[Federal Register Volume 81, Number 223 (Friday, November 18, 2016)]
[Rules and Regulations]
[Pages 82142-82269]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 2016-25348]
[[Page 82141]]
Vol. 81
Friday,
No. 223
November 18, 2016
Part IV
Securities and Exchange Commission
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17 CFR Parts 270 and 274
Investment Company Liquidity Risk Management Programs; Final Rule
Federal Register / Vol. 81 , No. 223 / Friday, November 18, 2016 /
Rules and Regulations
[[Page 82142]]
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SECURITIES AND EXCHANGE COMMISSION
17 CFR Parts 270 and 274
[Release Nos. 33-10233; IC-32315; File No. S7-16-15]
RIN 3235-AL61
Investment Company Liquidity Risk Management Programs
AGENCY: Securities and Exchange Commission.
ACTION: Final rule.
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SUMMARY: The Securities and Exchange Commission is adopting new rules,
a new form and amendments to a rule and forms designed to promote
effective liquidity risk management throughout the open-end investment
company industry, thereby reducing the risk that funds will be unable
to meet their redemption obligations and mitigating dilution of the
interests of fund shareholders. The amendments also seek to enhance
disclosure regarding fund liquidity and redemption practices. The
Commission is adopting new rule 22e-4, which requires each registered
open-end management investment company, including open-end exchange-
traded funds (``ETFs'') but not including money market funds, to
establish a liquidity risk management program. Rule 22e-4 also requires
principal underwriters and depositors of unit investment trusts
(``UITs'') to engage in a limited liquidity review. The Commission is
also adopting amendments to Form N-1A regarding the disclosure of fund
policies concerning the redemption of fund shares. The Commission also
is adopting new rule 30b1-10 and Form N-LIQUID that generally will
require a fund to confidentially notify the Commission when the fund's
level of illiquid investments that are assets exceeds 15% of its net
assets or when its highly liquid investments that are assets fall below
its minimum for more than a specified period of time. The Commission
also is adopting certain sections of Forms N-PORT and N-CEN that will
require disclosure of certain information regarding the liquidity of a
fund's holdings and the fund's liquidity risk management practices.
DATES: Effective Dates: This rule is effective January 17, 2017 except
for the amendments to Form N-CEN (referenced in 17 CFR 274.101) which
are effective June 1, 2018.
Compliance Dates: The applicable compliance dates are discussed in
section III.M. of this final rule.
FOR FURTHER INFORMATION CONTACT: Zeena Abdul-Rahman, John Foley, Andrea
Ottomanelli Magovern, Naseem Nixon, Amanda Hollander Wagner, Senior
Counsels; Thoreau Bartmann, Melissa Gainor, Senior Special Counsels; or
Kathleen Joaquin, Senior Financial Analyst, Investment Company
Rulemaking Office, at (202) 551-6792, Ryan Moore, Assistant Chief
Accountant, or Matt Giordano, Chief Accountant at (202) 551-6918,
Office of the Chief Accountant, Division of Investment Management,
Securities and Exchange Commission, 100 F Street NE., Washington, DC
20549-8549.
SUPPLEMENTARY INFORMATION: The Securities and Exchange Commission (the
``Commission'') is adopting new rules 22e-4 [17 CFR 270.22e-4] and
30b1-10 [17 CFR 270.223], under the Investment Company Act of 1940 [15
U.S.C. 80a-1 et seq.] (``Investment Company Act'' or ``Act''); new
Form-N-LIQUID [referenced in 17 CFR 274.30b1-10] under the Investment
Company Act; amendments to Form-N-1A [referenced in 17 CFR 274.11A]
under the Investment Company Act and the Securities Act of 1933
(``Securities Act'') [15 U.S.C. 77a et seq.]; and adopting sections to
Form N-PORT [referenced in 17 CFR 274.150] and Form N-CEN [referenced
in 17 CFR 274.101] under the Investment Company Act.\1\
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\1\ Unless otherwise noted, all references to statutory sections
are to the Investment Company Act, and all references to rules under
the Investment Company Act are to Title 17, Part 270 of the Code of
Federal Regulations [17 CFR 270].
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Table of Contents
I. Introduction
II. Background
A. Open-End Funds
B. The Role of Liquidity in Open-End Funds
C. Recent Developments in the Open-End Fund Industry
D. Overview of Current Practices
E. Rulemaking Adoption Overview
III. Discussion
A. Program Requirement and Scope of Rule 22e-4
B. Assessment, Management, and Review of Liquidity Risk
C. Classifying the Liquidity of a Fund's Portfolio Investments,
and Disclosure and Reporting Requirements Regarding Portfolio
Investments' Liquidity Classifications
D. Highly Liquid Investment Minimum
E. Limitation on Funds' Illiquid Investments
F. Policies and Procedures Regarding Redemptions in Kind
G. Cross-Trades
H. Board Approval and Designation of Program Administrative
Responsibilities
I. Recordkeeping Requirements
J. ETFs
K. Limitation on Unit Investment Trusts' Investments in Illiquid
Investments
L. Disclosure and Reporting Requirements Regarding Liquidity
Risk and Liquidity Risk Management
M. Effective and Compliance Dates
IV. Economic Analysis
A. Introduction and Primary Goals of Regulation
B. Economic Baseline
C. Benefits and Costs, and Effects on Efficiency, Competition,
and Capital Formation
V. Paperwork Reduction Act Analysis
A. Introduction
B. Rule 22e-4
C. Form N-PORT
D. Form N-LIQUID and Rule 30b1-10
E. Form N-CEN
F. Form N-1A
VI. Final Regulatory Flexibility Act Analysis
A. Need for the Rule
B. Significant Issues Raised by Public Comment
C. Small Entities Subject to the Rule
D. Projected Reporting, Recordkeeping, and Other Compliance
Requirements
E. Agency Action To Minimize Effect on Small Entities
VII. Statutory Authority and Text of Amendments
Text of Rules and Forms
I. Introduction
Redeemability is a defining feature of open-end investment
companies.\2\ At the time the Act was adopted, this feature was
recognized as unique to open-end investment companies,\3\ and the Act's
classification of management investment companies as either open-end
(``open-end funds'' or ``funds'') \4\ or
[[Page 82143]]
closed-end, upon which several of the Act's other provisions depend,
turns on whether the investment company's shareholders have the right
to redeem their shares on demand. When the Investment Company Act was
enacted, it was understood that redeemability meant that an open-end
fund had to have a liquid portfolio.\5\ Since the 1940s, the Commission
has stated that open-end funds should maintain highly liquid portfolios
and recognized that this may limit their ability to participate in
certain transactions in the capital markets.\6\ Section 22(e) of the
Act enforces the shareholder's right of prompt redemption in open-end
funds by compelling such funds to make payment on shareholder
redemption requests within seven days of receiving the request.
Potential dilution of shareholders' interests in open-end funds also
was a significant concern of Congress when drafting the Act and was
among the noted abuses that led to the enactment of the Act, as
reflected in sections 22(a) and (c).\7\
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\2\ See Investment Trusts and Investment Companies: Letter from
the Acting Chairman of the SEC, A Report on Abuses and Deficiencies
in the Organization and Operation of Investment Trusts and
Investment Companies (1939), at n.206 (``[T]he salient
characteristic of the open-end investment company . . . was that the
investor was given a right of redemption so that he could liquidate
his investment at or about asset value at any time that he was
dissatisfied with the management or for any other reason.''). An
open-end investment company is required by law to redeem its
securities on demand from shareholders at a price approximating
their proportionate share of the fund's net asset value (``NAV'')
next calculated by the fund after receipt of such redemption
request.
\3\ See Investment Trusts and Investment Companies: Hearings on
S. 3580 before a Subcomm. of the Senate Comm. on Banking and
Currency, 76th Cong., 3d Sess. (1940) (``1940 Senate Hearings
Transcript''), at 453 (Statement of Mahlon E. Traylor) (``Open-end
companies are unlike any other type of investment company,
principally because of the highly important distinguishing feature
that their shareholders can, by contract right, withdraw their
proportionate interest at will simply by surrendering their shares
to the company for redemption at liquidating value.'').
\4\ In-Kind ETFs (as defined below) are included when we refer
to ``funds'' or ``open-end funds'' throughout this Release, except
in the sections discussing classifying the liquidity of a fund's
portfolio positions and the highly liquid investment minimum
requirement, from which In-Kind ETFs are excepted. We have done this
for conciseness and we recognize that these naming conventions
differ from the text of rule 22e-4. Additionally, while a money
market fund is an open-end management investment company, money
market funds are not subject to the rules and amendments we are
adopting (except certain amendments to Form N-CEN and Form N-1A) and
thus are not included when we refer to ``funds'' or ``open-end
funds'' in this Release except where specified.
\5\ See Investment Trusts and Investment Companies: Hearings on
H.R. 10065 before a Subcomm. of the House Comm. on Interstate and
Foreign Commerce, 76th Cong., 3d Sess. 112 (1940), at 57 (Statement
of Robert E. Healy) (``due to the right of the stockholder to come
in and demand a redemption, the [open-end fund] has to keep itself
in a very liquid position. That is, it has to be able to turn its
securities into money on very short notice.'').
\6\ 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.'').
\7\ See 1940 Senate Hearings Transcript, supra footnote 3, at
37, 137-145 (stating that, among the abuses that served as a
backdrop for the Act, were ``practices which resulted in substantial
dilution of investors' interests'', including backward pricing by
fund insiders to increase investment in the fund and thus enhance
management fees, but causing dilution of existing investors in the
fund).
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Although the Investment Company Act provides funds with a seven-day
window to pay proceeds upon an investor's redemption, the settlement
period for open-end fund redemptions has shortened considerably over
the years. There are several reasons for shorter settlement periods,
including broker-dealer settlement cycle requirements,\8\ evolving
industry standards, and technological advances in the settlement
infrastructure.\9\ In addition, many funds state in their prospectuses
that investors can ordinarily expect to receive redemption proceeds in
shorter periods than seven days.\10\ At the same time, open-end funds
have experienced significant growth,\11\ markets have grown more
complex, and funds pursue more complex investment strategies, including
fixed income and alternative investment strategies focused on less
liquid asset classes. These trends have made the role of fund liquidity
and liquidity management more important than ever in reducing the risk
that a fund will be unable to meet its obligations to redeeming
shareholders or other obligations under applicable law, while also
minimizing the impact of those redemptions on the fund (i.e.,
mitigating investor dilution). Furthermore, recent events have
demonstrated the significant adverse consequences to remaining
investors in a fund when it fails to adequately manage liquidity.\12\
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\8\ Open-end funds that are redeemed through broker-dealers must
meet redemption requests within three business days because broker-
dealers are subject to rule 15c6-1 under the Securities Exchange Act
of 1934 (the ``Exchange Act''), which establishes a three-day (T +
3) settlement period for security trades effected by a broker or a
dealer.
\9\ Generally, settlement time frames for mutual fund shares
have been shortening for decades. See Open-End Fund Liquidity Risk
Management Programs; Swing Pricing; Re-Opening of Comment Period for
Investment Company Reporting Modernization Release, Investment
Company Act Release No. 31835 (Sept. 22, 2015) [80 FR 62274 (Oct.
15, 2015)] (``Proposing Release''), at section II.C.2. See also,
e.g., T+2 Industry Steering Committee, Shortening the Settlement
Cycle: The Move to T+2 (2015), at n.18, available at http://www.ust2.com/pdfs/ssc.pdf (``In today's environment . . . open-end
mutual funds settle through NSCC generally on a T+1 basis (excluding
certain retail trades which typically settle on T+3).''). See also
Amendment to Securities Transaction Settlement Cycle, Securities
Exchange Act Release No. 34-78962 (September 29, 2016) [81 FR 69240
(October 05, 2016)].
\10\ See, e.g., Fidelity Commonwealth Trust rule 485(b)
Registration Statement (June 29, 2016), available at https://www.sec.gov/Archives/edgar/data/205323/000137949116004602/filing776.htm (``Normally, redemptions will be processed by the next
business day, but it may take up to seven days to pay the redemption
proceeds if making immediate payment would adversely affect the
fund.''); PIMCO Funds rule 485(b) Registration Statement (Feb. 26,
2016), available at https://www.sec.gov/Archives/edgar/data/810893/000119312516481663/d149399d485bpos.htm#chapter_7_3686 (``Redemption
proceeds will normally be mailed to the redeeming shareholder within
three calendar days . . . [but] may take up to seven days.'').
\11\ As of the end of 2015, there were 10,633 open-end funds
(excluding money market funds, but including ETFs), as compared to
5,279 at the end of 1996. See Investment Company Institute, 2016
Investment Company Fact Book (2016) (``2016 ICI Fact Book''),
available at https://www.ici.org/pdf/2016_factbook.pdf.
\12\ For example, during the pendency of our proposal, the Third
Avenue Focused Credit Fund, a non-diversified open-end fund, adopted
a plan of liquidation, and requested and obtained exemptive relief
to suspend shareholder redemptions, following a period of heavy
redemption requests that the fund stated reduced the fund's
portfolio liquidity. The Third Avenue Focused Credit Fund has yet to
complete the liquidation of fund assets. Additionally, the fund
reported that, as a result of the continuous liquidation of
securities without reinvestment, the fund became increasingly more
concentrated, which negatively impacted performance. See Third
Avenue Trust and Third Avenue Management LLC, Investment Company Act
Release No. 31943 (Dec. 16, 2015) (``Third Avenue Temporary
Order''); Third Avenue Focused Credit Fund Semi-Annual Report to
Shareholders (April 30, 2016), available at: http://thirdave.com/wp-content/uploads/2016/06/Q2-2016-TFCIX-Semi-Annual-Report.pdf (``The
Fund is considerably more concentrated than it has ever been. As we
have been liquidating securities and not recycling the cash, the top
10 holdings have increased from 32.6% at March 31, 2015 to
approximately 67% of the Fund. We are increasingly dependent on the
top 10 names to drive performance.''). See also infra footnotes 81-
84 and accompanying text.
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We remain committed, as the primary regulator of open-end funds, to
designing regulatory programs that respond to the risks associated with
the increasingly complex portfolio composition and operations of the
asset management industry. In developing the proposed rules, Commission
staff engaged with large and small fund complexes to better understand
funds' management of liquidity risk. Through these outreach efforts our
staff has learned that, while some funds and their managers have
developed extensive liquidity risk management programs, others have
dedicated significantly fewer resources, attention and focus to
managing liquidity risk in a formalized way. We believe that it is in
the interest of funds and fund investors to create a regulatory
framework that would reduce the risk that a fund will be unable to meet
its redemption obligations and minimize dilution of shareholder
interests by promoting stronger and more effective liquidity risk
management across open-end funds.
We sought to address these goals with the proposal on fund
liquidity risk management that we published in late 2015.\13\ This
proposal would have required funds to: establish liquidity risk
management programs, including classifying and monitoring each
portfolio asset's level of liquidity and designating a minimum amount
of highly liquid investments; provide additional reporting to us; and
enhance disclosure to investors regarding the liquidity of fund
portfolios and how funds manage liquidity risk and redemption
obligations. In order to
[[Page 82144]]
provide funds with an additional tool to mitigate potential dilution
and to manage fund liquidity, the proposal included amendments to rule
22c-1 under the Act to permit funds (except money market funds and
ETFs) to use ``swing pricing,'' a process of adjusting the NAV of a
fund's shares to pass on to purchasing or redeeming shareholders more
of the costs associated with their trading activity.\14\
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\13\ See Proposing Release, supra footnote 9.
\14\ We note that we are adopting swing pricing, and associated
changes to Form N-PORT and N-CEN in a companion release. See
Investment Company Swing Pricing, Investment Company Act Release No.
32316 (Oct. 13, 2016) (``Swing Pricing Adopting Release''). All
comments on the proposed swing pricing rules and associated issues
are discussed in that release.
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We received more than 70 comment letters on the proposal.\15\ The
majority of commenters generally supported a requirement that funds
adopt a formal, written liquidity risk management program that is risk
oriented and principles based, although many provided suggestions and
alternatives for us to consider.\16\ Many commenters objected to
certain aspects of the proposal, particularly the liquidity
classification requirement, the three-day liquid asset minimum, and the
requirement that funds publicly disclose the liquidity of each
portfolio position.\17\ Several commenters specifically supported
applying the liquidity risk management requirements to all open-end
funds, with the exception of money market funds.\18\ Others expressed
concerns with regard to ETFs, and recommended that the Commission
exclude ETFs that primarily satisfy purchase and redemption orders in
kind from the liquidity risk management requirements or develop a more
tailored liquidity risk management program applicable to ETFs.\19\
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\15\ The comment letters on the Proposing Release (File No. S7-
16-15) are available at http://www.sec.gov/comments/s7-16-15/s71615.shtml.
\16\ See, e.g., Comment Letter of Investment Company Institute
(Jan. 13, 2016) (``ICI Comment Letter I''); Comment Letter of
BlackRock Inc. (Jan. 13, 2016) (``BlackRock Comment Letter'');
Comment Letter of Charles Schwab Investment Management (Jan. 13,
2016) (``Charles Schwab Comment Letter'').
\17\ See, e.g., ICI Comment Letter I (arguing that the six-
category asset classification scheme and three-day liquid asset
minimum are problematic and encourage a ``one-size-fits-all''
approach rather than a risk-based approach to liquidity management);
Charles Schwab Comment Letter (arguing that public disclosure of the
liquidity of each portfolio position may confuse and mislead
investors).
\18\ See, e.g., Comment Letter of HSBC Global Asset Management
(Jan. 13, 2016) (``HSBC Comment Letter'') (supporting the exclusion
of closed-end funds and money market funds from the liquidity risk
management requirements); Charles Schwab Comment Letter (supporting
the application of the risk management requirements to ETFs).
\19\ See, e.g., ICI Comment Letter I; BlackRock Comment Letter
(suggesting that the Commission should develop a separate and
comprehensive rule addressing the different types of ETFs and their
respective risks). The comments we received addressing exchange-
traded managed funds (``ETMFs'') suggested that the Commission treat
ETMFs in the same manner as ETFs and did not recommend any further
unique treatment of ETMFs. See Comment Letter of the American Bar
Association (Feb. 11, 2016); Comment Letter of Financial Services
Roundtable (Jan. 13, 2016) (``FSR Comment Letter'').
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Today, after consideration of the many comments we received, we are
adopting the proposal with a number of modifications to enhance the
effectiveness and workability of the rule's liquidity risk management
requirements. The Commission is adopting new rule 22e-4, which will
require each fund to adopt and implement a written liquidity risk
management program designed to assess and manage the fund's liquidity
risk, which will be overseen by the fund's board. As discussed in more
detail below, the Commission is modifying from the proposal some of the
liquidity risk management program elements, including reducing the
liquidity classification categories from six to four, providing
tailored program requirements for ETFs, and revising the fund board
oversight requirements.
The new rule contains a highly liquid investment minimum
requirement, which is similar to the proposed three-day liquid asset
minimum. However, instead of barring a fund from purchasing securities
other than highly liquid investments if the fund falls below its
minimum as proposed for the three-day liquid asset minimum, under the
adopted rules, if the fund falls below its highly liquid investment
minimum, it would: (1) Report that occurrence to the fund board at its
next scheduled meeting; (2) if it is below the minimum for more than a
brief period of time, report the occurrence to the board and, on Form
N-LIQUID, to the Commission within one business day; and (3) develop
and provide to the board a plan for restoring the minimum within a
reasonable period of time.
We also are adopting a 15% limitation on funds' purchases of
illiquid investments, largely as proposed, but the definition of
investments considered illiquid and subject to this 15% limit has been
enhanced and substantially harmonized with the classification system we
are adopting today. Additionally, the Commission is adopting new
reporting Form N-LIQUID, which will require a fund to confidentially
notify the Commission within one business day if the fund's illiquid
investment holdings exceed 15% of its net assets or if its highly
liquid investments fall below its minimum for more than a brief period
of time. Furthermore, much as proposed, the Commission is adopting
reporting and disclosure requirements under Form N-CEN, Form N-PORT,
and Form N-1A regarding liquidity risk and liquidity risk management.
In response to commenters' concerns, a number of the additional
reporting items on Form N-PORT will be non-public.\20\
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\20\ If any provision of these rules, or the application thereof
to any person or circumstance, is held to be invalid, such
invalidity shall not affect other provisions or application of such
provisions to other persons or circumstances that can be given
effect without the invalid provision or application.
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Taken together, these reforms are designed to provide investors
with increased protection regarding how liquidity in their open-end
funds is managed, thereby reducing the risk that funds will be unable
to meet redemption or other legal obligations, and mitigating dilution
of the interests of fund shareholders. These reforms also are intended
to give investors better information to make investment decisions, and
to give the Commission better information to conduct comprehensive
monitoring and oversight of an ever-evolving fund industry.
II. Background
A. Open-End Funds
As we discussed in the Proposing Release, individual and
institutional investors increasingly have come to rely on investments
in open-end funds to meet their financial needs and access the capital
markets. At the end of 2015, 54.9 million households, or 44.1 percent
of all U.S. households owned funds.\21\ Funds allow investors to pool
their investments with those of other investors so that they may
together benefit from fund features such as professional investment
management, diversification, and liquidity. Fund shareholders share the
gains and losses of the fund, and also share its costs.\22\
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\21\ See 2016 ICI Fact Book, supra footnote 11, at 12.
\22\ There are currently four primary kinds of open-end funds:
Money market funds, mutual funds other than money market funds,
ETFs, and ETMFs. Money market funds are a special kind of mutual
fund that complies with the requirements of rule 2a-7 under the Act.
ETFs registered with the Commission are organized either as open-end
management investment companies or unit investment trusts. See
section 4(2) of the Act (defining ``unit investment trust'' as an
investment company which (A) is organized under a trust indenture,
contract of custodianship or agency, or similar instrument, (B) does
not have a board of directors, and (C) issues only redeemable
securities, each of which represents an undivided interest in a unit
of specified securities, but does not include a voting trust). Most
ETFs are organized as open-end management investment companies and,
except where specified, when we refer to ETFs in this Release, we
are referring to ETFs that are organized as open-end management
investment companies.
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As noted above, investors in mutual funds can redeem their shares
on each business day and, by law, must receive approximately their pro
rata share of the fund's net assets (or its cash value) within seven
calendar days after receipt of a redemption request.\23\ Under the
Act's definition of redeemable security, open-end funds have the right
to redeem shareholders in cash or in kind (that is, by delivering
certain assets from the fund's portfolio, rather than cash, to a
redeeming shareholder).\24\ However, while funds often reserve the
right to redeem in kind for certain redemption requests, the majority
of mutual funds redeem only in cash for a variety of reasons, including
the limited ability and/or unwillingness of fund shareholders to
receive securities rather than cash.\25\
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\23\ See section 2(a)(32) of the Act (defining a ``redeemable
security'' as any security, other than short-term paper, that
entitles its holder to receive approximately his proportionate share
of the issuer's current net assets, or the cash equivalent thereof),
and section 22(e) of the Act (providing, in part, that no registered
investment company shall suspend the right of redemption, or
postpone the date of payment upon redemption of any redeemable
security in accordance with its terms for more than seven days after
tender of the security absent specified unusual circumstances). See
also rule 22c-1 (requiring that redeemable securities be transacted
``at a price based on the current net asset value of such security
which is next computed after receipt of a tender of such security
for redemption or of an order to purchase or sell such security'').
\24\ Prior to the adoption of the Act, open-end funds largely
redeemed fund shares in cash and, as such, a redeemable security was
generally understood to mean a security that was redeemable for
cash. See, e.g., Investment Trusts and Investment Companies: Senate
Report 1775 on S. 4108, 76th Cong., 3d Sess. (1940), at 2 (``[a
redeemable security] is, a security which provides that the holder
may tender it to the company at any time and receive a sum of money
approximating the current market value of his proportionate interest
in the company's assets.''[emphasis added]). However, section
2(a)(32) has traditionally been interpreted to give funds the option
of redeeming their shares in cash or in kind. See, e.g., Investment
Trusts and Investment Companies: Report of the Securities and
Exchange Commission Part I (1939) at 21 (``A company is of the
`open-end' type if a shareholder has the right to require the
company to purchase or redeem or cause the purchase or redemption of
the shares representing his proportionate interest in the company's
properties, or the cash equivalent of such interest.''); see also
Adoption of (1) Rule 18f-1 Under the Investment Company Act of 1940
to Permit Registered Open-End Investment Companies Which Have the
Right to Redeem In Kind to Elect to Make Only Cash Redemptions and
(2) Form-N-18F-1, Investment Company Act Release No. 6561 (June 14,
1971) [36 FR 11919 (June 23, 1971)] (``Rule 18f-1 and Form N-18F-1
Adopting Release'') (stating that the definition of ``redeemable
security'' in section 2(a)(32) of the Investment Company Act ``has
traditionally been interpreted as giving the issuer the option of
redeeming its securities in cash or in kind.'').
\25\ See Comment Letter of Invesco Advisers, Inc. (Jan. 13,
2016) (``Invesco Comment Letter'') (``The primary problem with using
redemptions in kind to meet large redemptions is the willingness and
ability of the redeeming entity to receive securities instead of
cash.''). See also Money Market Fund Reform; Amendments to Form PF,
Investment Company Act Release No. 30551 (June 5, 2013) [78 FR
36834, (June 19, 2013)] (``2013 Money Market Fund Reform Proposing
Release''), at n.473 and accompanying text (stating that ``[m]any
commenters believed that requiring in-kind redemptions would be
technically unworkable due to complex valuation and operational
issues that would be imposed on both the fund and on investors
receiving portfolio securities.'').
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ETFs also offer investors an undivided interest in a pool of
assets.\26\ ETF shares, similar to listed stocks, are bought and sold
throughout the day by investors on an exchange through a broker-
dealer.\27\ In addition, like mutual funds, ETFs provide redemption
rights on a daily basis, but, pursuant to exemptive orders, such
redemption rights may be exercised only by certain large market
participants--typically broker-dealers--called ``authorized
participants.'' \28\ When an authorized participant transacts with an
ETF to purchase and sell ETF shares, these share transactions are
structured in large blocks called ``creation units.'' Most ETFs are
structured so that an authorized participant will purchase a creation
unit with a ``portfolio deposit,'' which is a basket of assets (and
sometimes cash) that generally reflects the composition of the ETF's
portfolio.\29\ After purchasing a creation unit, an authorized
participant may hold the ETF shares or sell (or lend) some or all of
them to investors in the secondary market. Similarly, for most ETFs,
when an authorized participant wishes to redeem ETF shares, it presents
a creation unit of ETF shares to the ETF for redemption and receives in
return a ``redemption basket,'' the contents of which are publicly
declared by the ETF before the beginning of the trading day.\30\
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\26\ Since 2003, the number of ETFs traded in U.S. markets has
increased by more than 2,200 funds, and the assets held by ETFs have
increased from $151 billion at the end of 2003 to $2.1 trillion at
the end of 2015. See 2016 ICI Fact Book, supra footnote 11, at 60.
\27\ See Exchange-Traded Funds, Investment Company Act Release
No. 28193 (Mar. 11, 2008) [73 FR 14618 (Mar. 18, 2008)] (``ETF
Proposing Release'').
\28\ Authorized participants may purchase and redeem ETF shares
at the ETF's NAV from the ETF.
\29\ The ETF publicly declares the contents of the portfolio
deposit before the beginning of the trading day. See Request for
Comment on Exchange-Traded Products, Securities Exchange Act Release
No. 75165 (June 12, 2015) [80 FR 34729 (June 17, 2015)] (``2015 ETP
Request for Comment''), at nn.19-20 and accompanying text.
\30\ See ETF Proposing Release, supra footnote 27, at n.24 and
accompanying text.
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ETMFs are a hybrid between a traditional mutual fund and an
ETF.\31\ Like ETFs, ETMFs have shares listed and traded on a national
securities exchange; directly issue and redeem shares in creation units
only; impose fees on creation units issued and redeemed to authorized
participants to offset the related costs to the ETMFs; and primarily
utilize in-kind transfers of portfolio deposits in issuing and
redeeming creation units. Like mutual funds, ETMFs are bought and sold
at prices linked to NAV and seek to maintain the confidentiality of
their current portfolio positions.
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\31\ The Commission approved ETMFs in 2014 and the first ETMFs
have since been launched. See Eaton Vance Management, et al.,
Investment Company Act Release No. 31333 (Nov. 6, 2014) (notice of
application) (``ETMF Notice'') and In the Matter of Eaton Vance
Management, et al., Investment Company Act Release No. 31361 (Dec.
2, 2014) (order) (``ETMF Order''). Given the similarities between
ETFs and ETMFs and that the new requirements will apply to ETMFs as
they do to ETFs, this Release generally includes ETMFs in the term
``ETF'' and separately mentions ETMFs only if appropriate. See supra
footnote 19.
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B. The Role of Liquidity in Open-End Funds
1. Introduction
A hallmark of open-end funds is that they must be able to convert
some portion of their portfolio holdings into cash on a frequent basis
because they issue redeemable securities, and are required by section
22(e) of the Investment Company Act to make payment to shareholders for
securities tendered for redemption within seven days of their tender
(although some funds may reserve the right to make redemptions in kind
for certain redemption requests). As a practical matter, many investors
expect to receive redemption proceeds in fewer than seven days as some
mutual funds represent in their prospectuses that they will generally
pay redemption proceeds on a next business day basis.\32\ Given the
statutory and regulatory requirements for meeting redemption requests,
as well as any potential liability for representations made to
investors regarding payment of redemption proceeds, a mutual fund must
adequately manage the liquidity of its portfolio so that redemption
requests can be satisfied in a timely manner.
---------------------------------------------------------------------------
\32\ See supra footnote 10; see also supra footnote 8 (noting
that open-end funds that are redeemed through broker-dealers must
meet redemption requests within three business days due to the
application of rule 15c6-1 under the Exchange Act).
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Sufficient liquidity of ETF portfolio positions also is important.
Many ETFs typically make in-kind redemptions of creation units, which
can mitigate the need for ETFs to maintain cash compared to mutual
funds, particularly if the in-kind redemptions are of a representative
basket of the ETF's
[[Page 82146]]
portfolio assets that do not alter the ETF's liquidity profile.
However, transferring illiquid or less liquid instruments to the
redeeming authorized participants could result in a liquidity cost to
the authorized participants or other market participants, which could
increase the cost of their participation and interfere with their role
in the ETF arbitrage mechanism, resulting in the ETF trading at
increased bid-ask spreads and/or a premium or discount to its NAV and
ultimately impacting investors.\33\ Declining liquidity in an ETF's
basket assets also could affect the ability of an authorized
participant or other market participants to readily assemble the basket
for purchases of creation units and to sell securities received upon
redemption of creation units.
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\33\ A significant amount of illiquid securities in an ETF's
portfolio can make arbitrage opportunities more difficult to
evaluate because it would be difficult for market makers to price,
trade, and hedge their exposure to the ETF. See infra footnote 843
and accompanying text. Commenters noted that the effective
functioning of this arbitrage mechanism has been pivotal to the
operation of ETFs. See ICI Comment Letter I.
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In addition, all ETFs reserve the right to satisfy redemption
requests in cash rather than in kind, but the extent to which ETFs
satisfy redemption requests in cash varies. While many ETFs redeem in
cash only rarely, some ETFs ordinarily redeem authorized participants
in cash. ETFs that elect to redeem authorized participants in cash in
more than a de minimis amount, like mutual funds, would need to ensure
that they have adequate portfolio liquidity (in conjunction with any
other liquidity sources) to meet shareholder redemptions.
As noted above, ETMFs have features of both mutual funds and ETFs.
As ETMFs would redeem their shares on a daily basis from authorized
participants, ETMFs would need to hold sufficiently liquid assets to
meet such redemptions to the extent that the ETMFs satisfy the
redemption requests in cash. As with ETFs, however, the ETMFs' practice
of making in-kind redemptions could mitigate the need to maintain cash.
Further, as ETMF market makers would not engage in the same kind of
arbitrage as ETF market makers because the pricing of the ETMF shares
is linked to the fund's NAV (subject to execution costs), the liquidity
of an ETMF's portfolio is more relevant to an ETMF's ability to meet
redemptions and the amount of execution costs than to an arbitrage
function.
2. Statutory and Regulatory Requirements
An open-end fund's failure to maintain sufficiently liquid assets
or otherwise manage liquidity implicates multiple provisions of the
Act, as well as other federal securities laws and regulations. Section
2(a)(32) of the Act,\34\ when read together with sections 4(2) and
5(a),\35\ creates an obligation on open-end funds and UITs to provide
shareholders with approximately their proportionate share of NAV upon
the presentation of a redemption request. Section 22(e) of the Act
provides in turn that the right of redemption may not be suspended and
payment of redemption proceeds may not be postponed for more than seven
days after tender of a redeemable security absent specified unusual
circumstances.\36\
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\34\ See supra footnote 23.
\35\ Section 4(2) of the Act defines a ``unit investment trust''
as an investment company which, among other things, ``issues only
redeemable securities.'' Section 5(a) of the Act defines an ``open-
end company'' as a ``management company which is offering for sale
or has outstanding any redeemable security of which it is the
issuer''.
\36\ Section 22(e) of the Act permits open-end funds to suspend
redemptions and postpone payment for redemptions already tendered
for any period during which the New York Stock Exchange (``NYSE'')
is closed (other than customary weekend and holiday closings) and in
three additional situations if the Commission has made certain
determinations. First, a fund may suspend redemptions for any period
during which trading on the NYSE is restricted, as determined by the
Commission. Second, a fund may suspend redemptions for any period
during which an emergency exists, as determined by the Commission,
as a result of which it is not reasonably practicable for the fund
to: (i) Liquidate its portfolio securities, or (ii) fairly determine
the value of its net assets. Third, a fund may suspend redemptions
for such other periods as the Commission may by order permit for the
protection of fund shareholders. The Commission has rarely issued
orders permitting the suspension of redemptions for periods of
restricted trading or emergency circumstances but has issued orders
``for such other periods'' under section 22(e)(3) on a few
occasions. See, e.g., In the Matter of The Reserve Fund, on behalf
of two of its series, the Primary Fund and the U.S. Government Fund,
Investment Company Act Release No. 28386 (Sept. 22, 2008) [73 FR
55572 (Sept. 25, 2008)]; In the Matter of Municipal Lease Securities
Fund, Inc., Investment Company Act Release No. 17245 (Nov. 29,
1989); Third Avenue Temporary Order, supra footnote 12. Money market
funds are able to suspend redemptions in certain limited
circumstances. See rule 22e-3 under the Act; see also the Proposing
Release, supra footnote 9, at n.155.
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For decades, the Commission has recognized that because open-end
funds hold themselves out at all times as being prepared to meet these
statutory redemption requirements, they have a responsibility to manage
the liquidity of their investment portfolios in a manner consistent
with those obligations and any other related representations.\37\ Thus,
long-standing Commission guidelines contain a liquidity standard that
generally limits an open-end fund's aggregate holdings of ``illiquid
assets'' to no more than 15% of the fund's net assets (the ``15%
guideline'').\38\ Under the 15% guideline, a portfolio security or
other asset is considered illiquid if it cannot be sold or disposed of
in the ordinary course of business within seven days at approximately
the value at which the fund has valued the investment.\39\ The 15%
guideline has generally caused funds to limit their exposures to
particular types of securities that cannot be sold within seven days
and that the Commission and staff have indicated may be illiquid,
depending on the facts and circumstances, such as private equity
securities and certain other privately placed or restricted securities
\40\ as well as certain instruments or transactions not maturing in
seven days or less, including term repurchase agreements.\41\
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\37\ See Statement Regarding ``Restricted Securities'',
Investment Company Act Release No. 5847 (Oct. 21, 1969) [35 FR 19989
(Dec. 31, 1970)] (``Restricted Securities Release'') (``Because
open-end companies hold themselves out at all times as being
prepared to meet redemptions within seven days, it is essential that
such companies maintain a portfolio of investments that enable them
to fulfill that obligation. This requires a high degree of liquidity
in the assets of open-end companies because the extent of redemption
demands or other exigencies are not always predictable.''); see also
Resale of Restricted Securities; Changes to Method of Determining
Holding Period of Restricted Securities Under Rules 144 and 145,
Investment Company Act Release No. 17452 (Apr. 23, 1990) [55 FR
17933 (Apr. 30, 1990)] (``Rule 144A Release'') (adopting rule 144A
under the Securities Act of 1933 (the ``Securities Act'')).
\38\ Revisions of Guidelines to Form N-1A, Investment Company
Act Release No. 18612 (Mar. 12, 1992) [57 FR 9828 (Mar. 20, 1992)]
(``Guidelines Release''), at section III (``If an open-end company
holds a material percentage of its assets in securities or other
assets for which there is no established market, there may be a
question concerning the ability of the fund to make payment within
seven days of the date its shares are tendered for redemption. The
usual limit on aggregate holdings by an open-end investment company
of illiquid assets is 15% of its net assets.''). The Guidelines
Release modified prior Commission guidance that set a 10% limit on
illiquid assets for open-end funds. See Restricted Securities
Release, supra footnote 37.
\39\ Guidelines Release, supra footnote 38; see also ETF
Proposing Release, supra footnote 27; Valuation of Debt Instruments
and Computation of Current Price Per Share by Certain Open-End
Investment Companies (Money Market Funds), Investment Company Act
Release No. 13380 (July 11, 1983) [48 FR 32555 (July 18, 1983)]
(``Money Market Funds Release''); see also Rule 144A Release, supra
footnote 37.
\40\ See Restricted Securities Release, supra footnote 37.
Securities offered pursuant to rule 144A under the Securities Act
may be considered liquid under the 15% guideline depending on
certain factors. See Rule 144A Release, supra footnote 37.
\41\ See Periodic Repurchases by Closed-End Management
Investment Companies; Redemptions by Open-End Management Investment
Companies and Registered Separate Accounts at Periodic Intervals or
with Extended Payment, Investment Company Act Release No. 18869
(July 28, 1992) [57 FR 34701 (Aug. 6, 1992)] (``Interval Fund
Proposing Release''). The Commission has not established a set of
required factors that must be considered when assessing the
liquidity of these or other types of securities under the 15%
guideline. However, in the context of rule 144A securities, the
Commission had provided ``examples of factors that would be
reasonable for a [fund's] board of directors to take into account''
but which would not necessarily be determinative. See Rule 144A
Release, supra footnote 37. These factors include: The frequency of
trades and quotations for the security; the number of dealers
willing to purchase or sell the security and the number of other
potential purchasers; dealer undertakings to make a market in the
security; and the nature of the security and the nature of the
marketplace in which it trades, including the time needed to dispose
of the security, the method of soliciting offers, and the mechanics
of transfer.
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[[Page 82147]]
Relatedly, the Commission has recognized that the liquidity
management practices of open-end funds implicate certain antifraud
provisions of the securities laws.\42\ For example, section 34(b) of
the Act makes it unlawful for any person to make any untrue statement
of a material fact in any document filed with the Commission or
transmitted pursuant to the Act, or the keeping of which is required by
section 31(a) of the Act, or to omit to state any fact necessary in
order to prevent the statements made therein, in light of the
circumstances under which they were made, from being materially
misleading.\43\
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\42\ See Restricted Securities Release, supra footnote 37 (``To
the extent a material percentage of the assets of an open-end
company consist of restricted securities which cannot publicly be
sold without registration under the Securities Act, the ability of
the company to comply with the provisions of the Investment Company
Act relating to redemption, and to fulfill the implicit
representations made in its prospectus with respect thereto, may be
adversely affected. In any such situation, the investment company
concerned and the persons responsible for the sale of its securities
should give careful consideration to the possible application of the
provisions of section 10(b) of the Exchange Act and Rule 10b-5
thereunder.''); see also Money Market Funds Release, supra footnote
39 (explaining that because ``most money market funds promise
investors that they will receive proceeds much sooner'' than seven
days and ``experience a greater and perhaps less predictable volume
of redemption transactions than do other investment companies,''
they ``must have sufficient liquidity to meet redemption requests on
a more immediate basis''). The Commission has considered the failure
to take risk-limiting measures in other contexts to implicate
antifraud provisions as well. See Adoption of Revisions to Rules
Regulating Money Market Funds, Investment Company Act Release No.
18005 (Feb. 20, 1991) (``The Commission believes that there is a
significant danger of misleading investors if an investment company
holds itself out as a money market fund when it engages in
investment strategies not consistent with the risk-limiting
conditions of rule 2a-7. It is therefore necessary and appropriate
in the public interest and for the protection of investors for the
Commission to adopt a new paragraph (b) of rule 2a-7 prohibiting an
investment company from holding itself out as a `money market fund'
unless it meets the risk-limited conditions of rule 2a-7.'').
\43\ Exercising authority under section 34(b) and sections 9(b),
38(a), and 42 of the Act, the Commission adopted paragraph (b) of
rule 2a-7 in 1997, which provides that ``it shall be an untrue
statement of a material fact within the meaning of section 34(b) of
the Act for a registered investment company . . . to hold itself out
to investors as a money market fund or the equivalent of a money
market fund'' unless the fund complies with rule 2a-7. Under rule
2a-7, money market funds must maintain sufficient liquidity to meet
reasonably foreseeable redemptions, generally must invest at least
10% of their portfolios in assets that can provide daily liquidity
and at least 30% of their portfolios in assets that can provide
weekly liquidity, and may not acquire any illiquid security if,
immediately after the acquisition, the money market fund would have
invested more than 5% of its total assets in illiquid securities.
Rule 2a-7. Additionally, the Commission adopted amendments to rule
2a-7 in 2014 that, among other things: (i) Give boards of directors
of money market funds discretion to impose a liquidity fee or
temporarily suspend the right of redemption if a fund's weekly
liquidity level falls below the required regulatory threshold; and
(ii) require all non-government money market funds to impose a
liquidity fee if the fund's weekly liquidity level falls below a
designated threshold of 10%, unless the fund's board determines that
imposing such a fee is not in the best interests of the fund. See
Money Market Fund Reform; Amendments to Form PF, Investment Company
Act Release No. 31166 (July 23, 2014) [79 FR 47736 (Aug. 14, 2014)]
(``2014 Money Market Fund Reform Adopting Release'').
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In addition, section 206(4) \44\ of the Investment Advisers Act of
1940 (``Advisers Act'') and rule 206(4)-8 thereunder make it unlawful
for any adviser to an investment fund to engage in any act, practice,
or course of business which is fraudulent, deceptive, or
manipulative.\45\ Additionally, section 10(b) of the Exchange Act and
rule 10b-5 thereunder make it unlawful, among other things, for any
person, in connection with the purchase or sale of securities, to
employ any device, scheme, or artifice to defraud or to make any untrue
statement of a material fact or to omit to state a material fact
necessary in order to make the statements made not misleading, or
engage in any act, practice, or course of business which operates or
would operate as a fraud or deceit upon any persons. Finally, section
17(a) of the Securities Act similarly makes it unlawful for any person
in the offer or sale of any securities or any security-based swap
agreement by the use of any means or instruments of transportation or
communication in interstate commerce or by use of the mails, directly
or indirectly, to employ any device, scheme, or artifice to defraud, to
obtain money or property by means of any untrue statement of a material
fact or any omission to state a material fact necessary in order to
make the statements made, in light of the circumstances under which
they were made, not misleading, or to engage in any transaction,
practice, or course of business which operates or would operate as a
fraud or deceit upon the purchaser.\46\
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\44\ Section 206(4) of the Advisers Act grants the Commission
authority, by rules and regulations, to define and prescribe means
reasonably designed to prevent such acts, practices, and courses of
business as are fraudulent, deceptive, or manipulative.
\45\ Additionally, section 206(1) of the Advisers Act makes it
unlawful for an adviser to employ any device, scheme or artifice to
defraud any client or prospective client, and section 206(2) makes
it unlawful for an adviser to engage in any transaction, practice or
course of business which operates as a fraud or deceit upon any
client or prospective client. See Prohibition of Fraud by Advisers
to Certain Pooled Investment Vehicles, Investment Advisers Act
Release No. 2628 (August 3, 2007) [72 FR 44756 (August 9, 2007)], at
n.3 and accompanying text.
\46\ See In the Matter of Evergreen Investment Management
Company, LLC and Evergreen Investment Services, Inc., Investment
Company Act Release No. 28759 (June 8, 2009) (settled order)
(``Evergreen Order'') (settlement of allegations that a mutual fund
and its underwriter violated, and its adviser aided and abetted
violations of, section 22(c) of the Act and rule 22c-1(a) through
purchases and redemptions at materially overstated NAV. The order
found that the fund's adviser materially misrepresented the fund's
performance and NAV in reviewing and approving the fund's prospectus
in violation of section 34(b) of the Act.).
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As the Commission has previously noted, an open-end fund
``represents to investors, in its prospectus, that it will, as required
by section 22(e) of the Act, redeem its securities at approximate net
asset value within seven days after tender.'' \47\ Similarly, an open-
end fund that is redeemed through broker-dealers generally represents
to investors that it will redeem its securities within three days, as
required by rule 15c6-1.\48\ Failure by a fund to maintain a
sufficiently liquid portfolio or to otherwise manage liquidity risk
calls into question the fund's ability to fulfill the representations
(explicit or implicit) made in its prospectus regarding its ability to
meet its redemption obligations, as well as its status as an open-end
fund. Such failure thus potentially exposes the fund, the investment
adviser that manages the fund, and the persons responsible for the sale
of the fund's securities to the possible application of the antifraud
[[Page 82148]]
provisions of the securities laws referenced above.\49\
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\47\ Restricted Securities Release, supra footnote 37.
\48\ See also Proposing Release, supra footnote 9, at II.C.2
(``We also have observed that some open-end funds disclose in their
prospectuses that they generally will satisfy redemption requests in
even shorter periods of time than T + 3, including on a next-
business-day basis.''). As the Commission has previously noted, most
money market funds disclose that they will pay redemptions even more
quickly, often on the same day that the request is received by the
fund, and thus ``must have sufficient liquidity to meet redemption
requests on a more immediate basis.'' Money Market Funds Release,
supra footnote 39.
\49\ See Restricted Securities Release, supra footnote 37;
Proposing Release, supra footnote 9, at n.77 (``Disclosures by open-
end funds are subject to the antifraud provisions of the federal
securities laws. Therefore there may be liability under these
provisions if a fund fails to meet redemptions with seven days or
any shorter time disclosed in the fund's prospectus or advertising
materials.'') (citing section 17(a) of the Securities Act, section
10(b) of the Exchange Act and rule 10b-5 under the Exchange Act, and
section 34(b) of the Exchange Act); id. at n.109 (``[F]unds'
redemption obligations are also governed by any disclosure to
shareholders that a fund has made about the time within which it
will meet redemption requests, as disclosures by open-end funds are
subject to the antifraud provisions of the federal securities
laws.''); id. at III.C (``We believe that assessing and managing
liquidity risk in a comprehensive manner is critical to a fund's
ability to honor redemption requests within the seven-day period
required under section 22(e) . . . as well as within any shorter
time period disclosed in the fund's prospectus or advertising
materials or required for purposes of rule 15c6-1.''); id. at
III.C.3.d (requesting public comment on whether liquid asset minimum
requirements tighter than three days may be warranted ``given that
there may be liability under the antifraud provisions of the federal
securities laws if a fund fails to meet redemptions within any
shorter time disclosed in the fund's prospectus or advertising
materials.'').
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In addition to the foregoing concerns, an insufficiently liquid
portfolio implicates provisions of the Act and regulations thereunder
concerning fund valuation.\50\ A fund's ability to properly value its
portfolio securities is important, primarily because, under the Act,
fund shareholders are entitled to their proportionate share of the
fund's NAV upon redemption. Section 2(a)(41) of the Act and rule 2a-4
thereunder provide that in determining NAV, funds must value
``securities for which market quotations are readily available'' at
current market value, and must value all other securities and assets at
``fair value as determined in good faith by the board of directors.''
Illiquid or less liquid assets are less likely to have readily
available market quotations, and thus are more likely to require a fair
value determination. Determining the fair value of illiquid or less
liquid assets consistent with section 2(a)(41) and rule 2a-4 can pose a
number of challenges, some of which the Commission has previously
described in the context of the acquisition of restricted
securities,\51\ and improper valuation of such assets could result in
liability under the antifraud provisions.\52\ The difficulties valuing
illiquid or less liquid securities also implicate section 22(c) and
rule 22c-1, which requires the use of the next-determined NAV for
pricing purchases and redemptions. Transactions in such securities are
more likely to be effected at prices that differ from fair value and,
therefore, may result in increasing risk of investor dilution.\53\
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\50\ See Restricted Securities Release, supra footnote 37
(describing the ``serious problems of valuation'' arising from fund
acquisition of restricted securities); Guidelines Release, supra
footnote 38 (noting that a fund ``must maintain a high degree of
portfolio liquidity'' to meet the requirements under section 22(e),
rule 22c-1(a) and rule 2a-4).
\51\ See Restricted Securities Release, supra footnote 37 at n.1
and accompanying text for a discussion of the various valuation
challenges facing purchasers and sellers of restricted securities.
\52\ See Restricted Securities Release, supra footnote 37. As
the Commission explained there, ``[t]he offering price of securities
issued by a management investment company is premised upon the net
asset value of such shares as determined pursuant to [section
2(a)(41)] of the Act and Rule 2a-4 thereunder and is so represented
in its prospectus.'' Consequently, ``the improper valuation of
restricted securities held by such a company would distort the net
asset value of the shares being offered or, in the case of an open-
end company, redeemed, and would therefore constitute a fraud and
deceit within the meaning of section 10(b) and Rule 10b-5.'' See
also infra footnote 66.
\53\ See Restricted Securities Release, supra footnote 37, at
n.1 (``the valuation of restricted securities by reference to the
market price for unrestricted securities of the same class assumes
that the market price for unrestricted securities of the same class
is representative of the fair value of the securities. This may not
be the case when the market for the unrestricted securities is very
thin, i.e., only a limited volume of shares are available for
trading.'').
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A separate and independent issue arising from the failure to
maintain a sufficiently liquid portfolio is the risk of shareholder
dilution associated with improper fund pricing. Thus, section
22(a),\54\ when read together with section 22(c),\55\ 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 the outstanding
fund shares. In its 1969 guidance on restricted securities, the
Commission observed that a fund with significant holdings of restricted
securities may have to engage in private sales on short notice to meet
redemption obligations, which could result in the fund ``receiving less
than its carrying value of the restricted securities.'' \56\ That, in
turn, would ``result in a preference in favor of the redeeming
shareholders and a diminution of the NAV per share of shareholders who
have not redeemed,'' further highlighting the need for funds to
maintain ``a high degree of liquidity'' given the unpredictability of
redemption demands or other exigencies.\57\ Similarly, here, as a
general matter, to the extent a fund's portfolio is made up of a large
amount of illiquid or less liquid securities, the fund may face
difficulties meeting shareholder redemption requests while at the same
time protecting the value of the shares of existing shareholders from
dilution. Limited liquidity may hinder the portfolio manager's ability
to defensively reposition the fund in anticipation of shifting or
volatile markets because asset sales necessary to effectuate those
shifts can be executed only with substantial liquidity costs. If
limited liquidity in the fund's portfolio limits which assets the fund
can sell to meet redemptions, such limited liquidity also could even
result in the fund straying from its investment objective. Accordingly,
a fund that does not effectively manage its liquidity risk may become
constrained in its portfolio management, to the detriment of its
investors and contrary to the way the fund represents its investment
strategy to the public.\58\ Therefore, when constructing a fund's
portfolio of securities, it is essential for the fund to take into
account the importance of maintaining a portfolio that is liquid enough
to fulfill the fund's obligations under these provisions.\59\
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\54\ Section 22(a) authorizes securities associations registered
under section 15A of the Exchange Act to prescribe rules related to
the method of computing purchase and redemption prices of redeemable
securities and the minimum time period that must elapse after the
sale or issue of such securities before any resale or redemption may
occur, for the purpose of ``eliminating or reducing so far as
reasonably practicable any dilution of the value of other
outstanding securities of such company or any other result of such
purchase, redemption, or sale which is unfair to holders of such
other outstanding securities.''
\55\ Section 22(c) 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, whether or not members of any
securities association, to the same extent, covering the same
subject matter, and for the accomplishment of the same ends as are
prescribed in section 22(a) in respect of the rules which may be
made by a registered securities association governing its members.
\56\ See Restricted Securities Release, supra footnote 37.
\57\ Id.
\58\ See Restricted Securities Release, supra footnote 37 (``It
is desirable that an open-end company retain maximum flexibility in
the choice of portfolio securities which, on the basis of their
relative investment merits, could best be sold where necessary to
meet redemptions.'').
\59\ Id.
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As previously discussed, in addition to the seven-day redemption
requirement in section 22(e), rule 15c6-1 under the Exchange Act also
affects the timing of open-end fund redemptions because the rule
requires broker-dealers to settle securities transactions, including
transactions in open-end fund shares, within three business days after
the trade date. Furthermore, rule 22c-1 under the Act, the ``forward
pricing'' rule, requires funds, their principal underwriters, and
dealers to sell and redeem fund shares
[[Page 82149]]
at a price based on the current NAV next computed after receipt of an
order to purchase or redeem fund shares, even though fund assets may be
sold in subsequent days in order to meet redemption obligations.\60\
---------------------------------------------------------------------------
\60\ See infra footnotes 73-76 and accompanying text for a
discussion of why this calculation method is permitted under rule
22c-1 and rule 2a-4.
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With the exception of money market funds subject to rule 2a-7 under
the Act,\61\ the Commission has not promulgated rules requiring open-
end funds to invest in a minimum level of liquid assets.\62\ As
discussed above, the Commission has historically taken the position
that, in order to comply with section 22(e) and other applicable legal
provisions, open-end funds should maintain a high degree of portfolio
liquidity to ensure that their portfolio securities and other assets
can be sold and the proceeds used to satisfy redemptions in a timely
manner.\63\ In addition to a fund's ``general responsibility to
maintain a level of portfolio liquidity that is appropriate under the
circumstances,'' the Commission has stated that open-end funds must
engage in ongoing portfolio liquidity monitoring to determine whether
an adequate level of portfolio liquidity is being maintained in light
of their redemption obligations.\64\
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\61\ See supra footnote 43.
\62\ However, the Commission has issued guidelines concerning
funds' portfolio liquidity. See supra footnote 38 and accompanying
text.
\63\ See Restricted Securities Release, supra footnote 37; see
also Rule 144A Release, supra footnote 37.
\64\ Guidelines Release, supra footnote 38, at n.11 (``[T]he
Commission expects funds to monitor portfolio liquidity on an
ongoing basis to determine whether, in light of current
circumstances, an adequate level of liquidity is being maintained.
For example, an equity fund that begins to experience a net outflow
of assets because investors increasingly shift their money from
equity to income funds should consider reducing its holdings of
illiquid securities in an orderly fashion in order to maintain
adequate liquidity.''). Therefore, under current SEC guidance, a
fund experiencing net outflows may wish to consider managing its
illiquid asset holdings to maintain adequate liquidity. Similarly, a
fund may need to determine whether it is appropriate to take certain
actions when the fund has determined that a previously liquid
holding has become illiquid due to changed circumstances. See also
Rule 144A Release, supra footnote 37, at n.61.
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Registered investment companies and their investment advisers are
subject to rules under the Act and the Advisers Act requiring them to
adopt and implement written compliance policies and procedures
reasonably designed to prevent various violations of laws and
regulations. Rule 38a-1 under the Act requires registered investment
companies to adopt and implement written policies and procedures
reasonably designed to prevent violations of the federal securities
laws by the fund, including policies and procedures that provide for
the oversight of compliance by certain of the fund's service providers,
including the fund's investment adviser; the rule also requires board
approval and review of the service providers' compliance policies and
procedures. Additionally, rule 206(4)-7 under the Advisers Act requires
registered investment advisers to adopt and implement written
compliance policies and procedures reasonably designed to prevent
violations of the Advisers Act and the rules thereunder by the adviser
or any of its supervised persons. Such compliance policies and
procedures should be appropriately tailored to reflect each firm's
particular compliance risks.\65\ For example, an open-end fund holding
a significant portion of its assets in securities with long settlement
periods or that trade infrequently may be subject to relatively greater
liquidity risks than other open-end funds, and should appropriately
tailor its policies and procedures in light of its particular risks and
circumstances. The Commission has brought enforcement actions under the
compliance rules against funds and their advisers for failures to adopt
and/or implement policies and procedures reasonably designed to prevent
violations relating to, for example, disclosure, valuation, and pricing
for assets with limited liquidity.\66\
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\65\ In the compliance rules adopting release, the Commission
highlighted certain, non-exclusive examples of particular areas to
be addressed in funds' and advisers' policies and procedures. For
example, it stated that funds or advisers should adopt policies and
procedures regarding valuation and the pricing of portfolio
securities and fund shares, as well as the processing of fund
shareholder transactions in accordance with rule 22c-1. See
Compliance Programs of Investment Companies and Investment Advisers,
Investment Company Act Release No. 26299 (Dec. 17, 2003) [68 FR
74714 (Dec. 24, 2003)] (``Rule 38a-1 Adopting Release'') (``These
pricing requirements are critical to ensuring fund shares are
purchased and redeemed at fair prices and that shareholder interests
are not diluted.''). The Commission also identified ``portfolio
management processes'' as an issue that should be covered in the
compliance policies and procedures of a fund or its adviser and
indicated that each fund should tailor its policies and procedures
to address the fund's particular compliance risks. See id., at n.82
(noting that the chief compliance officer's annual report should
discuss the fund's particular compliance risks and any changes that
were made to the policies and procedures to address newly identified
risks). The Commission further identified ``the accuracy of
disclosures made to investors, clients, and regulators'' as an issue
to be covered.
\66\ See In re Citigroup Alternative Investments LLC & Citigroup
Glob. Markets Inc., Investment Advisers Act Release No. 4174 (Aug.
17, 2015) (settled order) (hedge fund adviser failed to adopt
policies and procedures to prevent misrepresentations to private
fund investors about fund performance and liquidity and violated
rule 206(4)-7); In re J. Kenneth Alderman, CPA, et al., Investment
Company Act Release No. 30557 (Jun. 13, 2013) (settled order)
(respondent directors failed to exercise their responsibilities with
respect to adoption and implementation of valuation policies and
procedures by mutual funds holding securities with reduced liquidity
and caused funds' violations of rule 38a-1); In re UBS Glob. Asset
Mgmt. (Americas) Inc., Investment Company Act Release No. 29920
(Jan. 17, 2012) (settled order) (mutual fund adviser failed to
implement fair value pricing procedures with respect to subordinated
fixed income securities without an active market and violated rule
38a-1); In re Morgan Asset Mgmt., Inc., et al., Investment Company
Act Release No. 29704 (June 22, 2011) (settled order) (mutual fund
adviser failed to implement valuation procedures in pricing fixed
income securities backed by subprime mortgages and violated rule
38a-1).
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Thus, funds and their advisers already are required to adopt and
implement written compliance policies and procedures reasonably
designed to prevent violations of various provisions implicated by fund
liquidity, including those provisions identified above. The liquidity
risk management program requirements of rule 22e-4, which we are
adopting here, in effect will provide more specific and enhanced
requirements in certain areas already generally covered by the
compliance program rules.
In short, there are a number of statutory and regulatory provisions
across the federal securities laws that bear on redemptions and the
potential dilution of shareholders' interests. New rule 22e-4 advances
the purposes of the Act by enhancing the ability of funds to meet their
redemption obligations, reducing the risk of shareholder dilution, and
reducing the potential for antifraud violations.\67\
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\67\ One commenter argued that the Commission lacks the
statutory authority to issue rule 22e-4. Comment Letter of Justin
Banks (Jan. 13, 2016) (``Banks Comment Letter'') (considering the
authority conferred by sections 22(c), 22(e), and 38 of the Act,
although we note that in referring to our authority under section
38, the commenter actually quoted and addressed the text of section
39 of the Act.). We disagree. The Commission has ample authority
under the Act, including sections 22(c), 22(e), and 38(a), as well
as under the antifraud provisions of the federal securities laws, to
require that open-end funds maintain adequate liquidity and adopt
responsible liquidity risk management policies and procedures. See
supra section II.B.2. Section 38(a), in particular, gives the
Commission authority to issue rules, regulations, and orders ``as
are necessary or appropriate to the exercise of the powers conferred
upon the Commission elsewhere in this title.'' As discussed above,
the liquidity risk management program required under rule 22e-4 is
necessary and appropriate to reduce the risk that funds will be
unable to meet their redemption obligations, to improve industry-
wide liquidity risk management practices, to mitigate potential
dilution of the interests of non-redeeming shareholders, and to
increase the likelihood that funds are able to fulfill
representations made in their prospectuses and advertising materials
and implicit in their open-end status.
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[[Page 82150]]
3. Liquidity Management by Open-End Funds
Portfolio managers consider a variety of factors in addition to
liquidity when constructing a fund's portfolio, including but not
limited to the fund's investment strategies, economic and market
trends, portfolio asset credit quality, and tax considerations.
Nevertheless, meeting redemption obligations is fundamental for open-
end funds, and funds must manage liquidity in order to meet these
obligations.\68\ Several factors influence how liquidity management by
open-end funds affects the equitable treatment of investors in a fund,
investor redemption behavior, and potentially the orderly operation of
the markets when fulfilling redemption obligations.
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\68\ See Comment Letter of Investment Company Institute on the
Notice Seeking Comment on Asset Management Products and Activities,
Docket No. FSOC-2014-0001(``FSOC Notice'') (Mar. 25, 2015) (``ICI
FSOC Notice Comment Letter'') (``For mutual funds, the central
importance of meeting redemptions means that liquidity management is
a key element of regulatory compliance, investment risk management,
and portfolio management--and a constant area of focus. Even before
launching a mutual fund, the fund manager and fund board consider
whether the fund's proposed investments and strategies are suitable
for the mutual fund structure, including whether it will be able to
satisfy applicable regulatory requirements on an ongoing basis. If
not, the manager may decide to offer that strategy through a
different vehicle (e.g., a closed-end fund or a private fund).'').
See also supra footnotes 2, 3, and 5-7.
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First, it is important to consider how a fund meets redemptions.
When a fund receives redemption requests from shareholders, and the
fund does not have cash on hand to meet those redemptions,\69\ the fund
may sell portfolio assets to generate cash to meet the redemptions and
generally has the discretion to determine which assets will be
sold.\70\ It is possible that a fund would choose to sell its most
liquid assets first. This method of selling is limited to some degree
by the investment strategies of the fund, and a fund pursuing this
method of meeting redemptions to any significant degree may need to
adjust its portfolio so that the fund continues to follow its
investment strategies. A fund that chooses to sell its most liquid
assets to meet fund redemptions may minimize the effect of the
redemptions on short-term fund performance for redeeming and remaining
shareholders, but may leave remaining shareholders in a potentially
less liquid and riskier fund until the fund adjusts the portfolio.\71\
An ETF redeeming in kind with its most liquid assets first would
similarly leave remaining shareholders in a potentially less liquid and
riskier fund. In contrast to meeting redemptions by selling its most
liquid assets first, a fund alternatively could choose to meet
redemptions by selling, to the best of its ability, a ``strip'' of the
fund's portfolio (i.e., a cross-section or representative selection of
the fund's portfolio assets).\72\ Funds also could choose to meet
redemptions by selling a range of assets in between its most liquid, on
one end of the spectrum, and a perfect pro rata strip of assets, on the
other end of the spectrum. Similarly, an ETF redeeming in kind could
use a pro rata strip of assets. Additionally, funds could choose to
opportunistically pare back or eliminate holdings in a particular asset
or sector to meet redemptions.
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\69\ A fund can have cash on hand to meet redemptions from cash
held in the fund's portfolio, cash received from investor purchases
of fund shares, interest payments and dividends on portfolio
securities, or maturing bonds. See, e.g., Comment Letter of Fidelity
Investments on the Notice Seeking Comment on Asset Management
Products and Activities, Docket No. FSOC-2014-0001 (Mar. 25, 2015)
(``Fidelity FSOC Notice Comment Letter''), at n.17 (``[S]ecurities
do not need to be sold every time a redemption order is placed. Sale
of fund assets is necessary only when gross redemptions
significantly exceed net inflows.'').
\70\ A fund may also obtain cash by other available means such
as bank lines of credit, but funds infrequently utilize this method
to meet redemptions. See Proposing Release, supra footnote 9, at
n.35 and accompanying text. See also infra footnote 262 and
accompanying text for a discussion of the use of interfund lending
as an alternative source of cash for funds.
\71\ See Proposing Release, supra footnote 9, at n.37 and
accompanying text.
\72\ There are practical limitations on a fund's ability to sell
a pro rata slice of its portfolio, such as minimum trade sizes,
transfer restrictions, illiquid assets, tax complications from
certain sales, and avoidance of odd lot positions.
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Second, the effect of redemptions on shareholders is determined by
how and when those redemptions affect the price of the fund's shares.
Under rule 22c-1, all investors who redeem from an open-end fund on any
particular day must receive the NAV next calculated by the fund after
receipt of such redemption request.\73\ As most funds, with the
exception of money market funds, calculate their NAV only once a day,
this means that redemption requests received during the day receive the
end of day NAV, typically calculated as of 4 p.m. Eastern time.\74\
When calculating a fund's NAV, however, rule 2a-4 requires funds to
reflect changes in holdings of portfolio securities and changes in the
number of outstanding shares resulting from distributions, redemptions,
and repurchases no later than the first business day following the
trade date.\75\ We allowed this calculation method to provide funds
with additional time and flexibility to incorporate last-minute
portfolio transactions into their NAV calculations on the business day
following the trade date, rather than on the trade date.\76\ As a
practical matter, this calculation method also gave broker-dealers,
retirement plan administrators, and other intermediaries additional
time to receive transactions submitted before the cut-off time on the
trade date, which then may be reflected in the fund's NAV on the
business day following the trade date.
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\73\ 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.
\74\ Commission rules do not require that a fund calculate its
NAV at a specific time of day. Current NAV must be computed at least
once daily, subject to limited exceptions, Monday through Friday, at
the specific time or times set by the board of directors. See rule
22c-1(b)(1).
\75\ Rule 2a-4(a)(2)-(3).
\76\ 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)].
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Nevertheless, we recognize that trading activity and other changes
in portfolio holdings associated with meeting redemptions may occur
over multiple business days following the redemption request. If these
activities occur (and their associated costs are reflected in NAV) in
days following redemption requests, the costs of providing liquidity to
redeeming investors could be borne by the remaining investors in the
fund, thus potentially diluting the interests of non-redeeming
shareholders.\77\ The less liquid the fund's portfolio holdings, the
greater these liquidity costs can become.\78\
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\77\ The transaction costs associated with redemptions can vary
significantly, with some costs having a more immediate impact on
shareholders than others. For example, during times of heightened
market volatility and wider bid-ask spreads for the fund's
underlying holdings, selling the fund's investments to meet
redemptions will necessarily result in costs to the fund, which in
turn may negatively impact investors who chose to redeem in the days
immediately following the stress event. The impact of such costs on
the remaining fund investors can vary depending on when a
shareholder chooses to redeem. See, e.g., Comment Letter of Mutual
Fund Directors Forum on the Notice Seeking Comment on Asset
Management Products and Activities, Docket No. FSOC-2014-0001 (Mar.
25, 2015), at 6.
\78\ See, e.g. Comment Letter of Morningstar, Inc. (Jan. 13,
2016) (``Morningstar Comment Letter''). See also Proposing Release,
supra footnote 9, at n.45 and accompanying text.
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There can be significant adverse consequences to remaining
investors in a fund that does not adequately manage liquidity.\79\ As
noted above, the
[[Page 82151]]
proportion of illiquid assets held by a fund can increase if the fund
sells its more liquid portfolio assets to meet redemptions. This in
turn could adversely affect the fund's risk profile and cause the fund
to have difficulty meeting future shareholder redemptions.\80\ For
example, during the pendency of our proposal, the Third Avenue Focused
Credit Fund, a non-diversified open-end fund, adopted a plan of
liquidation, and requested and obtained exemptive relief to suspend
shareholder redemptions.\81\ The Commission noted that the fund
represented that, at the time the fund and its investment adviser
requested exemptive relief, it had experienced a significant level of
redemption requests over the prior six-month period that reduced the
fund's portfolio liquidity, as well as a significant decline in its
NAV.\82\ The fund's board authorized the plan of liquidation after it
determined that additional redemptions would have to be made at prices
that would unfairly disadvantage the fund's remaining shareholders.\83\
This event highlights the extent to which shareholders can be harmed
when a fund holding portfolio assets that entail significant liquidity
risk does not adequately anticipate the effects of market deterioration
and increased shareholder redemptions.\84\ Furthermore, if a fund finds
that it can sell portfolio assets only at prices that incorporate a
significant discount to the assets' stated value, the discounted sale
prices can materially affect the fund's NAV.
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\79\ See, e.g., Jason Greene & Charles Hodges, The Dilution
Impact of Daily Fund Flows on Open-end Mutual Funds, 65 J. of Fin.
Econ. 131 (2002) (``Greene & Hodges'') (``Active trading of open-end
funds has a meaningful economic impact on the returns of passive,
nontrading shareholders, particularly in U.S.-based international
funds. The overall sample of domestic equity funds shows no dilution
impact, but we find an annualized negative impact of 0.48% in
international funds (and nearly 1% for a subsample of funds whose
daily flows are particularly large).'').
\80\ See, e.g., In re Heartland Advisors, Inc., et al.,
Investment Company Act Release No. 28136 (Jan. 25, 2008)
(``Heartland Release'') (settled order) (finding that certain high-
yield bond funds experienced liquidity problems (caused in part by
adviser's unwillingness to sell bond holdings at prices below which
the funds had valued them) and, as a result, the funds borrowed
heavily against a line of credit to meet fund redemption requests,
and investors redeemed fund shares at prices that benefited
redeeming shareholders at the expense of remaining and new
investors).
\81\ See Third Avenue Temporary Order, supra footnote 12. But
see infra footnote 209 and accompanying text. We note that there is
no assurance that the Commission would grant similar relief in the
future. See also ICI Comment Letter I (``Third Avenue Focused Credit
Fund experienced a significant level of redemption requests and an
ongoing reduction in the liquidity of its portfolio securities,
which consisted largely of junk bonds . . . The SEC granted a
temporary order under section 22(e)(3) after expressing concerns
with a board-approved plan of liquidation that provided for
distribution to shareholders of the fund's remaining net cash and a
separate transfer of the fund's other assets into a liquidating
trust.''); BlackRock Comment Letter (``[A]s recently demonstrated by
the issues meeting redemption requests that were experienced by the
Third Avenue Focused Credit Fund, a small and highly concentrated
portfolio can present its own liquidity challenges.''); see also
infra footnote 84.
