Investment Company Liquidity Risk Management Programs

Federal RegisterNov 18, 2016

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SECURITIES AND EXCHANGE COMMISSION

17 CFR Parts 270 and 274

[Release Nos. 33-10233; IC-32315; File No. S7-16-15]

RIN 3235-AL61

Investment Company Liquidity Risk Management Programs

AGENCY:

Securities and Exchange Commission.

ACTION:

Final rule.

SUMMARY:

The Securities and Exchange Commission is adopting new rules, a new form and amendments to a rule and forms designed to promote effective liquidity risk management throughout the open-end investment company industry, thereby reducing the risk that funds will be unable to meet their redemption obligations and mitigating dilution of the interests of fund shareholders. The amendments also seek to enhance disclosure regarding fund liquidity and redemption practices. The Commission is adopting new rule 22e-4, which requires each registered open-end management investment company, including open-end exchange-traded funds (“ETFs”) but not including money market funds, to establish a liquidity risk management program. Rule 22e-4 also requires principal underwriters and depositors of unit investment trusts (“UITs”) to engage in a limited liquidity review. The Commission is also adopting amendments to Form N-1A regarding the disclosure of fund policies concerning the redemption of fund shares. The Commission also is adopting new rule 30b1-10 and Form N-LIQUID that generally will require a fund to confidentially notify the Commission when the fund's level of illiquid investments that are assets exceeds 15% of its net assets or when its highly liquid investments that are assets fall below its minimum for more than a specified period of time. The Commission also is adopting certain sections of Forms N-PORT and N-CEN that will require disclosure of certain information regarding the liquidity of a fund's holdings and the fund's liquidity risk management practices.

DATES:

Effective Dates:

This rule is effective

January 17, 2017 except for the amendments to Form N-CEN (referenced in 17 CFR 274.101) which are effective June 1, 2018.

Compliance Dates:

The applicable compliance dates are discussed in section III.M. of this final rule.

FOR FURTHER INFORMATION CONTACT:

Zeena Abdul-Rahman, John Foley, Andrea Ottomanelli Magovern, Naseem Nixon, Amanda Hollander Wagner, Senior Counsels; Thoreau Bartmann, Melissa Gainor, Senior Special Counsels; or Kathleen Joaquin, Senior Financial Analyst, Investment Company Rulemaking Office, at (202) 551-6792, Ryan Moore, Assistant Chief Accountant, or Matt Giordano, Chief Accountant at (202) 551-6918, Office of the Chief Accountant, 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 adopting new rules 22e-4 [17 CFR 270.22e-4] and 30b1-10 [17 CFR 270.223], under the Investment Company Act of 1940 [15 U.S.C. 80a-1

et seq.

] (“Investment Company Act” or “Act”); new Form-N-LIQUID [referenced in 17 CFR 274.30b1-10] under the Investment Company 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.

]; and adopting sections to Form N-PORT [referenced in 17 CFR 274.150] and Form N-CEN [referenced in 17 CFR 274.101] under the Investment Company Act.

Unless otherwise noted, all references to statutory sections are to the Investment Company Act, and all references to rules under the Investment Company Act are 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

C. Recent Developments in the Open-End Fund Industry

D. Overview of Current Practices

E. Rulemaking Adoption Overview

III. Discussion

A. Program Requirement and Scope of Rule 22e-4

B. Assessment, Management, and Review of Liquidity Risk

C. Classifying the Liquidity of a Fund's Portfolio Investments, and Disclosure and Reporting Requirements Regarding Portfolio Investments' Liquidity Classifications

D. Highly Liquid Investment Minimum

E. Limitation on Funds' Illiquid Investments

F. Policies and Procedures Regarding Redemptions in Kind

G. Cross-Trades

H. Board Approval and Designation of Program Administrative Responsibilities

I. Recordkeeping Requirements

J. ETFs

K. Limitation on Unit Investment Trusts' Investments in Illiquid Investments

L. Disclosure and Reporting Requirements Regarding Liquidity Risk and Liquidity Risk Management

M. Effective and Compliance Dates

IV. Economic Analysis

A. Introduction and Primary Goals of Regulation

B. Economic Baseline

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

V. Paperwork Reduction Act Analysis

A. Introduction

B. Rule 22e-4

C. Form N-PORT

D. Form N-LIQUID and Rule 30b1-10

E. Form N-CEN

F. Form N-1A

VI. Final Regulatory Flexibility Act Analysis

A. Need for the Rule

B. Significant Issues Raised by Public Comment

C. Small Entities Subject to the Rule

D. Projected Reporting, Recordkeeping, and Other Compliance Requirements

E. Agency Action To Minimize Effect on Small Entities

VII. Statutory Authority and Text of Amendments

Text of Rules and Forms

I. Introduction

Redeemability is a defining feature of open-end investment companies.

At the time the Act was adopted, this feature was recognized as unique to open-end investment companies,

and the Act's classification of management investment companies as either open-end (“open-end funds” or “funds”)

closed-end, upon which several of the Act's other provisions depend, turns on whether the investment company's shareholders have the right to redeem their shares on demand. When the Investment Company Act was enacted, it was understood that redeemability meant that an open-end fund had to have a liquid portfolio.

Since the 1940s, the Commission has stated that open-end funds should maintain highly liquid portfolios and recognized that this may limit their ability to participate in certain transactions in the capital markets.

Section 22(e) of the Act enforces the shareholder's right of prompt redemption in open-end funds by compelling such funds to make payment on shareholder redemption requests within seven days of receiving the request. Potential dilution of shareholders' interests in open-end funds also was a significant concern of Congress when drafting the Act and was among the noted abuses that led to the enactment of the Act, as reflected in sections 22(a) and (c).

See

Investment Trusts and Investment Companies: Letter from the Acting Chairman of the SEC, A Report on Abuses and Deficiencies in the Organization and Operation of Investment Trusts and Investment Companies (1939), at n.206 (“[T]he salient characteristic of the open-end investment company . . . was that the investor was given a right of redemption so that he could liquidate his investment at or about asset value at any time that he was dissatisfied with the management or for any other reason.”). An open-end investment company 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 (“NAV”) next calculated by the fund after receipt of such redemption request.

See

Investment Trusts and Investment Companies: Hearings on S. 3580 before a Subcomm. of the Senate Comm. on Banking and Currency, 76th Cong., 3d Sess. (1940) (“1940 Senate Hearings Transcript”), at 453 (Statement of Mahlon E. Traylor) (“Open-end companies are unlike any other type of investment company, principally because of the highly important distinguishing feature that their shareholders can, by contract right, withdraw their proportionate interest at will simply by surrendering their shares to the company for redemption at liquidating value.”).

In-Kind ETFs (as defined below) are included when we refer to “funds” or “open-end funds” throughout this Release, except in the sections discussing classifying the liquidity of a fund's portfolio positions and the highly liquid investment minimum requirement, from which In-Kind ETFs are excepted. We have done this for conciseness

and we recognize that these naming conventions differ from the text of rule 22e-4. Additionally, while a money market fund is an open-end management investment company, money market funds are not subject to the rules and amendments we are adopting (except certain amendments to Form N-CEN and Form N-1A) and thus are not included when we refer to “funds” or “open-end funds” in this Release except where specified.

See

Investment Trusts and Investment Companies: Hearings on H.R. 10065 before a Subcomm. of the House Comm. on Interstate and Foreign Commerce, 76th Cong., 3d Sess. 112 (1940), at 57 (Statement of Robert E. Healy) (“due to the right of the stockholder to come in and demand a redemption, the [open-end fund] has to keep itself in a very liquid position. That is, it has to be able to turn its securities into money on very short notice.”).

See

Investment Trusts and Investment Companies: Report of the Securities and Exchange Commission (1942), at 76 (“Open-end investment companies, because of their security holders' right to compel redemption of their shares by the company at any time, are compelled to invest their funds predominantly in readily marketable securities. Individual open-end investment companies, therefore, as presently constituted, could participate in the financing of small enterprises and new ventures only to a very limited extent.”).

See

1940 Senate Hearings Transcript,

supra

footnote 3, at 37, 137-145 (stating that, among the abuses that served as a backdrop for the Act, were “practices which resulted in substantial dilution of investors' interests”, including backward pricing by fund insiders to increase investment in the fund and thus enhance management fees, but causing dilution of existing investors in the fund).

Although the Investment Company Act provides funds with a seven-day window to pay proceeds upon an investor's redemption, the settlement period for open-end fund redemptions has shortened considerably over the years. There are several reasons for shorter settlement periods, including broker-dealer settlement cycle requirements,

evolving industry standards, and technological advances in the settlement infrastructure.

In addition, many funds state in their prospectuses that investors can ordinarily expect to receive redemption proceeds in shorter periods than seven days.

At the same time, open-end funds have experienced significant growth,

markets have grown more complex, and funds pursue more complex investment strategies, including fixed income and alternative investment strategies focused on less liquid asset classes. These trends have made the role of fund liquidity and liquidity management more important than ever in reducing the risk that a fund will be unable to meet its obligations to redeeming shareholders or other obligations under applicable law, while also minimizing the impact of those redemptions on the fund (

i.e.,

mitigating investor dilution). Furthermore, recent events have demonstrated the significant adverse consequences to remaining investors in a fund when it fails to adequately manage liquidity.

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.

Generally, settlement time frames for mutual fund shares have been shortening for decades.

See

Open-End Fund Liquidity Risk Management Programs; Swing Pricing; Re-Opening of Comment Period for Investment Company Reporting Modernization Release, Investment Company Act Release No. 31835 (Sept. 22, 2015) [80 FR 62274 (Oct. 15, 2015)] (“Proposing Release”), at section II.C.2.

See also

Amendment to Securities Transaction Settlement Cycle, Securities Exchange Act Release No. 34-78962 (September 29, 2016) [81 FR 69240 (October 05, 2016)].

