Open-End Fund Liquidity Risk Management Programs and Swing Pricing; Form N-PORT Reporting

Federal RegisterDec 16, 2022

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SECURITIES AND EXCHANGE COMMISSION

17 CFR Parts 270 and 274

[Release Nos. 33-11130; IC-34746; File No. S7-26-22]

RIN 3235-AM98

Open-End Fund Liquidity Risk Management Programs and Swing Pricing; Form N-PORT Reporting

AGENCY:

Securities and Exchange Commission.

ACTION:

Proposed rule.

SUMMARY:

The Securities and Exchange Commission (“Commission”) is proposing amendments to its current rules for open-end management investment companies (“open-end funds”) regarding liquidity risk management programs and swing pricing. The proposed amendments are designed to improve liquidity risk management programs to better prepare funds for stressed conditions and improve transparency in liquidity classifications. The amendments are also designed to mitigate dilution of shareholders' interests in a fund by requiring any open-end fund, other than a money market fund or exchange-traded fund, to use swing pricing to adjust a fund's net asset value (“NAV”) per share to pass on costs stemming from shareholder purchase or redemption activity to the shareholders engaged in that activity. In addition, to help operationalize the proposed swing pricing requirement, and to improve order processing more generally, the Commission is proposing a “hard close” requirement for these funds. Under this requirement, an order to purchase or redeem a fund's shares would be executed at the current day's price only if the fund, its designated transfer agent, or a registered securities clearing agency receives the order before the pricing time as of which the fund calculates its NAV. The Commission also is proposing amendments to reporting and disclosure requirements on Forms N-PORT, N-1A, and N-CEN that apply to certain registered investment companies, including registered open-end funds (other than money market funds), registered closed-end funds, and unit investment trusts. The proposed amendments would require more frequent reporting of monthly portfolio holdings and related information to the Commission and the public, amend certain reported identifiers, and make other amendments to require additional information about funds' liquidity risk management and use of swing pricing.

DATES:

Comments should be received on or before February 14, 2023.

ADDRESSES:

Comments may be submitted by any of the following methods:

Electronic Comments

• Use the Commission's internet comment form (

https://www.sec.gov/rules/submitcomments.htm

); or

• Send an email to

rule-comments@sec.gov.

Please include File Number S7-26-22 on the subject line.

Paper Comments

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

All submissions should refer to File Number S7-26-22. This file number should be included on the subject line if email is used. To help the Commission process and review your comments more efficiently, please use only one method of submission. The Commission will post all comments on the Commission's website (

https://www.sec.gov/rules/proposed.shtml

). Comments are also available for website viewing and printing in the Commission's Public Reference Room, 100 F Street NE, Washington, DC 20549, on official business days between the hours of 10 a.m. and 3 p.m. Operating conditions may limit access to the Commission's Public Reference Room. All comments received will be posted without change. Persons submitting comments are cautioned that we do not redact or edit personal identifying information from comment submissions. You should submit only information that you wish to make available publicly.

Studies, memoranda, or other substantive items may be added by the Commission or staff to the comment file during this rulemaking. A notification of the inclusion in the comment file of any such materials will be made available on our website. To ensure direct electronic receipt of such notifications, sign up through the “Stay Connected” option at

www.sec.gov

to receive notifications by email.

FOR FURTHER INFORMATION CONTACT:

Mykaila DeLesDernier, Y. Rachel Kuo, James Maclean, Nathan R. Schuur, Senior Counsels; Angela Mokodean, Branch Chief; Brian M. Johnson, Assistant Director, at (202) 551-6792 or

IM-Rules@sec.gov,

Investment Company Regulation Office, Division of Investment Management, Securities and Exchange Commission, 100 F Street NE, Washington, DC 20549-8549.

SUPPLEMENTARY INFORMATION:

The Commission is proposing to amend the following rules and forms:

15 U.S.C. 80a-1

et seq.

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 part 270].

15 U.S.C. 77a

et seq.

Commission reference

CFR citation

(17 CFR)

Investment Company Act of 1940 (“Act” or “Investment Company Act”):

Rule 22c-1

§ 270.22c-1.

Rule 22e-4

§ 270.22e-4.

Rule 30b1-9

§ 270.30b1-9.

Rule 31a-2

§ 270.31a-2.

Form N-PORT

§ 274.150.

Form N-CEN

§ 274.101.

Securities Act of 1933 (“Securities Act”)

and Investment Company Act:

Form N-1A

§§ 239.15A and 274.11A.

Table of Contents

I. Introduction

A. Open-End Funds and Existing Regulatory Framework

1. Liquidity Risk Management

2. Swing Pricing

B. March 2020 Market Events

C. Rulemaking Overview

II. Discussion

A. Amendments Concerning Funds' Liquidity Risk Management Programs

1. Amendments to the Classification Framework

2. Highly Liquid Investment Minimums

3. Limit on Illiquid Investments

B. Swing Pricing

1. Proposed Swing Pricing Requirement

2. Amendments to Swing Threshold Framework

3. Determining Flows

4. Swing Factors

C. Hard Close

1. Purpose and Background

2. Pricing Requirements

3. Effects on Order Processing, Intermediaries and Investors, and Certain Transaction Types

4. Other Proposed Amendments to Rule 22c-1

5. Amendments to Form N-1A

D. Alternatives to Swing Pricing and a Hard Close Requirement

1. Alternatives to Swing Pricing

2. Alternatives to a Hard Close

3. Additional Illustrative Examples

E. Reporting Requirements

1. Amendments to Form N-PORT

2. Amendments to Form N-CEN

F. Technical and Conforming Amendments

G. Exemptive Order Rescission and Withdrawal of Commission Staff Statements

H. Transition Periods

III. Economic Analysis

A. Introduction

B. Baseline

1. Regulatory Baseline

2. Overview of Certain Industry Order Management Practices

3. Liquidity Externalities in the Mutual Fund Sector

4. Affected Entities

C. Benefits and Costs of the Proposed Amendments

1. Liquidity Risk Management Program

2. Swing Pricing

3. Hard Close Requirement

4. Commission Reporting and Public Disclosure

D. Effects on Efficiency, Competition, and Capital Formation

1. Efficiency

2. Competition

3. Capital Formation

E. Alternatives

1. Liquidity Risk Management

2. Swing Pricing

3. Hard Close Requirement

4. Commission Reporting and Public Disclosure

F. Request for Comment

IV. Paperwork Reduction Act

A. Introduction

B. Rule 22e-4

C. Rule 22c-1

D. Form N-PORT

E. Form N-1A

F. Form N-CEN

G. Request for Comment

V. Initial Regulatory Flexibility Analysis

A. Reasons for and Objectives of the Proposed Actions

B. Legal Basis

C. Small Entities Subject to the Amendments

D. Projected Reporting, Recordkeeping, and Other Compliance Requirements

1. Liquidity Risk Management Programs

2. Swing Pricing

3. Hard Close

4. Reporting Requirements

E. Duplicative, Overlapping, or Conflicting Federal Rules

F. Significant Alternatives

G. General Request for Comment

VI. Consideration of Impact on the Economy

Statutory Authority

I. Introduction

When the Investment Company Act was enacted, a primary concern was the potential for dilution of shareholders' interests in open-end investment companies.

In addition, the ability of shareholders to redeem their shares in an investment company on demand is a defining feature of open-end investment funds.

Section 22 of the Act reflects these concerns and priorities. For example, section 22(c) gives the Commission broad powers to regulate the pricing of redeemable securities for the purpose of eliminating or reducing so far as reasonably practicable any dilution of the value of outstanding fund shares.

Section 22(e) of the Act establishes a shareholder right of prompt redemption in open-end funds by requiring such funds to make payments on shareholder redemption requests within seven days of receiving the 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), at 37, 137-145 (stating that among the abuses that served as a backdrop for the Act were practices that 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) (statements of Commissioner Healy and Mr. Bane).

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 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

section 22 of the Act; rule 22c-1.

Section 22(c) of the Act authorizes the Commission to make rules and regulations applicable to registered investment companies and to principal underwriters of, and dealers in, the redeemable securities of any registered investment company related to the method of computing purchase and redemption prices of redeemable securities for the purpose of eliminating or reducing so far as reasonably practicable any dilution of the value of other outstanding securities of the fund or any other result of the purchase or redemption that is unfair to investors in the fund's other outstanding securities.

See also supra

note 9 and accompanying text (discussing an estimated number of Americans who invest in mutual funds).

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.”).

While the Act requires open-end funds to pay redemptions within seven days, as a practical matter most investors expect to receive redemption proceeds in fewer than seven days. For example, many mutual funds represent in their prospectuses that they will pay redemption proceeds on the next business day after the redemption. In addition, open-end funds redeemed through broker-dealers must meet redemption requests within two business days because of rule 15c6-1 under the Exchange Act, which establishes a two-day (T+2) settlement period for trades effected by broker-dealers.

The Commission has proposed to amend rule 15c6-1 to establish a T+1 settlement period for broker-dealer trades.

See

Shortening the Securities Transaction Settlement Cycle, Exchange Act Release No. 34-94196 (Feb. 9, 2022) [87 FR 10436 (Feb. 24, 2022)].

In terms of pricing, an order to purchase or redeem fund shares must receive a price based on the current NAV next computed after receipt of the order.

Open-end funds typically calculate their NAVs once a day. Purchase and redemption requests submitted throughout the day receive the NAV calculated at the end of that day, which is typically calculated as of 4 p.m. ET.

These provisions are designed to promote equitable treatment of fund shareholders when buying and selling fund shares.

Rule 22c-1 under the Act. The process of calculating or “striking” the NAV of the fund's shares on any given trading day is based on several factors, including the market value of portfolio securities, fund liabilities, and the number of outstanding fund shares, among others. Rule 2a-4 requires, when determining the NAV, that funds reflect changes in holdings of portfolio securities and changes in the number of outstanding shares resulting from distributions, redemptions, and repurchases no later than the first business day following the trade date. As indicated in the adopting release for rule 2a-4, this calculation method provides funds with additional time and flexibility to incorporate last-minute portfolio transactions into their NAV calculations on the business day following the trade date, rather than on the trade date.

See

Adoption of Rule 2a-4 Defining the Term “Current Net Asset Value” in Reference to Redeemable Securities Issued by a Registered Investment Company, Investment Company Act Release No. 4105 (Dec. 22, 1964) [29 FR 19100 (Dec. 30, 1964)].

Commission rules do not require that a fund calculate its NAV at, or as of, a specific time of day. Current NAV must be computed at least once daily, subject to limited exceptions, Monday through Friday, at the pricing time set by the board of directors.

See

rule 22c-1(b)(1).

A characteristic of open-end funds is that fund shareholders share the gains and losses of the fund, as well as the costs. As a result, there are circumstances in which the transaction activity of certain investors leads to costs that are distributed across all shareholders, unfairly reducing the value (or “diluting”) the interests of shareholders who did not engage in the underlying transactions. For example, while redemption orders receive the next computed NAV, the fund may incur costs on subsequent days to meet those redemptions, because the fund may engage in trading activity and make other changes in its portfolio holdings over multiple business days following the redemption order. As a result, the costs of providing liquidity to redeeming investors can be borne by the remaining investors in the fund and dilute the interests of non-redeeming shareholders. Similarly, when shareholders purchase shares in the fund, costs may arise when the fund buys portfolio investments to invest the proceeds of the purchase, and the fund and its shareholders may bear those costs in days following the purchase request, diluting the interests of the non-purchasing shareholders.