\82\ Third Avenue Temporary Order, supra footnote 12. At the
time that the fund adopted its plan of liquidation, the fund had
experienced $1.1 billion in estimated net outflows for the year to
date through December 9, 2015, which was more than 145% of the
fund's total net assets as of that date. Furthermore, in November
2015, the fund experienced a total of $317 million in estimated net
redemptions and the fund's retail class NAV per share fell from
$7.82 to $7.09.
\83\ Id. See also Third Avenue Management, Press Release: Third
Avenue Management Obtains Exemptive Relief for Focused Credit Fund
(Dec. 16, 2015), available at: http://thirdave.com/news/press-release-third-avenue-management-obtains-exemptive-relief-for-focused-credit-fund/ (``As a result of the [SEC] exemptive order,
redemptions are suspended for all shareholders, and . . . the
[fund's adviser] will be able to conduct an orderly liquidation
without having to resort to forced selling of securities at reduced
or disadvantaged prices.'').
\84\ See Comment Letter of Americans for Financial Reform (Jan.
13, 2016) (``AFR Comment Letter'') (``By all accounts, Third Avenue
was holding the great majority of its assets in illiquid distressed
debt and had very limited cash reserves, a strategy that can
increase returns but at the price of greatly increased risks for
investors . . . While the Third Avenue fund may be an outlier in
terms of the sheer volume of illiquid assets it holds, evidence also
indicates that larger and more significant funds are also testing
the bounds of previous SEC guidance on liquidity, and are holding a
large fraction of potentially illiquid assets. If such funds come
under selling pressure, the need to dispose of such assets could add
to market stress in ways that have a negative impact on corporate
credit and the real economy, as well as potentially harming
investors.''); see also Heartland Release, supra footnote 80.
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These factors in fund redemptions--either individually or in
combination--can create incentives in times of liquidity stress in the
markets for shareholders to redeem quickly to avoid further losses (or
a ``first-mover advantage'').\85\ If shareholder redemptions are
motivated by this first-mover advantage, they can lead to increasing
outflows, and as the level of outflows from a fund increases, the
incentive for remaining shareholders to redeem may also increase.
Additionally, a fund experiencing large outflows as a result of
redemptions may be exposed to predatory trading activity in the
securities it holds.\86\ Regardless of whether investor redemptions are
motivated by a first-mover advantage or other factors, there can be
significant adverse consequences to remaining investors in a fund when
it fails to adequately manage liquidity.\87\ This underlines the
importance of fund liquidity management for advancing investor
protection by reducing the risk that a fund would be unable to meet
redemption obligations without significant dilution of remaining
investors' interests in the fund.
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\85\ See infra footnotes 1086-1088 and accompanying text for a
discussion of the first-mover advantage and its negative
consequences. But see Comment Letter of Nuveen Investments on the
Notice Seeking Comment on Asset Management Products and Activities,
Docket No. FSOC-2014-0001 (Mar. 25, 2015) (``Nuveen FSOC Notice
Comment Letter''), at 10 (stating that there is no evidence that
shareholders are actually motivated by a first-mover advantage);
Comment Letter of BlackRock on the Notice Seeking Comment on Asset
Management Products and Activities, Docket No. FSOC-2014-0001 (Mar.
25, 2015) (``BlackRock FSOC Notice Comment Letter''), at 17 (stating
that although incentives to redeem may exist, this does not
necessarily imply that investors will in fact redeem en masse in
times of market stress, but also noting that a well-structured fund
``should seek to avoid features that could create a `first-mover
advantage' in which one investor has an incentive to leave'' before
others); Comment Letter of Association of Institutional Investors on
the Notice Seeking Comment on Asset Management Products and
Activities, Docket No. FSOC-2014-0001 (Mar. 25, 2015), at 10-11
(``The empirical evidence of historical redemption activity, even
during times of market stress, supports the view that either (i)
there are not `incentives to redeem' that are sufficient to overcome
the asset owner's asset allocation decision or (ii) that there are
disincentives, such as not triggering a taxable event, that outweigh
the hypothesized `incentives to redeem.' ''); Comment Letter of The
Capital Group Companies on the Notice Seeking Comment on Asset
Management Products and Activities, Docket No. FSOC-2014-0001 (Mar.
25, 2015), at 8 (``We also do not believe that the mutualization of
fund trading costs creates any first mover advantage.''); ICI FSOC
Notice Comment Letter, supra footnote 68, at 7 (``Investor behavior
provides evidence that any mutualized trading costs must not be
sufficiently large to drive investor flows. We consistently observe
that investor outflows are modest and investors continue to purchase
shares in most funds even during periods of market stress.''). See
also discussion of the potential first-mover advantage in the
Proposing Release, supra footnote 9, at n.49.
\86\ See, e.g., Joshua Coval & Erik Stafford, Asset Fire Sales
(and Purchases) in Equity Markets, 86 J. Fin. Econ. 479 (2007)
(``Coval & Stafford'') (``Funds experiencing large outflows tend to
decrease existing positions, which creates price pressure in the
securities held in common by distressed funds. Similarly, the
tendency among funds experiencing large inflows to expand existing
positions creates positive price pressure in overlapping holdings.
Investors who trade against constrained mutual funds earn
significant returns for providing liquidity. In addition, future
flow-driven transactions are predictable, creating an incentive to
front-run the anticipated forced trades by funds experiencing
extreme capital flows.''); Teodor Dyakov & Marno Verbeek, Front-
Running of Mutual Fund Fire-Sales, 37 J. of Bank. and Fin. 4931
(2013) (``Dyakov & Verbeek'') (``We show that a real-time trading
strategy which front-runs the anticipated forced sales by mutual
funds experiencing extreme capital outflows generates an alpha of
0.5% per month during the 1990-2010 period . . . Our results suggest
that publicly available information of fund flows and holdings
exposes mutual funds in distress to predatory trading.''). See
discussion of predatory trading concerns in the Proposing Release,
supra footnote 9, at nn.805-809 and accompanying text.
\87\ See Proposing Release, supra footnote 9, at n.37.
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There also is a potential for adverse effects on the markets when
open-end funds fail to adequately manage
[[Page 82152]]
liquidity.\88\ For example, if liquid asset levels are insufficient to
meet redemptions, funds may sell less-liquid portfolio assets at
discounted or even fire sale prices. These sales can produce
significant negative price pressure on those assets and correlated
assets. Accordingly, redemptions and funds' liquidity risk management
can affect not just the remaining investors in the fund, but any other
investors holding these assets. Depending on the asset and the level of
stress, such liquidity stress on the assets held in the fund has the
potential to transmit stress to other funds or portions of the market
as well.\89\
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\88\ See, e.g., See Comment Letter of Americans for Financial
Reform on the FSOC Notice (Mar. 27, 2015) (``AFR FSOC Notice Comment
Letter'') (citing evidence that ``bond fire sales by mutual funds
during the financial crisis created direct economic harm to real
economy companies, reducing investment and profitability over a
period of years.''); Fidelity FSOC Notice Comment Letter, supra
footnote 69, at 18 (``Managing liquidity levels to fulfill [a fund
adviser's] fiduciary obligations benefits [redeeming and remaining]
shareholders as well as the broader financial markets.'').
\89\ See Proposing Release, supra footnote 9, at n.54.
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C. Recent Developments in the Open-End Fund Industry
Recent industry developments have underlined our focus on the
importance of sufficient liquidity and liquidity risk management
practices in open-end funds.\90\ These developments include significant
growth in assets of, and shareholder inflows into, open-end funds with
fixed income strategies and alternative strategies since 2008 and the
evolution of settlement periods and redemption practices utilized by
open-end funds. We will discuss each of these developments in turn.
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\90\ We note that, up until 1970, open-end funds had limited
investments in the bond market. See Protecting Investors: A Half
Century of Investment Regulation (May 1992) for a discussion of the
regulatory and market developments that occurred between 1940 and
1992.
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1. Fixed Income Funds and Alternative Funds
We have observed significant growth in cash flows into, and assets
of, fixed income mutual funds and fixed income ETFs (excluding
ETMFs).\91\ As growth in fixed income fund assets was occurring, we
increased our focus on fixed income market structure, publishing a
report on the municipal securities markets in 2012 and holding a
roundtable focused on the fixed income markets in 2013.\92\ In
addition, Commissioners and Commission staff have spoken about the need
to focus on potential risks relating to the fixed income markets and
their underlying liquidity.\93\ Commission staff also has focused on
the nature of liquidity risk management in fixed income funds,
including by selecting fixed income funds as an examination priority in
2014, 2015, and 2016.\94\
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\91\ Assets in these funds grew from $1.5 trillion at the end of
2008 to $3.6 trillion at the end of 2015, with net inflows exceeding
$1.4 trillion during that period. These figures were obtained from
staff analysis of Morningstar Direct data, and are based on fund
categories defined by Morningstar. While mutual funds holding U.S.
equities continue to make up the largest category of funds in terms
of fund assets, their share of the total industry assets has
declined from 65.2% in 2000 to 44.7% in 2015. DERA Study, infra
footnote 95, at Table 2. The statistics in the DERA Study were
calculated through the end of 2014. Commission staff used the CRSP
US Mutual Fund Database to update them as of the end of 2015.
\92\ See Securities and Exchange Commission, Transcript:
Roundtable on Fixed Income Markets (Apr. 16, 2013), available at
https://www.sec.gov/spotlight/fixed-income-markets/2013-04-16-fixed-income-markets-transcript.txt (discussing, among other topics,
liquidity characteristics and risks in the municipal bond and
corporate bond markets); Securities and Exchange Commission, Report
on the Municipal Securities Market (July 31, 2012), available at
https://www.sec.gov/news/studies/2012/munireport073112.pdf
(discussing, among other topics, the low liquidity, opacity and
fragmentation of the municipal securities market).
\93\ See Proposing Release, supra footnote 9, at n.62.
\94\ See, e.g., IM Guidance Update No. 2014-01, Risk Management
in Changing Fixed Income Market Conditions (Jan. 2014) (``2014 Fixed
Income Guidance Update''), available at https://www.sec.gov/divisions/investment/guidance/im-guidance-2014-1.pdf; National Exam
Program, Office of Compliance Inspections and Examinations,
Examination Priorities for 2016 (2016), available at https://www.sec.gov/about/offices/ocie/national-examination-program-priorities-2016.pdf (``Amidst the changes in fixed income markets
over the past several years, we will examine advisers to mutual
funds, ETFs, and private funds that have exposure to potentially
illiquid fixed income securities. We will also examine registered
broker-dealers that have become new or expanding liquidity providers
in the marketplace. These examinations will include a review of
various controls in these firms' expanded business areas, such as
controls over market risk management, valuation, liquidity
management, trading activity, and regulatory capital''); National
Exam Program, Office of Compliance Inspections and Examinations,
Examination Priorities for 2015 (2015) (``National Exam Program 2015
Examination Priorities''), available at http://www.sec.gov/about/offices/ocie/national-examination-program-priorities-2015.pdf
(``With interest rates expected to rise at some point in the future,
we will review whether mutual funds with significant exposure to
interest rate increases have implemented compliance policies and
procedures and investment and trading controls sufficient to ensure
that their funds' disclosures are not misleading and that their
investments and liquidity profiles are consistent with those
disclosures.''); National Exam Program, Office of Compliance
Inspections and Examinations, Examination Priorities for 2014
(2014), available at http://www.sec.gov/about/offices/ocie/national-examination-program-priorities-2014.pdf (``The staff will monitor
the risks associated with a changing interest rate environment and
the impact this may have on bond funds and related disclosures of
risks to investors.'').
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We also have observed significant growth in alternative mutual
funds over the last decade.\95\ Although the assets of open-end funds
pursuing alternative strategies accounted for a relatively small
percentage of the mutual fund market as of December 2014, the growth of
assets in these funds has been substantial. Assets of open-end funds
with alternative strategies grew from approximately $365 million at the
end of 2005 to approximately $334 billion at the end of 2014.\96\
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\95\ Paul Hanouna, Jon Novak, Tim Riley & Christof Stahel,
Liquidity and Flows of U.S. Mutual Funds, Division of Economic and
Risk Analysis White Paper (Sept. 2015) (``DERA Study''), at 7-8,
available at https://www.sec.gov/dera/staff-papers/white-papers/liquidity-white-paper-09-2015.pdf . While there is no clear
definition of ``alternative'' in the mutual fund space, an
alternative mutual fund is generally understood to be a fund whose
primary investment strategy falls into one or more of the three
following buckets: (i) Non-traditional asset classes (for example,
currencies or managed futures funds); (ii) non-traditional
strategies (such as long/short equity, event driven); and/or (iii)
less liquid assets (such as private debt). Their investment
strategies often seek to produce positive risk-adjusted returns that
are not closely correlated to traditional investments or benchmarks,
in contrast to traditional mutual funds that historically have
pursued long-only strategies in traditional asset classes.
\96\ See Proposing Release, supra footnote 9 at nn.64-66 and
accompanying text. See also id.
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Unlike alternative mutual funds and ETFs, private funds (such as
hedge funds and private equity funds) and closed-end funds pursuing
similar alternative strategies can invest in portfolio assets that are
relatively illiquid without generating the same degree of redemption
risk for the fund because investor redemption rights are often
limited.\97\ In addition, investor expectations of private funds'
redemption rights differ from the redemption expectations of typical
retail investors in open-end funds.\98\ For example, investors in
private equity funds typically commit their capital for the life of the
fund.\99\
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\97\ A private fund is an issuer that would be an investment
company, as defined in section 3 of the Investment Company Act, but
for the exclusion from the definition of ``investment company'' in
section 3(c)(1) or 3(c)(7) of the Act. Section 202(a)(29) of the
Advisers Act.
\98\ Hedge Funds often contain ``lock-up'' provisions and impose
gates, suspensions of redemptions, and side pockets to manage
liquidity stress. See Proposing Release, supra footnote 9, at n.69
and accompanying text.
\99\ See Comment Letter of the Private Equity Growth Capital
Council on the Notice Seeking Comment on Asset Management Products
and Activities, Docket No. FSOC-2014-0001 (Mar. 25, 2015).
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In contrast, alternative strategy mutual funds and ETFs have no
such ability to tailor investor redemption rights based on the
liquidity profile of the funds' portfolios. Yet some of these funds
seek to pursue similar investment strategies as hedge funds and other
private funds, while still being bound
[[Page 82153]]
by the redemption obligations applicable to open-end funds.
Accordingly, our staff has been focused on the liquidity of alternative
strategy mutual funds and ETFs (excluding ETMFs), as well as the nature
of liquidity and redemption risks faced by investors in these funds
given their legal right to be paid the proceeds of any redemption
request within seven days and a fund's representations about payment in
less than seven days.\100\ Certain observations by the Commission's
Division of Economic and Risk Analysis (``DERA'') have lent further
support to our focus on liquidity risk management practices in this
industry segment, as DERA's analysis has shown that alternative
strategy mutual funds demonstrate cash flows that are significantly
more volatile than other strategies, indicating that these funds may
face higher levels of redemptions, and thus higher liquidity risk.\101\
Volatility in flows places additional importance on liquidity risk
management to prevent some of the consequences from a failure to
adequately manage liquidity discussed in section II.B.2 above. The
final rules and rule amendments build off of many of the observations
we and our staff have made through efforts examining the growth in
funds and ETFs with fixed income strategies and alternative strategies.
---------------------------------------------------------------------------
\100\ See Proposing Release, supra footnote 9, at n.72.
\101\ See DERA Study, supra footnote 95.
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2. Evolution of Settlement Periods and Redemption Practices
Practices relating to securities trade settlement periods and the
timing of the payment of redemption proceeds to investors also have
evolved considerably over the decades since the Commission last
addressed liquidity needs in open-end funds.\102\ Due to the adoption
of rule 15c6-1 under the Exchange Act in 1993, the standard settlement
time frame declined from five business days (T+5) to three business
days (T+3).\103\ Furthermore, while standard settlement periods for
securities trades in many markets have tended to fall significantly
over the last several decades--and investor expectations that
redemption proceeds will be paid promptly after redemption requests
have risen--settlement periods for other securities held in large
amounts by certain funds have not fallen correspondingly. For example,
some bank loan funds do not consider most of their portfolio holdings
to be illiquid and generally represent in their disclosures that they
comply with the Commission's current guidelines,\104\ even though the
settlement periods associated with some bank loans and participations
may extend beyond the period of time the fund would be required to meet
shareholder redemptions. This creates a potential mismatch between the
timing of the receipt of cash upon sale of these assets and the payment
of cash for shareholder redemptions.\105\
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\102\ See supra footnotes 7-9 and accompanying text.
\103\ The decline in the securities trading settlement period
from T+5 to T+3 prompted funds that were sold through broker-dealers
to satisfy redemption requests within three business days. See supra
footnote 32.
\104\ See supra section II.B.3.
\105\ See discussion of this timing mismatch of the Proposing
Release, supra footnote 9, at n.79 and accompanying text.
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Overall, the evolution of the market towards shorter settlement
periods--and corresponding fund disclosures--combined with open-end
funds holding certain securities with longer settlement periods have
raised concerns for us about whether fund portfolios are sufficiently
liquid to support a fund's ability to meet its redemption and other
legal obligations.
D. Overview of Current Practices
Over the last several years, Commission staff has observed through
a variety of different events the current liquidity risk management
practices at a cross-section of fund complexes with varied investment
strategies. The staff has observed that liquidity risk management
techniques may vary across funds, including funds within the same fund
complex, in light of unique fund characteristics, including, for
example, the nature of a fund's investment objectives or strategies,
the composition of the fund's investor base, and historical fund flows.
These observations collectively have shown the staff that, even with
various unique characteristics, many open-end funds and fund complexes
have implemented procedures for assessing and managing the liquidity of
their portfolio assets.\106\
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\106\ There are varying degrees of formality in the adoption and
implementation of these procedures. Several commenters also
discussed existing liquidity risk management practices. See, e.g.,
Blackrock Comment Letter; ICI Comment Letter I; Comment Letter of
Vanguard (Jan. 6, 2016) (``Vanguard Comment Letter'').
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Specifically, some of the funds observed by the staff assess their
ability to sell particular assets within various time periods
(typically focusing on one-, three-, and/or seven-day periods).\107\ In
conducting this analysis, these funds may take into account relevant
market, trading, and other factors, and monitor whether their initial
liquidity determination should be changed based on changed market
conditions. This process helps these funds determine their ability to
meet redemption requests without significant dilution in various market
conditions within the disclosed period for payment of redemption
proceeds.
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\107\ See 2014 Fixed Income Guidance Update, supra footnote 94
(noting that fund advisers ``generally assess overall fund liquidity
and funds' ability to meet potential redemptions over a number of
periods'' and discussing certain steps that fund advisers may
consider taking given potential fixed income market volatility); see
also Proposing Release, supra footnote 9, at n.151 and accompanying
text.
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Funds observed by the staff that have implemented procedures for
assessing the liquidity of their portfolio assets also often have
developed controls to manage fund portfolio liquidity risk and the risk
of changing levels of shareholder redemptions, such as holding certain
amounts of the fund's portfolio in highly liquid investments, setting
minimum cash reserves, and establishing committed back-up lines of
credit or interfund lending facilities.\108\ A few of the funds
observed by staff conduct stress testing relating to the availability
of liquid assets to cover possible levels of redemptions.\109\ Some of
these funds' advisers also have periodic discussions with their boards
of directors about how the funds approach liquidity risk management and
what emerging risks they are observing relating to liquidity risk. The
staff has observed that some of the funds with the more thorough
liquidity risk management practices have appeared to be able to better
meet periods of higher than typical redemptions without significantly
altering their risk profile or materially affecting their performance,
and thus with less dilutive impacts.
---------------------------------------------------------------------------
\108\ See Proposing Release, supra footnote 9, at n.100 and
accompanying text.
\109\ See Proposing Release, supra footnote 9, at n.101.
---------------------------------------------------------------------------
Conversely, the Commission is concerned that some funds employ
liquidity risk management practices that are substantially less
rigorous. Some funds observed by the staff do not take different market
conditions into account when evaluating portfolio asset liquidity, and
do not conduct any ongoing liquidity monitoring. Some funds do not
incorporate any independent oversight of fund liquidity risk management
outside of the portfolio management process.\110\ Staff has observed
that some of these funds, when faced with higher than normal
redemptions, experienced particularly
[[Page 82154]]
poor performance compared with their benchmark and some even
experienced an adverse change in the fund's risk profile, each of which
can increase the risk of investor dilution as well as the risk that the
fund will be unable to meet those redemptions.
---------------------------------------------------------------------------
\110\ See Proposing Release, supra footnote 9, at n.102.
---------------------------------------------------------------------------
Finally, the Commission learned through staff outreach that many
funds treat their risk management process for assessing the liquidity
profile of portfolio assets, and the incorporation of market and
trading information, as entirely separate from their assessment of
assets under the 15% guideline. The former process is typically
conducted on an ongoing basis through the fund's risk management
function, through the fund's portfolio management function, or through
the fund's trading function (or a combination of the foregoing), while
assessment of assets under the 15% guideline is more typically
conducted upon purchase of an asset through the fund's compliance or
``back-office'' functions, with little indication that information
generated from the risk management or trading functions informs the
compliance determinations. This functional divide may be a by-product
of the limitations of the 15% guideline as a stand-alone method for
comprehensive liquidity risk management, a situation that our final
liquidity risk management program framework is meant to address.\111\
---------------------------------------------------------------------------
\111\ See supra section II.B.2 for a discussion of the
limitations of the 15% guideline.
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Overall, our staff outreach has increased our understanding of some
of the valuable liquidity risk management practices employed by some
firms as a matter of prudent risk management. This outreach also has
shown us the great diversity in liquidity risk management practices
that raises concerns regarding various funds' ability to meet their
redemption and other legal obligations and minimize the effects of
dilution under certain conditions. Collectively, these observations
have informed our understanding of the need for an enhanced minimum
baseline requirement for fund management of liquidity risk.
E. Rulemaking Adoption Overview
Against this background, today we are adopting a set of reforms
designed to promote effective liquidity risk management throughout the
open-end fund industry and thereby reduce the risk that funds will not
be able to meet redemption or other legal obligations and mitigate
potential dilution of the interests of fund shareholders. We believe
that limitations on illiquid holdings and more effective liquidity risk
management among funds would, in turn, result in significant investor
protection benefits and enhance the fair and orderly operation of the
markets.\112\ The final amendments also seek to enhance reporting and
disclosure regarding fund liquidity and redemption practices.
---------------------------------------------------------------------------
\112\ See infra section IV.C.
---------------------------------------------------------------------------
First, we are adopting new rule 22e-4, which requires each
registered open-end fund, including open-end ETFs but not including
money market funds, to adopt and implement a written liquidity risk
management program reasonably designed to assess and manage the fund's
liquidity risk.\113\ The new rule requires a fund's liquidity risk
management program to incorporate certain specified elements. These
include: (i) Assessment, management, and periodic review of the fund's
liquidity risk; (ii) classification of the liquidity of each of the
fund's portfolio investments,\114\ as well as at-least-monthly reviews
of the fund's liquidity classifications; (iii) determining and
periodically reviewing a highly liquid investment minimum--the
percentage of its net assets that the fund invests in highly liquid
investments that are assets; (iv) limiting the fund's investment in
illiquid investments that are assets to no more than 15% of the fund's
net assets; and (v) for funds that engage in, or reserve the right to
engage in, redemptions in kind, the establishment of policies and
procedures regarding how they will engage in such redemptions in kind.
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\113\ See rule 22e-4(b). Rule 22e-4, as adopted today, defines
``liquidity risk'' as the risk that a fund could not meet requests
to redeem shares issued by the fund without significant dilution of
remaining investors' interests in the fund.
\114\ As discussed in more detail below, rule 22e-4 as adopted
requires a fund to classify each of the fund's portfolio
investments, including investments that are liabilities of the fund
(e.g., certain out-of-the-money derivatives transactions). See infra
footnote 480 and accompanying text. As proposed rule 22e-4 would
have required each fund to classify the liquidity of its portfolio
positions (or portions of a position in a particular asset), but did
not specifically address the treatment of a fund's holdings that are
liabilities. Thus, in this Release, we use the term ``assets'' when
referring to the proposed classification requirement and comments on
the proposed requirement, and the term ``investments'' when
referring to the adopted classification requirement.
---------------------------------------------------------------------------
The liquidity risk assessment requirement generally provides a
broad, principles-based foundational framework for a fund's liquidity
risk management program, including a requirement that the fund assess
whether its investment strategy is appropriate for an open-end fund.
The final rule also provides for a tailored program for ETFs, requiring
them to consider additional factors as part of their liquidity risk
assessment and management that reflect potential liquidity-related
concerns that could arise from the structure and operation of ETFs, and
excepting ETFs that redeem in kind (``In-Kind ETFs'') from the
classification and highly liquid investment minimum requirements.\115\
The final rule also provides that funds whose assets primarily consist
of highly liquid investments need not adopt a highly liquid investment
minimum.\116\ Additionally, rule 22e-4 will not apply to closed-end
funds, and will apply to principal underwriters and depositors of UITs
only to a limited degree, as discussed further below. The
classification requirement will provide important liquidity profile
information to the Commission and investors and reflects that liquidity
may be viewed as falling on a spectrum rather than a binary conclusion
that an investment is either ``liquid'' or ``illiquid.'' \117\ The
highly liquid investment minimum requirement is aimed at decreasing the
[[Page 82155]]
likelihood that funds would be unable to meet their redemption
obligations.
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\115\ Under the final rule, each ``In-Kind ETF,'' or an ETF that
meets redemptions through in-kind transfers of securities,
positions, and assets other than a de minimis amount of cash, will
be subject to the tailored program requirement. See rule 22e-4(a)(9)
(definition of ``In-Kind Exchange Traded Fund'' or ``In-Kind ETF'');
rule 22e-4(b)(1)(i)(D) (incorporating additional factors that an ETF
would be required to consider as applicable as part of its liquidity
risk assessment and management that reflect liquidity-related risks
that could be particularly relevant to the ETF). Under rule 22e-
4(a)(5), the term ``fund'' is defined to exclude an In-Kind ETF. As
a result, rule 22e-4(b)(1)(ii) and rule 22e-4(b)(1)(iii), which
apply to funds as defined in rule 22e-4(a)(5), exclude In-Kind ETFs
from the classification and highly liquid investment minimum
requirements, respectively.
\116\ See rule 22e-4(b)(1)(iii) (applying the highly liquid
investment minimum requirement only to a fund that does not
primarily hold assets that are highly liquid investments).
\117\ The Commission is adopting a classification framework
consisting of four liquidity categories based on the number of days
within which it is determined that the investment is reasonably
expected to be convertible to cash (or, in the case of the least-
liquid categories, sold or disposed of) without the conversion (or,
in the case of the least-liquid categories, sale or disposition)
significantly changing the market value of the investment. More
specifically, as discussed below, rule 22e-4 would require a fund to
classify each of its portfolio investments into one of the following
liquidity categories: Highly liquid investments (category based on
fund's reasonable expectation that an investment can be converted to
cash within three business days); moderately liquid investments
(category based on fund's reasonable expectation that an investment
can be converted to cash within four to seven calendar days); less
liquid investments (category based on fund's reasonable expectation
that an investment can be sold or disposed of in seven calendar days
but the settlement is reasonably expected to be greater than seven
calendar days); and illiquid investments (category based on fund's
reasonable expectation that an investment cannot be sold or disposed
of within seven calendar days).
---------------------------------------------------------------------------
Rule 22e-4 includes board oversight provisions related to the
liquidity risk management program. Specifically, a fund's board will
approve, but not design, the fund's liquidity risk management program,
as well as the fund's designation of the fund's investment adviser or
officers as responsible for administering the day-to-day aspects of the
fund's liquidity risk management program.\118\ A fund also will be
subject to board reporting requirements to the extent that its
investments in assets that are highly liquid investments fall below its
minimum or its assets that are illiquid investments rise above 15% of
its net assets.\119\ We anticipate that the new program requirement
will result in investor protection benefits, as improved liquidity risk
management could decrease the chance that a fund could meet its
redemption obligations only with significant dilution of remaining
investors' interests or changes to the fund's risk profile.
---------------------------------------------------------------------------
\118\ Rule 22e-4(b)(2).
\119\ Rule 22e-4(b)(1)(iii)(A)(3) and rule 22e-4(b)(1)(iv).
---------------------------------------------------------------------------
Rule 22e-4, by requiring funds to limit illiquidity and manage
liquidity, should reduce the potential likelihood and extent of
dilution of non-transacting shareholders that otherwise could result
from redemptions effected at prices determined in accordance with rules
22c-1 and 2a-4. Thus, rule 22e-4, although it is numbered with
reference to section 22(e), has a broader scope and also should
separately help rule 22c-1 operate so as to reduce dilution, as
contemplated by sections 22(a) and (c).
Second, we are adopting certain public disclosure- and confidential
reporting-related rules and amendments to provide shareholders and
other users with additional information with respect to funds'
liquidity risk profile as well as assist the Commission in its
monitoring efforts. Specifically, we are adopting reporting
requirements on Form N-PORT that will require a fund to report monthly
position-level liquidity classification information and its highly
liquid investment minimum to the Commission on a confidential
basis.\120\ Form N-PORT will also require a fund to publicly disclose
the aggregated percentage of its portfolio representing each of the
four classification categories adopted by the Commission as of the end
of each of its fiscal quarters.\121\
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\120\ We are adopting Form N-PORT today in a companion release.
See Investment Company Reporting Modernization, Investment Company
Act Release No. 32314 (October 13, 2016) (``Investment Company
Reporting Modernization Adopting Release'') We discuss the Form N-
PORT reporting requirements related to rule 22e-4 in this Release,
including the requirements that a fund report: (i) The liquidity
classification assigned to each portfolio position (which may be
based on asset type to the extent discussed below); (ii) the asset
type label that the fund has assigned to each portfolio position,
using any asset type labeling scheme the fund employs in its own
portfolio management systems; and (iii) the fund's highly liquid
investment minimum.
\121\ This information will be reported monthly on Form N-PORT,
but it will be disclosed to the public only for the third month of
each fiscal quarter with a 60-day delay.
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We are adopting new rule 30b1-10 and Form N-LIQUID to require a
fund to confidentially notify the Commission when the fund's illiquid
investment holdings exceed 15% of its net assets or if its amount of
highly liquid investments declines below its highly liquid investment
minimum for more than a brief period of time. We also are adopting
amendments to Form N-1A to require a fund to publicly disclose certain
information regarding the fund's redemption procedures. Finally, we are
adopting requirements for funds to provide information on Form N-CEN
about funds' use of lines of credit and interfund lending.
We anticipate that these new requirements will facilitate the
Commission's risk and compliance monitoring efforts by providing
greater transparency regarding the liquidity characteristics of fund
portfolio holdings, as well as its ability to monitor and assess
compliance with rule 22e-4. While Form N-PORT and Form N-CEN are
primarily designed to assist the Commission, we believe that the
requirements to publicly disclose certain information will also help
investors and other potential users utilize information on particular
funds' liquidity-related risks and redemption policies, which in turn
may assist investors in making more informed investment choices.\122\
As further discussed below, we believe that these reporting
requirements strike the right balance between protecting the funds from
certain adverse effects that could arise from public disclosure of
detailed portfolio liquidity information with the need to provide
shareholders and other users with improved information about funds'
liquidity risk profile.
---------------------------------------------------------------------------
\122\ See, e.g., Comment Letter of Markit on the Notice Seeking
Comment on Asset Management Products and Activities, Docket No.
FSOC-2014-0001 (Mar. 25, 2015) (``[W]e believe that liquidity and
redemption risk contained in asset management products can be
mitigated by providing risk managers or investors of pooled
investment vehicles better information about the liquidity risk
associated with pool investments so that they can price it more
accurately. This could be done through, among other things,
disclosures of the `prudent valuation' (accounting for pricing
uncertainty) of the fund's investments and the implementation of
appropriate liquidity risk management policies and procedures.'').
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III. Discussion
A. Program Requirement and Scope of Rule 22e-4
Today the Commission is adopting rule 22e-4 under the Investment
Company Act. This rule will require each registered open-end management
investment company, including open-end ETFs but not including money
market funds, to establish a written liquidity risk management program.
Rule 22e-4 will not apply to closed-end funds, and will apply to UITs
only to a limited degree, as discussed further below.
1. Liquidity Risk Management Program
Rule 22e-4 generally will require each registered open-end
management investment company to establish a written liquidity risk
management program. The majority of commenters generally supported the
proposed requirement for each fund to adopt a formal, written liquidity
risk management program,\123\ although many commenters objected to
certain aspects of the proposal and suggested modifications to certain
proposed program elements, as discussed in more detail below. Other
commenters opposed the proposed written program requirement, asserting
that funds have a history of successfully managing their liquidity and
that the proposed requirement was thus unnecessary.\124\ We continue to
believe, as discussed in the Proposing Release, that the program
requirement will produce significant investor protection benefits, in
light of the fact that funds are not currently subject to specific
requirements under
[[Page 82156]]
the federal securities laws or Commission rules obliging them to manage
their liquidity risk. Outreach by Commission staff has identified
practices at some funds that raise concerns regarding funds' ability to
meet their redemption obligations and lessen the effects of
dilution.\125\ The Commission is thus adopting, as proposed, a
requirement for each fund to adopt and implement a written liquidity
risk management program.\126\ However, we note that the program
requirement we are adopting incorporates modifications to most of the
proposed program elements.\127\
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\123\ See, e.g., Comment Letter of Alternative Investment
Management Association (Jan. 13, 2016) (``AIMA Comment Letter'');
Comment Letter of Capital Research and Management Company (Jan. 13,
2016) (``CRMC Comment Letter''); Comment Letter of Cohen & Steers
(Jan. 13, 2016) (``Cohen & Steers Comment Letter''); Comment Letter
of Dechert LLP (Jan. 13, 2016) (``Dechert Comment Letter''); Comment
Letter of Fidelity Management & Research Company (Jan. 13, 2016)
(``Fidelity Comment Letter''); Comment Letter of Association of the
Bar of the City of New York (Jan. 13, 2016) (``NYC Bar Comment
Letter''); Comment Letter of Securities Industry and Financial
Markets Association (Jan. 13, 2016) (Comments on Proposal to Require
Liquidity Risk Management Programs and Related Liquidity
Disclosures) (``SIFMA Comment Letter I''); Comment Letter of T. Rowe
Price (Jan. 13, 2016) (``T. Rowe Comment Letter'').
\124\ See Comment Letter of Cove Street Capital (Oct. 8, 2015)
(``Cove Street Comment Letter''); Comment Letter of Jim H. Francis
(Nov. 4, 2015); Comment Letter of Jordana Keefer (Jan. 7, 2016)
(``Keefer Comment Letter''); Comment Letter of Don G. Powell (Oct.
5, 2015); Comment Letter of John Wahh (Oct. 1, 2015) (``Wahh Comment
Letter'').
\125\ See Proposing Release, supra footnote 9, at section
IV.C.1.b.
\126\ See rule 22e-4(b).
\127\ As discussed throughout this Release, we believe that
these modifications respond appropriately to specific concerns noted
by commenters and help to increase the effectiveness of the program
requirement in advancing the Commission's goals, while at the same
time reducing associated burdens.
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A fund may, as it determines appropriate, expand its liquidity risk
management procedures and related disclosure concerning liquidity risk
beyond the required program elements.\128\ While a fund would be
required to adhere to certain requirements--such as the requirement to
classify the liquidity of a fund's portfolio investments and determine
a highly liquid investment minimum \129\--in other respects, the
proposed program requirements would permit each fund to tailor its
liquidity risk management program to the fund's particular risks and
circumstances. Commenters stressed that many funds are currently
engaged in operational practices that are designed to support fund
liquidity and the redeemability of fund shares.\130\ Commenters also
noted that funds' approaches to liquidity risk management should, and
currently do, differ markedly depending on their individual risks.\131\
We believe that the program requirement will permit funds that already
have programs that satisfy the rule requirements to continue to engage
in the liquidity risk management practices that they have found to be
effective. However, the program requirement's common obligations should
strengthen liquidity risk management across the fund industry, while
also providing important transparency into funds' liquidity profiles
and risk management practices.
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\128\ See supra footnotes 113-115 and accompanying text for a
description of the required program elements.
\129\ In-Kind ETFs are excepted from the classification and
highly liquid investment minimum requirements. See infra section
III.J. In addition, funds whose portfolios consist primarily of
highly liquid investments would not be required to determine a
highly liquid investment minimum. See infra section III.D.5.
\130\ See, e.g., ICI Comment Letter I; BlackRock Comment Letter;
Invesco Comment Letter; Vanguard Comment Letter.
\131\ See, e.g., ICI Comment Letter I; Dechert Comment Letter;
Vanguard Comment Letter.
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2. Scope of Rule 22e-4 and Related Disclosure and Reporting
Requirements
The liquidity risk management program requirements of rule 22e-4,
as well as related disclosure and reporting requirements, will apply to
all registered open-end funds, except money market funds.\132\ Rule
22e-4 will apply to open-end ETFs, but incorporates tailored program
requirements to reflect their particular liquidity-related risks.\133\
The final rule also excludes from the highly liquid investment minimum
requirement funds whose portfolios consist primarily of highly liquid
investments. Closed-end funds are excluded from the scope of rule 22e-
4,\134\ and UITs are not subject to the rule's general program
requirement, although each UIT's principal underwriter or depositor
will be required to determine, on or before the date of the initial
deposit of portfolio securities into the UIT, that the portion of
illiquid investments that the UIT holds or will hold at the date of
deposit that are assets is consistent with the redeemable nature of the
securities it issues.\135\ We discuss these scope determinations in
more detail below.
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\132\ Although money market funds are excluded from the scope of
rule 22e-4, they will be subject to the amendments to Form N-1A and
Form N-CEN. See infra section III.A.2.a (``Inclusion of Funds with
All Investment Strategies and Inclusion of ETFs within the Scope of
Rule 22e-4''); section III.A.2.b (``Inclusion of Funds of All Sizes
within the Scope of Rule 22e-4''); and section III.A.2.e
(``Exclusion of Money Market Funds from the Scope of Rule 22e-4'').
\133\ See infra section III.J.
\134\ See infra section III.A.2.c (``Exclusion of Closed-End
Funds from the Scope of Rule 22e-4'').
\135\ See infra section III.K.
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a. Inclusion of Funds With All Investment Strategies and Inclusion of
ETFs Within the Scope of Rule 22e-4
We are not excluding funds with any particular strategies from the
scope of rule 22e-4.\136\ We proposed to apply rule 22e-4 to all open-
end funds (except money market funds) regardless of the fund's
investment strategy, stating that even funds with investment strategies
that have historically entailed little liquidity risk could experience
liquidity stresses in certain environments.\137\ We also stated that
different types of funds within the same broad investment strategy
could demonstrate different levels of liquidity and relatedly,
different levels of liquidity risk.
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\136\ But see infra section III.D.5 (discussing exclusion of In-
Kind ETFs as well as funds that primarily hold highly liquid
investments from the highly liquid investment minimum requirement).
\137\ See Proposing Release, supra footnote 9, at nn.123-125 and
accompanying text.
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Some commenters expressed concern about the costs of some of the
proposed requirements relative to the liquidity risks typically
associated with certain investment strategies,\138\ as well as concerns
about burdensome effects of some particular requirements for certain
strategies.\139\ Other commenters, however, generally supported a
program requirement that applies to all registered open-end funds,
regardless of the fund's investment strategy.\140\ We believe the
modifications to the proposal we are adopting (in particular, changes
to the classification requirement and the proposed three-day liquid
asset minimum requirement) appropriately address commenters' concerns
and reflect support that some commenters provided for a program
requirement that applies to all registered open-end funds.
---------------------------------------------------------------------------
\138\ See, e.g., infra footnote 1107 and accompanying text.
\139\ For example, some commenters expressed concerns about the
extent to which the proposed liquidity classification factors were
applicable to certain investment strategies, particularly funds that
invest in fixed income or other OTC assets (see, e.g., Comment
Letter of Federated Investors, Inc. (Jan. 13, 2016) (``Federated
Comment Letter''); Comment Letter of Government Finance Officers
Association (Jan. 13, 2016) (``GFOA Comment Letter''); Comment
Letter of Nuveen Fund Advisors, LLC (Jan. 13, 2016) (``Nuveen
Comment Letter''); Comment Letter of OppenheimerFunds (Jan. 13,
2016) (``Oppenheimer Comment Letter'')). Commenters also expressed
concerns about the extent to which a three-day liquid asset minimum
requirement could impede an index fund's ability to track its index
(see, e.g., BlackRock Comment Letter; HSBC Comment Letter; Invesco
Comment Letter; SIFMA Comment Letter I).
\140\ See, e.g., CRMC Comment Letter; Comment Letter of Eaton
Vance Investment Managers (Jan. 13, 2016) (``Eaton Vance Comment
Letter I'').
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As noted above, rule 22e-4 will apply to open-end ETFs, although we
are adopting certain tailored program requirements for ETFs.\141\ Some
commenters objected to all or certain proposed program requirements
applying to ETFs.\142\ We respond in detail to these comments in
section III.J below. We note, however, that while ETFs' liquidity risks
can differ from the liquidity risks faced by other open-end funds, ETFs
still have liquidity-related risks that could affect their
shareholders, as well as the broader markets in which they operate. The
tailored requirements that we are
[[Page 82157]]
adopting for ETFs respond to commenters' suggestions that the
Commission tie these funds' liquidity risk management obligations to
the particular risks that they face, as well as our assessment of how
these funds' risks could most appropriately be addressed.\143\
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\141\ We note that rule 22e-4 only applies to ETFs that are
structured as open-end funds. For ease of reference, however, unless
indicated otherwise, when we refer to ETFs we mean open-end ETFs
only.
\142\ See infra footnotes 839-841 and accompanying text.
\143\ See infra section III.J.
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b. Inclusion of Funds of All Sizes Within the Scope of Rule 22e-4
Also, as proposed, we are not excluding any fund from the scope of
rule 22e-4 on the basis of size or adopting different liquidity
requirements for relatively small funds. As discussed in the Economic
Analysis section below, smaller funds tend to demonstrate relatively
high flow volatility, and thus we believe they should be subject to the
same liquidity risk management requirements as other funds.\144\
Conversely, some commenters argued that the proposed classification
requirement could unduly burden larger funds by inappropriately making
these funds appear to be less liquid than they actually are, and we
have incorporated certain modifications to the proposed classification
requirement that we believe respond to these concerns, as discussed
below.\145\
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\144\ See infra footnote 1160 and accompanying text.
\145\ See infra section III.C.3.b.
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c. Exclusion of Closed-End Funds From the Scope of Rule 22e-4
As proposed, rule 22e-4 would have excluded closed-end investment
companies from the scope of rule 22e-4. As discussed in detail in the
Proposing Release, closed-end funds' liquidity needs are different from
those of open-end funds, because closed-end funds generally do not
issue redeemable securities and are not subject to sections 22(c) and
22(e) of the Investment Company Act.\146\ Although closed-end interval
funds do have to comply with certain liquidity standards under rule
23c-3 and therefore must manage their liquidity risk, we are not
subjecting them to rule 22e-4 because they are already required to
adopt written liquidity procedures under rule 23c-3(b)(10)(iii).\147\
Closed-end interval funds may be better able to anticipate their
liquidity needs than open-end funds because closed-end interval funds
do not permit daily redeemability, closed-end interval funds must limit
the size and timing of repurchase offers, and rule 23c-3 requires
shareholders who wish to tender their shares pursuant to a repurchase
offer to provide advance notice thereof to such funds.\148\ Commenters
uniformly agreed that closed-end funds should be excluded from the
scope of rule 22e-4 and we continue to believe that closed-end funds
(including closed-end interval funds) should be excluded from the
rule's scope.
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\146\ See Proposing Release, supra footnote 9, at nn.132-135 and
accompanying text. Certain closed-end funds (``closed-end interval
funds'') do elect to repurchase their shares at periodic intervals
pursuant to rule 23c-3 under the Investment Company Act.
\147\ See Proposing Release, supra footnote 9, at n.134.
\148\ See id., at text following n.135.
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d. Separate Requirements for UITs Under Rule 22e-4
As proposed, the scope of rule 22e-4 did not include UITs.\149\ As
adopted today, the rule will require a limited liquidity review under
which the UIT's principal underwriter or depositor determines, on or
before the date of the initial deposit of portfolio securities into the
UIT, that the portion of the illiquid investments that the UIT holds or
will hold at the date of deposit that are assets is consistent with the
redeemable nature of the securities it issues.\150\ UITs and their
principal underwriters and depositors will not, however, be subject to
any of the rule's other liquidity risk management program requirements.
---------------------------------------------------------------------------
\149\ See Proposing Release, supra footnote 9, at section
III.A.2.
\150\ See rule 22e-4(c). The rule also requires UITs to maintain
a record of that determination for the life of the UIT and for five
years thereafter.
---------------------------------------------------------------------------
While one commenter supported excluding UITs from the scope of rule
22e-4,\151\ several other commenters argued that ETFs structured as
UITs should be subject to the same rule requirements as ETFs structured
as open-end funds.\152\ We respond in detail to these comments in
section III.K below, including discussing how we believe the
requirement to determine that a UIT's illiquid investment holdings are
consistent with the redeemable nature of the UIT's securities responds
to commenters' concerns.
---------------------------------------------------------------------------
\151\ See ICI Comment Letter I.
\152\ See, e.g., Comment Letter of Anonymous (Jan. 13, 2016)
(``Anonymous Comment Letter I''); BlackRock Comment Letter.
---------------------------------------------------------------------------
e. Exclusion of Money Market Funds From the Scope of Rule 22e-4
Finally, as proposed, money market funds are excluded from the
scope of rule 22e-4. Money market funds are currently subject to
extensive requirements concerning the liquidity of their portfolio
assets that are more stringent in many respects than the requirements
of rule 22e-4, due to the historical redemption patterns of money
market fund investors and the characteristics of the assets held by
money market funds.\153\ Money market funds also are already subject to
broad liquidity-related disclosure and reporting requirements,\154\ and
they have certain tools at their disposal to manage heavy redemptions
that are not available to other open-end funds.\155\ For these reasons,
we did not include money market funds within the scope of the proposed
rule, and commenters uniformly agreed that money market funds should be
excluded from the rule's scope.\156\ We continue to believe that money
market funds should be excluded from the scope of rule 22e-4.
---------------------------------------------------------------------------
\153\ See Proposing Release, supra footnote 9, at nn.145-150 and
accompanying text.
\154\ See id., at nn.151-152 and accompanying text.
\155\ See id., at nn.153-155 and accompanying text.
\156\ See, e.g., CRMC Comment Letter; Eaton Vance Comment Letter
I; ICI Comment Letter I; Comment Letter of Voya Investment
Management (Jan. 12, 2016) (``Voya Comment Letter'').
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B. Assessment, Management, and Review of Liquidity Risk
Section 22(e) of the Investment Company Act requires a registered
investment company \157\ to make payment to shareholders for securities
tendered for redemption within seven days of their tender.\158\ The
legislative history of the Act indicates that shareholder dilution was
a significant concern of the Act's framers.\159\ An open-end fund's
ability to pay redeeming shareholders within this seven-day period
without significant dilution is directly related to its liquidity.
Thus, assessing and managing liquidity risk in a comprehensive manner
is critical to an open-end fund's capacity to honor redemption requests
within this seven-day period, as well as within any shorter time period
disclosed in the fund's prospectus or advertising materials, while
mitigating dilution.
---------------------------------------------------------------------------
\157\ See supra footnote 4 and accompanying text.
\158\ See supra footnote 36.
\159\ See supra footnote 7 and accompanying text.
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Today we are adopting a new liquidity risk assessment and
management framework for funds. Specifically, rule 22e-4 requires a
fund to assess, manage, and periodically review its liquidity risk,
considering certain factors as applicable. As discussed in more detail
below, the requirements we are adopting incorporate a definition of
``liquidity risk'' that focuses on whether a fund can meet redemption
requests without significant dilution of remaining investors' interests
rather than, as proposed, whether the fund can meet redemption requests
without materially
[[Page 82158]]
affecting the fund's NAV.\160\ We are also adopting certain changes to
the proposed factors that a fund would consider in assessing and
managing its liquidity risk. These changes aim to simplify and
streamline the proposed liquidity risk assessment and management
factors, and reflect additional considerations that the Commission,
along with certain commenters, believes could entail heightened
liquidity risk. Notably, the proposed requirement to consider a fund's
investment strategy and portfolio liquidity in assessing and managing
liquidity risk now incorporates the instruction that this consideration
includes whether the investment strategy is appropriate for an open-end
fund, as well as whether the strategy involves a relatively
concentrated portfolio or large positions in particular issuers.\161\
Additionally, the proposed requirement to consider a fund's short-term
and long-term cash flow projections has been simplified to eliminate
the five separate sub-considerations relevant to this factor that were
incorporated in the proposed rule, but which now are discussed as
guidance in this Release.\162\
---------------------------------------------------------------------------
\160\ See infra section III.B.1.a.
\161\ See infra section III.B.2.a.
\162\ See infra section III.B.2.b.
---------------------------------------------------------------------------
We proposed liquidity risk assessment and management program
requirements with the primary goals of reducing the risk that funds
would be unable to meet redemption and other legal obligations,
minimizing dilution, and elevating the overall quality of liquidity
risk management across the fund industry while at the same time
providing funds with reasonable flexibility to adopt policies and
procedures that would be most appropriate to assess and manage their
liquidity risk.\163\ As we discuss throughout this section, we believe
that the modified requirements we are adopting today continue to
reflect these goals, while promoting a more efficient and workable
framework.
---------------------------------------------------------------------------
\163\ See Proposing Release, supra footnote 9, at paragraph
following n.261.
---------------------------------------------------------------------------
1. Definition of ``Liquidity Risk''
Rule 22e-4, as adopted today, defines ``liquidity risk'' as the
risk that a fund could not meet requests to redeem shares issued by the
fund without significant dilution of remaining investors' interests in
the fund.\164\ This definition is largely similar to the proposed
definition of ``liquidity risk,'' that is, the risk that a fund could
not meet requests to redeem shares issued by the fund that are expected
under normal conditions, or are reasonably foreseeable under stressed
conditions, without materially affecting the fund's NAV.\165\ However,
in response to comments, the revised definition substitutes the phrase
``without significant dilution of remaining investors' interests in the
fund'' for the phrase ``without materially affecting the fund's net
asset value.'' The definition also does not include references to
redemption requests that are expected under normal conditions or
reasonably foreseeable under stressed conditions. Instead, the final
definition simply refers to ``requests to redeem.'' We believe our
modifications to the liquidity risk factors used to assess a fund's
liquidity risk, as discussed below, make any reference to market
conditions within the definition of liquidity risk unnecessary,
confusing, and duplicative.\166\
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\164\ When determining whether a fund's liquidity risk will
cause significant dilution for purposes of this definition, a fund
should consider the impact of liquidity risk on the total net assets
of the fund and the adverse consequences such dilution will have on
all the fund's remaining shareholders. Furthermore, as discussed
above, a fund's inability to meet redemption requests may cause harm
to shareholders. See, e.g., supra footnotes 81-84 and accompanying
text for a discussion of the suspension of shareholder redemptions
in the Third Avenue Focused Credit Fund following a period of heavy
redemptions that the fund stated reduced the fund's portfolio
liquidity.
\165\ See proposed rule 22e-4(a)(7); see also Proposing Release,
supra footnote 9, at text accompanying n.255.
\166\ See rule 22e-4(b)(1)(i).
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a. Evaluating Risk of Significant Dilution of Remaining Investors'
Interests
Multiple commenters objected to the proposed inclusion of any NAV-
impact standard in the definition of ``liquidity risk.'' One commenter
argued that including the concept of ``without materially affecting the
fund's net asset value'' in the definition of liquidity risk would
inappropriately merge liquidity and valuation, which are subject to
different regulatory and compliance controls.\167\ Many commenters also
objected that including such a price concept in the definition of
``liquidity risk'' would incorrectly indicate that market impact can be
accurately identified and measured separate from market price movements
generally.\168\ These commenters argued that many factors (including
market volatility, portfolio composition, and trade execution and
activity) influence the price at which a fund transacts in a security
as well as the levels of cash the fund holds, and thus it is difficult
to identify the effects of the fund's transaction activity on the
fund's NAV. Finally, some commenters argued that the inclusion of a
NAV-impact standard in the definition of ``liquidity risk'' could lead
investors to believe that appropriate liquidity risk management will
protect their investments from declining in value.\169\
---------------------------------------------------------------------------
\167\ See SIFMA Comment Letter I.
\168\ See, e.g., Comment Letter of Credit Suisse (Jan. 13, 2016)
(``Credit Suisse Comment Letter''); Comment Letter of Dodge & Cox
(Jan. 21, 2016) (``Dodge & Cox Comment Letter''); Comment Letter of
MFS Investment Management (Jan. 13, 2016) (``MFS Comment Letter'');
SIFMA Comment Letter I; Comment Letter of Investment Company
Institute (May 17, 2016) (``ICI Comment Letter III'') (encouraging
the Commission to adopt a definition of liquidity risk that
incorporates language related directly to dilution rather than value
impact on the NAV).
\169\ See, e.g., ICI Comment Letter I; MFS Comment Letter; SIFMA
Comment Letter I.
---------------------------------------------------------------------------
While we agree that liquidity and valuation are distinct concepts,
we consider these concepts as having certain inter-relationships.
First, liquidity risk in an open-end fund inherently involves an
assessment of the liquidity of the fund's investments. Common
definitions of investment liquidity include consideration of the value
impact or costs from trading that investment.\170\ Second, our staff
has observed in its outreach many occasions when a fund was unwilling
to transact
[[Page 82159]]
in certain portfolio investments when such sales would yield a price
that the fund considered unacceptable.\171\ This relationship is clear
in the Commission guidelines limiting a fund's investment in illiquid
investments. These guidelines specify that an illiquid investment is
one that cannot be sold or disposed of within seven days at
approximately the value at which the fund has valued the investment''
(emphasis added).\172\ We continue to believe that the inclusion of a
conceptual relationship between liquidity and sale price in the
definition of ``liquidity risk'' is appropriate.\173\ Such a
relationship indicates that liquidity risk involves the risk that a
fund will not be able to meet redemption requests under any
circumstances, as well as the risk that a fund could meet redemption
requests, but only in a manner that adversely affects the fund's non-
redeeming shareholders through significant dilution.\174\
---------------------------------------------------------------------------
\170\ See, e.g., Radhakrishnan Gopalan, et al., Asset Liquidity
and Stock Liquidity, 47 J. Fin & Quant. Anal. 333 (2012), available
at http://apps.olin.wustl.edu/faculty/gopalan/asset_stock_liquidity.pdf (``An asset is liquid if it can be
converted into cash quickly and at a low cost.''); Yakov Amihud &
Haim Mendelson, Liquidity, Asset Prices, and Financial Policy, 47
Fin. Anal. J. 56 (1991), available at http://www.jstor.org/stable/4479488?seq=1#page_scan_tab_contents (``An asset is liquid if it can
be bought or sold at the current market price quickly and at low
cost.'').
In addition, we note that many funds disclose liquidity risk as
a principal investment risk in their prospectuses, and these
disclosures often reference possible adverse value impacts from
selling fund investments under certain conditions. See, e.g., Schwab
Strategic Trust rule 485(b) Registration Statement (June 30, 2016),
available at https://www.sec.gov/Archives/edgar/data/1454889/000119312516632635/d203200d485bpos.htm (``Liquidity Risk. The fund
may be unable to sell certain securities, such as illiquid
securities, readily at a favorable time or price, or the fund may
have to sell them at a loss.''); Voya Variable Funds rule 485(b)
Registration Statement (May 1, 2016), available at https://www.sec.gov/Archives/edgar/data/2664/000119312516562669/d124096d485bpos.htm (``Liquidity: If a security is illiquid, the
[fund] might be unable to sell the security at a time when the
[fund's] manager might wish to sell, or at all. Further, the lack of
an established secondary market may make it more difficult to value
illiquid securities, exposing the [fund] to the risk that the price
at which it sells illiquid securities will be less than the price at
which they were valued when held by the [fund]. The prices of
illiquid securities may be more volatile than more liquid
investments. The risks associated with illiquid securities may be
greater in times of financial stress. The [fund] could lose money if
it cannot sell a security at the time and price that would be most
beneficial to the Portfolio.'').
\171\ That is, the price that a portfolio manager could
realistically receive for certain portfolio investments could, in
effect, render such investments de facto illiquid if these pricing
considerations cause the portfolio manager to refrain from selling
them. See, e.g., Third Avenue Temporary Order, supra footnote 12
(``On December 9, 2015, after considering the environment the Fund
was in and the likelihood that incremental sales of portfolio
securities to satisfy additional redemptions would have to be made
at prices that would unfairly disadvantage all remaining
shareholders, the Board determined that the fairest action on behalf
of all shareholders would be to adopt a plan of liquidation.'').
\172\ See supra footnote 39 and accompanying text.
\173\ We also note that several commenters favorably discussed
foreign and international regulators' liquidity risk management
regimes, including ones that define the concepts of liquid (or
illiquid) portfolio assets, as well as funds' liquidity risk, with
reference to value impact or a discount that the fund may incur upon
sale. See, e.g., Dechert Comment Letter (favorably discussing
certain liquidity risk management requirements, including the
definition of ``liquidity risk,'' under the UCITS Directive); ICI
Comment Letter I (noting that the Commission could look to other
jurisdictions, including the European Union, for support for a
principles-based program rule); Invesco Comment Letter (also noting
that the UCITS Directive provides a framework for a principles-based
liquidity risk management program requirement); see also Commission
Directive 2010/43/EU, OJ L 176 (2010), at Ch. 1, Art. 3(8) (defining
``liquidity risk'' as ``the risk that a position in the UCITS
portfolio cannot be sold, liquidated or closed at limited cost in an
adequately short time frame and that the ability of the UCITS to
comply at any time with its redemption obligation is thereby
compromised''); Ontario Securities Commission, Report on Staff's
Continuous Disclosure Review of Mutual Fund Practices Relating to
Portfolio Liquidity, OSC Staff Notice 81-727 (June 25, 2015)
(definition of ``illiquid asset'' refers to the ``ability to readily
dispose of a portfolio asset through a market facility on which
public quotations are available at a price that approximates the
amount at which the portfolio asset is valued'').
We note as well that U.S. banking regulators have defined
``liquidity'' as ``a financial institution's capacity to meet its
cash and collateral obligations at a reasonable cost.'' Interagency
Policy Statement on Funding and Liquidity Risk Management, 75 FR
13656 (Mar. 22, 2010), available at http://www.occ.gov/news-issuances/federal-register/75fr13656.pdf.
\174\ See supra footnote 79 and accompanying text.
---------------------------------------------------------------------------
We believe a definition of ``liquidity risk'' that includes a
reference to the value impact from trading portfolio investments should
not imply that mutual fund shareholders are guaranteed a protected NAV
or that the fund cannot sell investments at a loss due to market risk,
credit deterioration, or liquidity risk. Indeed, funds' narrative risk
disclosure in their registration statements and other shareholder
communications generally should make clear those risks that could
adversely affect the fund's NAV, yield, and total return, including
liquidity-related risks.\175\ However, we believe defining liquidity
risk clarifies what funds must manage under rule 22e-4, and, for the
reasons discussed above, we believe impacts on valuation may play a
significant role in evaluating the ability to effectively meet
shareholder redemptions while lessening the effects of dilution.
---------------------------------------------------------------------------
\175\ See, e.g., Item 4(b) of Form N-1A.
---------------------------------------------------------------------------
Nonetheless, we agree with commenters that using the proposed
specific standard of ``materially affecting the fund's NAV'' may pose
certain challenges. We recognize that it may be difficult to calculate
the particular market impact that a fund's transactions in an
investment will have on that investment's price, which some commenters
suggested was inherent to the proposed standard. There could be other
reasons for a fund's NAV fluctuating, separate from the fund's sales of
portfolio investments to meet redemption requests as well.
Accordingly, in the final rule we have modified the NAV-impact
standard in the definition of ``liquidity risk'' to substitute the
phrase ``without significant dilution of remaining investors' interests
in the fund'' for the phrase ``without materially affecting the fund's
net asset value.'' This revised standard more directly corresponds to
the concerns of the Act \176\ and rule 22e-4 by focusing on meeting
investor redemptions without dilution.
---------------------------------------------------------------------------
\176\ See supra footnote 32and accompanying text for a
discussion of the liquidity concerns of the Act.
---------------------------------------------------------------------------
We also note that commenter interpretations of the term
``materially'' varied, with some commenters adopting very narrow
interpretations \177\ of the term and others taking a more broad
view.\178\ We note that, for purposes of this definition, the term
``significant'' is not meant to reference slight NAV movements, the
causes of which may not be easily distinguishable, nor is it limited
only to fire-sale situations. Instead, a fund's liquidity risk
management program should focus on the fund's ability to meet
redemptions in a manner that does not harm shareholders.\179\ In
particular, ``significant'' dilution of remaining investors' interests
in the fund can occur at much lower levels of dilution than what would
occur in a fire sale situation. We believe ``significant'' conveys more
effectively than ``materially'' that the definition is not meant to
reference slight NAV movements, while avoiding the confusion around the
term ``materially'' evident in the comment letters and better focusing
the rule on the level of dilution that would harm remaining investors'
interests even in the absence of a fire sale.
---------------------------------------------------------------------------
\177\ See Comment Letter of Interactive Data Pricing and
Reference Data (Dec. 18, 2015) (``Interactive Data Comment Letter'')
(noting that there are several possible interpretations of the term,
including an NAV price impact based on a one penny movement, among
others.).
\178\ See SIFMA Comment Letter I (proposing the Commission
substitute the phrase ``assuming no fire-sale discounting'' for the
phrase ``without materially affecting the fund's net assets'' and
arguing that a fire-sale standard is a more appropriate outer
boundary for price movements.). We believe that adopting a fire-sale
standard as the outer boundary for price movements would be
inappropriate because such an extreme outer boundary would fail to
capture a fund's liquidity risk exposure during normal and stressed
conditions and would, thus, inadequately address the liquidity risk
management concerns of rule 22e-4.
\179\ The classification requirements under rule 22e-4 include a
value impact standard as well, which is based on the number of days
within which it is determined that an investment would be
convertible to cash (or, in the case of the less-liquid and illiquid
categories, sold or disposed of) without the conversion (or, in the
case of the less-liquid and illiquid categories, sale or
disposition) significantly changing the market value of the
investment. See infra section III.C and accompanying text.
---------------------------------------------------------------------------
Under rule 22e-4, a fund would be required to adopt a liquidity
risk management program that is ``reasonably designed to assess and
manage the fund's liquidity risk.'' A fund's liquidity risk management
program should be appropriately tailored to reflect that fund's
particular liquidity risks. Therefore, while a fund is required to
consider certain liquidity risk factors specified in rule 22e-4 as
applicable, a fund may also, as it determines appropriate, expand its
liquidity risk management program beyond the required program elements,
and must do so to the extent it would be necessary to effectively
assess and manage its liquidity risk.\180\ This
[[Page 82160]]
requirement, however, requires a fund to assess and manage liquidity
risk and does not require a fund to eliminate all adverse impacts of
liquidity risk, which would be incompatible with an investment product
such as a mutual fund or ETF, whose NAV may fluctuate for a variety of
reasons, including changing liquidity conditions.
---------------------------------------------------------------------------
\180\ Rule 22e-4(b) requires that a fund ``adopt and implement a
written liquidity risk management program that is reasonably
designed to assess and manage its liquidity risk,'' and identifies
certain specific elements that a fund must consider in doing so.
---------------------------------------------------------------------------
b. Expected and Reasonably Foreseeable Redemption Requests
As proposed, the definition of ``liquidity risk'' would have
required funds to consider redemption requests that are expected under
normal conditions, as well as those that are reasonably foreseeable
under stressed conditions. Some commenters stated that the concept of
redemption requests that are reasonably foreseeable under stressed
conditions was vague and could subject funds to ex-post second
guessing.\181\ One commenter suggested that the Commission clarify: (i)
Whether funds should address both normal and reasonably foreseeable
stressed conditions (or select one set of conditions) in assessing
liquidity risk; and (ii) the level of market stress that funds should
assume in conducting a liquidity risk assessment.\182\
---------------------------------------------------------------------------
\181\ See Federated Comment Letter; NYC Bar Comment Letter.
\182\ See AFR Comment Letter.
---------------------------------------------------------------------------
The final definition of liquidity risk eliminates references to
redemption requests that are expected under normal conditions or
reasonably foreseeable under stressed conditions. The final definition
simply refers to ``requests to redeem.'' We believe our modifications
to the liquidity risk factors used to assess a fund's liquidity risk,
including the clarification that a fund must consider certain liquidity
risk factors both during normal and reasonably foreseeable stressed
conditions, makes any reference to market conditions within the
definition of liquidity risk unnecessary, confusing and duplicative. We
believe the revised definition also addresses commenters' concerns that
the proposed definition was unclear. We have provided guidance below
regarding each liquidity risk factor and the need to consider normal
and reasonably foreseeable stressed market conditions.
2. Liquidity Risk Factors
Rule 22e-4 will require each fund to assess, manage, and
periodically review (with such review occurring no less frequently than
annually) its liquidity risk, considering the following factors as
applicable:
Investment strategy and liquidity of portfolio investments
during both normal and reasonably foreseeable stressed conditions
(including whether the investment strategy is appropriate for an open-
end fund, the extent to which the strategy involves a relatively
concentrated portfolio or large positions in particular issuers, and
the use of borrowings for investment purposes and derivatives);
Short-term and long-term cash flow projections during both
normal and reasonably foreseeable stressed conditions; and
Holdings of cash and cash equivalents, as well as
borrowing arrangements and other funding sources.\183\
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\183\ See rule 22e-4(b)(1)(i). We note that rule 22e-4 as
adopted also includes two additional factors that an ETF will have
to consider as applicable in assessing, managing, and periodically
reviewing its liquidity risk, which reflect potential liquidity-
related concerns that could arise from the structure and operation
of ETFs (including In-Kind ETFs). These are: (i) The relationship
between the ETF's portfolio liquidity and the way in which, and the
prices and spreads at which, ETF shares trade, including, the
efficiency of the arbitrage function and the level of active
participation by market participants (including authorized
participants); and (ii) the effect of the composition of baskets on
the overall liquidity of the ETF's portfolio. These factors are
discussed in more detail below. See infra section III.J.
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A fund may incorporate other considerations, in addition to these
factors, in evaluating its liquidity risk.
Like the rule we are adopting today, rule 22e-4 as proposed would
have required each fund to assess its liquidity risk, taking certain
specified factors into account.\184\ Specifically, the proposed rule
would have required each fund to take the following factors into
account in assessing the fund's liquidity risk: (i) Short-term and
long-term cash flow projections, considering size, frequency, and
volatility of historical purchases and redemptions of fund shares
during normal and stressed periods; the fund's redemption policies; the
fund's shareholder ownership concentration; the fund's distribution
channels; and the degree of certainty associated with the fund's short-
term and long-term cash flow projections; (ii) the fund's investment
strategy and liquidity of portfolio investments; (iii) use of
borrowings and derivatives for investment purposes; and (iv) holdings
of cash and cash equivalents, as well as borrowing arrangements and
other funding sources.\185\ The person(s) designated to administer the
liquidity risk management program must also conduct reviews of the
adequacy and effectiveness of the implementation of the liquidity risk
management program, and such reviews must occur no less frequently than
annually.\186\ Commenters generally supported the requirement for a
fund to assess its liquidity risk.\187\ Additionally, some commenters
expressed support for the proposed liquidity risk factors, as well as
the proposed requirement to consider these factors in assessing
liquidity risk.\188\ However, several commenters objected to the
proposed requirement for a fund to consider certain specified factors
and suggested instead that consideration of the factors be permissive
instead of mandatory.\189\
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\184\ See Proposing Release, supra footnote 9, at section
III.C.1.
\185\ See proposed rule 22e-4(b)(2)(iii).
\186\ See id.
\187\ See, e.g., AFR Comment Letter; Comment Letter of CFA
Institute (Jan. 12, 2016) (``CFA Comment Letter''); FSR Comment
Letter; ICI Comment Letter I.
\188\ See, e.g., AFR Comment Letter; CRMC Comment Letter; ICI
Comment Letter I; Invesco Comment Letter.
\189\ See, e.g., CFA Comment Letter; MFS Comment Letter; Voya
Comment Letter.
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We continue to believe that the factors are central to evaluating
and managing a fund's liquidity risk and that requiring each fund to
consider, as a baseline, a standard set of factors for assessing and
managing liquidity risk would promote effective and thorough liquidity
risk management across the fund industry. However, we recognize that
some of the proposed factors may not be applicable in assessing and
managing the liquidity risk of certain funds or types of funds.\190\
One commenter requested that we clarify that a fund only needs to
consider factors relevant to its operations, which may include some or
all of the factors outlined in rule 22e-4, and others not
enumerated.\191\ We agree, and to the extent any liquidity risk factor
specified in rule 22e-4 is not applicable to a particular fund, the
fund will not be required to consider it in assessing and managing its
liquidity risk. We have therefore added the words ``as applicable'' in
the rule's instruction to consider the specified factors.\192\ For
example, a fund will not be required to consider the use of borrowings
for investment purposes and derivatives, as specified under rule 22e-
4(b)(1)(i)(A), if that fund does not engage in borrowing
[[Page 82161]]
or use derivatives. Similarly, a fund that maintains borrowing sources
for investment purposes will be required to consider the use of
borrowings for investment purposes as specified under the rule. We also
believe that condensing and simplifying the proposed factors helps
respond to commenters' concerns that the proposed factors were overly
complex \193\ and potentially inapplicable to certain funds.\194\
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\190\ See Proposing Release, supra footnote 9, at section
III.C.1.