See, e.g.,

Fidelity Commonwealth Trust rule 485(b) Registration Statement (June 29, 2016),

available at

https://www.sec.gov/Archives/edgar/data/205323/000137949116004602/filing776.htm

(“Normally, redemptions will be processed by the next business day, but it may take up to seven days to pay the redemption proceeds if making immediate payment would adversely affect the fund.”); PIMCO Funds rule 485(b) Registration Statement (Feb. 26, 2016),

available at

https://www.sec.gov/Archives/edgar/data/810893/000119312516481663/d149399d485bpos.htm#chapter_7_3686

(“Redemption proceeds will normally be mailed to the redeeming shareholder within three calendar days . . . [but] may take up to seven days.”).

As of the end of 2015, there were 10,633 open-end funds (excluding money market funds, but including ETFs), as compared to 5,279 at the end of 1996.

See

Investment Company Institute, 2016 Investment Company Fact Book (2016)

(“2016 ICI Fact Book”), available at

https://www.ici.org/pdf/2016_factbook.pdf

For example, during the pendency of our proposal, the Third Avenue Focused Credit Fund, a non-diversified open-end fund, adopted a plan of liquidation, and requested and obtained exemptive relief to suspend shareholder redemptions, following a period of heavy redemption requests that the fund stated reduced the fund's portfolio liquidity. The Third Avenue Focused Credit Fund has yet to complete the liquidation of fund assets. Additionally, the fund reported that, as a result of the continuous liquidation of securities without reinvestment, the fund became increasingly more concentrated, which negatively impacted performance.

See

Third Avenue Trust and Third Avenue Management LLC, Investment Company Act Release No. 31943 (Dec. 16, 2015) (“Third Avenue Temporary Order”); Third Avenue Focused Credit Fund Semi-Annual Report to Shareholders (April 30, 2016),

available at:

http://thirdave.com/wp-content/uploads/2016/06/Q2-2016-TFCIX-Semi-Annual-Report.pdf

(“The Fund is considerably more concentrated than it has ever been. As we have been liquidating securities and not recycling the cash, the top 10 holdings have increased from 32.6% at March 31, 2015 to approximately 67% of the Fund. We are increasingly dependent on the top 10 names to drive performance.”).

See also

rule 22c-1 (requiring that redeemable securities be transacted “at a price based on the current net asset value of such security which is next computed after receipt of a tender of such security for redemption or of an order to purchase or sell such security”).

Prior to the adoption of the Act, open-end funds largely redeemed fund shares in cash and, as such, a redeemable security was generally understood to mean a security that was redeemable for cash.

See, e.g.,

Investment Trusts and Investment Companies: Senate Report 1775 onS. 4108, 76th Cong., 3d Sess. (1940), at 2 (“[a redeemable security] is, a security which provides that the holder may tender it to the company at any time and

receive a sum of money

approximating the current market value of his proportionate interest in the company's assets.”[emphasis added]). However, section 2(a)(32) has traditionally been interpreted to give funds the option of redeeming their shares in cash or in kind.

See, e.g.,

Investment Trusts and Investment Companies: Report of the Securities and Exchange Commission Part I (1939) at 21 (“A company is of the `open-end' type if a shareholder has the right to require the company to purchase or redeem or cause the purchase or redemption of the shares representing his proportionate interest in the company's properties, or the cash equivalent of such interest.”);

see also

Adoption of (1) Rule18f-1 Under the Investment Company Act of 1940 to Permit Registered Open-End Investment Companies Which Have the Right to Redeem In Kind to Elect to Make Only Cash Redemptions and (2) Form-N-18F-1, Investment Company Act Release No. 6561 (June 14, 1971) [36 FR 11919 (June 23, 1971)] (“Rule 18f-1 and Form N-18F-1 Adopting Release”) (stating that the definition of “redeemable security” in section 2(a)(32) of the Investment Company Act “has traditionally been interpreted as giving the issuer the option of redeeming its securities in cash or in kind.”).

See

Comment Letter of Invesco Advisers, Inc. (Jan. 13, 2016) (“Invesco Comment Letter”) (“The primary problem with using redemptions in kind to meet large redemptions is the willingness and ability of the redeeming entity to receive securities instead of cash.”).

See also

Money Market Fund Reform; Amendments to Form PF, Investment Company Act Release No. 30551 (June 5, 2013) [78 FR 36834, (June 19, 2013)] (“2013 Money Market Fund Reform Proposing Release”), at n.473 and accompanying text (stating that “[m]any commenters believed that requiring in-kind redemptions would be technically unworkable due to complex valuation and operational issues that would be imposed on both the fund and on investors receiving portfolio securities.”).

ETFs also offer investors an undivided interest in a pool of assets.

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

In addition, like mutual funds, ETFs provide redemption rights on a daily basis, but, pursuant to exemptive orders, such redemption rights may be exercised only by certain large market participants—typically broker-dealers—called “authorized participants.”

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.

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. 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 publicly declared by the ETF before the beginning of the trading day.

Since 2003, the number of ETFs traded in U.S. markets has increased by more than 2,200 funds, and the assets held by ETFs have increased from $151 billion at the end of 2003 to $2.1 trillion at the end of 2015.

See

2016 ICI Fact Book,

supra

footnote 11, at 60.

See

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

Authorized participants may purchase and redeem ETF shares at the ETF's NAV from the ETF.

The ETF publicly declares the contents of the portfolio deposit before the beginning of the trading day.

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 nn.19-20 and accompanying text.

See

ETF Proposing Release,

supra

footnote 27, at n.24 and accompanying text.

ETMFs are a hybrid between a traditional mutual fund and an ETF.

Like ETFs, ETMFs 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 are bought and sold at prices linked to NAV and seek to maintain the confidentiality of their current portfolio positions.

The Commission approved ETMFs in 2014 and the first ETMFs have since been launched.

See

Eaton Vance Management,

et al.,

Investment Company Act Release No. 31333 (Nov. 6, 2014) (notice of application) (“ETMF Notice”) and In the Matter of Eaton Vance Management,

et al.,

Investment Company Act Release No. 31361 (Dec. 2, 2014) (order) (“ETMF Order”). Given the similarities between ETFs and ETMFs and that the new requirements will apply to ETMFs as they do to ETFs, this Release generally includes ETMFs in the term “ETF” and separately mentions ETMFs only if appropriate.

See supra

footnote 19.

B. The Role of Liquidity in Open-End Funds

1. Introduction

A hallmark of open-end funds is that they must be able to convert some portion of their portfolio holdings into cash on a frequent basis because they issue redeemable securities, and are required by section 22(e) of the Investment Company Act to make payment to shareholders for securities tendered for redemption within seven days of their tender (although some funds may reserve the right to make redemptions in kind for certain redemption requests). As a practical matter, many investors expect to receive redemption proceeds in fewer than seven days as some mutual funds represent in their prospectuses that they will generally pay redemption proceeds on a next business day basis.

Given the statutory and regulatory requirements for meeting redemption requests, as well as any potential liability for representations made to investors regarding payment of redemption proceeds, a mutual fund must adequately manage the liquidity of its portfolio so that redemption requests can be satisfied in a timely manner.

See supra

footnote 10;

see also

the Proposing Release,

supra

footnote 9, at n.155.

For decades, the Commission has recognized that because open-end funds hold themselves out at all times as being prepared to meet these statutory redemption requirements, they have a responsibility to manage the liquidity of their investment portfolios in a manner consistent with those obligations and any other related representations.

Thus, long-standing Commission guidelines contain a liquidity standard that generally limits an open-end fund's aggregate holdings of “illiquid assets” to no more than 15% of the fund's net assets (the “15% guideline”).

Under the 15% guideline, a portfolio security or other asset is considered illiquid if it cannot be sold or disposed of in the ordinary course of business within seven days at approximately the value at which the fund has valued the investment.

The 15% guideline has generally caused funds to limit their exposures to particular types of securities that cannot be sold within seven days and that the Commission and staff have indicated may be illiquid, depending on the facts and circumstances, such as private equity securities and certain other privately placed or restricted securities

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

See

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.”);

see also

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 of 1933 (the “Securities Act”)).

Revisions of Guidelines to Form N-1A, Investment Company Act Release No. 18612 (Mar. 12, 1992) [57 FR 9828 (Mar. 20, 1992)] (“Guidelines Release”), 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.”). The Guidelines Release modified prior Commission guidance that set a 10% limit on illiquid assets for open-end funds.

See

Restricted Securities Release,

supra

footnote 37.

Guidelines Release,

supra

footnote 38;

see also

ETF Proposing Release,

supra

footnote 27; 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)] (“Money Market Funds Release”);

see also

Rule 144A Release,

supra

footnote 37.

See

Restricted Securities Release,

supra

footnote 37. Securities offered pursuant to rule 144A under the Securities Act may be considered liquid under the 15% guideline depending on certain factors.

See

Rule 144A Release,

supra

footnote 37.

See

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)] (“Interval Fund Proposing Release”). 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 under the 15% guideline. However, in the context of rule 144A securities, the Commission had provided “examples of factors that would be reasonable for a [fund's] board of directors to take into account” but which would not necessarily be determinative.

See

Rule 144A Release,

supra

footnote 37. 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.

Relatedly, the Commission has recognized that the liquidity management practices of open-end funds implicate certain antifraud provisions of the securities laws.

For example, section 34(b) of the Act makes it unlawful for any person to make any untrue statement of a material fact in any document filed with the Commission or transmitted pursuant to the Act, or the keeping of which is required by section 31(a) of the Act, or to omit to state any fact necessary in order to prevent the statements made therein, in light of the circumstances under which they were made, from being materially misleading.

See

Restricted Securities Release,

supra

footnote 37 (“To the extent a material percentage of the assets of an open-end company consist of restricted securities which cannot publicly be sold without registration under the Securities Act, the ability of the company to comply with the provisions of the Investment Company Act relating to redemption, and to fulfill the implicit representations made in its prospectus with respect thereto, may be adversely affected. In any such situation, the investment company concerned and the persons responsible for the sale of its securities should give careful consideration to the possible application of the provisions of section 10(b) of the Exchange Act and Rule 10b-5 thereunder.”);

see also

Money Market Funds Release,

supra

footnote 39 (explaining that because “most money market funds promise investors that they will receive proceeds much sooner” than seven days and “experience a greater and perhaps less predictable volume of redemption transactions than do other investment companies,” they “must have sufficient liquidity to meet redemption requests on a more immediate basis”). The Commission has considered the failure to take risk-limiting measures in other contexts to implicate antifraud provisions as well.