Transaction costs associated with redemptions or purchases can vary. The less liquid the fund's portfolio holdings, the greater the liquidity costs associated with redemption and purchase activity can become and the greater the possibility of dilution effects on fund shareholders. For example, during times of heightened market volatility and wider bid-ask spreads for the fund's underlying holdings, selling fund investments to meet investor redemptions results in greater costs to the fund. Moreover, funds also incur transaction costs outside of stressed periods. Although these costs would generally be smaller than in times of heighted market volatility, they also are borne by fund investors and, particularly over time, also can result in dilution.

In times of liquidity stress, there may be incentives for shareholders to redeem fund shares quickly to avoid further losses, to redeem fund shares for cash in times of uncertainty, or to obtain a “first-mover” advantage by avoiding anticipated trading costs and dilution associated with other investors' redemptions. This perceived advantage may lead to increasing outflows, further exacerbating the effect on remaining shareholders and incentivizing increased shareholder redemptions. Whether investors redeem because they need cash or want to capitalize on a first-mover advantage, the remaining investors in the fund may, particularly in times of stress, experience dilution of their interests in the fund.

1. Liquidity Risk Management

In 2016, the Commission adopted rule 22e-4 under the Act (the “liquidity rule”) to require open-end funds to adopt and implement liquidity risk management programs. Rule 22e-4 was designed to address concerns that open-end funds investing in less liquid securities may have difficulty meeting redemption requests without significant dilution of remaining investors' interests in the fund.

Rule 22e-4 requires: (1) assessment, management, and periodic review of a fund's liquidity risk; (2) classification of the liquidity of each of a fund's portfolio investments into one of four prescribed categories—ranging from highly liquid investments to illiquid investments—including at-least-monthly reviews of these classifications; (3) determination and periodic review of a highly liquid investment minimum for certain funds; (4) limitation on illiquid investments; and (5) board oversight.

See

Liquidity Rule Adopting Release,

supra

note 8, at section II.B.

Funds are also subject to related reporting requirements. For example, funds must report the liquidity classifications of their holdings confidentially to the Commission on Form N-PORT. A fund also must immediately report to the Commission on Form N-RN and to the fund's board if its portfolio becomes more than 15% illiquid, as well as if the fund breaches a highly liquid investment minimum

established as part of its liquidity risk management program for seven consecutive days.

While the compliance dates for specific provisions of rule 22e-4 varied, most funds were required to be in compliance with all requirements of the rule in 2019.

Form N-RN was previously titled Form N-LIQUID.

See

Use of Derivatives by Registered Investment Companies and Business Development Companies, Investment Company Act Release No. 34084 (Nov. 2, 2020) [85 FR 83162 (Dec. 21, 2020)] (“Derivatives Adopting Release”).

Small entities were required to be in compliance with the reporting requirements under Form N-PORT by Mar. 1, 2020.

See

Investment Company Liquidity Disclosure, Investment Company Act Release No. 33142 (June 28, 2018) [83 FR 31859 (July 10, 2018)] (“2018 Liquidity Disclosure Adopting Release”).

In 2018, the Commission adopted amendments designed to improve the reporting and disclosures of liquidity information by open-end funds.

These amendments modified certain aspects of the liquidity framework by requiring funds to disclose information about the operation and effectiveness of their liquidity risk management program in their shareholder reports instead of requiring funds to disclose aggregate liquidity classifications publicly in Form N-PORT.

Since that time, some individual investors have stated that they care about being able to redeem but do not need narrative information about how a fund manages its liquidity, while some other commenters have suggested that aggregate liquidity classifications would be more helpful than narrative shareholder report disclosure.

We recently removed the narrative disclosure requirement because, in practice, it did not meaningfully augment other information already available to shareholders.

Id.

The Commission also adopted amendments to Form N-PORT to allow funds classifying the liquidity of their investments pursuant to their liquidity risk management programs to report multiple liquidity classification categories for a single position under specified circumstances.

See

2018 Liquidity Disclosure Adopting Release,

supra

note 22.

See infra

notes 303 to 305 and accompanying text (discussing these comments in more detail).

See

Tailored Shareholder Reports for Mutual Funds and Exchange-Traded Funds; Fee Information in Investment Company Advertisements, Investment Company Act Release No. 34731 (Oct. 26, 2022) (“Tailored Shareholder Reports Adopting Release”) at nn.462-472 and accompanying text.

When the Commission adopted the 2018 amendments, it stated that Commission staff would continue to monitor and solicit feedback on the implementation of the liquidity framework and inform the Commission what steps, if any, the staff recommends in light of this monitoring.

The Commission stated its expectation that this evaluation would take into account at least one full year's worth of liquidity classification data from large and small entities to allow funds and the Commission to gain experience with the classification process and to allow analysis of its benefits and costs based on actual practice. As discussed below, we have had the opportunity since the adoption of these amendments to evaluate the liquidity framework while taking into account the data available to us regarding funds' liquidity risk management programs.

We discuss our evaluation of the current liquidity framework throughout this release.

See

2018 Liquidity Disclosure Adopting Release,

supra

note 22, at paragraph accompanying n.125.

See infra

sections I.B and II.A.

2. Swing Pricing

In 2016, the Commission adopted a rule permitting registered open-end funds (except money market funds or ETFs), under certain circumstances, to use swing pricing, which is the process of adjusting the price above or below a fund's NAV per share to effectively pass on the costs stemming from shareholder purchase or redemption activity to the shareholders associated with that activity.

When a shareholder purchases or redeems fund shares, the price of those shares does not typically account for the transactions costs, including trading costs and changes in market prices, that may arise when the fund buys portfolio investments to invest proceeds from purchasing shareholders or sells portfolio investments to meet shareholder redemptions.

Swing pricing is an investor protection tool currently available to funds to mitigate potential dilution and manage fund liquidity as a result of investor redemption and purchase activity.

Swing Pricing Adopting Release,

supra

note 11; rule 22c-1(a)(3).

See

Swing Pricing Adopting Release,

supra

note 11, at section II.A.1.

The 2016 swing pricing rule requires that, for funds choosing to use swing pricing, the fund's NAV is adjusted by a specified amount (the “swing factor”) once the level of net purchases into or net redemptions from the fund has exceeded a specified percentage of the fund's NAV (the “swing threshold”). A fund's swing factor is permitted to take into account only the near-term costs expected to be incurred by the fund as a result of net purchases or net redemptions on that day and may not exceed an upper limit of 2% of the NAV per share. The rule also requires a fund that uses swing pricing to adopt swing pricing policies and procedures that specify the process for determining the fund's swing factor and swing threshold. The fund's board must approve the fund's swing pricing policies and procedures, the fund's swing factor upper limit, and the swing threshold. The board also must review a written report on the adequacy and effectiveness of the fund's swing pricing policies and procedures at least annually.

In the time since the adoption of the rule, no U.S. funds have implemented swing pricing. While swing pricing has been a commonly employed anti-dilution tool in Europe, including among U.S.-based fund managers that also operate funds in Europe, U.S. funds face unique operational obstacles in its implementation. When considering the adoption of the 2016 swing pricing rule, the Commission received comment letters articulating the operational issues that funds may encounter if they implemented swing pricing.

In response to the concerns raised by commenters, the Commission adopted an extended effective date to allow for the creation of industry-wide operational solutions to facilitate the implementation of swing pricing more effectively. In that release, the Commission stated that it had directed Commission staff to review, two years after the rule's effective date, market practices associated with funds' use of swing pricing to mitigate dilution and to provide the Commission with the results of its review.

Since that time, we have evaluated market practices associated with funds' lack of use of swing pricing, and this release reflects that evaluation. Despite over five years passing since adoption, the industry has not developed an operational solution to facilitate implementation of swing pricing, nor have individual market participants.

See

Comment Letter of BlackRock on Open-End Fund Liquidity Risk Management Programs; Swing Pricing; Re-Opening of Comment Period for Investment Company Reporting Modernization Release, Investment Company Act File No. 31835 (Sep. 22, 2015) [80 FR 62274 (Oct. 15, 2015)] (“2015 Proposing Release”), File No. S7-16-15; Comment Letter of Dodge & Cox on 2015 Proposing Release, File No. S7-16-15; Comment Letter of Pacific Investment Management Company LLC on 2015 Proposing Release, File No. S7-16-15; Comment Letter of Securities Industry and Financial Markets Association on 2015 Proposing Release, File No. S7-16-15. The comment file for the 2015 Proposing Release, where these comment letters can be accessed, is

available at https://www.sec.gov/comments/s7-16-15/s71615.shtml.

See

Swing Pricing Adopting Release,

supra

note 11, at section II.A.1.

After the Commission adopted the current swing pricing rule, the industry formed working

groups to explore potential operational solutions to facilitate funds' ability to implement swing pricing.

See

Evaluating Swing Pricing: Operational Considerations, Addendum (June 2017),

available at https://www.ici.org/system/files/attachments/ppr_17_swing_pricing_summary.pdf

(“2017 ICI Swing Pricing White Paper”).

We understand that the industry has been unable to develop an operational solution to implement swing pricing largely because funds currently are unable to obtain sufficient fund flow information before they finalizes their NAVs, a necessary precursor to determining whether a fund needs to use swing pricing on any particular day. Generating fund flow information involves a broad network of market participants with multiple layers of systems, including, among others, funds, transfer agents, broker-dealers, retirement plan recordkeepers, banks, and the National Securities Clearing Corporation (“NSCC”). In general, many mutual funds use prices as of 4 p.m. ET (or the “pricing time”) to value the funds' underlying holdings for purposes of computing their NAVs for the current day. This time is established by the fund's board of directors. Typically, investors may place orders to purchase or redeem mutual fund shares with the fund's transfer agent or with intermediaries as late as 3:59 p.m. ET for execution at that day's NAV. When the transfer agent or an intermediary receives an order before the pricing time, that order typically receives that day's price. An investor who submits an order after the pricing time must receive the next day's price.

While some investors may place orders by opening an account directly with the fund's transfer agent, we understand that the majority of mutual fund orders are placed with intermediaries, such as broker-dealers, banks, and retirement plan recordkeepers.

Some intermediaries do not transmit flow details to the fund's transfer agent or the clearing agency until after the fund has finalized its NAV calculation and disseminated the NAV to pricing vendors, media, and intermediaries (“NAV dissemination”). NAV dissemination tends to occur between 6 p.m. ET and 8 p.m. ET. Indeed, the fund's transfer agent or the clearing agency often do not receive a significant portion of orders until after midnight—

i.e.,

the next day.

This contributes to a mismatch between the extent of flow information funds require to implement swing pricing and the flow information funds currently have before the pricing time. For example, based on staff outreach, we understand that some funds receive only around half of their daily volume by 6 p.m. ET.

We are also aware of a separate review of funds' receipt of flow data for a quarter in 2016, which found that only 70% of actual and estimated trade flow could be delivered by 6 p.m. ET.