\191\ See ICI Comment Letter I.
\192\ See rule 22e-4(b)(1)(i) (requiring a fund to consider,
``as applicable,'' certain factors); see also FSR Comment Letter
(supporting the proposed liquidity risk assessment requirement and
agreeing with the Commission's position in the proposal that a fund
would not be required to consider those factors that are not
applicable to that particular fund).
\193\ See, e.g., Comment Letter of Better Markets, Inc. (Jan.
13, 2016) (``Better Markets Comment Letter'').
\194\ See, e.g., ICI Comment Letter I; MFS Comment Letter.
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As noted above, this list of liquidity risk factors is not meant to
be exhaustive. In assessing, managing, and periodically reviewing its
liquidity risk, a fund may take into account considerations in addition
to the factors set forth in rule 22e-4 and must do so to the extent
necessary to adequately assess and manage the fund's liquidity
risk.\195\ For example, as discussed in the Proposing Release, if a
fund elects to conduct stress testing to determine whether it has
sufficient liquid investments to cover different levels of redemptions,
a fund may wish to incorporate the results of this stress testing into
its liquidity risk assessment and management.\196\ We continue to
believe that stress tests that analyze the proposed factors could be
particularly useful to a fund in evaluating its liquidity risk.
---------------------------------------------------------------------------
\195\ See note 180 and accompanying text.
\196\ See Proposing Release, supra footnote 9, at paragraph
accompanying n.266.
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Below we provide guidance on specific issues associated with each
of the liquidity risk factors and also discuss the Commission's
decision to adopt each of these factors (some with modifications).
a. Investment Strategy and Portfolio Liquidity
We are adopting the proposed requirement for a fund to consider its
investment strategy and portfolio liquidity in assessing, managing, and
periodically reviewing its liquidity risk, but with certain
modifications in response to commenters.\197\ The principal changes
include a requirement to consider whether the investment strategy is
appropriate for an open-end fund, as well as the extent the strategy
involves a relatively concentrated portfolio or large positions in
particular issuers, and a clarification that this factor should be
assessed both during normal and reasonably foreseeable stressed
conditions.
---------------------------------------------------------------------------
\197\ See rule 22e-4(b)(1)(i)(A).
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We continue to believe that various aspects of a fund's investment
strategy--including whether the fund is actively or passively managed
\198\ and a fund's portfolio management decisions that are meant in
part to decrease an undesirable tax impact on the fund \199\-- could
significantly affect the fund's liquidity risk. Also the extent to
which the fund is diversified, including a fund's status as a regulated
investment company under Subchapter M of the Internal Revenue Code, as
well as its principal investment strategies as disclosed in its
prospectus, could affect its liquidity risk in that the fund could be
limited by its diversification obligations in its ability to sell
certain portfolio securities.\200\ We note, for example, that the Third
Avenue Focused Credit Fund stated that its status as a regulated
investment company under Subchapter M limited the fund's ability to
return cash to its shareholders after it suspended redemptions because
of its need to comply with certain asset diversification tests to
maintain its regulated investment company status.\201\ As discussed in
the Proposing Release, we also continue to caution that while a fund's
investment strategy is an important factor in evaluating a fund's
liquidity risk, different types of funds within the same broad
investment strategy may demonstrate different levels of liquidity, (and
thus, presumably, different levels of liquidity risk).\202\
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\198\ See Proposing Release, supra footnote 9, at paragraph
accompanying nn.292-295 (discussing factors that could increase or
decrease the liquidity risk associated with index-based strategies
versus actively-managed strategies).
\199\ See Proposing Release, supra footnote 9, at paragraph
accompanying n.299 (detailing the ways in which a fund's tax
management strategy could make its portfolio managers unwilling to
sell certain portfolio assets in order to meet redemptions, which
could in turn increase the fund's liquidity risk compared to a
similarly situated fund).
\200\ See Proposing Release, supra footnote 9, at paragraph
accompanying nn.296-298 (discussing the extent to which a fund's
portfolio is diversified (or, relatedly, a fund's concentration in
certain types of portfolio assets) could have ramifications on the
fund's potential liquidity risk, including the ways that various
diversification requirements could constrain its ability to sell
certain portfolio securities in order to meet redemptions).
\201\ See Third Avenue Focused Credit Fund Update (Mar. 8,
2016), available at http://thirdave.com/wp-content/uploads/2016/04/03-09-16-FCF-Call-Transcript-1.pdf (noting that, because one of the
diversification tests under Subchapter M would require the fund to
have less than 50% of its assets in concentrated positions, the fund
needed to retain cash in order not to violate this test, in light of
the manner in which it chose to manage the fund's liquidation of its
other assets).
\202\ See Proposing Release, supra footnote 9, at n.301 and
accompanying text.
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Consideration of Strategy Appropriateness for Open-End Fund Structure
We are adopting several modifications to the proposed requirement
to consider a fund's investment strategy and portfolio liquidity in
assessing, managing, and periodically reviewing its liquidity risk.
First, we clarify in final rule 22e-4 that consideration of investment
strategy must take into account whether the fund's strategy is
appropriate for an open-end fund. This clarification reflects several
commenters' suggestions that a fund's liquidity risk management program
could (or should) involve a consideration of whether the fund's
investment strategy and permissible holdings are suitable for the open-
end structure.\203\
---------------------------------------------------------------------------
\203\ See BlackRock Comment Letter (``[W]e recommend that the
Commission consider whether funds should be required to explicitly
address the level of position concentration that is appropriate for
the fund's investment strategy and investor profile in [liquidity
risk management] policies and procedures''); ICI Comment Letter I
(``A risk-based liquidity management program could require a fund
manager, when launching a new mutual fund, to assess whether the
fund's investment strategy and permissible holdings are suitable for
the open-end structure in light of [its] liquidity
characteristics.''); see also CRMC Comment Letter (encouraging the
Commission to consider whether certain funds may be inappropriate
for the open-end fund structure).
---------------------------------------------------------------------------
We agree with this suggestion raised by commenters. As discussed
above, all open-end funds are subject to section 22(e) of the
Investment Company Act, which requires a fund to pay redemption
proceeds within seven days after receipt of a redemption request, and
hold themselves out at all times as being able to meet redemptions (in
many cases within an even shorter period of time).\204\ To the extent
that a fund's investment strategy involves investing in securities
whose liquidity is limited, or otherwise entails a significant degree
of liquidity risk, the fund may not be able to meet its redemption and
other legal obligations, or may not meet redemptions without diluting
its shareholders' interests in the fund. We understand that it is a
common best practice for a fund and its management to consider the
appropriateness of a fund's investment strategy in the context of
launching an open-end fund, and then for an open-end fund to continue
to manage its liquidity risk such that its strategy and holdings remain
appropriate for the open-end structure. However, not all funds appear
to consider this. Also, as we have observed funds beginning to pursue
more complex investment
[[Page 82162]]
strategies,\205\ we believe it is appropriate to require that each
open-end fund consider whether it has a liquidity risk management
framework in place that corresponds with the liquidity risks inherent
in its strategy and its structure as a fund that offers redeemable
securities.
---------------------------------------------------------------------------
\204\ See supra footnotes 34-36, 42-47 and accompanying text.
\205\ See supra footnote 11 and accompanying text.
---------------------------------------------------------------------------
We believe that specifically requiring an open-end fund to consider
whether its investment strategy is appropriate for the open-end
structure would supplement existing practices and provide an important
additional layer of shareholder protection. For example, this
requirement will likely cause funds to evaluate the suitability of
investment strategies that will be permitted under the 15% illiquid
investment requirement, but still could entail significant liquidity
risk--such as strategies involving highly concentrated portfolios, or
strategies involving investment in portfolio investments that are so
sensitive to stressed conditions that funds may not be able to find
purchasers for those investments during stressed periods.\206\
Furthermore, funds that have significant holdings of securities with
extended settlement periods may face challenges operating as open-end
funds and should take these holdings into account when determining
whether the fund's portfolio is appropriate for an open-end fund.\207\
For example, primarily holding securities with extended settlement
periods beyond seven days may not be appropriate for an open-end fund,
as primarily having such extended settlement holdings may raise
concerns with the fund's ability to meet redemptions within seven days,
particularly if the fund has not established adequate other sources of
liquidity.
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\206\ We note that, when a fund files its initial registration
statement and post-effective amendments thereto with the
Commission's Division of Investment Management for review,
Commission staff could request information from the fund regarding
the fund's basis for determining that its investment strategy is
appropriate for the open-end structure, just as staff currently may
request information from a fund to support its disclosure reflecting
the fund's compliance with various provisions of the Investment
Company Act and rules thereunder.
\207\ See infra footnote 378 and accompanying text.
---------------------------------------------------------------------------
Because a fund will be required to consider the liquidity risk
factors (as applicable) in periodically reviewing its liquidity risk,
the final rule requires a fund's periodic liquidity risk review to
include a consideration of whether the fund's investment strategy is
appropriate for an open-end fund.\208\ For example, if a fund's
illiquid investments exceed 15% of net assets, this could indicate that
the fund is encountering liquidity pressures that could significantly
impair the fund's ability to meet its redemption and other legal
obligations. In this case, we believe it would be appropriate for a
fund to review and potentially update its liquidity risk management
procedures for handling the fund's high levels of illiquid investment
holdings. In circumstances in which it appears unlikely that the fund
will be able to reduce its illiquid investment holdings to or below 15%
within a period of time commensurate with its redemption obligations, a
fund's periodic liquidity risk review could lead the fund to reconsider
its continued operation as an open-end fund.\209\
---------------------------------------------------------------------------
\208\ See infra section III.B.3.
\209\ Moreover, we note that actions that either directly or
indirectly extinguish the rights of shareholders to redeem their
shares could, depending on the facts and circumstances, involve
violations of section 22(e) and other provisions of the Act, such as
section 48(a) (prohibiting a person from doing indirectly, through
another person, what that person is prohibited by the Act from doing
directly).
---------------------------------------------------------------------------
Consideration of Portfolio Concentration, and Holdings of Large
Portfolio Positions
We also are adopting a modification to the proposed liquidity risk
factors to clarify that consideration of a fund's investment strategy
must include an evaluation of whether the strategy involves a
relatively concentrated portfolio or large positions in particular
issuers. Some commenters suggested that funds with extraordinarily
concentrated portfolios may have particular liquidity risks that could
make redeemability from these funds especially challenging.\210\ Our
evaluation of these comments, together with recent events discussed
below, have led us to revise the proposed ``investment strategy''
liquidity risk factor to focus on fund concentration issues.
---------------------------------------------------------------------------
\210\ See, e.g., BlackRock Comment Letter; CRMC Comment Letter;
ICI Comment Letter I; Invesco Comment Letter.
---------------------------------------------------------------------------
We believe that this component of a fund's investment strategy is a
particularly significant factor in evaluating the extent to which
investment strategy contributes to liquidity risk. As we noted in the
Proposing Release, while a fund with a relatively more diversified
portfolio that needs to sell portfolio investments to build liquidity
may be able to select investments for sale based on whether the markets
for those investments are favorable, a relatively less diversified fund
may have fewer options (i.e., because it has less choice of investments
to sell or because the markets for its portfolio investments are
uniform or correlated) and could thus be compelled to transact in
unfavorable markets.\211\ In addition, as discussed below, holding a
large portion of a particular issue could adversely affect a fund's
ability to convert the position to cash without a value impact, and
this can hamper a fund's portfolio management flexibility due to the
higher liquidity risk in its positions.\212\ Thus, we believe that
investment strategies that involve holding large portions of a
particular issue--particularly if the market for these securities is
thinly traded \213\ or if the fund's strategy involves investment in a
relatively small number of holdings--could notably increase a fund's
liquidity risk. As discussed above, the recent suspension of
redemptions by Third Avenue Focused Credit Fund, which had a
concentrated portfolio and large holdings of particular issues,
illustrates how these methods of concentration directly affect
liquidity risk, which in turn could adversely affect shareholders to
the extent that they are not able to redeem their shares, or redeem
their shares only at a significant discount.\214\
---------------------------------------------------------------------------
\211\ See Proposing Release, supra footnote 9, at paragraph
accompanying nn.296-298.
However, as also discussed above, the extent to which a fund is
required to be diversified, including a fund's status as a regulated
investment company under Subchapter M of the Internal Revenue Code,
could affect its liquidity risk in that the fund could be limited by
its diversification obligations in its ability to sell certain
portfolio securities. See supra footnotes 200-201 and accompanying
text.
\212\ See infra footnote 440 and accompanying text; infra
paragraph accompanying footnote 450.
\213\ See infra footnote 544 and accompanying text.
\214\ See, e.g., Jeffrey Ptak & Sarah Bush, Third Avenue Focused
Credit Abruptly Shuttered, Morningstar (Dec. 11, 2015), available at
http://ibd.morningstar.com/article/article.asp?id=733021&CN=brf295,http://ibd.morningstar.com/archive/archive.asp?inputs=days=14;frmtId=12,%20brf295 (noting that ``Third
Avenue Focused Credit stood out for its large, concentrated
allocation to distressed and other low-quality fare''); see also
Third Avenue Temporary Order, supra footnote 12 (noting that
``Applicants further state that relief permitting the Fund to
suspend redemptions in connection with its liquidation would permit
the Fund to liquidate its assets in an orderly manner and prevent
the Fund from being forced to sell assets at unreasonably low prices
to meet redemptions.'').
---------------------------------------------------------------------------
Use of Borrowings for Investment Purposes and Derivatives
We have incorporated the proposed requirement to consider a fund's
use of borrowings for investment purposes and derivatives within the
requirement to consider investment strategy in assessing, managing, and
periodically reviewing a fund's liquidity risk.\215\ As
[[Page 82163]]
proposed, this consideration was not included within the investment
strategy factor, but instead was a stand-alone liquidity risk factor.
However, we believe that including this consideration within the
general investment strategy factor is clearer, because a fund's use of
borrowings for investment purposes and derivatives may be viewed as a
component of its investment strategy. We note that we have also revised
the phrase ``use of borrowings and derivatives for investment
purposes'' that was used in the Proposing Release, and instead are
using the term, ``use of borrowings for investment purposes and
derivatives'' in the final rule. We have made this revision in order to
clarify that funds should consider all derivatives, including those
used for hedging purposes. As proposed, this provision could
potentially have been read to exclude the consideration of derivatives
used for hedging, which was not the intent of the proposed requirement.
We believe this clarification will make clear that the requirement is
for a fund to consider both use of borrowings for investment purposes
and use of derivatives in general. One commenter stated that it agreed
that funds should consider the use of derivatives when assessing
liquidity risk, including the extent and types of derivatives used, as
well as the structure and terms of a fund's derivatives
transactions.\216\ No commenters suggested that a fund's use of
borrowings for investment purposes and derivatives is inapplicable to a
fund's liquidity risk (provided that the fund engages in borrowing or
uses derivatives \217\).
---------------------------------------------------------------------------
\215\ See proposed rule 22e-4(b)(2)(iii)(C); rule 22e-
4(b)(1)(i)(A).
\216\ See CFA Comment Letter.
\217\ See supra footnotes 191-192 and accompanying text
(clarifying that, to the extent one of the factors specified in rule
22e-4(b)(1)(i) is not applicable to a particular fund, the fund
would not be required to consider that factor in assessing its
liquidity risk).
---------------------------------------------------------------------------
We continue to believe that the potential effects of the use of
borrowings for investment purposes and derivatives are relevant to
assessing, managing, and periodically reviewing a fund's liquidity
risk.\218\ As we noted in the Proposing Release, borrowing for
investment purposes, whether from a bank \219\ or through financing
transactions such as reverse repurchase agreements and short
sales,\220\ may affect a fund's liquidity risk.\221\ Similarly, a
fund's use of derivatives such as futures, forwards, swaps and written
options may affect a fund's liquidity risk as well.\222\ We note that
in addition to the liquidity of the derivatives positions themselves,
assessing, managing, and periodically reviewing liquidity risk
generally may include an evaluation of the potential liquidity demands
that may be imposed on the fund in connection with its use of
derivatives, including any variation margin or collateral calls the
fund may be required to meet.\223\ To the extent the fund is required
to make payments to a derivatives counterparty, those assets would not
be available to meet shareholder redemptions.
---------------------------------------------------------------------------
\218\ See Proposing Release, supra footnote 9, at section
III.C.1.c.
\219\ See id., at n.303 and accompanying text (noting that, in
addition to the asset coverage limitations imposed by section 18 of
the Investment Company Act, any borrowing from a bank would be
subject to the terms agreed between a fund and the bank, including
terms relating to the maturity date of the borrowing and any
circumstances under which the borrowing may be required to be
repaid).
\220\ See id., at nn.304-305 and accompanying text (noting that
funds that borrow for investment purposes, for example through
financing transactions such as reverse repurchase agreements and
short sales, generally do so in reliance on certain Commission
guidance, under which funds cover their obligations under such
transactions by segregating certain liquid assets, and discussing
the effects of asset segregation on funds' liquidity risk).
Segregated assets are considered to be unavailable for sale or
disposition, including for redemptions, unless replaced by other
appropriate non-segregated assets of equal value. See Securities
Trading Practices of Registered Investment Companies, Investment
Company Act Release No. 10666 (Apr. 18, 1979) [44 FR 25128 (Apr. 27,
1979)] (``Release 10666''). This means that a fund that receives
significant redemption requests may need to exit a portion of its
financing transactions in order make more liquid investments
available for sale to fulfill such requests. Furthermore, if a fund
seeks to exit its financing transactions in a declining market, it
may need to dispose of a greater amount of its more liquid holdings
in order to repay its borrowings, thereby reducing the amount of
liquid investments it has available to meet redemptions.
Consequently, a fund's assessment and management of its liquidity
risk must include an evaluation of the nature and extent of its
borrowings and the potential impact of borrowings on the fund's
overall liquidity profile.
\221\ We note that borrowings for investment purposes pose a
variety of liquidity risks, including the risk that redemptions may
require the sale of securities in amounts exceeding the amount of
the redemption, resulting in a reduction of the fund's borrowings.
Additionally, even without redemptions, the fund may need to sell
securities and reduce borrowings if its investment values decline,
which may have negative effects on the fund's liquidity.
\222\ See Proposing Release, supra footnote 9, at paragraph
accompanying nn.306-307 (discussing how the use of derivatives may
affect a fund's liquidity risk). Funds that use derivatives under
which they have an obligation to pay typically do so in reliance on
the guidance we provided in Release 10666 and in related no-action
letters issued by our staff, and therefore segregate liquid assets
in respect of their obligations under derivatives transactions. See
generally Use of Derivatives by Investment Companies under the
Investment Company Act of 1940, Investment Company Act Release No.
29776 (Aug. 31, 2011) [76 FR 55237 (Sept. 7, 2011)], at 13-17; see
also Use of Derivatives by Registered Investment Companies and
Business Development Companies, Investment Company Act Release No.
31933 (Dec. 1, 2015) [80 FR 80884 (Dec. 28, 2015)] (``2015
Derivatives Proposing Release''), at n.47 and accompanying text; see
also supra footnote 220. Derivatives may therefore raise concerns
that are similar to those discussed at footnote 220 in the context
of borrowings. Funds also may be required to dispose of assets in
order to post required margin with respect to their short sale
transactions. In addition, some derivatives transactions--
particularly those that are complex or entered into OTC--may be less
liquid, have longer settlement periods, or be more difficult to
price than other types of investments, which potentially increases
the amount of time required to exit such transactions.
\223\ See In re OppenheimerFunds, Inc., et al., Investment
Company Act Release No. 30099 (June 6, 2012) (settled action)
(``OppenheimerFunds Release'') (alleging the adviser made misleading
statements regarding two fixed income mutual funds that suffered
significant losses during the 2008 financial crisis primarily due to
their use of total return swaps to obtain exposure to commercial
mortgage-backed securities and noting that the funds ``had to raise
cash for anticipated [total return swap] contract payments by
selling depressed bonds into an increasingly illiquid market.'').
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Consideration of Investment Strategy and Portfolio Liquidity During
Normal and Reasonably Foreseeable Stressed Conditions
Finally, we also are modifying the proposed liquidity risk
assessment requirement to clarify that certain liquidity risk factors
must be considered during both normal and reasonably foreseeable
stressed conditions. As proposed, rule 22e-4 did not specify whether a
consideration of these factors should consider normal conditions,
stressed conditions, or both. One commenter stated that the proposed
rule's treatment of stressed conditions was unclear,\224\ and another
said that the proposed rule was unclear about what needed to be
considered in assessing ``stress.'' \225\ For those liquidity risk
factors that could vary depending on market conditions (i.e., a fund's
portfolio liquidity and cash flow projections), we believe that it is
appropriate to require a fund to evaluate those factors in normal and
reasonably foreseeable stressed conditions. Thus, if a fund's portfolio
strategy involves investing in securities whose liquidity is likely to
decline in stressed conditions, a fund should take this into account in
determining how its portfolio liquidity could contribute to its overall
liquidity risk. For example, a fund's portfolio liquidity could
decrease in stressed conditions if such conditions led to market
participants pulling back on transacting in the fund's portfolio
securities, or if stressed conditions affecting other assets or asset
classes were to have correlated effects on the fund's portfolio
securities. In considering normal and reasonably foreseeable stressed
conditions, funds should consider historical experience but should
recognize that such
[[Page 82164]]
experience may not necessarily be indicative of future outcomes,
depending on changes in market conditions and the fund's particular
circumstances.
---------------------------------------------------------------------------
\224\ See BlackRock Comment Letter.
\225\ See AFR Comment Letter.
---------------------------------------------------------------------------
We note that ``stressed'' conditions will likely entail different
scenarios for different types of funds. For example, differing levels
of changes in interest rates and/or interest rates' implied volatility
could affect two bond funds very differently, depending on factors such
as the maturity, coupon rates and other characteristics of the funds'
portfolio holdings. Assessment of stressed conditions also should take
into account stresses originating outside of market stress. For
example, certain funds could be significantly affected by geopolitical
stresses, such as an emerging markets debt fund whose holdings'
liquidity is affected by factors such as economic uncertainty in the
holdings' countries of issuance. The extent to which stressed
conditions are reasonably foreseeable will vary depending on the fund's
facts and circumstances.
b. Cash Flow Projections
We are adopting the requirement for a fund to consider its short-
term and long-term cash flow projections, during both normal and
reasonably foreseeable stressed conditions, in assessing and managing
its liquidity risk.\226\ The proposed rule also included the
requirement for a fund to consider its cash flow projections in
assessing its liquidity risk. However, we are adopting some
modifications to this proposed requirement. Most significantly,
although the proposed rule specified five separate considerations a
fund would have to take into account in evaluating the extent to which
its cash flow projections contribute to its liquidity risk, rule 22e-4
as adopted today does not enumerate these five considerations. Instead,
we are discussing these five considerations as guidance that funds
should generally take into account in evaluating their cash flow
projections, as discussed in more detail below.
---------------------------------------------------------------------------
\226\ See rule 22e-4(b)(1)(i)(B).
---------------------------------------------------------------------------
We continue to believe, as discussed in the Proposing Release, that
understanding a fund's cash flows is important in determining whether
the fund will have sufficient cash to satisfy redemption requests.\227\
We also continue to believe that the better a fund's portfolio and risk
managers are able to predict the fund's net flows, the better they will
be able to measure and manage the fund's liquidity risk.\228\
Predictability about whether periods of market stress or declines in
fund performance generally lead to increased redemptions of fund shares
is particularly significant, as careful liquidity risk management
during these periods could prevent the need to sell less-liquid
portfolio assets under unfavorable circumstances. This type of selling,
in turn, could create significant negative price pressure on the assets
and, to the extent the fund continues to hold a portion of those
assets, decrease the value of the assets still held by the fund at
least temporarily.\229\ To the extent a fund understands the
composition of its shareholder base (for example, among retirement
investors, other individual investors, or discretionary accounts), it
may be able to better predict fund flows in response to market events
or fund performance.
---------------------------------------------------------------------------
\227\ See Proposing Release, supra footnote 9, at nn.267-268 and
accompanying text.
\228\ See id., at n.269 and accompanying text. See also Fidelity
Comment Letter (noting that the predictability of fund cash flows
varies depending on the predictability of the redemption behavior of
the fund's shareholder base. ``[F]unds whose shareholders include
investors who purchased shares distributed through a retirement
program or other planned savings program may exhibit redemption
patterns that are relatively more predictable.''); BlackRock Comment
Letter (noting that funds may need additional data from their
distributors and transfer agents regarding shareholder redemption
activity to allow funds to make short-term and long-term cash
projections).
\229\ See Proposing Release, supra footnote 9, at n.270 and
accompanying text.
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Consideration of Cash Flow Projections During Normal and Reasonably
Foreseeable Stressed Periods
We also are revising the rule to require a fund to consider its
short-term and long-term cash flow projections during both normal and
reasonably foreseeable stressed conditions.\230\ As discussed above,
proposed rule 22e-4 would have required a fund, in evaluating short-
term and long-term cash flow projections, to consider the size,
frequency, and volatility of historical purchases and redemptions of
fund shares during normal and stressed periods.\231\ Although we are
not including a specific requirement for a fund to consider historical
purchases and redemptions in considering its cash flow projections, we
believe continuing to incorporate the concept of normal and reasonably
foreseeable stressed conditions within the requirement to consider cash
flow projections is critical for a fund to obtain a complete picture of
how its cash flows may affect its liquidity risk, particularly because
greater, more frequent, or more volatile outflows during stressed
conditions could exacerbate a fund's liquidity risk.\232\ A fund and
its portfolio and/or risk managers should review the guidance we
provide below regarding funds' evaluation of the size, frequency, and
volatility of historical purchases and redemptions of fund shares
during normal and reasonably foreseeable stressed circumstances, as
well as similar funds' purchases and redemptions, in determining how
normal and reasonably foreseeable stressed market conditions could
affect a fund's cash flows and contribute to the fund's liquidity
risk.\233\
---------------------------------------------------------------------------
\230\ See rule 22e-4(b)(1)(i)(B).
\231\ See proposed rule 22e-4(b)(2)(iii)(A)(1).
\232\ See Proposing Release, supra footnote 9, at text
accompanying and following n.273.
\233\ See infra footnotes 236-239 and accompanying text.
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Guidance on Evaluating a Fund's Cash Flow Projections
As discussed above, rule 22e-4 as adopted today requires a fund to
consider its short-term and long-term cash flow projections during both
normal and reasonably foreseeable stressed conditions in assessing,
managing, and periodically reviewing liquidity risk. This liquidity
risk factor simplifies the rule as proposed, which would have codified
five separate considerations that would comprise a fund's consideration
of its cash flow projections--namely, (i) the size, frequency, and
volatility of historical purchases and redemptions of fund shares
during normal and reasonably foreseeable stressed periods, (ii) the
fund's redemption policies, (iii) the fund's shareholder ownership
concentration, (iv) the fund's distribution channels, and (v) the
degree of certainty associated with the fund's short-term and long-term
cash flow projections. Instead of enumerating these five considerations
in the text of rule 22e-4, we are discussing each of them as guidance
in this Release (together, the ``cash flow guidance considerations'').
We are not codifying the cash flow guidance considerations to
simplify the rule 22e-4 liquidity risk factors and to alleviate certain
commenter concerns about the complexity of the proposed factors.
Commenters argued that the requirement to consider a specified list of
multiple liquidity risk factors is overly complex--making compliance
more difficult for funds, and oversight more difficult for the
Commission.\234\ Commenters discussed the dangers of an analysis that
mandates consideration of multiple factors becoming a generic
``checklist'' approach to liquidity risk management that does not fully
capture
[[Page 82165]]
the business practices, strategies, and risks that are germane to
certain funds.\235\ We agree that requiring an overly complex liquidity
risk assessment analysis could lead to this result, to the detriment of
investors. Such procedures could appear to be robust, but in actuality
may not reflect (or may underweight) a fund's most significant risk
factors because of the perceived requirement to focus on enumerated
factors that may not be particularly important to a fund's operations
and risks. Thus, we believe that simplifying the cash flow liquidity
risk factor in rule 22e-4 will benefit funds and their shareholders and
continue to advance the Commission's goal of promoting meaningful
liquidity risk analysis.
---------------------------------------------------------------------------
\234\ See, e.g., Better Markets Comment Letter.
\235\ See, e.g., MFS Comment Letter.
---------------------------------------------------------------------------
With respect to the size, frequency, and volatility of historical
purchases and redemptions of fund shares, we continue to believe, as
discussed in the Proposing Release, that funds whose historical net
flows are relatively less volatile in terms of size and frequency will
likely entail less liquidity risk than similar funds with more volatile
net flows.\236\ A fund should generally review historical purchases and
redemptions of fund shares across a variety of market conditions in
order to determine how the fund's flows may differ during normal and
reasonably foreseeable stressed periods (keeping in mind that
historical experience may not necessarily be indicative of future
outcomes).\237\ In addition to considering its own historical flow
data, a fund, particularly a fund without substantial operating
history, should consider purchase and redemption activity in funds with
similar investment strategies.\238\ A fund may wish to evaluate whether
the size, frequency, and volatility of its shareholder flows follow any
discernible patterns (for example, patterns relating to seasonality,
shareholder tax considerations, fund advertising, changes in fund
performance ratings provided by third-party rating agencies, and the
fund's investment strategy and size).\239\
---------------------------------------------------------------------------
\236\ See Proposing Release, supra footnote 9, at nn.272 and
accompanying text.
\237\ See supra footnotes 230-233 and accompanying text. A fund
may find it instructive to understand when its highest, lowest, most
frequent, and most volatile purchases and redemptions occurred
within various time horizons, such as the past one, five, ten, and
twenty years (as applicable, considering the fund's operating
history).
\238\ See Proposing Release, supra footnote 9, at text following
n.273. We note that consideration of similar funds' purchases and
redemptions could show whether the fund's historical flows are
typical or aberrant compared to those seen in similar funds and
assist new funds in predicting flow patterns.
\239\ See Proposing Release, supra footnote 9, at nn.274-279 and
accompanying text (discussing how a fund's investment strategy could
contribute to its shareholder flows and noting that smaller funds
may experience greater flow volatility). For instance, we understand
that certain investors tend to trade in and out of ETFs with index-
based strategies frequently because they invest in these ETFs for
hedging and/or short-term trading purposes.
---------------------------------------------------------------------------
We also continue to believe that a fund generally should consider
its normal redemption policies and practices in evaluating the extent
to which its cash flow projections may contribute to its liquidity
risk. Specifically, as discussed in the Proposing Release, a fund
should generally consider its disclosed or advertised time period for
paying (or endeavoring to pay) redemption proceeds and whether this
time period varies based on the payment method the fund employs.\240\
For example, a fund whose policies require it to typically pay
redeeming shareholders on a next-day basis may have fewer options for
managing high levels of redemptions than a fund whose policies require
it to typically pay redeeming shareholders on a T + 3 basis.\241\
---------------------------------------------------------------------------
\240\ See Item 6(b) of Form N-1A (requiring a fund to briefly
identify the procedures for redeeming shares); infra section III.M.1
(discussing amendments to Item 11 of Form N-1A).
\241\ To illustrate, when a fund that pays redemption proceeds
within one day receives a large redemption request and a fund that
pays redemption proceeds within three business days receives a
redemption request of the same size, the first fund must satisfy the
full request within one day, whereas the second fund has more time
to satisfy the redemption request. Even though the shareholder flows
of the first and second fund are identical, the redemption policies
of the first fund magnify its liquidity risks by requiring that the
fund pay redemptions quickly. See, e.g., Proposing Release, supra
footnote 9, at n.270.
---------------------------------------------------------------------------
A fund's shareholder ownership concentration also could affect its
cash flow projections, as a fund that has a concentrated set of
beneficial owners could experience considerable cash outflows from
redemptions by a single or small number of shareholders, or by the
decisions of an intermediary that has discretionary power over a
significant number of shareholder accounts.\242\ This in turn could
hamper a fund's management of liquidity risk if the fund does not have
procedures in place to manage large redemptions. For these reasons, we
believe a fund should consider the extent to which its shareholder
concentration affects its liquidity risk, particularly taking into
account other factors that could magnify shareholder concentration-
related liquidity risk (e.g., if a fund has an investment strategy that
attracts shareholders who trade based on short-term price movements).
---------------------------------------------------------------------------
\242\ We note that a relatively concentrated fund shareholder
base may make it easier for funds to communicate with those
shareholders or intermediaries about anticipated future redemptions,
and thus plan liquidity demands. However, those shareholders are
under no legal obligation to forewarn the fund of their redemptions
and, particularly in times of stress, may not do so.
---------------------------------------------------------------------------
We also continue to believe that a fund should consider how its
distribution channels could affect its cash flows, including the
predictability of its cash flows. For example, a fund may wish to
consider the extent to which its redemption practices could depend on
its distribution channels,\243\ as well as whether its distribution
channels (particularly, whether the fund's shares are held through
omnibus accounts) could make it difficult for a fund to be fully aware
of the composition of its underlying investor base,\244\ including
investor characteristics that could affect the fund's short-term and
long-term flows.\245\ A fund's distribution channels could affect its
cash flow predictions because certain distribution channels are
generally correlated with particular purchase and redemption
patterns.\246\ Additionally, we note that investors in mutual funds
distributed through certain channels also may have similar purchase and
redemption characteristics relating to their financial and tax-related
needs.\247\
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\243\ For example, mutual funds that are sold through broker-
dealers will generally have to meet redemption requests within three
business days, because rule 15c6-1 under the Exchange Act
effectively establishes a T+3 settlement period for purchases and
sales of securities (other than certain types of securities exempted
by the rule) effected by a broker or dealer, unless a different
settlement period is expressly agreed to by the parties at the time
of the transaction.
\244\ See, e.g., Comment Letter of Coalition of Mutual Fund
Investors (Jan. 18, 2016) (``CMFI Comment Letter'') (raising
concerns regarding omnibus account transparency).
\245\ These investor characteristics could include whether
ownership in the mutual fund is relatively concentrated, as well as
whether the types of underlying investors in the fund typically
share common investment goals affecting redemption frequency and
timing.
\246\ For instance, investors in mutual funds distributed
through a retirement plan channel or other planned savings channel
(such as a qualified tuition plan authorized by section 529 of the
Internal Revenue Code) may be more likely to be long-term investors
who do not trade based on short-term price movements, and their
purchase and redemption patterns thus may be relatively predictable
compared to those of other investors.
\247\ For example, taxable investors who are considering
purchasing mutual fund shares around capital gains distribution
dates have an incentive to delay their purchases until after the
distribution, but non-taxable shareholders (such as those who invest
through IRAs and other tax-deferred accounts) face no such incentive
for delaying purchases. See Woodrow T. Johnson & James M. Poterba,
Taxes and Mutual Fund Inflows around Distribution Dates, NBER
Working Paper 13884 (Mar. 2006, rev'd Mar. 2008), available at
http://economics.mit.edu/files/2512; see also supra footnote 239 and
accompanying text (discussing seasonality in mutual fund flows).
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[[Page 82166]]
Finally, we continue to believe that a fund should consider the
degree of certainty surrounding its short-term and long-term cash flow
projections. A fund could consider the length of its operating history
(including the fund's experience during points of market instability,
illiquidity, or volatility) and any purchase and redemption patterns. A
fund may use ranges in considering cash flow projections and their
relationship to liquidity risk. If a fund has implemented policies to
encourage certain shareholders (e.g., large shareholders or
institutional shareholders) to provide advance notification of their
intent to redeem a significant number of shares of the fund, this could
increase the degree of probability surrounding its cash flow
projections.\248\
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\248\ We understand, based on staff outreach, that advance
notification procedures are a relatively common liquidity risk
management tool that funds currently employ. See Comment Letter of
Invesco on the Notice Seeking Comment on Asset Management Products
and Activities, Docket No. FSOC-2014-0001 (Mar. 25, 2015), at 11
(``Invesco FSOC Notice Comment Letter'') (noting that Invesco has
advance notification arrangements regarding anticipated redemptions
above certain levels in place with certain distribution partners).
---------------------------------------------------------------------------
c. Holdings of Cash and Cash Equivalents, Borrowing Arrangements, and
Other Funding Sources
We are adopting the requirement for a fund to consider its holdings
of cash and cash equivalents, as well as its borrowing arrangements and
other funding sources, in assessing, managing, and periodically
reviewing its liquidity risk, as proposed.\249\ As discussed in the
Proposing Release, current U.S. Generally Accepted Accounting
Principles (``GAAP'') define cash equivalents as short-term, highly
liquid investments that are readily convertible to known amounts of
cash and that are so near their maturity that they present
insignificant risk of changes in value because of changes in interest
rates.\250\ While we understand based on staff outreach and the
comments we received on the proposal that many asset managers establish
minimum cash and cash equivalent targets as part of their liquidity
risk management practices,\251\ commenters stated that significant cash
and cash equivalent holdings are not necessarily appropriate for all
funds and as a stand-alone tool do not necessarily entirely mitigate
liquidity risk.\252\ We agree with commenters that the amount of cash
and cash equivalent holdings appropriate for liquidity risk management
depends on a particular fund's facts and circumstances. Similarly, we
agree with commenters that significant holdings of cash and cash
equivalents could still be insufficient to protect a fund with large
holdings of illiquid investments (or investments whose liquidity
decreases significantly during stressed periods) if the fund were faced
with heavy redemptions.\253\ But we continue to believe that holdings
of cash and cash equivalents can be a valuable liquidity risk
management tool because these holdings tend to remain very liquid under
nearly all market conditions.\254\ Thus, a fund could use its cash and
cash equivalent holdings in normal and stressed conditions to meet some
redemption requests without significant dilution of remaining
investors' interests. Holdings of cash and cash equivalents also could
provide a fund's portfolio manager with flexibility to readjust its
portfolio as it deems advantageous (either in terms of performance or
risk management) under changing market circumstances. We therefore
believe it is appropriate for a fund to consider its holdings of cash
and cash equivalents as part of its liquidity risk assessment.
---------------------------------------------------------------------------
\249\ See rule 22e-4(b)(1)(i)(C).
\250\ See Proposing Release, supra footnote 9, at n.311 and
accompanying text.
\251\ See, e.g., Comment Letter of Pacific Investment Management
Company LLC (Jan. 13, 2016) (``PIMCO Comment Letter'').
\252\ See, e.g., ICI Comment Letter I (noting that fund
complexes that specialize in U.S. equity funds, especially those
focusing on large-cap stocks, are likely to be able to meet
redemptions with only modest holdings of cash or cash equivalents
because the U.S. equity market is so liquid); see also infra
footnote 662 and accompanying text (discussing commenters' concerns
that the proposed three-day liquid asset minimum requirement would
be construed to require a fund specifically to hold cash and cash
equivalents, which commenters argued could prevent funds from
meeting their principal investment strategies and could give
investors a false sense of security that cash buffers will eliminate
liquidity risk).
\253\ We also note that a substantial investment in cash and
cash equivalents could decrease a fund's total return and/or cause
the fund to diverge from its investment strategy, and thus a fund
may wish to calibrate its holdings of these instruments to manage
its liquidity risk while taking these concerns into consideration.
\254\ We note that cash and cash equivalent holdings and
borrowing arrangements are just two of several liquidity management
tools that are at a fund's disposal. Though we are requiring funds
to consider these tools, the rule neither creates a substantive
obligation on funds to maintain specific levels of cash and cash
equivalents nor requires funds to procure any specific borrowing
arrangements.
---------------------------------------------------------------------------
Several commenters discussed the extent to which a fund's borrowing
arrangements and other funding sources could shape the fund's liquidity
risk. Some commenters strongly supported the use of borrowing
arrangements to help mitigate liquidity risk, asserting that funds
historically have generally succeeded in managing liquidity risk,
partly due to lines of credit and interfund lending.\255\ Commenters
also asserted that obtaining access to backup sources of liquidity like
lines of credit, interfund lending arrangements, and repurchase
agreements should be considered beneficial as the flexibility to use
these liquidity sources has value to a fund's shareholders.\256\
However, another commenter argued that asset managers should not meet
redemptions through the use of borrowing facilities other than to meet
short-term settlement mismatches, as this could potentially
disadvantage non-redeeming investors.\257\
---------------------------------------------------------------------------
\255\ See, e.g., Comment Letter of Independent Directors Council
(Jan. 13, 2016) (``IDC Comment Letter'').
\256\ See, e.g., BlackRock Comment Letter; Oppenheimer Comment
Letter.
\257\ See HSBC Comment Letter.
---------------------------------------------------------------------------
We continue to believe that entering into borrowing or other
funding arrangements could assist a fund in meeting redemption requests
in certain cases (for example, by bridging any timing mismatches
between when a fund is required to pay redeeming shareholders and when
any asset sales that the fund has executed in order to pay redemptions
will settle).\258\ However, we have concerns that, in some situations,
borrowing arrangements may not be beneficial to a fund's liquidity risk
management to the extent that the fund's use of borrowings to meet
redemptions leverages the fund at the expense of non-redeeming
investors. In such a case, non-redeeming shareholders would effectively
bear the costs of borrowing and the increased risk to the fund created
by leverage.\259\ Thus, we believe that funds should consider the
likely overall benefits and risks in including such borrowing or other
funding arrangements within a liquidity risk management program.
---------------------------------------------------------------------------
\258\ See Proposing Release, supra footnote 9, at n.314 and
accompanying text.
\259\ See Heartland Release, supra footnote 80.
---------------------------------------------------------------------------
In evaluating the extent to which a fund's borrowing arrangements
could help the fund manage its liquidity risk, a fund may wish to
consider any aspects of those arrangements that could limit the fund's
ability to borrow. For instance, a fund generally may wish to consider
the terms of the credit facility (e.g. whether the credit facility is
committed or uncommitted), as well as the financial health of the
institution(s) providing the facility. A fund also generally should
consider whether a credit facility would be shared among multiple funds
within a fund family.
[[Page 82167]]
When a credit facility is shared, a fund should assess the extent the
facility mitigates its liquidity risk given the liquidity risk
associated with the other funds sharing the facility.\260\ Similarly,
with respect to interfund lending within a family of funds, the terms
of an interfund lending arrangement and any conditions required under
exemptive relief permitting the arrangement \261\ (including
limitations on the circumstances in which interfund lending may be
used) will shape the role that interfund lending has in a fund's
overall liquidity risk management.\262\
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\260\ See Proposing Release, supra footnote 9, at paragraph
accompanying nn.314-317.
\261\ See, e.g., Nationwide Mutual Fund, et al., Investment
Company Act Release No. 32115 (May 16, 2016) [81 FR 31988 (May 20,
2016)] (notice of application) (``Nationwide Exemptive Relief'');
TCW Alternative Funds, et al., Investment Company Act Release No.
32113 (May 11, 2016) [81 FR 30585 (May 17, 2016)] (notice of
application) (``TCW Exemptive Relief''); see also Proposing Release,
supra footnote 9, at paragraph accompanying nn.318-319.
\262\ For example, it is common for such exemptive orders to
permit interfund lending in circumstances in which there is a timing
mismatch between when a fund is required to pay redeeming
shareholders and when any asset sales that the fund has executed in
order to pay redemptions will settle (e.g., a fund may be required
to pay redeeming shareholders within three business days, but the
portfolio transactions the fund has executed in order to pay these
shareholders may not settle for seven days). A fund can reasonably
predict that it will repay borrowed money relatively quickly and
reliably under these circumstances. Under these conditions, this
type of borrowing would tend to be low risk, and thus entail less
liquidity risk than borrowing money to pay redemptions without
already having secured a price at which the assets used to cover the
borrowing will be sold.
Funds may only engage in interfund lending when it is in the
best interests of both the lending and the borrowing fund. The
exemptive relief anticipates a fund family's interfund lending
arrangements include an assessment of: (i) If the fund participates
as a lender, any effect its participation may have on the fund's
liquidity risk; and (ii) if the fund participates as a borrower,
whether the fund's portfolio liquidity is sufficient to satisfy its
obligation to repay the loan along with its other liquidity needs.
See Nationwide Exemptive Relief, supra footnote 261; TCW Exemptive
Relief, supra footnote 261. For example, the relief is not intended
to permit a fund to act as lender of last resort to a borrowing
fund.
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3. Periodic Review of a Fund's Liquidity Risk
Rule 22e-4 as adopted includes the requirement for a fund to
periodically review the fund's liquidity risk, taking into account the
same liquidity risk factors a fund would have to consider in initially
assessing and managing its liquidity risk.\263\ The proposed rule also
included the requirement for a fund to periodically review its
liquidity risk, considering those factors it would evaluate in
initially assessing its liquidity risk.\264\ Commenters generally
supported the proposed liquidity risk review requirement.\265\
Specifically, some commenters agreed that this requirement will help
further the Commission's goals,\266\ expressed support for the proposed
liquidity risk review factors,\267\ and agreed with the Commission's
general approach of permitting funds to develop their own policies and
procedures for conducting periodic liquidity risk reviews.\268\ Other
commenters objected to the requirement for a fund to consider certain
specified liquidity risk review factors and suggested instead that
consideration of the factors be made permissive instead of
mandatory.\269\ Still another commenter argued that the proposed
liquidity risk review approach gives funds too much discretion and
recommended that the Commission adopt a baseline standard for the
frequency of funds' liquidity risk reviews (i.e., adopt an annual or
quarterly review requirement).\270\
---------------------------------------------------------------------------
\263\ See rule 22e-4(b)(1)(i).
\264\ See proposed rule 22e-4(b)(2)(iii).
\265\ See, e.g., CRMC Comment Letter; CFA Comment Letter;
Fidelity Comment Letter; ICI Comment Letter I.
\266\ See CRMC Comment Letter.
\267\ See, e.g., CRMC Comment Letter; ICI Comment Letter I.
\268\ See, e.g., CFA Comment Letter; Fidelity Comment Letter.
\269\ See, e.g., MFS Comment Letter; Voya Comment Letter.
\270\ See Better Markets Comment Letter.
---------------------------------------------------------------------------
We are adopting a periodic review requirement substantially as
proposed. As discussed above, we have revised the liquidity risk
factors that a fund must consider in assessing, managing, and
periodically reviewing its liquidity risk. A fund will not have to
consider any factor that is not applicable to a particular fund.\271\
This requirement is principles-based, and thus each fund may develop
and adopt procedures to review the fund's liquidity risk tailored as
appropriate to reflect the fund's particular facts and circumstances.
---------------------------------------------------------------------------
\271\ See supra footnote 192 and accompanying text.
---------------------------------------------------------------------------
After evaluating commenters' concerns about the liquidity risk
assessment factors, we continue to believe that these factors, modified
as discussed above, are central to reviewing a fund's liquidity risk.
We also continue to believe that requiring each fund to consider a
baseline set of factors, as applicable, in reviewing liquidity risk
would promote effective liquidity risk management across the fund
industry. As discussed above,\272\ we believe that our changes to the
proposed liquidity risk factors--which highlight particular risks but
also condense and simplify some proposed factors--strike an appropriate
balance between promoting consistency in funds' consideration of a
standard set of liquidity risk factors and easing burdens associated
with this analysis.
---------------------------------------------------------------------------
\272\ See supra footnotes 193-194 and accompanying text.
---------------------------------------------------------------------------
We considered a commenter's suggestion that the Commission adopt a
minimum frequency for funds' liquidity risk review, and we have
modified the proposed rule to clarify that a fund's periodic review of
its liquidity risk must occur no less frequently than annually.\273\ As
discussed below, we are adopting a requirement that a fund periodically
review, no less frequently than annually its highly liquid investment
minimum (as determined considering the same factors that a fund would
reference in periodically reviewing its liquidity risk).\274\ Because
this review of a fund's highly liquid investment minimum would, de
facto, necessitate a fund's review of its liquidity risk, we believe it
is appropriate to align the minimum periods for these reviews.
Similarly, as discussed further below, we also are adopting a
requirement that a fund's board must review, no less frequently than
annually, a written report that describes a review of the adequacy of
the fund's liquidity risk management program.\275\ Accordingly, the
minimum period for the liquidity risk review will be aligned with the
period in which this report will be presented to the fund's board,
creating further synergies. We note, however, that a fund may determine
that it is appropriate for its liquidity risk to be reviewed more
frequently than annually, depending on the extent to which the required
review factors could vary based on market- or sector-wide developments,
as well as changes to the fund's operations or other fund-specific
circumstances.
---------------------------------------------------------------------------
\273\ See rule 22e-4(b)(1)(i).
\274\ See infra section III.D.4.
\275\ See infra section III.H.2.
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C. Classifying the Liquidity of a Fund's Portfolio Investments, and
Disclosure and Reporting Requirements Regarding Portfolio Investments'
Liquidity Classifications
Today we are adopting requirements for each fund, with the
exception of In-Kind ETFs, to classify the liquidity of its portfolio
investments. Rule 22e-4 as adopted today requires a fund to classify
the liquidity of each portfolio investment based on the number of days
within which it determined that it reasonably expects an investment
would be convertible to cash (or, in the case of the less-liquid and
illiquid categories, sold or disposed of) without the conversion (or,
in the case of the less-
[[Page 82168]]
liquid and illiquid categories, sale or disposition) significantly
changing the market value of the investment. Specifically, rule 22e-4
will require a fund to classify each of its portfolio investments,
including its derivatives transactions,\276\ into one of four liquidity
categories:
---------------------------------------------------------------------------
\276\ See rule 22e-4(b)(1)(ii). The final rule requires a fund
to classify all portfolio investments, including investments that
are liabilities of the fund. See infra section III.C.3.c.
---------------------------------------------------------------------------
Highly liquid investments, defined as cash and any
investment reasonably expected to be convertible to cash in current
market conditions in three business days or less without the conversion
to cash significantly changing the market value of the investment.
Moderately liquid investments, defined as any investment
reasonably expected to be convertible to cash in current market
conditions in more than three calendar days but in seven calendar days
or less without the conversion to cash significantly changing the
market value of the investment.
Less liquid investments, defined as any investment
reasonably expected to be sold or disposed of in current market
conditions in seven calendar days or less without the sale or
disposition significantly changing the market value of the investment,
but where the sale or disposition is reasonably expected to settle in
more than seven calendar days.
Illiquid investments, defined as any investment that may
not reasonably be expected to be sold or disposed of in current market
conditions in seven calendar days or less without the sale or
disposition significantly changing the market value of the investment.
This determination must be based on information obtained after
reasonable inquiry; the term ``convertible to cash'' in the category
definitions refers to the ability to be sold, with the sale settled.
The final rule requires a fund to take into account relevant ``market,
trading, and investment-specific considerations'' in classifying its
portfolio investments' liquidity, but the rule does not detail a list
of factors comprising these considerations.\277\ This Release does
include, however, guidance on certain considerations that a fund may
wish to evaluate in taking into account relevant market, trading, and
investment-specific considerations when classifying the liquidity of
its portfolio investments.\278\ The fund may classify portfolio
investments based on asset class, so long as the fund or its
adviser,\279\ after reasonable inquiry, does not have information about
any market, trading, or investment-specific considerations that are
reasonably expected to significantly affect the liquidity
characteristics of an investment that would suggest a different
classification for that investment.\280\ As discussed in more detail
below, the fund also must consider the investment's market depth in
classifying the investment.\281\ The fund also must review its
portfolio investments' classifications at least monthly and 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.\282\ Finally, the fund
must take into account certain considerations for highly liquid
investments that it has segregated to cover certain derivatives
transactions.\283\
---------------------------------------------------------------------------
\277\ See rule 22e-4(b)(1)(ii).
\278\ See infra section III.C.4.
\279\ The term ``adviser'' as used in this Release and rule 22e-
4 generally refers to any person, including a sub-adviser, that is
an ``investment adviser'' of an investment company as that term is
defined in section 2(a)(20) of the Investment Company Act. See infra
paragraph accompanying footnote 818 (discussing the coordination of
liquidity risk management efforts undertaken by various service
providers, including a fund's sub-adviser(s)).
\280\ See rule 22e-4(b)(1)(ii)(A).
\281\ More specifically, the fund must determine whether trading
varying portions of a position in a particular investment, in sizes
that the fund would reasonably anticipate trading, is reasonably
expected to significantly affect the liquidity of that investment,
and if so, the fund must take this determination into account when
classifying the liquidity of that investment. See rule 22e-
4(b)(1)(ii)(B).
\282\ See rule 22e-4(b)(1)(ii); see also rule 22e-4(b)(1)(i)
(imposing an ongoing responsibility on the fund to assess and manage
its liquidity risk).
\283\ More specifically, with respect to the fund's derivatives
transactions that it has classified as moderately liquid
investments, less liquid investments, and illiquid investments, it
must identify the percentage of the fund's highly liquid investments
that it has segregated to cover, or pledged to satisfy margin
requirements in connection with, derivatives transactions in each of
these classification categories. See rule 22e-4(b)(1)(ii)(C); see
also rule 22e-4(b)(1)(iii)(B) (addressing such percentage of highly
liquid investments in connection with determining whether a fund
primarily holds highly liquid investments).
---------------------------------------------------------------------------
Rule 22e-4 as proposed would have required each fund to classify
the liquidity of its portfolio positions (or portions of a position in
a particular asset) and review the liquidity classification of each
position on an ongoing basis.\284\ In classifying and reviewing the
liquidity of portfolio assets, proposed rule 22e-4 would have required
a fund to consider the number of days within which a fund's position in
a portfolio asset (or portions of a position in a particular asset)
would be convertible to cash at a price that does not materially affect
the value of that asset immediately prior to sale.\285\ Based on this
determination, made using information obtained after reasonable
inquiry, the proposed rule would have required a fund to classify each
of its positions in a portfolio asset (or portions thereof) into one of
six liquidity categories: (i) Convertible to cash within 1 business
day; (ii) convertible to cash within 2-3 business days; (iii)
convertible to cash within 4-7 calendar days; (iv) convertible to cash
within 8-15 calendar days; (v) convertible to cash within 16-30
calendar days; and (vi) convertible to cash in more than 30 calendar
days.\286\ The proposed rule would have required a fund to consider
certain specified factors, to the extent applicable, in determining the
time period in which a portfolio position (or portion thereof) would be
convertible to cash.\287\
---------------------------------------------------------------------------
\284\ See Proposing Release, supra footnote 9, at section III.B.
\285\ Proposed rule 22e-4(b)(2)(i).
\286\ Proposed rule 22e-4(b)(2)(i).
\287\ Proposed rule 22e-4(b)(2)(ii); see also infra section
III.C.4.
---------------------------------------------------------------------------
Although some commenters acknowledged potential benefits to the
proposed classification requirement, most commenters were generally
opposed to the proposed six-category liquidity classification
framework. As discussed further below, commenters' primary objections
were concerns that the proposed classification framework would: (i) Not
reflect current liquidity risk management practices or industry ``best
practices''; (ii) require funds to make overly subjective projections
about asset liquidity, particularly to the extent that they would have
to project a fund's ability to sell and settle a position well into the
future; (iii) place undue reliance on third-party data vendors and
analysts; (iv) incorporate a materiality standard that is unclear and
impractical to apply; and (v) inappropriately require funds to take
position size and settlement timing into account when classifying the
liquidity of a portfolio position.
Commenters suggested many alternatives to the proposed
classification requirement--both changes to the structure of the
proposed classification requirement, as well as suggestions about more
granular aspects of the proposed requirement. Although the details
vary, commenters raised three primary structural alternatives to the
proposed classification requirement: (i) A ``principles-based''
liquidity classification approach, where each fund would have to
classify the liquidity of its portfolio assets, but the Commission
would not require any
[[Page 82169]]
specific classification scheme; \288\ (ii) a simplified version of the
proposed classification system, with fewer classification categories
based on shorter time projections than the proposal; \289\ and (iii) an
approach with new classification categories based on qualitative
distinctions in the market- and trading-related characteristics of
different asset classes under different market conditions, which
generally would rely on the Commission mapping different asset classes
to each of these new classification categories.\290\
---------------------------------------------------------------------------
\288\ See, e.g., AIMA Comment Letter; Comment Letter of the Loan
Syndications and Trading Association (Jan. 13, 2016) (``LSTA Comment
Letter''); Comment Letter of State Street Global Advisors (Jan. 13,
2016) (``State Street Comment Letter''); Comment Letter of
Wellington Management Company LLP (Jan. 13, 2016) (``Wellington
Comment Letter'').
\289\ See, e.g., Eaton Vance Comment Letter I; Interactive Data
Comment Letter; Comment Letter of Markit (Jan. 13, 2016) (``Markit
Comment Letter''); Comment Letter of Wells Fargo Funds Management,
LLC (Jan. 13, 2016) (``Wells Fargo Comment Letter''). Commenters
generally suggested three, four, or five classification categories.
\290\ See, e.g., BlackRock Comment Letter; MFS Comment Letter;
Nuveen Comment Letter; Comment Letter of Systemic Risk Council (Jan.
13, 2016) (``SRC Comment Letter'').
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Our adopted liquidity classification requirement most closely
resembles the second alternative described above and is designed to
respond to commenters' concerns while also continuing to advance the
Commission's goals. As discussed in the Proposing Release, we
understand that funds today employ different practices for assessing
the liquidity of their portfolios.\291\ After considering comments,
however, we continue to believe that a liquidity classification
framework based on a days-to-cash determination, with certain
modifications from the proposal, is an effective approach to further
our goals of creating a meaningful, uniform framework for reporting to
the Commission and providing public disclosure about funds' liquidity
profiles. To achieve this goal, we believe the rule must provide a
consistent methodology for assessing portfolio liquidity. This
methodology also will form the basis for the highly liquid investment
minimum and illiquid investment limit, each of which we believe will
play an important role in fund liquidity risk management, as discussed
in detail below. We also believe this classification system maintains
the benefits of a spectrum-based liquidity analysis while responding to
concerns about the burden and level of precision implied by the
proposed approach.
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\291\ See Proposing Release, supra footnote 9, at section III.B.
---------------------------------------------------------------------------
While we agree that the suggested ``principles-based'' alternative
approach would have benefits in terms of flexibility and funds' ability
to leverage their existing procedures for assessing portfolio
liquidity,\292\ this approach would not provide a uniform methodology
for funds' liquidity assessment procedures. It thus would not
meaningfully advance our goal of establishing a foundation for
reasonably comparable reporting to the Commission and disclosure to the
public about funds' portfolio liquidity.\293\ In particular, this
approach would not permit detailed reporting about funds' portfolio
investments' liquidity in a structured data format, as with reports on
Form N-PORT, and thus would not provide an efficient basis for the
Commission and its staff to monitor funds' portfolio liquidity and
liquidity risk.
---------------------------------------------------------------------------
\292\ See, e.g., supra footnote 288; see also section IV.C.
\293\ See infra section III.C.6.
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We likewise believe the third alternative classification system,
based on liquidity characteristics of different asset classes--as
opposed to a days-to-cash framework--may not provide clear distinctions
between each liquidity category without the Commission assigning
specific asset classes to each classification category. Given the size
of the fund industry and the wide variety and types of asset classes
held by funds, we believe that it would be impractical for the
Commission or its staff to attempt to prescriptively categorize every
asset class by liquidity. Further, the classification requirement is
designed to provide information regarding the liquidity of portfolio
investments under current market conditions. We are concerned that a
classification system by which the Commission assigns specific asset
classes to specific liquidity categories would not be sufficiently
flexible to account for the impact changing market conditions may have
on the liquidity of fund investments.
Relatedly, some commenters suggested an alternative classification
system could be based on notions of liquidity other than ``days-to-
cash,'' including, in whole or in part, on the fraction of average
daily trading volume that each position size corresponds to, the
expected behavior of bid-ask spreads in a given asset, or more
qualitative liquidity buckets (e.g. ``converted to cash quickly under
most circumstances'').\294\ Other commenters suggested that all of the
classification categories be defined based on a days-to-cash or days-
to-trade determination,\295\ while some recommended that only certain
of the categories (generally, the relatively more liquid categories) be
defined based on a days-to-cash or days-to-trade determination.\296\
After considering comments, we have chosen to adopt a classification
system that most closely resembles the second alternative raised by
commenters and includes days-to-cash determinations for the more liquid
categories. As noted below, some of the more specific criteria
suggested by commenters in place of days-to-cash may not be appropriate
for all asset classes, while more qualitative criteria make it more
difficult to compare classifications across funds relative to the days-
to-cash approach in the rule.\297\
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\294\ See, e.g., AFR Comment Letter; BlackRock Comment Letter;
SRC Comment Letter.
\295\ AFR Comment Letter; Cohen & Steers Comment Letter; PIMCO
Comment Letter; Charles Schwab Comment Letter.
\296\ Oppenheimer Comment Letter; SIFMA Comment Letter I; T.
Rowe Comment Letter.
\297\ See infra section IV.C.1.
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1. Primary Elements of Classification Framework
a. Consolidation of Proposed Classification Categories
Similar to the proposed classification requirement, the final
classification requirement is generally based on a framework that would
require a fund to determine the number of days in which each portfolio
investment is convertible to cash. However, the final classification
framework reduces the number of classification categories from six (as
proposed) to four. In addition, a fund may classify portfolio
investments based on asset class under the final classification
requirement, so long as the fund or its adviser does not have
information about any market, trading, or investment-specific
considerations that are reasonably expected to significantly affect the
liquidity characteristics of an investment and that would require a
different classification for that investment. When we proposed the rule
22e-4 classification requirement, we noted that the framework was meant
to promote a more nuanced approach than a classification requirement
under which a fund would simply designate assets as liquid or
illiquid.\298\ The proposed approach also was meant to provide the
basis for detailed reporting and disclosure about the liquidity of
funds' portfolio positions in a structured data format, as the six
liquidity categories described above would be incorporated
[[Page 82170]]
into the fund's portfolio holdings reported on proposed Form N-
PORT.\299\
---------------------------------------------------------------------------
\298\ See Proposing Release, supra footnote 9, at n.174 and
accompanying and following text.
\299\ See id.
---------------------------------------------------------------------------
Multiple commenters expressed concerns about the proposed six-
category classification framework. Many argued that the proposed
classification method would require funds to make overly subjective
projections about asset liquidity because predicting the time to
liquidate a position for cash at a given price--particularly well into
the future--is limited by required assumptions and market data
availability, even for sophisticated asset managers.\300\ They stated
that making relatively subjective liquidity determinations would render
liquidity assessments inconsistent across funds, and any appearance of
objectivity and comparability among funds' liquidity assessments thus
would be false.\301\ Relatedly, commenters also maintained that the
proposed liquidity classification categories were overly granular and
therefore could present a false appearance of precision about portfolio
assets' liquidity.\302\ For example, commenters argued that determining
whether an asset can be converted to cash in 15 calendar days versus 16
calendar days (that is, distinguishing between the fourth and fifth
proposed classification categories) cannot realistically be known or
predicted with accuracy.\303\ Some commenters advocated reducing the
number of classification categories \304\ and expressed concern that
the proposal would entail overly subjective classification analysis,
which would give funds too much discretion to determine which assets
are relatively liquid and thus make enforcement difficult and hinder
meaningful risk mitigation.\305\ Finally, commenters also predicted
that the complexity of analyses inherent in the proposed six-category
classification framework, and related operational burdens, could cause
many funds to either shift their classification obligations to third-
party analysts entirely, or to rely heavily on data provided by third-
party vendors to help simplify funds' own classification analyses.\306\
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\300\ See, e.g., Comment Letter of Michael Aguilar, et al. (Jan.
12, 2016) (``Aguilar Comment Letter''); Credit Suisse Comment
Letter; Comment Letter of J.P. Morgan Asset Management (Jan. 13,
2016) (``J.P. Morgan Comment Letter''); Voya Comment Letter.
\301\ See, e.g., AIMA Comment Letter; CRMC Comment Letter; T.
Rowe Comment Letter; Vanguard Comment Letter.
\302\ See, e.g., Cohen & Steers Comment Letter; MFS Comment
Letter; Nuveen Comment Letter; SIFMA Comment Letter I.
\303\ See, e.g., Credit Suisse Comment Letter.
\304\ See AFR Comment Letter; see also Better Markets Comment
Letter (expressing concern about the complexity of the proposed
classification requirement).
\305\ See Better Markets Comment Letter; SRC Comment Letter.
\306\ See, e.g., FSR Comment Letter; Comment Letter of Brian
Reid, Chief Economist, Investment Company Institute (Jan. 13, 2016)
(``ICI Comment Letter II''); Charles Schwab Comment Letter; Wells
Fargo Comment Letter.
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After considering these comments, we agree that the level of
precision implied by the proposed six-category classification system
could have unintended negative consequences. We also agree that the six
liquidity classification categories that we proposed could lead to
varying liquidity assessments and could give rise to an appearance of a
level of precision about liquidity determinations that may not be
achievable for some funds or asset classes. However, we continue to
believe that a classification approach that involves funds evaluating
investments' liquidity across a liquidity spectrum (as opposed to
making a binary determination of whether an investment is liquid or
illiquid) provides a basis for more meaningful reporting and disclosure
about funds' portfolio liquidity. Our opinion corresponds with many
commenters' views that there are significant benefits associated with
evaluating portfolio assets' liquidity across a spectrum.\307\
---------------------------------------------------------------------------
\307\ See, e.g., CRMC Comment Letter; HSBC Comment Letter; J.P.
Morgan Comment Letter; Comment Letter of MSCI (Jan. 13, 2016)
(``MSCI Comment Letter'').
---------------------------------------------------------------------------
We believe that condensing the six proposed categories into four
categories should decrease the variability in funds' liquidity
assessments, since funds will not be required to make liquidity
distinctions that are as detailed as would have been required under the
proposal. The adopted categories also should reduce inconsistency in
funds' liquidity assessments because the new categories do not include
time periods in the least-liquid categories that are as granular or
projected as far in the future as under the proposal. Furthermore, we
believe that the adopted categories could decrease variability in some
funds' liquidity assessments because we understand that the four
adopted categories may correspond more closely than the proposed
categories with classification methods and categories that some funds
currently use in evaluating their portfolio liquidity.\308\ For
example, the time frames referenced in the moderately liquid, less
liquid, and illiquid classification categories are tied to the seven-
calendar-day period in which funds are required to pay redeeming
shareholders under section 22(e) of the Investment Company Act. We
understand through staff outreach conducted prior to the proposal that
certain funds already classify their portfolios across a number of
liquidity categories, taking into account days-to-cash determinations
and focusing on assets that can be used to meet redemptions in the
short- and medium-term.\309\ Certain commenters likewise acknowledged
that some asset managers may currently classify portfolio positions
with categories that take days-to-cash or days-to-trade determinations
into account, although not at the level of detail suggested by the
proposal or for all classes of portfolio assets.\310\
---------------------------------------------------------------------------
\308\ See infra text accompanying footnotes 366, 375, 383.
\309\ See Proposing Release, supra footnote 9, at paragraph
accompanying n. 183.
\310\ See, e.g., HSBC Comment Letter; MFS Comment Letter; Nuveen
Comment Letter; Wellington Comment Letter.
---------------------------------------------------------------------------
We recognize that, although we are providing a uniform
classification framework, different funds may still classify the
liquidity of similar investments differently, based on the facts and
circumstances informing their analyses. This simply reflects the fact
that different funds likely have different views on liquidity based on
considerations such as their assessment of various market, trading, and
investment-specific factors, and the size of their position in a
particular investment. We acknowledge that liquidity can be difficult
to estimate and that there is no agreed-upon measure of liquidity for
all asset classes.\311\ Nevertheless, we believe the reporting of the
liquidity classification information to us, and aggregated information
to the public, will provide important information about fund liquidity.
---------------------------------------------------------------------------
\311\ Indeed our recognition of these facts is part of what has
lead us to adopt requirements that the more detailed liquidity
classification of each individual portfolio investment be reported
to us confidentially, with only the aggregated fund liquidity
profile reported publicly, as discussed in section III.C.6 below.
---------------------------------------------------------------------------
b. Market, Trading, and Investment-Specific Considerations
Rule 22e-4 as adopted today requires a fund to take into account
``relevant market, trading, and investment-specific considerations'' in
classifying and reviewing its portfolio investments' liquidity.\312\
Rule 22e-4 as proposed did not include this requirement but instead
included an enumerated list of nine separate factors that a fund would
be specifically required to consider, as applicable, in classifying and
reviewing the liquidity of its portfolio assets.\313\
[[Page 82171]]
The Proposing Release requested comment generally on whether the
Commission should codify the proposed list of nine liquidity
classification factors. While one commenter agreed that the factors
should be codified,\314\ most opposed codification and stated that
funds should be permitted, but not required, to consider the
factors.\315\ Commenters stated that codifying the proposed factors
would mandate a classification process that would be overly burdensome
on funds' resources \316\ and could limit portfolio managers' ability
to rely on industry expertise in evaluating portfolio assets'
liquidity.\317\ One commenter specifically expressed concern that ``the
scope and complexity of the required analysis may excessively burden
fund boards of directors and may actually act to distract fund managers
and directors from the assessment of liquidity and redemption risk,
which we view as the more important analysis.'' \318\ Commenters also
argued that a codified list of liquidity assessment factors could
create a presumption that a fund must consider each factor in
evaluating each portfolio holding, even if certain factors would not be
useful or relevant to evaluating certain portfolio assets'
liquidity.\319\ Some commenters also stated that a codified list of
factors could lead funds to place undue reliance on third-party data
vendors,\320\ and such reliance could result in these vendors being
viewed as ``rating agencies'' for liquidity, which could lead to
potential systemic risk issues.\321\ In addition, they expressed more
granular concerns about certain of the proposed factors, which are
discussed in detail in section III.C.4 below.
---------------------------------------------------------------------------
\312\ See rule 22e-4(b)(1)(ii).
\313\ Rule 22e-4 as proposed would have required a fund to take
into account the following nine factors, to the extent applicable,
when classifying the liquidity of each portfolio position in a
particular asset: (1) Existence of an active market for the asset,
including whether the asset is listed on an exchange, as well as the
number, diversity, and quality of market participants; (2) frequency
of trades or quotes for the asset and average daily trading volume
of the asset (regardless of whether the asset is a security traded
on an exchange); (3) volatility of trading prices for the asset; (4)
bid-ask spreads for the asset; (5) whether the asset has a
relatively standardized and simple structure; (6) for fixed income
securities, maturity and date of issue; (7) restrictions on trading
of the asset and limitations on transfer of the asset; (8) the size
of the fund's position in the asset relative to the asset's average
daily trading volume and, as applicable, the number of units of the
asset outstanding; and (9) relationship of the asset to another
portfolio asset. See proposed rule 22e-4(b)(2)(ii). These proposed
factors are discussed in more detail in infra section III.C.4.