See

Adoption of Revisions to Rules Regulating Money Market Funds, Investment Company Act Release No. 18005 (Feb. 20, 1991) (“The Commission believes that there is a significant danger of misleading investors if an investment company holds itself out as a money market fund when it engages in investment strategies not consistent with the risk-limiting conditions of rule 2a-7. It is therefore necessary and appropriate in the public interest and for the protection of investors for the Commission to adopt a new paragraph (b) of rule 2a-7 prohibiting an investment company from holding itself out as a `money market fund' unless it meets the risk-limited conditions of rule 2a-7.”).

Exercising authority under section 34(b) and sections 9(b), 38(a), and 42 of the Act, the Commission adopted paragraph (b) of rule 2a-7 in 1997, which provides that “it shall be an untrue statement of a material fact within the meaning of section 34(b) of the Act for a registered investment company . . . to hold itself out to investors as a money market fund or the equivalent of a money market fund” unless the fund complies with rule 2a-7. 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 adopted amendments to rule 2a-7 in 2014 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.

See

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”).

In addition, section 206(4)

of the Investment Advisers Act of 1940 (“Advisers Act”) and rule 206(4)-8 thereunder make it unlawful for any adviser to an investment fund to engage in any act, practice, or course of business which is fraudulent, deceptive, or manipulative.

Additionally, section 10(b) of the Exchange Act and rule 10b-5 thereunder make it unlawful, among other things, for any person, in connection with the purchase or sale of securities, to employ any device, scheme, or artifice to defraud or to make any untrue statement of a material fact or to omit to state a material fact necessary in order to make the statements made not misleading, or engage in any act, practice, or course of business which operates or would operate as a fraud or deceit upon any persons. Finally, section 17(a) of the Securities Act similarly makes it unlawful for any person in the offer or sale of any securities or any security-based swap agreement by the use of any means or instruments of transportation or communication in interstate commerce or by use of the mails, directly or indirectly, to employ any device, scheme, or artifice to defraud, to obtain money or property by means of any untrue statement of a material fact or any omission to state a material fact necessary in order to make the statements made, in light of the circumstances under which they were made, not misleading, or to engage in any transaction, practice, or course of business which operates or would operate as a fraud or deceit upon the purchaser.

Section 206(4) of the Advisers Act grants the Commission authority, by rules and regulations, to define and prescribe means reasonably designed to prevent such acts, practices, and courses of business as are fraudulent, deceptive, or manipulative.

Additionally, section 206(1) of the Advisers Act makes it unlawful for an adviser to employ any device, scheme or artifice to defraud any client or prospective client, and section 206(2) makes it unlawful for an adviser to engage in any transaction, practice or course of business which operates as a fraud or deceit upon any client or prospective client.

See

Prohibition of Fraud by Advisers to Certain Pooled Investment Vehicles, Investment Advisers Act Release No. 2628 (August 3, 2007) [72 FR 44756 (August 9, 2007)], at n.3 and accompanying text.

See

In the Matter of Evergreen Investment Management Company, LLC and Evergreen Investment Services, Inc., Investment Company Act Release No. 28759 (June 8, 2009) (settled order) (“Evergreen Order”) (settlement of allegations that a mutual fund and its underwriter violated, and its adviser aided and abetted violations of, section 22(c) of the Act and rule 22c-1(a) through purchases and redemptions at materially overstated NAV. The order found that the fund's adviser materially misrepresented the fund's performance and NAV in reviewing and approving the fund's prospectus in violation of section 34(b) of the Act.).

As the Commission has previously noted, an open-end fund “represents to investors, in its prospectus, that it will, as required by section 22(e) of the Act, redeem its securities at approximate net asset value within seven days after tender.”

Similarly, an open-end fund that is redeemed through broker-dealers generally represents to investors that it will redeem its securities within three days, as required by rule 15c6-1.

Failure by a fund to maintain a sufficiently liquid portfolio or to otherwise manage liquidity risk calls into question the fund's ability to fulfill the representations (explicit or implicit) made in its prospectus regarding its ability to meet its redemption obligations, as well as its status as an open-end fund. Such failure thus potentially exposes the fund, the investment adviser that manages the fund, and the persons responsible for the sale of the fund's securities to the possible application of the antifraud

provisions of the securities laws referenced above.

Restricted Securities Release,

supra

footnote 37.

See also

Proposing Release,

supra

footnote 9, at II.C.2 (“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.”). As the Commission has previously noted, most money market funds disclose that they will pay redemptions even more quickly, often on the same day that the request is received by the fund, and thus “must have sufficient liquidity to meet redemption requests on a more immediate basis.” Money Market Funds Release,

supra

footnote 39.

See

Restricted Securities Release,

supra

footnote 37; Proposing Release,

supra

footnote 9, at n.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 with seven days or any shorter time disclosed in the fund's prospectus or advertising materials.”) (citing 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);

id.

at n.109 (“[F]unds' 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.”);

id.

at III.C (“We believe that assessing and managing liquidity risk in a comprehensive manner is critical to a fund's ability to honor redemption requests within the seven-day period required under section 22(e) . . . as well as within any shorter time period disclosed in the fund's prospectus or advertising materials or required for purposes of rule 15c6-1.”);

id.

at III.C.3.d (requesting public comment on whether liquid asset minimum requirements tighter than three days may be warranted “given that there may be liability under the antifraud provisions of the federal securities laws if a fund fails to meet redemptions within any shorter time disclosed in the fund's prospectus or advertising materials.”).

In addition to the foregoing concerns, an insufficiently liquid portfolio implicates provisions of the Act and regulations thereunder concerning fund valuation.

A fund's ability to properly value its portfolio securities is important, primarily because, under the Act, fund shareholders are entitled to their proportionate share of the fund's NAV upon redemption. Section 2(a)(41) of the Act and rule 2a-4 thereunder provide that in determining NAV, funds must value “securities for which market quotations are readily available” at current market value, and must value all other securities and assets at “fair value as determined in good faith by the board of directors.” Illiquid or less liquid assets are less likely to have readily available market quotations, and thus are more likely to require a fair value determination. Determining the fair value of illiquid or less liquid assets consistent with section 2(a)(41) and rule 2a-4 can pose a number of challenges, some of which the Commission has previously described in the context of the acquisition of restricted securities,

and improper valuation of such assets could result in liability under the antifraud provisions.

The difficulties valuing illiquid or less liquid securities also implicate section 22(c) and rule 22c-1, which requires the use of the next-determined NAV for pricing purchases and redemptions. Transactions in such securities are more likely to be effected at prices that differ from fair value and, therefore, may result in increasing risk of investor dilution.

See

Restricted Securities Release,

supra

footnote 37 (describing the “serious problems of valuation” arising from fund acquisition of restricted securities); Guidelines Release,

supra

footnote 38 (noting that a fund “must maintain a high degree of portfolio liquidity” to meet the requirements under section 22(e), rule 22c-1(a) and rule 2a-4).

See

Restricted Securities Release,

supra

footnote 37 at n.1 and accompanying text for a discussion of the various valuation challenges facing purchasers and sellers of restricted securities.

See

Restricted Securities Release,

supra

footnote 37. As the Commission explained there, “[t]he offering price of securities issued by a management investment company is premised upon the net asset value of such shares as determined pursuant to [section 2(a)(41)] of the Act and Rule 2a-4 thereunder and is so represented in its prospectus.” Consequently, “the improper valuation of restricted securities held by such a company would distort the net asset value of the shares being offered or, in the case of an open-end company, redeemed, and would therefore constitute a fraud and deceit within the meaning of section 10(b) and Rule 10b-5.”

see also

Rule 144A Release,

supra

footnote 37.

Guidelines Release,

supra

footnote 38, at n.11 (“[T]he Commission expects funds to monitor portfolio liquidity on an ongoing basis to determine whether, in light of current circumstances, an adequate level of liquidity is being maintained. For example, an equity fund that begins to experience a net outflow of assets because investors increasingly shift their money from equity to income funds should consider reducing its holdings of illiquid securities in an orderly fashion in order to maintain adequate liquidity.”). Therefore, under current SEC guidance, a fund experiencing net outflows may wish to consider managing its illiquid asset holdings to maintain adequate liquidity. Similarly, a fund may need to determine whether it is appropriate to take certain actions when the fund has determined that a previously liquid holding has become illiquid due to changed circumstances.

See also

Rule 144A Release,

supra

footnote 37, at n.61.

Registered investment companies and their investment advisers are subject to rules under the Act and the Advisers Act requiring them to adopt and implement written compliance policies and procedures reasonably designed to prevent various violations of laws and regulations. Rule 38a-1 under the Act requires registered investment companies to adopt and implement written policies and procedures reasonably designed to prevent violations of the federal securities laws by the fund, including policies and procedures that provide for the oversight of compliance by certain of the fund's service providers, including the fund's investment adviser; the rule also requires board approval and review of the service providers' compliance policies and procedures. Additionally, rule 206(4)-7 under the Advisers Act requires registered investment advisers to adopt and implement written compliance policies and procedures reasonably designed to prevent violations of the Advisers Act and the rules thereunder by the adviser or any of its supervised persons. Such compliance policies and procedures should be appropriately tailored to reflect each firm's particular compliance risks.

For example, an open-end fund holding a significant portion of its assets in securities with long settlement periods or that trade infrequently may be subject to relatively greater liquidity risks than other open-end funds, and should appropriately tailor its policies and procedures in light of its particular risks and circumstances. The Commission has brought enforcement actions under the compliance rules against funds and their advisers for failures to adopt and/or implement policies and procedures reasonably designed to prevent violations relating to, for example, disclosure, valuation, and pricing for assets with limited liquidity.