Without sufficient actual or estimated flow information before the fund finalizes its NAV, funds cannot implement swing pricing because the determination of whether to swing the fund's NAV depends on the size of net flows.

In 2021, an estimated 18% of U.S. households owning mutual funds purchased them directly from the mutual fund company.

See

2022 ICI Fact Book,

supra

note 9, at Figure 7.8.

NSCC currently is the only registered clearing agency for fund shares. A significant portion of mutual fund orders are processed through NSCC's Fund/SERV platform.

See

Depositary Trust and Clearing Corporation 2021 Annual Report,

available at https://www.dtcc.com/annuals/2021/performance/dashboard

(stating that the value of transactions Fund/SERV processed in 2021 was $8.5 trillion and the volume for this period was 261 million transactions). A part of the platform, referred to as Defined Contribution Clearance & Settlement, focuses on purchase, redemption, and exchange transactions in defined contribution and other retirement plans. This service handled a volume of nearly 154 million transactions in 2021.

See id.

We understand based on staff outreach that the time by which a fund receives flow information varies to some extent based on the fund's investor base. For example, funds with large investments by retirement plans generally receive a larger portion of their flow information after 6 p.m. ET than other funds.

See

2017 ICI Swing Pricing White Paper,

supra

note 33 (stating that, for instance, intermediaries trading via traditional Fund/SERV, such as traditional brokerage and managed account activity, transmit orders to the fund by 7 p.m. ET but, with system and procedural enhancements, processing and submission of orders as actual trades might be able to occur prior to 6 p.m. ET). This paper also suggested that 90% to 100% of trade flow (actual or estimated) is required to apply swing pricing between 4 p.m. and 6 p.m. ET.

B. March 2020 Market Events

In March 2020, at the onset of the COVID-19 pandemic in the United States, most segments of the open-end fund market witnessed large-scale investor outflows. Investors' concerns about the potential impact of the COVID-19 pandemic led investors to reallocate their assets into cash and short-dated, near-cash investments.

The resulting outflows from many open-end funds placed pressure on these funds to generate liquidity quickly in order to meet investor redemptions. Equity and debt security prices fell as yields rose. Uncertainty throughout the U.S. economy and asset-price volatility rose, and credit spreads and bid-ask spreads widened.

The large outflows open-end funds faced during March 2020, combined with the widening bid-ask spreads funds encountered when purchasing or selling portfolio investments at that time, likely contributed to dilution of the value of funds' shares for remaining investors.

See

SEC Staff Report on U.S. Credit Markets Interconnectedness and the Effects of the COVID-19 Economic Shock (Oct. 2020) (“SEC Staff Interconnectedness Report”), at 17 to 18,

available at

https://www.sec.gov/files/US-Credit-Markets_COVID-19_Report.pdf

. Staff reports and other staff documents (including those cited herein) represent the views of Commission staff and are not a rule, regulation, or statement of the Commission. The Commission has neither approved nor disapproved the content of these documents and, like all staff statements, they have no legal force or effect, do not alter or amend applicable law, and create no new or additional obligations for any person.

See id.,

at 3 and 6 to 8 (discussing that the market structure of certain segments of the credit market contributed to market stress in Mar. 2020, including reduced dealer inventories and reluctance to accommodate customer demand in some cases). On Apr. 1, 2020, the Board of Governors of the Federal Reserve System (“Federal Reserve”) made a temporary change to its supplementary leverage ratio rule to allow banking organizations to expand their balance sheets as appropriate to continue to serve as financial intermediaries, stating that the rule's regulatory restrictions may constrain the firms' ability to continue to serve as financial intermediaries and to provide credit to households and businesses in the face of rapid deteriorations in Treasury market liquidity conditions and significant inflows of customer deposits and increased reserve levels.

See

Federal Reserve Board Announces Temporary Changes to its Supplementary Leverage Ratio Rule to Ease Strains in the Treasury Market Resulting from the Coronavirus and Increase Banking Organizations' Ability to Provide Credit to Households and Businesses (Apr. 1, 2020),

available at https://www.federalreserve.gov/newsevents/pressreleases/bcreg20200401a.htm.

We do not have specific data about the dilution fund shareholders experienced in Mar. 2020 because funds do not report information about their trading activity and the prices at which they purchase and sell each instrument. However, European funds experienced similar market conditions as U.S. funds and, to mitigate dilution during this period, many European funds increased their use of swing pricing and the size of their swing factors.

See infra

paragraph accompanying note 60. European funds are subject to regulatory regimes that differ in some respects from the U.S. regime for open-end funds. We are not aware, however, of differences between the regimes that would have significantly reduced dilution for U.S. funds relative to European funds during this period, such that European funds needed to use swing pricing to mitigate dilution that U.S. funds were not experiencing due to regulatory or other differences.

Open-end funds are a large and important component of U.S. markets. At the end of 2019, assets in open-end funds totaled $21 trillion.

Fixed-income funds accounted for $5.3 trillion, or 25% of total open-end fund assets.

Bank loan assets were nearly $100 billion, or less than 2% of total fixed-income fund assets. At the end of March 2020, following the height of the COVID-19 related market stress, assets in open-end funds (including ETFs) fell

Of this amount, ETFs had assets of $4.4 trillion and other open-end funds had assets of $16.4 trillion. Money market funds and funds of funds are excluded from calculations relating to the size and redemptions of open-end funds.

Fixed-income funds, excluding ETFs, had assets of $4.5 trillion, and fixed-income ETFs had assets of $800 billion.

17% ($3.6 trillion) from $20.8 trillion in December 2019 to a total of $17.2 trillion. Assets of open-end funds excluding ETFs fell 18% ($2.9 trillion) from $16.4 trillion to $13.5 trillion, and ETF assets fell 17% (approximately $760 billion) from $4.4 trillion to $3.7 trillion. Of this amount, fixed-income mutual fund assets fell 5.5%, although fixed-income ETFs' assets increased slightly.

In addition, bank loan fund assets fell by 30% in March 2020, or from $100 billion to $70 billion, compared to the level of assets reported in December 2019.

Fixed-income funds, excluding ETFs, had assets of approximately $4.1 trillion, while fixed-income ETFs' assets increased slightly from Dec. 2019 levels to $830 billion.

EP16DE22.002

The market disruptions of the March 2020 period included significant redemption activity in open-end funds.

Throughout 2019, net flows into open-end funds averaged approximately $32.4 billion, or 0.2% per month.

During this same period, fixed-income funds experienced a steady inflow of approximately $41.7 billion, or 0.9% per month on average.

In March 2020, however, open-end funds had outflows totaling $329.4 billion, or 1.7% of prior period assets.

The majority of these outflows were from fixed-income funds, which had $286.6 billion in outflows.

Taxable bond funds had outflows of $241.7 billion (or 5.2% of prior period assets), of which, bank loan funds had outflows of $12.4 billion (or 13.4% of prior period assets in these funds).

Municipal bond funds had $44.9 billion in outflows (or 4.9% of prior period assets).

Open-end funds also experienced heightened outflows in other stressed periods, such as the last quarter of 2008, but outflows in March 2020 surpassed those witnessed in these other periods. For example, during the last quarter of 2008, investors withdrew $65 billion from bond funds. Total outflows for bond funds during this period never exceeded 1.5% of total net assets.

See

ICI, 2009 Investment Company Fact Book, Figure 2.10 and accompanying text,

available at

https://www.ici.org/system/files/attachments/2009_factbook.pdf

(calculating net flows as a three-month moving average of net flows as a percentage of previous month-end assets, and excluding high yield bond funds).

Open-end funds (excluding ETFs) had average net flows of approximately $4.8 billion (or 0.04% per month). ETFs had average net flows of approximately $27.7 billion (or 0.7% per month).

Fixed-income funds (excluding ETFs) had inflows of $28.8 billion (or 0.7% per month on average). Fixed-income ETFs had inflows of $12.5 billion (or 1.7% per month on average).

Open-end funds (excluding ETFs) had outflows totaling $336.8 billion, or 1.7% of prior period assets. ETFs had inflows totaling $7.3 billion, or 2% of prior period assets. The majority of ETF inflows were for equity ETFs, which had $14.7 billion in inflows. Allocation, alternative, commodity, and miscellaneous/other ETFs had inflows of $13.2 billion. The inflows into some types of ETFs were partially offset by outflows of $20.6 billion from fixed-income ETFs.

Open-end funds (excluding ETFs) had outflows of approximately $266 billion, and ETFs had outflows of approximately $20.6 billion.

For open-end funds (excluding ETFs) this included outflows of $223.3 billion (5.9%) for taxable bond funds (of which, bank loan funds had outflows of $11.4 billion (13.6%)). For ETFs this included outflows of $18.4 billion (2.2%) for taxable bond ETFs (of which, bank loan ETFs had outflows of approximately $1 billion (11.2%))

For open-end funds (excluding ETFs) this included outflows of $42.6 billion (5%) for municipal bond funds. For ETFs this included outflows of $2.2 billion (4.3%) for municipal bond ETFs.

EP16DE22.003

During the period of market turmoil, bid-ask spreads spiked by as much as 100 basis points for high-yield bonds and 150-200 basis points for investment-grade bonds.

In general, the bond market and bank loan market experienced significant price declines in March 2020. The price for 10 year U.S. Treasuries increased by roughly 4.6%. The price of corporate bonds declined by 7%.

The price of leveraged loans decreased by roughly 13%.

The heightened volatility and demand for liquidity drove stress throughout the market, particularly in the bond fund and bank loan fund markets. Price declines were not limited to these markets, however. For example, the price for U.S. small cap equities decreased by roughly 24%.

See

SEC Staff Interconnectedness Report,

supra

note 38, at 37.

The decline in the price of corporate bonds is measured by the BBG U.S. Corporate Bond Index.

The decline in the price of leveraged loans was measured by the S&P Leveraged Loan Price Index.

The decline in the price of U.S. small cap equities was measured by the Russell 2000 Total Return Index.

Beginning in mid-March 2020, the Federal Reserve, with the approval of the Department of the Treasury, used its emergency powers to intervene by providing timely and sizable interventions in an effort to stabilize the markets. The official sector interventions included, among others, the Secondary Market Corporate Credit Facility, introduced on March 23, 2020. This facility supported market liquidity by purchasing in the secondary market corporate bonds issued by investment grade U.S. companies, as well as U.S.-listed ETFs whose investment objective is to provide broad exposure to the market for U.S. corporate bonds.

See, e.g.,

Press Release, Federal Reserve Announces Extensive New Measures to Support the Economy (Mar. 23, 2020),

available at https://www.federalreserve.gov/newsevents/pressreleases/monetary20200323b.htm; https://www.federalreserve.gov/monetarypolicy/smccf.htm

(describing the Secondary Market Corporate Credit Facility in particular).

After the Federal Reserve announced that it would be using its emergency powers for official sector interventions, market stress relating to the COVID-19 pandemic began to subside. Assets in open-end funds, including fixed income funds, began to increase. By December 2020, open-end fund assets had increased to $24 trillion, with fixed-income funds (excluding ETFs) reaching $6 trillion in assets, and fixed-income ETFs surpassing $1 trillion in assets.

Bank loan fund assets remained essentially unchanged, however, from March 2020 levels and remained at $68 billion.