\314\ See, e.g., CRMC Comment Letter.
\315\ See, e.g., AFR Comment Letter; Invesco Comment Letter;
J.P. Morgan Comment Letter; Vanguard Comment Letter.
\316\ See, e.g., CFA Comment Letter; LSTA Comment Letter;
Oppenheimer Comment Letter.
\317\ See, e.g., Federated Comment Letter; Charles Schwab
Comment Letter.
\318\ See AFR Comment Letter.
\319\ See, e.g., ICI Comment Letter I (``We are concerned that
[the proposed factors'] inclusion in the rule could create a
presumption that funds consider each factor in evaluating each
portfolio holding . . .''); Oppenheimer Comment Letter (``As an
example, a fund that invests solely in equity securities of large
capitalization issuers that are traded on U.S. exchanges might
reasonably determine that the frequency of trades in those equity
securities and their average daily trading volumes are sufficient
factors to determine their liquidity, and that consideration of
factors such as bid-ask spread and volatility of trading prices are
not useful or informative in a liquidity assessment. However,
because these securities have observable bid-ask spreads and
volatility, the fund would nonetheless be required to obtain and
consider such data.'').
\320\ See, e.g., Dechert Comment Letter; Dodge & Cox Comment
Letter; Comment Letter of the Mutual Fund Directors Fund (``MFDF
Comment Letter''); T. Rowe Comment Letter.
\321\ See, e.g., Federated Comment Letter; ICI Comment Letter
II; MFDF Comment Letter; SIFMA Comment Letter I.
---------------------------------------------------------------------------
After considering commenters' suggestions and concerns, we are not
including the classification factors in the rule as proposed because we
are concerned that including this list in rule 22e-4 could lead funds
to focus too heavily on evaluating certain factors that may not be
particularly relevant to the liquidity of a specific fund's portfolio
investments, the evaluation of which may not help produce meaningful
outcomes in terms of effective classification. This could operate to
the detriment of efficient and appropriate liquidity assessments that
focus on the liquidity characteristics most directly affecting a
particular asset class or investment.
We are instead adopting a principles-based requirement that a fund
take into account relevant market, trading, and investment-specific
considerations in classifying its portfolio investments. We understand
based on staff outreach that it is common for some funds, in assessing
the liquidity of their portfolio investments, to look only at basic
structural characteristics of an investment (such as asset class or
restrictions on transfer) and not to supplement this analysis with
market information or other potentially relevant factors.\322\ This
could lead to circumstances in which a fund's liquidity classifications
do not reflect a fund's actual ability to sell its portfolio
investments without significant dilution to meet redemptions within a
given time period, or do not otherwise result in an accurate picture of
a fund's liquidity profile. Thus, we believe that the classification
requirement must require funds to evaluate relevant considerations in
making liquidity determinations. We believe the requirement to take
into account relevant market, trading, and investment-specific
considerations achieves this goal and is broad and flexible enough to
be relevant for all investment strategies and fund risk profiles. In
addition, we continue to believe that the proposed classification
factors could help funds in evaluating relevant market, trading, and
investment-specific considerations, and thus we have included guidance
on many of these areas in section III.C.4 of this Release that may be
relevant to a fund's assessment of portfolio investments' liquidity
characteristics.
---------------------------------------------------------------------------
\322\ See, e.g., infra section III.E.
---------------------------------------------------------------------------
We understand that some third-party service providers currently
provide data and analyses assessing the relative liquidity of a fund's
portfolio investments, and that many of these service providers assess
certain market, trading, and investment-specific considerations in
doing so. We believe that a fund could appropriately use this type of
data to inform or supplement its own consideration of the liquidity of
an asset class or investment. However, a fund would not be required to
do so.\323\ Also, we generally believe that a fund should consider
having the person(s) at the fund or investment adviser designated to
administer the fund's liquidity risk management program review the
quality of any data received from third parties, as well as the
particular methodologies used and metrics analyzed by third parties, to
determine whether this data would effectively inform or supplement the
fund's consideration of its portfolio holdings' liquidity
characteristics. This review could include an assessment of whether
modifications to an ``off-the-shelf'' product are necessary to
accurately reflect the liquidity characteristics of the fund's
portfolio holdings. As discussed above, certain commenters expressed
concern that the proposed six-category classification framework,
including the proposed codification of certain factors that a fund
would be required to consider (as applicable) in classifying its
portfolio holdings, would place undue reliance on data vendors and
analysts, and that such reliance could produce potential systemic risk
issues.\324\ We believe that our decisions to simplify the proposed
classification framework and not to include the proposed classification
[[Page 82172]]
factors as part of rule 22e-4, together with the guidance on the
appropriate use of data vendors discussed in this paragraph, should
largely mitigate these concerns.
---------------------------------------------------------------------------
\323\ See Nuveen Comment Letter (requesting that the Commission
confirm that data from third-party vendors may be used in a fund's
assessment of liquidity, but that funds are not required to use data
provided by third-party vendors in classifying the liquidity of
their portfolio assets).
\324\ See supra footnotes 320-321 and accompanying text.
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c. Value Impact Standard
As discussed further below, in a modification to the proposed
standard, each of the liquidity categories included in the
classification requirement we are adopting requires a fund to determine
the time period in which an investment would be reasonably expected to
be converted to cash (or in some cases, sold or disposed of) in current
market conditions without the conversion to cash (or in some cases,
sale or disposition) significantly changing the market value of the
investment.\325\ This modification highlights that the standard does
not require a fund to actually re-value or re-price the investment for
classification purposes, nor does the standard require the fund to
incorporate general market movements in liquidity determinations or
estimate market impact to a precise degree.
---------------------------------------------------------------------------
\325\ See rule 22e-4(a)(6); 22e-4(a)(8); 22e-4(a)(10); and 22e-
4(a)(12). We note the term ``market value'' as used in the value
impact standard includes the value of investments that are fair
valued.
---------------------------------------------------------------------------
Many commenters opposed the value impact standard incorporated in
the proposed liquidity classification requirement--that the asset was
convertible to cash ``at a price that does not materially affect the
value of that asset immediately prior to sale.'' \326\ Many suggested
that the value impact component of the proposed standard was
inappropriate for liquidity analyses \327\ and should be eliminated
from the classification requirement.\328\ Commenters particularly were
concerned that a ``materiality'' standard could be difficult and
impractical to apply because they argued any sale of an asset could
impact its market value to some degree.\329\ They stated that it is
difficult to separate and quantify the market impact of a fund's trades
in a particular asset from other reasons that an asset's price could
move (such as market events), particularly in dynamic markets, and that
projections of future market impact are difficult to make.\330\
Furthermore, they stated that without further guidance from the
Commission funds may not know what ``material'' should mean in the
context of the proposed classification requirement.\331\ Some
commenters specifically noted that the proposed value impact standard
differed from the value impact standard incorporated in the
Commission's guidelines limiting funds' illiquid asset holdings, which
is based on whether a fund could sell an asset at approximately the
value at which the fund has valued it, and that conflicting standards
could raise confusion and operational difficulties.\332\ Finally,
several commenters argued that the inclusion of the value impact
standard in the proposed classification categories could give fund
shareholders the false impression that the fund guarantees a protected
NAV.\333\
---------------------------------------------------------------------------
\326\ See, e.g., BlackRock Comment Letter; MFS Comment Letter;
Comment Letter of Milliman Financial Risk Management LLC (Jan. 7,
2016) (``Milliman Comment Letter''); Vanguard Comment Letter.
\327\ See, e.g., Eaton Vance Comment Letter I; Fidelity Comment
Letter; PIMCO Comment Letter; Vanguard Comment Letter.
\328\ See, e.g., CRMC Comment Letter; J.P. Morgan Comment Letter
(recognizing, however, the concern underlying the proposed
standard--``namely that if funds sell assets at `fire sale' prices
there can be negative price pressure on those assets as well as
correlated assets, which could transmit stress to other funds or
portions of the market''); PIMCO Comment Letter; Vanguard Comment
Letter.
\329\ See, e.g., CRMC Comment Letter; IDC Comment Letter; PIMCO
Comment Letter; T. Rowe Comment Letter.
\330\ See, e.g., BlackRock Comment Letter; CRMC Comment Letter;
MFS Comment Letter; Voya Comment Letter.
\331\ See, e.g., Aguilar Comment Letter; Markit Comment Letter;
Milliman Comment Letter; SIFMA Comment Letter I.
\332\ See, e.g., Interactive Data Comment Letter; NYC Bar
Comment Letter; see also infra text accompanying footnotes 341-342
(discussing the harmonization of the value impact standard
incorporated in the definition of ``illiquid asset'' that we are
adopting with the standard incorporated in the rule 22e-4
classification requirement generally).
\333\ See, e.g., BlackRock Comment Letter; ICI Comment Letter
III; PIMCO Comment Letter; SIFMA Comment Letter I.
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As we noted when discussing the definition of ``liquidity risk,''
we continue to believe that incorporating a value impact analysis into
liquidity considerations is appropriate because it indicates that
liquidity risk for a fund captures not just the risk of being unable to
meet redemption requests, but also the risk that a fund could only meet
redemption requests in a manner that significantly dilutes the funds'
non-redeeming shareholders. Separately, as we noted above, the
inclusion of some consideration of value impact is common in
regulators' characterization of portfolio liquidity and fund liquidity
risk.\334\ Because we believe that the liquidity of portfolio
investments is a significant component of a fund's overall liquidity
risk,\335\ we continue to believe that the inclusion of a value impact
standard in the rule 22e-4 classification categories is appropriate. We
also understand that many current trade order management systems
estimate value impacts that may result from trades, which may assist
funds in making these estimates.
---------------------------------------------------------------------------
\334\ See supra footnote 173.
\335\ See rule 22e-4(b)(1)(i)(A) (requiring a fund to consider
its portfolio investments' liquidity in assessing its liquidity
risk).
---------------------------------------------------------------------------
Nevertheless, we have determined that certain modifications to the
proposed value impact standard are warranted to address certain
concerns raised by commenters. First, we recognize that in complying
with the value impact standard, funds will be making assessments about
the trading behavior of certain asset classes (and individual
investments, for investments that need to be treated on an exception
basis in the final classification framework we are adopting today).
Accordingly, funds should be able to rely on their reasonable
expectations at the time they make these assessments, and we do not
expect them to estimate to a precise degree the market impact of
trading that investment or the value of that investment as the trades
occur.\336\ As a result, we have modified the final rule to provide
that an investment's classification be based a fund's reasonable
expectations in current market conditions (emphasis added).\337\ We
also expect that the consolidation of the liquidity classification
categories into ones that only require days-to-cash projections out to
seven days should also mitigate commenters' concerns about the
uncertainty involved in these value impact projections because the
consolidated categories do not involve projections as far into the
future as the proposed categories.
---------------------------------------------------------------------------
\336\ In the proposal, we noted that the proposed term
``immediately prior to sale'' was not meant to require a fund to
anticipate and determine in advance the precise current value of an
asset at the moment before the fund would sell the asset. We believe
that the alterations to the final value impact standard reinforce
this intent. See Proposing Release, supra footnote 9, at text
following n.170
\337\ A fund's reasonable expectations pertain to each aspect of
the definition of highly liquid investments, moderately liquid
investments, less liquid investments, and illiquid investments--
i.e., a fund may rely on its reasonable expectations as to the
fund's ability to convert the investment to cash (or, in some cases,
sell or dispose of the investment) in current market conditions in a
certain number of days and a fund may rely on its reasonable
expectations as to whether the conversion to cash (or, in some
cases, sale or disposition) of the investment can be done without
significantly changing the market value of the investment.
---------------------------------------------------------------------------
We also changed the standard to capture only value impacts that
significantly change the investment's market value, rather than the
proposed standard that focused on materially affecting the value of the
asset immediately prior to sale (emphasis added). We believe that funds
will be less likely to interpret significant changes in market value as
capturing very small movements in price, and
[[Page 82173]]
thus this change should address commenters' concern that the proposal
would create a value impact standard that is impractical to apply
because any sale of an investment could affect its market value to some
degree. We also believe that a fund's classification policies and
procedures should address what it would consider to be a significant
change in market value. Common alternatives that commenters suggested
in place of the proposed value impact standard included an ``assuming
no fire sale discounting'' (or similar) standard \338\ or various
quantitative materiality standards.\339\ We believe a standard based on
fire sale discounting would be too high of a value impact threshold,
whereas suggested quantitative standards would be too precise and
require burdensome calculations. However, we believe that the final
value impact standard of ``without the conversion to cash (or in some
cases, sale or disposition) significantly changing the market value''
appropriately balances our desire to capture the risk of dilution in
cases of inadequate liquidity, while not also requiring funds to
account for every possible value movement.
---------------------------------------------------------------------------
\338\ See, e.g., SIFMA Comment Letter I; T. Rowe Comment Letter;
see also AFR Comment Letter (suggesting standard should be that an
asset could be sold at a price that does not create harm to fund
shareholders due to the fund being forced to accept disadvantageous
terms of sale in order to find a buyer).
\339\ See, e.g., Interactive Data Comment Letter (asset could be
sold at a price that has a less than 5% impact on the value of that
asset; asset could be sold at a price that does not create a 1 penny
or more impact on the fund's NAV; fund could use volatility measures
to determine security-specific materiality thresholds).
---------------------------------------------------------------------------
Finally, we note that the final value impact standard does not
require the fund to incorporate general market movements in liquidity
determinations. We recognize that there can be many reasons for the
market value of a particular investment to fluctuate, separate from the
fund's transactions in those investments. We do not intend for the
value impact standard to capture movements in an investment's value due
to market events. For this reason, we are not adopting a value impact
standard based on the fund's most recent valuation of that investment
as suggested by some commenters.\340\ This type of standard may have
required a fund to compare the investment's traded price with the
fund's prior day valuation of the investment--such a comparison likely
would reflect the effects of general market movements. The value impact
standard we are adopting today only requires a fund to consider the
market value impact of a hypothetical sale of an investment.
---------------------------------------------------------------------------
\340\ IDC Comment Letter; NYC Bar Comment Letter.
---------------------------------------------------------------------------
We recognize that the value impact standard incorporated in the
``illiquid investment'' definition is slightly different from the
standard used in the definition of ``illiquid asset'' under the
Commission's current guidelines, as the latter is based on whether a
fund could sell an asset at ``approximately the value at which the fund
has valued the investment.'' \341\ We believe the revised value impact
standard in the illiquid investment definition is preferable both
because it prevents confusion by harmonizing the value impact standards
within the classification framework and because, as just discussed, it
removes any confusion that the value impact standard incorporates
general market movements that would occur between when a fund strikes
its NAV and when it trades the investment.\342\
---------------------------------------------------------------------------
\341\ See supra section II.B.2
\342\ See also infra section III.C.2.d.
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With respect to commenters' concerns that the inclusion of a value
impact standard in the rule 22e-4 classification categories could give
fund shareholders the false impression that the fund guarantees a
protected NAV, we do not believe that the final rule's classification
categories imply a protected NAV. As noted in our discussion of the
rule 22e-4 definition of ``liquidity risk,'' we believe that funds'
narrative risk disclosure in their registration statements and other
shareholder communications generally should make clear those risks that
could adversely affect the fund's NAV, yield, and total return,
including liquidity-related risks. All open-end funds are required to
disclose that loss of money is a risk of investing in the fund.\343\
---------------------------------------------------------------------------
\343\ See Item 4(b)(1)(i) of Form N-1A.
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d. Consideration of Current Market Conditions
The definition of each liquidity category in the classification
requirement we are adopting today specifically requires a fund to
consider the time period in which an investment can be converted to
cash (or, in some cases, sold or disposed of) in current market
conditions.\344\ The ``current market conditions'' specification is a
change from the proposed classification requirement, which did not
explicitly require that a fund consider current market conditions in
making liquidity classification determinations.\345\ The proposal,
however, did require a fund to ``engage in an ongoing review'' of the
liquidity of each of its portfolio positions.\346\ The Commission
suggested in the Proposing Release that a fund's policies and
procedures for reviewing the liquidity of its portfolio positions
generally should include procedures for assessing market-wide
developments, as well as security- and asset-class-specific
developments that could demonstrate a need to change the liquidity
classification of a portfolio position.\347\ The proposal's ongoing
review standard (as opposed to the at-least-monthly review standard we
are adopting today \348\) thus would have implicitly required that a
fund's liquidity determinations reflect current market conditions.
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\344\ See rule 22e-4(a)(6); 22e-4(a)(8); 22e-4(a)(10); and 22e-
4(a)(12). See also infra section III.C.5. (discussing the
requirement to review liquidity classifications at least monthly and
more frequently if changes in relevant market, trading, and
investment-specific considerations are reasonably expected to
materially affect one or more of a fund's classifications of
investments) and section III.E. (discussing the prohibition on
acquiring illiquid investments if, immediately after acquisition,
the fund would have invested more than 15% of its net assets in
illiquid investments that are assets).
\345\ See proposed rule 22e-4(b)(2)(i).
\346\ Id.
\347\ See Proposing Release, supra footnote 9, at text following
n.253.
\348\ See section III.C.5.
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Multiple commenters requested guidance and provided suggestions
regarding the market conditions a fund should consider in classifying
its portfolio assets' liquidity. Some commenters requested clarity on
whether a fund would be required to classify the liquidity of its
portfolio assets based on an assessment of normal market conditions or
stressed market conditions.\349\ One commenter suggested that the
Commission provide additional guidance on how to assess the value
impact that a fund's sale of portfolio assets could have under future
stressed market conditions.\350\ Additionally, one commenter suggested
that any final liquidity classification framework should incorporate an
assessment of reasonably foreseeable stressed conditions instead of
current market conditions.\351\
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\349\ See, e.g., AFR Comment Letter; HSBC Comment Letter.
\350\ See ICI Comment Letter II.
\351\ See AFR Comment Letter.
---------------------------------------------------------------------------
In addition to the commenters who requested clarification or made
suggestions about the market conditions referenced in the proposed
liquidity classification framework, multiple commenters suggested
alternative classification schemes that would more explicitly define
liquidity categories based on distinctions in how a particular asset
would trade under normal versus stressed market
[[Page 82174]]
conditions.\352\ One commenter suggested that this alternative method
of defining liquidity classification categories would reflect directly
the extent to which assets' liquidity can dynamically change as market
conditions evolve.\353\
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\352\ See, e.g., BlackRock Comment Letter; J.P. Morgan Comment
Letter; SIFMA Comment Letter III; T. Rowe Comment Letter.
\353\ See BlackRock Comment Letter. This commenter also noted
that ``the time needed to liquidate a position at a given price in a
normal market environment will not be reflective of the market
impact incurred when liquidating positions during stressed
markets.''
---------------------------------------------------------------------------
After considering commenters' suggestions and concerns, we are
adopting liquidity classification categories that reflect current
market conditions. We appreciate commenters' concerns that liquidity
classifications based on current market conditions capture only a
moment-in-time picture of a fund's portfolio liquidity, which may not
accurately reflect liquidity in changing market conditions. We also
appreciate commenters' concerns that investments that are relatively
liquid under normal conditions may exhibit significantly reduced
liquidity during times of stress.\354\ However, we are concerned that
requiring a fund to predict how an investment may trade in stressed
market conditions would introduce an additional layer of subjectivity
into the classification process. Specifically, we are concerned that
funds would likely assume varying levels of stress when classifying the
liquidity of their portfolio investments. We believe that liquidity
categories requiring consideration of stressed conditions thus could
impede our goals of promoting consistency in funds' processes for
assessing portfolio investments' liquidity and enhancing the data
quality of funds' liquidity-related reporting and disclosure.
Conversely, we believe the requirement to assess current market
conditions would increase consistency among funds' liquidity
determinations by limiting the number of variables informing funds'
classification determinations. Although we understand that the adopted
classification scheme may not produce absolute consistency in how funds
classify the liquidity of their portfolio investments as funds'
assumptions and individual facts and circumstances may differ,\355\
classifying based on current market conditions will result in all
funds' classifications at a given time reflecting the same market
conditions.
---------------------------------------------------------------------------
\354\ See generally MFS Comment Letter; NYC Bar Comment Letter.
\355\ As discussed above, we recognize that funds are likely to
make different assumptions in classifying the liquidity of their
portfolio investments depending on the facts and circumstances
relating to funds and their trading practices. See supra paragraph
accompanying footnote 311.
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We believe that it would be informative to Commission staff to
understand how the same set of market conditions could disparately
affect different funds' assessments of their liquidity and that of
different asset classes. Also, we note that, to the extent that the
markets in which funds' portfolio investments trade are currently
stressed, consideration of current market conditions would de facto
reflect consideration of stressed market conditions. Therefore, the
requirement to consider current market conditions, along with the
requirement for funds to review the liquidity of their portfolio
investments at least monthly \356\ and the Form N-PORT reporting
requirements concerning funds' liquidity classifications,\357\ will
provide data that will help the staff evaluate the role of changing
market conditions on funds' liquidity by comparing liquidity data
across different sets of current market conditions over time. We
believe this liquidity data would be more useful than data based on
projected stressed market conditions, because it would reflect funds'
assessments in light of actual, not anticipated, market stresses.
---------------------------------------------------------------------------
\356\ See infra section III.C.5.
\357\ See infra section III.C.6.b.
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Finally, we note that while we are not incorporating a requirement
to evaluate potential future stressed market conditions in the
portfolio investment liquidity classification requirement, we continue
to believe that it is appropriate to require funds to consider
reasonably foreseeable stressed conditions as part of the liquidity
risk assessment and management requirements.\358\ We believe that
funds' liquidity risk assessment should inform the extent to which
funds are prepared to manage their liquidity under both normal and
reasonably foreseeable stressed conditions--particularly because, for
many asset classes, liquidity is adversely affected by market stress
and funds need to have a liquidity risk management program that is
resilient under all market conditions. Thus, as discussed throughout
this Release, a fund must establish liquidity risk management policies
and procedures appropriate in light of both normal and reasonably
foreseeable stressed market conditions.
---------------------------------------------------------------------------
\358\ See supra section III.B. In discussing funds' liquidity
risk assessment obligations under rule 22e-4, we note above that if
a fund conducts stress testing to determine whether it has
sufficient liquid investments to cover different levels of
redemptions, a fund should incorporate the results of this stress
testing into its liquidity risk assessment. See supra footnote 196.
---------------------------------------------------------------------------
2. Discussion of Specific Classification Categories
a. Highly Liquid Investments
The classification requirement we are adopting today requires a
fund to identify its ``highly liquid investments,'' that is, cash held
by a fund and investments that the fund reasonably expects to be
convertible to cash in current market conditions in three business days
or less without the conversion to cash significantly changing the
market value of the investment. This category condenses the first two
liquidity classification categories in the proposed classification
requirement (assets convertible to cash within one business day, as
well as two-to-three business days) to simplify the proposed
classification framework. Multiple commenters who suggested simplified
alternatives to the proposed approach suggested including a
classification category based on portfolio assets' convertibility to
cash within three days.\359\ One such commenter suggested that ``highly
liquid assets'' should include cash and any asset that can be converted
to cash in the ordinary course of business within three business
days.\360\ Additionally, another commenter agreed that, given current
redemption practices, funds should assess how much liquidity they may
need over a three-day period.\361\
---------------------------------------------------------------------------
\359\ See, e.g., Federated Comment Letter; Fidelity Comment
Letter; SIFMA Comment Letter I; Vanguard Comment Letter.
\360\ See Vanguard Comment Letter.
\361\ See MFDF Comment Letter (stating in the context of the
proposed three-day liquid asset minimum, that ``[g]iven current
redemption practices in the industry, we agree with the Commission
that funds should assess how much liquidity they may need, both in
normal and stressed market conditions, over a three-day period to
effectively meet anticipated redemption requests.'').
---------------------------------------------------------------------------
We continue to believe, as discussed in the Proposing Release, that
it is important for funds to determine what percentage of their
portfolio is convertible to cash--that is, available to meet
redemptions--within the relatively short term. We understand that most
funds typically pay redemption proceeds within a fairly short period
(typically, one to three days) after receiving a shareholder's
redemption request, even though a fund may disclose that it reserves
the right to delay payment for up to seven calendar days, as permitted
by section 22(e) of the Act.\362\ Likewise, funds may find it useful to
identify portfolio investments
[[Page 82175]]
that may be converted to cash quickly in order to meet unexpected or
unusually high redemption requests, or to rebalance or otherwise adjust
a portfolio's composition in all market conditions.
---------------------------------------------------------------------------
\362\ See supra footnote 9 and accompanying text.
---------------------------------------------------------------------------
We also understand that funds often consider which portfolio
investments can be sold and settled on a T + 1 to T + 3 basis when
determining their very liquid investments.\363\ While such an analysis
may be useful, our decision to define highly liquid investments to
include any investment that the fund reasonably expects to be
convertible into cash in current market conditions in three business
days or less is founded in our belief that funds should understand what
portion of their investments are convertible to cash in a short period
of time taking into account current market conditions, not solely on
which asset transactions can be settled in three days or less from the
trade date. An investment that takes two days to sell but one day to
settle, for example, would be convertible to cash in a short period of
time. Conversely, an asset that may settle two days after trade date,
but which is reasonably expected to take at least three days to trade,
would not be available in a short period of time. Accordingly, we
believe we have appropriately defined ``highly liquid investments''
under rule 22e-4 notwithstanding initiatives to shorten the standard
settlement cycle for most broker-dealer transactions from T + 3 to T +
2.\364\
---------------------------------------------------------------------------
\363\ See supra footnote 309.
\364\ See supra footnote 9.
---------------------------------------------------------------------------
In addition, we emphasize that the highly liquid investment
category (and the related highly liquid investment minimum) should not
be interpreted as the Commission suggesting that a fund should, as a
matter of routine practice, meet redemptions first by selling its
highly liquid investments. Rather, we believe part of a thorough
understanding of a fund's liquidity profile includes an understanding
of the nature and level of the fund's highly liquid holdings.\365\ As
noted above, we understand that funds currently place significance on
understanding the portion of their portfolio representing very liquid
investments, as it is not unusual for funds to determine the percentage
of their portfolio that can be liquidated in the short-to-medium
term.\366\ We anticipate that a fund could determine that a broad
variety of investments within different asset classes could be
classified as highly liquid investments, depending on facts and
circumstances.\367\
---------------------------------------------------------------------------
\365\ See infra footnote 374 and accompanying text (discussing
the use of moderately liquid assets to meet redemption requests).
\366\ See supra footnote 363 and accompanying text.
\367\ See infra section III.D.
---------------------------------------------------------------------------
We note that, as with the proposal, the highly liquid investment
category measures the time period in which an investment could be
converted to cash in business days, as opposed to the other liquidity
categories, which use calendar days. Some commenters suggested that,
instead of the references to both business days and calendar days, the
categories that the Commission adopts should only reference business
days.\368\ One commenter stated that basing all classification
categories on business days instead of calendar days would be
``preferable from a consistency standpoint, and reasonable given the
lack of expectations around receiving cash flows on non-business
days.'' \369\ Other commenters suggested alternative liquidity
classification categories that, like the proposed categories, would
reference both business days and calendar days.\370\
---------------------------------------------------------------------------
\368\ See, e.g., Interactive Data Comment Letter; Nuveen Comment
Letter.
\369\ See Interactive Data Comment Letter; see also ICI Comment
Letter I; T. Rowe Comment Letter (noting that the proposed
classification categories could require a fund to make difficult
distinctions in determining which assets can be converted to cash in
three business days versus four calendar days). The note to rule
22e-4(b)(1)(ii) addresses situations where the period to convert an
investment to cash depends on the calendar or business day
convention. See infra footnotes 376 and accompanying text.
\370\ See, e.g., Markit Comment Letter; PIMCO Comment Letter.
---------------------------------------------------------------------------
After considering these comments, we are continuing to reference
business days in the highly liquid investment definition we are
adopting, while referencing calendar days in the other liquidity
classification categories. We appreciate commenters' concerns that
classification categories that reference both business days and
calendar days could add some complexity in the assumptions and models
that funds may use in classifying the liquidity of their portfolio
investments. However, as discussed below, we believe it is important to
tie the time frames referenced in the moderately liquid, less liquid,
and illiquid classification categories to the seven-calendar-day period
in which funds are required to pay redeeming shareholders under section
22(e) of the Investment Company Act.\371\ Although we could have
referenced calendar days instead of business days in the highly liquid
investment definition to help standardize the time periods referenced
in all of the classification categories, we continue to reference
business days in this classification category for several reasons.
First, for short time periods, a calendar day standard could be
unworkable and create absurd results if the time period were to
encompass weekends or holidays, during which trading cannot be expected
to occur. Second, many of the alternate classification categories that
commenters suggested incorporated categories that referenced a three-
business-day period,\372\ and we understand from these comments and
staff outreach that this is a workable (and, for some fund complexes,
currently-used) period for a fund to consider in assessing the
liquidity of its portfolio investments.\373\
---------------------------------------------------------------------------
\371\ See infra sections III.C.2.b-d.
\372\ See, e.g., Fidelity Comment Letter; Invesco Comment
Letter; T. Rowe Comment Letter; Vanguard Comment Letter.
\373\ We also note that rule 15c6-1 under the Exchange Act,
which was adopted in 1993 and became effective in 1995, established
three business days as the standard settlement period for securities
trades effected by a broker-dealer. Thus, we understand that many
funds pay redemption proceeds within three business days after
receiving a redemption request, because a broker or dealer will be
involved in the redemption process. See supra footnote 32 and
accompanying text. See also supra footnote 366.
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b. Moderately Liquid Investments
A fund also will be required to identify its ``moderately liquid
investments,'' that is, those investments the fund reasonably expects
to be convertible into cash in current market conditions in more than
three calendar days, but in seven calendar days or less, without the
conversion to cash significantly changing the market value of the
investment. These investments are those that are not immediately or
very quickly convertible to cash, but that nevertheless may be
converted to cash in a time frame that would permit funds to pay
redeeming shareholders within the seven-day period established by
section 22(e) of the Investment Company Act. We expect that this
classification category will be an important component of the Form N-
PORT reporting obligations because it will provide the Commission with
information regarding the portion of a fund's portfolio that is not on
the most liquid end of the spectrum, but still is sufficiently liquid
to meet redemption requests within the statutory seven-day period
without causing significant dilution. We also anticipate that the
public will have an interest in gaining transparency into this
information on an aggregate basis.\374\ Several commenters who
suggested simplified alternatives to the proposed classification
approach
[[Page 82176]]
recommended including a classification category based on portfolio
investments' convertibility to cash within seven days.\375\
---------------------------------------------------------------------------
\374\ See infra section III.C.6.c.
\375\ See, e.g., Federated Comment Letter; Fidelity Comment
Letter; PIMCO Comment Letter; Vanguard Comment Letter.
---------------------------------------------------------------------------
We understand that circumstances could arise in which the sale and
settlement period for a particular portfolio position could be viewed
as within three business days or four-to-seven calendar days. For
example, if a sale were to occur on a Thursday and be settled on a
Monday, the sale and settlement period could be viewed either as within
three business days or four calendar days. This situation could cause
ambiguity for reporting purposes. Thus, rule 22e-4, similar to the
proposed rule, includes a note stating that a fund should classify the
portfolio position based on the shorter period (i.e., as a highly
liquid investment).\376\
---------------------------------------------------------------------------
\376\ See note to rule 22e-4(b)(1)(ii); see also note to
proposed rule 22e-4(b)(2)(i); see also supra footnote 369
(discussing comments that noted situations where the period to
convert an asset to cash depends on the calendar or business day
convention).
---------------------------------------------------------------------------
c. Less Liquid Investments
Additionally, a fund will be required to identify its ``less liquid
investments,'' that is, those investments that the fund reasonably
expects to be able to sell or dispose of in current market conditions
in seven calendar days or less a without the sale or disposition
significantly changing the market value of the investment, but where
the sale or disposition is reasonably expected to settle in more than
seven calendar days. Thus, the less liquid investments category focuses
on investments whose sale cannot be settled quickly. For example,
transactions in certain types of securities--such as certain foreign
securities \377\ and U.S. bank loan participations \378\--have
historically entailed settlement periods that are longer than standard
settlement periods in the broader securities markets. If a fund were to
determine that securities within these asset classes, or other asset
classes with longer-than-standard settlement periods, were able to be
sold within seven calendar days, but could not be settled within this
period, the fund should classify these securities as less liquid
investments. As an example, 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.
Thus, these securities would be considered to be less liquid
investments because they would be reasonably expected to settle in more
than seven calendar days. We note that trades in certain investments,
however, may take an extended period of time to settle.\379\ In the
event of an extended settlement period, at some point, a fund may need
to consider re-classifying such an investment as illiquid.\380\ We also
note that if a fund holds a forward contract on a security, such as a
forward in a transaction in the ``To-Be-Announced'' (``TBA'')
market,\381\ the convert to cash determination for that instrument may
be based on the forward contract and not on the underlying securities
to be received.\382\
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\377\ See, e.g., Comment Letter of the Global Foreign Exchange
Division to the European Commission and the European Securities and
Markets Authority re: Consistent Regulatory Treatment for Incidental
Foreign Exchange (FX) Transactions Related to Foreign Securities
Settlement--``FX Security Conversions'' (Mar. 25, 2014), available
at www.gfma.org/Initiatives/Foreign-Exchange-(FX)/GFMA-FX-Division-
Submits-Comments-to-the-HKMA-on-the--Treatment-of-Securities-
Conversion-Transactions-under-the-Margin-and-Other-Risk-Mitigation-
Standards (``Typically, the settlement cycle for most non-EUR
denominated securities is trade date plus three days (`T + 3').
Accordingly, the bank custodian or broker-dealer would enter into a
FX transaction on a T + 3 basis as well. In some securities markets,
for example in South Africa, the settlement cycle can take up to
seven days (T + 7).'').
\378\ See, e.g., BlackRock, Who Owns the Assets? A Closer Look
at Bank Loans, High Yield Bonds and Emerging Market Debt, Viewpoint
(Sept. 2014) (``Who Owns the Assets?''), available at https://www.blackrock.com/corporate/en-fi/literature/whitepaper/viewpoint-closer-look-selected-asset-classes-sept2014.pdf; Michael Mackenzie &
Tracy Alloway, Lengthy US loan settlements prompt liquidity fears,
Fin. Times (May 1, 2014) available at http://www.ft.com/intl/cms/s/0/32181cb6-d096-11e3-9a81-00144feabdc0.html; Comment Letter of
OppenheimerFunds on the Notice Seeking Comment on Asset Management
Products and Activities, Docket No. FSOC-2014-0001 (Mar. 25, 2015)
(stating that ``loans still take longer to settle than other
securities. Median settlement times for buy-side loan sales are 12
days'' and noting that an ``important tool in managing settlement
times is the establishment of a credit line dedicated to bank loan
funds.''). See also LSTA Comment Letter.
\379\ See infra footnote 416 and accompanying text.
\380\ See rule 22e-4(b)(1)(ii) (requiring review of portfolio
classifications at least monthly, and 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).
\381\ In the TBA market, lenders enter into forward contracts to
sell agency mortgage-backed securities and agree to deliver such
securities on a settlement date in the future. The specific agency
mortgage-backed securities that will be delivered in the future may
not yet be created at the time the forward contract is entered into.
The purchaser will contract to acquire a specified dollar amount of
mortgage-backed securities, which may be satisfied when the seller
delivers one or more mortgage-backed securities pools at settlement.
For a discussion of the TBA market, see Task Force on Mortgage-
Backed Securities Disclosure, Staff Report: Enhancing Disclosure in
the Mortgage-Backed Securities Markets (Jan. 2003), at section
II.E.2, available at http://www.sec.gov/news/studies/mortgagebacked.htm.
\382\ See ICI Comment Letter I (noting that the ``TBA market is
similar to the futures market, in which physically-settled futures
contracts may trade continuously (e.g., daily) but the underlying
reference assets are delivered at a later date (e.g., once every 3
months).'').
---------------------------------------------------------------------------
The ``less liquid investments'' category, like the ``moderately
liquid investments'' category and the ``illiquid investments''
category, directly reflects the statutorily required seven-day period
for meeting redemption requests. The ``less liquid investments''
category is meant to identify for the Commission and its staff, as well
as investors and other potential users, the portion of a fund's
portfolio investments that may be available to meet redemption requests
within seven days, but only to the extent that the fund addresses the
lengthier settlement period associated with these investments. Because
less liquid investments are those that may be sold, but not settled,
within seven days, a fund generally could use less liquid investments
to meet redemptions within seven days only if the fund obtained an
additional source of financing (for example, a line of credit) to
bridge the period until the sales would settle, or if the fund used its
cash holdings to meet the redemptions while simultaneously selling the
less liquid investment and then replenishing its cash holdings upon
settlement.
Transparency regarding the portion of a fund's portfolio held in
less liquid investments also could demonstrate those investments that
could be liquidated in order to meet redemptions that would occur more
than a week in the future, if a fund were to enter into a period of
extended redemptions that it anticipates would last for multiple days.
Because an open-end fund has an obligation to meet redemption requests
within seven days, we believe it is important for funds to identify
those investments that could pose certain challenges in being used to
meet redemption requests within that time period, for purposes of the
fund's own liquidity risk assessment and management,\383\ as well as to
provide transparency into certain funds or strategies that could have
relatively limited liquidity compared to peer funds.
---------------------------------------------------------------------------
\383\ For example, a fund's holdings of less liquid investments
typically would be a relevant consideration when assessing whether
its strategy is appropriate for an open-end fund and determining its
highly liquid investment minimum. See supra section III.B; see also
infra section III.D.2.
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d. Illiquid Investments
A fund also will be required to identify those investments that it
[[Page 82177]]
considers to be ``illiquid investments.'' Rule 22e-4 as adopted today
defines an illiquid investment as any investment that a fund reasonably
expects cannot be sold or disposed of in current market conditions in
seven calendar days or less without the sale or disposition
significantly changing the market value of the investment. Like the
``less liquid investments'' and ``moderately liquid investments''
category, the ``illiquid investments'' category references the
statutorily required seven-day period for meeting redemption requests.
However, while the ``less liquid investments'' and ``moderately liquid
investments'' categories are based on the time period in which
investments are convertible to cash--that is, sold with the sale
settled--the ``illiquid investments'' category only reflects the period
for selling (or otherwise disposing of) an investment and does not also
consider settlement timing.
Rule 22e-4 as proposed would have included a limit on funds'
ability to acquire ``15% standard assets,'' or any asset that may not
be sold or disposed of in the ordinary course of business within seven
calendar days at approximately the value ascribed to it by the
fund.\384\ Under the proposal, 15% standard assets were not a category
in the classification framework. In determining whether an asset was a
15% standard asset, a fund would not have been required to take into
account any specific market or other factors, or assess position size
as it could reflect market depth, in determining whether it could sell
the asset within seven days without the specified value impact.\385\
The proposed limit was intended to be consistent with the Commission's
guidelines limiting funds' holdings of illiquid assets to 15% of net
assets \386\ and most commenters supported the proposed 15% limit.\387\
---------------------------------------------------------------------------
\384\ See proposed rule 22e-4(b)(2)(iv)(D).
\385\ See Proposing Release, supra footnote 9, at text following
n.355.
\386\ See id., at section III.C.4.
\387\ See, e.g., Federated Comment Letter; Fidelity I Comment
Letter; SIFMA Comment Letter I; State Street Comment Letter.
---------------------------------------------------------------------------
We understand, however, that funds have engaged in a variety of
practices in determining the illiquidity of investments. It has been
our staff's experience that some of these practices are less robust
than others. We believe that the definition of illiquid investments we
are adopting today will provide a clear standard for determining the
illiquidity of investments and will better ensure that all funds are
determining the illiquidity of investments more consistently. We
recognize, however, that as a result of this new definition, some funds
may take into account relevant market, trading, and investment-specific
considerations, as well as market depth, for the first time and
therefore, as discussed below, some funds may determine that a greater
percentage of holdings are illiquid.\388\
---------------------------------------------------------------------------
\388\ See infra paragraph accompanying footnote 419.
---------------------------------------------------------------------------
We note that some commenters suggested strengthening the current
illiquid asset guidelines.\389\ Many commenters also suggested that
these assets continue to be referred to as ``illiquid assets'' (not 15%
standard assets) and be harmonized with any classification system that
the Commission ultimately adopts.\390\ Additionally, commenters
requesting such a harmonization also stated that value impact standards
should be consistent between the 15% standard asset definition and the
categories used in the classification.\391\
---------------------------------------------------------------------------
\389\ See infra footnotes 399-401 and accompanying text.
\390\ See, e.g., AFR Comment Letter; BlackRock Comment Letter;
Interactive Data Comment Letter; Markit Comment Letter.
\391\ See, e.g., AFR Comment Letter; Markit Comment Letter.
---------------------------------------------------------------------------
We have determined to incorporate an illiquid investment category
into rule 22e-4's broader classification requirement for several
reasons. Specifically, harmonizing funds' illiquid investment
determinations with the general liquidity classification framework will
create consistency in the value impact standards across liquidity
categories.\392\ As noted above, the illiquid investment value impact
standard in final rule 22e-4 has been changed from whether a fund could
sell an investment at ``approximately the value at which the fund has
valued the investment,'' to whether a fund could sell the investment
``without the sale or disposition significantly changing the market
value of the investment.'' \393\ We are adopting this new value impact
standard for illiquid investment determinations in part as a response
to commenters' concerns about confusion that could arise from
conflicting standards. Accordingly, the value impact standard for
illiquid investments is substantially identical to the value impact
standard for all other classification categories.\394\ As discussed in
more detail above, the final classification value impact standard
highlights that: (i) The standard does not require a fund to actually
re-value or re-price an investment for classification purposes; and
(ii) the standard does not require the fund to incorporate general
market movements in liquidity determinations or estimate market impact
to a precise degree.\395\
---------------------------------------------------------------------------
\392\ See supra section III.C.1.c.
\393\ See rule 22e-4(a)(8).
\394\ Compare rule 22e-4(a)(8) with rule 22e-4(a)(6), (10) and
(12).
\395\ See supra section III.C.1.c.
---------------------------------------------------------------------------
Significantly, in harmonizing features of the illiquid investment
category with other categories in the liquidity classification
framework, we also are replacing existing Commission guidance on
identifying illiquid assets with new regulatory requirements regarding
the process for determining that certain investments are illiquid.\396\
In the Proposing Release, we noted that we were proposing to withdraw
Commission guidance because we believed the proposal would provide ``a
more comprehensive framework for funds to evaluate the liquidity of
their assets.'' \397\ We also requested comment on whether additional
guidance is needed in connection with the proposed codification of the
Commission's illiquid asset guidelines. Although many commenters
supported the proposed codification of the Commission's guidelines on
illiquid assets,\398\ most did not specifically comment on the
Commission's proposal to withdraw the guidance associated with its
illiquid asset guidelines. However, certain commenters suggested that
stronger requirements and guidance regarding assets subject to the 15%
limit could be appropriate.\399\ One commenter expressed concern that
the Commission's guidelines today are having only a ``limited impact on
fund behavior'' and that the current 15% limit ``applies to an
inappropriately narrow range of assets and is therefore ineffective as
an investor protection mechanism.'' \400\ This commenter suggested that
the limit should encompass not only those assets that are not able to
be sold within seven days at approximately the value ascribed by the
fund, but also those assets that cannot be converted to cash (that is,
sold with the sale settled) within this same period, taking into
account this same value impact standard.\401\
---------------------------------------------------------------------------
\396\ See infra footnote 561 and accompanying text.
\397\ See Proposing Release, supra footnote 9, at text following
n.356.
\398\ See supra footnote 387.
\399\ See, e.g., AFR Comment Letter; see also Keefer Comment
Letter; Wahh Comment Letter (both suggesting that the 15% standard
not just be limited to the time of purchase, but instead should be
an ongoing requirement).
\400\ See AFR Comment Letter.
\401\ Id.
---------------------------------------------------------------------------
We agree with those commenters that suggested the Commission's
current guidelines, together with many funds' interpretation of these
guidelines today,
[[Page 82178]]
may result in funds only focusing on certain largely structural
features that can lessen the liquidity of an investment (such as
transfer restrictions and trading halts) rather than more market- and
trading-based features. This can result in funds considering only an
artificially narrow set of portfolio investments to be illiquid. As we
discussed in the Proposing Release, we understand that today it is
common--even for complexes with generally robust liquidity risk
management procedures--to treat the process for determining whether an
investment is illiquid under the current Commission guidelines as a
compliance or ``back-office'' function, with little indication that
information generated from the risk or portfolio management functions
informs the compliance determinations. Thus, we understand that some
funds currently may determine that an investment is liquid, rather than
illiquid, primarily based on certain structural characteristics of the
investment without assessing market or trading information or other
potentially relevant factors. Such investments include private equity
securities and certain other privately placed or restricted
securities,\402\ as well as certain instruments or transactions that by
their structure do not mature and are not readily transferable in seven
days or less, including term repurchase agreements.\403\ While a focus
on structural features alone may be appropriate in some circumstances
(for example, an across-the-board assumption that all securities with a
trading halt are illiquid, without an additional assessment of market
or trading factors), in other circumstances the failure to consider
market, trading, and other relevant information could result in a fund
considering an investment to be liquid even if the fund cannot
reasonably expect to sell amounts it reasonably anticipates trading
without the sale or disposition significantly changing the market value
of the investment within seven calendar days.
---------------------------------------------------------------------------
\402\ See Restricted Securities Release, supra footnote 37; see
also Rule 144A Release, supra footnote 37.
\403\ See Interval Fund Proposing Release, supra footnote 41.
---------------------------------------------------------------------------
For these reasons, rule 22e-4 as adopted today, requires a fund to
incorporate certain additional considerations in determining whether an
investment is illiquid. We are withdrawing existing guidance and
replacing it with new regulatory requirements and guidance regarding
the process for determining whether a portfolio investment is
illiquid.\404\ A fund would have to take into account ``relevant
market, trading, and investment-specific considerations'' when
determining whether an investment is an illiquid investment.\405\
---------------------------------------------------------------------------
\404\ See rule 22e-4(b)(1)(ii), (iv).
\405\ See rule 22e-4(b)(1)(ii).
---------------------------------------------------------------------------
The guidance the Commission provides below on matters funds might
consider in assessing market, trading, and investment-specific
considerations reflects factors that the Commission has previously said
are reasonable examples of factors to evaluate in determining whether a
rule 144A security is liquid and makes them more generally applicable
to assessing liquidity of other investments.\406\ Thus, this guidance
draws on past Commission guidance for evaluating whether a certain type
of investment is liquid or illiquid, and extends this process to a
fund's liquidity determinations regarding all types of investments. We
recognize that the guidance in the Rule 144A Release anticipates that
fund boards will determine whether certain securities are liquid or
illiquid.\407\ While we have considered the specific guidance factors
discussed in the Rule 144A Release in the context of the guidance we
provide herein with respect to classifying the liquidity of portfolio
investments, neither our guidance nor the final rule places the
responsibility for determining whether a specific security is liquid or
illiquid on the fund's board. The board would, however, be responsible
for approving the fund's liquidity risk management program, which
provides the framework for evaluating the liquidity of the fund's
investments, and for reviewing (at least annually) a written report
that describes a review of the program's adequacy and the effectiveness
of its implementation. Overall, a fund must classify its investments by
focusing on those market, trading, and investment-specific
considerations that are relevant to its portfolio. We believe that this
principles-based approach should result in funds making realistic and
well-informed determinations about investments' liquidity (or
illiquidity) based on analysis beyond simple decisions solely about
structural features of an asset class.
---------------------------------------------------------------------------
\406\ See infra footnotes 560 and 561 and accompanying text.
\407\ See Rule 144A Release, supra footnote 37 (stating that
``determination of the liquidity of Rule 144A securities in the
portfolio of an investment company issuing redeemable securities is
a question of fact for the board of directors to determine, based
upon the trading markets for the specific security.'').
---------------------------------------------------------------------------
As with other liquidity classification categories and as discussed
in more detail in section III.C.3.a below, funds can determine illiquid
investments on an asset-class basis, with exceptions for investments
whose liquidity characteristics significantly differ from the class.
For example, a fund could employ procedures whereby certain asset
classes are initially considered liquid, and then further evaluated to
decide whether relevant market, trading, and investment-specific
considerations should result in a particular investment being treated
as an exception and a change to the initial liquidity
determination.\408\ A fund could use the specific guidance factors we
discuss in section III.C.4 below as part of its process for taking into
account relevant market, trading, and investment-specific
considerations in determining whether an investment is illiquid. For
example, a fund that generally considers certain high-yield bonds not
to be illiquid (for instance, a fund that typically considers high-
yield domestic corporate bonds to be moderately liquid investments)
could determine that certain securities within this class are actually
illiquid investments, based on restrictions on trading that could occur
if one of these bonds' issuers were to enter bankruptcy and the debt
were to become distressed. Conversely, a fund that generally considers
certain investments to be illiquid (such as rule 144A securities) could
determine that some of these investments should be included in another
liquidity category based on relevant market, trading, and investment-
specific considerations.\409\
---------------------------------------------------------------------------
\408\ See infra section III.C.3.a (discussing that, under rule
22e-4, a fund would generally be permitted to classify its portfolio
investments according to their asset class, but if it has
information that a particular investment has different liquidity
characteristics than other investments within the same asset class,
it would need to treat that investment as an exception to the way
that the fund classifies its other holdings within the same asset
class).
\409\ See rule 22e-4(b)(ii). See also section III.C (discussing
the various considerations required when classifying the liquidity
of fund securities).
---------------------------------------------------------------------------
We also understand, based on staff outreach, that some fund
complexes make determinations of whether a portfolio investment is
liquid (or illiquid) under the current Commission guidelines based on
whether a single trading lot for the investment can be sold within
seven days under normal market circumstances. Certain funds interpret
this to allow them to declare an entire holding to be liquid even if
they could only sell a very small portion of it without a significant
value impact. Staff has observed that these fund practices and
interpretations of current
[[Page 82179]]
Commission guidelines may result in a fund determining that very few,
if any, portfolio investments are illiquid under the current
guidelines, even in situations in which the liquidity of a large
portion of a fund's portfolio is fairly limited.
Given the practices described above when funds did not consider
market depth in making liquidity determinations and considering the
comments discussed above regarding the proposed illiquid asset limit,
under the final rule, a fund will be required to consider market depth
in determining whether to classify portfolio investments as illiquid
investments. To the extent that the fund determines that trading
varying portions of a position is reasonably expected to significantly
affect the liquidity characteristics of that investment--that is, the
market depth for the investment is reasonably expected to significantly
affect its liquidity--the fund would need to take this into account in
classifying the investment as illiquid.\410\ These are the same market
depth considerations a fund would have to take into account in
classifying the liquidity of its portfolio investments generally, as
discussed in detail below.\411\
---------------------------------------------------------------------------
\410\ Rule 22e-4(b)(1)(ii).
\411\ See infra III.C.3.b.
---------------------------------------------------------------------------
Members of the fund industry have argued that because a fund will
not likely need to sell its entire position in a particular investment
under normal market circumstances, liquidity determinations should be
based on the sale of a single trading lot for that investment, except
in unusual circumstances.\412\ However, a fund could encounter
situations in which it needs to liquidate larger portions than one
trading lot of its positions in order to meet redemption requests, but
cannot do so within the seven-day time period required under section
22(e). As discussed below, we believe that the market depth
considerations required by the final classification requirement will
appropriately require a fund to consider situations in which the size
of a fund's holdings could significantly affect those holdings'
liquidity and impact the fund's ability to manage its liquidity risk--
that is, when portfolio liquidity may be significantly constrained by
the fund's ability to trade meaningful sizes of its portfolio holdings.
We believe this assessment of market depth will assist in illiquidity
determinations incorporating a realistic analysis of a fund's ability
to meet redemption requests without significant dilution, and thus in
funds better managing liquidity risk.
---------------------------------------------------------------------------
\412\ See Investment Company Institute, Valuation and Liquidity
Issues for Mutual Funds (Feb. 1997), at 42.
---------------------------------------------------------------------------
As discussed above, one commenter suggested extending the
definition of illiquid assets to encompass not only those assets that
are not able to be sold within seven days at approximately the value
ascribed by the fund, but also those assets where the sale cannot be
settled within this same period, taking into account the same value
impact standard.\413\ After considering this suggestion, we have
ultimately decided that the ``illiquid investments'' category under
rule 22e-4 should reflect only the period for selling or disposing of
an investment and not also consider settlement timing. Instead, the
``less liquid'' category reflects those investments that could be sold,
but not settled, within seven days without a significant value impact.
Investments that cannot be sold within seven days without a significant
value impact (illiquid investments, under rule 22e-4) have different
liquidity characteristics and are essentially less liquid than
investments that can be sold within seven days without a significant
value impact, but whose sale cannot be settled within this period (less
liquid investments, under rule 22e-4).\414\ As discussed above, less
liquid investments could still be considered a limited source of
liquidity for meeting redemptions within the seven-day period specified
under section 22(e) of the Act, with the caveat that a fund may have to
address certain challenges associated with their settlement, whereas a
fund's illiquid investments are structurally or as a matter of market
dynamics less liquid and a fund may be unable to use them to meet
redemptions within seven days.\415\
---------------------------------------------------------------------------
\413\ See supra footnote 401 and accompanying text.
\414\ When a fund sells an asset (even if the transaction has
not yet settled), the fund has a receivable on its books, and any
potential loss from the sale of that asset will be reflected in the
fund's NAV. If the fund has an asset it cannot sell, however, the
fund continues to be exposed to the risk of unknown potential loss
until the asset can be sold.
\415\ See supra paragraph accompanying footnote 383 (discussing
less liquid investments and the extent to which less liquid
investments may be available to meet redemption requests within
seven days if a fund addresses certain challenges associated with
their sale and settlement).
---------------------------------------------------------------------------
However, we note that trades in certain investments may take an
extended period of time to settle. Trades in some low quality loans,
for example, may not settle for a number of months.\416\ A fund that
holds less liquid investments with extended settlement periods must
develop a liquidity risk management program that takes into account the
liquidity risks associated with extended settlement periods.\417\ These
policies and procedures could include limits on the amount of less
liquid investments with extended settlement periods a fund will hold or
more frequent liquidity classification reviews for this type of
holding. Such a fund may also wish to consider the circumstances in
which it would seek to obtain expedited settlement (where possible) and
establish tailored policies and procedures regarding how and when it
would seek expedited settlement. Funds may also wish to consider
whether to obtain an additional source of financing (for example, a
committed line of credit dedicated to that fund) to bridge the period
until the sales would settle.
---------------------------------------------------------------------------
\416\ See e.g., Michael Mackenzie and Tracy Alloway, Lengthy US
loan settlements prompt liquidity fears, Financial Times (May 1,
2014), available at http://www.ft.com/cms/s/0/32181cb6-d096-11e3-9a81-00144feabdc0.html#axzz4HQiQv5wj (noting that a quarter of new
loans being issued were taking more than 30 days to settle).
\417\ Such extended settlement period securities have the
potential to pose heightened liquidity risks for funds, and thus
policies and procedures that are reasonably designed to assess and
manage the liquidity risk of a fund that holds such securities would
take into account the particular liquidity risks raised by such
holdings. See rule 22e-4(b)(1)(i).
---------------------------------------------------------------------------
We believe that the new requirement to take into account market,
trading, and investment-specific considerations, as well as to consider
market depth, in identifying illiquid investments responds to the
concern that the way illiquid investments are currently defined has
only limited effects on funds' liquidity risk management and the
liquidity of their portfolios.\418\ We understand that, to the extent a
fund is not currently taking into account market, trading, and
investment-specific considerations or market depth when assessing the
illiquidity of its investments, the new regulatory requirements
regarding the process for determining that certain investments are
illiquid under the rule are likely to result in the fund determining
that a greater percentage of its holdings are illiquid than under the
guidelines. In extreme circumstances, this--in combination with the
limitation on funds' illiquid investment holdings to 15% of its net
assets discussed at section III.E below--could cause certain funds to
have to modify their investment strategies or reconsider their
structure as open-end funds. We also understand that these requirements
will entail additional operational costs, to
[[Page 82180]]
the extent that funds today do not generally take into account relevant
market, trading, and investment-specific considerations, or market
depth, in determining whether their portfolio investments are illiquid.
However, as discussed in detail in the Economic Analysis section below,
we believe that these costs are justified by the investor protection
benefits that we believe will result from better portfolio liquidity
assessments.\419\
---------------------------------------------------------------------------
\418\ See supra footnote 400 and accompanying text.
\419\ See infra section 0.C.
---------------------------------------------------------------------------
3. Required Classification Procedures
a. Classification Based on Asset Class
Rule 22e-4, as adopted today, generally permits a fund to, as a
starting point, classify the liquidity of its portfolio investments
according to their asset class.\420\ Notwithstanding this general
approach, a fund will be required to separately classify any investment
if the fund or its adviser, after reasonable inquiry, 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.\421\ For example, if the
fund or its adviser were to know that particular large-capitalization
equity was affected by adverse events at the issuer that caused it to
have different liquidity characteristics than the asset class as a
whole, it would be required to treat that investment as an exception
and classify it separately. As another example, a fund could decide
that high credit quality corporate bonds generally fall into a
particular liquidity category, but if the fund or its adviser had
information that certain bonds' bid-ask spreads are significantly wider
or more volatile than those of their peers, it would be required under
rule 22e-4 to separately assess these bonds and potentially classify
them into a less-liquid category than the fund's other holdings within
the same asset class. We expect that, based on a fund's responsibility
under the rule to classify each of its investments after reasonable
inquiry and taking into account relevant market, trading, and
investment-specific considerations, there are some asset classes, such
as those encompassing some bespoke complex derivatives or complex
structured securities,\422\ that have such a range of liquidity
characteristics that each position would need to be classified
individually.
---------------------------------------------------------------------------
\420\ See rule 22e-4(b)(1)(ii)(A).
\421\ Id.
\422\ See 2015 Derivatives Proposing Release, infra footnote 222
(discussing bespoke complex derivatives).
---------------------------------------------------------------------------
Rule 22e-4 as proposed would not have allowed a fund to, as a
starting point, classify its portfolio investments according to asset
class. The proposed rule instead would have required a fund to classify
each of its positions in a portfolio asset (or portions of a position)
according to the liquidity categories included in the rule.\423\ In the
Proposing Release, we requested comment on whether the proposed
classification requirement and associated liquidity categories
reflected the manner in which funds currently assess and categorize the
liquidity of their portfolio holdings as part of their portfolio and
risk management.
---------------------------------------------------------------------------
\423\ Proposed rule 22e-4(b)(2)(i).
---------------------------------------------------------------------------
Many commenters objected to the proposed position-level
classification requirement, arguing that it does not reflect recognized
liquidity risk management practices and does not reflect industry best
practices.\424\ Commenters likewise maintained that, instead of
assessing portfolio liquidity on a position-by-position basis, asset
managers tend to focus on the liquidity of certain asset classes and/or
generally view liquidity at the portfolio level based on a ``top-down''
analysis.\425\ On the other hand, some commenters acknowledged that
certain asset managers may classify the liquidity of individual
portfolio positions within a range of categories, albeit not at the
level of detail suggested by the proposal, or for all classes of
portfolio assets.\426\
---------------------------------------------------------------------------
\424\ See, e.g., Credit Suisse Comment Letter; Dodge & Cox
Comment Letter; PIMCO Comment Letter; Vanguard Comment Letter.
\425\ See, e.g., Dodge & Cox Comment Letter; ICI Comment Letter
III; IDC Comment Letter; Charles Schwab Comment Letter.
\426\ See CFA Comment Letter; MFS Comment Letter; Nuveen Comment
Letter; Wellington Comment Letter.
---------------------------------------------------------------------------
Commenters stated that considering portfolio liquidity on the basis
of asset class, at least as a starting point, has practical,
operational, and conceptual benefits compared to considering the
liquidity of each portfolio position individually.\427\ Commenters
stated that assets with certain similar characteristics are often
``highly comparable and substitutable from a liquidity perspective,''
\428\ and liquidity assessments based on asset class would permit a
fund manager to account for differences in market structure and
portfolio management objectives among asset classes.\429\ Commenters
also argued that evaluating and classifying each portfolio asset
individually would be ``overly burdensome and near-impossible to
manage,'' as a fund complex may collectively hold hundreds of thousands
of individual portfolio assets,\430\ and the data required to classify
each asset individually may not be readily available for all asset
types (particularly for fixed income or other OTC assets).
---------------------------------------------------------------------------
\427\ See, e.g., Dechert Comment Letter; HSBC Comment Letter;
ICI Comment Letter I; Wellington Comment Letter.
\428\ See ICI Comment Letter I.
\429\ See Vanguard Comment Letter.
\430\ See Fidelity Comment Letter.
---------------------------------------------------------------------------
Relatedly, multiple commenters suggested alternative liquidity
classification schemes that would be based on an ``asset-type mapping
with exceptions'' analysis.\431\ These alternatives used an approach
where a fund's portfolio assets' liquidity generally would be
classified by asset class--with exceptions to the extent a particular
portfolio asset demonstrates liquidity characteristics that differ from
the liquidity of its asset class generally and that are deemed to make
the position substantially more or less liquid.\432\ Assets treated on
an exception basis could be placed in a different liquidity category
than the rest of their asset class, which could be either higher or
lower.\433\ The asset class analysis provisions of final rule 22e-4
generally take this approach. The primary difference between
commenters' ``asset-type mapping with exceptions'' suggested approaches
and the approach incorporated in final rule 22e-4 is that commenters'
suggested approaches would rely on the Commission (or an industry
group) assigning default liquidity categories to each asset class,
whereas the approach we are adopting would depend on each fund
performing this exercise based on its adviser's individual experience
in the markets.
---------------------------------------------------------------------------
\431\ See SIFMA Comment Letter III; see also BlackRock Comment
Letter; T. Rowe Comment Letter.
\432\ See, e.g., SIFMA Comment Letter III.
\433\ Id.
---------------------------------------------------------------------------
We believe that this approach strikes an appropriate balance
between lessening operational burdens associated with classification
and recognizing that many investments within an asset class may be
considered interchangeable from a liquidity perspective, on one hand,
and providing reasonably precise liquidity classifications that
appropriately reflect investments' liquidity characteristics, on the
other hand. This approach also should leverage fund managers' current
practices to a greater degree than under the proposal. A fund's asset-
class-based classification procedures should incorporate sufficient
detail to meaningfully distinguish between asset
[[Page 82181]]
classes and sub-classes. For example, a fund may wish to distinguish
how it classifies its equity securities based on factors such as the
market(s) in which the security's issuer is based, market
capitalization, and whether the security is common or preferred stock.
As another example, a fund may wish to distinguish its fixed income
securities based on factors such as issuer type, the market(s) in which
the issuer is based, seniority, age, and credit quality, and to
distinguish its holdings of structured products based on tranche
seniority and credit quality. We do not consider it appropriate for a
fund to use very general asset class categories (e.g., ``equities,''
``fixed income,'' and ``other'') in classifying the liquidity of its
portfolio investments, as these broad categories would likely not
permit a fund to identify investments with fungible liquidity
characteristics. A fund's asset-class-based classification procedures
also should include procedures for updating default asset-class
liquidity classifications as relevant market, trading, and investment-
specific considerations warrant.\434\
---------------------------------------------------------------------------
\434\ See rule 22e-4(b)(1)(ii) (requiring funds to classify
their investments taking into account relevant market, trading, and
investment-specific considerations and to review their portfolio
investments' classifications if changes in these considerations are
reasonably expected to materially affect one or more of their
investments' classifications).
---------------------------------------------------------------------------
A fund would be required to separately classify any investment
within an asset class if the fund or its adviser were to have
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 (its ``exception
processes'').\435\ Rule 22e-4 does not specify precisely how a fund
must identify investments that should be classified separately as part
of its exception processes. However, reasonably designed policies and
procedures would likely include specifying the sources of inputs that
inform its exception processes (for example, inputs from the fund's
portfolio management, risk management, and/or trading functions), as
well as particular variables that could affect the fund's
classification of certain investments. For example, a fund could
determine that a particular investment should be classified differently
than other investments within its asset class if the market for that
particular investment were exceptional in terms of size, breadth, or
depth, or if the investment's typical bid-ask spreads were generally
wider, narrower, or more volatile than the bid-ask spreads of other
assets within the asset class. A fund could incorporate an assessment
of the liquidity classification guidance factors discussed below, as
the fund determines appropriate, in its exception processes.\436\
---------------------------------------------------------------------------
\435\ See rule 22e-4(b)(1)(ii)(A).
\436\ See infra section III.C.4.
---------------------------------------------------------------------------
b. Required Procedures for Considering Market Depth
Under rule 22e-4 as adopted today, a fund would be required to
determine whether trading varying portions of a position in a
particular portfolio investment, in sizes that the fund would
reasonably anticipate trading, is reasonably expected to significantly
affect the liquidity characteristics of that investment.\437\ To the
extent that the fund determines that trading varying portions of a
position is reasonably expected to significantly affect the liquidity
characteristics of that investment--that is, the market depth for the
investment is reasonably expected to significantly affect its
liquidity--the fund would need to take this into account in classifying
the liquidity of that investment.\438\ As discussed in more detail
below, this requirement would have a fund consider portions of a
portfolio position that are larger than a single trading lot, but not
necessarily the position's full size, in assessing its portfolio
investments' liquidity.
---------------------------------------------------------------------------
\437\ See rule 22e-4(b)(1)(ii)(B).
\438\ Id.
---------------------------------------------------------------------------
These market depth-related requirements are meant to substitute
for, and modify, the language of proposed rule 22e-4 that would have
effectively required a fund to consider position size in classifying
the liquidity of its portfolio investments. As discussed above,
proposed rule 22e-4 would have had a fund consider, for each portfolio
position, the amount of time it would take to convert the entire
position, or portions thereof, to cash.\439\ Under this proposed
requirement, if a fund were to conclude that it would take the fund
longer to convert its entire position in an asset to cash, it could
determine, for example, that 50% of the position should be classified
in one liquidity category, and the remaining 50% should be classified
in another category.
---------------------------------------------------------------------------
\439\ See proposed rule 22e-4(b)(2)(i); see also supra section
III.C.2.d.
---------------------------------------------------------------------------
This aspect of the proposed requirement arose from our belief that
a fund should consider its ability to trade larger portions of a
portfolio asset than a single trading lot in assessing its portfolio
investments' liquidity. The ability to quickly trade larger portions of
a particular position is a reflection of market depth for a particular
asset, which is a well-recognized aspect of assessing liquidity.\440\
In the Proposing Release, we responded to arguments that because a fund
will not likely need to sell its entire position in a particular asset
under normal market conditions, liquidity determinations should be
based on the sale of a single trading lot for that asset, except in
unusual circumstances.\441\ We noted that, although we agreed that a
fund not being able to convert its entire position in an asset to cash
at a price that does not materially affect the value of that asset
should not, by itself, be dispositive of a portfolio asset's liquidity,
assessing liquidity only on the basis of the ability to sell and
receive cash for a single trading lot of an asset ignores the fact that
a fund may need to sell all (or a significant portion) of its
position.\442\
---------------------------------------------------------------------------
\440\ See infra footnote 526 and accompanying text.
\441\ See Proposing Release, supra footnote 9, at n.177 and
accompanying text.
\442\ See id., at paragraph accompanying n.177. For example, a
fund needing to sell certain assets in order to meet redemptions may
need to sell more than one trading lot of a particular asset. In
addition, a fund may determine to dispose of an entire position
because of deteriorating credit quality or other portfolio
management factors. Similarly, an index fund may need to sell an
entire position in an asset if that asset falls out of the tracked
index.
---------------------------------------------------------------------------
Multiple commenters expressed concern about the proposed
requirement to consider full position size in classifying the liquidity
of a fund's portfolio assets.\443\ Commenters argued that many industry
participants currently assess asset liquidity by trading lot (as
opposed to evaluating whether a fund can exit an entire position within
a certain time period), reflecting that a fund generally would not need
to liquidate an entire large position unexpectedly.\444\ Commenters
also contended that this aspect of the proposal could result in large
funds' portfolio liquidity appearing artificially low compared to
smaller funds because large funds are more likely to hold larger
positions and determine that they could not quickly liquidate these
positions entirely without a value impact.\445\ Commenters argued that
it could be misleading for large funds to
[[Page 82182]]
appear to be less liquid than smaller funds, because large funds'
portfolios might actually entail less liquidity risk compared to
smaller funds (because each position, while large in absolute size, is
a smaller portion of the overall portfolio than may be the case in
smaller funds), and large funds may have greater resources than smaller
funds to manage liquidity effectively.\446\ For example, one commenter
stated that large funds often have more diversified holdings than
smaller funds and may wield more negotiating power with broker-
dealers.\447\
---------------------------------------------------------------------------
\443\ See, e.g., BlackRock Comment Letter; IDC Comment Letter;
SIFMA Comment Letter I; Wellington Comment Letter.
\444\ See, e.g., ICI Comment Letter I; Charles Schwab Comment
Letter; Vanguard Comment Letter.
\445\ See, e.g., BlackRock Comment Letter; ICI Comment Letter I;
Oppenheimer Comment Letter; SIFMA Comment Letter I.
\446\ See, e.g., SIFMA Comment Letter I; see also BlackRock
Comment Letter; Oppenheimer Comment Letter; Vanguard Comment Letter;
Wellington Comment Letter.
\447\ See BlackRock Comment Letter.
---------------------------------------------------------------------------
The market depth approach we are adopting takes commenters'
concerns into account, although as discussed above we continue to
believe that an investment strategy involving large positions in
particular issuers--particularly if the fund's portfolio is relatively
concentrated--is relevant to assessing liquidity risk.\448\ We
appreciate that, in many cases, a fund may not have to trade large
portions of its portfolio holdings in relatively short time periods in
order to meet redemptions, or to otherwise manage its liquidity risk.