In the compliance rules adopting release, the Commission highlighted certain, non-exclusive examples of particular areas to be addressed in funds' and advisers' policies and procedures. For example, it stated that funds or advisers should adopt policies and procedures regarding valuation and the pricing of portfolio securities and fund shares, as well as the processing of fund shareholder transactions in accordance with rule 22c-1.

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 identified “portfolio management processes” as an issue that should be covered in the compliance policies and procedures of a fund or its adviser and indicated 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). The Commission further identified “the accuracy of disclosures made to investors, clients, and regulators” as an issue to be covered.

See

In re Citigroup Alternative Investments LLC & Citigroup Glob. Markets Inc., Investment Advisers Act Release No. 4174 (Aug. 17, 2015) (settled order) (hedge fund adviser failed to adopt policies and procedures to prevent misrepresentations to private fund investors about fund performance and liquidity and violated rule 206(4)-7); In re J. Kenneth Alderman, CPA,

et al.,

Investment Company Act Release No. 30557 (Jun. 13, 2013) (settled order) (respondent directors failed to exercise their responsibilities with respect to adoption and implementation of valuation policies and procedures by mutual funds holding securities with reduced liquidity and caused funds' violations of rule 38a-1); In re UBS Glob. Asset Mgmt. (Americas) Inc., Investment Company Act Release No. 29920 (Jan. 17, 2012) (settled order) (mutual fund adviser failed to implement fair value pricing procedures with respect to subordinated fixed income securities without an active market and violated rule 38a-1); In re Morgan Asset Mgmt., Inc.,

et al.,

Investment Company Act Release No. 29704 (June 22, 2011) (settled order) (mutual fund adviser failed to implement valuation procedures in pricing fixed income securities backed by subprime mortgages and violated rule 38a-1).

Thus, funds and their advisers already are required to adopt and implement written compliance policies and procedures reasonably designed to prevent violations of various provisions implicated by fund liquidity, including those provisions identified above. The liquidity risk management program requirements of rule 22e-4, which we are adopting here, in effect will provide more specific and enhanced requirements in certain areas already generally covered by the compliance program rules.

In short, there are a number of statutory and regulatory provisions across the federal securities laws that bear on redemptions and the potential dilution of shareholders' interests. New rule 22e-4 advances the purposes of the Act by enhancing the ability of funds to meet their redemption obligations, reducing the risk of shareholder dilution, and reducing the potential for antifraud violations.

One commenter argued that the Commission lacks the statutory authority to issue rule 22e-4. Comment Letter of Justin Banks (Jan. 13, 2016) (“Banks Comment Letter”) (considering the authority conferred by sections 22(c), 22(e), and 38 of the Act, although we note that in referring to our authority under section 38, the commenter actually quoted and addressed the text of section 39 of the Act.). We disagree. The Commission has ample authority under the Act, including sections 22(c), 22(e), and 38(a), as well as under the antifraud provisions of the federal securities laws, to require that open-end funds maintain adequate liquidity and adopt responsible liquidity risk management policies and procedures.

See supra

section II.B.2. Section 38(a), in particular, gives the Commission authority to issue rules, regulations, and orders “as are necessary or appropriate to the exercise of the powers conferred upon the Commission elsewhere in this title.” As discussed above, the liquidity risk management program required under rule 22e-4 is necessary and appropriate to reduce the risk that funds will be unable to meet their redemption obligations, to improve industry-wide liquidity risk management practices, to mitigate potential dilution of the interests of non-redeeming shareholders, and to increase the likelihood that funds are able to fulfill representations made in their prospectuses and advertising materials and implicit in their open-end status.

3. Liquidity Management by Open-End Funds

Portfolio managers consider a variety of factors in addition to liquidity when constructing a fund's portfolio, including but not limited to the fund's investment strategies, economic and market trends, portfolio asset credit quality, and tax considerations. Nevertheless, meeting redemption obligations is fundamental for open-end funds, and funds must manage liquidity in order to meet these obligations.

Several factors influence how liquidity management by open-end funds affects the equitable treatment of investors in a fund, investor redemption behavior, and potentially the orderly operation of the markets when fulfilling redemption obligations.

See Comment Letter of Investment Company Institute on the Notice Seeking Comment on Asset Management Products and Activities, Docket No. FSOC-2014-0001(“FSOC Notice”) (Mar. 25, 2015) (“ICI FSOC Notice Comment Letter”) (“For mutual funds, the central importance of meeting redemptions means that liquidity management is a key element of regulatory compliance, investment risk management, and portfolio management—and a constant area of focus. Even before launching a mutual fund, the fund manager and fund board consider whether the fund's proposed investments and strategies are suitable for the mutual fund structure, including whether it will be able to satisfy applicable regulatory requirements on an ongoing basis. If not, the manager may decide to offer that strategy through a different vehicle (

e.g.,

a closed-end fund or a private fund).”).

See also

Proposing Release,

supra

footnote 9, at n.45 and accompanying text.

There can be significant adverse consequences to remaining investors in a fund that does not adequately manage liquidity.

As noted above, the

proportion of illiquid assets held by a fund can increase if the fund sells its more liquid portfolio assets to meet redemptions. This in turn could adversely affect the fund's risk profile and cause the fund to have difficulty meeting future shareholder redemptions.

The Commission noted that the fund represented that, at the time the fund and its investment adviser requested exemptive relief, it had experienced a significant level of redemption requests over the prior six-month period that reduced the fund's portfolio liquidity, as well as a significant decline in its NAV.

The fund's board authorized the plan of liquidation after it determined that additional redemptions would have to be made at prices that would unfairly disadvantage the fund's remaining shareholders.

This event highlights the extent to which shareholders can be harmed when a fund holding portfolio assets that entail significant liquidity risk does not adequately anticipate the effects of market deterioration and increased shareholder redemptions.

Furthermore, if a fund finds that it can sell portfolio assets only at prices that incorporate a significant discount to the assets' stated value, the discounted sale prices can materially affect the fund's NAV.

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).”).

See, e.g.,

In re Heartland Advisors, Inc.,

et al.,

Investment Company Act Release No. 28136 (Jan. 25, 2008) (“Heartland Release”) (settled order) (finding 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).

See

Third Avenue Temporary Order,

supra

footnote 12.

But see infra

footnote 209 and accompanying text. We note that there is no assurance that the Commission would grant similar relief in the future.

See also

ICI Comment Letter I (“Third Avenue Focused Credit Fund experienced a significant level of redemption requests and an ongoing reduction in the liquidity of its portfolio securities, which consisted largely of junk bonds . . . The SEC granted a temporary order under section 22(e)(3) after expressing concerns with a board-approved plan of liquidation that provided for distribution to shareholders of the fund's remaining net cash and a separate transfer of the fund's other assets into a liquidating trust.”); BlackRock Comment Letter (“[A]s recently demonstrated by the issues meeting redemption requests that were experienced by the Third Avenue Focused Credit Fund, a small and highly concentrated portfolio can present its own liquidity challenges.”);

see also

Heartland Release,

supra

footnote 80.

These factors in fund redemptions—either individually or in combination—can create incentives in times of liquidity stress in the markets for shareholders to redeem quickly to avoid further losses (or a “first-mover advantage”).

If shareholder redemptions are motivated by this first-mover advantage, they can lead to increasing outflows, and as the level of outflows from a fund increases, the incentive for remaining shareholders to redeem may also increase. Additionally, a fund experiencing large outflows as a result of redemptions may be exposed to predatory trading activity in the securities it holds.

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.

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 significant dilution of remaining investors' interests in the fund.

See infra

footnotes 1086-1088 and accompanying text for a discussion of the first-mover advantage and its negative consequences.

But see

Comment Letter of Nuveen Investments on the Notice Seeking Comment on Asset Management Products and Activities, Docket No. FSOC-2014-0001 (Mar. 25, 2015) (“Nuveen FSOC Notice Comment Letter”), at 10 (stating that there is no evidence that shareholders are actually motivated by a first-mover advantage); Comment Letter of BlackRock on the Notice Seeking Comment on Asset Management Products and Activities, Docket No. FSOC-2014-0001 (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 Notice Seeking Comment on Asset Management Products and Activities, Docket No. FSOC-2014-0001 (Mar. 25, 2015), 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 Notice Seeking Comment on Asset Management Products and Activities, Docket No. FSOC-2014-0001 (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

footnote 68, 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.”).

See also

discussion of the potential first-mover advantage in the Proposing Release,

supra

footnote 9, at n.49.

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

discussion of predatory trading concerns in the Proposing Release,

supra

footnote 9, at nn.805-809 and accompanying text.

See

Proposing Release,

supra

footnote 9, at n.37.

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. Depending on the asset and the level of stress, such liquidity stress on the assets held in the fund has the potential to transmit stress to other funds or portions of the market as well.

See, e.g.,

See Comment Letter of Americans for Financial Reform on the FSOC Notice (Mar. 27, 2015) (“AFR FSOC Notice Comment Letter”) (citing evidence that “bond fire sales by mutual funds during the financial crisis created direct economic harm to real economy companies, reducing investment and profitability over a period of years.”); Fidelity FSOC Notice Comment Letter,

supra

footnote 69, 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.”).

See

Proposing Release,

supra

footnote 9, at n.54.

C. Recent Developments in the Open-End Fund Industry

Recent industry developments have underlined our focus on the importance of sufficient liquidity and 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. We will discuss each of these developments in turn.

We note that, up until 1970, open-end funds had limited investments in the bond market.

See

Protecting Investors: A Half Century of Investment Regulation (May 1992) for a discussion of the regulatory and market developments that occurred between 1940 and 1992.

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 (excluding ETMFs).

As growth in fixed income fund assets was occurring, we increased our focus on fixed income market structure, publishing a report on the municipal securities markets in 2012 and holding a roundtable focused on the fixed income markets in 2013.

In addition, Commissioners and Commission staff have spoken about the need to focus on potential risks relating to the fixed income markets and their underlying liquidity.

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, 2015, and 2016.

Assets in these funds grew from $1.5 trillion at the end of 2008 to $3.6 trillion at the end of 2015, with net inflows exceeding $1.4 trillion during that period. These figures were obtained from staff analysis of Morningstar Direct data, and are based on fund categories defined by Morningstar. 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 44.7% in 2015. DERA Study,

infra

footnote 95, at Table 2. The statistics in the DERA Study were calculated through the end of 2014. Commission staff used the CRSP US Mutual Fund Database to update them as of the end of 2015.

