the fund's liquidity risk. 111 Under the proposed rule, liquidity risk would be defined as the risk that a fund could not meet requests to redeem shares issued by the fund that are expected under normal conditions, or are reasonably foreseeable under stressed conditions, without materially affecting the fund's net asset value. 112 Proposed rule 22e-4 specifies that a fund's liquidity risk management program shall include the following required program elements: (i) classification, and ongoing review of the classification, of the liquidity of each of the fund's positions in a portfolio asset (or portions of a position in a particular asset); (ii) assessment and periodic review of the fund's liquidity risk; and (iii) management of the fund's liquidity risk, including the investment of a set minimum portion of net assets in assets that the fund believes are convertible to cash within three business days at a price that does not materially a [Text truncated at 120,000 characters. The full text is on the page linked above.] --- Source: Frix Law Library, https://www.frixlaw.com/law-library/documents/fr%3A2015-24507. Public record. Not legal advice.