For example, a fund may not need to often quickly convert large
portions of its portfolio investments to cash, based on its cash flow
projections (e.g., if the fund's investors are known to be primarily
long-term investors) and other liquidity risk assessment factors.\449\
We also recognize that there could be situations in which the
requirement to consider entire position size in classifying a fund's
portfolio investments, regardless of the size of trades a fund
typically engages in, could make a fund appear to be less liquid than
the fund's actual trading experiences in light of its portfolio
investments' market depth. This could be misleading if the fund were
actually able to trade a large percentage of its holdings fairly
quickly without the fund's trades significantly moving the investments'
prices. We believe that the required market depth considerations
incorporated into the final classification requirement will permit a
fund to more realistically assess the liquidity of its portfolio
investments because they allow a fund to classify and review its
portfolio investments taking into account position sizes that the fund
would reasonably anticipate trading.
---------------------------------------------------------------------------
\448\ See supra footnotes 210-212 and accompanying text.
\449\ See rule 22e-4(b)(1)(i).
---------------------------------------------------------------------------
We believe that if a fund reasonably anticipates trading sizeable
portions of its portfolio positions, the fund's portfolio liquidity
could be adversely affected by a lack of market depth for its portfolio
investments. A fund could reasonably anticipate trading sizeable
portions of its portfolio positions if it often trades relatively large
portions of its portfolio positions. Likewise, a fund may not trade
larger portions of its portfolio positions on a regular basis, but
could reasonably anticipate, based on past flow patterns or current
market conditions that it could encounter larger-than-typical
redemptions that would necessitate larger portfolio trades. In both of
these examples, such a fund could conclude that it may be difficult to
find trading partners for a particular portfolio investment, or may be
difficult to sell the investment within a particular time frame without
this sale causing a significant value impact. For this reason, rule
22e-4 requires a fund to consider the sizes of a particular investment
that the fund would reasonably anticipate trading and whether trading
in such sizes could significantly affect the investment's liquidity. If
so, the fund would be required to take this into account in classifying
the liquidity of that portfolio investment.\450\ If the fund
determined, after conducting the required market depth analysis, that a
downward adjustment in the liquidity classification of a particular
investment is appropriate, the new liquidity classification that the
fund assigns to this investment would apply to the entirety of the
fund's position in that investment (not, as proposed, to portions of
that position). This approach is meant to lessen burdens on funds, as
well as respond to commenters' concerns, by focusing a fund's market
depth considerations on circumstances in which a fund's practices in
trading varying portions of its portfolio positions could have a
disproportionate effect on its portfolio investments' liquidity.
---------------------------------------------------------------------------
\450\ See rule 22e-4(b)(1)(ii)(B).
---------------------------------------------------------------------------
Rule 22e-4 directs a fund to consider sizes that the fund would
reasonably anticipate trading in assessing the impact of market depth
on an investment's liquidity.\451\ Depending on the liquidity risk
factors that a fund must consider under rule 22e-4(b)(1)(i), as well as
other factors including the fund's size, a fund could reasonably
anticipate selling various portions of its position in a particular
portfolio investment, or various dollar amounts or block sizes of a
particular portfolio investment.\452\ For example, it may be
appropriate for a fund with a highly liquid portfolio, with very stable
and minimal cash flow projections and significant cash holdings and
operating in very stable market conditions, to adopt policies and
procedures that consider whether trading relatively small fractions of
each of the fund's portfolio holdings would result in significant
liquidity impacts. On the other hand, we would generally consider it
appropriate for a fund whose holdings are relatively illiquid and/or
fairly concentrated, with unpredictable cash flow projections or
deteriorating market conditions in the markets in which it invests, to
consider whether trading larger portions of its portfolio holdings
would result in significant liquidity impacts.
---------------------------------------------------------------------------
\451\ Id.
\452\ See, e.g., Kapil Phadnis, Block Trading in Today's
Electronic Markets, Bloomberg Tradebook (May 20, 2015), available at
http://www.bloombergtradebook.com/blog/block-trading-in-todays-electronic-markets/ (discussing block trading in the equity markets
and noting that New York Stock Exchange Rule 72 defines a ``Block''
as at least 10,000 shares or $200,000, whichever is less); Got
Liquidity?, BlackRock Investment Institute (Sept. 2012) (``Got
Liquidity?''), at 6, available at https://www.blackrock.com/investing/literature/whitepaper/got-liquidity-us-version.pdf
(indicating that, from 2010-2012, block trades of over $5 million
represented between approximately 30%-45% of the U.S. investment
grade corporate bond market's trading volume).
---------------------------------------------------------------------------
c. Classification Issues Arising With Respect to Derivatives
Transactions
Rule 22e-4 requires that the liquidity classification and review
requirements cover each of the fund's investments, including
derivatives transactions, and that a fund take into account relevant
market, trading, and investment-specific considerations in classifying
the liquidity of its investments.\453\ The rule also states that for
derivatives transactions that a fund has classified as moderately
liquid investments, less liquid investments, and illiquid investments,
the fund must identify the percentage of its highly liquid investments
that are segregated to cover, or pledged to satisfy margin requirements
in connection with, derivatives transactions in each of these
classification categories.\454\ A fund also will be required to
disclose these percentages on its Form N-PORT filings.\455\ We believe
a fund's disclosure of this percentage will permit
[[Page 82183]]
the Commission and its staff to understand what percentage of a fund's
highly liquid investment minimum is composed of encumbered assets, and
will allow the public to better understand that a certain percentage of
a fund's highly liquid investments may not be immediately available for
liquidity risk management purposes. The final rule does not require the
fund to determine or disclose the percentage of the fund's moderately
liquid investments or less liquid investments that the fund has
segregated to cover, or pledged in connection with, its derivatives
transactions, because we understand that funds are less likely to post
moderately or less liquid investments as margin or collateral. We also
expect that investors and others will find most valuable information
regarding the extent to which the fund's highly liquid investments are
segregated or pledged in connection with derivatives transactions
because understanding that percentage may give investors a better
understanding of whether such assets are truly available to make
redemptions.
---------------------------------------------------------------------------
\453\ Rule 22e-4(b)(1)(ii).
\454\ Rule 22e-4(b)(1)(ii)(C). Because, as discussed below, a
fund generally will segregate certain liquid assets in order to
cover the fund's obligations under its derivatives transactions,
rule 22e-4 assumes that a fund would not segregate any of its assets
identified as illiquid investments to cover its derivatives
transactions. See infra footnote 462 and accompanying text.
\455\ See infra section III.C.6.b.
---------------------------------------------------------------------------
These requirements replace the proposed requirement for a fund to
consider the ``relationship of [an] asset to another portfolio asset''
in classifying and reviewing the liquidity of its portfolio
assets,\456\ as well as the derivatives-focused guidance that the
Commission provided in the Proposing Release regarding this proposed
classification factor.\457\ The Commission's guidance was meant to give
direction to funds' liquidity classification of derivatives
transactions and the assets that a fund may segregate to cover its
obligations under these transactions.\458\ As discussed below, we are
not adopting the proposed factors that a fund would have had to
consider in classifying the liquidity of its portfolio holdings,
including the ``relationship of [an] asset to another portfolio asset''
factor.\459\ However, we are adopting new classification provisions in
rule 22e-4 that will apply to derivatives transactions \460\ as well as
a provision that will address assets segregated to cover derivatives
transactions \461\ so that funds consistently consider certain unique
aspects of these transactions, and also to respond to commenters'
concerns stemming from the treatment of derivatives under the proposal.
---------------------------------------------------------------------------
\456\ See proposed rule 22e-4(b)(2)(ii)(I).
\457\ See Proposing Release, supra footnote 9, at section
III.B.2.i.
\458\ Id.
\459\ Instead, we are requiring that a fund must take into
account market, trading, and investment-specific considerations in
classifying the liquidity of its portfolio investments. See rule
22e-4(b)(1)(ii); see also supra section III.C.1.b. We provide
guidance below on specific factors that a fund may find appropriate
to consider in furtherance of this requirement. See infra section
III.C.4.
\460\ See rule 22e-4(b)(1)(ii).
\461\ See rule 22e-4(b)(1)(ii)(C). This provision also applies
to assets pledged to satisfy margin requirements in connection with
derivatives transactions.
---------------------------------------------------------------------------
In the Proposing Release, we noted that when funds enter into
certain transactions that implicate section 18 of the Investment
Company Act, they generally will maintain, in a segregated account,
certain liquid assets in order to ``cover'' the fund's obligation under
the transactions.\462\ We applied this framework to certain financing
transactions in Release 10666, issued in 1979,\463\ and also understand
that funds today apply this framework to certain derivatives, based on
the guidance we provided in Release 10666 and on no-action letters
issued by our staff.\464\ We explained in Release 10666 that ``[a]
segregated account freezes certain assets of the investment company and
renders such assets unavailable for sale or other disposition.'' \465\
We also stated in Release 10666 that only certain types of liquid
assets should be placed in a segregated account.
---------------------------------------------------------------------------
\462\ See Proposing Release, supra footnote 9, at section
III.B.2.i.
\463\ Release 10666, supra footnote 220. In December 2015, the
Commission proposed a new exemptive rule, rule 18f-4, which would
permit funds to enter into derivatives transactions and financial
commitment transactions notwithstanding section 18 of the Investment
Company Act, provided that the funds comply with the conditions of
the proposed rule. In proposing rule 18f-4, the Commission noted
that, should the rule be adopted, it would rescind Release 10666 and
relevant staff no-action letters. See 2015 Derivatives Proposing
Release, supra footnote 222, at section III.I.
\464\ See generally 2015 Derivatives Proposing Release, supra
footnote 222, at section II.B (providing background information on
the application of section 18 and Release 10666 to derivatives and
certain other transactions).
\465\ See also Dear Chief Financial Officer Letter from Lawrence
A. Friend, Chief Accountant, Division of Investment Management (Nov.
7, 1997) (staff letter taking the position that a fund could
segregate assets by designating such assets on its books, rather
than establishing a segregated account at its custodian).
---------------------------------------------------------------------------
Thus, we noted in the Proposing Release that, although assets used
by a fund to cover derivatives and other transactions should be liquid
when considered in isolation, when evaluating their liquidity for
purposes of proposed rule 22e-4, the fund would have to consider that
they are being used to cover other transactions and, consistent with
our position in Release 10666, are ``frozen'' and ``unavailable for
sale or other disposition.'' \466\ We stated that because these assets
are only available for sale to meet redemptions once the related
derivatives position is disposed of or unwound, a fund should classify
the liquidity of these segregated assets using the liquidity of the
derivative instruments they are covering. We also provided guidance
that, when a formerly segregated asset is no longer segregated, a fund
generally should assess, as part of the proposed ongoing liquidity
classification review requirement, whether the liquidity classification
given to the portfolio asset when it was segregated continues to be
appropriate. Finally, we noted in the Proposing Release that in
addition to the liquidity of a fund's derivatives positions themselves,
assessing a fund's liquidity risk generally may include an evaluation
of the potential liquidity demands that may be imposed on the fund in
connection with its use of derivatives, including any variation margin
or collateral calls the fund may be required to meet.\467\
---------------------------------------------------------------------------
\466\ See Proposing Release, supra footnote 9, at section
III.B.2.i.
\467\ See id., at n.309 and accompanying text.
---------------------------------------------------------------------------
The Proposing Release included a request for comment on the
proposed ``relationship of [an] asset to another portfolio asset''
liquidity classification factor, which included asking whether rule
22e-4 should explicitly require a fund to classify the liquidity of a
position (or portions of a position in a particular asset) used to
cover a derivative position using the same liquidity classification
category as it assigned to the derivative, and whether the Commission
should provide additional guidance regarding the circumstances in which
a fund should consider the liquidity of a particular portfolio asset in
relation to the liquidity of another asset.\468\ Multiple commenters
raised concerns about the proposed ``relationship of [an] asset to
another portfolio asset'' liquidity classification factor and
accompanying guidance in the Proposing Release.\469\ Many stated that
the Commission's guidance as to classifying segregated assets using the
liquidity of the derivative instrument they are covering would be
unworkable and would raise costly operational burdens, because funds
currently do not identify individual liquid assets to cover specific
derivatives transactions.\470\ Instead,
[[Page 82184]]
commenters noted that it is common in the fund industry for a fund to
review its outstanding obligations under its derivatives positions on a
portfolio basis and determine an aggregate amount of liquid assets that
must be segregated in connection with the transactions requiring
coverage.\471\ One commenter suggested that, instead of the proposed
``relationship of [an] asset to another portfolio asset'' liquidity
classification factor, the Commission alternatively could require funds
to assign liquidity classifications to cover assets on an aggregate
portfolio basis in amounts corresponding to the aggregate amount of
derivatives exposure in each liquidity category.\472\
---------------------------------------------------------------------------
\468\ See id., at section III.B.2.j.
\469\ See, e.g., Dechert Comment Letter; Milliman Comment
Letter; T. Rowe Comment Letter; Vanguard Comment Letter.
\470\ See, e.g., Dechert Comment Letter; ICI Comment Letter I;
Invesco Comment Letter; Vanguard Comment Letter. But see Nuveen
Comment Letter (suggesting that, for purposes of the alternative
liquidity classification approach that it recommends, a security
used specifically to cover a derivatives transaction that cannot be
unwound within seven days (and thus the derivative would be
classified as ``illiquid'' under the commenter's recommended
approach) also would be considered to be ``illiquid'' under that
approach).
\471\ See Dechert Comment Letter.
\472\ See id.; see also ICI Comment Letter I (suggesting that
the Commission add an item to Form N-PORT's Schedule of Portfolio
Investments that permits a fund to note whether an asset (or portion
thereof) is encumbered or linked to other assets as of the reporting
date, without separately tying to or identifying a ``linked''
asset).
---------------------------------------------------------------------------
Some commenters also argued that the guidance provided in the
proposal could make an otherwise liquid but segregated asset appear to
be less liquid than it actually is when considered in isolation.\473\
For example, if a cash equivalent security were used to cover a
derivative that the fund determined to be convertible to cash within 8-
15 days, under the Commission's guidance, the cash equivalent also
would be classified as an asset that could be converted to cash within
8-15 days. However, the fund would be able to replace the cash
equivalent as a coverage asset with another liquid asset at any time,
which would immediately unencumber the cash equivalent (but would
encumber other liquid assets with the same value).
---------------------------------------------------------------------------
\473\ See ICI Comment Letter I; T. Rowe Comment Letter.
---------------------------------------------------------------------------
Finally, commenters generally discussed features of derivatives
transactions informing the way that their liquidity would be classified
under proposed rule 22e-4. One commenter noted that the proposal seemed
to suggest that derivatives are inherently more risky and present
greater liquidity risk than other, more traditional assets.\474\ This
commenter maintained that, in some situations, derivatives may be more
liquid than more traditional assets. Another commenter stated that,
while the liquidity of a derivatives transaction depends on the
derivative's underlying reference asset to some degree, its liquidity
also largely stems from the needs of other market participants for that
kind of derivative.\475\
---------------------------------------------------------------------------
\474\ See T. Rowe Comment Letter.
\475\ See Milliman Comment Letter.
---------------------------------------------------------------------------
The requirements in rule 22e-4 regarding the classification of a
fund's derivatives transactions are meant to clarify and simplify the
application of the classification requirements to derivatives
transactions and respond to commenters' concerns. First, rule 22e-4
specifies that the liquidity classification and review requirements
apply to each of the fund's investment transactions (including
derivatives) and requires a fund to take into account relevant market,
trading, and investment-specific considerations in classifying
derivatives' liquidity.\476\ In addition, we have modified rule 22e-4
from the proposal to require a fund to classify each of the fund's
portfolio investments.\477\ We have made this change to clarify that
the classification requirement (and the other requirements of rule 22e-
4) applies to all of a fund's investment positions, regardless of
whether they are assets or liabilities, as the proposal intended.\478\
The proposed classification requirement, which would have required each
fund to classify the liquidity of its portfolio positions (or portions
of a position in a particular asset), could potentially have been read
to exclude certain derivatives and other transactions that are
classified as liabilities on the fund's balance sheet.\479\ Final rule
22e-4 thus requires the liquidity of all derivatives transactions to be
classified, regardless of if they are classified as assets or
liabilities on a fund's balance sheet, for the sake of operational
simplicity, completeness (e.g., to help reduce confusion regarding a
fund's liquidity profile as disclosed on Form N-PORT), and because all
derivatives transactions could implicate portfolio liquidity insofar as
other assets are segregated to cover these derivatives and derivatives
in a liability position involve transactions for which a fund would be
required to pay fund assets to exit the transaction.\480\
---------------------------------------------------------------------------
\476\ Rule 22e-4(b)(1)(ii). As with other portfolio investments,
funds may classify derivatives transactions by asset class, so long
as the fund or its adviser does not have information about any
market, trading, or investment-specific considerations that are
reasonably expected to significantly affect the liquidity
characteristics of a particular derivative that would require a
different classification for that derivative. Rule 22e-
4(b)(1)(ii)(A).
\477\ We note that in the Proposing Release, we requested
comment on whether the rule should ``focus not just on the liquidity
of the fund's assets but also more specifically and prominently on
its liabilities, such as derivatives obligations, that may affect
the liquidity of the fund.'' See Proposing Release, supra footnote
9, at text following n.155.
\478\ We note that use of the term ``investments'' is consistent
with other reporting requirements on Form N-PORT, and reflects the
proposal's discussions of the classification requirement applying to
all of a fund's portfolio positions, not just those that are assets.
See, e.g., id., at section III.B. (``[W]e are proposing new
requirements for classifying and monitoring the liquidity of funds'
portfolio positions.''; ``The proposed liquidity categorization
process would be in addition to the existing 15% guideline (which
would be retained, as discussed below) and would require a fund to
assess the liquidity of its portfolio positions individually, as
well as the liquidity profile of the fund as a whole.'' [emphasis
added]). See also Investment Company Reporting Modernization
Adopting Release, supra footnote 120.
\479\ We note, however, that no commenters suggested that the
proposal's use of the terms ``assets'' and ``positions''
interchangeably would lead to derivatives or other investments that
are liabilities not being subject to the rule, and that many
commenters discussed the impact of the classification requirement on
a variety of derivatives and other transactions that could be
liabilities. See, e.g., ICI Comment Letter (discussing
classifications of derivatives and TBA transactions); HSBC Comment
Letter (noting that ``[T]o the extent that this is possible, Asset
Managers should attempt to take all liabilities into account when
trying to calculate liquidity for a given fund.''). Nonetheless, to
eliminate any potential confusion, we are changing the term
``assets'' to ``investments'' throughout rule 22e-4, related
reporting items and definitions on Form N-PORT and Form N-LIQUID.
\480\ See rule 22e-4(b)(1)(ii) (requiring funds to classify each
of the portfolio investments, including each of the fund's
derivatives transactions). We have made corresponding changes to
each of the liquidity categories to account for the classification
of all portfolio investments (i.e., the liquidity categories under
rule 22e-4 as adopted are highly liquid investments, moderately
liquid investments, less liquid investments, and illiquid
investments).
---------------------------------------------------------------------------
Besides specifying that the liquidity of a derivatives transaction
must be classified taking into account relevant market, trading, and
investment-specific considerations, rule 22e-4 provides no derivatives-
specific factors that a fund would have to evaluate in classifying a
derivatives transactions' liquidity. We generally agree with
commenters' suggestions that the liquidity of a derivatives transaction
may depend on market demand for that kind of derivative, as well as the
liquidity of the derivative's underlying reference asset.\481\ Whether
a derivatives transaction is centrally cleared also could indicate that
the transaction is more liquid than an equivalent transaction that is
not cleared.\482\ In classifying and reviewing the liquidity of a
derivatives transaction, like classifying the liquidity of any
portfolio investment, a fund should consider the guidance factors
discussed in this Release, to the extent the factors are applicable and
the fund deems their
[[Page 82185]]
consideration to be appropriate.\483\ The provision in rule 22e-4
stating that a fund may generally classify its portfolio investments
according to their asset class applies to the fund's derivatives
transactions,\484\ as do the rule's market depth provisions.\485\ The
definitions of ``highly liquid investment,'' ``moderately liquid
investment,'' and ``less liquid investment'' that refer to the ability
to convert an investment to cash or dispose of an investment within a
specified period, with respect to derivatives transactions that the
fund classifies as liabilities on its balance sheet,\486\ should be
read to refer to the time period in which the fund reasonably expects
to be able to exit a transaction.
---------------------------------------------------------------------------
\481\ See supra footnotes 474-475 and accompanying text.
\482\ See, e.g., Deutsche Bank Research, Liquidity Is Key for
the Central Clearing of Derivatives (Mar. 12, 2015), available at
https://www.dbresearch.com/PROD/DBR_INTERNET_EN-PROD/PROD0000000000352403/Liquidity_is_key_for_the_central_clearing_of_deriv.pdf; see also
infra footnote 552.
\483\ See infra section III.C.4.
\484\ Rule 22e-4(b)(1)(ii)(A).
\485\ Rule 22e-4(b)(1)(ii)(B).
\486\ See supra footnote 480 and accompanying text.
---------------------------------------------------------------------------
Along with classifying the liquidity of each of its derivative
transactions, final rule 22e-4 requires a fund to identify, for
derivatives transactions that a fund has classified as moderately
liquid investments, less liquid investments, and illiquid investments,
the percentage of the fund's highly liquid investments that are
segregated to cover, or pledged to satisfy margin requirements in
connection with, the transactions in each of these classification
categories.\487\ When a fund's assets are segregated or pledged in
connection with derivatives transactions, they are only available for
sale to meet redemptions once the related derivatives position is
disposed of or unwound (or if other assets are segregated or pledged in
their place). Thus, even if the segregated or pledged assets would, on
their own, be considered extremely liquid, they would effectively not
be able to be used to meet redemption requests or to rebalance or
otherwise adjust a portfolio's composition in order to manage liquidity
risk. As discussed below, we believe that it is important, for purposes
of transparency regarding a fund's portfolio liquidity, to provide
clarity that certain percentages of a fund's investments may not be
functionally available to meet redemptions or for other liquidity risk
management purposes.\488\
---------------------------------------------------------------------------
\487\ Rule 22e-4(b)(1)(ii)(C).
\488\ See infra section III.C.6.
---------------------------------------------------------------------------
We believe that requiring a fund to determine the percentage of
highly liquid investments that are segregated to cover, or pledged to
satisfy margin requirements in connection with, its derivatives
transactions classified in each of the ``moderately liquid,'' ``less
liquid,'' and ``illiquid'' classification categories strikes an
appropriate balance between providing this transparency and reducing
burdens on funds. Under this approach, a fund generally would not need
to specifically identify particular assets that are segregated or
pledged to cover specific derivatives transactions, but instead a fund
will calculate the percentage of highly liquid investments segregated
or pledged to cover derivatives transactions that include derivatives
transactions classified in each of the other three classification
categories. For purposes of calculating these percentages, a fund that
has segregated or pledged non-highly liquid investments as well as
highly liquid investments to cover derivatives transactions, should
first use segregated or pledged assets that are highly liquid
investments to cover derivatives transactions classified in the three
lower liquidity classification categories.\489\ This approach should
promote consistency and comparability across funds. In the absence of
such an instruction, some funds might instead take the opposite
approach, and assume that segregated non-highly liquid investments
first cover these less liquid derivatives transactions, creating
inconsistencies between funds.
---------------------------------------------------------------------------
\489\ See note to rule 22e-4(b)(1)(ii)(C). However, if a fund
has specifically identified individual assets that are not highly
liquid investments as being segregated to cover such derivatives
transactions, the fund may match those specific segregated assets to
specific derivatives transactions and need not assume that
segregated highly liquid assets cover those derivatives.
---------------------------------------------------------------------------
The approach in the final rule responds to commenters' concerns
that funds rarely identify and segregate a specific liquid asset
against an individual derivative on a one-for-one relationship,\490\
and would reduce burdens that could result if the Commission's
liquidity classification rules were to require a fund to do so. It also
responds to commenters' concerns that linking the liquidity of specific
segregated assets to the liquidity of a fund's derivatives transactions
could understate the liquidity of those segregated assets, since a fund
may be able to readily substitute another liquid asset for the
segregated asset.\491\ However, the Commission's approach also would
provide the basis for needed transparency for the Commission, its
staff, and the public into the way that a fund's segregated or pledged
assets may affect the fund's overall portfolio liquidity. Rule 22e-4,
which requires a fund only to determine percentages of segregated or
pledged assets comprising the fund's highly liquid investments,
reflects our belief that this transparency is especially important with
respect to funds' highly liquid investments. As noted above, a fund's
disclosure of percentages of its highly liquid investments that are
segregated or pledged assets would permit the Commission and its staff
to understand what percentage of a fund's highly liquid investment
minimum is composed of encumbered assets, and would allow the public to
better understand that a certain percentage of a fund's highly liquid
investments may not be immediately available for liquidity risk
management purposes.
---------------------------------------------------------------------------
\490\ See supra footnote 470 and accompanying text.
\491\ See supra footnote 473 and accompanying paragraph. We
note, however, that the ability to substitute may not improve the
overall liquidity of the portfolio.
---------------------------------------------------------------------------
While a fund will not need to identify which of its particular
assets are segregated in connection with particular derivatives
transactions, it will need to identify the percentage of its highly
liquid investments that are segregated or pledged with respect to
derivatives transactions classified in each of the moderately liquid,
less liquid, and illiquid classification categories. We recognize that
these requirements will likely entail additional evaluation of the
liquidity character of a fund's segregated assets compared to what a
fund might do today as part of its current asset segregation
procedures.\492\ We believe these burdens are justified, however, by
the important transparency benefits of identifying the percentages of
highly liquid investments that are segregated or pledged assets.
---------------------------------------------------------------------------
\492\ See infra section IV.C.1.
---------------------------------------------------------------------------
We also note that these burdens are further reduced because under
the rule a fund need not identify the percentage of segregated or
pledged assets covering derivatives that are highly liquid investments,
or the percentage of segregated or pledged assets that are moderately
liquid investments or less liquid investments.\493\ A fund would be
permitted to exclude its derivatives transactions that are classified
as highly liquid investments in determining the percentages of highly
liquid investments that are segregated or pledged assets since the fund
could dispose of or exit these derivatives transactions within three
business days and the segregated or pledged assets also would be
available to the fund for liquidity risk management purposes within
three business days. Furthermore, as described in the preceding
paragraph, the rule's requirement to identify the percentages of a
fund's highly liquid investments that are also segregated or
[[Page 82186]]
pledged assets reflects our belief that asset segregation or margin
transparency is most important with respect to a fund's highly liquid
investments.
---------------------------------------------------------------------------
\493\ See rule 22e-4(b)(1)(ii)(C).
---------------------------------------------------------------------------
4. Guidance on Liquidity Classification Factors
Unlike rule 22e-4 as proposed, final rule 22e-4 does not include an
enumerated list of factors that a fund would be specifically required
to consider in classifying and reviewing the liquidity of its portfolio
investments. The rule instead generally requires a fund to take into
account ``relevant market, trading, and investment-specific
considerations'' in classifying and reviewing its portfolio
investments' liquidity.\494\ In contrast, under the proposed rule a
fund would have been required to take the following nine factors into
account, to the extent applicable, when classifying the liquidity of
each portfolio position in a particular asset:
---------------------------------------------------------------------------
\494\ See supra section III.C.1.b.
---------------------------------------------------------------------------
Existence of an active market for the asset, including
whether the asset is listed on an exchange, as well as the number,
diversity, and quality of market participants;
Frequency of trades or quotes for the asset and average
daily trading volume of the asset (regardless of whether the asset is a
security traded on an exchange);
Volatility of trading prices for the asset;
Bid-ask spreads for the asset;
Whether the asset has a relatively standardized and simple
structure;
For fixed income securities, maturity and date of issue;
Restrictions on trading of the asset and limitations on
transfer of the asset;
The size of the fund's position in the asset relative to
the asset's average daily trading volume and, as applicable, the number
of units of the asset outstanding; and
Relationship of the asset to another portfolio asset.\495\
---------------------------------------------------------------------------
\495\ Proposed rule 22e-4(b)(2)(ii).
---------------------------------------------------------------------------
The Proposing Release requested comment generally on whether the
Commission should codify a list of liquidity classification factors (as
discussed above) \496\ and also requested comments relating to the
usefulness of the proposed factors generally, as well as specific
comments on the proposed factors.\497\ With respect to the general
usefulness of the proposed factors, multiple commenters suggested that
the proposed factors would be largely informative in assessing assets'
relative liquidity,\498\ but others advised that the proposed factors
would not be useful in assisting fund management in making liquidity
determinations.\499\ Some who objected to the proposed factors argued
that their usefulness would be limited by the fact that they would be
based on backward-looking data and thus may not reflect future
conditions.\500\ Some commenters also argued that some of the proposed
factors (e.g., frequency of trades or quotes for an asset and average
daily trading volume of an asset) are generally more appropriate for
assessing the liquidity of exchange-traded securities than securities
that are traded over-the-counter (``OTC'') and that evaluating certain
OTC securities using the proposed factors may make these securities
appear to be less liquid than they actually are.\501\ For example,
multiple commenters contended that certain fixed income securities tend
to trade infrequently on any given day, but these securities' liquidity
is nevertheless quite high because a fund would generally be able to
sell them fairly quickly.\502\ As discussed specifically below,
commenters also expressed more granular concerns about certain of the
proposed factors (specifically, frequency of trades or quotes for an
asset, trading price volatility, position size, and relationship of an
asset to another portfolio asset \503\).
---------------------------------------------------------------------------
\496\ See supra section III.C.1.b.
\497\ See Proposing Release, supra footnote 9, at section
III.B.2.j.
\498\ See, e.g., CRMC Comment Letter; ICI Comment Letter I; J.P.
Morgan Comment Letter; Nuveen Comment Letter.
\499\ See, e.g., Cove Street Comment; GFOA Comment Letter; MFS
Comment Letter; Vanguard Comment Letter.
\500\ See, e.g., Cove Street Comment; Dodge & Cox Comment
Letter; Vanguard Comment Letter.
\501\ See, e.g., Banks Comment Letter; LSTA Comment Letter;
Milliman Comment Letter; Wells Fargo Comment Letter.
\502\ See, e.g., GFOA Comment Letter; MFS Comment Letter; T.
Rowe Comment Letter; Vanguard Comment Letter.
\503\ For a discussion of commenters' concerns about this
proposed factor in the context of derivatives transactions, see
supra section III.C.3.c.
Commenters also expressed concerns about this proposed factor in
the context of assets used for hedging or risk mitigation purposes.
In the Proposing Release, we stated that, when a fund purchases an
asset (a ``hedging asset'') in order to hedge or mitigate the risks
associated with another asset (a ``hedged asset''), the fund should
consider the liquidity of the hedged asset when evaluating the
liquidity of the hedging asset. Commenters stated that current
industry practice often involves hedging aggregate portfolio
exposures, not specific securities. See, e.g., ICI Comment Letter I;
Milliman Comment Letter; Oppenheimer Comment Letter; T. Rowe Comment
Letter. These commenters argued that the Commission's guidance
instructing a fund to classify the liquidity of hedging assets in
consideration of the hedged asset's liquidity classification would
therefore be unworkable and would raise costly operational burdens,
because funds do not currently link hedging assets and hedged assets
on a one-for-one basis.
Unlike in the context of derivatives transactions, in which we
have stated that a fund must segregate assets to cover derivatives
transactions, and this renders the segregated assets ``frozen'' and
``unavailable for sale or other disposition'' (see supra footnote
465 and accompanying text), we have not previously stated that
purchasing assets with the intent to hedge or mitigate the risks
associated with another asset makes those hedging assets unavailable
for sale. We thus do not view the linkages between hedging and
hedged assets to be directly analogous with the linkages between
derivatives transactions and assets segregated to cover those
derivatives transactions, and we are not stating in this Release the
guidance we included in the Proposing Release regarding the proposed
``relationship of an asset to another portfolio asset'' in the
context of assets used for hedging or risk mitigation purposes.
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As discussed above, we are not codifying the proposed factors in
part because we understand that certain factors would be more
informative to some funds than others, depending on the fund's
investment strategy and liquidity risk profile. We also are concerned
that codifying the factors, particularly if applied in a ``check-the-
box'' fashion, could lead funds to adopt classification processes that
do not reflect the extent of a fund's ability to sell its portfolio
investments to meet redemptions within a given time period without a
market impact, or do not otherwise result in an accurate picture of a
fund's liquidity profile.\504\ However, we continue to believe that the
proposed classification factors could be useful and relevant as aspects
of the general market, trading, and investment-specific considerations
that a fund must take into account under the final rule. Thus, in this
section III.C.4, we discuss each of the factors that funds could
consider in evaluating portfolio investments' liquidity characteristics
and managing liquidity risk.\505\ Based on staff outreach across the
fund industry, we understand that certain of these factors reflect
certain common considerations that funds often take into account in
evaluating their portfolio investments' liquidity.\506\ Moreover, as
discussed above, multiple commenters stated that the proposed rule
included factors that, largely, are useful for assessing a fund's
assets' relative liquidity.\507\ For example, some
[[Page 82187]]
commenters agreed that factors such as those incorporated in the
proposal are generally relevant considerations to use when evaluating
asset liquidity and would help promote effective liquidity risk
assessments,\508\ and that portfolio assets' liquidity should be
evaluated using a variety of inputs such as those that the proposed
factors represent.\509\ Some suggested that the Commission discuss the
factors as guidance accompanying its adoption of rule 22e-4.\510\
Overall, we believe this approach provides flexibility that should
facilitate meaningful liquidity analyses, and encourages funds to
consider relevant information.
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\504\ Cf. supra paragraph accompanying footnote 322.
\505\ Our discussion of factors that could be considered by
funds does not include the proposed ``relationship of [an] asset to
another portfolio asset'' factor because guidance on this factor, as
discussed above, has been replaced by requirements in rule 22e-4
regarding classification issues that arise with respect to
derivatives transactions. See supra footnotes 456-461 and
accompanying text; see also supra footnote 503 (discussing this
proposed factor in the context of assets used for hedging or risk
mitigation purposes).
\506\ See Proposing Release, supra footnote 9, at text preceding
n.200.
\507\ See supra footnote 498 and accompanying text.
\508\ See, e.g., CRMC Comment Letter; Fidelity Comment Letter;
J.P. Morgan Comment Letter; Nuveen Comment Letter.
\509\ See, e.g., HSBC Comment Letter; MSCI Comment Letter.
\510\ See, e.g., IDC Comment Letter; Invesco Comment Letter;
J.P. Morgan Comment Letter; SIFMA Comment Letter I.
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We acknowledge, as stated by some commenters, that certain of these
factors may involve consideration of backward-looking data and thus may
not account for ways in which changing market conditions could affect
the liquidity of certain asset classes or investments.\511\ But we
believe analyzing past data, while considering how that data may change
in the future, is an inherent aspect of all risk management and does
not render such analysis fruitless. In addition, the review
requirements embedded in the classification framework, when combined
with the liquidity risk assessment requirement to consider portfolio
liquidity during normal and reasonably foreseeable stressed periods,
further responds to this critique. We also are cognizant that, for
certain fixed income or other OTC assets or asset classes, certain of
the proposed liquidity classification factors, if considered standing
alone, may appear to make these assets or classes to appear less liquid
than they actually are. In the guidance below, we discuss special
concerns that may be relevant to funds' consideration of the liquidity
characteristics of fixed income or other OTC assets.\512\
---------------------------------------------------------------------------
\511\ See supra footnote 500 and accompanying text.
\512\ See, e.g., text accompanying infra footnotes 536-538 and
545-558.
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As discussed above, a fund generally is permitted to classify the
liquidity of its portfolio investments according to their asset class.
Thus, a fund may wish to consider the guidance discussed below in
assessing the general liquidity characteristics of the asset classes in
which it invests. For investments that the fund determines must be
treated as an ``exception'' and classified separate from their asset
class,\513\ the guidance provided below could assist funds in
identifying and classifying those investments that may demonstrate
liquidity characteristics that are distinct from the fund's other
portfolio holdings within that same asset class.
---------------------------------------------------------------------------
\513\ See rule 22e-4(b)(1)(ii)(A).
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The guidance we provide below is not meant to cover an exhaustive
list of considerations that a fund may take into account in evaluating
its portfolio investments' liquidity. Also, we recognize that specific
liquidity concerns appropriate for consideration could vary depending
on the issuer and the particular investment.\514\ Even if a fund's
liquidity classification policies and procedures were to incorporate
all of the guidance factors discussed below, a fund may decide that it
is appropriate to focus more heavily on certain factors and less on
others in evaluating its portfolio investments' liquidity.
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\514\ See, e.g., Fidelity Comment Letter; LSTA Comment Letter;
Nuveen Comment Letter; T. Rowe Comment Letter (each suggesting that
the Commission clarify that not every factor is required to be
considered to evaluate the liquidity of each of a fund's portfolio
assets).
---------------------------------------------------------------------------
In the following sections, we discuss certain factors that a fund
could consider in assessing the liquidity of its portfolio investments
and provide guidance on specific issues associated with each of these
factors. We also discuss comments we received on the proposed
classification factors.
a. Existence of Active Market for an Asset Class or Investment;
Exchange-Traded Nature of an Asset Class or Investment
We continue to believe that the manner in which a fund may sell an
asset class (or particular portfolio investment), including whether an
asset class or investment is generally listed on an exchange, may
affect the liquidity of that asset class or investment.\515\ While in
general, being listed on a developed and recognized exchange may
increase an investment's liquidity,\516\ we note, as certain commenters
mentioned,\517\ the fact that an investment is exchange-traded does not
necessarily mean that a fund would be able to sell or convert that
investment to cash within a relatively short period.\518\ For example,
a small-cap equity stock might be listed on an exchange but trade quite
infrequently, which would tend to decrease its relative liquidity.
Conversely, as commenters discuss, we agree that certain securities
that are traditionally traded in OTC markets, such as corporate bonds,
may not typically be designed to be traded frequently and instead are
more often ``bought and held,'' but certain of these securities
nevertheless may be readily saleable without the conversion to cash (or
in some cases, sale or disposition) significantly changing their market
value.\519\ Additionally, securities issued (or guaranteed as to
principal and interest) by the U.S. government do not trade on
exchanges, but are typically considered to be quite liquid.\520\
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\515\ See Proposing Release, supra footnote 9, at section
III.B.2.a (discussing the proposed requirement for a fund to
consider, to the extent applicable, the existence of an active
market for an asset, including whether the asset is listed on an
exchange, as well as the number, diversity, and quality of market
participants, in classifying the liquidity of each portfolio
position in a particular asset).
\516\ See, e.g., Basel Committee on Banking Supervision, Basel
III: The Liquidity Coverage Ratio and Liquidity Risk Monitoring
Tools (Jan. 2013), at part 1, section II.A.1, available at http://www.bis.org/publ/bcbs238.pdf; see also Nuveen FSOC Notice Comment
Letter, supra footnote 85 (``While securities that trade on
exchanges . . . or in deep principal/over-the-counter (``OTC'')
markets (e.g., U.S. Treasuries) are generally liquid even in
stressed markets, other securities that trade on an OTC basis . . .
have faced increasing liquidity challenges in normal markets and can
be subject to insufficient quality bids in times of stress as market
makers pull back their capital. This can make it not only more
difficult to sell these securities, but also to accurately value
those assets that are retained.'').
\517\ See, e.g., ICI Comment Letter I.
\518\ We note that in certain cases the exchange on which an
investment is listed may not be the primary market for that
security. For example, we understand that certain bonds that are
exchange listed trade predominantly in the OTC markets. See, e.g.,
Types of Bonds, How Big Is the Market, and Who Buys?, available at
http://www.investinginbonds.com/learnmore.asp?catid=5&subcatid=18&id=174 (``[T]he vast majority of
bond transactions, even those involving exchange-listed issues, take
place in [OTC] market.'').
\519\ See id.
\520\ See rule 15c3-1(c)(2)(vi)(A)(1) under the Exchange Act
(describing securities haircuts for securities issued or guaranteed
as to principal or interest by the United States or any agency
thereof); see also Liquidity Coverage Ratio: Liquidity Risk
Measurement Standards (Sept. 9, 2014) [79 FR 61440 (Oct. 10, 2014)]
(``Liquidity Coverage Ratio Release'') (in liquidity coverage ratio
rule adopted by the Office of the Comptroller of the Currency, Board
of Governors of the Federal Reserve System, and the Federal Deposit
Insurance Corporation, ``Level 1 Liquid Assets'' are described as
securities issued or unconditionally guaranteed as to timely payment
of principal and interest by the U.S. Department of the Treasury,
and liquid and readily-marketable securities issued or
unconditionally guaranteed as to the timely payment of principal and
interest by any other U.S. government agency (provided that its
obligations are fully and explicitly guaranteed by the full faith
and credit of the U.S. government)).
---------------------------------------------------------------------------
In assessing the effect that being traded on an exchange could have
on an asset class's or investment's liquidity, a fund generally should
evaluate how this consideration informs the liquidity characteristics
of any ETF shares in which it invests. We understand that certain
funds, particularly funds with
[[Page 82188]]
investment strategies involving relatively less liquid portfolio
securities (such as micro-cap equity funds, high-yield bond funds, and
bank loan funds), may invest a portion of their assets in ETFs with
strategies similar to the fund's investment strategy because they view
ETF shares as having characteristics that enhance the liquidity of the
fund's portfolio.\521\ Specifically, in discussions with Commission
staff, funds that invest in ETF shares have suggested that they find
that these shares are more readily tradable, are less expensive to
trade, and have shorter settlement periods than other types of
portfolio investments.\522\ In addition, unlike investments in cash,
cash equivalents, and other highly liquid instruments, funds also have
suggested to Commission staff that investing in ETFs with the same (or
a similar) strategy as the fund's investment strategy permits the fund
to remain fully invested in assets that reflect the fund's investment
concentrations, risks, and performance potential.\523\
---------------------------------------------------------------------------
\521\ See, e.g., Katy Burne, Institutions Pour Cash Into Bond
ETFs, Wall Street Journal (Mar. 1, 2015), available at http://www.wsj.com/articles/institutions-pour-cash-into-bond-etfs-1425250969. Funds' investments in ETFs are subject to the Investment
Company Act's limitations on investments in shares issued by other
registered investment companies. See section 12(d)(1)(A) of the Act.
Currently, these practices do not concern ETMFs.
The Commission's 2015 Request for Comment on Exchange-Traded
Products requested comment on whether investors' expectations of the
nature of the liquidity of an exchange-traded product (including an
ETF) holding relatively less liquid portfolio securities differ from
their expectations of the liquidity of the underlying portfolio
securities. See 2015 ETP Request for Comment, supra footnote 29, at
Question 49. Commenters expressed a range of views on the question.
See, e.g., Comment Letter of Vanguard on the 2015 ETP Request for
Comment (Aug. 17, 2015) (stating that the disclosures made by ETFs
in prospectuses, shareholder reports, and Web sites ``ensures that
investors and market participants have the necessary information to
make informed investment decisions''); Comment Letter of ETF Radar
on the 2015 ETP Request for Comment (Aug. 8, 2015) (stating that
investor expectations of liquidity depend on the skill of the
investor); Comment Letter of Danny Reich on the 2015 ETP Request for
Comment (July 2, 2015) (stating that there is a ``false assumption''
that underlying assets have the same liquidity as the ETP,
particularly with respect to bond ETPs).
\522\ See Proposing Release, supra footnote 9, at section
III.C.6.b.
\523\ See id.
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While we appreciate that ETFs' exchange-traded nature could make
these instruments useful to funds in managing purchases and redemptions
under certain conditions (for example, ETFs' settlement times could
more closely reflect the time in which a fund has disclosed that it
will typically redeem fund shares), funds should consider the extent to
which relying substantially on ETFs to manage liquidity risk is
appropriate. The liquidity of an ETF, particularly in times of
declining market liquidity, is limited by the liquidity of the market
for the ETF's underlying securities and, in fact, may be impaired based
on factors not directly related to the liquidity of the underlying
securities.\524\ Thus, shares of an ETF whose underlying securities are
relatively less liquid may not be able to be counted on to provide
liquidity to a fund investing in these shares during times of stress.
In the case of a significant decline in market liquidity, if authorized
participants were unwilling or unable to trade ETF shares in the
primary market, and the majority of trading took place among investors
in the secondary market, the ETF's shares could trade continuously at a
premium or a discount to the value of the ETF's underlying portfolio
securities. This could frustrate the expectations of secondary market
participants who count on the creation and redemption process to align
the prices of ETF shares and their underlying portfolio securities. We
therefore encourage funds to assess the liquidity characteristics of an
ETF's underlying securities, as well as the characteristics of the ETF
shares themselves, in classifying the liquidity of ETF shares under
rule 22e-4(b)(1)(ii).
---------------------------------------------------------------------------
\524\ See ETF Proposing Release, supra footnote 27, at section
III.A.1; see also Tyler Durden, What Would Happen if ETF Holders
Sold All at Once? Howard Marks Explains, Zero Hedge (Mar. 26, 2015),
available at http://www.zerohedge.com/news/2015-03-26/what-would-happen-if-etf-holders-sold-all-once-howard-marks-explains (``Thus we
can't get away from depending on the liquidity of the underlying
high yield bonds. The ETF can't be more liquid than the underlying,
and we know the underlying can become highly illiquid.''). But see,
e.g., Shelly Antoniewicz, Plenty of Players Provide Liquidity for
ETFs, ICI Viewpoints (Dec. 2, 2014), available at http://www.ici.org/viewpoints/view_14_ft_etf_liquidity (stating that most
of the trading activity in bond ETF shares is done in the secondary
market and not through creations and redemptions with authorized
participants).
---------------------------------------------------------------------------
Other Trading Mechanism Considerations
The means of trading a particular asset class or investment can
affect its liquidity regardless of whether the investment is a security
traded on an exchange. For example, whether an asset class or
investment is generally traded in a bilateral transaction with a single
dealer, or through an electronic auction mechanism where a trader can
simultaneously contact multiple counterparties, can have different
effects on its liquidity.\525\ The liquidity effects associated with
choice of trading mechanism may differ depending on the asset class or
investment being traded and other market conditions, and therefore it
is difficult to make general statements regarding the correlation
between a particular trading mechanism and the liquidity of the asset
class or investment being traded. For this reason, a fund may wish to
consider past experience in using different trading mechanisms to sell
a certain asset class or investment.
---------------------------------------------------------------------------
\525\ See, e.g., Terrence Hendershott & Ananth Madhavan, Click
or Call? Auction versus Search in the Over-the-Counter Market., 70
J. of Fin. 419 (Feb. 2015), available at http://faculty.haas.berkeley.edu/hender/Click_Call_OTC.pdf.
---------------------------------------------------------------------------
Diversity and Quality of Market Participants
In addition, the diversity and quality of market participants for a
particular asset class or investment also could contribute to the
liquidity of that asset class or investment. A fund may wish to
consider the number of market makers on both the buying and selling
sides of transactions. A fund also may wish to consider the quality of
market participants purchasing and selling a particular asset class or
investment, and may wish to assess, in particular: The market
participant's capitalization; the reliability of the market
participant's trading platform(s); and the market participant's
experience and reputation transacting in various types of assets. We
believe that the diversity and quality of market participants may be
meaningful in assessing a portfolio investment's liquidity because it
is common for relatively liquid asset classes and investments to have
active sale or repurchase markets at all times with diverse market
participants.\526\ The presence of multiple active market makers may be
a sign that a market is liquid.\527\ Diversity of market participants,
on both the buying and selling sides of transactions, may also be a
significant point for a fund to consider because it tends to reduce
market concentration and may facilitate a
[[Page 82189]]
market remaining liquid during periods of stress.\528\
---------------------------------------------------------------------------
\526\ See, e.g., Abdourahmane Sarr & Tonny Lybek, Measuring
Liquidity in Financial Markets, IMF Working Paper (Dec. 2002),
available at http://www.imf.org/external/pubs/ft/wp/2002/wp02232.pdf
(``Liquid markets tend to exhibit five characteristics: (i)
Tightness (ii) immediacy, (iii) depth, (iv) breadth, and (v)
resiliency.'').
\527\ See, e.g., Sunil Wahal, Entry, Exit, Market Makers, and
the Bid-Ask Spread, 10 Rev. of Fin. Stud. 871 (1997), available at
https://www.acsu.buffalo.edu/~keechung/MGF743/Readings/H1.pdf
(``Large-scale entry (exit) is associated with substantial declines
(increases) in quoted end-of-day inside spreads, even after
controlling for the effects of changes in volume and volatility. The
spread changes are larger in magnitude for issues with few market
makers; however, even for issues with a large number of market
makers, substantial changes in quoted spreads take place.'').
\528\ See, e.g., Amir Rubin, Ownership Level, Ownership
Concentration, and Liquidity, 10 J. Fin. Markets 219 (Aug. 2007),
available at http://www.sciencedirect.com/science/article/pii/S1386418107000134 (``We examine the link between the liquidity of a
firm's stock and its ownership structure, specifically, how much of
the firm's stock is owned by insiders and institutions, and how
concentrated is their ownership. We find that the liquidity-
ownership relation is mostly driven by institutional ownership
rather than insider ownership. Importantly, liquidity is positively
related to total institutional holdings but negatively related to
institutional block holdings.'').
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b. Frequency of Trades or Quotes; Average Daily Trading Volume
In general, we continue to believe that a high frequency of trades
or quotes for a particular asset class or investment tends to indicate
that a particular asset class or investment has relatively high
liquidity.\529\ However, as many commenters raised and as discussed
below, low trading frequency and trading volume does not necessarily
indicate low liquidity, particularly for asset classes and investments
that are not exchange-traded.\530\ Also, we note that the frequency of
trades or quotes for a particular asset class or investment is not a
perfect or complete measure of liquidity, and a fund may wish to also
consider trade size in assessing the relationship between trade
frequency and liquidity.\531\ In evaluating the frequency of trades
(and bid and ask quotes) for an asset class or investment, a fund may
wish to generally consider, among other relevant factors, the number of
dealers quoting prices for that asset class or investment, the number
of other potential purchasers and sellers, and dealer undertakings to
make a market in the asset class or investment.
---------------------------------------------------------------------------
\529\ See Proposing Release, supra footnote 9, at section
III.B.2.b (discussing the proposed requirement for a fund to
consider, to the extent applicable, the frequency of trades or
quotes for a particular asset, as well as the asset's average daily
trading volume (regardless of whether the asset is a security traded
on an exchange), in classifying the liquidity of each portfolio
position in a particular asset).
\530\ See infra footnotes 536-538 and accompanying text.
\531\ For example, 100 trades at $100 might or might not signify
greater liquidity than 50 trades at $200, although they are likely
to suggest better liquidity than one trade at $10,000. See Erik
Banks, Liquidity Risk: Managing Funding and Asset Risk (2nd ed.
2013), at 169.
---------------------------------------------------------------------------
High average trading volume also tends to be correlated with
greater liquidity, particularly for exchange-traded asset classes and
investment. In general, high average daily trading volume for a
particular asset class or investment indicates a deep market for that
asset class or investment, which in turn indicates that a fund may be
able to convert its holdings in that asset class or investment to cash
without the conversion (or in some cases, sale or disposition)
significantly changing the market value.\532\ Especially for exchange-
traded asset classes or investments, a fund may wish to consider the
number of days of zero or very low trading volume during the prior
month, year, or other relevant period, as this could indicate
particularly limited liquidity. As one commenter suggested, and we
agree, a fund may wish to consider not only the historical average
trading volume of the asset class or assets in which its invests, but
also whether trading volume is likely to change under different or
stressed market conditions.\533\ High trading volume is not always
indicative of available liquidity for a particular asset class or
investment, however. For example, high trading volumes might be
associated with high selling pressure on the asset class or investment,
and trades at that time may have a high value impact.\534\ Also, as one
commenter suggested, even if a particular asset class or investment
were to exhibit high trading volume, the ability to convert the asset
class or investment to cash without the conversion (or in some cases,
sale or disposition) significantly changing the market value may also
depend on other factors such as investors' appetite for risk and the
perceived ``safety'' of specific securities in ``risk-off'' flight-to-
quality market conditions.\535\
---------------------------------------------------------------------------
\532\ See id.; see also Fidelity FSOC Notice Comment Letter,
supra footnote 69 (``Liquidity management is linked to portfolio
managers' attention to market risks indicated by . . . shrinking
transaction volumes which exacerbate the impact cost for additional
trading'').
We note that double-counting of trades is a potential issue to
consider when assessing average trading volume. Double-counting
occurs because of differences between dealer and auction markets. In
a dealer market, trades are ``double-counted'' because the dealer
buys from person A and then sells to person B. In an auction market,
person A and B trade directly. See, e.g., Anne M. Anderson & Edward
A. Dyl, Trading Volume: NASDAQ and the NYSE, 63 Fin. Analysts J. 79
(May/June 2007), available at http://www.cfapubs.org/doi/abs/10.2469/faj.v63.n3.4693.
\533\ See Interactive Data Comment Letter (suggesting that the
Commission consider requiring a fund to consider the potential daily
trading volume of its portfolio assets instead of, as proposed, the
average daily trading volume of its assets).
\534\ See, e.g., HSBC Comment Letter; see also e.g., Jennifer
Huang & Jiang Wang, Liquidity and Market Crashes, 22 Rev. of Fin.
Stud. 2607 (2009), available at http://rfs.oxfordjournals.org/content/22/7/2607.full (discussing how there can be high selling
pressure (and high volume) along with low liquidity and how this can
create market crashes); Mark Carlson, A Brief History of the 1987
Stock Market Crash with a Discussion of the Federal Reserve
Response, Federal Reserve Board Working Paper 2007-13 (Nov. 2006),
available at http://www.federalreserve.gov/pubs/feds/2007/200713/200713pap.pdf (discussing how the 1987 stock market crash had both
high volume and low liquidity).
\535\ See HSBC Comment Letter.
---------------------------------------------------------------------------
Multiple commenters stressed that, particularly for fixed income
and other typically OTC asset classes and assets, relatively low
trading volume does not necessarily correlate with low liquidity. For
example, many commenters discussed the low turnover of the corporate
bond market, which is driven by factors such as the buy-and-hold nature
of bond investing, the distribution of an issuer's borrowing across
many different bond issues, and the fact that portfolio managers may
deem many bonds to be substitutes for one another based on common
characteristics such as issuer, sector, credit quality, and
maturity.\536\ Commenters argued that, despite the relatively low
turnover that is typical in the corporate bond market, these assets are
commonly considered to be readily tradable at market-clearing
prices.\537\ Commenters made similar arguments about the dynamics of
the municipal bond market, noting that municipal securities' trading
volume is not normally high, particularly during stable financial
periods, but municipal securities (especially those that are investment
grade) are commonly considered to be easily saleable.\538\ We generally
agree with commenters' concerns that the consideration of trading
volume as a liquidity indicator should not by itself imply that low
trading volume necessarily indicates low liquidity. Rather, it may
indicate that other information needs to be assessed to make a
liquidity determination. For asset classes and investments that
typically demonstrate low trading volume, funds may wish to consider
how the other liquidity characteristics of those asset classes and
investments, including but not limited to other guidance factors
discussed in this Release, may affect the time period and value impact
associated with the class's or investment's ability to be converted to
cash. Analysis of capital structure and credit quality of a particular
asset class or investment, as well as bid-ask spreads and maturity/date
of issue, may be particularly useful in considering the liquidity of
investments whose trading volume is normally low.
---------------------------------------------------------------------------
\536\ See, e.g., Nuveen Comment Letter; Vanguard Comment Letter.
\537\ See, e.g., Nuveen Comment Letter; Vanguard Comment Letter.
\538\ See, e.g., GFOA Comment Letter; Nuveen Comment Letter.
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[[Page 82190]]
c. Volatility of Trading Prices
We continue to believe that trading price volatility is potentially
a valuable metric to consider in evaluating an asset class's or
investment's liquidity.\539\ In general, there is an inverse
relationship between liquidity and volatility,\540\ as lack of
liquidity in a particular investment tends to amplify price volatility
for that asset.\541\ Additionally, the Commission understands that
certain funds and fund groups have historically experienced liquidity
disruptions during periods of extreme market volatility, such as the
June 2013 ``taper tantrum'' \542\ and the October 2014 ``flash crash.''
\543\ As one commenter suggested, and we agree, if a fund holds asset
classes or investments that are thinly traded, the fund may wish to
consider volatility of evaluated pricing information in assessing the
liquidity of those asset classes or investments.\544\
---------------------------------------------------------------------------
\539\ See Proposing Release, supra footnote 9, at section
III.B.2.c (discussing the proposed requirement for a fund to
consider, to the extent applicable, the volatility of trading prices
for its portfolio assets, in classifying the liquidity of each
portfolio asset).
\540\ See, e.g., Tarun Chordia, Asani Sarkar & Avanidhar
Subrahmanyam, An Empirical Analysis of Stock and Bond Market
Liquidity, Federal Reserve Bank of New York Staff Reports, No. 164
(Mar. 2003), available at http://www.newyorkfed.org/research/staff_reports/sr164.pdf (finding that unexpected liquidity and
volatility shocks are positively and significantly correlated across
stock and bond markets).
\541\ See, e.g., Prachi Deuskar, Extrapolative Expectation:
Implications for Volatility and Liquidity (Aug. 2007), available at
https://business.illinois.edu/pdeuskar/Deuskar_Extrapolative_Liquidity_Volatility.pdf (``Illiquidity
amplifies supply shocks, increasing realized volatility of prices,
which feeds into subsequent volatility forecasts.''); see also
Fidelity FSOC Notice Comment Letter, supra footnote 69, at 21
(``Liquidity management is linked to portfolio managers' attention
to market risks indicated by . . . increasing market- and security-
specific volatility.'').
\542\ In May 2013, Ben Bernanke, then Chairman of the Federal
Reserve Board, announced that the Federal Reserve may start scaling
back its asset purchase program--in which the Federal Reserve
purchased approximately $85 billion worth of bonds and mortgage-
backed securities each month--sooner than investors expected. This
caused interests rates on fixed income products to spike, and bond
prices to fall dramatically. This market dislocation came to be
known as the ``taper tantrum. See Christopher Condon & Jeff Kearns,
Fed Worried About Triggering Another `Taper Tantrum', Bloomberg
(Oct. 8, 2014), available at http://www.bloomberg.com/news/articles/2014-10-08/fed-worried-about-triggering-another-taper-tantrum-.
\543\ See Joint Staff Report: The U.S. Treasury Market on
October 15, 2014 (July, 13, 2015), available at https://www.treasury.gov/press-center/press-releases/Documents/Joint_Staff_Report_Treasury_10-15-2015.pdf (``On October 15, 2014,
the market for U.S. Treasury securities, futures, and other closely
related financial markets experienced an unusually high level of
volatility and a very rapid round-trip in prices. Although trading
volumes were high and the market continued to function, liquidity
conditions became significantly strained.'').
\544\ See Interactive Data Comment Letter (suggesting that the
Commission consider replacing the proposed ``volatility of trading
prices for the asset'' classification factor with ``volatility of
traded or evaluated pricing information,'' to make this proposed
factor more applicable to fixed income assets and other asset
classes that may be thinly traded).
---------------------------------------------------------------------------
d. Bid-Ask Spreads
Bid-ask spreads--the difference between bid and offer prices for a
particular investment--have historically been viewed as a useful
measure for assessing the liquidity of assets,\545\ and we continue to
believe that a fund may consider this factor useful in classifying the
liquidity of a particular asset class or investment.\546\ The bid-ask
spread of a particular investment is related to the riskiness of that
investment, as well as the length of time that a broker-dealer believes
it will have to hold the investment before selling it.\547\ In general,
high bid-ask spreads for a particular asset class or investment
correlate with a lack of liquidity in that asset class or investment.
For example, when liquidity was significantly constricted during the
2007-2009 financial crisis, bid-ask spreads on U.S. investment grade
bonds were notably elevated.\548\ However, bid-ask spreads alone do not
necessarily provide a comprehensive understanding of an investment's
liquidity. For instance, bid-ask spreads are often constrained by the
increments in which prices are quoted.\549\ Additionally, as one
commenter noted, bid-ask spreads do not take into account the volume
and scale of a portfolio manager's intended buy and sell
transactions.\550\
---------------------------------------------------------------------------
\545\ See, e.g., Michael J. Fleming, Measuring Treasury Market
Liquidity, Federal Reserve Bank of New York Economic Policy Review
(Sept. 2003), available at https://www.newyorkfed.org/medialibrary/media/research/epr/03v09n3/0309flempdf.pdf (providing a literature
review of studies analyzing bid-ask spreads in relation to Treasury
market liquidity); see also Fidelity FSOC Notice Comment Letter,
supra footnote 69, at 21 (``Liquidity management is linked to
portfolio managers' attention to market risks indicated by . . .
heightened market impact costs (as indicated by widening bid/ask
spreads)'').
\546\ See Proposing Release, supra footnote 9, at section
III.B.2.d (discussing the proposed requirement for a fund to
consider, to the extent applicable, its portfolio assets' bid-ask
spreads when assessing its portfolio assets' liquidity).
\547\ See MarketAxess, The MarketAxess Bid-Ask Spread Index
(BASI): A More Informed Picture of Market Liquidity in the U.S.
Corporate Bond Market (2013), available at http://www.marketaxess.com/pdfs/research/marketaxess-bid-ask-spread-index-BASI.pdf (discussing methodology for developing an index that tracks
bid-ask spreads of U.S. corporate bonds).
\548\ See, e.g., Got Liquidity?, supra footnote 452, at 7; see
also Rich Estabrook, Diminished Liquidity in the Corporate Bond
Market: Implications for Fixed Income Investors, Oppenheimer (Mar.
16, 2015), at 1, available at http://www.opco.com/trend-analysis/final_liquidity_report-031615.pdf.
\549\ See, e.g., Michael A. Goldstein & Kenneth A. Kavajecz,
Eighths, Sixteenths, and Market Depth: Changes in Tick Size and
Liquidity Provision on the NYSE, 56 J. Fin. Econ. 125 (2000),
available at https://www.researchgate.net/publication/4978467_Eighths_Sixteenths_and_Market_Depth_Changes_in_Tick_Size_and_Liquidity_Provision_on_the_Nyse (``Using limit order data provided
by the NYSE, we investigate the impact of reducing the minimum tick
size on the liquidity of the market. While both spreads and depths
(quoted and on the limit order book) declined after the NYSE's
change from eighths to sixteenths, depth declined throughout the
entire limit order book as well. The combined effect of smaller
spreads and reduced cumulative limit order book depth has made
liquidity demanders trading small orders better off; however,
traders who submitted larger orders in lower volume stocks did not
benefit, especially if those stocks were low priced.''); Hendrik
Bessembinder, Tick Size, Spreads, and Liquidity: An Analysis of
Nasdaq Securities Trading Near Ten Dollars, 9 J. of Fin.
Intermediation 213 (July 2000), available at http://
www.acsu.buffalo.edu/~keechung/MGF743/Readings/G4.pdf (``There is no
evidence of a reduction in liquidity with the smaller tick size. The
largest spread reductions occur for stocks whose market makers avoid
odd-eighth quotes. This finding provides support for models implying
that changes in the tick size can affect equilibrium spreads on a
dealer market and indicates that the relation between tick size and
market quality is more complex than the imposition of a constraint
on minimum spread widths.'').
\550\ See HSBC Comment Letter.
---------------------------------------------------------------------------
e. Standardization and Simplicity of Asset Class's or Investment's
Structure
We continue to believe that whether an asset class or investment
has a relatively standardized and simple structure is generally
relevant to a fund's evaluation of an asset class's or investment's
liquidity.\551\ Investments that trade OTC with terms set at issuance
such as sizes, maturities, coupons, and payment dates may be relatively
more liquid compared to similarly situated investments without
standardized terms. Standardization can increase liquidity by
simplifying the ability to quote and trade securities, enhancing
operational efficiency to execute and settle trades, and improving
secondary market transparency. Some types of OTC-traded securities
exhibit a relatively high level of standardization, such as government
and agency bonds, futures contracts, and certain swap contracts.
Central clearing of certain OTC-traded securities, which generally
requires the terms of these securities to be highly standardized, has
been associated with an increase in these investments' liquidity, as
measured by factors such as the bid-ask spreads for these investments
and the number of dealers providing quotes for these
[[Page 82191]]
investments.\552\ However, standardization alone may not be indicative
of an investment's liquidity. For example, corporate bond issuers
commonly have large numbers of bonds outstanding, and trading can be
fragmented among that universe of bonds.\553\ However, as discussed
above, we understand that market participants may consider many
corporate bonds to be highly comparable and substitutable from a
liquidity perspective, to the extent that they share common
characteristics such as issuer, sector, credit quality, and
maturity.\554\
---------------------------------------------------------------------------
\551\ See Proposing Release, supra footnote 9, at section
III.B.2.e (discussing the proposed requirement for a fund to
consider, to the extent applicable, the standardization and
simplicity of structure of its portfolio assets when assessing its
portfolio assets' liquidity).
\552\ See, e.g., Yee Cheng Loon & Zhaodong (Ken) Zhong, The
Impact of Central Clearing on Counterparty Risk, Liquidity, and
Trading: Evidence from the Credit Default Swap Market, 112 J. of
Fin. Econ. 91 (Apr. 2014), available at http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2176561 (analyzing the impact of central
clearing on credit default swaps and finding that cleared reference
entities experience an improvement in both liquidity and trading
activity relative to non-cleared entities); Joshua Slive, Jonathan
Witmer & Elizabeth Woodman, Liquidity and Central Clearing: Evidence
from the CDS Market, Bank of Canada Working Paper 2012-38 (Dec.
2012), available at http://www.bankofcanada.ca/wp-content/uploads/2012/12/wp2012-38.pdf (analyzing ``the relationship between
liquidity and central clearing using information on credit default
swap clearing at ICE Trust and ICE Clear Europe,'' and finding that
``the introduction of central clearing is associated with a slight
increase in the liquidity of a contract'' (but noting that the
effects of central clearing on liquidity must be viewed in light of
the fact that the central counterparty chooses the most liquid
contracts for central clearing, consistent with liquidity
characteristics being important in determining the safety and
efficiency of clearing)). But see Manmohan Singh, Collateral,
Netting and Systemic Risk in the OTC Derivatives Market, IMF Working
Paper 10/99 (Apr. 1, 2010), available at https://www.imf.org/external/pubs/cat/longres.cfm?sk=23741.0 (arguing that large
increases in collateral posted for the centrally cleared trades
negatively affect market liquidity given that most large banks will
be reluctant to offload their positions to central counterparties).
\553\ For example, while each of the top ten largest issuers in
the United States had one common equity security outstanding as of
April 2014, these issuers collectively had more than 9,000 bonds
outstanding. See BlackRock, Corporate Bond Market Structure: The
Time for Reform Is Now, Viewpoint (Sept. 2014), at 7, available at
https://www.blackrock.com/corporate/en-mx/literature/whitepaper/viewpoint-corporate-bond-market-structure-september-2014.pdf.
\554\ See supra footnote 536 and accompanying text.
---------------------------------------------------------------------------
f. Maturity and Date of Issue of Fixed Income Securities
We continue to believe that, with respect to the fixed income
investments a fund holds in its portfolio, those investments' maturity,
as well as their date of issue, are significant indicators of their
liquidity.\555\ In general, a fixed income asset trades most frequently
in the time directly following issuance, and its trading volume
decreases in the asset's remaining time to maturity.\556\ Thus ``on-
the-run'' securities (that is, bonds or notes of a particular maturity
that were most recently issued) tend to trade significantly more
frequently than their ``off-the-run'' counterparts (that is, bonds or
notes issued before the most recently issued bond or note of a
particular maturity).\557\ Because high trading volume generally
suggests relatively high liquidity,\558\ a fixed income asset's date of
issuance and maturity, which in turn are generally correlated with the
trading volume of a fixed income asset, together are important
liquidity indicators. We understand, based on staff outreach and
industry knowledge, that remaining time to maturity is a key factor
that fixed income funds commonly consider in assessing the liquidity of
their portfolio positions.
---------------------------------------------------------------------------
\555\ See Proposing Release, supra footnote 9, at section
III.B.2.f (discussing the proposed requirement for a fund to
consider, with respect to fixed income assets, these assets'
maturity and date of issue when assessing their liquidity).
\556\ See, e.g., Sugato Chakravarty & Asani Sarkar, Liquidity in
U.S. Fixed Income Markets: A Comparison of the Bid-Ask Spread in
Corporate, Government and Municipal Bond Markets, Federal Reserve
Board of New York Staff Report No. 73 (Mar. 1999), available at
http://papers.ssrn.com/sol3/papers.cfm?abstract_id=163139.
\557\ The on-the-run phenomenon refers to the fact that, in
fixed income markets, securities with nearly identical cash flows
trade at different yields and with different liquidity. In
particular, most recently issued (i.e., on-the-run) government bonds
of a certain maturity are generally more liquid than previously
issued (i.e., off-the-run or old) bonds maturing on similar dates.
See, e.g., Paolo Pasquariello & Clara Vega, The on-the-run liquidity
phenomenon, 92 J. of Fin. Econ. 1-24 (Apr. 2009), available at
http://webuser.bus.umich.edu/ppasquar/onofftherun.pdf (analyzing the
liquidity differentials of on-the-run and off-the-run U.S. Treasury
bonds and finding, among other things, that on-the-run and off-the-
run liquidity differentials are economically and statistically
significant--showing that on-the-run bonds tend to be more liquid
than their off-the-run counterparts--even after controlling for
certain intrinsic characteristics of the bonds); Michael Barclay,
Terrence Hendershott & Kenneth Kotz, Automation versus
Intermediation: Evidence from Treasuries Going Off the Run, 61 J. of
FIN. 2395 (Oct. 2006), available at http://faculty.haas.berkeley.edu/hender/on-off.pdf (discussing how ``when
Treasury securities go `off the run' their trading volume drops by
more than 90%'').
\558\ See supra section III.C.4.b.
---------------------------------------------------------------------------
g. Restrictions on Trading; Limitations on Transfer
We continue to believe that restrictions on trading certain
investments, as well as limitations on an investment's transfer, may
adversely affect those investments' liquidity.\559\ For example,
although we are replacing existing Commission guidance on identifying
illiquid assets (including the specific factors listed in the Rule 144A
Release regarding the liquidity of a rule 144A security) \560\ with new
regulatory requirements regarding the process for determining that
certain investments are illiquid, we believe that the restricted nature
of a rule 144A security is one factor that generally should be
considered by a fund in evaluating the liquidity of a rule 144A
security.\561\ Regardless of whether a portfolio investment is a
restricted security, it may nevertheless be subject to other
limitations on transfer. For example, for securities that are traded in
certain foreign markets, government approval may be required for the
repatriation of investment income, capital, or the proceeds of sales of
securities by foreign investors.\562\ Portfolio investments furthermore
may be subject to certain contractual limitations on transfer.\563\
Securities subject to transfer limitations in general are less liquid
than securities without such limitations.