See

Securities and Exchange Commission, 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); Securities and Exchange Commission, 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).

See

Proposing Release,

supra

footnote 9, at n.62.

See, e.g.,

IM Guidance Update No. 2014-01, Risk Management in Changing Fixed Income Market Conditions (Jan. 2014) (“2014 Fixed Income Guidance Update”),

available at

https://www.sec.gov/divisions/investment/guidance/im-guidance-2014-1.pdf

; National Exam Program, Office of Compliance Inspections and Examinations, Examination Priorities for 2016 (2016),

available at

https://www.sec.gov/about/offices/ocie/national-examination-program-priorities-2016.pdf

(“Amidst the changes in fixed income markets over the past several years, we will examine advisers to mutual funds, ETFs, and private funds that have exposure to potentially illiquid fixed income securities. We will also examine registered broker-dealers that have become new or expanding liquidity providers in the marketplace. These examinations will include a review of various controls in these firms' expanded business areas, such as controls over market risk management, valuation, liquidity management, trading activity, and regulatory capital”); National Exam Program, Office of Compliance Inspections and Examinations, Examination Priorities for 2015 (2015) (“National Exam Program 2015 Examination Priorities”),

available at

http://www.sec.gov/about/offices/ocie/national-examination-program-priorities-2015.pdf

(“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.”); National Exam Program, Office of Compliance Inspections and Examinations, Examination Priorities for 2014 (2014),

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 significant growth in alternative mutual funds over the last decade.

Although the assets of open-end funds pursuing alternative strategies accounted for a relatively small percentage of the mutual fund market as of December 2014, the growth of assets in these funds has been substantial. Assets of open-end funds with alternative strategies grew from approximately $365 million at the end of 2005 to approximately $334 billion at the end of 2014.

Paul Hanouna, Jon Novak, Tim Riley & Christof Stahel,

Liquidity and Flows of U.S. Mutual Funds,

Division of Economic and Risk Analysis White Paper (Sept. 2015) (“DERA Study”), at 7-8,

available at

https://www.sec.gov/dera/staff-papers/white-papers/liquidity-white-paper-09-2015.pdf

. 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.

See

Proposing Release,

supra

footnote 9 at nn.64-66 and accompanying text.

see also

Proposing Release,

supra

footnote 9, at n.151 and accompanying text.

Funds observed by the staff that have implemented procedures for assessing 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 investments, setting minimum cash reserves, and establishing committed back-up lines of credit or interfund lending facilities.

108

A few of the funds observed by staff conduct stress testing relating to the availability of liquid assets to cover possible levels of redemptions.

109

Some of these funds' advisers also have periodic discussions with their boards of directors about how the funds approach liquidity risk management and what emerging risks they are observing relating to liquidity risk. The staff has 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 their risk profile or materially affecting their performance, and thus with less dilutive impacts.

108

See

Proposing Release,

supra

footnote 9, at n.100 and accompanying text.

109

See

Proposing Release,

supra

footnote 9, at n.101.

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.

110

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 as well as the risk that the fund will be unable to meet those redemptions.

110

See

Proposing Release,

supra

footnote 9, at n.102.

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 final liquidity risk management program framework is meant to address.

111

See supra

section II.B.2 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 and other legal 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 Adoption Overview

Against this background, today we are adopting a 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 or other legal obligations and mitigate potential dilution of the interests of fund shareholders. We believe that limitations on illiquid holdings and more effective liquidity risk management among funds would, in turn, result in significant investor protection benefits and enhance the fair and orderly operation of the markets.

112

The final amendments also seek to enhance reporting and disclosure regarding fund liquidity and redemption practices.

112

See infra

section IV.C.

First, we are adopting new rule 22e-4, which requires each registered open-end fund, including open-end ETFs but not including money market funds, to adopt and implement a written liquidity risk management program reasonably designed to assess and manage the fund's liquidity risk.

113

The new rule requires a fund's liquidity risk management program to incorporate certain specified elements. These include: (i) Assessment, management, and periodic review of the fund's liquidity risk; (ii) classification of the liquidity of each of the fund's portfolio investments,

114

as well as at-least-monthly reviews of the fund's liquidity classifications; (iii) determining and periodically reviewing a highly liquid investment minimum—the percentage of its net assets that the fund invests in highly liquid investments that are assets; (iv) limiting the fund's investment in illiquid investments that are assets to no more than 15% of the fund's net assets; and (v) for funds that engage in, or reserve the right to engage in, redemptions in kind, the establishment of policies and procedures regarding how they will engage in such redemptions in kind.

113

See

rule 22e-4(b). Rule 22e-4, as adopted today, defines “liquidity risk” as the risk that a fund could not meet requests to redeem shares issued by the fund without significant dilution of remaining investors' interests in the fund.

114

As discussed in more detail below, rule 22e-4 as adopted requires a fund to classify each of the fund's portfolio

investments,

including investments that are liabilities of the fund (

e.g.,

certain out-of-the-money derivatives transactions).

See infra

footnote 480 and accompanying text. As proposed rule 22e-4 would have required each fund to classify the liquidity of its portfolio positions (or portions of a position in a particular asset), but did not specifically address the treatment of a fund's holdings that are liabilities. Thus, in this Release, we use the term “assets” when referring to the proposed classification requirement and comments on the proposed requirement, and the term “investments” when referring to the adopted classification requirement.

The liquidity risk assessment requirement generally provides a broad, principles-based foundational framework for a fund's liquidity risk management program, including a requirement that the fund assess whether its investment strategy is appropriate for an open-end fund. The final rule also provides for a tailored program for ETFs, requiring them to consider additional factors as part of their liquidity risk assessment and management that reflect potential liquidity-related concerns that could arise from the structure and operation of ETFs, and excepting ETFs that redeem in kind (“In-Kind ETFs”) from the classification and highly liquid investment minimum requirements.

115

The final rule also provides that funds whose assets primarily consist of highly liquid investments need not adopt a highly liquid investment minimum.

116

Additionally, rule 22e-4 will not apply to closed-end funds, and will apply to principal underwriters and depositors of UITs only to a limited degree, as discussed further below. The classification requirement will provide important liquidity profile information to the Commission and investors and reflects that liquidity may be viewed as falling on a spectrum rather than a binary conclusion that an investment is either “liquid” or “illiquid.”

117

The highly liquid investment minimum requirement is aimed at decreasing the

likelihood that funds would be unable to meet their redemption obligations.

115

Under the final rule, each “In-Kind ETF,” or an ETF that meets redemptions through in-kind transfers of securities, positions, and assets other than a

de minimis

amount of cash, will be subject to the tailored program requirement.

See

rule 22e-4(a)(9) (definition of “In-Kind Exchange Traded Fund” or “In-Kind ETF”); rule 22e-4(b)(1)(i)(D) (incorporating additional factors that an ETF would be required to consider as applicable as part of its liquidity risk assessment and management that reflect liquidity-related risks that could be particularly relevant to the ETF). Under rule 22e-4(a)(5), the term “fund” is defined to exclude an In-Kind ETF. As a result, rule 22e-4(b)(1)(ii) and rule 22e-4(b)(1)(iii), which apply to funds as defined in rule 22e-4(a)(5), exclude In-Kind ETFs from the classification and highly liquid investment minimum requirements, respectively.

116

See

rule 22e-4(b)(1)(iii) (applying the highly liquid investment minimum requirement only to a fund that does not primarily hold assets that are highly liquid investments).

117

The Commission is adopting a classification framework consisting of four liquidity categories based on the number of days within which it is determined that the investment is reasonably expected to be convertible to cash (or, in the case of the least-liquid categories, sold or disposed of) without the conversion (or, in the case of the least-liquid categories, sale or disposition) significantly changing the market value of the investment. More specifically, as discussed below, rule 22e-4 would require a fund to classify each of its portfolio investments into one of the following liquidity categories:

Highly liquid

investment

(category based on fund's reasonable expectation that an investment can be converted to cash within three business days);

moderately liquid

investment

(category based on fund's reasonable expectation that an investment can be converted to cash within four to seven calendar days);

less liquid

investment

(category based on fund's reasonable expectation that an investment can be sold or disposed of in seven calendar days but the settlement is reasonably expected to be greater than seven calendar days); and

illiquid

investment

(category based on fund's reasonable expectation that an investment cannot be sold or disposed of within seven calendar days).

Rule 22e-4 includes board oversight provisions related to the liquidity risk management program. Specifically, a fund's board will approve, but not design, the fund's liquidity risk management program, as well as the fund's designation of the fund's investment adviser or officers as responsible for administering the day-to-day aspects of the fund's liquidity risk management program.

118

A fund also will be subject to board reporting requirements to the extent that its investments in assets that are highly liquid investments fall below its minimum or its assets that are illiquid investments rise above 15% of its net assets.

119

We anticipate that the new program requirement will result in investor protection benefits, as improved liquidity risk management could decrease the chance that a fund could meet its redemption obligations only with significant dilution of remaining investors' interests or changes to the fund's risk profile.

118

Rule 22e-4(b)(2).

119

Rule 22e-4(b)(1)(iii)(A)(3) and rule 22e-4(b)(1)(iv).

Rule 22e-4, by requiring funds to limit illiquidity and manage liquidity, should reduce the potential likelihood and extent of dilution of non-transacting shareholders that otherwise could result from redemptions effected at prices determined in accordance with rules 22c-1 and 2a-4. Thus, rule 22e-4, although it is numbered with reference to section 22(e), has a broader scope and also should separately help rule 22c-1 operate so as to reduce dilution, as contemplated by sections 22(a) and (c).

Second, we are adopting certain public disclosure- and confidential reporting-related rules and amendments to provide shareholders and other users with additional information with respect to funds' liquidity risk profile as well as assist the Commission in its monitoring efforts. Specifically, we are adopting reporting requirements on Form N-PORT that will require a fund to report monthly position-level liquidity classification information and its highly liquid investment minimum to the Commission on a confidential basis.