From Apr. to Dec. 2020, fixed-income funds averaged $75 billion in inflows, or 1.4% per month. Ultrashort and short-term bond funds experienced average monthly inflows of $16 billion and 2% of assets over this period.

Other Observations From March 2020

Beyond data evidencing the liquidity stress funds faced in March 2020, we also observed the stress through staff outreach to the industry. During this period, fund managers discussed their liquidity concerns with Commission staff and the potential need for emergency relief. Fund managers explored various emergency relief actions. For example, some fund managers requested emergency relief that would provide additional flexibility for interfund lending and other short-term funding to help meet redemptions, which the Commission provided.

Some managers suggested emergency relief to permit funds to impose redemption fees that exceed 2% to mitigate dilution, including fees that ETFs can charge authorized participants to cover liquidity and transaction costs.

Some fund managers that have successfully used swing pricing in Europe urged the Commission to explore emergency actions to facilitate funds' ability to operationalize the Commission's current swing pricing rule. Some fund managers also suggested there was a need for Federal Reserve interventions. These discussions indicated that fund managers sought additional means to quickly address liquidity and dilution concerns during this period of financial stress.

See

Order Under Sections 6(c), 12(d)(1)(J), 17(b), 17(d) and 38(b) of the Investment Company Act of 1940 and Rule 17d-1 Thereunder Granting Exemptions from Specified Provisions of the Investment Company Act and Certain Rules Thereunder, Investment Company Act Release No. 33821 (Mar. 23, 2020),

available at https://www.sec.gov/rules/other/2020/ic-33821.pdf.

Although the Commission provided this relief for a period of time, we understand funds generally did not use it.

ETFs typically externalize the costs associated with purchases and redemptions of shares by redeeming in kind and by charging a fixed and/or variable fee to authorized participants to offset both transfer and other transaction costs that an ETF (or its service provider) may incur, as well as brokerage, tax-related, foreign exchange, execution, market impact, and other costs and expenses related to the execution of trades resulting from such transaction. The amount of these fixed and variable fees typically depends on whether the authorized participant effects transactions in kind or with cash and is related to the costs and expenses associated with transactions effected in kind versus in cash. For example, when an authorized participants redeems ETF shares by selling a creation unit to the ETF, the fees that the ETF imposes defray the costs of liquidity the redeeming authorized participant receives. This, in turn, mitigates the risk of diluting non-redeeming authorized participants when an ETF redeems its shares.

During these conversations, several fund managers with operations in both the U.S. and Europe discussed their experience with swing pricing in Europe and indicated that swing pricing would have been a useful tool for U.S. funds to have had in March 2020. Swing pricing was widely used in several European jurisdictions during the March 2020 stressed period to reduce dilution from rising transaction costs.

In these jurisdictions, some funds used partial swing pricing (where a NAV adjustment occurs only if net flows exceed a swing threshold), some funds used full swing pricing (where a NAV adjustment occurs any time a fund has net inflows or net outflows), and some funds did not use swing pricing. Many European funds increased their use of swing pricing and increased the size of their swing factors during the stressed period. For example, a voluntary survey conducted by the Bank of England and Financial Conduct Authority of a subset of fund managers in the United Kingdom (“UK”) indicated that the use of swing pricing more than doubled from the last quarter of 2019 to the first quarter of 2020.

Due to increasing transaction costs, several European funds lowered their swing thresholds in March 2020, with some moving to full swing pricing for net redemptions.

Funds also increased the size of their swing factors to account for the increase in liquidity and transaction costs. For example, a survey of Luxembourg UCITS found that while the average swing factor for the survey sample hovered around zero before the turmoil, it increased by more than 100 basis points on average during the market stress.

The survey of UK-authorized

funds similarly found that the size of swing factors increased during this period and that some funds that had capped the size of their swing factors needed to temporarily remove these caps.

In terms of the effects of using swing pricing during March 2020, one study found that swing pricing allowed surveyed funds to recoup roughly 0.06% of total net assets on average from redeeming investors during three weeks of elevated redemptions in March 2020.

Funds in countries such as Luxembourg, Ireland, the United Kingdom, and the Netherlands had implemented swing pricing and it was well-established market practice. In Mar. 2020, funds in some countries, such as France, Spain, and Germany, had more recently begun to employ swing pricing as an anti-dilution method.

See

Lessons from COVID-19: Liquidity Risk Management and Open-Ended Funds, BlackRock ViewPoint (Jan. 2021),

available at https://www.blackrock.com/corporate/literature/whitepaper/viewpoint-addendum-lessons-from-covid-liquidity-risk-management-is-central-to-open-ended-funds-january-2021.pdf.

See

Liquidity management in UK open-ended funds: Report based on a joint Bank of England and Financial Conduct Authority survey (Mar. 2021),

available at https://www.bankofengland.co.uk/report/2021/liquidity-management-in-uk-open-ended-funds

(“Bank of England Survey”). The increase in the use of partial and full swing pricing included the increase in the number of funds using swing pricing as well as the increase in the frequency of its use for funds that already used swing pricing. The survey also found that some funds did not use swing pricing or other tools during the period because, for example, net outflows of certain funds were below levels at which they would consider applying swing pricing or other tools.

See id.

(stating that, out of a total of 202 surveyed funds that were authorized to use swing pricing, 45 funds decided to reduce their swing threshold during this period, including 18 funds that switched temporarily to full swing pricing during the market stress); ICI, Experiences of European Markets, UCITS, and European ETFs During the COVID-19 Crisis (Dec. 2020),

available at https://www.ici.org/doc-server/pdf%3A20_rpt_covid4.pdf

(“Respondents reported that some UCITS lowered their partial swing thresholds during March to take into consideration the impact flows could have on investors from increased transaction costs in underlying markets. . . Some UCITS using partial swing pricing lowered their threshold for redemptions to zero in March (which is equivalent to full swing pricing) in response to market volatility that had caused bid-ask spreads to widen on underlying securities.”); Claessens, Stijn, and Lewrick, Ulf, “Open-ended bond funds: systemic risks and policy implications” (Dec. 2021)

available at https://www.bis.org/publ/qtrpdf/r_qt2112c.pdf

(stating that, in a survey of 57 Luxembourg actively managed bond UCITS based on a supervisory data collection, these funds lowered swing thresholds on average from net outflows of 1% of total net assets before Mar. 2020 to less than 0.5% of total net assets) (“Claessens and Lewrick”).

See also

rule 22e-4(a)(2) (defining “business day” to exclude customary business holidays).

See

Liquidity Rule Adopting Release,

supra

note 8, at paragraphs accompanying nn.109 and 110 (stating that staff had observed that some funds with more thorough liquidity risk management practices appeared to be able to better meet periods of higher than typical redemptions without significantly altering their risk profile or materially affecting their performance, while some funds with substantially less rigorous liquidity risk management practices experienced particularly poor performance compared with their benchmark when faced with higher than normal redemptions).

Based on an analysis of weekly flows of equity and fixed-income funds over a period of more than ten years, outflows greater than 6.6% occurred 1% of the time in a pooled sample across weeks and funds.

Based on this analysis, we estimate that a random fund in a random week has approximately a 0.5% chance of experiencing redemptions in excess of the 10% stressed trade size, and there were 3.4% of weeks where more than 1% of funds experienced net redemptions exceeding the proposed stressed trade size. We believe that weekly outflows at the 99th percentile is a useful approximation of the level of outflows funds may experience in future stressed conditions.

However, because it is difficult to predict future stress events, including the effect and length of such events—particularly without official sector interventions—we believe it is appropriate to require funds to use a stressed trade size amount of 10%, which is moderately higher than the 6.6% weekly outflow figure discussed above. We also considered, during this same historical period, equity and fixed-income funds had weekly inflows of greater than 8% for 1% of the time in a pooled sample across weeks and funds. In addition, large, concentrated inflows have the possibility of translating to similarly large outflows. For example, if the large inflows are the result of investment by an institutional investor or a fund's inclusion in a model portfolio, the fund may experience similarly large outflows if the investor mandate changes or if the fund is removed from the model portfolio.

Based on an analysis of historical Morningstar weekly fund flow data for equity and fixed income funds from 2009 through 2021.

See infra

sections III.B.4.a and III.C.1.a.i (providing additional equity and fixed income flow data and discussing this analysis in more detail). While some Morningstar data is available for 2008, we have not included that data in our historical flow analyses in this release because of gaps in the 2008 data (

e.g.,

the 2008 dataset covers a more limited set of funds). Other available flow information for 2008, such as from the ICI Fact Book, is not granular enough for purposes of our analyses.

We believe weekly outflows is a better proxy for the stressed trade size than daily outflows because stressed conditions may take some time to fully present in flows and often result in outflows that continue over several days or more.

Under the proposed approach, a fund would apply its stressed trade size to each investment to determine its liquidity classifications. We have observed that funds generally determine and apply a reasonably anticipated trade size to each investment or asset class currently (commonly referred to as

pro rata

or vertical slice methods). We have also observed, however, that some funds have applied the reasonably anticipated trade size in such a manner that the trading would be satisfied largely by selling the fund's most liquid investments, resulting in smaller assumed trade sizes for purposes of classifying the fund's less liquid investments.

As recognized above, small assumed sale sizes can result in more liquid classifications generally, as sales of small amounts are less likely to affect the market value of the investment significantly and typically can be converted to U.S. dollars more quickly. We are particularly concerned that use of small assumed sale sizes for non-highly liquid investments can overstate the liquidity of these investments and reduce the effectiveness of a fund's liquidity risk management program when a fund needs to sell a larger-than-assumed portion to meet redemptions under stressed conditions or for any other portfolio management reason. Requiring funds to apply the 10% stressed trade size to each investment would better prepare funds to manage their liquidity in stressed conditions, when a fund may be required to sell positions that are larger than the assumed sale sizes some funds are using currently. The amendments to replace the determination of a reasonably anticipated trade size with a stressed trade size are designed to enhance a fund's preparation for stressed conditions, including the potential for sizeable outflows.

See

Liquidity Rule Adopting Release,

supra

note 8, at paragraph accompanying n.1084. We do not suggest that a fund should only, or primarily, use its most liquid investments to meet shareholder redemptions.

See id.,

at n.661 and accompanying paragraph.

We request comment on the proposed requirement for funds to apply a stressed trade size to each investment in their liquidity classification determinations:

1. Should we require funds to use a stressed trade size, as proposed? Would the change from reasonably anticipated trade size to stressed trade size materially change the proportion of investments classified in a given liquidity category? If yes, how? Would the proposed stressed trade size affect certain types of funds more than others? Would the proposed stressed trade size be likely to overstate or understate liquidity?

2. Is the proposed stressed trade size of 10% appropriate? If not, what minimum trade size would be appropriate and why? For example, should we increase or decrease the stressed trade size to, for example, 15% or 5% or some other threshold? Is there

other data that should factor into setting the stressed trade size?

3. Should the stressed trade size vary for different types of funds and, if so, how? For instance, should the stressed trade size be a function of the fund's flow history, such as the 99th percentile highest week of the fund's absolute or net flows over a given period (

e.g.,

3 years, 5 years, 10 years, or the life of the fund)? Should the stressed trade size be the higher of a specified value applied to each investment or the 99th percentile highest week of absolute flows?