---------------------------------------------------------------------------
\559\ See Proposing Release, supra footnote 9, at section
III.B.2.g (discussing the proposed requirement for a fund to
consider restrictions on trading and limitations on transfer in
classifying the liquidity of each portfolio asset).
\560\ See Rule 144A Release, supra footnote 37, at text
following n.62.
\561\ See id. While we are withdrawing the guidance in the Rule
144A Release, including the guidance that boards are responsible for
determining if a security is liquid or illiquid, we note that the
guidance factors discussed in the Rule 144A Release are consistent
with certain of the guidance factors discussed in this Release.
\562\ See, e.g., HSBC Comment Letter; HSBC Global Research,
Emerging Markets Currency Guide 2012 (Dec. 2011), available at
https://www.hsbcnet.com/gbm/attachments/rise-of-the-rmb/currency-guide-2012.pdf?WT.ac=CIBM_gbm_pro_rmbrise_pbx01_On; see also
Liquidity Coverage Ratio Release, supra footnote 520, at section
II.B.3.iv (discouraging banking entities from holding a
disproportionate amount of their eligible highly qualified liquid
assets in locations outside the United States where unforeseen
impediments may prevent timely repatriation of such assets during a
liquidity crisis).
\563\ See, e.g., Stephen H. Bier, Julien Bourgeois & Joseph
McClain, Mutual Funds and Loan Investments, The Investment Lawyer:
Covering Legal and Regulatory Issues of Asset Management, Vol. 22,
No. 3 (Mar. 2015), at 2, available at http://www.dechert.com/files/Uploads/Documents/FSG/Mutual%20Funds%20and%20Loan%20Investments%20-%20The%20Investment%20Lawyer.pdf (``[M]any loans and assignment
trades remain bespoke transactions that require consents from
borrowers or key syndicate members, and loan documents are still
negotiated written documents that require human review. As a result
. . . the mechanics of loan trades and certain trade settlement
times cause funds to carefully monitor liquidity considerations
surrounding loan investments. . . . [In making such determinations,
funds] typically consider factors common to general liquidity
determinations, as well as factors specific to the loan markets,
which can include: (i) The legal limitations on the transferability
or sale of a loan including the requirement to obtain consents from
borrowers or syndicate agents and members prior to assignment; (ii)
the existence of a trading market for the loans and the estimated
depth of the market; (iii) the frequency of trades or quotes for the
loan; (iv) the estimated length of the settlement period; and (v)
the borrower's health.'').
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[[Page 82192]]
5. Liquidity Classification Review Requirement
Under rule 22e-4 as adopted today, a fund would be required to
review its portfolio investments' classifications at least monthly in
connection with reporting the liquidity classification for each
portfolio investment on Form N-PORT, as well as 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.\564\ A fund generally could
classify and review the liquidity classifications of its portfolio
investments according to their asset class; however, the fund must
separately classify and review any investment within an asset class if
the fund or its adviser, after reasonable inquiry, 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 other securities
within that asset class.\565\
---------------------------------------------------------------------------
\564\ See rule 22e-4(b)(1)(ii).
\565\ See rule 22e-4(b)(1)(ii)(A).
---------------------------------------------------------------------------
As discussed in the Proposing Release, the Commission has
previously stated that it ``expects funds to monitor portfolio
liquidity on an ongoing basis to determine whether, in light of current
circumstances, an adequate level of liquidity is being maintained.''
\566\ Some have interpreted this statement to mean that the Commission
does not intend for a fund to reassess the liquidity status of
individual securities on an ongoing basis, but instead to monitor
whether a fund portfolio's overall liquidity profile is appropriate in
light of its redemption obligations.\567\ While we agree that a fund
should monitor the liquidity of its portfolio holistically, we note
that the decreased liquidity of individual portfolio components can
directly affect the ability of a fund to meet its redemption
obligations without significant dilution of remaining investors'
interests in the fund.\568\ We thus believe that specifically requiring
a fund to review the classifications of its portfolio investments made
under rule 22e-4 would reduce the risk that a fund would be unable to
meet its redemption obligations without significant investor dilution.
---------------------------------------------------------------------------
\566\ See Proposing Release, supra footnote 9, at nn.246-248 and
accompanying text (citing Guidelines Release, supra footnote 38, at
section II).
\567\ See id., at n.247 (citing Investment Company Institute,
Valuation and Liquidity Issues for Mutual Funds (Feb. 1997), at 45).
\568\ See, e.g., Third Avenue Temporary Order, supra footnote 12
(``On December 9, 2015, after considering the environment the Fund
was in and the likelihood that incremental sales of portfolio
securities to satisfy additional redemptions would have to be made
at prices that would unfairly disadvantage all remaining
shareholders, the Board determined that the fairest action on behalf
of all shareholders would be to adopt a plan of liquidation.''); see
also Heartland Release, supra footnote 80.
---------------------------------------------------------------------------
As proposed, rule 22e-4 would have required a fund to review its
liquidity classifications on an ongoing basis.\569\ Also, like the
proposed classification requirement, the proposed review requirement
would have required a fund to take into account a list of specified
factors, as the fund determines applicable, in reviewing its portfolio
assets' liquidity.\570\ In the Proposing Release, we stated that a fund
may wish to determine the frequency of ongoing review of portfolio
positions' liquidity classifications based in part on the liquidity of
its portfolio holdings, as well as the timing of its portfolio
acquisitions and turnover.\571\ In addition, we noted in the Proposing
Release that, at a minimum, a fund would review its liquidity
classifications at least monthly in order to accurately report this
information on proposed Form N-PORT.\572\ Proposed rule 22e-4 did not
include provisions that would permit a fund to review its portfolio
assets' liquidity on an asset-class basis.
---------------------------------------------------------------------------
\569\ Proposed rule 22e-4(b)(2)(i).
\570\ Proposed rule 22e-4(b)(2)(ii).
\571\ See Proposing Release, supra footnote 9, at text
accompanying n.252.
\572\ See id., at n.253.
---------------------------------------------------------------------------
We sought comment in the Proposing Release about the proposed
ongoing review requirement. Several commenters suggested that the
Commission adopt a general liquidity classification review requirement,
without incorporating specific factors that a fund would be required to
consider during the course of its review.\573\ One commenter argued
that the frequency of the proposed review requirement was unclear and
recommended that the Commission adopt more specific standards
associated with review frequency.\574\ Multiple commenters expressed
concerns about the potential burden associated with an ``ongoing''
review requirement \575\ and suggested that these concerns could be
mitigated by replacing the proposed requirement to classify the
liquidity of each portfolio position with a ``top-down'' requirement
permitting funds to classify their portfolio assets' liquidity on an
asset-class basis.\576\
---------------------------------------------------------------------------
\573\ See, e.g., CFA Comment Letter; Vanguard Comment Letter.
\574\ See Better Markets Comment Letter.
\575\ See, e.g., Dechert Comment Letter; ICI Comment Letter I;
LSTA Comment Letter; T. Rowe Comment Letter.
\576\ See, e.g., LSTA Comment Letter.
---------------------------------------------------------------------------
We believe that the review requirement we are adopting, together
with the rule provision specifying that a fund would generally be
permitted to review its liquidity classifications with reference to its
holdings' asset classes, advances our goal of requiring funds to
appropriately re-evaluate the liquidity of their portfolio holdings,
while responding to commenters' concerns. As discussed in the Proposing
Release, we understand that some funds currently may not review the
liquidity of their portfolio investments on a continuing basis after
they are acquired.\577\ In particular, we understand that certain funds
may initially determine that certain investments are liquid or illiquid
but will not regularly re-evaluate these initial classifications, even
in light of changing market conditions. We understand that some funds,
on the other hand, currently reassess the liquidity of their portfolio
investment regularly based on market-wide developments, as well as
events affecting particular securities or asset classes.\578\
---------------------------------------------------------------------------
\577\ See Proposing Release, supra footnote 9, at paragraph
accompanying n.250.
\578\ See id., at n.250 and accompanying text; see also ICI
Comment Letter I.
---------------------------------------------------------------------------
Rule 22e-4 as adopted requires a fund to review its liquidity
classifications at least monthly, in connection with reporting its
liquidity classifications monthly on Form N-PORT.\579\ This requirement
responds to the recommendation that the Commission adopt more specific
standards associated with review frequency. Moreover, in order to
determine whether its holdings are consistent with the fund's highly
liquid investment minimum, as well as the rule 22e-4 limitation on
illiquid investments, a fund would have to determine whether its
initial classification determinations have changed based on market
conditions or other developments. Therefore, rule 22e-4 also includes
the requirement for a fund to review its liquidity classifications more
frequently than monthly if changes in relevant market, trading, and
investment-specific considerations are reasonably expected to
materially affect one or more of its investment classifications.\580\
For example, relevant market-wide developments could include changes in
interest rates or other macroeconomic events, market-wide volatility,
market-wide flow changes, dealer inventory or capacity changes, and
extraordinary
[[Page 82193]]
events such as natural disasters or political upheaval.\581\ Asset-
class and investment-specific developments that a fund may wish to
consider include, among others, regulatory changes affecting certain
asset classes and corporate events (such as bankruptcy, default,
pending restructuring, or delisting, as well as reputational events).
We believe that the rule's requirement that a fund review its liquidity
classifications at least monthly, as well as more frequently in light
of market-related and other changes that could materially affect a
fund's investment classifications, will provide funds with more
direction as to the frequency of their classification reviews, as well
as circumstances that could lead to a classification review, than the
proposed ongoing review requirement.
---------------------------------------------------------------------------
\579\ See rule 22e-4(b)(1)(ii).
\580\ See id.
\581\ See, e.g., 2014 Fixed Income Guidance Update, supra
footnote 94.
---------------------------------------------------------------------------
We believe that the review requirement we are adopting, as opposed
to the proposed ongoing review requirement, permits funds to tailor
their review of liquidity classifications in light of the liquidity
character of a fund's portfolio investments. The modifications to rule
22e-4 clarify that we do not expect a fund to constantly reassess all
of its portfolio investments' liquidity. Also, the review requirement
that we are adopting would not require a fund to consider a detailed
list of specific factors in the course of conducting its liquidity
classification reviews. Instead, as discussed above, it would require a
fund to take into account ``relevant market, trading, and investment-
specific considerations'' in reviewing its investments' liquidity.\582\
---------------------------------------------------------------------------
\582\ See rule 22e-4(b)(1)(ii).
---------------------------------------------------------------------------
Finally, the review requirement that we are adopting, like the rule
22e-4 classification requirement, would permit a fund to generally
review its portfolio investments' liquidity according to their asset
class (provided that the fund must identify, and separately review, any
investment within an asset class that the fund determines should be
reviewed separately based on its liquidity characteristics).\583\ We
believe that this approach will permit funds to increase their
efficiency in classifying and reviewing portfolio investments'
liquidity.
---------------------------------------------------------------------------
\583\ See rule 22e-4(b)(1)(ii)(A).
---------------------------------------------------------------------------
6. Liquidity Classification Reporting and Disclosure Requirements
In connection with the liquidity classification requirement of rule
22e-4, we are requiring, largely as proposed and with certain
modifications in response to comments, a fund to report the liquidity
classification assigned to each of the fund's portfolio investments on
Form N-PORT.\584\ Position-level liquidity classification information
will be reported to the Commission in a structured data format on a
confidential basis rather than released every three months to the
public.\585\ Under the final rules, a fund will also be required to
publicly report on Form N-PORT the aggregated percentage of its
portfolio investments that falls into each of the four liquidity
classification categories outlined above.\586\ This aggregate
information will be disclosed to the public only for the third month of
each fiscal quarter with a 60-day delay. While we acknowledge that
liquidity classification determinations may be to some extent
subjective and that such information reported on Form N-PORT may be
non-standardized, we believe that, on balance, our staff, investors,
and other potential users would benefit from the information that will
be reported on Form N-PORT that currently may not be reported or
disclosed by funds. We believe that this greater transparency about
liquidity at the fund-level will provide our staff, investors, and
other potential users with a helpful picture of the general liquidity
characteristics of funds and help them better understand the liquidity
risks associated with a particular fund. We also believe that this
information will help investors make more informed investment
decisions.
---------------------------------------------------------------------------
\584\ Rather than report the liquidity classification among six
categories as under the proposal, funds will be required to report
liquidity classifications among four liquidity categories, which may
be based on asset type to the extent discussed above. See Item C.7.
of Form N-PORT. We have modified the numbering convention for items
within Form N-PORT from the proposal to be consistent with Form N-
PORT as adopted in the Investment Company Reporting Modernization
Adopting Release.
\585\ See General Instruction F of Form N-PORT.
\586\ Item B.8.a. of Form N-PORT. We note that such reporting is
designed to serve as a snapshot of a fund's liquidity on the last
business or calendar day of the month. See rule 30b1-9 under the
Investment Company Act (requiring reporting on Form N-PORT to be
current as of the last business day, or last calendar day, of the
month). Accordingly, the aggregate percentage of portfolio
investments in each of the four liquidity classification categories
need not reflect pending transactions, but instead should reflect
the balance of investments in each category on the last business or
calendar day of the month.
---------------------------------------------------------------------------
As part of this public disclosure, a fund would publicly disclose
the percentages of its highly liquid investments that are segregated to
cover, or pledged to satisfy margin requirements in connection with,
the fund's derivatives transactions that the fund has classified in the
moderately liquid, less liquid, and illiquid investments classification
categories in light of the requirement in rule 22e-4 that the liquidity
classification cover each of the fund's derivatives transactions,
discussed above.\587\ This derivatives transactions information will
also be made public for the third month of each fiscal quarter with a
60-day delay.
---------------------------------------------------------------------------
\587\ Item B.8.b. of Form N-PORT. This derivatives transactions
reporting requirement corresponds to the modification in rule 22e-
4(b)(1)(ii)(C), discussed above.
---------------------------------------------------------------------------
Most commenters opposed the proposed Form N-PORT reporting
requirement, and particularly objected to having position-level
liquidity information reported on Form N-PORT made public.\588\ We
believe that the additions to Form N-PORT adopted today in this Release
address many of these concerns. We discuss these additions, the
comments we received on the proposal, as well as modifications we made
to the proposal in response to comments, in more detail below.
---------------------------------------------------------------------------
\588\ See, e.g., Cohen & Steers Comment Letter; NYC Bar Comment
Letter; SIFMA Comment Letter I; Wellington Comment Letter.
---------------------------------------------------------------------------
a. Reporting Liquidity Classification of Portfolio Investments
We proposed to require a fund to report on Form N-PORT the
liquidity classification of each of the fund's positions (or portions
of a position) in a portfolio asset using the proposed classification
system of rule 22e-4.\589\ As discussed above, most commenters opposed
the proposed classification regime, and many offered varied
classification alternatives for fund liquidity risk management and
reporting purposes. As discussed previously, we are today adopting a
liquidity classification requirement under rule 22e-4 based on a
``days-to-cash'' framework as proposed, but with a number of
modifications informed by commenter recommendations that we believe
address many commenters' concerns about the classification process
itself.
---------------------------------------------------------------------------
\589\ See Proposing Release, supra footnote 9, at section
III.G.2.a.
---------------------------------------------------------------------------
A number of commenters supported reporting liquidity
classifications to the Commission on Form N-PORT, provided that it was
not publicly disclosed.\590\ For example, one
[[Page 82194]]
commenter expressed support for reporting position-level liquidity
classifications to the Commission, noting that the Commission should
have the data it needs to monitor fund holdings and liquidity
determinations, examine potential outliers, and, if an unexpected
market event occurs (e.g., the default of a significant institution),
quickly assess the potential impact on mutual funds it supervises.\591\
Another commenter expressed the belief that the proposed liquidity
classifications data could be appropriate for Commission oversight
purposes.\592\
---------------------------------------------------------------------------
\590\ See, e.g., Dechert Comment Letter; Interactive Data
Comment Letter; J.P. Morgan Comment Letter; Nuveen Comment Letter.
Some commenters suggested that the Commission evaluate reported
classification data for a period of time to determine whether the
information is appropriate for public disclosure. See BlackRock
Comment Letter; Fidelity Comment Letter; SIFMA Comment Letter III.
\591\ See J.P. Morgan Comment Letter.
\592\ See State Street Comment Letter.
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On the other hand, a few commenters objected to reporting liquidity
classifications, as proposed, even if such information is disclosed
only to the Commission.\593\ Some commenters stated that there is
limited utility in the proposed classification information for the
Commission since the information would be subjective and methodology-
specific, which would lead to results that would preclude comparisons
across funds, limiting the utility of this information for the
Commission's monitoring of industry-wide data.\594\ In addition, one
commenter expressed concerns about the security of sensitive
information filed with the Commission due to recent high-profile
cybersecurity breaches both in the governmental and private
sectors.\595\
---------------------------------------------------------------------------
\593\ See Federated Comment Letter; Fidelity Comment Letter;
Invesco Comment Letter; SIFMA Comment Letter I.
\594\ See, e.g., BlackRock Comment Letter; Fidelity Comment
Letter; Wellington Comment Letter.
\595\ See Invesco Comment Letter.
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We continue to believe that requiring funds to report the liquidity
classification of their portfolio investments is vital to our ongoing
monitoring and oversight efforts. A key goal of the rulemaking is to
allow us to monitor funds' liquidity profiles (both on a fund-by-fund
basis and across funds) over time, and respond as appropriate. Absent
the required reporting on Form N-PORT, our ability to engage in such
efforts would be limited and less efficient. We believe that the
changes made to the classification system discussed above should serve
to mitigate commenters' concerns about the difficulties of making
comparisons across the industry, in light of the reduced number of
categories for classification. We recognize that there is still likely
to be variation between funds in how they classify certain asset
classes and investments, and believe that despite any variations, this
liquidity information will be useful and valuable to us. We will be
able to identify different fund liquidity classification practices, and
use that information to gain insight into how different funds view
liquidity in the market, and whether there are any identifiable
liquidity concerns. We also note that despite any concerns about
variation of practices across funds limiting comparability, we expect
that the reported information will allow us to generally monitor
specific funds' liquidity on a consistent basis across time, and
identify how their views of the liquidity of their investments change.
We believe that such information will assist us in better assessing
liquidity risk in the open-end fund industry, which can inform our
policy and guidance. We also believe that this information will assist
us in monitoring for compliance with rule 22e-4 and identifying
potential outliers in fund liquidity classifications for further
inquiry, as appropriate. We recognize that liquidity classifications,
similar to valuation- and pricing-related matters, inherently involve
judgment and estimations by funds. We also understand that the
liquidity classification of an asset class or investments may vary
across funds depending on the facts and circumstances relating to the
funds and their trading practices.\596\ We do not believe that data
based on estimations of market conditions on a fund-by-fund basis is
uninformative or of limited utility because of the information's
sometimes fund-specific, subjective nature.\597\ Rather, we believe
that even with potential variances in determinations, the liquidity
information reported will be informative to the Commission.
Furthermore, we believe that members of the fund industry are generally
in the best position to provide current information on the conditions
of fund liquidity since they are in the markets every day trading
securities and observe how markets are evolving and related liquidity
characteristics are changing.
---------------------------------------------------------------------------
\596\ See, e.g., Comment Letter of the Investment Company
Institute on Investment Company Reporting Modernization Release
(Aug. 11, 2015) (``These [liquidity] judgments may differ among
personnel and certainly among fund complexes.''); Comment Letter of
Invesco Advisers, Inc. on Investment Company Reporting Modernization
Release (Aug. 11, 2015) (``Invesco and other fund complexes could
reasonably differ in their assessments of the liquidity of a
particular security, even though both complexes have a sound method
for determining liquidity and follow their own reasonable
procedures.'').
\597\ See supra footnote 594 and accompanying text.
---------------------------------------------------------------------------
In sum, we believe that the modified reporting requirements on Form
N-PORT will provide the Commission with meaningful data concerning the
liquidity of portfolio investments across the fund industry and at the
same time lessen burdens on funds classifying and reporting liquidity
information (compared to the proposal). Accordingly, we are adopting
the requirement for funds to report the liquidity classification of
their portfolio investments to the Commission.
b. Non-Public Disclosure of Liquidity Classification Information
Reported on Form N-PORT
We proposed that liquidity classification information reported on
Form N-PORT at the portfolio position level be disclosed to the public
for the third month of each fiscal quarter with a 60-day delay. One
commenter expressed general support for regulatory initiatives aimed at
improving transparency.\598\ Several commenters expressed support for
public disclosure of liquidity information if the framework for
classification was modified from the proposed six-category liquidity
classification framework to alternative frameworks proposed by
commenters that generally measured the liquidity of portfolio positions
based on asset type and included less classification categories.\599\
---------------------------------------------------------------------------
\598\ See Interactive Data Comment Letter.
\599\ See, e.g., Charles Schwab Comment Letter; FSR Comment
Letter; Nuveen Comment Letter; Vanguard Comment Letter.
---------------------------------------------------------------------------
On the other hand, most commenters opposed the proposed public
disclosure of the liquidity classification. Some commenters expressed
concerns that the value to the public of the position-level liquidity
classification information on Form N-PORT, as proposed, would be
limited.\600\ Many other commenters expressed concerns that the public
disclosure of the position-level liquidity classification information
could be potentially misleading to investors for various reasons. For
example, many commenters contended that, while the position-by-position
information reported would be subjective, the numeric days-to-
settlement presentation proposed on Form N-PORT could imply a false
sense of precision of the data to
[[Page 82195]]
fund investors.\601\ Many of these commenters also argued that
providing subjective, position-level liquidity classification
information to the public could potentially result in misleading
comparisons across funds,\602\ with some commenters noting that such
comparisons could disadvantage certain funds over others.\603\ While
reports on Form N-PORT would be submitted to the Commission within 30
days after month end, some commenters voiced concerns that the
liquidity data presented on Form N-PORT would be stale for the public
given that the reports, as proposed, would be available every third
month of a fund's fiscal quarter with a 60-day delay, adding to the
risk of misleading investors about the real-time state of a portfolio's
liquidity.\604\
---------------------------------------------------------------------------
\600\ See, e.g., Better Markets Comment Letter (expressing
concerns that the proposal's three-day liquid asset minimum and 15%
standard assets are determined by the fund and that the liquidity
classifications reported on Form N-PORT would be stale information
for the public); Morningstar Comment Letter (also stating concerns
that the information available to the public under the proposal
would be stale and expressing the belief that investors could find
it difficult to compare the liquidity characteristics of portfolios
from different funds).
\601\ See, e.g., Dechert Comment Letter; Eaton Vance Comment
Letter I; Federated Comment Letter; LSTA Comment Letter; Morningstar
Comment Letter.
\602\ See, e.g., BlackRock Comment Letter; IDC Comment Letter;
J.P. Morgan Comment Letter; Voya Comment Letter.
\603\ See, e.g., BlackRock Comment Letter; IDC Comment Letter;
ICI Comment Letter I; Wellington Comment Letter.
\604\ See, e.g., FSR Comment Letter; LSTA Comment Letter;
Morningstar Comment Letter (noting that given public disclosure on
N-PORT would be provided infrequently, the information might well be
very out of date when an investor reviews it, thereby providing
little benefit to investors); NYC Bar Comment Letter.
---------------------------------------------------------------------------
Many commenters also expressed concerns that public disclosure of
the proposed position-level liquidity classification information would
ultimately harm fund shareholders and the fund market for a variety of
reasons. Some commenters argued that public reporting would facilitate
predatory trading practices, particularly during periods of liquidity
stress, ultimately harming fund investors.\605\ Commenters expressed
the belief that public reporting of liquidity classifications at the
position-level exacerbates these concerns, noting, for example, that in
the event a fund experiences a liquidity issue, public information
about its portfolio-level liquidity classifications may expose the fund
to predatory trading.\606\ In addition, several commenters expressed
concern that public reporting of position-level liquidity
classifications could be harmful to the fund market, arguing that such
reporting would incentivize homogenized liquidity determinations and
comparative liquidity ``ratings'' from third-party service
providers,\607\ as well as ``window dressing'' at period ends prior to
disclosure, increasing the potential for systemic risks in the fund
industry. \608\ Other commenters suggested that the Commission evaluate
reported classification data for a period of time to determine whether
the information is appropriate for public disclosure.\609\
---------------------------------------------------------------------------
\605\ See BlackRock Comment Letter (stating that publicly
available position-level data exacerbated Third Avenue's troubles as
other market participants knew of the holdings of the Focused Credit
Fund and used that information to the detriment of the fund). See
also e.g., Federated Comment Letter; ICI Comment Letter I; SIFMA
Comment Letter I; Voya Comment Letter.
\606\ See, e.g., SIFMA Comment Letter I.
\607\ See, e.g., Charles Schwab Comment Letter; Wellington
Comment Letter; Comment Letter of Wellington Management Company LLP
(June 10, 2016) (``Wellington Comment Letter II''); Wells Fargo
Comment Letter.
\608\ See, e.g., Dechert Comment Letter; LSTA Comment Letter;
NYC Bar Comment Letter; Oppenheimer Comment Letter.
\609\ See, e.g., BlackRock Comment Letter; Fidelity Comment
Letter; SIFMA Comment Letter I.
---------------------------------------------------------------------------
While many of these commenters objected to the proposed position-
level public disclosure of liquidity classifications, several
commenters did not object to making more aggregated portfolio-level
disclosure of liquidity data available to the public.\610\ These
commenters suggested that, while position-level liquidity data may pose
concerns as discussed above, providing the public a portfolio-level
``roll up'' of the liquidity levels of the fund may provide useful data
and would be unlikely to raise the same kind of issues.\611\
---------------------------------------------------------------------------
\610\ See, e.g., Nuveen Comment Letter; T. Rowe Comment Letter.
\611\ See, e.g., Nuveen Comment Letter; T. Rowe Comment Letter.
---------------------------------------------------------------------------
We recognize that the level of position-level detail necessary for
the Commission and our staff to effectively monitor fund liquidity may
not be necessary for other users. We understand that some data
collectors would prefer to use information reported on Form N-PORT
proposed under the Investment Company Reporting Modernization proposal
(which we are adopting concurrently), such as monthly portfolio
holdings data, rather than the classification information proposed in
the liquidity proposal.\612\ Furthermore, we understand that for many
investors, the proposed specific position-level liquidity data would be
likely unnecessarily detailed, and that aggregated or ``rolled up''
portfolio-level information about fund liquidity may be more easily
understandable and usable. As discussed below, such aggregated
information will likely result in more user friendly and digestible
portrayals of fund liquidity, and at the same time we expect will avoid
many of the potential harms suggested by commenters that might result
from position-level disclosure to the public. Such a layered reporting
and disclosure regime should allow the Commission and investors each to
access the liquidity information likely most useful for their purposes.
---------------------------------------------------------------------------
\612\ See Morningstar Comment Letter.
---------------------------------------------------------------------------
We also appreciate the limitations and subjectivity of the
liquidity classification process, and thus understand the risks of
investors potentially giving too much weight to a fund manager's
individual liquidity classification choices. The classification of
portfolio investments at the position-level under the days-to-cash
framework involves a number of assumptions and methodologies that could
result in classifications that vary from fund to fund. As a result, the
liquidity classification information reported for the same or similar
asset classes and investments could vary because of complex differences
in methodologies and assumptions that may not be reported on Form N-
PORT nor easily explained to investors but would be available to the
Commission in inspections.\613\
---------------------------------------------------------------------------
\613\ A fund has the option of providing explanatory notes
related to its filing to explain any of its methodologies, including
related assumptions, in Part E of Form N-PORT. See Instruction G to
Form N-PORT.
---------------------------------------------------------------------------
We appreciate the concerns raised by commenters that reporting
publicly position-level data could imply a false sense of precision
about the liquidity profile of a fund and that, given the delay in the
public reporting of portfolio-level classification information (60 days
after quarter-end), the position-level information will likely be out
of date when reviewed by investors. While we can take these potential
variances in liquidity classifications of assets into account in
evaluating and using the data for the Commission's purposes in
observing potential trends in liquidity profiles across the fund
industry, it may be more difficult to explain them to investors.
Furthermore, the Commission would receive portfolio-level
classification information within 30 days of month-end, thereby
increasing the utility of the classification information for Commission
purposes. We expect that providing only aggregated liquidity
classification information on the funds' portfolio assets publicly may
mitigate some of these concerns. This level of detail should
appropriately focus investors on the fund's general liquidity profile
and general trends in fund liquidity rather than individual security-
level liquidity decisions, in light of the concerns discussed above.
Some commenters also raised concerns that public reporting of
[[Page 82196]]
liquidity classifications at the position level could potentially
expose investors to harm, including, for example, potentially exposing
a fund to predatory trading, particularly during periods of liquidity
stress.\614\ We believe, however, that the aggregated public disclosure
on Form N-PORT once each quarter with a 60-day lag would alleviate
these predatory trading concerns given that those engaged in predatory
trading would not have information about a fund's own assessment of its
liquidity characteristics in real-time and would not have the detailed
position-level information in real time necessary to pursue such
strategies.
---------------------------------------------------------------------------
\614\ See, e.g., ICI Comment Letter; Cohen and Steers Comment
Letter; Dechert Comment Letter; Nuveen Comment Letter.
---------------------------------------------------------------------------
For these reasons, we find that it is neither necessary nor
appropriate in the public interest or for the protection of investors
to make liquidity classification information for each portfolio
investment publicly available.\615\ We also are adopting amendments to
Form N-PORT to require a fund to publicly disclose the aggregated
percentage of its portfolio assets representing each of the four
classification categories outlined in Form N-PORT and related rule 22e-
4,\616\ as discussed in more detail below. We believe that providing
liquidity classification data attributable to each portfolio investment
to the Commission and fund-level data to investors is an efficient
approach to present liquidity information in a manner that both
satisfies the Commission's need for position-level liquidity data for
its regulatory oversight purposes and provides useful fund liquidity
information to investors.
---------------------------------------------------------------------------
\615\ See section 45(a) of the Investment Company Act, which
requires information in investment company forms to be made
available to the public, unless we find that public disclosure is
neither necessary nor appropriate in the public interest or for the
protection of investors. See also General Instruction F of Form N-
PORT.
\616\ See Item B.8. of Form N-PORT.
---------------------------------------------------------------------------
In addition, the Commission recognizes the importance of sound data
security practices and protocols for non-public information, including
information that may be competitively sensitive. The Commission has
substantial experience with storage and use of non-public information
reported on Form PF and delayed public disclosure of information on
Form N-MFP (although the Commission no longer delays public disclosure
of reports on Form N-MFP), as well as other non-public information that
the Commission handles in its ordinary course of business. Commission
staff is carefully evaluating the data security protocols that will
apply to non-public data reported on Form N-PORT in light of the
specific recommendations and concerns raised by commenters. Drawing on
its experience, the staff is working to design controls and systems for
the use and handling of Form N-PORT data in a manner that reflects the
sensitivity of the data and is consistent with the maintenance of its
confidentiality.\617\ In advance of the compliance date, we expect that
the staff will have reviewed the controls and systems in place for the
use and handling of non-public information reported on Form N-PORT.
---------------------------------------------------------------------------
\617\ See Reporting by Investment Advisers to Private Funds and
Certain Commodity Pool Operators and Commodity Trading Advisors on
Form PF, Investment Advisers Act Release No. 3308 (Oct. 31, 2011)
[76 FR 71228 (Nov. 16, 2011)]. We recognize that there are
differences between the N-PORT reporting requirements and the Form
PF reporting requirements, such as frequency, granularity, and
registration status, and our recognition of these differences guides
our evaluation of appropriate measures for preservation of data
security for reported information.
---------------------------------------------------------------------------
c. Public Fund-Level Aggregate Liquidity Profile Reporting
As previously discussed, we are adopting, with modifications, the
proposed requirement that funds report to the Commission on a non-
public basis the liquidity classification assigned to each portfolio
position on Form N-PORT. Some commenters expressed concerns that the
value to the public of the position-level liquidity classification
information on Form N-PORT, as proposed, would be limited.\618\ Other
commenters recommended that, as an alternative to the proposal, the
Commission make available to the public a general assessment of the
liquidity of the portfolio at the fund level, rather than the
individual security level,\619\ with more detailed information,
including the fund's assessment of the liquidity of each asset at the
individual security level, provided to the Commission but kept
confidential.\620\
---------------------------------------------------------------------------
\618\ See, e.g., Better Markets Comment Letter; Morningstar
Comment Letter.
\619\ See, e.g., Dechert Comment Letter; Federated Comment
Letter; LSTA Comment Letter; NYC Bar Comment Letter.
\620\ See, e.g., SIFMA Comment Letter I; Charles Schwab Comment
Letter.
---------------------------------------------------------------------------
We appreciate these comments and recognize that position-level
liquidity classification data, while valuable for Commission purposes,
may be of limited use for everyday investors. We find persuasive
commenters' recommendations to provide the public with a general
assessment of the liquidity of a portfolio at the fund level as an
approach to provide everyday investors useful information on fund
liquidity. As a result, we are adopting amendments to Form N-PORT to
require a fund to publicly report for the third month of each fiscal
quarter with a 60-day delay the aggregate percentage of its portfolio
representing each of the four classification categories outlined in
Form N-PORT and related rule 22e-4.\621\ For purposes of this reporting
item, a fund would report the aggregate percentage of investments that
are assets in each liquidity category compared to total portfolio
investments that are assets (not including liabilities) of the
fund.\622\
---------------------------------------------------------------------------
\621\ See Item B.8.a. of Form N-PORT.
\622\ See id.
---------------------------------------------------------------------------
In order to avoid misleading investors about the actual
availability of highly liquid investments to meet redemptions, a fund
also will be required to publicly report on Form N-PORT the percentage
of its highly liquid investments that it has segregated to cover, or
pledged to satisfy margin requirements in connection with, derivatives
transactions that are classified as moderately liquid, less liquid, or
illiquid investments.\623\ As discussed above, we proposed to require a
fund to consider the relationship of an asset to another portfolio
asset in classifying the liquidity of its portfolio assets reported on
Form N-PORT and to consider guidance that a fund should classify the
liquidity of assets segregated to cover derivatives obligations using
the liquidity of the derivative instruments such assets are
covering.\624\ One commenter suggested that the Commission add an item
to the Schedule of Portfolio Investments on Form N-PORT that permits a
fund to note whether an asset (or portion thereof) is encumbered or
linked to other assets as of the reporting date.\625\ Another commenter
suggested that the Commission require funds to assign liquidity
classifications to cover assets on an aggregate portfolio basis in
amounts corresponding to the aggregate amount of derivatives exposure
in each liquidity category.\626\
---------------------------------------------------------------------------
\623\ See Item B.8.b. of Form N-PORT; see also supra section
III.C.3.c.
\624\ See Proposing Release, supra footnote 9, at section
III.B.2; see also supra section III.C.3.c.
\625\ See ICI Comment Letter I; see also supra section
III.C.3.c.
\626\ See Dechert Comment Letter; see also supra section
III.C.3.c.
---------------------------------------------------------------------------
In consideration of the commenters' recommendations, we believe
that our modification to the proposal to require a fund to report
publicly the percentage of the fund's highly liquid investments that
are segregated to cover, or pledged to satisfy margin requirements in
connection with, the fund's derivatives
[[Page 82197]]
transactions that are classified in each liquidity category strikes an
appropriate balance between providing investors with useful information
about the impact of derivatives coverage obligations on the percentage
of a fund's highly liquid investments and lessening operational burdens
associated with classifying investments. Since the public will only
receive asset liquidity classification information on an aggregate
level and only the Commission will receive liquidity classifications on
an investment-by-investment basis, we believe that the suggested
alternative to add an item to the Schedule of Portfolio Investments on
Form N-PORT linking an asset encumbered to other assets in connection
with derivatives transactions would not be a helpful means to inform
investors about the connection between derivatives obligations and the
availability of highly liquid investments to meet redemptions. We
believe that without public reporting of the percentage of a fund's
highly liquid investments that are segregated to cover, or pledged to
satisfy margin requirements in connection with, a fund's derivatives
transactions that are not themselves highly liquid investments, the
reported percentage of a fund's highly liquid investments could be
potentially misleading to investors if a portion of highly liquid
investments are not available to meet redemptions due to derivatives
transactions obligations.
Overall, we continue to believe that investors currently have
limited information about the liquidity of fund investments and would
benefit from enhanced information to evaluate funds and assess the
potential for returns and risks of a particular fund. We expect that
many investors will use liquidity reporting information to better
understand the liquidity risks associated with a particular fund for
purposes of making more informed investment decisions and will benefit
from aggregate information about a fund's overall liquidity. Moreover,
we believe that requiring a fund to publicly disclose only the
aggregate percentage of its portfolio assets representing each of the
four classification categories balances commenters' concerns about
certain adverse effects that could arise from public reporting of
detailed portfolio liquidity information with investors' need for
improved information about funds' liquidity risk profiles.
d. Illiquid Investments
As discussed above, rule 22e-4, as adopted, combines a fund's
illiquid investment determinations with the general liquidity
classification framework reported on Form N-PORT.\627\ In the Proposing
Release, in connection with the codification of the 15% guideline that
an open-end fund may not invest in the aggregate more than 15% of its
net assets in ``illiquid securities,'' we proposed to require funds to
report on Form N-PORT whether each portfolio asset is a ``15% standard
asset,'' as defined under the proposal,\628\ in addition to reporting
the liquidity of each of the fund's positions (or portions of a
position) in a portfolio asset using six proposed categories.\629\ One
commenter opposed requiring reporting of the 15% standard asset at the
individual portfolio asset level, raising concerns that public
disclosure could have adverse effects on funds.\630\ Another commenter
opposed reporting of the 15% standard asset at the individual portfolio
asset level if publicly disclosed in addition to the proposed six
liquidity classification categories, stating that the distinction
between the two pieces of data would make sense to industry experts but
would be confusing and potentially misleading to typical
investors.\631\
---------------------------------------------------------------------------
\627\ See supra section III.C.2.d.
\628\ See Proposing Release, supra footnote 9, at section
III.G.2.b.
\629\ See Proposing Release, supra footnote 9, at section
III.G.2.a.
\630\ See Cohen & Steers Comment Letter.
\631\ See Federated Comment Letter.
---------------------------------------------------------------------------
After considering these comments, we agree that presenting to the
public liquidity classification information and the 15% standard asset
designation separately could potentially confuse investors. As
discussed in more detail in section III.C previously, we believe that
it is more appropriate to harmonize the rule 22e-4 limit on illiquid
investments, referred to as 15% standard assets under the proposal,
with the rule's broader liquidity classification requirement by
incorporating an illiquid investment category into the classification
requirement. Likewise, we believe that this harmonization should be
reflected in reports on Form N-PORT. Thus, we are adopting, modified
from the proposal, an illiquid investment category into Form N-PORT
that corresponds with rule 22e-4's broader classification
requirement.\632\ By doing this, a fund's exposure to illiquid
investments may be viewed as part of the fund's overall liquidity
profile in a more clear and concise manner. Furthermore, we are
persuaded by some of the concerns raised by commenters regarding the
unintended adverse effects that public disclosure of illiquid
investment information on the portfolio position level could have on
funds and fund investors. As adopted, liquidity classification
information reported on the portfolio position level will be non-public
on Form N-PORT, as discussed in more detail above.
---------------------------------------------------------------------------
\632\ See Item C.7. of Form N-PORT.
---------------------------------------------------------------------------
We expect to use this information to monitor fund compliance with
the prohibition of acquiring illiquid investments if the fund would
have invested more than 15% of its net assets in illiquid investments
that are assets and analyze liquidity trends in the fund industry.
Overall, we believe that maintaining this information on illiquid
investments as part of the liquidity classification information
reported on Form N-PORT will provide the Commission with meaningful
data, including information regarding exposure to illiquid investments
across the fund industry.
D. Highly Liquid Investment Minimum
Today we are adopting a requirement that each fund determine its
``highly liquid investment minimum,'' or the minimum amount of the
fund's net assets that the fund invests in highly liquid investments
that are assets.\633\ In determining its highly liquid investment
minimum, a fund will be required to consider the factors the fund also
has to consider, as applicable, in assessing its liquidity risk under
rule 22e-4.\634\ Additionally, in determining whether a fund is meeting
its highly liquid investment minimum, the fund will look only to its
investments that are assets of the fund.\635\ Rule 22e-4 as adopted
today also requires a fund to adopt and implement policies and
procedures for responding to a shortfall in a fund's highly liquid
investments below its highly liquid investment minimum.\636\ These
policies and procedures must include reporting to the fund's board of
directors, no later than the board's next regularly scheduled meeting,
regarding any shortfall of the fund's highly liquid investments
compared to its minimum. A fund is required to report to its board
[[Page 82198]]
within one business day, and submit a non-public report to the
Commission, if its highly liquid investment minimum shortfall lasts
more than seven consecutive calendar days.\637\ A fund's board of
directors is not normally required to specifically approve the fund's
highly liquid investment minimum, although during a time that a fund's
highly liquid investments are below the fund's determined minimum
level, a fund's highly liquid investment minimum can be changed only
with board approval.\638\ Additionally, a discussion of the fund's
minimum must be included in the written annual report to the board on
the adequacy and effectiveness of the fund's liquidity risk management
program. Funds whose portfolio assets consist primarily of highly
liquid investments, as well as In-Kind ETFs, are not subject to the
highly liquid investment minimum requirement.\639\
---------------------------------------------------------------------------
\633\ Rule 22e-4(a)(7). Rule 22e-4(a)(7) refers to highly liquid
investments that are ``assets'' to make clear that when evaluating
whether a fund is meeting its highly liquid investment minimum, the
fund should look to its investments with positive values. Highly
liquid investments that have negative values should not be netted
against highly liquid investments that have positive values when
calculating whether the fund is meeting its highly liquid investment
minimum. Thus, only highly liquid investments that have positive
values (i.e., ``assets'') should be used in the numerator. Cf. infra
footnote 744 (discussing the use of the term ``assets'' in the 15%
limit on illiquid investments).
\634\ Rule 22e-4(b)(1)(iii)(A)(1).
\635\ Rule 22e-4(a)(7).
\636\ Rule 22e-4(b)(1)(iii)(A)(3).
\637\ Id. See also Item D.1 of new Form N-LIQUID.
\638\ Rule 22e-4(b)(1)(iii)(A)(1).
\639\ Rule 22e-4(b)(1)(iii)(A); see also rule 22e-4(a)(5)
(excluding money market funds and In-Kind ETFs from the definition
of ``fund'').
---------------------------------------------------------------------------
As described in more detail below, this requirement is a
modification of the proposed ``three-day liquid asset minimum,'' which
also would have required a fund to determine the percentage of the
fund's net assets to be invested in relatively liquid assets (under the
proposal, ``three-day liquid assets,'' or cash and any asset
convertible to cash within three business days at a price that does not
materially affect the value of that asset immediately prior to
sale).\640\ In determining its three-day liquid asset minimum, the
proposed rule would have required a fund to consider the factors the
fund would have to consider, as applicable, in assessing its liquidity
risk under rule 22e-4.\641\ Under the proposal, a fund would have been
prohibited from acquiring any asset other than a three-day liquid asset
if, after acquisition, the fund would hold fewer three-day liquid
assets than the percentage specified under its three-day liquid asset
minimum.\642\ Also under the proposal, a fund's board would have had to
approve the fund's three-day liquid asset minimum and any changes
thereto.\643\
---------------------------------------------------------------------------
\640\ Proposed rule 22e-4(a)(8); proposed rule 22e-
4(b)(2)(iv)(A)-(C).
\641\ Proposed rule 22e-4(b)(2)(iv)(A).
\642\ Proposed rule 22e-4(b)(2)(iv)(C).
\643\ Proposed rule 22e-4(b)(3)(i).
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The goal of the proposed three-day liquid asset minimum requirement
was to increase the likelihood that a fund would hold adequate liquid
assets to meet redemption requests without materially affecting the
fund's NAV.\644\ The proposed three-day liquid asset minimum also was
intended to be structured in a way that would foster consistency in
funds' consideration of relevant liquidity risk factors, while
permitting flexibility in implementing this liquidity risk management
tool as appropriate given the diverse range of funds it would
cover.\645\ It was intended to work together with other aspects of the
proposed liquidity risk management program designed to help ensure that
while funds would consider the spectrum of liquidity in their
portfolios (in part through the proposed classification requirement),
they would pay particular attention to the most liquid and least liquid
ends of this spectrum.\646\
---------------------------------------------------------------------------
\644\ See Proposing Release, supra footnote 9, at section
III.C.3.
\645\ Id.
\646\ See id., at sections III.B.1, III.C and III.C.3.
---------------------------------------------------------------------------
Many commenters agreed that a requirement for a fund to determine a
minimum--or, per some commenters' suggestions, a target--amount of
relatively liquid assets would assist funds in effectively meeting
redemption requests under a variety of market conditions.\647\ Some, on
the other hand, suggested that a minimum or target requirement would
not necessarily enhance a fund's ability to meet shareholder
redemptions because the amount of liquid assets a fund may need is
dynamic and unpredictable, and in extraordinary stressed market
conditions no particular amount of liquid assets may end up being
sufficient to meet redemptions.\648\ Commenters also objected to the
structure of the proposed minimum requirement, particularly the fact
that the requirement would not permit a fund to acquire relatively less
liquid assets if the fund were to fall below its minimum, arguing that
the requirement could actually increase shareholder redemptions during
times of stress.\649\ In addition, commenters expressed concerns that
the proposed requirement could prevent funds from meeting their
principal investment strategies \650\ and that it could effectively
prevent funds from holding or acquiring favorable, but relatively less
liquid, assets under certain circumstances, which could intensify
market stress as well as adversely affect a fund's NAV.\651\ Finally,
some commenters expressed concerns about the potential operational
burdens associated with the proposed three-day liquid asset minimum
requirement.\652\
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\647\ See, e.g., AFR Comment Letter; Charles Schwab Comment
Letter; CRMC Comment Letter; Wells Fargo Comment Letter.
\648\ See, e.g., Dechert Comment Letter; HSBC Comment Letter;
Invesco Comment Letter; MFS Comment Letter.
\649\ See, e.g., BlackRock Comment Letter; SIFMA Comment Letter
I.
\650\ See, e.g., Invesco Comment Letter; Oppenheimer Comment
Letter; Cohen & Steers Comment Letter; ICI Comment Letter I.
\651\ See, e.g., BlackRock Comment Letter; Credit Suisse Comment
Letter; ICI Comment Letter I; NYC Bar Comment Letter.
\652\ See, e.g., Federated Comment Letter; ICI Comment Letter I.
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Some commenters also suggested alternatives to the proposed three-
day liquid asset minimum. As discussed further below, a number of
commenters suggested requiring funds to maintain a ``target'' or
threshold amount of certain liquid assets.\653\ Other commenters
suggested requiring funds to consider whether to maintain a target
amount of liquid assets \654\ or to adopt policies and procedures to
address shareholder redemptions, which could include targets or
ranges.\655\ As discussed below, we believe the highly liquid
investment minimum requirement we are adopting strikes an appropriate
balance in promoting the benefits intended by the proposed three-day
liquid asset minimum requirement, including consistency in funds'
consideration of certain factors relevant to their liquidity risk
management procedures, while at the same time lessening the likelihood
of certain adverse consequences identified by commenters.
---------------------------------------------------------------------------
\653\ See, e.g., Invesco Comment Letter (suggesting that funds
be required to maintain a ``target'' range of three-day and/or
seven-day liquid assets); PIMCO Comment Letter (suggesting that a
minimum cash target could be established by the investment manager);
BlackRock Comment Letter (suggesting that funds could be required to
take several steps to ensure an appropriate level of Tier 1 and Tier
2 assets, which could be articulated as a range or target); Credit
Suisse Comment Letter.
\654\ See, e.g., SIFMA Comment Letter I; Oppenheimer Comment
Letter.
\655\ See, e.g., Dechert Comment Letter; IDC Comment Letter.
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1. Anticipated Benefits of Highly Liquid Investment Minimum
Like the proposed three-day liquid asset requirement, we believe
that the highly liquid investment minimum requirement will increase the
likelihood that a fund would be prepared to meet redemption requests
without significant dilution of remaining investors' interests in the
fund. Some commenters noted that it is common for funds to assess how
much liquidity they may need under various market conditions in order
to meet redemptions over a relatively short time horizon and suggested
that targeting a certain level of relatively liquid assets is an
appropriate way for a fund to manage its liquidity
[[Page 82199]]
risk.\656\ To the extent that a fund already aims to invest a specified
portion of its portfolio in relatively liquid assets, we anticipate
that such funds may already be substantially in compliance with the
highly liquid investment minimum requirement we are adopting today.
More importantly, it would require those funds that do not currently
consider what an appropriate baseline level of liquidity might be to do
so.
---------------------------------------------------------------------------
\656\ See, e.g., supra footnote 653.
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As with the proposal, we believe that the final highly liquid
investment minimum requirement will help encourage consistency in
funds' consideration of certain factors relevant to their liquidity
risk management procedures. This is an important benefit compared to
some commenters' suggestions that funds simply be required to have
policies and procedures to address shareholder redemptions (which could
include liquid asset minimums or targets), but not to specify any
particular procedures within this general requirement.\657\ As with the
proposal, we believe that the approach we are adopting appropriately
encourages regularity and thoroughness in funds' consideration of
certain risk factors, while at the same time promoting flexibility in
funds' management of this risk. Under rule 22e-4 as adopted, a fund
will be able to determine its own highly liquid investment minimum, as
well as (within a fairly broad range) the assets it will hold to
satisfy its minimum.\658\ We believe that the requirement we are
adopting provides important additional flexibility to funds' liquidity
risk management practices in that a fund will be required to adopt
policies and procedures, but would be permitted to design them as
appropriate to respond to shortfalls in highly liquid investments
relative to the fund's minimum.
---------------------------------------------------------------------------
\657\ See supra footnote 655; see also infra section IV
(discussing other reasonable alternatives to the highly liquid
investment minimum requirement).
\658\ See rule 22e-4(b)(1)(iii)(A)(1).
---------------------------------------------------------------------------
As noted above, some commenters suggested that a minimum
requirement would not necessarily enhance funds' ability to meet
shareholder redemptions. We agree that the highly liquid investment
minimum requirement we are adopting, standing alone, may not be a
sufficient safeguard for funds to manage liquidity risk under all
market conditions. However, we believe that, together with the rest of
the liquidity risk management program requirements we are adopting, it
is a central tool to help put a fund in a solid position to meet
redemption requests without significant dilution of remaining
investors' interests. The highly liquid investment minimum requirement,
together with the classification requirement and the 15% limitation on
a fund's investments in illiquid investments that are assets, is meant
to be a primary component of a fund's overall approach to liquidity
risk management. While the classification requirement would illustrate
the spectrum of a fund's portfolio liquidity, the highly liquid
investment minimum requirement and the 15% limitation on illiquid
investments would focus the fund's attention on each end of that
liquidity spectrum--the fund's most liquid and least liquid
investments, respectively.
Based on a fund's liquidity risk assessment, the fund could
determine what additional liquidity risk management tools, if any,
together with the highly liquid investment minimum requirement and the
15% limitation on illiquid investments, would best permit the fund to
meet redemptions and help prevent significant investor dilution. We
also believe that the highly liquid investment minimum requirement will
be a useful liquidity risk management tool because we understand, based
on staff outreach and comments that we received on the proposal, that
the requirement we are adopting is similar to liquidity risk management
strategies that many funds currently use.\659\
---------------------------------------------------------------------------
\659\ See supra footnote 656 and accompanying text.
---------------------------------------------------------------------------
While certain commenters expressed concern that the proposed three-
day liquid asset minimum requirement could unduly encourage funds to
use only their most liquid assets in meeting redemptions (which
commenters argued could lead to additional redemptions from funds in
stressed periods),\660\ we note that the minimum requirement--both as
proposed and as adopted--was never meant to suggest that a fund should
only, or primarily, use its most liquid investments to meet shareholder
redemptions.\661\ Nor is it meant, as commenters argued, to suggest
that funds should hold cash-like buffers that investors may
inappropriately assume will eliminate funds' liquidity risk.\662\
Indeed, we noted in the Proposing Release that assets eligible for
inclusion in a fund's three-day liquid asset minimum holdings could
include a broad variety of securities, as well as cash and cash
equivalents.\663\ Moreover, because the final highly liquid investment
minimum requirement would not prohibit a fund from acquiring
investments other than highly liquid investments if a fund were to fall
below its minimum, we believe that the final requirement may convey
more effectively than the proposal that a fund is not guaranteed to
hold a certain level of cash or highly liquid investments at all times.
---------------------------------------------------------------------------
\660\ See, e.g., BlackRock Comment Letter.
\661\ See, e.g., Proposing Release, supra footnote 9, at section
II.B.2 (discussing how funds may choose to sell assets in ``strips''
or in a range of liquidity).
\662\ See, e.g., CFA Comment Letter.
\663\ See Proposing Release, supra footnote 9, at paragraph
following n.343.
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As with the proposed three-day liquid asset minimum requirement, we
believe an important feature of the highly liquid investment minimum
requirement we are adopting is the flexibility it provides for a fund
to determine an appropriate highly liquid investment minimum
considering its particular risk factors, as well as (within a fairly
broad range) the assets it will hold to satisfy its minimum. We
acknowledge that, for certain funds that currently have relatively less
liquid portfolios, the highly liquid investment minimum requirement
could cause a fund to modify its investment strategy if, after
consideration of the required factors, the fund were to determine it is
appropriate to invest in higher amounts of highly liquid investments.
In these circumstances, we believe such a modification would be
appropriate. We discuss the costs associated with any modifications to
funds' investment strategies that could result from the final highly
liquid investment minimum requirement in the Economic Analysis section
below.
2. Consideration of Liquidity Risk Factors
Rule 22e-4 requires a fund to consider the liquidity risk factors
set forth in the rule, as applicable, in determining its highly liquid
investment minimum.\664\ Under the proposed rule, a fund likewise would
have been required to consider the proposed rule's liquidity risk
assessment factors in determining its three-day liquid asset
minimum.\665\ Several commenters suggested that these factors should be
guidance that funds may consider in setting a minimum or target for
relatively liquid assets, but should not be mandatory considerations a
fund would be required to assess.\666\ Commenters also objected to the
requirement that funds determine their three-day liquid asset minimum
based
[[Page 82200]]
on liquidity risk under both normal and reasonably foreseeable stressed
conditions, arguing that this requirement would result in funds being
forced to maintain artificially high levels of three-day liquid
assets.\667\ Some commenters also discussed more granular objections to
certain of the proposed factors to be used in determining a fund's
three-day liquid asset minimum, such as certain aspects of the proposed
requirements to consider a fund's shareholder concentration \668\ and
borrowing arrangements.\669\
---------------------------------------------------------------------------
\664\ Rule 22e-4(b)(1)(iii)(A)(1).
\665\ Proposed rule 22e-4(b)(2)(iv)(A)-(B).
\666\ See, e.g., Oppenheimer Comment Letter; Charles Schwab
Comment Letter; SIFMA Comment Letter I.
\667\ See, e.g., NYC Bar Comment Letter; SIFMA Comment Letter I.
\668\ See SIFMA Comment Letter I.
\669\ See Cohen & Steers Comment Letter.
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We continue to believe it is appropriate for a fund to be
required--not only permitted--to consider a specified set of liquidity
risk factors in determining its highly liquid investment minimum. We
believe requiring every fund to consider multiple aspects of its
history, policies, strategy, and operations in determining its highly
liquid investment minimum will lead to a general industry-wide baseline
for the minimum requirement. However, we are making certain
modifications to the proposed liquidity risk factors, including only
requiring funds to consider applicable factors, to respond to
commenters' concerns about this aspect of the requirement.
a. Modifications to Proposed Requirement To Consider Liquidity Risk
Factors
As discussed above, the liquidity risk factors we are adopting
today incorporate certain modifications to the proposed factors,\670\
and thus these modifications flow through with respect to a fund's
consideration of these factors in determining its highly liquid
investment minimum. We believe that the guidance that we provide in
section III.B.2 regarding a fund's consideration of these factors in
assessing its liquidity risk also is appropriate for a fund to take
into account when determining its highly liquid investment minimum.
With the exception of the recommendations about specific factors or
guidance discussed below, we did not receive comments on the proposed
factors or the guidance provided in the Proposing Release regarding
these factors.
---------------------------------------------------------------------------
\670\ See supra section III.B.2.
---------------------------------------------------------------------------
Some commenters recommended that the Commission confirm that funds
may consider and weigh the factors as they deem appropriate and
relevant for purposes of the proposed minimum requirement,\671\ and we
agree that a fund should give the most weight to the factors that it
deems most relevant for determining its highly liquid investment
minimum. Moreover, to the extent any liquidity risk assessment factor
is not applicable to a particular fund, the fund would not be required
to consider that factor in determining its highly liquid investment
minimum. We have therefore added the words ``as applicable'' in the
rule,\672\ and we note that, in this context, the phrase ``as
applicable'' is meant to refer to those factors that are relevant to a
fund's particular facts and circumstances. For example, a fund would
not be required to consider the use of borrowings for investment
purposes, as specified under rule 22e-4(b)(1)(i)(A), if that fund does
not engage in borrowing.\673\ Conversely, however, a fund that
maintains borrowing sources for investment purposes would be required
to consider the use of borrowings for investment purposes as specified
under the rule. The addition of ``as applicable'' should help respond
to commenters' concerns that codifying a list of required factors as a
provision of the proposed minimum requirement would ``create an overly
rigid structure and a one-size-fits-all approach that may result in
unnecessary focus on factors that are irrelevant to certain funds.''
\674\
---------------------------------------------------------------------------
\671\ See, e.g., Oppenheimer Comment Letter; SIFMA Comment
Letter I.
\672\ See rule 22e-4(b)(1)(iii)(A)(1); see also supra footnote
192 and accompanying text.
\673\ See supra section III.B.2.
\674\ See SIFMA Comment Letter I; see also e.g., Charles Schwab
Comment Letter; Oppenheimer Comment Letter (suggesting that it is
critically important that funds be afforded a certain amount of
flexibility in setting the fund's three-day liquid asset minimum).
---------------------------------------------------------------------------
We continue to believe that a fund should consider both normal and
reasonably foreseeable stressed conditions in determining the amount of
highly liquid investments it will hold, based on the liquidity risk
assessment factors. However, in a change from the proposal, the rule
specifies that only those stressed conditions that are reasonably
foreseeable during the period until the next review of the highly
liquid investment minimum (emphasis added) should be considered when a
fund determines its highly liquid investment minimum.\675\ As discussed
above, some commenters expressed concern that the requirement for funds
to consider normal and reasonably foreseeable stressed conditions in
determining their three-day liquid asset minimum could suggest that all
funds should hold a high level of cash or other highly liquid assets at
all times, which could in turn encourage funds to maintain portfolio
liquidity levels that are disproportionate relative to their liquidity
risk.\676\ We believe that requiring consideration of only those
stressed conditions that are reasonably foreseeable during the period
until the next review of the highly liquid investment minimum should
address commenters' concerns and should help ensure that the highly
liquid investment minimum requirement leads funds to hold levels of
portfolio liquidity that are appropriate in light of their reasonably
anticipated liquidity risk.
---------------------------------------------------------------------------
\675\ See rule 22e-4(b)(1)(iii)(A)(1); see also rule 22e-
4(b)(1)(iii)(A)(2) (requiring funds to periodically review, no less
frequently than annually, the highly liquid investment minimum).
\676\ See supra footnote 667 and accompanying text. Commenters
argued that this, in turn, could lead to declines in fund
performance, which shareholders would experience in the form of
lower returns. See, e.g., Fidelity Comment Letter; Invesco Comment
Letter; J.P. Morgan Comment Letter; Wells Fargo Comment Letter.
---------------------------------------------------------------------------
This change also responds to commenters' concerns about perceived
ambiguity in the length of time over which the proposed rule would have
required funds to forecast the effect of stressed conditions on the
liquidity risk factors.\677\ Under the final rule, funds are required
to periodically review, no less frequently than annually, their highly
liquid investment minimum. Thus, the requirement to consider stressed
conditions only to the extent they are reasonably foreseeable during
the period until the next review of the highly liquid investment
minimum, limits consideration of stressed conditions to whatever time
frame the fund has determined for review of its highly liquid
investment minimum, but no longer than one year. We note that if a fund
encounters extremely stressed market conditions, beyond those that were
reasonably foreseeable during the period until the next review of the
highly liquid investment minimum, that could increase its liquidity
risk to unusual levels, the fund should consider adjusting its highly
liquid investment minimum at that time, and indeed a fund should
generally review its highly liquid investment minimum more frequently
than annually if circumstances warrant.
---------------------------------------------------------------------------
\677\ See, e.g., MFS Comment Letter (noting that the proposal
fails to indicate the period of time over which the estimate of
foreseeable redemptions is to be calculated); see also SIFMA Comment
Letter I (``We do not agree, however, that in making their Highly
Liquid Asset Target determinations, funds should be required to
forecast the timing, severity or potential impact of stressed market
conditions or other events affecting the fund that have occurred in
the past but for which there is no reasonable way to accurately
predict their recurrence.'').
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[[Page 82201]]
b. Role of Liquidity Risk Factors in Determining the Highly Liquid
Investment Minimum
As noted above, rule 22e-4 requires a fund to consider the
liquidity risk factors set forth in the rule, as applicable, in
determining its highly liquid investment minimum. In summary, a fund
must consider, as applicable, its: (i) Investment strategy and
portfolio liquidity during normal conditions, and during stressed
conditions to the extent such conditions are reasonably foreseeable
during the period until the next review of the highly liquid investment
minimum; (ii) short-term and long-term cash flow projections during
normal conditions, and during stressed conditions to the extent such
conditions are reasonably foreseeable during the period until the next
review of the highly liquid investment minimum; and (iii) holdings of
cash and cash equivalents, as well as borrowing arrangements and other
funding sources.\678\ In addition to these factors, an ETF also must
consider, as applicable: (i) The relationship between the ETF's
portfolio liquidity and the way in which, and the prices and spreads at
which, ETF shares trade, including the efficiency of the arbitrage
function and the level of active participation by market participants
(including authorized participants); and (ii) the effect of the
composition of baskets on the overall liquidity of the ETF's
portfolio.\679\
---------------------------------------------------------------------------
\678\ Rule 22e-4(b)(1)(i)(A)-(C); rule 22e-4(b)(1)(iii)(A)(1).
\679\ Rule 22e-4(b)(1)(i)(D); rule 22e-4(b)(1)(iii)(A)(1); see
also infra section III.J. (discussing liquidity risk management
program elements tailored to ETFs).
---------------------------------------------------------------------------
With respect to a fund's consideration of its investment strategy
and portfolio liquidity in determining its highly liquid investment
minimum, we continue to believe that the less liquid a fund's overall
portfolio investments are, the higher a fund may want to establish its
highly liquid investment minimum. Similarly, funds with certain
investment strategies that typically have had greater volatility of
flows than other investment strategies--such as alternative funds and
emerging market debt funds--would generally need highly liquid
investment minimums that are higher than funds whose strategies tend to
entail less flow volatility. For funds that use borrowings for
investment purposes and derivatives, we continue to believe that, all
else equal, a fund with a leveraged strategy (e.g., a fund with
leverage through bank borrowings or that has significant fixed
obligations to derivatives counterparties) generally would need a
highly liquid investment minimum that is higher than a fund that does
not.\680\ Similarly, when setting the fund's highly liquid investment
minimum, we believe a fund that has or expects to have a significant
amount of highly liquid investments segregated to cover derivatives
transactions or pledged to satisfy margin requirements in connection
with derivatives transactions should take into account the fact that
such segregated or pledged highly liquid investments may not be
available to meet redemptions. However, this guidance is not meant to
suggest that a fund should only, or primarily, use highly liquid
investments to meet shareholder redemptions. Rather, in the examples
provided in this paragraph, we believe that holding a relatively high
level of assets that are highly liquid investments would both support a
fund in meeting redemption requests in a manner that does not dilute
non-redeeming shareholders, and assist the fund in readjusting its
portfolio as necessary to handle stressed conditions, weathering
periods of heightened volatility, and managing its obligations to
derivatives counterparties.
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\680\ See Proposing Release, supra footnote 9, at paragraphs
accompanying n.339. As discussed in the Proposing Release, we
believe that a leveraged fund has an increased risk that it will be
unable to meet redemptions and an increased risk of investor
dilution compared to an equivalent fund with no leverage. For
example, a fund with leverage through bank borrowings may have to
meet margin calls if a security the fund provided to the bank to
secure the loan declines in value. Such margin calls can render
highly liquid portfolio assets unavailable to meet investor
redemptions, which can increase dilution and the risk the fund will
be unable to meet redemptions.
Similarly, a fund that has significant fixed obligations to
derivatives counterparties (for example, from a total return swap or
writing credit default swaps) must pay out on these obligations when
due, even if it means selling the fund's more liquid, high quality
assets to raise cash. See, e.g., OppenheimerFunds Release, supra
footnote 223.
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Regarding a fund's cash flow projections, we continue to believe
that the Commission's cash flow guidance considerations could be useful
to a fund in setting its highly liquid investment minimum.\681\ We
generally expect that a fund would evaluate the Commission's guidance
on these considerations and determine whether each would be useful and
relevant in setting the fund's highly liquid investment minimum. In
addition, a fund may wish to consider employing some form of stress
testing \682\ or consider specific historical redemption scenarios in
determining its highly liquid investment minimum.
---------------------------------------------------------------------------
\681\ See supra section III.B.2.b. These five guidance
considerations include: (i) The size, frequency, and volatility of
historical purchases and redemptions of fund shares during normal
and reasonably foreseeable stressed periods; (ii) the fund's
redemption policies; (iii) the fund's shareholder ownership
concentration; (iv) the fund's distribution channels; and (v) the
degree of certainty associated with the fund's short-term and long-
term cash flow projections.
\682\ See supra footnote 196 and accompanying text.
---------------------------------------------------------------------------
Each of the cash flow guidance considerations--either standing
alone, but especially viewed in combination with one another--are
potentially significant features that could materially affect the risk
of significant redemptions and thus could influence a fund's
determination of its highly liquid investment minimum. For example, a
fund with a concentrated shareholder base has a high risk that only one
or two shareholders deciding to redeem can cause the fund to sell a
significant amount of assets, which depending on the liquidity of the
fund's portfolio and how it meets those redemptions, can dilute
remaining shareholders. Similarly, a fund whose redemption policy is to
satisfy all redemptions on a next business day basis (T + 1) or that is
sold through distribution channels that historically attract investors
with more volatile and/or unpredictable flows also should consider
setting a higher minimum level for its assets that are highly liquid
investments than a fund that, all else equal, does not face these
risks.
In setting a highly liquid investment minimum, a fund should
consider the degree of certainty associated with the fund's short-term
and long-term cash flow projections. Projections may only be as good as
the extent and quality of information that informs them. For example,
if a fund does not have substantial visibility into its shareholder
base (e.g., because the fund's shares are principally sold through
intermediaries that do not provide shareholder transparency) or if a
fund is uncertain about changing market conditions which are likely to
materially affect the fund's level of net redemptions, it may make
projections but be quite uncertain about the reliability of those
projections. In these circumstances, a fund should consider setting its
highly liquid investment minimum to reflect this uncertainty, for
example, by providing a cushion or multiple of its cash flow
projections in the event realized net redemptions are significantly
higher.
One commenter objected that shareholder ownership concentration,
which is discussed in this Release as a guidance factor that could be
used in evaluating cash flows (but in the proposal would have been
required to be considered in analyzing a fund's cash flow projections),
should not be a
[[Page 82202]]
determinative consideration for a fund in establishing its appropriate
level of relatively liquid assets.\683\ This commenter expressed
concern that ``accentuating the significance of this sub-factor in the
context of new or recently launched funds, which may have a small
number of shareholders relative to more established funds, could have a
severe anti-competitive effect and create an unwarranted barrier to the
introduction of new funds.'' We agree that emphasizing shareholder
concentration could lead new funds to increase their holdings of
relatively liquid investments. However, we note that substantial
shareholder concentration, even for new or recently launched funds,
could give rise to significant liquidity risk, and thus this
consideration should not be discounted when a fund whose investor base
is significantly concentrated determines its highly liquid investment
minimum.\684\ New or recently launched funds that have a concentrated
shareholder base should consider disclosing the risk of redemption by
one or more such shareholders in the fund's prospectus.\685\ To the
extent that a new fund's shareholder base becomes significantly less
concentrated as the fund matures, the fund may wish to take this into
consideration in reviewing its highly liquid investment minimum and
adjusting it as it determines appropriate.
---------------------------------------------------------------------------
\683\ See SIFMA Comment Letter I.
\684\ As discussed above, a fund may also take into account the
types of shareholders in the fund and whether those shareholders
share common investment goals affecting redemption frequency and
timing. Additionally, a fund may take into account other liquidity
risk management tools available to it, such as redemption fees, when
determining its highly liquid investment minimum.
\685\ See SIFMA Comment Letter I (suggesting that the Commission
encourage such prospectus disclosure). We recognize that other
factors, such as the size of a fund's positions and the liquidity of
those positions, could impact the extent to which this risk could
affect the fund.
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With respect to a fund's consideration of its holdings of cash and
cash equivalents in determining its highly liquid investment minimum,
we continue to believe that these holdings may provide funds with
important flexibility to manage their liquidity risks. Our staff has
observed that it is relatively common for fund complexes to target a
minimum amount of cash or cash equivalent holdings in the fund, with
the assumption that cash and cash equivalent holdings would allow the
fund to meet redemptions in a stressed period without realizing
significant discounts to its holdings' carrying values when they are
sold. Holding cash or cash equivalents also could readily permit funds
to rebalance or otherwise adjust a portfolio's composition in order to
manage liquidity risk. Similarly, the availability of a line of credit
or other funding sources to meet redemptions could assist a fund in
managing liquidity risk, although as discussed below, depending on the
nature of use, the use of a line of credit could raise other
issues.\686\ To the extent that a fund determines that any of these
considerations could indicate decreased liquidity risk, these
considerations could provide important inputs regarding the level that
the fund deems appropriate for its highly liquid investment minimum.