120

Form N-PORT will also require a fund to publicly disclose the aggregated percentage of its portfolio representing each of the four classification categories adopted by the Commission as of the end of each of its fiscal quarters.

121

120

We are adopting Form N-PORT today in a companion release.

See

Investment Company Reporting Modernization, Investment Company Act Release No. 32314 (October 13, 2016) (“Investment Company Reporting Modernization Adopting Release”) We discuss the Form N-PORT reporting requirements related to rule 22e-4 in this Release, including the requirements that a fund report: (i) The liquidity classification assigned to each portfolio position (which may be based on asset type to the extent discussed below); (ii) the asset type label that the fund has assigned to each portfolio position, using any asset type labeling scheme the fund employs in its own portfolio management systems; and (iii) the fund's highly liquid investment minimum.

121

This information will be reported monthly on Form N-PORT, but it will be disclosed to the public only for the third month of each fiscal quarter with a 60-day delay.

We are adopting new rule 30b1-10 and Form N-LIQUID to require a fund to confidentially notify the Commission when the fund's illiquid investment holdings exceed 15% of its net assets or if its amount of highly liquid investments declines below its highly liquid investment minimum for more than a brief period of time. We also are adopting amendments to Form N-1A to require a fund to publicly disclose certain information regarding the fund's redemption procedures. Finally, we are adopting requirements for funds to provide information on Form N-CEN about funds' use of lines of credit and interfund lending.

We anticipate that these new requirements will facilitate the Commission's risk and compliance monitoring efforts by providing greater transparency regarding the liquidity characteristics of fund portfolio holdings, as well as its ability to monitor and assess compliance with rule 22e-4. While Form N-PORT and Form N-CEN are primarily designed to assist the Commission, we believe that the requirements to publicly disclose certain information will also help investors and other potential users utilize information on particular funds' liquidity-related risks and redemption policies, which in turn may assist investors in making more informed investment choices.

122

As further discussed below, we believe that these reporting requirements strike the right balance between protecting the funds from certain adverse effects that could arise from public disclosure of detailed portfolio liquidity information with the need to provide shareholders and other users with improved information about funds' liquidity risk profile.

122

See, e.g.,

Comment Letter of Markit on the Notice Seeking Comment on Asset Management Products and Activities, Docket No. FSOC-2014-0001 (Mar. 25, 2015) (“[W]e 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.”).

III. Discussion

A. Program Requirement and Scope of Rule 22e-4

Today the Commission is adopting rule 22e-4 under the Investment Company Act. This rule will require each registered open-end management investment company, including open-end ETFs but not including money market funds, to establish a written liquidity risk management program. Rule 22e-4 will not apply to closed-end funds, and will apply to UITs only to a limited degree, as discussed further below.

1. Liquidity Risk Management Program

Rule 22e-4 generally will require each registered open-end management investment company to establish a written liquidity risk management program. The majority of commenters generally supported the proposed requirement for each fund to adopt a formal, written liquidity risk management program,

123

although many commenters objected to certain aspects of the proposal and suggested modifications to certain proposed program elements, as discussed in more detail below. Other commenters opposed the proposed written program requirement, asserting that funds have a history of successfully managing their liquidity and that the proposed requirement was thus unnecessary.

124

We continue to believe, as discussed in the Proposing Release, that the program requirement will produce significant investor protection benefits, in light of the fact that funds are not currently subject to specific requirements under

the federal securities laws or Commission rules obliging them to manage their liquidity risk. Outreach by Commission staff has identified practices at some funds that raise concerns regarding funds' ability to meet their redemption obligations and lessen the effects of dilution.

125

The Commission is thus adopting, as proposed, a requirement for each fund to adopt and implement a written liquidity risk management program.

126

However, we note that the program requirement we are adopting incorporates modifications to most of the proposed program elements.

127

123

See, e.g.,

Comment Letter of Alternative Investment Management Association (Jan. 13, 2016) (“AIMA Comment Letter”); Comment Letter of Capital Research and Management Company (Jan. 13, 2016) (“CRMC Comment Letter”); Comment Letter of Cohen & Steers (Jan. 13, 2016) (“Cohen & Steers Comment Letter”); Comment Letter of Dechert LLP (Jan. 13, 2016) (“Dechert Comment Letter”); Comment Letter of Fidelity Management & Research Company (Jan. 13, 2016) (“Fidelity Comment Letter”); Comment Letter of Association of the Bar of the City of New York (Jan. 13, 2016) (“NYC Bar Comment Letter”); Comment Letter of Securities Industry and Financial Markets Association (Jan. 13, 2016) (Comments on Proposal to Require Liquidity Risk Management Programs and Related Liquidity Disclosures) (“SIFMA Comment Letter I”); Comment Letter of T. Rowe Price (Jan. 13, 2016) (“T. Rowe Comment Letter”).

124

See

Comment Letter of Cove Street Capital (Oct. 8, 2015) (“Cove Street Comment Letter”); Comment Letter of Jim H. Francis (Nov. 4, 2015); Comment Letter of Jordana Keefer (Jan. 7, 2016) (“Keefer Comment Letter”); Comment Letter of Don G. Powell (Oct. 5, 2015); Comment Letter of John Wahh (Oct. 1, 2015) (“Wahh Comment Letter”).

125

See

Proposing Release,

supra

footnote 9, at section IV.C.1.b.

126

See

rule 22e-4(b).

127

As discussed throughout this Release, we believe that these modifications respond appropriately to specific concerns noted by commenters and help to increase the effectiveness of the program requirement in advancing the Commission's goals, while at the same time reducing associated burdens.

A fund may, as it determines appropriate, expand its liquidity risk management procedures and related disclosure concerning liquidity risk beyond the required program elements.

128

While a fund would be required to adhere to certain requirements—such as the requirement to classify the liquidity of a fund's portfolio investments and determine a highly liquid investment minimum

129

—in other respects, the proposed program requirements would permit each fund to tailor its liquidity risk management program to the fund's particular risks and circumstances. Commenters stressed that many funds are currently engaged in operational practices that are designed to support fund liquidity and the redeemability of fund shares.

130

Commenters also noted that funds' approaches to liquidity risk management should, and currently do, differ markedly depending on their individual risks.

131

We believe that the program requirement will permit funds that already have programs that satisfy the rule requirements to continue to engage in the liquidity risk management practices that they have found to be effective. However, the program requirement's common obligations should strengthen liquidity risk management across the fund industry, while also providing important transparency into funds' liquidity profiles and risk management practices.

128

See supra

footnotes 113-115 and accompanying text for a description of the required program elements.

129

In-Kind ETFs are excepted from the classification and highly liquid investment minimum requirements.

See infra

section III.J. In addition, funds whose portfolios consist primarily of highly liquid investments would not be required to determine a highly liquid investment minimum.

See infra

section III.D.5.

130

See, e.g.,

ICI Comment Letter I; BlackRock Comment Letter; Invesco Comment Letter; Vanguard Comment Letter.

131

See, e.g.,

ICI Comment Letter I; Dechert Comment Letter; Vanguard Comment Letter.

2. Scope of Rule 22e-4 and Related Disclosure and Reporting Requirements

The liquidity risk management program requirements of rule 22e-4, as well as related disclosure and reporting requirements, will apply to all registered open-end funds, except money market funds.

132

Rule 22e-4 will apply to open-end ETFs, but incorporates tailored program requirements to reflect their particular liquidity-related risks.

133

The final rule also excludes from the highly liquid investment minimum requirement funds whose portfolios consist primarily of highly liquid investments. Closed-end funds are excluded from the scope of rule 22e-4,

134

and UITs are not subject to the rule's general program requirement, although each UIT's principal underwriter or depositor will be required to determine, on or before the date of the initial deposit of portfolio securities into the UIT, that the portion of illiquid investments that the UIT holds or will hold at the date of deposit that are assets is consistent with the redeemable nature of the securities it issues.

135

We discuss these scope determinations in more detail below.

132

Although money market funds are excluded from the scope of rule 22e-4, they will be subject to the amendments to Form N-1A and Form N-CEN.

See infra

section III.A.2.a (“Inclusion of Funds with All Investment Strategies and Inclusion of ETFs within the Scope of Rule 22e-4”); section III.A.2.b (“Inclusion of Funds of All Sizes within the Scope of Rule 22e-4”); and section III.A.2.e (“Exclusion of Money Market Funds from the Scope of Rule 22e-4”).

133

See infra

section III.J.

134

See infra

section III.A.2.c (“Exclusion of Closed-End Funds from the Scope of Rule 22e-4”).

135

See infra

section III.K.

a. Inclusion of Funds With All Investment Strategies and Inclusion of ETFs Within the Scope of Rule 22e-4

We are not excluding funds with any particular strategies from the scope of rule 22e-4.

136

We proposed to apply rule 22e-4 to all open-end funds (except money market funds) regardless of the fund's investment strategy, stating that even funds with investment strategies that have historically entailed little liquidity risk could experience liquidity stresses in certain environments.

137

We also stated that different types of funds within the same broad investment strategy could demonstrate different levels of liquidity and relatedly, different levels of liquidity risk.

136

But see infra

section III.D.5 (discussing exclusion of In-Kind ETFs as well as funds that primarily hold highly liquid investments from the highly liquid investment minimum requirement).

137

See

Proposing Release,

supra

footnote 9, at nn.123-125 and accompanying text.

Some commenters expressed concern about the costs of some of the proposed requirements relative to the liquidity risks typically associated with certain investment strategies,

138

as well as concerns about burdensome effects of some particular requirements for certain strategies.

139

Other commenters, however, generally supported a program requirement that applies to all registered open-end funds, regardless of the fund's investment strategy.

140

We believe the modifications to the proposal we are adopting (in particular, changes to the classification requirement and the proposed three-day liquid asset minimum requirement) appropriately address commenters' concerns and reflect support that some commenters provided for a program requirement that applies to all registered open-end funds.

138

See, e.g., infra

footnote 1107 and accompanying text.