4. Should the method of applying the stressed trade size to each investment vary for different types of funds and, if so, how? Are there types of investments that should be excluded or use a different stressed trade size? Are there other, more appropriate methods of applying a stressed trade size across different type of investments and portfolios?

5. Instead of establishing a set stressed trade size, should we set a minimum stressed trade size and provide factors for determining if a fund should have a higher stressed trade size? If so, what factors should funds consider in setting their stressed trade size?

ii. Determining a Significant Change to Market Value

Currently, when a fund makes liquidity classifications under rule 22e-4, it must analyze whether a sale or disposition would significantly change the market value of the investment. In the adopting release for rule 22e-4, the Commission explained that this value impact analysis captures the risk of a fund only being able to meet redemption requests in a manner that significantly dilutes the non-redeeming shareholders.

The Commission established the value impact standard to capture the risk of dilution in cases of inadequate liquidity, while not requiring funds to account for every possible value movement.

We propose to establish a minimum value impact standard that defines more specifically what constitutes a significant change in market value.

We believe the proposed change would improve the quality of funds' liquidity classifications by preventing funds from over-estimating the liquidity of their investments and would improve comparability of funds' liquidity classifications. In addition, the proposed approach is consistent with more effective practices we have observed from some funds and liquidity classification vendors, as discussed below.

See

Liquidity Rule Adopting Release,

supra

note 8, at paragraph accompanying n.334.

See id.,

at paragraph accompanying n.339.

See proposed rule 22e-4(a) (definition of “Significantly changing the market value of an investment”).

Under the current rule, a fund may determine value impact in a variety of ways, depending on the type of asset, or vendor, model, or system used. There also is variation in the depth and sophistication of funds' analyses. We believe the variation in how a fund may determine value impact leads to differences in the quality of funds' classifications, limits comparability of funds' classifications across the same or similar investments, and may cause funds to over-estimate the liquidity of their investments.

The proposed definition of a significant change in market value would require a fund to consider the size of the sale relative to the depth of the market for the instrument.

This would vary depending on the type of investment. For shares listed on a national securities exchange or a foreign exchange, we believe selling or disposing of more than 20% of the security's average daily trading volume would indicate a level of market participation that is significant.

We understand that if a fund sold more than 20% of the average daily trading volume of a listed equity security, such a large sale is likely to result in a significant change in the security's market value, which would dilute remaining investors in the fund. We have observed that a standard based on average daily trading volume is consistent with practices many funds and vendors apply for assessing value impact for listed equity investments today.

To determine average daily trading volume, we propose to require funds to measure the average daily trading volume over the preceding 20 business days. We believe using a period of 20 business days provides an appropriate measure of daily trading volume, which would reflect current market conditions as well as consider a period of recent market history. The 20 business day period is intended to strike a balance between longer periods that are less reflective of current conditions and shorter periods that can be skewed easily by an abnormally high or low volume day. For purposes of measuring average daily trading volume, the preceding 20 business days include those days where U.S. markets are open but where one or more international markets are closed, such as “Golden Week,” a week in Japan including multiple Japanese public holidays. A fund would count these and any other trading days where shares were not traded as zero volume days for the relevant investment.

The proposed rule would continue to provide that an investment's classification is based on a fund's reasonable expectations in current market conditions.

See

Liquidity Rule Adopting Release,

supra

note 8, at section III.C.1.d (discussing comments and suggestions on the consideration of market conditions). Thus, a fund would be able to rely on its reasonable expectations at the time it makes the value impact assessment. Although we are proposing to require funds to assume an element of stressed conditions in their liquidity classifications through the stressed trade size, a broader requirement to predict how an investment may trade in stressed market conditions would introduce additional variables into the classification process that could increase the risk of misclassifications and decrease the data quality of funds' liquidity-related reporting and disclosure.

Under this proposal, the sale or disposition must be below 20% of the security's average daily trading volume. A fund may choose to impose a stricter limitation of any percentage under 20%, for example, 15% of average daily trading volume.

Through staff outreach, we observed many funds using some percent of average daily trading volume (

e.g.,

15%, 20%, or 25%) that the fund's investment can represent if it wants to be able to sell into daily volume without affecting market prices. In practice, this meant funds would estimate the number of days it would take to sell or dispose of the reasonably anticipated trade size without approaching the set percentage of average daily trading volume to avoid impacting the value significantly. We observed funds calculating the average daily trading volume taking into account different sources, and for different time periods, ranging from 10 days to 6 months.

For any investments other than shares listed on a national securities exchange or a foreign exchange, such as fixed-income securities and derivatives, we propose to define a significant change in market value as any sale or disposition that a fund reasonably expects would result in a decrease in sale price of more than 1%. Funds currently use a variety of methods to determine significant changes in market value in fixed-income securities, taking into account different groups of comparable securities, asset class characteristics and volatility, number and depth of market makers, bid-offer spread size, volume of the security or similar securities, and elasticity of prices in the security or similar securities. For purposes of the proposed rule, a decrease of more than 1% would indicate a level of value impact that is significant because the fund is selling or disposing of a relatively large position or because the market for the investment has constricted, and bid-ask spreads have widened. We also understand that several commonly employed liquidity models currently use this price decrease measure. We acknowledge that not all liquidity models specify a price decrease explicitly as the determination for a significant change in market value and some funds would have to make changes to convert to this more

objective threshold. The proposed value impact standard would improve funds' abilities to perform quality checks and back testing and would allow the Commission to better analyze classification data across funds.

In considering whether a sale is reasonably expected to result in a price decrease of more than 1%, the fund would be required to consider the size of the sale relative to the depth of the market for the instrument. As part of that analysis, we believe a fund generally should consider, among other things, the width of bid-offer spreads. This is because the width of bid-offer spreads is an important consideration in analyzing the costs of selling a security and thus whether a sale would result in a price decrease exceeding 1%. For example, a sale would be more likely to result in a price decline of more than 1% if the trade size is large in relation to the market for that instrument or if bid-ask spreads are wide, or if both are the case. Wide, or widening, bid-ask spreads may indicate a lower level of demand for the instrument, which makes it more likely that a sale of the instrument would result in a price decline of more than 1%.

We request comment on our proposed definition of significant change in market value:

6. Would funds have to make significant changes to their liquidity classification methodologies to reflect the proposed amendments to the value impact standard? If so, what effect would those changes have on a fund's liquidity risk management program?

7. Should we define value impact through average daily trading volume or price decline, as proposed? Should we use a different definition of value impact instead, and if so, should it depend on the type of investment? Should different types of funds have different value impact standards? If yes, what standards, and for what types of funds?

8. For shares listed on a national securities exchange or a foreign exchange, should we define a significant change in market value as selling or disposing of more than 20% of the average daily trading volume, as proposed? Are there other types of investments for which an average daily trading volume test would be appropriate? For example, is there data available for fixed-income securities that funds could use objectively to analyze market participation under a value impact standard?

9. Should the percent of average daily trading volume be higher or lower (

e.g.,

15% or 25%)? Should the measurement period for the average daily trading volume be longer or shorter than the proposed 20 business days (

e.g.,

10, 30, or 40 business days)? Should days where shares were not traded be counted as zero volume days as proposed or in some other manner? Are there circumstances in which the average daily trading volume test should vary by instrument, type of instrument, or trading venue?

10. For investments that are not listed on a national securities exchange or foreign exchange, should we define a significant change in market value as any sale or disposition that the fund reasonably expects would result in a price decline of more than 1%, as proposed? Should the identified percentage be higher or lower (

e.g.,

0.5% or 2%)? Should this standard for determining a significant change in market value apply to all investments? Would funds need additional guidance or parameters to measure this standard consistently, including what inputs or comparable investments may be used in determining the price decline?

11. Should the 1% price decline definition of value impact be applied against the fund's last valuation of an investment, which would include both the effect of the fund's sale and market moves?

iii. Removing Asset Class Classification

Under current rule 22e-4, a fund may generally classify and review its portfolio investments (including the fund's derivatives transactions) according to their asset class. However, a fund must separately classify and review any investment within an asset class if the fund or its adviser has information about any market, trading, or investment-specific considerations that are reasonably expected to significantly affect the liquidity characteristics of that investment as compared to the fund's other portfolio holdings within that asset class.

The current provision was intended to strike a balance between reducing operational burdens associated with classification and providing reasonably precise liquidity classifications that appropriately reflect investments' liquidity characteristics.

The burden to determine individual investment classifications may have decreased since the adoption of the rule for many funds as these funds became more familiar with and developed their liquidity risk management programs and, in some cases, developed automated processes for classifying investments or employed sophisticated liquidity classification vendors that provide economies of scale. In addition, in practice there may be weaknesses in asset class level classifications that may result in a lack of reasonably precise classifications. Therefore, we propose to remove the asset class method of classification from the rule.

See

rule 22e-4(b)(1)(ii)(A).

See

Liquidity Rule Adopting Release,

supra

note 8, at section III.C.3.a. The current approach was also intended to leverage fund managers' current practices and to recognize that many investments within an asset class may be considered interchangeable from a liquidity perspective.

Through outreach, we understand that asset class level classifications are not widely used by many funds. But, where these asset class level classifications are used, this method runs the risk of over-estimating the liquidity of a fund's investments and not adjusting quickly in times of stress. After a fund has begun to use asset class level classifications, and particularly if classifications are reviewed only on a monthly basis, it might be difficult for a fund to identify instances where a given investment's liquidity characteristics do not align with the characteristics of other investments in the asset class because individual investment liquidity data is not being collected and analyzed. Through outreach, we observed that funds generally established a process and timing for liquidity assessments and did not change those processes or timing as market conditions changed, and particularly were unlikely to do so under stressed conditions. For example, during a stress event like March 2020, a fund using asset class level classifications may not be equipped to re-classify a subset of investments in an asset class adeptly in response to changing conditions that affect those investments directly. Also, because funds classify a significant portion of their holdings as highly liquid, we believe this potential gap in identifying investments that a fund should classify differently from other investments in the asset class is more likely to over-estimate, rather than under-estimate, the liquidity of a fund's investments. These tendencies run counter to the premise of the current rule's classification system, which presumed that a fund would use efficiencies such as asset class level classifications and monthly review of classifications only when market conditions or other factors did not indicate that a shift to a more granular or frequent classification is appropriate.

Therefore, we are

proposing to remove asset class level classifications to provide more precise liquidity classifications that appropriately reflect investments' liquidity characteristics.

See

rule 22e-4(b)(1)(ii) (identifying the circumstances in which a fund must review its portfolio investments' classifications more

frequently than monthly); rule 22e-4(b)(1)(ii)(A) (identifying the circumstances in which a fund must separately classify and review an investment within an asset class instead of classifying according to the investment's asset class).

Moreover, asset class level classifications are not compatible with the other changes we are proposing to the classification framework, including the proposed definitions of the value impact standard. It would also be difficult for a fund to meaningfully apply at the asset class level a standard based on average daily trading volume or a price decline in a given investment because the average trading volume, or market depth generally, can vary from investment to investment even within the same asset class. Classifying each investment separately therefore allows a more precise assessment of that investment's liquidity. In addition, because the proposed rule would include specific minimum standards for classifying investments, it may reduce burdens of classifying investments while improving the quality of classifications relative to the current rule, consistent with the Commission's objectives in originally allowing asset class level classifications. Finally, staff has observed through outreach that liquidity risk management programs have developed so that specific and individual portfolio investment liquidity classifications are widely used and the removal of asset class level classifications is consistent with that approach.