---------------------------------------------------------------------------
\686\ See infra footnote 688 and accompanying text.
---------------------------------------------------------------------------
Certain commenters indicated that the Commission should permit a
fund to reduce its required holdings of relatively liquid assets by the
amount of other sources of liquidity available to the fund, such as a
committed line of credit.\687\ Under these commenters' views, if a fund
were to determine that its highly liquid investment minimum would
typically be x% of the fund's net assets, a fund with a committed line
of credit representing y% of the fund's net assets should be able to
reduce its highly liquid investment minimum to x% minus y% of the
fund's net assets. We disagree with this approach for several reasons.
First, we believe that a mechanical subtraction of the amount of a
credit line available to a fund from the fund's highly liquid
investment minimum is inappropriate under circumstances in which all or
part of the line of credit is not guaranteed to be available to a
fund--for example, because it is a committed line of credit that may be
shared among other members of the fund family. Even if the credit
facility was committed just to the fund, the amount ultimately
available could depend on the financial health of the institution
providing the facility, as well as the terms and conditions of the
facility. Finally, as discussed in the Proposing Release, while a line
of credit can facilitate a fund's ability to meet unexpected
redemptions and can be taken into consideration when determining its
highly liquid investment minimum, we continue to believe that liquidity
risk management is better conducted primarily through construction of a
fund's portfolio.\688\
---------------------------------------------------------------------------
\687\ See, e.g., Cohen & Steers Comment Letter; Oppenheimer
Comment Letter.
\688\ See Proposing Release, supra footnote 9, at section
III.C.3; see also, e.g., HSBC Comment Letter (``The degree to which
a fund employs leverage can have a material impact on its liquidity
demands, particularly during periods of market stress. As such,
attempts to model liquidity risk should incorporate an assessment of
leverage and the extent to which this might intensify liquidity
demands for a given fund during different scenarios compared to
unleveraged funds.''); Nuveen FSOC Notice Comment Letter, supra
footnote 85 (``Funds without credit lines face the possibility of
not being able to sell sufficient assets to raise cash to fund
redemption requests, or having to sell assets at significantly
discounted values. To the extent that a fund draws on a credit line
to meet net redemptions (and thus temporarily leverages itself), it
increases its market risk at a time when markets are stressed. While
this can be potentially beneficial to long-term performance if the
asset class recovers, it increases the risk of loss to remaining
shareholders if markets continue to weaken.'').
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As with the proposed three-day liquid asset minimum requirement, a
fund would be required to maintain a written record of how its highly
liquid investment minimum was determined, including an assessment of
each of the factors.\689\ This would permit our examination staff to
ascertain that funds are indeed considering the required factors, as
applicable. As discussed in the Proposing Release, we continue to
generally believe that it would be extremely difficult to conclude,
based on the factors that a fund would be required to consider, that a
highly liquid investment minimum of zero would be appropriate.\690\
---------------------------------------------------------------------------
\689\ See rule 22e-4(b)(3)(iii); see also infra section III.I.
\690\ See Proposing Release, supra footnote 9, at paragraphs
accompanying and following n.341.
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3. Highly Liquid Investment Minimum Shortfall Policies and Procedures
Under rule 22e-4, a fund will be required to adopt specific
policies and procedures for responding to a shortfall in the fund's
assets that are highly liquid investments below its highly liquid
investment minimum (for purposes of this section, a fund's ``shortfall
policies and procedures''). A fund's shortfall policies and procedures,
as described in more detail below, must include reporting to the fund's
board of directors no later than the board's next regularly scheduled
meeting with a brief explanation of the causes of the shortfall, the
extent of the shortfall, and any actions taken in response.\691\ Also,
a fund's shortfall policies and procedures must include reporting
within one business day to the fund's board if a shortfall lasts more
than seven consecutive calendar days, including an explanation of how
the fund plans to restore its minimum within a reasonable period of
time.\692\
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\691\ See rule 22e-4(b)(1)(iii)(A)(3).
\692\ See id.
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a. Shortfall Policies and Procedures Requirement
Rule 22e-4 as proposed did not include the requirement for a fund
to adopt shortfall policies and procedures. This requirement replaces
the proposed prohibition against acquiring any asset
[[Page 82203]]
other than a three-day liquid asset if a fund's holdings of three-day
liquid assets were to drop below its three-day liquid asset minimum
(for purposes of this section, the ``proposed acquisition
limit'').\693\ As discussed above, commenters expressed concerns that
the proposed acquisition limit could have adverse effects on funds,
their shareholders, and the markets in which funds operate.
Specifically, commenters cautioned that shareholder redemptions could
increase if shareholders observe that a large redemption has taken
place and assume that the fund will not be able to effectively employ
its investment strategy due to the proposed prohibition on acquiring
any assets that are not three-day liquid assets.\694\ Commenters
suggested that this, in turn, could incentivize shareholders to redeem
quickly in times of stress, which could spark additional redemptions
from funds in stressed periods. Some commenters also argued that the
proposed acquisition limit could lead index funds to hold a level of
relatively liquid assets that causes them to deviate from the
construction of their indices \695\ and could cause funds that are
managed relative to a benchmark to experience higher tracking
error.\696\ Commenters also maintained that the proposed acquisition
limit could impair actively managed funds to the extent that it could
limit portfolio managers' discretion to purchase assets that they
believe would maximize funds' returns.\697\
---------------------------------------------------------------------------
\693\ See proposed rule 22e-4(b)(2)(iv)(C).
\694\ See, e.g., BlackRock Comment Letter.
\695\ See, e.g., Invesco Comment Letter; Dechert Comment Letter;
Oppenheimer Comment Letter.
\696\ See, e.g., HSBC Comment Letter; ICI I Comment Letter.
\697\ See, e.g., PIMCO Comment Letter; ICI I Comment Letter;
Federated Comment Letter.
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In addition, commenters argued that the proposed acquisition limit
could effectively prevent funds from holding or acquiring favorable,
but relatively less liquid, assets under certain circumstances, which
could intensify market stress as well as adversely affect a fund's
NAV.\698\ For example, some commenters suggested that a fund whose
three-day liquid asset holdings were to fall below its minimum could
feel pressure to sell less liquid assets in order to replenish its
three-day liquid assets, which could lead to excessive sales of less
liquid assets during times of market stress that could adversely affect
the fund's NAV.\699\ Relatedly, commenters suggested that the proposed
acquisition limit could produce harmful market effects if it were to
significantly increase the demand for relatively liquid assets, which
could conversely decrease demand for other asset types (making them
less liquid) and exacerbate market volatility.\700\ Commenters
expressed concern that any ``herding'' behavior that could result from
the proposed acquisition limit could become especially pronounced
during stressed periods.\701\ Commenters also argued that the proposed
acquisition limit could prevent a fund manager from purchasing certain
investments that it views as undervalued in a downturn, when the fund's
holdings of three-day liquid assets are at or below the fund's
minimum.\702\ They contended that this in turn could reduce the fund's
universe of potential investments and ability to invest in contrarian
and countercyclical ways,\703\ which could eliminate a potential pool
of buyers and thus could exacerbate an already stressed
environment.\704\
---------------------------------------------------------------------------
\698\ See, e.g., BlackRock Comment Letter; SIFMA I Comment
Letter; Wells Fargo Comment Letter.
\699\ See, e.g., Oppenheimer Comment Letter.
\700\ See, e.g., Invesco Comment Letter; Cohen & Steers Comment
Letter; ICI Comment Letter I; Wells Fargo Comment Letter.
\701\ See, e.g., ICI Comment Letter I; Wellington Comment Letter
II.
\702\ See, e.g., ICI Comment Letter I.
\703\ See, e.g., BlackRock Comment Letter; ICI Comment Letter I;
Wells Fargo Comment Letter.
\704\ See, e.g., SIFMA Comment Letter I; Invesco Comment Letter
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A significant number of commenters suggested that the Commission
adopt a liquid asset target in lieu of the proposed three-day liquid
asset minimum requirement--indeed, this was the most common alternative
suggestion to the proposed three-day liquid asset minimum
requirement.\705\ One primary distinction between the target
requirements that commenters recommended and the proposed three-day
liquid asset minimum requirement is that a target requirement would not
prohibit a fund from acquiring certain assets if a fund's holdings of
relatively liquid assets were to fall below the target. Instead, some
commenters stated that a fund should have a reasonable period to
respond to a shortfall of relatively liquid assets below the fund's
target, and/or that any such shortfalls must be reported to the fund's
board.\706\
---------------------------------------------------------------------------
\705\ See, e.g., supra footnote 653 and accompanying text; see
also infra section IV.C (discussing other reasonable alternatives to
the highly liquid investment minimum requirement).
\706\ See, e.g., Invesco Comment Letter; PIMCO Comment Letter;
Federated Comment Letter; J.P. Morgan Comment Letter.
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We continue to believe that fund shareholders' interests are
generally best served when the percentage of a fund's assets invested
in relatively liquid investments is at (or above) the level deemed
appropriate by the fund.\707\ The highly liquid investment minimum
requirement we are adopting would not prohibit a fund from acquiring
assets other than highly liquid investments when a fund's highly liquid
investments fall below its minimum. However, we believe that the
shortfall policies and procedures requirement we are adopting--which
replaces the proposed acquisition limit--provides flexibility while
also promoting effective liquidity management practices. We believe
this requirement also responds to concerns about a flat prohibition
against purchasing certain assets when the fund's assets that are
highly liquid investments drop below a certain level.
---------------------------------------------------------------------------
\707\ See Proposing Release, supra footnote 9, at n.346 and
accompanying text.
---------------------------------------------------------------------------
Additionally, we believe that the shortfall policies and procedures
requirement responds appropriately to commenters' concerns that there
could be appropriate reasons for a fund to acquire an investment other
than a highly liquid investment if a fund were to fall below its
minimum. The final highly liquid investment minimum requirement will
require that funds determine a level of assets that are highly liquid
investments designed to help them manage the fund through stressed
conditions or opportunistically readjust their portfolios, while
permitting a fund's portfolio liquidity to fall below this level when
determined appropriate from a risk management perspective or on account
of extenuating circumstances. The shortfall policies and procedures
requirement, including the reporting requirement, is meant to foster
discussion among the fund's management (and board) if its assets that
are highly liquid investments fall below the level the fund determined
to be an appropriate minimum. We further believe that the final highly
liquid investment minimum requirement appropriately responds to
commenters' concerns that the proposed acquisition limit could restrict
funds' ability to meet their principal investment strategies, to the
detriment of fund investors. The final requirement provides fund
managers more leeway than the proposed requirement to structure and
modify their portfolios because--as would be the case in the target
requirement commenters suggested--fund managers would not be prevented
from purchasing certain assets when a fund's holdings of assets that
are highly liquid investments drop below its highly liquid investment
minimum.
The highly liquid investment minimum requirement we are adopting,
together with the shortfall policies and
[[Page 82204]]
procedures requirement, also responds to commenters' concerns that the
proposed acquisition limit could exacerbate potential market stresses
and lead to other harmful market effects. Under the final rule, a fund
that falls below its highly liquid investment minimum would not be
restricted to acquiring only highly liquid investments, if acquiring
other investments were consistent with the fund's shortfall policies
and procedures. Also, as discussed above, the requirement that a fund
determine its highly liquid investment minimum taking into account only
those stressed conditions that are reasonably foreseeable during the
period until the next review of the highly liquid investment minimum
should decrease the probability that a fund could overweight its assets
that are highly liquid investments relative to its liquidity risk. This
also, in turn, should lessen demand for highly liquid investments
compared to the possible market effects of the proposed requirement.
Finally, we believe that the final highly liquid investment minimum
requirement, in conjunction with the shortfall policies and procedures
requirement, will help to mitigate some of the operational burdens that
commenters argued would accompany the proposal,\708\ while continuing
to advance the Commission's goals. We note that the highly liquid
investment minimum requirement will involve monitoring a fund's
portfolio investments' liquidity for compliance. We recognize that this
monitoring may result in operational costs, which could be greater for
funds with multiple sub-advisers to the extent that these funds would
need to build or otherwise implement systems to coordinate portfolio
liquidity information provided by each sub-adviser.\709\ However, we
expect that the operational costs associated with the final highly
liquid investment minimum requirement would be significantly less
compared to the proposal, which would have entailed the additional
costs of building systems that would bar the purchase of less liquid
investments if the fund were to fall below its minimum. We understand
that some fund complexes today already track a liquid asset minimum or
target, and for these funds, operational costs associated with the
final minimum requirement would only entail adjustments to their
current processes and not the costs of an entirely new systems build-
out.
---------------------------------------------------------------------------
\708\ See, e.g., Federated Comment Letter (suggesting that the
proposed requirement could present significant operational and
technological challenges because a fund's trade order management
system would need to maintain the liquidity classification for each
security in order to accurately monitor compliance with the fund's
three-day liquid asset minimum); ICI Comment Letter I (noting that
the proposed requirement would raise operational difficulties for
funds with multiple sub-advisers because compliance would
necessitate consideration of portfolio assets' liquidity at the fund
level, and thus the proposal would require a significant amount of
coordination among sub-advisers).
\709\ See also infra paragraph accompanying footnote 818
(discussing the coordination of liquidity risk management efforts
undertaken by various service providers, including a fund's sub-
adviser(s)).
---------------------------------------------------------------------------
b. Operation of Shortfall Policies and Procedures Requirement
Rule 22e-4 provides flexibility as to the particular shortfall
policies and procedures a fund may adopt because we believe that
different facts and circumstances could result in different funds
taking different approaches to address a decline in assets that are
highly liquid investments.\710\ We also recognize that it may be
difficult to contemplate or specify all appropriate factors to consider
(or their weighting) in advance of a shortfall, and that part of the
decision process requires an evaluation of the current stress event and
a determination of whether it is likely to persist (and for how long).
Nonetheless, a fund's shortfall policies and procedures could specify
some of the actions that a fund could consider taking to respond to a
highly liquid investment minimum shortfall under different conditions,
as well as market- and fund-specific circumstances that could shape a
fund's response to a particular shortfall occasion. For example, the
policies and procedures could outline some of the circumstances under
which it could be appropriate for a fund to purchase assets that are
not highly liquid investments, despite being below its minimum. If, for
example, the fund reasonably expected inflows in the near future (e.g.,
from a retirement plan platform), it may determine it is acceptable to
pursue an attractive buying opportunity despite a decline below the
fund's highly liquid investment minimum that it expects to be short-
term. It also could be appropriate, for example, for a fund to consider
selling certain relatively less liquid holdings over a period of time
and investing some of the proceeds in highly liquid investments.
---------------------------------------------------------------------------
\710\ For example, a fund may handle a shortfall due to changes
in market conditions differently than a shortfall due to increased
redemptions.
---------------------------------------------------------------------------
Similarly, as part of its shortfall policies and procedures, a fund
could set forth how it would set out a time frame by which it plans to
bring its assets that are highly liquid investments back up to the
level of its highly liquid investment minimum.\711\ If a fund
encounters highly liquid investment minimum shortfalls regularly, a
fund's liquidity risk management program administrator, potentially
together with the fund's broader risk management function, should
consider whether the fund's risk management policies and procedures
should be modified. We note that a fund's shortfall policies and
procedures could, but will not be required to, specify the persons who
will typically determine how, if at all, to respond to a shortfall (for
example, the person designated by the board to administer the fund's
liquidity risk management program, in conjunction with the fund's risk
managers and portfolio managers).
---------------------------------------------------------------------------
\711\ If a fund's highly liquid investment minimum shortfall
lasts more than seven consecutive calendar days, reporting to the
fund's board within one business day is required, including an
explanation of how the fund plans to restore its minimum within a
reasonable period of time. See rule 22e-4(b)(1)(iii)(A)(3).
---------------------------------------------------------------------------
As discussed below, although we are not requiring a fund's board to
specifically approve its highly liquid investment minimum, we continue
to believe that the board should play an oversight role with respect to
the minimum.\712\ A requirement to inform the board when a fund drops
below its highly liquid investment minimum, as well as the
circumstances leading to the fund's highly liquid investment minimum
shortfall and actions taken in response, will permit the board better
to understand circumstances that may give rise to heightened liquidity
risk. It also will provide important context for the board in
evaluating the effectiveness of the fund's highly liquid investment
minimum and the fund's liquidity risk management program generally.
Many commenters suggested that the Commission should adopt a board
reporting requirement when a fund's holdings of relatively liquid
assets drop below the level that the fund has generally targeted as
appropriate.\713\ Rule 22e-4 as adopted generally reflects these
suggestions.
---------------------------------------------------------------------------
\712\ See infra section III.H.3.
\713\ See, e.g., J.P. Morgan Comment Letter (suggesting a breach
would necessitate a report to the board); SIFMA I Comment Letter
(suggesting a ``highly liquid asset target'' and noting that
``[i]nstances where a fund dipped below its target percentage
[could] be reported to the fund board with an explanation from
management as to why the fund dipped below its target and any
resulting impact on the fund's liquidity risk profile''); Invesco
Comment Letter; Dechert Comment Letter.
---------------------------------------------------------------------------
As fund boards are charged with oversight and not day-to-day
management of funds' liquidity risk, we
[[Page 82205]]
believe that it is appropriate not to require that the fund's board be
informed that the fund has dropped below its highly liquid investment
minimum immediately when this occurs. Thus, rule 22e-4 requires that a
fund's board be informed of a highly liquid investment minimum
shortfall at the board's next regularly scheduled meeting.\714\ If a
fund were to drop below its highly liquid investment minimum multiple
times prior to the next regularly scheduled board meeting, fund
management could provide a single report to the board at that meeting
discussing each of these occurrences.
---------------------------------------------------------------------------
\714\ See rule 22e-4(b)(1)(iii)(A)(3).
---------------------------------------------------------------------------
However, we believe that when a fund's assets that are highly
liquid investments are below its minimum for an extended period of
time, this could indicate especially heightened liquidity risk, and
thus under these circumstances it is appropriate to report a highly
liquid investment minimum shortfall to the board within a shorter time
frame. We are therefore adopting the requirement for a fund to report
to its board of directors within one business day if its shortfall
lasts longer than seven consecutive calendar days. Rule 22e-4 requires
that this accelerated reporting include an explanation of how the fund
plans to restore the fund's highly liquid investment minimum within a
``reasonable'' period of time. Fund management generally should take
into account the fund's level of liquidity risk, as well as the facts
and circumstances leading to the highly liquid investment minimum
shortfall, in determining a reasonable time for returning the fund's
assets that are highly liquid investments to the fund's minimum level.
4. Periodic Review of Highly Liquid Investment Minimum
Rule 22e-4 requires a fund to periodically review, no less
frequently than annually, the fund's highly liquid investment
minimum.\715\ The proposed rule also included a periodic review
requirement with respect to the proposed three-day liquid asset
minimum, but instead of an annual minimum review requirement, the
proposed rule would have required that the periodic review be conducted
at least semi-annually.\716\ We requested comment on this proposed
review requirement generally, including the proposed minimum frequency
of a fund's review. We received few comments on the proposed review
requirement separate from general comments on the proposed three-day
liquid asset minimum, although we received general support for a review
requirement concerning a fund's target level of liquid assets.\717\
---------------------------------------------------------------------------
\715\ See rule 22e-4(b)(1)(iii)(A)(2).
\716\ See proposed rule 22e-4(b)(2)(iv)(B).
\717\ See, e.g., Oppenheimer Comment Letter.
---------------------------------------------------------------------------
We continue to believe, as discussed in the Proposing Release, that
a periodic review is a central component of the highly liquid
investment minimum requirement we are adopting.\718\ Although we
proposed a minimum semi-annual review requirement, we are adopting a
minimum annual review requirement primarily in order to correlate the
minimum period for a fund's highly liquid investment minimum review
with the minimum period in which a fund's board would be required to
review a written report describing the adequacy of the fund's liquidity
risk management program, as described in more detail below.\719\ The
minimum annual review period also would correlate with the requirement
for a fund to review its liquidity risk periodically, but no less
frequently than annually.\720\ We believe that correlating the time
periods for each review requirement in rule 22e-4 will reduce
compliance burdens and mitigate potential confusion that could arise
from disparate review periods.
---------------------------------------------------------------------------
\718\ See Proposing Release, supra footnote 9, at paragraph
following n.352.
\719\ See infra section III.H.2.
\720\ See supra section III.B.3.
---------------------------------------------------------------------------
We also do not believe that extending the highly liquid investment
minimum review period from a minimum of semi-annually to annually will
adversely affect funds or investors as a fund generally should review
its highly liquid investment minimum more frequently if circumstances
warrant. Additionally, as discussed above, a fund's board will be
regularly informed of any highly liquid investment minimum shortfalls.
Thus, the board will be aware of any liquidity risk management issues
that might warrant reconsideration of the fund's risk management
procedures or its highly liquid investment minimum.
Like the requirement for a fund to periodically review its
liquidity risk, the highly liquid investment minimum review requirement
will permit each fund to develop and adopt its own procedures for
conducting this review, taking into account the fund's particular facts
and circumstances. Additionally, we believe that in developing
comprehensive review procedures, a fund should generally consider
including procedures for evaluating regulatory, market-wide, and fund-
specific developments affecting the fund's liquidity risk. A fund also
may wish to adopt procedures specifying any circumstances that would
prompt more frequent review of the fund's highly liquid investment
minimum in addition to the annual minimum review required by the rule
(as well as the process for conducting more frequent reviews).\721\
---------------------------------------------------------------------------
\721\ See, e.g., supra footnote 273 and accompanying paragraph;
see also supra section III.D.2.a.
---------------------------------------------------------------------------
5. Exclusion for Funds Primarily Holding Assets That Are Highly Liquid
Investments
Rule 22e-4, as adopted, excludes a fund that primarily holds assets
that are highly liquid investments (a ``primarily highly liquid fund'')
from the requirements to determine and review a highly liquid
investment minimum, and to adopt shortfall policies and
procedures.\722\ We sought comment in the Proposing Release about
whether we should exclude certain funds from the proposed three-day
liquid asset minimum, such as funds that only invest in three-day
liquid assets. Commenters argued that a requirement for a fund to
determine a minimum portion of assets that it will invest in relatively
liquid assets is not suitable for funds that primarily invest in highly
liquid investment classes, given that a significant portion of the
fund's portfolio would be composed of such assets, and thus the
benefits associated with the three-day liquid asset minimum requirement
would not justify the burdens.\723\ After considering these comments
and reevaluating the costs and benefits of the proposal, we agree that
a primarily highly liquid fund should not be required to determine and
review a highly liquid investment minimum, or adopt shortfall policies
and procedures. We agree with commenters that the benefits associated
with these requirements as applied to
[[Page 82206]]
primarily highly liquid funds would not justify the associated
burdens.\724\
---------------------------------------------------------------------------
\722\ See rule 22e-4(b)(1)(iii)(A).
\723\ See, e.g., FSR Comment Letter (``[T]he Commission should
consider alternative regulatory approaches for index funds that seek
to track the performance of indices that are comprised of highly
liquid assets . . . .''); Dechert Comment Letter (citing Statement
on Open-End Fund Liquidity Risk Management Programs and Swing
Pricing, Commissioner Daniel M. Gallagher, Securities and Exchange
Commission (Sept. 22, 2015) (``Furthermore, for funds that invest
solely in assets that can be settled in three days or less--for
example, a fund that limits its investments to equity securities of
S&P 500 companies--the `three-day bucket' has no functional value.
Requiring such a fund to set its three-day bucket--whether it be at
1%, or 20% or even 90%--would be a meaningless exercise given that
the entire portfolio would be comprised of assets settled in three
days or less.'')).
\724\ For more discussion about the costs and burdens associated
with the highly liquid investment minimum requirement, see infra
section IV.C.
---------------------------------------------------------------------------
Under rule 22e-4, a fund whose portfolio consists primarily of
assets that are highly liquid investments would be excluded from the
highly liquid investment minimum requirement.\725\ Thus, we anticipate
that a primarily highly liquid fund would address in its liquidity risk
management program how it determines that it primarily holds assets
that are highly liquid investments, including, for example, how it
defines ``primarily.'' \726\ If a fund were to modify its investment
strategy or encounter strategy ``drift'' such that it no longer
primarily held assets that were highly liquid investments, it would be
required to adopt and review a highly liquid investment minimum, as
well as adopt and implement policies and procedures for responding to a
shortfall of the fund's assets that are highly liquid investments below
its minimum. We therefore believe that if a fund's investment strategy
is such that it cannot generally be predicted whether the fund would
primarily hold assets that are highly liquid investments (for example,
if the strategy were to entail a significant amount of volatility in
terms of the fund's portfolio liquidity), it would be difficult for the
fund's management to conclude that the fund should appropriately be
excluded from the highly liquid investment minimum requirement.
---------------------------------------------------------------------------
\725\ See rule 22e-4(b)(1)(iii)(A). Money market funds and In-
Kind ETFs also would be excluded from the highly liquid investment
minimum requirement. See rule 22e-4(a)(5) (defining ``fund,'' for
purposes of the rule as excluding money market funds and In-Kind
ETFs).
\726\ As noted by commenters, a highly liquid index fund would
be one example of a fund whose portfolio consists primarily (in the
case of these index funds, almost entirely) of assets that are
highly liquid investments. See supra footnote 723. In our view, if a
fund held less than 50% of its assets in highly liquid investments
it would be unlikely to qualify as ``primarily'' holding assets that
are highly liquid investments.
---------------------------------------------------------------------------
For purposes of determining whether a fund primarily holds assets
that are highly liquid investments, a fund must exclude from its
calculations the percentage of the fund's assets that are highly liquid
investments that it has segregated to cover derivatives transactions
that the fund has classified as moderately liquid investments, less
liquid investments, and illiquid investments, or pledged to satisfy
margin requirements in connection with those derivatives transactions,
as determined pursuant to rule 22e-4(b)(1)(ii)(C).\727\ As discussed
above, when a fund's assets are segregated or pledged in connection
with derivatives transactions, they may not be immediately available
for liquidity risk management purposes.\728\ Thus, a fund whose assets
that are highly liquid investments that are segregated or pledged in
connection with derivatives transactions may not have the same level of
liquidity risk management flexibility as a fund whose assets are highly
liquid investments that are not similarly segregated or pledged. While
we believe that the benefits associated with the highly liquid
investment minimum requirements as applied to primarily highly liquid
funds would not justify associated burdens,\729\ we believe that this
consideration is appropriate only to the extent a fund primarily holds
assets that are highly liquid investments that are not segregated or
pledged in connection with derivatives transactions. As an extreme
example, if a fund were to hold only assets that were highly liquid
investments that were segregated or pledged in connection with
derivatives transactions and that were not themselves classified as
highly liquid investments, none of its assets that were highly liquid
investments would be available to meet redemptions or otherwise manage
liquidity risk. Thus, we believe that such fund's assets that were
highly liquid investments would likely not be commensurate with its
liquidity risk profile as determined with reference to the liquidity
risk factors it would be required to consider under rule 22e-4.\730\
---------------------------------------------------------------------------
\727\ Rule 22e-4(b)(1)(iii)(B). As described above, a fund would
be permitted to exclude its derivatives transactions that are
classified as highly liquid investments in determining the
percentage of highly liquid investments that are segregated or
pledged assets because, since the fund could dispose of or exit
these derivatives transactions within three business days, the
associated segregated or pledged assets also would be available to
the fund for liquidity risk management purposes within three
business days. See supra text following footnote 493.
\728\ See supra section III.C.3.c.
\729\ See supra footnote 724 and accompanying text.
\730\ See supra section III.D.2 (discussing the rule 22e-4
requirement for a fund to consider certain liquidity risk factors in
determining its highly liquid investment minimum).
---------------------------------------------------------------------------
6. Highly Liquid Investment Minimum Reporting and Disclosure
Requirements
We proposed to amend Form N-PORT to add a new item that would
require each fund to disclose its three-day liquid asset minimum, as
such term was proposed to be defined in proposed rule 22e-4. One
commenter supported reporting the three-day liquid asset minimum in a
structured data format to the public as proposed.\731\ Certain other
commenters supported reporting the three-day liquid asset minimum in a
structured data format as proposed but to the Commission only.\732\ One
commenter did not support public disclosure of a fund's three-day
liquid asset minimum, as proposed, but said it would support public
disclosure of a fund's three-day liquid asset minimum if the Commission
adopted a recommended alternative to such definition.\733\
---------------------------------------------------------------------------
\731\ See Charles Schwab Comment Letter (noting that information
about the fund's liquidity risk management program will be
particularly helpful to investors, as will disclosure of a fund's
overall liquidity picture and a fund's three-day liquid asset
minimum).
\732\ See, e.g., CFA Comment Letter; Voya Comment Letter.
\733\ See Vanguard Comment Letter.
---------------------------------------------------------------------------
Some commenters, however, opposed public disclosure of both the
three-day liquid asset minimum as proposed and recommended alternatives
to the three-day liquid asset minimum. Commenters expressed concerns
that public disclosure could be misleading to investors, arguing that
any minimum reported on Form N-PORT would be subjective, presented
without context, and may not reflect a fund's actual portfolio
management approach at the time the data is being relied upon by
investors.\734\ Other commenters contended that public disclosure could
interfere with a fund's investment strategy and promote unwarranted,
and potentially destabilizing, redemption activity by fund
shareholders, especially during times of stress.\735\ One commenter
stated that public disclosure of a liquidity minimum would also give
undue emphasis to a single element of a fund's liquidity risk
management program and could potentially encourage third parties to use
a single numerical figure as a basis for comparing funds, further
encouraging undue reliance on the liquidity minimum figure by
investors.\736\ Certain other commenters expressed concern that public
disclosure could potentially expose a fund to predatory trading
activity if the fund is seen as vulnerable to liquidity risks or is
under stress.\737\ In addition, one commenter contended that
comparisons of three-day liquid asset minimums could result in
competitive pressures for relatively
[[Page 82207]]
uniform minimums among funds with similar investment strategies,
ultimately harming fund investors.\738\
---------------------------------------------------------------------------
\734\ See, e.g., Eaton Vance Comment Letter I; J.P. Morgan
Comment Letter; NYC Bar Comment Letter; Voya Comment Letter.
\735\ See, e.g., Eaton Vance Comment Letter I; J.P. Morgan
Comment Letter; Wells Fargo Comment Letter.
\736\ See SIFMA Comment Letter I.
\737\ See, e.g., Eaton Vance Comment Letter I; SIFMA Comment
Letter.
\738\ See NYC Bar Comment Letter.
---------------------------------------------------------------------------
We are persuaded by some of the concerns expressed by commenters
regarding the potential risks to funds and fund investors of public
reporting of a fund's three-day liquid asset minimum, as proposed, or
any alternative formulation, including a fund's highly liquid
investment minimum, as adopted today. In response to comments, we are
adopting amendments to require a fund to report its highly liquid
investment minimum on Form N-PORT to the Commission on a non-public
basis.\739\ We believe that the requirement that a fund report to its
board when the fund's assets that are highly liquid investments fall
below the fund's highly liquid investment minimum, discussed above, is
a more appropriate tool to assist fund boards in their oversight of
fund liquidity risks, thereby ultimately protecting shareholder
interests in the fund.\740\
---------------------------------------------------------------------------
\739\ See General Instruction F of Form N-PORT.
\740\ See supra section III.D.3.
---------------------------------------------------------------------------
In light of the changes we are making to the way the highly liquid
investment minimum is established, the final modifications to Form N-
PORT require that if a fund's minimum has changed during the reporting
period, any prior minimums established by the fund during the reporting
period also be reported.\741\ Because, as discussed previously, we are
not requiring the fund's board to approve changes to the highly liquid
asset minimum, we believe it is important that any changes to the
minimum during a reporting period be included in Form N-PORT to help
mitigate the possibility of window dressing a fund's highly liquid
asset minimum at the end of the reporting period, and allow us to
monitor for changes to a fund's minimum. In addition, considering the
changes we have made to the way the minimum works from the proposal,
and consistent with the board and Commission reporting requirements we
are adopting relating to shortfalls of a fund's minimum, the final
amendments to Form N-PORT also require that if a fund is below its
minimum during the reporting period, a fund needs to report the number
of days it is below its minimum during the reporting period.\742\ We
believe that this reporting requirement will enhance our monitoring of
fund's compliance with the minimum and the board and Commission
reporting requirements contained elsewhere in rule 22e-4. These
additional reporting requirements also would be non-public, for the
same reasons discussed above.
---------------------------------------------------------------------------
\741\ See Item B.7.c. of Form N-PORT.
\742\ See Item B.7.b. of Form N-PORT.
---------------------------------------------------------------------------
Overall, we believe that such board oversight together with
confidential reporting to the Commission is a regulatory approach that
balances commenters' concerns about certain adverse effects that could
arise from public reporting of liquid investment minimums with the need
for enhanced investor protections and meaningful information for
Commission regulatory oversight responsibilities. We believe that it is
neither necessary nor appropriate in the public interest or for the
protection of investors to make information regarding a fund's highly
liquid investment minimum publicly available at this time.\743\
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\743\ See section 45 of the Act, which provides, in summary,
that the information contained in any report or other document filed
with the Commission pursuant to the Act shall be made available to
the public, unless by rules and regulations upon its own motion, or
by order upon application, the Commission finds that public
disclosure is ``neither necessary nor appropriate in the public
interest or for the protection of investors.''
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E. Limitation on Funds' Illiquid Investments
Rule 22e-4 includes a limit on a fund's ability to acquire illiquid
investments. 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.\744\ The rule's 15% limit on funds'
illiquid investments applies to all funds (including In-Kind
ETFs).\745\ Additionally, as discussed below, a fund will be required
to notify its board, and confidentially the Commission, when its
illiquid investments that are assets exceed 15% of its net assets.
Moreover, the person(s) designated to administer the liquidity risk
management program must explain in a report to the board the extent and
causes of the occurrence, and how the fund plans to bring its illiquid
investments that are assets to or below 15% of its net assets within a
reasonable period of time.\746\ If the amount of the fund's illiquid
investments that are assets is still above 15% of its net assets 30
days from the occurrence (and at each consecutive 30 day period
thereafter), the board of directors, including a majority of its
independent directors,\747\ must assess whether the plan presented to
it continues to be in the best interest of the fund.
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\744\ Rule 22e-4(b)(1)(iv). Rule 22e-4(b)(1)(iv) refers to
investments that are ``assets'' to make clear that the 15% limit on
illiquid investments applies to investments with positive values.
Illiquid investments that have negative values should not be netted
against illiquid investments that have positive values when
calculating compliance with the 15% limit. Thus, only illiquid
investments that have positive values (i.e., ``assets'') should be
used in the numerator.
\745\ See id.; see also rule 22e-4(a)(5) and (9) (defining the
terms ``fund'' and ``In-Kind ETF'' for purposes of the rule).
\746\ Rule 22e-4(b)(1)(iv)(A).
\747\ ``Independent directors'' as used herein refers to
directors who are not ``interested persons'' of a fund or In-Kind
ETF, as applicable, as that term is defined in section 2(a)(19) of
the Investment Company Act.
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The limitation on funds' illiquid investments is similar to the
limitation on ``15% standard assets'' in proposed rule 22e-4,\748\ in
that both requirements would limit the acquisition of assets that
cannot be sold or disposed of within seven days. However, there are
several key differences between the proposed and adopted requirements.
Specifically, the proposed rule would have had a fund identify 15%
standard assets in a process separate from the requirement to classify
portfolio assets' liquidity, whereas rule 22e-4 as adopted today
generally incorporates classification of portfolio investments as
illiquid into the process for classifying the liquidity of a fund's
portfolio investments generally. As discussed in sections III.C.1.b and
III.C.3.b above, a fund is required to take into account ``relevant
market, trading, and investment-specific considerations,'' and also is
required to consider market depth, in classifying an investment as
illiquid. Also as discussed above in section III.C.2.d, rule 22e-4
incorporates a modified value impact standard in the definition of
``illiquid investment'' from the value impact standard reflected in
[[Page 82208]]
the proposed definition of ``15% standard asset.''
---------------------------------------------------------------------------
\748\ See Proposing Release, supra footnote 9, at section
III.C.4. Under the proposed rule, ``15% standard asset'' was defined
as ``an asset that may not be sold or disposed of in the ordinary
course of business within seven calendar days at approximately the
value ascribed to it by the fund.'' Proposed rule 22e-4(a)(4). For
purposes of this definition, a fund would not have needed to
consider the size of the fund's position in the asset or the number
of days associated with receipt of proceeds of sale or disposition
of the asset. Id.
We note that, as proposed, the text of rule 22e-4 would have
limited the acquisition of 15% standard assets if, immediately after
the acquisition, the fund would have invested more than 15% of its
total assets (as opposed to net assets) in 15% standard assets. See
proposed rule 22e-4(b)(2)(iv)(D). This reference to ``total assets''
in the proposed rule text was intended to read ``net assets,'' as
was evident in the discussion of this rule provision in Proposing
Release, section III.C.4 (and elsewhere in the Proposing Release),
which consistently discussed the provision as limiting a fund's
acquisition of 15% standard assets if, immediately after the
acquisition, the fund would have invested more than 15% of its net
assets in 15% standard assets. Rule 22e-4 as adopted refers to ``net
assets'' instead of ``total assets.''
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The majority of commenters supported the codification of the
Commission's 15% guideline as proposed. Many commenters stated that the
15% guideline is an important investor protection measure and posited
that the guideline has proven to be a highly effective safeguard
against liquidity risk.\749\ One commenter specifically noted that
assets of open-end funds should be predominantly liquid and replacing
the guideline with a formal regulatory mandate would promote investor
protection.\750\ Another commenter viewed the 15% guideline as a clear
safeguard against liquidity risk that has the benefits of simplicity,
clarity, and easy administration.\751\ One commenter stated that
setting reasonable controls on, and monitoring the use of, illiquid
asset classes to ensure that they do not compromise the liquidity
offered to investors within the fund is an important element of
properly managing open-end funds.\752\ Finally, one commenter suggested
that the proposed codification of the 15% guideline would both increase
the likelihood that funds hold adequate liquid assets to meet
redemption requests without significant dilution and increase the
likelihood that a fund's portfolio is not concentrated in assets whose
liquidity is limited.\753\
---------------------------------------------------------------------------
\749\ See, e.g., Cohen & Steers Comment Letter; Eaton Vance
Comment Letter I; FSR Comment Letter; LSTA Comment Letter.
\750\ See State Street Comment Letter.
\751\ See Better Markets Comment Letter.
\752\ See BlackRock Comment Letter.
\753\ See CRMC Comment Letter.
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In addition, several commenters supported a limit on the amount of
illiquid assets that can be held by a fund generally, but suggested
alternatives to how the 15% standard would operate or the proposed
definition of 15% standard assets.\754\ In fact, most commenters who
expressed concerns regarding the proposed 15% limit did so in the
context of suggesting alternatives to the proposal or the proposed
definition of ``15% standard asset.'' Multiple commenters who discussed
the proposed limit suggested that the Commission should harmonize its
codification of the existing 15% guideline with the proposed
requirement for a fund to classify the liquidity of its portfolio
assets generally (i.e., they suggested that illiquid assets be the
least liquid classification category).\755\ Some commenters suggested
that any limit on illiquid assets should not just limit the acquisition
of illiquid assets, but also should require the fund to adjust its
portfolio if it exceeds the 15% limit.\756\ Finally, some commenters
suggested that a fund be required to notify its board and the
Commission if it exceeds the 15% limit.\757\ All other comments on the
proposed limit were comments regarding the definition of ``15% standard
asset'' and are discussed above in section III.C.2.d.
---------------------------------------------------------------------------
\754\ See, e.g., AFR Comment Letter; Blackrock Comment Letter;
Keefer Comment Letter; Wahh Comment Letter. In general, the comments
we received on the 15% standard did not specifically address the
amount of the limit; cf. footnote 761 and accompanying text.
\755\ See, e.g., Eaton Vance Comment Letter I; Federated Comment
Letter; SIFMA Comment Letter I; Markit Comment Letter.
\756\ See, e.g., Fidelity Comment Letter; Keefer Comment Letter;
Wahh Comment Letter. But see HSBC Comment Letter (arguing that
imposing a fixed time period in which holdings above the 15%
threshold must be divested would not be appropriate because it may
force sales at depressed prices to the detriment of investors).
\757\ See BlackRock Comment Letter; ICI Comment Letter I; SIFMA
Comment Letter III.
---------------------------------------------------------------------------
We agree with commenters who stated that codifying a limit on
funds' illiquid investments should be a central element of managing
open-end funds' liquidity risk, which in turn would further the
protection of investors. While we believe that the highly liquid
investment minimum requirement will increase the likelihood that each
fund holds adequate liquid assets to meet redemption requests without
significant dilution of remaining investors' interests in the fund, the
limit on illiquid investments also should increase the likelihood that
a fund's portfolio is not concentrated in investments whose liquidity
is extremely limited, and thus will serve as an across-the-board limit
on fund illiquidity. As discussed above, the Commission and staff have
in the past provided guidance in connection with the 15% guideline.
Today we are withdrawing this guidance along with the 15% guideline and
replacing it with new requirements for determining that an investment
is illiquid, as well as new guidance in this Release regarding these
requirements. We believe that the limit on illiquid investments that
are assets that we are adopting, together with the new definition of
``illiquid investments'' that encompasses additional elements for
determining that an investment is illiquid,\758\ provides a more
comprehensive framework for funds to evaluate the liquidity of their
investments.
---------------------------------------------------------------------------
\758\ See supra section III.C.2.d.
---------------------------------------------------------------------------
We also agree, as discussed in more detail in section III.C.2.d
above, that it is appropriate to harmonize the rule 22e-4 limit on
illiquid investments with the rule's broader liquidity classification
requirement by incorporating an illiquid investment category into the
classification requirement. We believe that this harmonization will
reduce confusion that could arise if we were to adopt requirements for
identifying illiquid investments that differed from the requirements
for classifying the liquidity of investments that are not
illiquid.\759\ Additionally, we believe the harmonization responds to
commenter concerns that, in practice, many funds believe very few of
their portfolio investments are subject to the 15% limit on illiquid
securities, since funds will be required to take into account
``relevant market, trading, and investment-specific considerations'' in
identifying illiquid investments and incorporate market depth
considerations as part of the rule's liquidity classification
requirement.\760\ A fund also will be required to consider a modified
value impact standard in determining if an investment is illiquid,
which as discussed above, we believe will help funds make more accurate
liquidity assessments, particularly for asset classes or investments
that are subject to intra-day price volatility.
---------------------------------------------------------------------------
\759\ See supra footnotes 392-395 and accompanying text.
\760\ See supra footnotes 399-401 and accompanying text.
---------------------------------------------------------------------------
One commenter suggested that, if the Commission adopts requirements
that would expand the set of assets that is subject to the 15% limit on
illiquid assets, it could consider extending the limit beyond 15%, or
extending the time-to-sale period associated with the definition of
``illiquid asset'' beyond seven days, in order to limit market
disruptions.\761\ We have considered this suggestion and have decided
that it is not necessary.\762\ We continue to believe that 15% is an
appropriate limit on illiquid investments that are assets. The
compliance period we are adopting for rule 22e-4 will permit funds to
come into compliance with the revised 15% illiquid investment limit
while minimizing market disruptions.\763\
---------------------------------------------------------------------------
\761\ See AFR Comment Letter.
\762\ As noted above, no other commenters specifically addressed
the amount of the limit.
\763\ See infra section III.M.1.
---------------------------------------------------------------------------
In the proposal, we requested comment as to whether we should
require a fund to divest its assets in excess of the 15% limit or
whether we should limit the time period in which a fund can exceed the
15% limit. As noted above, some commenters suggested that the 15% limit
should be a maintenance test, rather than an acquisition test,
requiring the fund to adjust its portfolio if it exceeds the 15%
[[Page 82209]]
limit.\764\ Another commenter argued that imposing a fixed time period
in which holdings above the 15% threshold must be divested would not be
appropriate because it may force sales at depressed prices to the
detriment of investors.\765\ In addition, one commenter noted the
importance of ensuring oversight once a fund breaches the 15% limit and
that efforts are made to reduce the fund's illiquid asset holdings
(when possible).\766\
---------------------------------------------------------------------------
\764\ See supra footnote 756 and accompanying text.
\765\ See HSBC Comment Letter.
\766\ See BlackRock Comment Letter; cf. PIMCO Comment Letter
(suggesting that, with respect to the proposed three day liquid
asset minimum, if a fund breaches the minimum, its manager should be
afforded a reasonable period of time to reposition the portfolio).
---------------------------------------------------------------------------
We believe that requiring a fund to divest illiquid investments if
the fund's holdings of illiquid investments that are assets exceed 15%
of net assets--which, as suggested by a commenter, could result in the
fund needing to sell the illiquid investments at prices that
incorporate a significant discount to the investments' stated value, or
even at fire sale prices--could adversely affect shareholders and could
potentially negate the liquidity risk management benefits of the
illiquid investment limit. Therefore, under the final rule, a fund will
be prohibited from acquiring any illiquid investment if, immediately
after the acquisition, its illiquid investments that are assets would
exceed 15% of its net assets.\767\
---------------------------------------------------------------------------
\767\ We recognize that some index funds currently implement
their strategies by using a full replication technique--i.e., by
investing in all of the component securities of an index. To the
extent an index tracked by an index fund would require a fund using
a full replication technique to invest more than 15% of its net
assets in illiquid investments that are assets, such fund could not
make those investments and would need to consider whether it should
continue to seek to track the performance of such index or whether
it should use a different investment technique, such as sampling, to
track the index.
---------------------------------------------------------------------------
We further believe, however, that a fund should not be permitted to
exceed the 15% limit on illiquid investments for an extended period of
time without board oversight. Therefore, because we believe that if a
fund's illiquid investments that are assets exceed the 15% limit it
could indicate that the fund is encountering harmful liquidity
pressures, the final rule requires, as suggested by commenters,\768\
that a fund promptly report such occurrence to its board and the
Commission.\769\ Specifically, the final rule requires funds that hold
more than 15% of their net assets in illiquid investments that are
assets to report such an occurrence to their boards of directors within
one business day, including an explanation of the extent and causes of
the occurrence and how they plan to bring their illiquid investments
that are assets to or below 15% of their net assets within a reasonable
period of time.\770\ We also anticipate that if a fund exceeds the 15%
limit on illiquid investments that are assets at any point during the
year, the written report to the board of directors regarding the
adequacy and effectiveness of the liquidity risk management program
would discuss the breach of the limit and, if the fund is still
breaching the 15% limit at the time of the report, the plan to bring
the fund's illiquid investments that are assets to or below 15% of its
net assets within a reasonable period of time.\771\ In addition, if the
amount of the fund's illiquid investments that are assets is still
above 15% of its net assets 30 days from the occurrence (and at each
consecutive 30 day period thereafter), the fund's board of directors,
including a majority of directors who are not interested persons of the
fund, must assess whether the plan presented to it, as described above,
continues to be in the best interest of the fund or in kind ETF.\772\
We believe these requirements appropriately balance our concerns
regarding the overall liquidity of the fund's portfolio with the
potential adverse effects that the forced sale of illiquid investments
could have on a fund and its shareholders. These requirements should
not result in funds selling their illiquid investments at fire sale
prices or at inopportune times because such a sale would likely not be
in the best interests of a fund and its shareholders. However, we
believe that board oversight is important when a fund's illiquid
investments exceed 15% of its net assets for an extended period of
time.
---------------------------------------------------------------------------
\768\ See supra footnote 757.
\769\ See infra section III.H.4 (discussing board oversight of
the illiquid investment limit).
\770\ Rule 22e-4(b)(1)(iv)(A); see also infra section III.H.4.
\771\ See infra section III.H.2 (discussing the written report
to the board on the adequacy and effectiveness of the liquidity risk
management program); see also rule 22e-4(b)(2)(iii).
\772\ See rule 22e-4(b)(1)(iv)(A) and (B).
---------------------------------------------------------------------------
We acknowledge that requiring a board assessment of the
appropriateness of the fund's plan to decrease its level of illiquid
investments every 30 days a fund holds illiquid assets in excess of 15%
of its net assets may impose burdens on boards and funds. Nonetheless,
we believe that such a requirement is appropriate in light of the
serious consequences that can result when a fund's liquidity becomes
impaired or further deteriorates, particularly for extended periods of
time.\773\ We expect that this requirement will appropriately focus
boards and funds on resolving liquidity impairments in a reasonable
period of time and in the best interests of the fund and its
shareholders. In light of the risks attendant in holding larger
proportions of illiquid investments, we believe it is important that
the board is provided sufficient information and regular updates so
that it can make an informed judgment. Accordingly, we believe this
periodic reassessment requirement in the rule is appropriate.
---------------------------------------------------------------------------
\773\ See, e.g., Discussion of liquidity issues associated with
the Third Avenue Focused Credit fund at n. 81.
---------------------------------------------------------------------------
Additionally, as discussed in section III.M.2 below, a fund will be
required to confidentially notify the Commission when its illiquid
investments that are assets exceed 15% of its net assets. As discussed
below, reporting of this information will assist Commission staff in
its monitoring efforts of liquidity, including monitoring not only the
reporting fund but also funds that may have comparable characteristics
to the reporting fund and may be similarly affected by market events.
The percentage of the fund's holdings invested in illiquid investments
that are assets also will be disclosed on Form N-PORT to the public on
a quarterly basis, with a 60-day delay, as discussed in section III.C.6
above, which will lead to increased transparency of the fund's profile
regarding holdings of illiquid investments at particular points in
time.
F. Policies and Procedures Regarding Redemptions in Kind
Many funds reserve the right to redeem their shares in-kind instead
of with cash.\774\ Mutual funds that reserve the right to redeem in
kind may use such redemptions to manage liquidity risk under
exceptional circumstances.\775\ While many funds
[[Page 82210]]
disclose that they have reserved the right to redeem in kind, most
funds often consider redemptions in kind to be a last resort or
emergency measure, and thus many do not have specific policies or
procedures in place governing such in-kind redemptions.\776\ Like the
proposal, the final rule requires a fund that engages in or reserves
the right to engage in in-kind redemptions to adopt and implement
written policies and procedures regarding in-kind redemptions as part
of the management of its liquidity risk.\777\ These policies and
procedures generally should address the process for redeeming in kind,
as well as the circumstances under which the fund would consider
redeeming in kind.
---------------------------------------------------------------------------
\774\ See, e.g., Rule 18f-1 and Form N-18F-1 Adopting Release,
supra footnote 24 (stating that the definition of ``redeemable
security'' in section 2(a)(32) of the Investment Company Act ``has
traditionally been interpreted as giving the issuer the option of
redeeming its securities in cash or in kind.'').
\775\ See Karen Damato, `Redemptions in Kind' Become Effective
for Tax Management, Wall Street Journal (Mar. 10, 1999), available
at http://www.wsj.com/articles/SB921028092685519084 (```Redemptions
in kind' are typically viewed by fund managers as an emergency
measure, a step they could take to meet massive redemptions in the
midst of a market meltdown.''). Besides using in-kind redemptions as
an emergency measure to manage liquidity risk, funds may also use
in-kind redemptions for other reasons. For example, funds may wish
to redeem certain investors (particularly, large, institutional
investors) in kind, because in-kind redemptions could have a lower
tax impact on the fund than selling portfolio securities in order to
pay redemptions in cash. This, in turn, could benefit the remaining
shareholders in the fund. See, e.g., id. (``If a fund has to sell
appreciated stocks to pay a redeeming shareholder, it realizes
capital gains. Unless the fund has offsetting capital losses, those
gains are distributed as taxable income to all remaining fund
holders. By contrast, when funds distribute stocks from their
portfolios, there is no tax event for the continuing holders.'').
\776\ See Proposing Release, supra footnote 9, at section
III.C.5
\777\ Rule 22e-4(b)(v). This requirement also applies to In-Kind
ETFs that are subject to the tailored regime discussed below. Id.
---------------------------------------------------------------------------
Multiple commenters welcomed efforts by the Commission to
facilitate funds' ability to use redemptions in kind and stated that
they considered redemptions in kind an important liquidity risk
management tool for allocating the cost of selling securities to meet
redemptions to redeeming investors.\778\ These commenters also
generally agreed that as part of a fund's management of its liquidity
risk, a fund should adopt and implement written policies and procedures
regarding in-kind redemptions.\779\ Commenters noted that there are
often logistical issues associated with paying in-kind redemptions, and
that this limits the availability of in-kind redemptions under many
circumstances.\780\ Commenters also noted that some shareholders are
generally unable or unwilling to receive in-kind redemptions, which may
limit its utility.\781\ These commenters agreed that requiring funds to
implement policies and procedures on in-kind redemptions in advance
would promote a focus on addressing any legal or operations issues
before the fund's use of redemptions in kind, thus making such
redemptions a more practical and effective liquidity management
tool.\782\
---------------------------------------------------------------------------
\778\ BlackRock Comment Letter (noting that redemptions in kind
allow costs to be externalized from the fund without the use of
mechanisms such as swing pricing).
\779\ See, e.g., BlackRock Comment Letter; Invesco Comment
Letter.
\780\ See, e.g., Invesco FSOC Notice Comment Letter, supra
footnote 248 (noting that while ``Invesco has on occasion exercised
rights to redeem in kind, in practice such rights are exercised
infrequently'').
\781\ See Peter Fortune, Mutual Funds, Part I: Reshaping the
American Financial System, New England Econ. Rev. (July/Aug. 1997)
(``Fortune'') at 47 (``A fund redeeming in kind does so at the risk
of its reputation and future business . . .''), available at http://www.bostonfed.org/economic/neer/neer1997/neer497d.htm; Invesco
Comment Letter.
\782\ ICI Comment Letter I; BlackRock Comment Letter.
---------------------------------------------------------------------------
Commenters also suggested that the Commission provide guidance on
the appropriate use of in-kind redemptions for funds.\783\ We expect
that effective fund policies and procedures on in-kind redemptions
would contemplate a variety of issues and circumstances. Well-designed
policies and procedures would likely address the particular
circumstances in which a fund might employ in-kind redemptions, for
example, detailing whether a fund would use in-kind redemptions at all
times, or only under stress, and what types of events may lead the fund
to use them. Such policies and procedures would also likely address
whether a fund would use in-kind redemptions for all redemption
requests or only for requests over a certain size.\784\
---------------------------------------------------------------------------
\783\ See, e.g., BlackRock Comment Letter.
\784\ One commenter suggested that fund sponsors should consider
redemptions in kind if withdrawal requests exceed a certain
percentage of a fund's total assets. See BlackRock Comment Letter.
---------------------------------------------------------------------------
Funds may also wish to consider having policies and procedures that
address the ability of investors to receive in-kind redemptions,
potentially including different procedures for different shareholder
types. For example, the policies and procedures might provide that
retail shareholders (who may not be operationally equipped to receive
in-kind redemptions) may be provided cash redemptions, but that
institutional investors who may be able to receive such securities,
would be paid out in-kind under certain circumstances. These procedures
may also consider whether holdings through omnibus accounts pose any
unique issues that should be addressed. Well-designed policies and
procedures would likely also address potential operational issues with
providing in-kind redemptions to various kinds of investors, and plan
out methods for addressing such operational issues. These might include
notifying large shareholders that may be subject to redemptions in kind
and setting up securities transfer processes for those shareholders in
advance.
Effective policies and procedures would also likely address how the
fund would determine which securities it would use in an in-kind
redemption (for example would it use illiquid or restricted
securities), or whether it plans to redeem securities in kind as a pro
rata ratio of the fund's securities holdings, or whether it would
redeem in a non-pro rata manner. For a fund that redeems pro rata,
policies and procedures might address how the fund plans in-kind
redemptions of odd lots or small lots of securities, and if a fund were
to do such odd lot transactions, how to process such transactions. They
may also consider how they would accomplish in-kind redemptions of
illiquid securities or securities that have restrictions on their
transferability, and the extent to which these securities would not be
redeemed in kind.
If a fund chooses not to redeem in a pro rata manner, effective
policies and procedures would likely address that securities redeemed
are selected and distributed in a manner that is fair and does not
disadvantage either the redeeming shareholder or the remaining
investors in the fund. We caution that if a fund redeems an investor's
interests in a fund by transferring an unrepresentative set of
securities to the investor, this may raise questions of shareholder
discrimination and unfairness (as well as potentially cherry picking
and favoritism), which should be addressed in the fund's policies and
procedures. For example, policies and procedures could address how to
ensure that any securities that are redeemed in kind in a non-pro rata
manner are valued properly, to ensure that the securities transferred
represent the proportionate share of the fund NAV.\785\ They might also
address how the fund would determine that shareholders are treated
fairly, and are not redeemed with securities the fund deems undesirable
or securities that have significant tax consequences. Relatedly, the
policies and procedures may also address how the fund evaluates the tax
consequences to the fund and the redeeming shareholder of distributing
certain securities, for example, whether distributing certain
securities that have significant capital gains or losses built in would
have inequitable results.
---------------------------------------------------------------------------
\785\ See section 2(a)(32) (definition of redeemable security).
Such a transaction may have significant negative consequences to the
redeeming recipient, particularly if the security provided was fair
valued improperly, was restricted, or was in other ways impaired.
---------------------------------------------------------------------------
Because the management and personnel capacity of funds facing heavy
redemptions and other liquidity stresses will likely be strained as
funds attempt to manage these pressures, the Commission believes that
requiring funds to have policies and procedures
[[Page 82211]]
dictating how fund's will implement in-kind redemptions will increase
the likelihood that in-kind redemptions will be a feasible risk
management tool, and may address any potential fund or shareholder
inequities. Accordingly, we are adopting this requirement largely as
proposed.\786\
---------------------------------------------------------------------------
\786\ The rule text has been slightly modified to make clear
that redemption in kind policies and procedures must address not
just how the fund will engage in redemptions in kind, but also when
it will do so. Rule 22e-4(b)(1)(v).
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G. Cross-Trades
Today, under rule 17a-7, funds may make certain affiliated
securities transactions between funds and certain affiliates (``cross
trades''), provided they meet certain protective conditions.\787\ Rule
17a-7 includes conditions that limit the portfolio assets that may be
cross-traded, and, as discussed below, cross-trades involving certain
less liquid assets may not be eligible to rely on the rule. As
discussed in the Proposing Release, some funds may consider engaging in
cross-trades to be a useful liquidity risk management tool. Cross-
trading can benefit funds and their shareholders by allowing funds that
are mutually interested in a securities transaction that is consistent
with the investment strategies of each fund to conduct the transaction
without incurring transaction costs and without generating a market
impact.\788\ However, cross-trades also have significant potential for
abuse. For example, as the Commission has previously stated, ``an
unscrupulous investment adviser might `dump' undesirable securities on
a registered investment company or transfer desirable securities from a
registered investment company to another more favored advisory client
in the complex. Moreover the transaction could be effected at a price
which is disadvantageous to the registered investment company.'' \789\
Cross-trade transactions also may be inconsistent with the investment
objectives, investment strategies, or risk profiles of participating
investment companies and other advisory clients.\790\
---------------------------------------------------------------------------
\787\ Section 17 of the Act restricts transactions between an
``affiliated person of a registered investment company or an
affiliated person of such affiliated person'' and that investment
company--for example, transactions between a fund and another fund
managed by the same adviser. A fund must therefore obtain exemptive
relief from the Commission before entering into purchase or sale
transactions with an affiliated fund, or execute such transactions
subject to the provisions of rule 17a-7 under the Investment Company
Act (permitting purchase and sale transactions among affiliated
funds and other accounts, under certain circumstances).
\788\ As noted above, rule 17a-7 requires that each cross-trade
be consistent with the policy of each fund participating in the
transaction and that no brokerage commissions, fees or other
remuneration be paid in connection with the transaction. Because
cross-trades are conducted privately between funds, they are not
transparent to market trading reporting systems and thus are
unlikely to generate a market impact.
\789\ Exemption of Certain Purchase or Sale Transactions Between
a Registered Investment Company and Certain Affiliated Persons
Thereof, Investment Company Act Release No. 11136 (Apr. 21, 1980)
[45 FR 29067 (May 1, 1980)]. See also Evergreen Order, supra
footnote 46 (fund's adviser failed to seek best execution in trading
fund securities and favored one client over another, thereby
engaging in transactions that operated as a fraud or deceit upon its
client in violation of section 206(2) of the Advisers Act).
\790\ A fund that provided a non-pro rata distribution of cash,
securities or other property to a shareholder that owns 5% or more
of the fund and/or gives any election to the shareholder about which
assets to receive may also raise affiliated transaction concerns
under section 17(a) and rule 17a-5, as such a transaction would fall
outside the exemption provided by rule 17a-5 and thus might be
viewed as a sale to or purchase from the fund by an affiliated
person.
---------------------------------------------------------------------------
Accordingly, rule 17a-7 requires that any cross-trades satisfy
certain conditions designed to prevent such abuses, including the
requirement that market quotations be readily available for each traded
security and that if the security is only traded over the counter, the
cross-trade be conducted at the average of the highest current
independent bid and lowest current independent offer determined on the
basis of reasonable inquiry.\791\ In requiring market quotations for
cross-traded securities, the Commission has stated that ``[r]eliance
upon such market quotations provides an independent basis for
determining that the terms of the transaction are fair and reasonable
to each participating investment company or other advisory client and
do not involve overreaching.'' \792\ Rule 17a-7 also requires that a
cross-trade transaction be ``consistent with the policy of each
registered investment company and separate series of a registered
investment company participating in the transaction, as recited in its
registration statement and reports filed under the Act.'' \793\
---------------------------------------------------------------------------
\791\ See rule 17a-7(b).
\792\ Exemption of Certain Purchase or Sale Transactions Between
a Registered Investment Company and Certain Affiliated Persons
Thereof, Investment Company Act Release No. 11676 (Mar. 10, 1981)
[45 FR 17011 (Mar. 17, 1981)]. The Commission has historically
declined to expand rule 17a-7 to cross-trades for which market
quotations were not readily available and where independent current
market prices were not available because these conditions increase
the potential for abuse through cross-trades. See id.
\793\ See rule 17a-7(c).
---------------------------------------------------------------------------
We noted in the Proposing Release that less liquid assets are less
likely to satisfy rule 17a-7 than highly liquid investments.\794\ Some
commenters expressed concern that this assertion would prohibit funds
from, or create a presumption against, cross-trading any assets deemed
less liquid,\795\ or directly incorporate liquidity classification
decisions into rule 17a-7 eligibility determinations.\796\ One
commenter, disagreeing with the assertion that less liquid assets are
less likely to satisfy rule 17a-7 than highly liquid assets, stated ``a
less actively traded security may be less liquid, but nonetheless have
readily available market quotations, and a fund may determine that
independent bid and offer prices are available in the market. The
relative illiquidity of the security itself will not alone be
determinative of whether prices are available for Rule 17a-7
purposes.'' \797\
---------------------------------------------------------------------------
\794\ See Proposing Release, supra footnote 9, at n.396 and
accompanying text.
\795\ See ICI Comment Letter I.
\796\ See Comment Letter of Simpson Thacher & Bartlett LLP (Jan.
14, 2016) (``Simpson Thacher Comment Letter'').
\797\ See Fidelity Comment Letter.
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We note that less liquid assets, by definition, are less likely to
trade in highly active markets that produce readily available market
quotations, which may make it more difficult to ensure that the terms
of a cross-trade transaction are fair and reasonable to each
participating investment company or other advisory client and do not
involve overreaching. As one commenter noted, ``rule 17a-7 broadly
requires the availability of accurate valuation information with
respect to any security proposed to be traded from one adviser-directed
account to another. This effectively requires such securities to be
relatively liquid.'' \798\ Moreover, the absence of highly active
markets for less liquid assets may exacerbate the concern discussed
above relating to ``dumping'' undesirable securities, because limited
markets for such assets indicates that there are fewer alternate
options for disposing of the assets. Similarly, the absence of highly
active markets for less liquid assets may exacerbate the concern
relating to a transfer of assets that is inconsistent with the
investment objective, investment strategies, or risk profile of each
participating investment company or other advisory client.
---------------------------------------------------------------------------
\798\ See id.
---------------------------------------------------------------------------
We agree that an assessment of an asset's liquidity, without more,
would not determine whether the asset is eligible for a cross-trade
transaction under rule 17a-7. However, as noted above, we believe that
any assets used in a cross-trade transaction should be scrutinized to
ensure that they satisfy all of rule 17a-7's requirements. Due to the
particular risks associated with cross-trading less liquid assets, it
may be
[[Page 82212]]
prudent for advisers to subject less liquid assets to careful review
(and potentially even a heightened review compared to other more liquid
assets) before engaging in such transactions.
We note that cross trading also implicates a fund's adviser's duty
to seek best execution for each fund or other advisory client, as well
as its duty of loyalty to each fund or other advisory client.\799\ An
adviser should not cause funds or other clients to enter into a cross-
trade unless doing so would be in the best interests of each fund or
other client participating in the transaction. Advisers should be
particularly sensitive to the possibility of heightened conflicts when
one or both of the clients is experiencing stress at the time of
consideration of a cross trade.
---------------------------------------------------------------------------
\799\ See, e.g., In re Western Asset Management Co., Investment
Company Act Release No. 30893 (Jan. 27, 2014) (settled action)
(stating that the adviser to funds and other advisory clients
engaging in cross-trading ``has a fiduciary duty of loyalty to its
clients and also must seek to obtain best execution for both its
buying and selling clients'' and finding that the adviser aided and
abetted and caused violations of section 17(a) and violated Advisers
Act section 206).
---------------------------------------------------------------------------
Under rule 38a-1, a fund's compliance policies and procedures
related to rule 17a-7 generally should contemplate how the fund meets
the rule's requirements with regard to less liquid assets. For example,
as part of these policies and procedures, a fund might consider
conducting a review of less liquid assets before cross-trading them to
ensure that ``market quotations are readily available,'' that a
``current market price'' is available, that the transaction is in line
with each participating investment company's or other advisory client's
investment objective, investment strategies and risk profile, and that
the cross-trade satisfies all other requirements set forth in rule 17a-
7. Reasonably designed policies and procedures thus would likely
specifically address how a fund would determine that such less liquid
securities are appropriately used when meeting the requirements of rule
17a-7. The specific review of a less liquid asset would likely vary
depending on the characteristics of the market or markets in which the
asset transacts, the characteristics of the asset itself, and the
nature of the funds potentially involved in the cross trade.
In crafting policies and procedures reasonably designed to address
the particular risks of cross-trading less liquid assets, a fund could
consider specifying the sources of the readily available market
quotations to be used to value the assets and establish specific
criteria for determining whether market quotations are current and
readily available, and include potential back-up sources if the primary
sources are not available. Funds should consider including in their
policies and procedures periodic reviews of the continuing
appropriateness of those sources of readily available market
quotations.
In addition, a fund's policies and procedures might also provide
for assessing the quality of quotations provided by dealers. The
quality of dealer quotations may vary depending upon, among other
things, the extent to which a dealer makes a market in or retains an
inventory in the particular security, or in similar securities, such
that the dealer maintains an awareness of changes in market factors
affecting the value of the security.\800\ ``Indications of interest''
and ``accommodation quotes,'' may not necessarily reflect the current
market values of the securities and thus are not ``market quotations''
or ``market values'' for the purposes of rule 17a-7.\801\
---------------------------------------------------------------------------
\800\ Dealers do not necessarily purport to provide quotations
for securities that reflect their current market values. Some
dealers may provide only ``indications of interest,'' i.e., non-firm
expressions of interest to trade that do not constitute quotations
or ``accommodation quotes''. See, e.g., Regulation NMS, Securities
Exchange Act Release No. 49325 (Feb. 26, 2004) [69 FR 11126 (Mar. 9,
2004)], at n.257. Cf. Rules 600(b)(8) and (62) under Regulation NMS
[17 CFR 242.600(b)(8) and 242.600(b)(62)] (defining ``bid or offer''
as ``the bid price or the offer price communicated by a member of a
national securities exchange or member of a national securities
association to any broker or dealer, or to any customer, at which it
is willing to buy or sell one or more round lots of an NMS security,
as either principal or agent, but shall not include indications of
interest,'' and defining ``quotation'' as ``a bid or an offer'').
\801\ Id. We also note that evaluated prices provided by pricing
services are not, by themselves, readily available market
quotations. See 2014 Money Market Fund Reform Adopting Release,
supra footnote 43, at n.895 and accompanying text.
---------------------------------------------------------------------------
In addition, reasonably designed policies and procedures likely
would also include compliance monitoring to help ensure that the
investment objective, investment strategies and risk profile of each
participating investment company or other advisory client are
scrutinized in conjunction with the characteristics of any cross-traded
asset to evaluate whether the asset transfer is not in line with any
objective or strategy or inappropriately shifts risk from one
investment company or other advisory client to another. Whether a
cross-trade is in the best interest of an investment company or other
client purchasing an asset may depend, in part, on the relative
liquidity of the purchaser's existing portfolio assets and the level of
redemptions that may be reasonably anticipated by the purchaser.
H. Board Approval and Designation of Program Administrative
Responsibilities
Directors, and particularly independent directors, play a critical
role in overseeing fund operations, although they generally may
delegate day-to-day management to a fund's adviser.\802\ As discussed
below, we are adopting as proposed the requirement for a fund's board
of directors to approve the investment adviser, officer, or officers
who are responsible for administering the program and to approve the
fund's written liquidity risk management program. However, in a change
from the proposal, the board will not be required to specifically
approve the fund's highly liquid investment minimum (except in the
limited circumstances that a fund below its minimum seeks to change it)
or to approve material changes to the program. Instead, similar to rule
38a-1, the board will be required to review, no less than annually, a
written report prepared by the investment adviser, officer, or officers
designated to administer the liquidity risk management program that
describes a review of the program's adequacy and effectiveness,
including, if applicable, the operation of the highly liquid investment
minimum, and any material changes to the program.\803\ As discussed in
detail below, the final rule retains a role for the board in overseeing
the fund's liquidity risk management program, but in response to
commenters, eliminates certain of the more specific and detailed
approval requirements.
---------------------------------------------------------------------------
\802\ See Investment Trusts and Investment Companies: Hearings
on H.R. 10065 Before a Subcomm. of the House Comm. on Interstate and
Foreign Commerce, 76th Cong., 3d Sess. 112 (1940) at 109 (describing
the board as an ``independent check'' on management); Burks v.