139

For example, some commenters expressed concerns about the extent to which the proposed liquidity classification factors were applicable to certain investment strategies, particularly funds that invest in fixed income or other OTC assets (

see, e.g.,

Comment Letter of Federated Investors, Inc. (Jan. 13, 2016) (“Federated Comment Letter”); Comment Letter of Government Finance Officers Association (Jan. 13, 2016) (“GFOA Comment Letter”); Comment Letter of Nuveen Fund Advisors, LLC (Jan. 13, 2016) (“Nuveen Comment Letter”); Comment Letter of OppenheimerFunds (Jan. 13, 2016) (“Oppenheimer Comment Letter”)). Commenters also expressed concerns about the extent to which a three-day liquid asset minimum requirement could impede an index fund's ability to track its index (

see, e.g.,

BlackRock Comment Letter; HSBC Comment Letter; Invesco Comment Letter; SIFMA Comment Letter I).

140

See, e.g.,

CRMC Comment Letter; Comment Letter of Eaton Vance Investment Managers (Jan. 13, 2016) (“Eaton Vance Comment Letter I”).

As noted above, rule 22e-4 will apply to open-end ETFs, although we are adopting certain tailored program requirements for ETFs.

141

Some commenters objected to all or certain proposed program requirements applying to ETFs.

142

We respond in detail to these comments in section III.J below. We note, however, that while ETFs' liquidity risks can differ from the liquidity risks faced by other open-end funds, ETFs still have liquidity-related risks that could affect their shareholders, as well as the broader markets in which they operate. The tailored requirements that we are

adopting for ETFs respond to commenters' suggestions that the Commission tie these funds' liquidity risk management obligations to the particular risks that they face, as well as our assessment of how these funds' risks could most appropriately be addressed.

143

141

We note that rule 22e-4 only applies to ETFs that are structured as open-end funds. For ease of reference, however, unless indicated otherwise, when we refer to ETFs we mean open-end ETFs only.

142

See infra

footnotes 839-841 and accompanying text.

143

See infra

section III.J.

b. Inclusion of Funds of All Sizes Within the Scope of Rule 22e-4

Also, as proposed, we are not excluding any fund from the scope of rule 22e-4 on the basis of size or adopting different liquidity requirements for relatively small funds. As discussed in the Economic Analysis section below, smaller funds tend to demonstrate relatively high flow volatility, and thus we believe they should be subject to the same liquidity risk management requirements as other funds.

144

Conversely, some commenters argued that the proposed classification requirement could unduly burden larger funds by inappropriately making these funds appear to be less liquid than they actually are, and we have incorporated certain modifications to the proposed classification requirement that we believe respond to these concerns, as discussed below.

145

144

See infra

footnote 1160 and accompanying text.

145

See infra

section III.C.3.b.

c. Exclusion of Closed-End Funds From the Scope of Rule 22e-4

As proposed, rule 22e-4 would have excluded closed-end investment companies from the scope of rule 22e-4. As discussed in detail in the Proposing Release, closed-end funds' liquidity needs are different from those of open-end funds, because closed-end funds generally do not issue redeemable securities and are not subject to sections 22(c) and 22(e) of the Investment Company Act.

146

Although closed-end interval funds do have to comply with certain liquidity standards under rule 23c-3 and therefore must manage their liquidity risk, we are not subjecting them to rule 22e-4 because they are already required to adopt written liquidity procedures under rule 23c-3(b)(10)(iii).

147

Closed-end interval funds may be better able to anticipate their liquidity needs than open-end funds because closed-end interval funds do not permit daily redeemability, closed-end interval funds must limit the size and timing of repurchase offers, and rule 23c-3 requires shareholders who wish to tender their shares pursuant to a repurchase offer to provide advance notice thereof to such funds.

148

Commenters uniformly agreed that closed-end funds should be excluded from the scope of rule 22e-4 and we continue to believe that closed-end funds (including closed-end interval funds) should be excluded from the rule's scope.

146

See

Proposing Release,

supra

footnote 9, at nn.132-135 and accompanying text. Certain closed-end funds (“closed-end interval funds”) do elect to repurchase their shares at periodic intervals pursuant to rule 23c-3 under the Investment Company Act.

147

See

Proposing Release,

supra

footnote 9, at n.134.

148

See id.,

at text following n.135.

d. Separate Requirements for UITs Under Rule 22e-4

As proposed, the scope of rule 22e-4 did not include UITs.

149

As adopted today, the rule will require a limited liquidity review under which the UIT's principal underwriter or depositor determines, on or before the date of the initial deposit of portfolio securities into the UIT, that the portion of the illiquid investments that the UIT holds or will hold at the date of deposit that are assets is consistent with the redeemable nature of the securities it issues.

150

UITs and their principal underwriters and depositors will not, however, be subject to any of the rule's other liquidity risk management program requirements.

149

See

Proposing Release,

supra

footnote 9, at section III.A.2.

150

See

rule 22e-4(c). The rule also requires UITs to maintain a record of that determination for the life of the UIT and for five years thereafter.

While one commenter supported excluding UITs from the scope of rule 22e-4,

151

several other commenters argued that ETFs structured as UITs should be subject to the same rule requirements as ETFs structured as open-end funds.

152

We respond in detail to these comments in section III.K below, including discussing how we believe the requirement to determine that a UIT's illiquid investment holdings are consistent with the redeemable nature of the UIT's securities responds to commenters' concerns.

151

See

ICI Comment Letter I.

152

See, e.g.,

Comment Letter of Anonymous (Jan. 13, 2016) (“Anonymous Comment Letter I”); BlackRock Comment Letter.

e. Exclusion of Money Market Funds From the Scope of Rule 22e-4

Finally, as proposed, money market funds are excluded from the scope of rule 22e-4. Money market funds are currently subject to extensive requirements concerning the liquidity of their portfolio assets that are more stringent in many respects than the requirements of rule 22e-4, due to the historical redemption patterns of money market fund investors and the characteristics of the assets held by money market funds.

153

Money market funds also are already subject to broad liquidity-related disclosure and reporting requirements,

154

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

155

For these reasons, we did not include money market funds within the scope of the proposed rule, and commenters uniformly agreed that money market funds should be excluded from the rule's scope.

156

We continue to believe that money market funds should be excluded from the scope of rule 22e-4.

153

See

Proposing Release,

supra

footnote 9, at nn.145-150 and accompanying text.

154

See id.,

at nn.151-152 and accompanying text.

155

See id.,

at nn.153-155 and accompanying text.

156

See, e.g.,

CRMC Comment Letter; Eaton Vance Comment Letter I; ICI Comment Letter I; Comment Letter of Voya Investment Management (Jan. 12, 2016) (“Voya Comment Letter”).

B. Assessment, Management, and Review of Liquidity Risk

Section 22(e) of the Investment Company Act requires a registered investment company

157

to make payment to shareholders for securities tendered for redemption within seven days of their tender.

158

The legislative history of the Act indicates that shareholder dilution was a significant concern of the Act's framers.

159

An open-end fund's ability to pay redeeming shareholders within this seven-day period without significant dilution is directly related to its liquidity. Thus, assessing and managing liquidity risk in a comprehensive manner is critical to an open-end fund's capacity to honor redemption requests within this seven-day period, as well as within any shorter time period disclosed in the fund's prospectus or advertising materials, while mitigating dilution.

157

See supra

footnote 4 and accompanying text.

158

See supra

footnote 36.

159

See supra

footnote 7 and accompanying text.

Today we are adopting a new liquidity risk assessment and management framework for funds. Specifically, rule 22e-4 requires a fund to assess, manage, and periodically review its liquidity risk, considering certain factors as applicable. As discussed in more detail below, the requirements we are adopting incorporate a definition of “liquidity risk” that focuses on whether a fund can meet redemption requests without significant dilution of remaining investors' interests rather than, as proposed, whether the fund can meet redemption requests without materially

affecting the fund's NAV.

160

We are also adopting certain changes to the proposed factors that a fund would consider in assessing and managing its liquidity risk. These changes aim to simplify and streamline the proposed liquidity risk assessment and management factors, and reflect additional considerations that the Commission, along with certain commenters, believes could entail heightened liquidity risk. Notably, the proposed requirement to consider a fund's investment strategy and portfolio liquidity in assessing and managing liquidity risk now incorporates the instruction that this consideration includes whether the investment strategy is appropriate for an open-end fund, as well as whether the strategy involves a relatively concentrated portfolio or large positions in particular issuers.

161

Additionally, the proposed requirement to consider a fund's short-term and long-term cash flow projections has been simplified to eliminate the five separate sub-considerations relevant to this factor that were incorporated in the proposed rule, but which now are discussed as guidance in this Release.

162

160

See infra

section III.B.1.a.

161

See infra

section III.B.2.a.

162

See infra

section III.B.2.b.

We proposed liquidity risk assessment and management program requirements with the primary goals of reducing the risk that funds would be unable to meet redemption and other legal obligations, minimizing dilution, and elevating the overall quality of liquidity risk management across the fund industry while at the same time providing funds with reasonable flexibility to adopt policies and procedures that would be most appropriate to assess and manage their liquidity risk.

163

As we discuss throughout this section, we believe that the modified requirements we are adopting today continue to reflect these goals, while promoting a more efficient and workable framework.

163

See

Proposing Release,

supra

footnote 9, at paragraph following n.261.

1. Definition of “Liquidity Risk”

Rule 22e-4, as adopted today, defines “liquidity risk” as the risk that a fund could not meet requests to redeem shares issued by the fund without significant dilution of remaining investors' interests in the fund.

164

This definition is largely similar to the proposed definition of “liquidity risk,” that is, 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 NAV.

165

However, in response to comments, the revised definition substitutes the phrase “without significant dilution of remaining investors' interests in the fund” for the phrase “without materially affecting the fund's net asset value.” The definition also does not include references to redemption requests that are expected under normal conditions or reasonably foreseeable under stressed conditions. Instead, the final definition simply refers to “requests to redeem.” We believe our modifications to the liquidity risk factors used to assess a fund's liquidity risk, as discussed below, make any reference to market conditions within the definition of liquidity risk unnecessary, confusing, and duplicative.