We request comment on the proposed removal of the provision permitting funds to classify the liquidity of their investments by asset class.

12. Should we preserve the ability of funds to use asset classes for liquidity determinations, as currently permitted? To what extent do funds currently rely on the provision allowing liquidity classifications by asset class? Would it be more or less burdensome for funds to classify investments individually under the proposal's specific minimum standards (such as the stressed trade size and the defining the value impact standard) than to separately classify any investment within an asset class whenever the fund or its adviser has market, trading, or investment-specific information indicating that the investment should be classified separately rather than as part of the relevant asset class?

13. Would the operational burden of individually classifying be balanced by the improved quality of data for each individual investment as compared to classifying by asset class? To what extent would investment-by-investment classifications differ compared to asset class level classification? Are there other benefits to removing asset class level classification, such as timely, useful, improved, or increased data?

14. Is reliance on this provision more common for certain types of funds or certain asset classes? Should asset class level classifications be limited to specific types of funds or asset classes?

15. If we permitted asset class level classifications, how should the stressed trade size and value impact standard in the proposal apply to asset class level classifications?

b. Amendments to Liquidity Classification Categories

We are proposing changes to the liquidity classification categories to improve funds' abilities to make timely payment on shareholder redemptions, without the sale of portfolio investments resulting in the dilution of outstanding fund shares. Section 22(e) of the Act establishes a right of prompt redemption in open-end funds by requiring such funds to make payments on shareholder redemption requests within seven days of receiving the request. In March 2020, in connection with the economic shock from the onset of the COVID-19 pandemic, open-end funds faced a significant amount of investor redemptions, and we believe additional changes to rule 22e-4 would assist funds in managing investor redemptions in future stressed conditions.

Rule 22e-4 currently allows funds to classify as less liquid investments those that the fund reasonably expects to be able to sell or dispose of in seven calendar days or less without significantly changing the market value of the investment, but that are reasonably expected to settle in more than seven calendar days.

Under the current rule, an investment is classified as illiquid if it cannot be sold or disposed of in seven calendar days or less without significantly changing the market value of the investment.

We propose to eliminate the less liquid classification category and amend the definition of illiquid investment to include those investments that a fund reasonably expects not to be convertible to U.S. dollars in current market conditions in seven calendar days or less without significantly changing the market value of the investment, as well as those investments whose fair value is measured using an unobservable input that is significant to the overall measurement.

Under the proposal to eliminate the less liquid classification category, the rule would therefore have only three liquidity classifications: highly liquid investments, moderately liquid investments, and illiquid investments. We also propose to amend the term “convertible to cash” to “convertible to U.S. dollars,” codifying prior Commission statements.

Finally, we propose to specify how to count the identified number of days an investment is convertible to U.S. dollars for purposes of the liquidity categories.

See

rule 22e-4(a)(10) (defining “less liquid investment”).

See

rule 22e-4(a)(8) (defining “illiquid investment”).

See

proposed rule 22e-4(a).

See

Liquidity Rule Adopting Release,

supra

note 8, at n.848 (“Cash means cash held in U.S. dollars, and would not include, for example, cash equivalents or foreign currency.”).

i. Removing the Less Liquid Investment Category and Classifying These Investments as Illiquid

We propose to eliminate the less liquid classification category and amend the definition of illiquid investment to include investments, in part, that a fund reasonably expects not to be convertible to U.S. dollars in seven calendar days or less without significantly changing the market value of the investment. Investments that funds currently classify as less liquid would become illiquid investments under the proposed amendments, absent changes to shorten the settlement time of many of those investments. Section 22(e) of the Act requires open-end funds to make payment on shareholder redemption requests within seven days of receiving the request. The proposed amendment to define an investment as illiquid if it does not settle to U.S. dollars in seven calendar days is designed to reduce the mismatch between the receipt of cash upon the sale of assets with longer settlement periods and the payment of shareholder redemptions. This would help prepare funds for future stressed conditions by reducing the risk of a fund not being able to meet shareholder redemptions. Unlike the current rule, the proposed rule would directly limit to 15% the amount of fund assets that are not reasonably expected to be convertible to U.S. dollars in seven days.

While funds may classify different types of investments as less liquid investments today, the most common type of investment in this category is bank loans.

Fund investments make

up approximately 15% of the bank loan market.

Filings on Form N-PORT show that over 90% of bank loan investments reported by open-end funds are classified as less liquid.

100

In 2015, commenters addressing concerns about liquidity in the bank loan market stated that significant efforts were then underway to materially improve settlement times in the bank loan market, which are typically longer than other asset classes.

101

Bank loans are not standardized and have individualized legal documentation. This provides flexibility of terms for bank loans, but also increases the time for a fund to settle a bank loan trade and receive proceeds from the sale, thus increasing the risk of the fund not being able to meet shareholder redemptions.

102

Based on Form N-PORT data, bank loans made up 77% and 60% of investments reported as less liquid in Feb. and Mar. 2020, respectively. In

addition to bank loans, a smaller number of fixed-income securities, mortgage-backed securities, and equities are categorized as less liquid investments.

See

Leveraged Loan Primer (last visited Oct. 4, 2022),

available at https://pitchbook.com/leveraged-commentary-data/leveraged-loan-primer#market-size

(stating that the Morningstar LSTA U.S. Leveraged Loan Index, which is used as a proxy for market size in the U.S., totaled approximately $1.375 trillion as of Feb. 2022). As of Dec. 2021, there are 746 open-end funds that classified approximately $204 billion in bank loan interests as reported on Form N-PORT. Using this data, we estimate that funds held approximately 15% of the bank loan market.

100

Based on Form N-PORT data, in 2021, more than 90% of the gross value of loans reported by open-end funds were classified as less liquid. This was also the case in Feb. and Mar. 2020.

101

See, e.g.,

Comment Letter of the Loan Syndications and Trading Association on 2015 Proposing Release,

supra

note 31, File No. S7-16-15,

available at https://www.sec.gov/comments/s7-16-15/s71615-57.pdf

(“LSTA Comment Letter”) (stating the goal of transforming syndicated loan settlement to a similar settlement period as most other asset classes).

102

See id.

Around the time that the Commission adopted the liquidity rule, the median settlement time for a loan sale was about 12 days.

103

In the Liquidity Rule Adopting Release, the Commission stated that a fund may need to consider re-classifying an investment as illiquid in the event of an extended settlement period.

104

By July 2021, the average time to settle a bank loan par trade in the secondary market increased to a then seven-year high of T+23, and the median was at T+15.

105

While median settlement time for bank loans in which funds invest has generally increased, Form N-PORT data has not shown funds reclassifying these investments to take into account extended settlement times.

103

See

LSTA Comment Letter.

104

See

Liquidity Rule Adopting Release,

supra

note 8, at n.380 and accompanying text.

105

See

LSTA, Secondary Trading & Settlement: Monthly July Executive Summary (Aug. 19, 2021),

available at https://www.lsta.org/news-resources/secondary-trading-settlement-monthly-july-executive-summary/?utm_source=rss&utm_medium=rss&utm_campaign=secondary-trading-settlement-monthly-july-executive-summary

. In addition, fewer trades settled within T+7, (just 20% of trades settled within the LSTA guideline during July, a nine-percentage point reduction from the previous year's monthly average) and settlements wider than T+20 increased 10-percentage points as of July 2021, to a 39% market share, nearly double that of the T+7 distribution.

We are proposing changes to remove the less liquid investment classification to reduce the risk that funds that invest significantly in less liquid investments may not be able to meet shareholder redemptions. While bank loan funds were able to meet redemption requests during March 2020, a period of significant outflows, we are concerned that they may not be able to meet shareholder redemptions in future stressed conditions, especially as investments in this asset class increase. During the month of March 2020, bank loan funds experienced outflows of approximately 13% of assets, more than any other type of fund. In addition, since March 2020, total registered investment company investments in bank loans have increased 50% to approximately $200 billion.

106

We understand that in past times of large outflows, the median buy-side settlement time for bank loans generally decreased and funds had a degree of success in effecting shorter settlement periods for these investments to help meet redemptions.

107

We are concerned, however, that in future stress events these attempts to shorten settlement times may fail since loans are not standardized, have individualized legal documentation, and rely on manual processes for settlement. We also understand that funds with significant extended settlement investments have used borrowing through lines of credit to meet redemptions, but lines of credit may not be available to all funds and borrowing imposes costs that can dilute the value of the fund for remaining investors. Based on Form N-CEN filings, several bank loan funds have accessed their lines of credit in their most recent reporting period.

108

We understand that the costs of borrowing have risen and credit has become more difficult to obtain over time.

106

This is based on Form N-PORT information as of Jan. 31, 2022.

107

See

LSTA Comment Letter (stating that settlement times have decreased in periods of large outflows, for example, in Aug. 2011, when bank loan funds experienced $8 billion of outflows (approximately 13% of assets). Similarly, in Mar. 2020, when bank loan funds experienced $12 billion of outflows (approximately 13% of assets), we understand that settlement times also generally decreased.

108

See infra

note 459 and accompanying text (providing information about bank loan funds' use of lines of credit as of Dec. 2021).

We believe that investments that funds currently classify as less liquid should be classified as illiquid investments and be subject to the 15% limit on illiquid investments, so that funds may be better prepared to satisfy redemptions in future stressed conditions without delay and without significant dilution. Using Form N-PORT data, we estimate that approximately 200 funds during March 2020 would have had illiquid investments over the 15% limit if this proposed change had been in effect, with bank loan funds being the largest type of affected fund.

109

As a result of the proposed amendments, more bank loan funds may contract for expedited settlement, which would involve costs. Alternatively, advisers with strategies that have 15% or more of assets in investments classified as less liquid and illiquid may change those strategies, close funds, or consider using a closed-end fund or other investment vehicle structure that is not subject to rule 22e-4. Further, potential additional demand for these investments could provide incentives to shorten the settlement cycle for bank loans more generally, which may reduce trading costs.

110

We believe that these amendments would reduce the risk of a fund not being able to satisfy redemptions without diluting the interests of remaining shareholders while waiting for the proceeds from the sale of an investment with extended settlement.

109

The number of funds is estimated by dividing the aggregate gross value in the relevant categories by the aggregate gross value reported.

110

See infra

section III.C.1.b.

ii. Additional Amendments to the Definition of Illiquid Investment

We also propose to amend the definition of illiquid investment to include investments whose fair value is measured using an unobservable input that is significant to the overall measurement. U.S. GAAP establishes a fair value hierarchy that categorizes into three levels the inputs to valuation techniques used to measure fair value.

111

The fair value measurements of investments are categorized in accordance with this three-level

hierarchy. The highest-level measurements are those developed using quoted, observable inputs in active markets for identical assets and liabilities (Level 1), such as prices for identical investments on a securities exchange; the lowest are those developed using unobservable inputs (Level 3).