166

164

When determining whether a fund's liquidity risk will cause significant dilution for purposes of this definition, a fund should consider the impact of liquidity risk on the total net assets of the fund and the adverse consequences such dilution will have on all the fund's remaining shareholders. Furthermore, as discussed above, a fund's inability to meet redemption requests may cause harm to shareholders.

See, e.g., supra

footnotes 81-84 and accompanying text for a discussion of the suspension of shareholder redemptions in the Third Avenue Focused Credit Fund following a period of heavy redemptions that the fund stated reduced the fund's portfolio liquidity.

165

See

proposed rule 22e-4(a)(7);

see also

Proposing Release,

supra

footnote 9, at text accompanying n.255.

166

See

rule 22e-4(b)(1)(i).

a. Evaluating Risk of Significant Dilution of Remaining Investors' Interests

Multiple commenters objected to the proposed inclusion of any NAV-impact standard in the definition of “liquidity risk.” One commenter argued that including the concept of “without materially affecting the fund's net asset value” in the definition of liquidity risk would inappropriately merge liquidity and valuation, which are subject to different regulatory and compliance controls.

167

Many commenters also objected that including such a price concept in the definition of “liquidity risk” would incorrectly indicate that market impact can be accurately identified and measured separate from market price movements generally.

168

These commenters argued that many factors (including market volatility, portfolio composition, and trade execution and activity) influence the price at which a fund transacts in a security as well as the levels of cash the fund holds, and thus it is difficult to identify the effects of the fund's transaction activity on the fund's NAV. Finally, some commenters argued that the inclusion of a NAV-impact standard in the definition of “liquidity risk” could lead investors to believe that appropriate liquidity risk management will protect their investments from declining in value.

169

167

See

SIFMA Comment Letter I.

168

See, e.g.,

Comment Letter of Credit Suisse (Jan. 13, 2016) (“Credit Suisse Comment Letter”); Comment Letter of Dodge & Cox (Jan. 21, 2016) (“Dodge & Cox Comment Letter”); Comment Letter of MFS Investment Management (Jan. 13, 2016) (“MFS Comment Letter”); SIFMA Comment Letter I; Comment Letter of Investment Company Institute (May 17, 2016) (“ICI Comment Letter III”) (encouraging the Commission to adopt a definition of liquidity risk that incorporates language related directly to dilution rather than value impact on the NAV).

169

See, e.g.,

ICI Comment Letter I; MFS Comment Letter; SIFMA Comment Letter I.

While we agree that liquidity and valuation are distinct concepts, we consider these concepts as having certain inter-relationships. First, liquidity risk in an open-end fund inherently involves an assessment of the liquidity of the fund's investments. Common definitions of investment liquidity include consideration of the value impact or costs from trading that investment.

170

Second, our staff has observed in its outreach many occasions when a fund was unwilling to transact

in certain portfolio investments when such sales would yield a price that the fund considered unacceptable.

171

This relationship is clear in the Commission guidelines limiting a fund's investment in illiquid investments. These guidelines specify that an illiquid investment is one that cannot be sold or disposed of within seven days

at approximately the value at which the fund has valued the investment”

(emphasis added).

172

We continue to believe that the inclusion of a conceptual relationship between liquidity and sale price in the definition of “liquidity risk” is appropriate.

173

Such a relationship indicates that liquidity risk involves the risk that a fund will not be able to meet redemption requests under any circumstances, as well as the risk that a fund could meet redemption requests, but only in a manner that adversely affects the fund's non-redeeming shareholders through significant dilution.

174

170

See, e.g.,

Radhakrishnan Gopalan,

et al., Asset Liquidity and Stock Liquidity,

47 J. Fin & Quant. Anal. 333 (2012),

available at

http://apps.olin.wustl.edu/faculty/gopalan/asset_stock_liquidity.pdf

(“An asset is liquid if it can be converted into cash quickly and at a low cost.”); Yakov Amihud & Haim Mendelson,

Liquidity, Asset Prices, and Financial Policy, 47 Fin. Anal. J.

56 (1991),

available at

http://www.jstor.org/stable/4479488?seq=1#page_scan_tab_contents

(“An asset is liquid if it can be bought or sold at the current market price quickly and at low cost.”).

In addition, we note that many funds disclose liquidity risk as a principal investment risk in their prospectuses, and these disclosures often reference possible adverse value impacts from selling fund investments under certain conditions.

See, e.g.,

Schwab Strategic Trust rule 485(b) Registration Statement (June 30, 2016),

available at

https://www.sec.gov/Archives/edgar/data/1454889/000119312516632635/d203200d485bpos.htm

(“Liquidity Risk. The fund may be unable to sell certain securities, such as illiquid securities, readily at a favorable time or price, or the fund may have to sell them at a loss.”); Voya Variable Funds rule 485(b) Registration Statement (May 1, 2016),

available at

https://www.sec.gov/Archives/edgar/data/2664/000119312516562669/d124096d485bpos.htm

(“Liquidity: If a security is illiquid, the [fund] might be unable to sell the security at a time when the [fund's] manager might wish to sell, or at all. Further, the lack of an established secondary market may make it more difficult to value illiquid securities, exposing the [fund] to the risk that the price at which it sells illiquid securities will be less than the price at which they were valued when held by the [fund]. The prices of illiquid securities may be more volatile than more liquid investments. The risks associated with illiquid securities may be greater in times of financial stress. The [fund] could lose money if it cannot sell a security at the time and price that would be most beneficial to the Portfolio.”).

171

That is, the price that a portfolio manager could realistically receive for certain portfolio investments could, in effect, render such investments de facto illiquid if these pricing considerations cause the portfolio manager to refrain from selling them.

See, e.g.,

Third Avenue Temporary Order,

supra

footnote 12 (“On December 9, 2015, after considering the environment the Fund was in and the likelihood that incremental sales of portfolio securities to satisfy additional redemptions would have to be made at prices that would unfairly disadvantage all remaining shareholders, the Board determined that the fairest action on behalf of all shareholders would be to adopt a plan of liquidation.”).

172

See supra

footnote 39 and accompanying text.

173

We also note that several commenters favorably discussed foreign and international regulators' liquidity risk management regimes, including ones that define the concepts of liquid (or illiquid) portfolio assets, as well as funds' liquidity risk, with reference to value impact or a discount that the fund may incur upon sale.

See, e.g.,

Dechert Comment Letter (favorably discussing certain liquidity risk management requirements, including the definition of “liquidity risk,” under the UCITS Directive); ICI Comment Letter I (noting that the Commission could look to other jurisdictions, including the European Union, for support for a principles-based program rule); Invesco Comment Letter (also noting that the UCITS Directive provides a framework for a principles-based liquidity risk management program requirement);

see also

Commission Directive 2010/43/EU, OJ L 176 (2010), at Ch. 1, Art. 3(8) (defining “liquidity risk” as “the risk that a position in the UCITS portfolio cannot be sold, liquidated or closed at limited cost in an adequately short time frame and that the ability of the UCITS to comply at any time with its redemption obligation is thereby compromised”); Ontario Securities Commission, Report on Staff's Continuous Disclosure Review of Mutual Fund Practices Relating to Portfolio Liquidity, OSC Staff Notice 81-727 (June 25, 2015) (definition of “illiquid asset” refers to the “ability to readily dispose of a portfolio asset through a market facility on which public quotations are available at a price that approximates the amount at which the portfolio asset is valued”).

We note as well that U.S. banking regulators have defined “liquidity” as “a financial institution's capacity to meet its cash and collateral obligations at a reasonable cost.” Interagency Policy Statement on Funding and Liquidity Risk Management, 75 FR 13656 (Mar. 22, 2010),

available at

http://www.occ.gov/news-issuances/federal-register/75fr13656.pdf

174

See supra

footnote 79 and accompanying text.

We believe a definition of “liquidity risk” that includes a reference to the value impact from trading portfolio investments should not imply that mutual fund shareholders are guaranteed a protected NAV or that the fund cannot sell investments at a loss due to market risk, credit deterioration, or liquidity risk. Indeed, funds' narrative risk disclosure in their registration statements and other shareholder communications generally should make clear those risks that could adversely affect the fund's NAV, yield, and total return, including liquidity-related risks.

175

However, we believe defining liquidity risk clarifies what funds must manage under rule 22e-4, and, for the reasons discussed above, we believe impacts on valuation may play a significant role in evaluating the ability to effectively meet shareholder redemptions while lessening the effects of dilution.

175

See, e.g.,

Item 4(b) of Form N-1A.

Nonetheless, we agree with commenters that using the proposed specific standard of “materially affecting the fund's NAV” may pose certain challenges. We recognize that it may be difficult to calculate the particular market impact that a fund's transactions in an investment will have on that investment's price, which some commenters suggested was inherent to the proposed standard. There could be other reasons for a fund's NAV fluctuating, separate from the fund's sales of portfolio investments to meet redemption requests as well.

Accordingly, in the final rule we have modified the NAV-impact standard in the definition of “liquidity risk” to substitute the phrase “without significant dilution of remaining investors' interests in the fund” for the phrase “without materially affecting the fund's net asset value.” This revised standard more directly corresponds to the concerns of the Act

176

and rule 22e-4 by focusing on meeting investor redemptions without dilution.

176

See supra

footnote 32and accompanying text for a discussion of the liquidity concerns of the Act.

We also note that commenter interpretations of the term “materially” varied, with some commenters adopting very narrow interpretations

177

of the term and others taking a more broad view.

178

We note that, for purposes of this definition, the term “significant” is not meant to reference slight NAV movements, the causes of which may not be easily distinguishable, nor is it limited only to fire-sale situations. Instead, a fund's liquidity risk management program should focus on the fund's ability to meet redemptions in a manner that does not harm shareholders.

179

In particular, “significant” dilution of remaining investors' interests in the fund can occur at much lower levels of dilution than what would occur in a fire sale situation. We believe “significant” conveys more effectively than “materially” that the definition is not meant to reference slight NAV movements, while avoiding the confusion around the term “mater

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