112

We acknowledge that observability is a valuation concept and may not always correspond to liquidity. The proposed amendment would require those funds not already classifying investments valued using unobservable inputs that are significant to the overall measurement as illiquid to change their classification practices and may change the liquidity profile for those funds under the rule to be less liquid. To the extent there is a liquid market for affected investments, this proposed amendment would cause funds to over-estimate the illiquidity of their portfolios. As of December 2021, 2,006 open-end funds held investments that were valued using unobservable inputs that are significant to the overall measurement (Level 3 investments), comprising $76.3 billion, or 0.27% of all open-end fund assets.

113

Among these, $16.9 billion were classified as highly liquid investments and $2.1 billion as moderately liquid investments.

114

Accordingly, we estimate that approximately 0.07% of all open-end fund assets would be affected by this amendment.

111

See

FASB ASC 820-10-35-37, which sets out a fair value hierarchy for accounting purposes, as compared to rule 2a-5, which provides a framework for fund valuation practices and determining fair value (including applying an appropriate methodology consistent with the principles of FASB Accounting Standard Codification Topic 820: Fair Value Measurement (“ASC Topic 820”)) for purposes of the Act.

See

Good Faith Determinations of Fair Value, Investment Company Act Release No. 34128 (Dec. 3, 2020) [86 FR 748 (Jan. 6, 2021) (“Valuation Adopting Release”)].

112

See

ASC Topic 820. U.S. GAAP requires funds to maximize the use of relevant observable inputs and minimize the use of unobservable inputs in valuing any asset or liability. In some cases, the inputs used to measure fair value might be categorized within different levels of the fair value hierarchy. In those cases, the fair value measurement is categorized in its entirety in the same level of the fair value hierarchy as the lowest level input that is significant to the overall measurement.

See

ASC 820-10-35-16AA and 820-10-35-37A. Examples of particular assets and liabilities that may be measured using Level 3 inputs include long-dated currency swaps, three-year options on exchange-traded shares, interest rate swaps, asset retirement obligations at initial recognition, and reporting units.

See

FASB ASC 820-10-55-22.

113

See infra

note 424 and accompanying paragraph. We observed that the investments classified as highly liquid that were Level 3 investments primarily were mortgage-backed securities.

114

We recognize that, in light of the proposed removal of the less liquid category, only those investments valued using unobservable inputs that are significant to the overall measurement that are classified as highly liquid or moderately liquid would be affected by this proposed amendment.

Where an investment is valued using unobservable inputs that are significant to the overall measurement, this may indicate that an active, liquid, and visible market for the investment does not exist. Where there is no active, liquid, and visible market for an investment, there may be a corresponding risk that the fund cannot sell the investment in time to meet redemptions without dilution. The proposal defines investments whose fair value is measured using unobservable inputs that are significant to the overall measurement as illiquid for purposes of this rule, which is intended to reduce this risk. By classifying these investments as illiquid, the proposal would establish a minimum standard for classifying the liquidity of an investment, which is designed to provide more consistent guideposts for liquidity classifications.

iii. Other Amendments Related to Liquidity Classification Categories

Amendments to the Definition of Moderately Liquid Investment

We propose to simplify the definition of moderately liquid investment to mean any investment that is neither a highly liquid investment nor an illiquid investment.

115

The moderately liquid investment category would continue to provide information about the portion of a fund's portfolio that is not on the most liquid end of the spectrum, but that still is sufficiently liquid to meet redemption requests within the statutory seven day period.

115

We also are proposing to remove a provision that addresses how to classify an investment that could be viewed as either a highly liquid investment or a moderately liquid investment because the ambiguity in classification that provision addresses is no longer present under the proposed amendments to those classifications.

See

note to paragraph (b)(1)(ii) introductory text in current rule 22e-4.

Amendments to the Definition of Convertible to Cash and References to Cash

We propose to amend the term “convertible to cash” to “convertible to U.S. dollars” and to make conforming amendments to the definition of this term to refer to the ability for a fund to sell or dispose of an investment, and for it to settle in U.S. dollars.

116

These amendments codify prior Commission statements. In the adopting release for rule 22e-4, the Commission stated that cash means “cash held in U.S. dollars, and would not include, for example, cash equivalents or foreign currency.”

117

The Commission also provided an example in that release in which the period of time it took to repatriate or convert a foreign currency to dollars factored into the analysis of how quickly a foreign security could convert to cash.

118

Some funds are classifying foreign investments as highly liquid taking into account solely the time it would take to convert the proceeds of a sale to the foreign currency. Similarly, some funds classify foreign currency as highly liquid without further analysis about the time that would be needed to convert that currency to U.S. dollars. We believe it is important to view the liquidity of fund investments in terms of convertibility to U.S. dollars within a specified period so that a fund is able to satisfy redemption requests in U.S. dollars.

119

This amendment is intended to promote the ability of funds to meet redemptions without diluting the interests of the remaining shareholders and increase consistency in how funds classify the liquidity of investments, including in foreign investments and foreign currencies. In addition to the definition of convertible to cash, we also propose to amend other references in rule 22e-4 to refer to U.S. dollars instead of cash for consistency and clarity.

120

116

See

proposed rule 22e-4(a) (defining “convertible to

U.S. dollars”

as the ability to be sold or disposed of, with the sale or disposition settled

in U.S. dollars

) (emphasis added). We also propose to amend the definition of convertible to U.S. dollars to refer to disposition of an investment, and not only sales. This is a conforming amendment, as current rule 22e-4 classifications otherwise refer to the ability to sell or dispose of an investment.

117

See

Liquidity Rule Adopting Release,

supra

note 8, at n.848.

118

See id.,

at paragraph accompanying n.379 (providing an example where certain foreign securities may be able to be sold in seven calendar days or less, but may be subject to capital controls that would limit the extent to which the foreign currency could be repatriated or converted to dollars within this time frame and explaining that these securities would be considered to be less liquid investments because they would be reasonably expected to settle in more than seven calendar days).

119

See id.,

at n.105 and accompanying text (noting concerns about the potential mismatch between the timing of receipt of cash for sales of fund assets and the payment of cash for shareholder redemptions).

120

See

proposed rule 22e-4(a) (defining “highly liquid investment” and “in-kind exchange traded fund”); and proposed rule 22e-4(b)(1)(i)(C) (listing liquidity risk factors).

Method for Counting the Number of Days

We propose to specify when a fund must start to measure the identified number of days in which it reasonably expects a stressed trade size of an investment would be convertible to U.S. dollars without significantly changing its market value. Currently, the rule does not directly specify when to begin counting the number of days an investment would be convertible to U.S. dollars, and funds have inconsistent practices as to when they begin this measurement. This inconsistency may lead certain funds to overestimate their liquidity classifications, and reduce

their ability to meet redemptions. This also detracts from comparability when analyzing trends across funds. For example, some funds may consider an investment highly liquid if it could be converted to U.S. dollars three business days after the date of the classification analysis, while others include the date of classification when counting the number of days. Those funds that begin counting after the date of the classification would have the advantage of counting an additional day as compared to those funds that include the date of classification, and their liquidity classifications may appear to be more liquid than a similar fund that begins counting on the date of classification. Therefore, we propose to specify that funds must count the day of classification when determining the period in which an investment is reasonably expected to be convertible to U.S. dollars.

121

For example, in order for a fund to classify an investment as highly liquid on Monday, it would need to reasonably expect that the investment could be sold and settled to U.S. dollars by Wednesday at the latest.

121

See

proposed rule 22e-4(b)(1)(ii)(A).

We request comment on the proposed amendments to the liquidity classification categories:

16. As proposed, should we eliminate the less liquid investment category and amend the illiquid investment definition to include an investment that a fund reasonably expects can be sold within seven calendar days without significantly changing the market value but is not convertible to U.S. dollars within that period (

i.e.,

investments that are currently classified as less liquid under the rule)? What effect would these proposed amendments have and how would those funds that significantly invest in such less liquid investments likely change?

17. Would the proposed amendment cause funds that currently hold less liquid investments to contract for expedited settlement for such investments? What are the advantages or limitations of contracting for expedited settlement? Would the proposed amendments provide an incentive to reduce settlement times in bank loan and other relevant markets more generally? If so, how long might it take to reduce settlement times in response to the rule and what would be the burdens associated with this change? Are there certain categories of bank loans or other investments for which market participants may be unable to reduce the settlement time to seven calendar days or less? Which investments and why? What other effects may occur, for example, would some funds change their strategies, liquidate, or choose to be structured as a different investment vehicle, such as a closed-end fund? If some funds would convert to closed-end funds, what type of closed-end fund would they likely choose (

e.g.,

interval fund, or a closed-end fund listed on an exchange)? Should we amend other rules, or provide relief from any specific rules or provisions of the Federal securities laws, to expedite changes to strategies or conversions to closed-end funds or other investment vehicles?

18. Some funds classify certain bank loans as highly liquid or moderately liquid today. What characteristics of these bank loans lead to a reasonable expectation that they will be convertible to cash in seven days or less without significantly changing the market value? Are funds considering contracts for expedited settlement? Would funds need additional guidance on how to assess the period in which a bank loan or other investment is

reasonably expected

to be convertible to U.S. dollars? For example, should we revise the proposed rule to require that funds consider, or provide guidance suggesting that funds may wish to consider: settlement time history for the individual or similar investments, average settlement times for the market, and guarantees for settlement or expedited settlement, as well as the contractual settlement period?

19. Have the costs of borrowing risen and has credit become more difficult to obtain over time for bank loan funds, particularly during stressed periods?

20. As proposed, should we remove the less liquid category and require funds to use a three category classification framework? Would the proposed changes simplify classifications and reduce burdens over time, after funds updated systems to reflect the change? Would the proposed changes appropriately reflect the liquidity of a fund, or would the current framework be more appropriate? Should funds be permitted to invest above 15% in less liquid investments if there are other methods or mechanisms to reduce the mismatch between the receipt of cash upon the sale of assets with longer settlement periods and the payment of shareholder redemptions or to address potential dilution associated with this mismatch? If so, what other methods or mechanisms should these funds be required or permitted to use (for example, swing pricing, gates to suspend redemptions, redemption fees, redemptions in kind, additional limits on less liquid investments, notice periods, or lengthening the settlement period for paying redemptions)?

122

If we permit (to the extent not already permitted) or require use of one or more of these tools, how should they be used (individually, in some combination with each other, or with other protections, such as disclosure, board approval, and Commission reporting)? Should we amend other rules, or provide relief from any specific rules or provisions of the Federal securities laws, to expedite or permit use of these methods and mechanisms?

123

122

With a notice period, an investor's redemption request would not be processed until the end of a notice period (

e.g.,

after 2 to 5 days). The investor would receive the next calculated price after the notice period ends, with payment occurring at the end of a settlement period. With a lengthened settlement period, a redeeming investor would receive the price next calculated after submitting the redemption order but would not receive payment until the end of a lengthened settlement period (

e.g.,

5 to 7 days after trade date).

123

See, e.g.,

section 22(e) of the Act (providing the conditions under which a registered investment company may suspend the right, or postpone the date, of redemption for more than seven days).

21. Should we provide that an investment is illiquid if it is not reasonably expected to be convertible to U.S. dollars in a shorter or longer period than seven calendar days? How would a shorter or longer period align with the requirement in section 22(e) of the Act for a fund to satisfy redemptions within seven days? If we provided a longer period of time to convert to U.S. dollars before an investment is classified as illiquid, how would funds prepare for the potential mismatch during stressed situations between the amount of available cash and the size of shareholder redemptions? Should we provide additional exemptions to allow funds to delay redemptions to shareholders under certain limited circumstances and conditions, such as independent director approval?

22. Are there circumstances in which an investment is fair valued using an unobservable input that is significant to the overall measurement, but the investment should not be treated as illiquid for purposes of the rule? Please explain and provide supporting data. Should we permit a fund to classify certain types of investments that are fair valued using unobservable inputs that are significant to the overall measurement as highly liquid or moderately liquid and, if so, which types? Should we instead treat investments that are fair valued using unobservable inputs that are significant to the overall measurement as presumptively illiquid, but permit funds to rebut this presumption? If so, what process should we require for rebutting the presumption? For example, should

we require funds to maintain records describing why they did not classify such an investment as illiquid? Should we require funds to disclose on Form N-PORT any circumstances in which they did not classify such an investment as illiquid?

23. Are there other types or characteristics of investments that we should include in the definition of illiquid investment? If so, which ones?

24. Should we amend the definition of moderately liquid investment, as proposed? Alternatively, should we retain the details in the current definition that specify the number of days in which a fund must reasonably expect an investment to be convertible to U.S. dollars in order to classify it as moderately liquid?

25. Would the proposed changes to the liquidity classifications affect investment options available to investors? For example, would bank loan funds only be available in non-open-end investment vehicles? What effect would these proposed changes have on those asset classes that are less available for investment by open-end funds for liquidity reasons, the availability of credit to borrowers, and more generally, on capital formation?

26. Should we amend the definition of convertible to cash and other references to cash in rule 22e-4 to refer to U.S. dollars, as proposed? Would these amendments raise issues for specific types of funds? If so, which ones and how? Would these amendments affect funds' investment strategies, including their allocation to foreign investments and U.S. dollars, or their performance?

27. Are there circumstances in which a fund would pay redemptions in a different currency than U.S. dollars? If so, would it be appropriate for that fund to be able to assess the time in which an investment could convert to that other currency for purposes of the rule?

28. In addition to sale and disposition, are there other ways an investment may be converted to U.S. dollars that should be included in the definition of convertible to U.S. dollars? If so, what are they?

29. Would the amendment to refer to U.S. dollars instead of cash in the definitions of highly liquid investment and convertible to cash materially change how funds classify highly liquid investments currently? If so, how?

30. Should we require funds to include the day of classification when counting the number of days to convert to U.S. dollars as proposed, or should we require funds to begin to count the number of days to convert to U.S. dollars on the following day? What are the advantages and disadvantages of this alternative? Would this alternative result in less conservative liquidity classifications for some funds or investments (

i.e.,

by causing some investments that otherwise would have been classified as moderately liquid to be classified as highly liquid) or impair a fund's ability to meet redemptions?

31. Instead of using the days an investment would be convertible to U.S. dollars in the liquidity classifications as proposed, should we separately set the number of days to: (1) make the trade; and (2) settle the trade or otherwise dispose of an investment, in determining liquidity classifications? Why or why not? Is there a different way the rule should measure the period that an investment is convertible to U.S. dollars?

c. Frequency of Classifications

Rule 22e-4 currently requires that funds review their liquidity classifications at least monthly in connection with reporting on Form N-PORT, and more frequently if changes in relevant market, trading, and investment-specific considerations are reasonably expected to materially affect one or more of their investments' classifications.

124

The current rule also requires a fund to monitor and take timely actions related to the liquidity of its investments, including changes to its liquidity profile. Specifically, the rule prohibits a fund from acquiring any illiquid investment if, immediately after the acquisition, the fund would have invested more than 15% of its net assets in illiquid investments that are assets.

125

In addition, the rule requires a fund to provide timely notice to its board, and to the Commission on Form N-RN, if the fund exceeds the 15% limit on illiquid investments, or if there is a shortfall of the fund's highly liquid investments below its highly liquid investment minimum for seven consecutive calendar days.

126

124

See

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

125

See

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

126

See

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

); Form N-RN Parts B through D.

We propose amendments to require a fund to classify all of its portfolio investments each business day instead of at least monthly.

127

Daily classification would reflect current market conditions more accurately and would provide funds with more data for analysis to prepare for future stressed conditions. We believe that daily classifications would assist liquidity risk program administrators in better monitoring of a fund's liquidity and enhance a fund's ability to more rapidly respond to changes that affect the liquidity of the fund's portfolio, reflecting more effective practices we have observed. In addition, daily classifications would help ensure that funds timely report shortfalls below the highly liquid investment minimum or breaches of the 15% limit on illiquid investments to the fund's board and to the Commission, which would better achieve the goals of the current provisions to provide board and Commission oversight of the fund's liquidity risk management program and its effectiveness.

127

See

proposed rule 22e-4(b)(1)(ii). Although rule 22e-4 currently requires funds to classify each of the fund's portfolio investments (including each of the fund's derivatives transactions), we have observed that some funds are not classifying all investments in their portfolios, such as positions in to-be-announced (TBA) contracts to trade mortgage-backed securities or the reinvestment of cash collateral received in securities lending arrangements.

Most funds did not report reclassifications of their portfolio investments despite extraordinary liquidity constraints in March 2020.

128

Based on the liquidity classification practices we observed in March 2020 and on filings covering this period, we are concerned that some funds effectively are equipped to classify their investments primarily on a monthly basis to meet reporting requirements and are not prepared to review classifications intra-month. Because intra-month analyses for these funds would be out of the ordinary and only occur when a fund determines that changes in relevant market, trading, and investment-specific considerations are reasonably expected to materially affect one or more of their investments' classifications, it may be especially challenging during stressed conditions for these funds to reclassify their investments intra-month. Requiring daily classification, while involving costs, may ultimately lead to a more efficient classification process for funds than monitoring trading conditions to determine if and when intra-month classifications are required. For

example, a daily classification requirement, in combination with the minimum standards we propose for trade size and value impact, may lead funds to modify their liquidity classification processes, which would make the process more standardized, timely, and efficient.

128

Despite the liquidity constraints in Mar. 2020, we observed through Form N-PORT filings that roughly 75% of funds did not reclassify any investment held in both Feb. and Mar. 2020. Specifically, roughly 80% of U.S. equity funds did not reclassify any holding that was held in both Feb. and Mar. 2020, while roughly 10% reclassified at least one investment into a more liquid category and roughly 13% reclassified at least one investment into a less liquid category. Roughly 55% of taxable bond funds reclassified on average 4% of their portfolios, with the median fund reclassifying 1% of its portfolio. Of the funds that reclassified, roughly 30% reclassified at least one investment into a more liquid category and roughly 44% reclassified at least one investment into a less liquid category. More funds did, however, reclassify in Mar. 2020 period than for either Feb. or Apr. 2020.

We request comment on the proposed amendments to require funds to classify the liquidity of their investments on a daily basis.

32. Should we require funds to classify all portfolio investments on a daily basis, as proposed? Would this proposed amendment result in a material change to how funds are currently classifying? To what extent do funds already classify the liquidity of their investments on a daily basis or collect the information they would need to classify daily? Would this proposed amendment better integrate liquidity risk management and portfolio management systems?

33. We also are proposing that funds use a stressed trade size and a defined value impact standard in determining liquidity classifications. Would those changes affect the burdens of classifying on a daily basis? Would those effects be different for different types of funds? For example, would it be easier to determine on a daily basis whether the sale of a stressed trade size of shares listed on an exchange would exceed 20% of the average daily trading volume for those shares than to determine whether the sale of a stressed trade size of other investments would result in a price decline of more than 1%?

34. Instead of classifying on a daily basis, should we require funds to classify the liquidity of their investments at some other frequency (

e.g.,

weekly, biweekly, or monthly)? If so, should we maintain the requirement for a fund to classify more frequently if changes in relevant market, trading, and investment-specific considerations are reasonably expected to materially affect one or more of its investments' classifications? Is there a different approach we should use effectively to require a fund to classify its investments in response to changing conditions? Are there certain types of funds that should be excluded from daily classifications? If so, which funds?

35. If we require funds to classify on a non-daily frequency, how would they monitor for compliance with the 15% limit on illiquid investments and the highly liquid investment minimum? How are those limits monitored for compliance now?

2. Highly Liquid Investment Minimums

a. Proposed Scope of the Requirement and Determination of the Minimum

Rule 22e-4 currently requires a fund to determine a highly liquid investment minimum if it does not primarily hold assets that are highly liquid investments. Funds that are subject to the highly liquid investment minimum requirements must determine a highly liquid investment minimum considering several factors, review the minimum at least annually, and adopt policies and procedures to respond to a shortfall of the fund's highly liquid investments below the minimum required.

129

We propose to require all funds to determine and maintain a highly liquid investment minimum of at least 10% of the fund's net assets, which is equivalent to the stressed trade size. In connection with this proposed requirement, we would remove the exclusion for funds that primarily invest in highly liquid investments (the “primarily exclusion”). The proposed amendments are designed to ensure that funds have sufficient liquid investments for managing stressed conditions and heightened levels of redemptions.

129

See

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

We assessed liquidity-related data reported on Forms N-PORT, as well as the development of liquidity risk management programs, through staff outreach to funds and advisers. Based on Form N-PORT filings, most funds do not determine a highly liquid investment minimum and instead rely on the primarily exclusion.

130

For those funds that have highly liquid investment minimums, the rule currently requires that they consider various liquidity factors, such as their investment strategy and cash-flow projections, in both normal and reasonably foreseeable stressed conditions.

131

We understand that those funds additionally consider factors such as asset class, market volatility, and shareholder concentration in their determinations.

130

Approximately 83% of funds holding 85% of net assets do not report setting a highly liquid investment minimum on Form N-PORT.

131

For these purposes, funds are required to consider certain factors during stressed conditions only to the extent they are reasonably foreseeable during the period until the next review of the highly liquid investment minimum.

See

rule 22e-4(b)(1)(iii)(A)(

As discussed above, by requiring fund liquidity classifications to assume the sale or disposition of a set stressed trade size, the proposal is intended to better prepare all funds for future stressed conditions.

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To help further prepare a fund for heightened levels of redemptions in stressed conditions, we are proposing to require the highly liquid investment minimum to be equal to or higher than the assumed stressed trade size. In setting the highly liquid investment minimum to be at least the stressed trade size, we considered data on fund flows for setting the stressed trade size as well as data reported on Form N-PORT on funds' current highly liquid investment minimums. As of March 2020, for funds that had determined a highly liquid investment minimum, the majority of those funds reported setting a highly liquid investment minimum of less than 10% of the fund's net assets. In contrast, approximately 8% of those funds reported setting a highly liquid investment minimum of more than 50% of the fund's net assets. Thus, while there is a wide divergence in highly liquid investment minimums, most of these funds have a minimum that is lower than the proposed 10% level. Given the level of weekly outflows some funds have experienced and the difficulty in predicting future stress events, we believe that a regulatory minimum of 10% for the highly liquid investment minimum would benefit investors by improving the ability of funds to meet shareholder redemptions in stressed scenarios.

132

See supra

sect

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