Lasker, 441 U.S. 471, 484 (1979) (citing Tannenbaum v. Zeller, 552
F.2d 402, 406 (2d. Cir. 1979)) (describing independent directors as
``independent watchdogs'').
\803\ See rule 22e-4(b)(2).
---------------------------------------------------------------------------
We believe the role of the board under the rule is one of general
oversight, and consistent with that obligation we expect that directors
will exercise their reasonable business judgment in overseeing the
program on behalf of the fund's investors. As discussed in the
Proposing Release, directors may satisfy their obligations with respect
to this initial approval by reviewing summaries of the liquidity risk
management program prepared by the fund's investment adviser, officer,
or officers administering the program, legal counsel, or other persons
familiar with the liquidity risk management
[[Page 82213]]
program.\804\ The summaries should familiarize directors with the
salient features of the program and provide them with an understanding
of how the liquidity risk management program addresses the required
assessment of the fund's liquidity risk.
---------------------------------------------------------------------------
\804\ See Proposing Release, supra footnote 9, at section III.D.
---------------------------------------------------------------------------
Many commenters expressed general support for board oversight of
the liquidity risk management program, although several objected to
certain of the board's specific responsibilities required under the
rule, in particular their approval of the three-day highly liquid asset
minimum and of material changes to the program.\805\ Given the board of
directors' historical oversight role, the Commission continues to
believe it is appropriate to require a fund's board to oversee the
fund's liquidity risk management program. The rule's requirements are
designed to facilitate the board's oversight of the adequacy and
effectiveness of the fund's liquidity risk management program.
---------------------------------------------------------------------------
\805\ See, e.g., ICI Comment Letter I; IDC Comment Letter; SIFMA
Comment Letter I.
---------------------------------------------------------------------------
Several commenters asked that the final rule include an express
standard of care (i.e., the business judgment rule) to which the
Commission would hold a fund's board accountable in this area.\806\ One
commenter requested that the final rule provide fund boards with a safe
harbor in approving specific elements of the program and clarification
that a board is not required to consider all of the enumerated factors
(specifically, any non-applicable factors) when setting and adjusting
the three-day liquid asset minimum.\807\ We believe that the changes
made to the board oversight role from the proposal should largely
address the commenters' concerns. In addition, we believe that the
board oversight role here is substantially similar to its role and
responsibilities in other contexts under the Investment Company Act,
and that providing a different standard of care for board action here
would not be appropriate.\808\
---------------------------------------------------------------------------
\806\ Fidelity Comment Letter; FSR Comment Letter; MFDF Comment
Letter; T. Rowe Comment Letter. See also NYC Bar Comment Letter
(suggesting codifying a good-faith, reasonable, business judgment
standard). One commenter also suggested that the proposed
requirement of keeping records of the board's determination related
to the factors considered when approving the three-day liquid asset
minimum is not appropriate in light of the board's historical role.
T. Rowe Comment Letter. We note that as discussed below, the board
will not specifically approve the highly liquid investment minimum,
thereby addressing the commenters' concerns about keeping records of
the factors used in the board's determination.
\807\ T. Rowe Comment Letter.
\808\ See, e.g., 2014 Money Market Fund Reform Adopting Release,
at text accompanying nn.266-267 (discussing the board's role under
the Investment Company Act).
---------------------------------------------------------------------------
1. Designation of Administrative Responsibilities to Fund Investment
Adviser, Officer, or Officers
We are adopting substantially as proposed the requirements that the
fund's board of directors approve the designation of the fund's
investment adviser, officer, or officers (which could not be solely
portfolio managers of the fund) responsible for administering the
fund's liquidity risk management program.\809\ We are also adopting,
substantially as proposed, the requirement that the administrator of
the program provide the board with a written report on the adequacy of
the fund's liquidity risk management program, including the highly
liquid investment minimum, and the effectiveness of its implementation,
at least annually.\810\ The Commission continues to believe this
approach properly tasks the person(s) who are in a position to manage
the fund's liquidity risks on a real-time basis with responsibility for
administration of the liquidity risk management program. Designating
the fund's investment adviser, officer, or officers responsible for the
administration of the fund's liquidity risk management program, subject
to board approval, is consistent with the way the Commission
understands most funds manage liquidity.\811\
---------------------------------------------------------------------------
\809\ See rule 22e-4(b)(2)(ii).
\810\ See rule 22e-4(b)(2)(iii). We note that a fund's sub-
adviser could be designated as the administrator of the program if
appropriate.
\811\ See American Bar Association, Fund Director's Guidebook,
Federal Regulation Of Securities Committee, (4th ed. 2015), at 82
(``Determining the liquidity of a security is primarily an
investment decision that is delegated to the investment adviser, but
directors may establish guidelines and standards for determining
liquidity.'').
---------------------------------------------------------------------------
We received little comment on this aspect of the proposal. A few
commenters agreed with the proposal that the board's responsibilities
should include approval of the program's administrator.\812\ We
continue to believe that requiring that the board approve the
designation of the administrator of the liquidity risk program is an
important step in board oversight of the program. We believe that
having the board approve the administrator should help enhance board
oversight of the program and allow for boards to better understand who
is responsible for administering it.
---------------------------------------------------------------------------
\812\ IDC Comment Letter; Voya Comment Letter.
---------------------------------------------------------------------------
One commenter argued that portfolio managers should administer the
program, contending that liquidity risk management requires investment
skills and swiftness during stress to manage redemptions.\813\ This
commenter believed that if a program administrator were independent
from portfolio management, then liquidity assessment might become
divorced from the investment process, which the commenter argued would
be disadvantageous to the fund and investors. We agree that portfolio
management provides valuable input into the liquidity risk management
process. However, we are concerned that if only portfolio managers run
the program, the program might not be administered with sufficient
independence to accomplish the goal of managing the risk of the fund's
liquidity. We believe that a fund generally should consider the extent
of influence portfolio managers may have on administration of the
program, and seek to provide independent voices and administration of
the program as a check on any potential conflicts of interest to the
extent appropriate. However, as the proposal noted, although the fund's
portfolio managers cannot be solely responsible for administering the
program, the administrator of the program might wish to consult with
the fund's portfolio manager, traders, risk managers, and others as
necessary or appropriate in administering a fund's liquidity risk
management program.\814\ Portfolio managers may also be a part of any
committee or group designated to administer the program, if more than
one person is so designated. The Commission understands that some funds
currently employ a dedicated risk management officer who consults with
the fund's portfolio management team. One commenter noted, and we
agree, that portfolio managers should provide day-to-day management of
funds, with an additional layer of oversight provided by the risk and
compliance framework.\815\ After review of the comments received, we
continue to believe that requiring the officer or officers responsible
for administering the fund's liquidity risk management program not to
be solely portfolio managers strikes the appropriate balance between
independence and expertise.
---------------------------------------------------------------------------
\813\ Invesco Comment Letter.
\814\ See Proposing Release, supra footnote 9, at section
III.D.3.
\815\ BlackRock Comment Letter.
---------------------------------------------------------------------------
The Commission recognizes that, in certain circumstances, a fund's
service providers might assist a fund and its investment adviser by
providing information relevant to a fund's assessing and managing
liquidity
[[Page 82214]]
risk.\816\ We note, however, that the primary parties responsible for a
fund's liquidity risk management are the fund itself and any parties to
whom the fund has delegated responsibility for administering the fund's
liquidity risk management program.
---------------------------------------------------------------------------
\816\ See Proposing Release, supra footnote 9, at section
III.D.3.
---------------------------------------------------------------------------
One commenter requested further guidance on what responsibilities
the administrator could delegate and to what extent the administrator
could rely upon third parties.\817\ The Proposing Release provided two
examples of when a fund's service providers could assist a fund and its
investment adviser in monitoring factors relevant to a fund's liquidity
risk and managing the fund's liquidity risk: Third parties could
provide data relevant to assessing fund flows, and a sub-adviser
necessarily would be responsible for investing a fund's assets in
accordance with the fund's three-day liquid asset minimum and any other
liquidity-related portfolio requirements adopted by the fund.\818\ As
proposed, the final rules require a fund to oversee any liquidity risk
monitoring or risk management activities undertaken by the fund's
service providers. We encourage the fund to communicate regularly with
its service providers as a part of its oversight and to coordinate the
liquidity risk management efforts undertaken by various parties.
---------------------------------------------------------------------------
\817\ Voya Comment Letter.
\818\ See Proposing Release, supra footnote 9, at section
III.D.3.
---------------------------------------------------------------------------
2. Oversight of the Liquidity Risk Management Program
Under the final rule, a fund will be required to obtain initial
approval of its written liquidity risk management program from the
fund's board of directors, including a majority of its independent
directors.\819\ Additionally, the fund's board will be required to
review a written report from the administrator of the fund's liquidity
risk management program, provided no less frequently than annually,
that addresses the operation of the program and assesses its adequacy
and effectiveness of implementation.\820\ In a change from the
proposal, a fund will not be required to obtain approval of any
material changes to the fund's liquidity risk management program from
the fund's board of directors, but instead such material changes will
be described in the report.\821\
---------------------------------------------------------------------------
\819\ See rule 22e-4(b)(2)(i).
\820\ As noted above, more frequent reports to the board may be
appropriate in certain circumstances. See supra footnote 771.
\821\ See rule 22e-4(b)(2).
---------------------------------------------------------------------------
Commenters raised concerns that the proposed rule imposed
management responsibilities on the fund's board of directors and
suggested that the Commission clarify that the board's role is to
provide oversight through approval of policies and procedures, whereas
management's role is to devise the specific details of the
program.\822\ Commenters contended that the final rule should mirror
rule 38a-1, requiring fund managers to explain material changes to the
program (including changes to the three-day liquid asset minimum) in an
annual report to the board, not to submit those changes for prior board
approval.\823\ These commenters felt that a requirement to discuss
material changes to the liquidity risk management program in an annual
update to the fund's board would strike an appropriate balance between
allowing the fund manager the flexibility to make changes to liquidity
risk management as market conditions might require, while also keeping
the fund's board informed.\824\
---------------------------------------------------------------------------
\822\ See, e.g., Cohen & Steers Comment Letter; FSR Comment
Letter; HSBC Comment Letter; NYC Bar Comment Letter.
\823\ See, e.g., BlackRock Comment Letter; FSR Comment Letter;
ICI Comment Letter I; Invesco Comment Letter.
\824\ See, e.g., BlackRock Comment Letter; Dechert Comment
Letter; Voya Comment Letter.
---------------------------------------------------------------------------
We agree with commenters that requiring funds to obtain approval
from fund boards before making material changes to a liquidity risk
management program risks the program becoming stale and outdated as
market changes occur, and is not consistent with the approach taken
under rule 38a-1. Accordingly, the final rule does not require prior
approval of material changes to the fund's liquidity risk management
program from the fund's board of directors. However, under the final
rule, the board is still required to approve the program initially and
to provide oversight of it, as well as review a report on the adequacy
and effectiveness of the program's implementation, which must include a
description of any material changes made to the program during the
period. We believe that this oversight role is consistent with the
board's historical responsibilities with respect to overseeing fund
operations.
3. Oversight of the Highly Liquid Investment Minimum
In a change from the proposal, under the final rule, boards will
not be required to approve the highly liquid investment minimum, nor
approve changes to it, except in the limited circumstances where a fund
seeks to change the minimum while the fund is below the pre-established
minimum. Commenters argued that because liquidity risk management,
including management of three day-liquid assets, is both technical and
fact-intensive and often requires day-to-day judgments, fund managers
should develop and administer the program, subject to board
review.\825\ Commenters were concerned that the requirement for a fund
to obtain board approval for setting and changing the three-day minimum
may cause delay that might harm fund shareholders.\826\ For example,
one commenter argued that requiring board approval, which might be
difficult to obtain on a timely basis, could cause a fund to stand idle
as market conditions changed, missing opportunities as board approval
was sought.\827\
---------------------------------------------------------------------------
\825\ See, e.g., CRMC Comment Letter; FSR Comment Letter; State
Street Comment Letter; Dodge & Cox Comment Letter.
\826\ Id.
\827\ Dechert Comment Letter.
---------------------------------------------------------------------------
We agree with commenters that requiring boards to approve the
highly liquid investment minimum may reduce its utility, as the minimum
may need to be revised on a more timely basis so that it can best
reflect the liquidity management needs of the fund under current market
conditions. In addition, we understand commenters' concerns that
requiring mutual fund boards to make day-to-day determinations
regarding the minimum amount of cash or liquid assets the fund should
hold may lead to a more detailed managerial role for the board.
However, in the limited circumstances where the program
administrator seeks to change the fund's highly liquid investment
minimum while the fund is below the pre-established minimum, the final
rules require the board to approve such a change. In the absence of
such a requirement, the administrator could simply change the minimum
if the fund dropped below it, avoiding the accountability of the board
approval requirements as well as reducing the minimum's utility as a
liquidity risk management tool. The final rule also requires the board
to receive a report whenever the fund falls below its highly liquid
investment minimum at its next regularly scheduled meeting and a report
of such a shortfall if the fund is below its highly liquid investment
minimum for more than 7 consecutive calendar days, within one business
day thereafter. The Commission believes these requirements properly
balance the ability of funds to move quickly in response to shifting
environments with
[[Page 82215]]
the boards' oversight of the liquidity risk management program.
4. Oversight of Illiquid Investment Limit
In a change from the proposal, the final rule will also require
that a fund board be informed within one business day if the fund's
holdings of illiquid investments exceed 15% of its net assets. In the
proposal, we requested comment as to whether additional aspects of a
fund's liquidity management program should be reported to a fund's
board. For the reasons discussed in the section on Form N-LIQUID, if a
fund's holdings of illiquid investments exceed 15% for any reason (for
example, if a fund experiences net redemptions leading to increased
holdings of illiquid investments) it may raise significant concerns
regarding the fund's management of its liquidity and ability to
continue to meet its redemption obligations. Accordingly, we believe
that such an event should be reported to the board immediately, as it
may have significant impacts on the ability of the fund to meet its
redemption obligations, and may compromise its liquidity risk
management.
As discussed in the section on Form N-LIQUID below, a number of
commenters also expressed support for the addition of an early warning
notification provision, under which funds would be required to notify
the Commission (or take other action) when illiquid investments held at
the end of a business day exceed 15% of net assets and continue to
exceed 15% of net assets three business days after the threshold was
first exceeded.\828\ As discussed in the section on Form N-LIQUID, we
are adopting a requirement that a fund report to the Commission within
one business day if the fund's holdings of illiquid investments exceed
15% percent of its net assets. One commenter suggested that such a
requirement would impose greater discipline on the oversight of fund
holdings of illiquid assets, and that a fund would likely consult with
the fund board in developing how to proceed in response.\829\ We agree,
and believe that if a fund were to file Form N-LIQUID because the
fund's holdings of illiquid investments exceeded 15% of its net assets,
a fund board should be informed, and should be informed quickly, so
that the board can provide oversight as the fund determines how to
address the level of illiquidity in the fund's portfolio. Accordingly,
as a complement to this new N-LIQUID requirement, the final rules
require that if a fund's holdings of illiquid investments exceed 15% of
its net assets, the fund board be informed of that fact within one
business day after the occurrence, with an explanation of the extent
and causes of the occurrence and how the fund plans to bring its
illiquid investments that are assets to or below 15% of its net assets
within a reasonable period of time.
---------------------------------------------------------------------------
\828\ See, e.g., ICI Comment Letter III; SIFMA Comment Letter
III (noting that this early warning notification could respond to
concerns raised by the Third Avenue Fund liquidation); see also
Third Avenue Temporary Order, supra footnote 12.
\829\ See ICI Comment Letter III.
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I. Recordkeeping Requirements
Under the final rules, and as we proposed, each fund will be
required to maintain a written copy of the policies and procedures
adopted as part of its liquidity risk management program for five
years, in an easily accessible place.\830\ Additionally, each fund will
be required to maintain copies of any materials provided to its board
in connection with the board's initial approval of the fund's liquidity
risk management program, and copies of written reports provided to the
board on the adequacy of the fund's liquidity risk management program,
including the fund's highly liquid investment minimum, and the
effectiveness of its implementation for at least five years after the
end of the fiscal year in which the documents were provided to the
board, the first two years in an easily accessible place.\831\ In a
change from the proposal, funds would also need to keep records of any
materials provided to the board related to the fund dropping below its
highly liquid investment minimum. As with the proposal, the final rules
also require each fund to keep a written record of how its highly
liquid investment minimum, and any adjustments thereto, were
determined, including the fund's assessment and periodic review of its
liquidity risk for a period of not less than five years, the first two
years in an easily accessible place, following the determination of,
and each change to, the fund's highly liquid investment minimum.\832\
---------------------------------------------------------------------------
\830\ See rule 22e-4(b)(3)(i). These policies and procedures
would include any shortfall policies and procedures adopted by a
fund. See id.
\831\ See rule 22e-4(b)(3)(ii).
\832\ See rule 22e-4(b)(3)(iii).
---------------------------------------------------------------------------
One commenter found the recordkeeping requirements consistent with
similar recordkeeping requirements that funds are currently required to
maintain.\833\ The recordkeeping requirement is designed to provide our
examination staff with a basis to evaluate a fund's compliance with the
requirements of rule 22e-4. We also anticipate that these records would
assist our staff in identifying weaknesses in a fund's liquidity risk
management. The five-year retention period is also consistent with the
period provided in rule 38a-1(d) under the Act. We believe consistency
in these retention periods is appropriate because funds currently have
compliance program-related recordkeeping procedures in place
incorporating a five-year retention period, which we believe lessen the
compliance burden to funds, compared to choosing a different retention
period, such as the six-year recordkeeping retention period under rule
31a-2 of the Act.
---------------------------------------------------------------------------
\833\ CFA Comment Letter.
---------------------------------------------------------------------------
The Commission continues to believe that the rule appropriately
balances recordkeeping-related burdens on funds and our examination
staff's ability to evaluate a fund's liquidity risk management program
in light of the requirements of rule 22e-4. We are therefore adopting
this aspect of the rule substantially as proposed.
J. ETFs
We are adopting certain tailored liquidity risk management program
requirements for ETFs.\834\ In assessing, managing, and periodically
reviewing its liquidity risk, an ETF will be required to consider
certain additional factors, as applicable, that take into account its
unique operation, as discussed further below.\835\ Like all funds, each
ETF also will be required to limit its investments in illiquid
investments to no more than 15% of its net assets and obtain certain
board approvals regarding the program. Certain ETFs that qualify as
``In-Kind ETFs,'' \836\ (generally ETFs that redeem shares in kind
except to a de minimis extent and that publish their holdings daily)
however, will not be required to classify their portfolio investments
or comply with the highly liquid investment minimum requirement.\837\
[[Page 82216]]
We believe these adjusted program requirements recognize and
appropriately require management of the unique liquidity risks found in
ETFs, and in particular In-Kind ETFs.
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\834\ References to ETFs in this section are to both in-kind and
other open-end ETFs, but not UIT ETFs (which are not subject to the
liquidity risk management program requirements), except where
specifically indicated otherwise. See infra section III.K for a
discussion of limited liquidity review requirements for principal
underwriters and depositors of UITs.
\835\ See rule 22e-4(b)(1)(i).
\836\ References to ``In-Kind ETFs'' include both ETFs and ETMFs
that meet the requirements in rule 22e-4(a)(9)) (defining an ``In-
Kind ETF''). See infra footnote 851 and accompanying text
(discussing a requirement that ETFs report their status as an ``In-
Kind ETF,'' when applicable, on Form N-CEN).
\837\ ETFs that redeem in cash, or that do not qualify otherwise
as ``In-Kind ETFs'' (as defined in rule 22e-4(a)(9)) will be subject
to the full set of liquidity risk management program elements,
including the classification and highly liquid investment minimum
requirements. See rule 22e-4(b)(1)(i)-(iii). Throughout the
discussion of liquidity risk management programs in this Release,
references to ``funds'' include ETFs that redeem in cash, except
where specifically indicated otherwise.
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A number of commenters on the proposal highlighted how ETFs differ
from mutual funds, and stated in particular that In-Kind ETFs do not
present the same type of liquidity risks as other funds.\838\ These
commenters suggested that the Commission: (i) Exempt either ETFs or In-
Kind ETFs entirely from proposed rule 22e-4; \839\ (ii) exempt either
ETFs or In-Kind ETFs from certain requirements of proposed rule 22e-4
(notably the portfolio liquidity classification and three-day liquid
asset requirements); \840\ or (iii) develop a more tailored liquidity
risk management program applicable to ETFs.\841\
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\838\ See, e.g., ICI Comment Letter; BlackRock Comment Letter;
Invesco Comment Letter; SIFMA Comment Letter I.
\839\ See, e.g., Invesco Comment Letter (suggesting an exemption
for all ETFs); FSR Comment Letter (suggesting an exemption for In-
Kind ETFs); SIFMA Comment Letter I (suggesting an exemption for In-
Kind ETFs).
\840\ See, e.g., State Street Comment Letter (suggesting an
exemption for In-Kind ETFs from the portfolio liquidity
classification and three-day liquid asset requirements); Dechert
Comment Letter (suggesting an exemption for all ETFs from the three-
day liquid asset requirements); ICI Comment Letter I (suggesting an
exemption for In-Kind ETFs from the three-day liquid asset
requirements); BlackRock Comment Letter (stating that the days-to-
cash framework in the portfolio liquidity classification
requirements is irrelevant for ETFs and suggesting an exemption for
at least In-Kind ETFs from the three-day liquid asset requirements).
\841\ See BlackRock Comment Letter; FSR Comment Letter.
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As noted above, we believe that ETFs, like mutual funds, face
liquidity risks.\842\ But we agree that In-Kind ETFs have different
liquidity risks than funds (including ETFs) that redeem in cash. This
is particularly the case because the redeeming shareholder (i.e.,
authorized participant or its customer), rather than the ETF, typically
will bear the direct costs associated with its liquidity needs, given
that if that authorized participant (or its customer) wants cash, it
must sell the in-kind assets and bear the costs of doing so. Therefore,
after further analysis, including carefully considering the comments
received, we are adopting tailored liquidity risk management program
requirements for ETFs as discussed further below.
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\842\ We note, as discussed previously, that ETFs will be
subject to the requirement to implement an overall liquidity risk
management program, including the requirement that the fund
determine whether its investment strategy is appropriate for an
open-end fund.
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We decline to exempt all ETFs from the rule entirely, because we
believe ETFs that redeem more than a de minimis amount in cash can have
substantially similar liquidity risks as mutual funds, and we believe
that all ETFs have certain unique additional risks discussed below. In
addition, while we agree that the classification and highly liquid
investment minimum components of the liquidity risk management program
we are adopting for other funds are not necessary for In-Kind ETFs, we
believe that In-Kind ETFs must maintain sufficient liquidity and assess
liquidity-related risks that could affect their shareholders. In this
regard, the liquidity of an ETF's portfolio positions is a factor that
may contribute to the bid-ask spread, the effective functioning of the
ETF's arbitrage mechanism and the ETF's shares trading at a price that
is at or close to NAV.\843\ For example, if an ETF holds illiquid or
less liquid investments, this will be reflected in the redemption
basket transferred to a redeeming authorized participant (or its
customer), which might result in a liquidity cost to the authorized
participant (or its customer or other market participants). This
increased cost could alter the authorized participant's decisions
regarding exactly when or whether to create or redeem the ETF's
creation units, possibly resulting in the ETF trading at increased
spreads and/or a price that deviates significantly from its NAV and
ultimately adversely impacting the ETF's investors.
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\843\ By this we mean that, and we generally expect that, each
day and over time an ETF's shares will trade at or close to the
ETF's intraday value. See 2015 ETP Request for Comment, supra
footnote 29 (``When providing exemptive or no-action relief under
the Exchange Act, the Commission and its staff have analyzed and
relied upon the representations from ETP issuers regarding the
continuing existence of effective and efficient arbitrage to help
ensure that the secondary market prices of ETP Securities do not
vary substantially from the value of their underlying portfolio or
reference assets.''); infra footnote 857. Because an ETF does not
determine its NAV in real time throughout the trading day, in
assessing whether this expectation is met, one looks to the
difference between the ETF shares' closing market price and the
ETF's end-of-day net asset value (i.e., its ``premium'' or
``discount''). See 2015 ETP Request for Comment, supra footnote 29.
With regard to ETMFs, as noted in the Proposing Release, ETMF market
makers would not engage in the same kind of arbitrage as ETF market
makers because all trading prices of ETMF shares are linked to NAV.
See Proposing Release, supra footnote 9, at n.458.
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Over the years, the Commission and staff have explored the
structural and operational differences between ETFs (including those
that redeem in kind) and other open-end funds (that redeem in cash),
solicited public comment, including on issues related to the potential
effects of illiquidity on the operation of ETFs and evaluated the
trading of ETFs in times of market stress.\844\ In 2015, the Commission
solicited public comment on topics related to the listing and trading
of exchange-traded investment products (``ETPs'') on national
securities exchanges and sales of these products by broker-
dealers.\845\ Of relevance here, the Commission sought comment on all
aspects of the arbitrage mechanism for ETPs (including ETFs), including
what characteristics of an ETP would facilitate or hinder the alignment
of secondary market share prices with the value of the underlying
portfolio reference assets and how arbitrage mechanisms work in the
case of ETPs with less-liquid underlying or reference assets. The
questions posed in this Release, as well as the comments received,
demonstrate the importance of assessing liquidity risks and liquidity
needs for all ETFs, including In-Kind ETFs. We considered the comments
received on the 2015 ETP Request for Comment in formulating the
proposed rule and the final rule we are adopting today.
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\844\ See, e.g., ETF Proposing Release, supra footnote 27; Staff
of the Office of Analytics and Research, Division of Trading and
Markets, Research Note: Equity Market Volatility on August 24, 2015
(Dec. 2015) (``August 24 Staff Report''), available at https://www.sec.gov/marketstructure/research/equity_market_volatility.pdf.
\845\ See 2015 ETP Request for Comment, supra footnote 29 at
n.10. The 2015 ETP Request for Comment did not address ETMFs'
listing and trading given that, at the time, no ETMFs were listed or
traded on an exchange.
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1. Definitions
Under the final rule, all ETFs must consider certain additional
liquidity risk assessment factors, if applicable, but only In-Kind ETFs
will be excluded from the classification and highly liquid investment
minimum requirements.\846\ We are defining an exchange-traded
[[Page 82217]]
fund or ``ETF'' as ``an open-end management investment company (or
series or class thereof), the shares of which are listed and traded on
a national securities exchange, and that has formed and operates under
an exemptive order under the Act granted by the Commission or in
reliance on an exemptive rule adopted by the Commission.'' \847\ We are
defining an ``In-Kind ETF'' to mean an ETF that meets redemptions
through in-kind transfers of securities, positions, and assets other
than a de minimis amount of cash and that publishes its portfolio
holdings daily.\848\ The definition of ``In-Kind ETF'' is intended to
distinguish this type of ETF, which, as described throughout this
Release, has a unique structure and raises different liquidity risks
than other open-end funds (that in most cases redeem shares in cash).
As discussed below, we believe that this definition of an In-Kind ETF
facilitates this distinction by limiting an ETF's redemption basket to
in-kind securities and other assets, and no more than a de minimis
amount of cash. In addition, the definition requires that an In-Kind
ETF publish the ETF's holdings daily.\849\ This daily publishing of ETF
holdings (or ``daily transparency'') is a condition of many of our ETF
orders, and we understand that even for ETFs not subject to that
condition, most provide this daily transparency as a matter of
course.\850\ We believe that requiring this daily transparency will
permit the sophisticated authorized participants that directly interact
with the ETF to effectively evaluate the liquidity of the ETF's
holdings. We also note that we are requiring an ETF to report publicly
to the Commission on Form N-CEN its designation as an In-Kind ETF as
defined in the final rule so that there is clarity on which ETFs meet
this definition and are thus subject to the tailored liquidity risk
management program.\851\
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\846\ We note that an in-kind ETF may not be able to avail
itself of the tailored liquidity risk management program where the
in-kind ETF operates as a class of a fund that also has mutual fund
classes. In such a case, for example, the liquidity classification
requirement would apply to the entire portfolio, thus applying to
both in-kind ETFs and other funds (e.g., mutual funds). UITs,
including ETFs structured as UITs, will not be subject to the
majority of the liquidity risk management program requirements. See
supra section III.A.2.d and infra section III.K (discussing rule
22e-4(c), that requires, on or before the date of initial deposit of
portfolio securities into a registered UIT (including ETF UITs), the
principal underwriter or depositor to determine that the portion of
the illiquid investments that the UIT holds or will hold at the date
of deposit that are assets is consistent with the redeemable nature
of the securities it issues and maintain a record of that
determination for the life of the UIT and for five years
thereafter).
\847\ See rule 22e-4(a)(4). We note that this definition is
substantially the same as the definition of ETF that we had proposed
as amendments to rule 22c-1. We also note that this definition is
substantially the same as the definition in Form N-1A.
\848\ See rule 22e-4(a)(9). Cash means cash held in U.S.
dollars, and would not include, for example, cash equivalents or
foreign currency.
\849\ Today, such daily publishing of ETF holdings involves
posting on the ETF's Web site on each day that the national
securities exchange on which the fund's shares are listed is open
for business, before commencement of trading of fund shares on the
exchange, the identities and quantities of the securities, assets or
other positions held by the fund, or its respective master fund,
that will form the basis for the fund's calculation of net asset
value at the end of the business day.
\850\ See, e.g., Foreside ETF Trust, et al., Investment Company
Act Release No. 32284 (Sep. 26, 2016) [81 FR 68079 (Oct. 3, 2016)]
(notice of application). We note that ETMFs are not required to
provide such daily transparency under their orders, and thus would
need to choose to provide such daily transparency if they wished to
take advantage if this provision.
\851\ See Item E.5 of Form N-CEN (``Is the Fund an `In-Kind
Exchange-Traded Fund' as defined in rule 22e-4 under the Act?''). In
addition, ETFs (including In-Kind ETFs) will be required to report
on Form N-CEN the average percentage value of creation units
purchased and redeemed both with in-kind securities and assets and
with cash, during the reporting period. See Investment Company
Reporting Modernization Adopting Release, supra footnote 120.
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Consistent with our exemptive orders, we recognize that there may
be circumstances under which an In-Kind ETF may use cash to meet
redemptions (in addition to securities and other non-cash assets). For
example, today an ETF that typically redeems in-kind may use cash to:
(i) Make up any difference between the NAV attributable to a creation
unit and the aggregate market value of the creation basket exchanged
for the creation unit (generally referred to as the ``balancing
amount'' in an ETF's exemptive order); (ii) correspond to uninvested
cash in the fund's portfolio (which, to the extent that this amount of
cash equals the fund's cash position in the portfolio, would be an
``in-kind'' redemption); or (iii) substitute for a portfolio position
or asset that is not eligible to be transferred in kind (e.g., a
derivative instrument that, pursuant to contract, is not
transferrable).\852\ By their nature, ``balancing amounts'' are small
amounts and thus would be de minimis. Accordingly, there are a number
of reasons, including those described above, why an In-Kind ETF may
find it prudent or necessary to use a de minimis amount of cash to meet
redemptions. However, if an In-Kind ETF were to use more than a de
minimis amount of cash (as determined in accordance with its written
policies and procedures) to meet redemptions (for any of the reasons
discussed above or otherwise), it would not qualify as an In-Kind ETF
and would need to comply with the liquidity risk management program
requirements applicable to other ETFs.\853\ By way of example, an ETF
that normally redeems in-kind, but delivers all cash to a single
authorized participant that elects to receive cash, would not be an ETF
that uses a de minimis amount of cash. However, depending on the
circumstances, an ETF that delivers cash only on one occasion may be
able to conclude that it qualifies as an In-Kind ETF in later years if
such circumstances are not repeated.
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\852\ We note that depending on the size of the position being
substituted for, such a transaction may not always be de minimis,
and thus the ETF may no longer be eligible to qualify for this
provision.
\853\ In-Kind ETFs are subject to rule 22e-4, including the
obligation to establish written policies and procedures for a
liquidity risk management program. As part of these written policies
and procedures, we would expect that an In-Kind ETF would determine
the amount of cash and the types of transactions that it will treat
as de minimis. If for any reason, an In-Kind ETF was not able to
meet redemptions with more than a de minimis amount of cash
consistent with those policies and procedures, such a fund would no
longer qualify as an In-Kind ETF and would thus no longer be
eligible to rely on this provision. See rule 22e-4(b)(1)(ii).
---------------------------------------------------------------------------
An In-Kind ETF generally should describe in its written policies
and procedures for its liquidity risk management program,\854\ to the
extent applicable, how the fund analyzes the ability of the ETF to
redeem in-kind in all market conditions such that it is unlikely to
suddenly fail to continue to qualify for this exception to the
classification and highly liquid investment minimum requirements, the
circumstances in which the In-Kind ETF may use a de minimis amount of
cash to meet a redemption, and what amount of cash would qualify as
such. As part of its policies and procedures, an In-Kind ETF generally
should also describe how the ETF will manage and/or approve any portion
of a redemption that is paid in cash and document the ETF's
determination that such a cash amount is de minimis. In making these
determinations, an In-Kind ETF may consider, if applicable: (i) The
amount (both in dollars and as a percentage of the entire redemption
basket) and frequency with which cash is used to meet redemptions; and
(ii) the circumstances and rationale for using cash to meet
redemptions.
---------------------------------------------------------------------------
\854\ Rule 22e-4 requires that an In-Kind ETF adopt and
implement a written liquidity risk management program reasonably
designed to assess and manage the fund's liquidity risk. See rule
22e-4(b).
---------------------------------------------------------------------------
As discussed above, in-kind redemptions mitigate certain liquidity
risks, but only to the extent that the fund can use in-kind
redemptions. This factor is particularly important for an In-Kind ETF
because such a fund may only include in its redemption basket a de
minimis amount of cash if it wants to qualify for the exclusion from
the classification and highly liquid investment minimum requirements.
If, for example, market conditions change and the fund can no longer
meet redemptions without more than a de minimis amount of cash, the
fund would no longer qualify as an In-Kind ETF. As a result, the ETF
would be required to comply with additional requirements under its
liquidity risk management program (including liquidity portfolio
classifications and highly liquid investment minimum).
[[Page 82218]]
2. Tailored Program Elements for ETFs
By adopting certain tailored liquidity risk management program
requirements for ETFs, we recognize, consistent with comments received,
that both ETFs that redeem in cash and In-Kind ETFs present unique
liquidity risks as compared to other funds. Some of these unique risks
were not specifically addressed in the generally applicable liquidity
risk management program as proposed, while still other aspects of the
general program were less applicable to the actual operation of In-Kind
ETFs, particularly those that offer daily transparency of holdings. Our
final rule is designed to address both issues. Accordingly, an ETF will
be required to adopt and implement a tailored liquidity risk management
program that has the unique elements discussed below, in addition to
the elements discussed elsewhere in this Release.
Liquidity Risk Assessment
An ETF, like other open-end funds, will be required to assess and
manage the fund's ``liquidity risk''--defined as the risk that a fund
could not meet requests to redeem shares issued by the fund without
significant dilution of remaining investors' interests in the
fund.\855\ As discussed above, we believe that this definition,
modified from the proposal as informed by commenter input, is
appropriate for all open-end funds, whether the fund redeems in cash or
in kind and whether the fund is a mutual fund or an ETF.\856\
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\855\ See rule 22e-4(a)(11) (defining liquidity risk); rule 22e-
4(b) (requiring each fund and in-kind ETF to adopt and implement a
written liquidity risk management program).
\856\ See supra section III.B.1 for a discussion of the
definition of liquidity risk, including comments received and
modifications made from the proposal.
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Illiquidity in an ETF's portfolio or its basket assets can
adversely impact investors by imposing costs on market participants
that could then potentially be reflected in a widening of the bid-ask
spread of the ETF shares. This widening could result in shareholders
transacting in an ETF's shares at market prices that do not maintain a
``close tie'' to the NAV per share of the ETF. As we have previously
stated, a close tie between ETF share market prices and the ETF's NAV
per share is important because section 22(d) and rule 22c-1 under the
Act are designed to require that all fund shareholders be treated
equitably.\857\ In addition, declining liquidity in an ETF's portfolio
also could affect a market maker's ability or willingness to make a
market in the product because arbitrage opportunities would be more
difficult to evaluate.\858\ This, in turn, could affect the liquidity
of the ETF shares, making it difficult for market participants to
price, trade and hedge.
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\857\ See generally H.R. REP. NO. 2639, 76th Cong., 3d Sess., 8
(1940). See also Investment Trusts and Investment Companies: Report
of the Securities and Exchange Commission, H.R. Doc. No. 279, 76th
Cong., 1st Sess., pt. 3, at 860-874 (1939); Spruce ETF Trust, et
al., Investment Company Act Release No. 31301 (Oct. 21, 2014) [79 FR
63964 (Oct. 27, 2014)] (notice of application) (to the extent that
investors would have to exit at a price substantially below the NAV
of the ETF, this would be ``contrary to the foundational principle
underlying section 22(d) and rule 22c-1 under the Act that all
shareholders be treated equitably when buying and selling their fund
shares''); Precidian ETFs Trust, et al., Investment Company Act
Release No. 31300 (Oct. 21, 2014) [79 FR 63971 (Oct. 27, 2014)]
(notice of application) (``A close tie between market price and NAV
per share of the ETF is the foundation for why the prices at which
retail investors buy and sell ETF shares are similar to the prices
at which Authorized Participants are able to buy and redeem shares
directly from the ETF at NAV. This close tie between prices paid by
retail investors and Authorized Participants is important because
section 22(d) and rule 22c-1 under the Act are designed to require
that all fund shareholders be treated equitably when buying and
selling their fund shares.'').
\858\ See supra footnote 843 and accompanying text.
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Under the final rule, ETFs will be required to assess, manage, and
periodically review the fund's liquidity risk and needs, taking into
account, as applicable, the liquidity risk factors for all funds (as
modified from the proposal) discussed previously.\859\ ETFs also must
consider the following additional factors, as applicable, that are
specific to the structure and operation of ETFs:
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\859\ See supra section III.B.2 (discussing the factors as
proposed and how the factors have been amended in the final rule to
address commenter concerns). We recognize that not all of these
factors may be applicable to all ETFs (and that some mutual funds
would not need to consider certain factors relevant only to ETFs).
---------------------------------------------------------------------------
The relationship between the ETF's portfolio liquidity and
the way in which, and the prices and spreads at which, ETF shares
trade, including the efficiency of the arbitrage function and the level
of active participation by market participants (including authorized
participants); \860\ and
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\860\ We note that this factor will not be applicable to ETMFs
to the same extent it applies to ETFs. ETMF market makers will not
engage in the same kind of arbitrage as ETF market makers and will
assume no intraday market risk with their positions in ETMF shares
as all trading prices are linked to NAV. See ETMF Notice, supra at
note 31 at n.21 and accompanying text.
---------------------------------------------------------------------------
The effect of the composition of baskets on the overall
liquidity of the ETF's portfolio.
We considered, in establishing these factors, comments received on
the Proposing Release and the 2015 ETP Request for Comment, as well as
the unique structure and operation of ETFs. We discuss these factors in
more detail below. As we noted with regard to other open-end funds, the
list of liquidity risk assessment factors for ETFs is not meant to be
exhaustive. Rather, an ETF generally should incorporate other
considerations in assessing its liquidity risk that it considers
appropriate.
ETF Trading--Arbitrage Function and Level of Activity of Market
Participants
As discussed above, the ETF structure permits only authorized
participants to purchase or redeem shares from an ETF and to transact
in the ETF's shares at the NAV per share. The combination of the
creation and redemption process with secondary market trading in ETF
shares provides arbitrage opportunities that, if effective, keep the
market price of the ETF's shares at or close to the NAV per share of
the ETF.\861\ If an ETF has a significant amount of illiquid securities
in its portfolio, market participants may find it more difficult to
evaluate opportunities and ultimately participate in the arbitrage
process (because of challenges in pricing, trading, and hedging their
exposure to the ETF). If the arbitrage function fails to operate
efficiently, investors could buy and sell the ETF shares at prices that
are not at or close to the NAV per share of the ETF, which may raise
concerns relating to section 22(d) of and rule 22c-1 under the Act
regarding whether all fund shareholders (authorized participants and
retail investors) are being treated equitably.\862\ We discussed in the
Proposing Release how the effective functioning of this arbitrage
mechanism has been pivotal to the operation of ETFs (and to the
Commission's approval of exemptions that allow their operation) and how
the liquidity of the ETF's portfolio positions is a factor that
contributes to the effective functioning of this arbitrage
mechanism.\863\
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\861\ We recognize that an ETF is not as likely as a mutual fund
to sell or in-kind transfer its portfolio holdings in order to meet
redemptions because an authorized participant generally will not
seek to create or redeem a basket with the ETF until there is a
sufficient deviation between the ETF shares' market price and the
ETF's NAV. As discussed previously, ETMF market makers would not
engage in the same kind of arbitrage as ETF market makers because
all trading prices of ETMF shares are linked to NAV. See supra
footnote 836.
\862\ See supra footnote 857.
\863\ See Proposing Release, supra footnote 9, at nn.23-30 and
accompanying text.
---------------------------------------------------------------------------
Commenters to the 2015 ETP Request for Comment also highlighted the
importance of portfolio liquidity on the efficiency of the ETF
arbitrage mechanism. During an extraordinary period of market
volatility on August 24, 2015 (``the August 24th Market Events''), for
example, many ETFs traded at prices materially different from the NAV
of the funds' underlying
[[Page 82219]]
portfolio assets.\864\ One commenter on the 2015 ETP Request for
Comment, in observing the August 24th Market Events, noted that there
are many reasons an ETF may trade at a substantial difference from the
NAV of its underlying constituent stocks, including a lack of liquidity
in the ETF constituents and a lack of liquidity in the ETF shares
themselves.\865\ Another commenter suggested that, where the market for
an underlying asset is illiquid, no amount of arbitrage will be
sufficient to equalize market discrepancies between underlying assets
and the fund's price, especially during times of market stress.\866\ In
addition, the level of active participation by market participants,
including market makers and authorized participants, in the trading of
ETF shares is important to the way in which, and the prices and spreads
at which, shares trade. As one commenter on the 2015 ETP Request for
Comment noted, the more authorized participants that are active in the
market, the more opportunities there are to trade and provide
liquidity.\867\ For these reasons, we are requiring that an ETF
consider the relationship between the liquidity of its portfolio and
the arbitrage function in assessing its liquidity risk (where
applicable).
---------------------------------------------------------------------------
\864\ August 24 Staff Report, supra footnote 844, at 5
(discussing large ETFs that traded at ``substantial discounts'' to
the ETFs' NAVs).
\865\ See Comment Letter of Modern Markets Initiative on 2015
ETP Request for Comment (Sept. 14, 2015), available at https://www.sec.gov/comments/s7-11-15/s71115-39.pdf.
\866\ See Comment Letter of Occupy the SEC on 2015 ETP Request
for Comment (Aug. 21, 2015), available at https://www.sec.gov/comments/s7-11-15/s71115-32.pdf.
\867\ See Comment Letter of Flow Traders Group on 2015 ETP
Request for Comment (Aug. 17, 2015), available at https://www.sec.gov/comments/s7-11-15/s71115-25.pdf.
---------------------------------------------------------------------------
Basket Composition
In-Kind ETFs create and redeem using baskets of securities and
other assets. These baskets may be highly correlated to the ETF's
overall portfolio. As we noted in the Proposing Release, the
composition of the basket can affect the liquidity of the ETF's
portfolio.\868\ For example, an ETF whose basket does not reflect a pro
rata share of the fund's portfolio may alter the liquidity profile of
the ETF's portfolio and may adversely affect the fund's future ability
to meet cash redemptions or mitigate shareholder dilution.\869\ We
recognize that certain market incentives exist to mitigate the
likelihood of significant or frequent divergence between an ETF's
basket and the fund's portfolio. For example, if an ETF's basket is not
correlated with the fund's portfolio, the ETF likely will develop a
higher tracking error. Nonetheless, such divergence may occur, with
potentially adverse consequences to the remaining shareholders in the
fund. Accordingly, we are requiring an ETF to consider the effect of
its basket composition on the fund's overall portfolio liquidity (even
if an ETF's creation and redemption baskets reflect a pro rata share of
the ETF's portfolio).\870\
---------------------------------------------------------------------------
\868\ See Proposing Release, supra footnote 9, at nn.23-24, 156-
157 and accompanying text.
\869\ Under limited circumstances, an index ETF's redemption
basket also may differ from the portfolio deposit made by the
authorized participant.
\870\ One commenter on the 2015 ETP Request for Comment,
discussing the potential effects of basket composition on an ETF's
overall liquidity, noted that an ETF whose basket reflects a pro
rata share of the ETF's portfolio will have a larger number of
securities in the basket, with the size of each individual position
potentially being smaller. This commenter suggested that, as a
result: (i) The smaller lots can be more difficult for an authorized
participant to trade efficiently, thereby increasing the bid/ask
spreads of the ETF; and (ii) the pro rata basket is more likely to
include less liquid or even illiquid securities that an ETF not
subject to the pro rata requirement can exclude. See Comment Letter
of Charles Schwab & Co. on the on 2015 ETP Request for Comment (Aug.
17, 2015), available at https://www.sec.gov/comments/s7-11-15/s71115-28.pdf.
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A few commenters also suggested that increasing ETF basket
flexibility and eliminating the two percent limitation on redemption
fees for ETFs would help enhance ETF liquidity and the orderly and
efficient operation of the arbitrage function.\871\ We are not
addressing these issues here because they are beyond the scope of this
rulemaking.
---------------------------------------------------------------------------
\871\ See, e.g., BlackRock Comment Letter; ICI Comment Letter I;
Fidelity Comment Letter.
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Portfolio Liquidity Classification
Under the final rule, an open-end fund (other than an In-Kind ETF)
will be required to classify each of the fund's portfolio investments
(generally by asset class) into one of four categories: Highly liquid
investments; moderately liquid investments; less liquid investments;
and illiquid investments. A number of commenters noted, as the
Commission recognized in the Proposing Release and as we reiterate
above, that an open-end fund (including an open-end ETF) that redeems
in cash has a different nature of liquidity risk than an ETF that
redeems through in-kind transfers of securities, positions, and other
assets.\872\
---------------------------------------------------------------------------
\872\ See, e.g., BlackRock Comment Letter; Proposing Release,
supra footnote 9.
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We note, for example, that when a mutual fund experiences daily net
redemptions, the fund will likely be required to sell its portfolio
holdings in order to generate cash to meet redemptions. To the extent
that a fund must sell a less liquid security in order to generate the
cash proceeds required, there is enhanced liquidity risk--that is, risk
that a fund cannot meet redemptions without significant dilution of
remaining investors. Therefore, we believe that it is appropriate for
such a fund to assess its liquidity risk by analyzing the amount of
time it will take, in current market conditions, to convert its
portfolio assets (without the conversion (or in some cases, sale or
disposition) significantly changing the market value of the
investments).
As discussed above, an In-Kind ETF's liquidity risk is different
from the liquidity risk of a fund that generally meets redemptions in
cash. Rather than liquidity risk affecting investors directly in their
ability to receive cash redemption proceeds, illiquidity in an ETF's
portfolio or its basket assets can adversely impact investors by
contributing to a widening of the bid-ask spread of the ETF shares.
This widening could result in shareholders transacting in an ETF's
shares at market prices that do not maintain a ``close tie'' to the NAV
per share of the ETF. The declining liquidity in an ETF's portfolio
also could affect the arbitrage function related to the ETF, as
discussed above.
Despite our concern about the specific liquidity-related risks in
ETFs described above, we view the liquidity classification information
for In-Kind ETFs as less necessary for the Commission, investors, and
other potential users of this information because, unlike for mutual
funds, the daily identity and weightings of ETF portfolio holdings are
well known to authorized participants and other ETF liquidity
providers, and would be required to be disclosed daily under our final
rules to qualify for the exemption from the classification
requirement.\873\
[[Page 82220]]
Authorized participants are the only shareholders that are permitted to
transact with the ETF at NAV, and these sophisticated broker-dealers
are more likely to be able to readily discern the ETF's liquidity
profile from this daily portfolio information.
---------------------------------------------------------------------------
\873\ See rule 22e-4(a)(9). See also, Precidian ETFs Trust, et
al., Investment Company Act Release No. 31300 (Oct. 21, 2014) [79 FR
63971 (Oct. 27, 2014)] (notice of application) (``The Commission
therefore has granted such exemptive relief to date only to those
actively managed ETFs that have provided daily transparency of their
portfolio holdings.''). The identity and weightings of the
constituents of affiliated indices are required by exemptive
application condition to be made publicly available on a daily
basis. See, e.g., Columbia ETF Trust I, et. al., Investment Company
Act Release No. 32134 (May 31, 2016) (order) (related application
with conditions available at: https://www.sec.gov/Archives/edgar/data/1233991/000119312516578039/d194333d40appa.htm). The identity
and weightings of the constituents of non-affiliated indexes are not
required to be made publicly available on a daily basis. However,
because: (1) These index compositions are generally broadly
available to liquidity providers either publicly, by subscription or
by license; and (2) index-based ETFs publish their purchase and
redemption baskets daily, and those baskets generally are tracking
baskets that represent either a pro rata replication of the index or
a sampling of the index, authorized participants and other ETF
liquidity providers should nonetheless be able to determine the
liquidity profile of a non-affiliated, index-based ETF on a daily
basis. Unlike ETFs, ETMF are only required to provide the same
disclosure about the identity and weightings of their portfolio
holdings as mutual funds.
---------------------------------------------------------------------------
We continue to believe that it is important that an In-Kind ETF
maintain sufficient liquidity in its portfolio. Accordingly, the final
rule requires that an In-Kind ETF, in assessing liquidity risk, take
into account certain factors that are more tailored to the way in which
such funds operate and the resulting liquidity risks. For example,
those factors include considering the relationship between portfolio
liquidity and the arbitrage function, as well as the effect of the
composition of in-kind baskets on the overall liquidity of the fund's
portfolio. However, given the more limited utility of this
classification information for the reasons described above, and
considering the burdens of tracking and reporting it to us, we do not
believe that it is appropriate to require an In-Kind ETF to classify
its portfolio investments into liquidity categories based on a ``days-
to-cash'' framework and report that information to the Commission.\874\
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\874\ In the Proposing Release, we proposed to apply the
portfolio liquidity classification requirement to open-end ETFs (in
addition to other open-end funds), in part, because, ETFs permit
authorized participants to redeem in cash (even if these funds
typically redeem in kind). See Proposing Release, supra footnote 9,
at n. 129 and accompanying text. Accordingly, we determined that it
was appropriate to require that all ETFs classify their portfolio
liquidity by assessing the fund's ability to convert portfolio
positions into cash. The final rule, however, establishes a more
tailored regulatory regime for In-Kind ETFs, that, by definition, do
not meet redemptions through more than a de minimis amount of cash.
Thus, under the final rule, we do not believe it is necessary to
require that In-Kind ETFs be subject to the portfolio liquidity
classification requirement (which is based on a ``days-to-cash'' or
``days-to-sell'' framework).
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Highly Liquid Investment Minimum
Under the final rule, an open-end fund (other than an In-Kind ETF)
will be required to determine a percentage of the fund's net assets
that it will invest in assets that are highly liquid investments. The
fund will determine its highly liquid investment minimum using the
first category in the liquidity classification requirement (i.e., cash
and assets convertible into cash within three business days). The fund
also will be required to take certain actions when the fund's highly
liquid investments fall below its minimum.\875\
---------------------------------------------------------------------------
\875\ See supra section III.D; rule 22e-4(b)(1)(iii).
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In determining to adopt a highly liquid investment minimum for
certain open-end funds, we considered comments received on proposed
rule 22e-4, which would have required a ``three-day liquid asset
minimum.'' \876\ Multiple commenters suggested that the concept of a
three-day liquid asset minimum does not take into account the unique
structural aspects of ETFs.\877\ One commenter suggested that the
concept of ``convertible into cash within three business days'' has
little relevance to an ETF that does not liquidate securities to meet
cash redemptions.\878\
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\876\ See supra section III.D.
\877\ See, e.g., Dechert Comment Letter; ICI Comment Letter I;
BlackRock Comment Letter; SIFMA Comment Letter I.
\878\ See BlackRock Comment Letter.
---------------------------------------------------------------------------
Consistent with the comments received, we are not requiring that an
In-Kind ETF adopt a highly liquid investment minimum. First, an open-
end fund will be required to establish its highly liquid investment
minimum using its ``highly liquid investment'' portfolio
classification. As discussed earlier, we have determined that it is not
necessary to require that an In-Kind ETF classify its portfolio
liquidity (e.g., into ``highly liquid investment,'' or ``moderately
liquid investment''). The portfolio liquidity classifications
incorporate a ``convertible to cash'' concept that is generally not
relevant for an In-Kind ETF (except in managing cash holdings to no
greater than a de minimis amount of cash). Because the highly liquid
investment minimum incorporates the same ``convertible to cash''
concept as the portfolio liquidity classifications (which, for the
reasons discussed above, we are not requiring for In-Kind ETFs), we do
not believe it is appropriate to require that an In-Kind ETF establish
a highly liquid investment minimum.
Second, the highly liquid investment minimum, as discussed above,
is intended to increase the likelihood that an open-end fund meets
redemption requests without significant dilution of remaining
investors. Open-end funds that redeem in cash and In-Kind ETFs operate
differently, and therefore evaluate liquidity risk differently. We
believe, for example, that it is necessary for an open-end fund that
meets redemptions in cash (including an ETF) to manage its liquidity
risk by establishing a minimum amount of highly liquid investments
that, as defined in the final rule, are quickly convertible to cash
(within 3 business days). In this way, the highly liquid investment
minimum increases the likelihood that the fund will be able to meet
redemption requests in cash without significant dilution of remaining
investors. Conversely, we believe, for example, that it is more
appropriate for an In-Kind ETF that meets redemptions through in-kind
transfers of securities, positions, and other assets (and no more than
a de minimis amount of cash) to, among other things, assess its
liquidity risk through consideration of the factors we have discussed
above (e.g., assessing the relationship between portfolio liquidity and
the arbitrage function). For these reasons, we are excluding In-Kind
ETFs from the highly liquid investment minimum requirement in rule
22e4.
We discussed above the requirement that funds (including ETFs)
other than In-Kind ETFs establish a highly liquid investment
minimum.\879\ One commenter noted that the three-day liquid asset
minimum might increase tracking error, or force an ETF to either
violate the terms of its exemptive order,\880\ or refuse in-kind
purchase requests from authorized participants, thus interfering with
the arbitrage mechanism that keeps ETF market prices close to their
underlying NAV.\881\ An ETF that does not qualify as an In-Kind ETF
necessarily meets redemptions through more than a de minimis amount of
cash. For the reasons discussed above, we believe that it is
appropriate to require a fund that meets redemptions, at least
partially in cash, to comply with the liquidity classification and
highly liquid investment minimum requirements.\882\ With regard to
tracking error, an ETF with an index-based strategy, like other open-
end funds, needs to balance its implementation of its investment
strategy with the need for appropriate liquidity risk management given
its obligation to meet redemptions without significant dilution. We
recognize that this balancing may result in tracking error, and such a
fund may wish to address and manage this risk through appropriately
designed policies and procedures. This concern, along with the concerns
regarding potentially violating an exemptive order, or
[[Page 82221]]
refusing an in-kind purchase request from an authorized participant,
are also mitigated by the additional flexibility provided for in the
final rule. Under the final rule (as compared with the proposal), a
fund that breaches its highly liquid investment minimum will be subject
to certain board reporting requirements, but will not be barred from
purchasing non-conforming assets (as would have been required as
proposed).\883\ Under the final rule, therefore, a fund will have
flexibility to address potentially adverse situations, including
tracking error, that may arise as a result of complying with the highly
liquid investment minimum.
---------------------------------------------------------------------------
\879\ See supra section III.D.
\880\ See ICI Comment Letter I (noting that if an ETF was
prohibited from accepting a less liquid asset, the ETF may violate a
requirement that that all creation baskets correspond pro rata to
the ETF's portfolio positions).
\881\ Id.
\882\ An ETF that does not qualify as an In-Kind ETF would not
be required to determine and periodically review a highly liquid
investment minimum if it holds primarily highly liquid investments.
See supra section III.D.
\883\ See supra section III.D.
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K. Limitation on Unit Investment Trusts' Investments in Illiquid
Investments
As noted above, the proposed scope of rule 22e4 did not include
UITs, although we requested comment on whether UITs should be included
within its scope, and whether we should include specific limitations on
UIT's holdings of illiquid assets at inception.\884\ As adopted today,
UITs remain excluded from the rule's liquidity risk management program
requirements. However, as suggested by some commenters, we are now
requiring a limited liquidity review for UITs. Under the final rules,
the UIT's principal underwriter or depositor must determine, on or
before the initial deposit of portfolio securities into the UIT, that
the portion of the illiquid investments that the UIT holds or will hold
at the date of deposit that are assets is consistent with the
redeemable nature of the securities it issues.\885\
---------------------------------------------------------------------------
\884\ See supra section III.A.2.d; Proposing Release, supra
footnote 9 at section III.A.3 and comment requests following n 156
(``alternatively, should we require UITs to meet certain minimum
liquidity requirements at the time of deposit of the securities . .
.'').
\885\ See rule 22e-4(c). The rule also requires UITs to maintain
a record of that determination for the life of the UIT and for five
years thereafter. See also Rule 144A Release supra footnote 37 at
n.61 (discussing liquidity requirements for UITs prior to the
adoption of rule 22e-4).
---------------------------------------------------------------------------
As discussed in detail in the Proposing Release, most UITs serve as
separate account vehicles used to fund variable annuity and variable
life insurance contracts,\886\ and these UITs essentially function as
pass-through vehicles, investing principally in securities of one or
more open-end investment companies that would be subject to rule 22e-
4.\887\ Also, UITs are not actively managed, and thus certain
provisions of rule 22e-4 that require a fund's board to approve and
oversee the fund's liquidity risk management program and the fund's
adviser, officer, or officers to administer it are inapposite to the
management structure of a UIT.\888\
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\886\ See Proposing Release, supra footnote 9, at n.139 and
accompanying text. We currently estimate that approximately 92.9% of
UITs serve as separate account vehicles (based on data as of
December 31, 2015).
\887\ See id., at nn.139-140 and accompanying text.
\888\ See id., at nn.141-143 and accompanying text.
---------------------------------------------------------------------------
Several commenters argued (in the context of ETFs organized as
UITs) that UITs may be subject to liquidity risk comparable to other
funds.\889\ As discussed previously, in recognition of the different
unmanaged organizational structure of UITs, we continue to believe that
including UITs within the scope of rule 22e-4's liquidity risk
management program requirements (or even the tailored program
requirements for ETFs that redeem in kind) would not be feasible.
However, we recognize that UITs may in some circumstances be subject to
liquidity risk (particularly where the UIT is not a pass-through
vehicle and the sponsor does not maintain an active secondary market
for UIT shares) as investor redemption requests may lead to dissipation
of UIT assets, forcing a UIT to sell securities that it holds to meet
redemptions.
---------------------------------------------------------------------------
\889\ See Anonymous Comment Letter I; BlackRock Comment Letter.
One of these commenters also observed that, while there are few ETFs
that are UITs, some of the largest ETFs in the world (by volume/
value traded) are UIT ETFs, and thus any liquidity risks faced by
these UIT ETFs could lead to significant adverse market
consequences. The commenter also expressed concern that excluding
UIT ETFs from the scope of rule 22e-4 may prompt more ETF sponsors
to structure ETFs as UITs rather than open-end funds to avoid being
subject to the liquidity risk management program requirement. See
Anonymous Comment Letter I. We recognize the risks of excluding
UIT's from 22e-4, and thus are adopting the liquidity review
requirement discussed in this section, as a tailored approach that
fits the unique unmanaged structure of UITs, including ETFs that are
structured as UITs. (ETMFs are not structured as UITs because, as
they are structured today, they are actively managed and thus cannot
operate as UITs.)
---------------------------------------------------------------------------
Accordingly, today we are adopting a limited liquidity review
requirement for UITs to require that a UIT's principal underwriter or
depositor determine upon initial deposit of a registered UIT that the
level of illiquid investments it will hold is consistent with the
redeemable nature of the securities it issues.\890\ Though commenters
focused their discussion on UITs that are ETFs, we believe it is
appropriate for the principal underwriter or depositor of any
registered UIT to conduct the initial liquidity assessment described
above on or before the date of the initial deposit of securities into
the UIT. The securities that the UIT is expected to hold should be
examined so that they are consistent with the ability of a UIT to issue
redeemable securities, much as an open-end fund will be required to
evaluate whether its investment strategy and the securities it holds is
appropriate for an open-end fund under the final liquidity risk
management program.\891\ Though UITs are not actively managed and do
not have a board of directors, corporate officers, or an investment
adviser to render advice during the life of the trust, making active
liquidity risk management inapposite to the management structure of a
UIT, we believe that this requirement of a tailored, one-time, initial
liquidity risk management requirement for UITs is in line with the
unmanaged structure of a UIT and its liquidity risk.\892\
---------------------------------------------------------------------------
\890\ See supra footnote 885 and accompanying text.
\891\ As noted above, all UITs are subject to the requirements
of section 22(e) and therefore must meet redemptions within seven
days. See also section 4(2).
\892\ With regard to UITs structured as ETFs in particular, we
agree with commenters' concerns that UIT ETFs' liquidity risks may
be comparable to those faced by other ETFs and that the relatively
large size of certain UIT ETFs could lead to significant market
consequences if these UIT ETFs were to encounter liquidity issues.
However, because UIT ETFs are unmanaged and must fully replicate
their underlying indices, we believe that a one-time determination
regarding liquidity concerns at the commencement of the offering of
a registered UIT is the appropriate manner to mitigate such
concerns.
---------------------------------------------------------------------------
We expect that this initial review requirement would in many
respects be similar to the process for determining whether a fund's
holding of illiquid investments is consistent with rule 22e-4's 15%
limitation on illiquid investments, taking into account the unique
structure and purpose of UITs. If a UIT were to hold or planned to hold
more than 15% of its investments in illiquid investments at the time of
initial deposit, such a level of illiquid investments is unlikely to be
consistent with the nature of the redeemable securities it issues.
Thus, if a UIT planned to hold significant amounts of illiquid
securities (in excess of 15%), its principal underwriter or depositor
would be unlikely to be able to make the determination that its
investment's liquidity is consistent with its issuance of redeemable
securities.
Due to the unmanaged structure of UITs and the fixed nature of
their portfolios, it would be inconsistent with their structure and
portfolios to require UITs to re-evaluate the securities they hold
based on their liquidity characteristics and change their investments
accordingly over time. Therefore, the requirement only applies at the
time of the UIT's creation. Although this is a one-time determination
at the time of the UIT's initial deposit, it should take into
[[Page 82222]]
account the planned structure of the UIT's holdings. In particular, if
the UIT tracks an index, the determination should consider the index
design and whether the index design is likely to lead to the UIT
holding an amount of illiquid assets that is inconsistent with the
redeemable nature of the securities it issues.
As discussed above, because of the unmanaged nature of an UIT, we
recognize that depending on its particular circumstances, after initial
deposit, an UIT might potentially hold a higher level of illiquid
investments due to redemptions or changes in the liquidity of the
investments it holds. Nonetheless, we expect that the requirement for
the depositor or principal underwriter to determine that the liquidity
of the investments the UIT holds is consistent with the nature of the
redeemable securities it issues at the time of initial deposit should
help enhance UIT liquidity.
L. Disclosure and Reporting Requirements Regarding Liquidity Risk and
Liquidity Risk Management
Receiving relevant information about the operations of a fund and
its principal investment risks is important to investors in choosing
the appropriate fund for their risk tolerances. Investors in open-end
funds generally expect funds to pay redemption proceeds promptly
following their redemption requests based, in part, on representations
made by funds in their disclosure documents. Currently, funds are not
expressly required to disclose how they manage the liquidity of their
investments, and limited information is available regarding fund
liquidity and whether the liquidity of a fund's portfolio securities
corresponds with its anticipated liquidity needs.
We are adopting, substantially as proposed with some modifications
in response to comment, amendments to Form N-1A that will require a
fund to further describe its procedures for redeeming the fund's shares
including the number of days following receipt of shareholder
redemption requests in which the fund typically expects to pay
redemption proceeds to redeeming shareholders and the methods the fund
typically uses to meet redemption requests, including whether those
methods are used regularly or only in stressed market conditions.\893\
We also are adopting an amendment to General Instruction A of Form N-1A
to conform the definition of ``exchange-traded fund'' to the definition
of ETF adopted today in connection with rule 22e-4 and the adoption of
Form N-CEN in the Investment Company Reporting Modernization Adopting
Release.\894\
---------------------------------------------------------------------------
\893\ See Items 11(c)(7) and (c)(8) of Form N-1A.
\894\ See infra footnote 906.
---------------------------------------------------------------------------
In addition, we are adopting new Form N-LIQUID to incorporate
information that would have previously been reported on Form N-PORT
under the proposal concerning a fund's investments in illiquid
investments, but with some modifications in response to comments. Under
this new reporting form, a fund is required to notify the Commission
when more than 15% of the fund's net assets are, or become, illiquid
investments that are assets as defined in rule 22e-4 and report
information about the investments affected.\895\ A fund also is
required to report on Form N-LIQUID if the fund's illiquid investments
that are assets previously exceeded 15% of net assets and the fund
determines that its illiquid investments that are assets have changed
to be less than or equal to 15% of net assets.\896\ In addition, under
the new form, a fund is required to notify the Commission if the fund's
holdings in highly liquid investments that are assets fall below the
fund's highly liquid investment minimum for more than 7 consecutive
calendar days.\897\ Information reported on Form N-LIQUID will be non-
public.
---------------------------------------------------------------------------
\895\ See Part A and Part B of Form N-LIQUID.
\896\ See Part C of Form N-LIQUID.
\897\ See Part D of Form N-LIQUID.
---------------------------------------------------------------------------
We are adopting, as proposed, the requirement that a fund report on
Form N-CEN information regarding the use of lines of credit, interfund
lending, and interfund borrowing.\898\ In addition, we are adopting a
new requirement that a fund report on Form N-CEN whether the fund is an
``In-Kind Exchange-Traded Fund'' as defined in rule 22e-4.\899\
---------------------------------------------------------------------------
\898\ See Item C.20 of Form N-CEN. In the Proposing Release, we
also proposed to add to Form N-CEN a requirement for funds to report
whether the fund required that an authorized participant post
collateral to the fund or any of its designated service providers in
connection with the purchase or redemption of fund shares during the
reporting period. See Proposing Release, supra footnote 9, at
section III.G.3.a. We are adopting this requirement in the
Investment Company Reporting Modernization Adopting Release. See
Investment Company Reporting Modernization Adopting Release, supra
footnote 120.
\899\ Item E.5 of Form N-CEN.
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Many commenters expressed general support for enhanced disclosures
regarding fund liquidity risk management practices.\900\ Some
commenters noted that understanding the liquidity dynamics of an
investment strategy employed by a fund would be beneficial to investors
\901\ and that enhanced information could assist the Commission in its
role as the primary regulator of investment companies and help
investors make more informed investing decisions by providing more
transparency into fund investment practices.\902\ Other commenters
expressed concerns with specific disclosure and reporting requirements
outlined in the proposal, which are discussed in detail below.
---------------------------------------------------------------------------
\900\ See, e.g., BlackRock Comment Letter; J.P. Morgan Comment
Letter; LPL Comment Letter (supporting increased disclosure about
liquidity); SIFMA Comment Letter I (expressing general support for
the proposed amendments to Form N-1A and proposed Form N-CEN).
\901\ See BlackRock Comment Letter.
\902\ See Charles Schwab Comment Letter.
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1. Amendments to Form N-1A
Form N-1A is used by open-end funds, including money market funds
and ETFs, to register under the Investment Company Act and to register
offerings of their securities under the Securities Act. We are
adopting, substantially as proposed, amendments to Form N-1A that will
require a fund to further describe its procedures for redeeming the
fund's shares including the number of days following receipt of
shareholder redemption requests in which the fund typically expects to
pay redemption proceeds to redeeming shareholders.\903\ A fund also
will be required to describe the methods the fund typically expects to
use to meet redemption requests in stressed and non-stressed market
conditions.\904\ Funds will not be required, however, to file as
exhibits to their registration statements credit agreements as we
proposed. We note that these amendments will apply to all open-end
funds, including money market funds and ETFs.\905\
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\903\ See Item 11(c)(7) of Form N-1A.
\904\ See Item 11(c)(8) of Form N-1A.
\905\ See supra footnote 4; see also infra section V.H.; and
Proposing Release, supra footnote 9, at section V.G.
---------------------------------------------------------------------------
In addition, we are adopting an amendment to General Instruction A
of Form N-1A to conform the definition of ``exchange-traded fund,''
which currently defines an ETF to mean, in part, a fund or class, ``the
shares of which are traded on a national securities exchange'' to the
definition of ETF adopted today in connection with rule /-4 and the
adoption of Form N-PORT and Form N-CEN in the Investment Company
Reporting Modernization Adopting Release, which both define an ETF, in
part, to mean a fund or class, ``the shares of which are listed and
traded on a national securities exchange.'' \906\
---------------------------------------------------------------------------
\906\ See General Instructions A of Form N-1A (emphasis added)
and General Instruction E of Form N-CEN. See also Investment Company
Reporting Modernization Adopting Release, supra footnote 120. For
purposes of reporting on proposed Form N-CEN, we proposed to define
(i) ``exchange-traded fund'' as an open-end management investment
company (or series or class thereof) or UIT, the shares of which are
listed and traded on a national securities exchange at market
prices, and that has formed and operates under an exemptive order
under the Investment Company Act granted by the Commission or in
reliance on an exemptive rule under the Act adopted by the
Commission and (ii) ``exchange-traded managed fund'' as an open-end
management investment company (or series or class thereof) or UIT,
the shares of which are listed and traded on a national securities
exchange at NAV-based prices, and that has formed and operates under
an exemptive order under the Investment Company Act granted by the
Commission or in reliance on an exemptive rule under the Act adopted
by the Commission. See Investment Company Reporting Modernization,
Investment Company Act Release No. 31610 (May 20, 2015) [80 FR 33590
(June 12, 2015)] (``Investment Company Reporting Modernization
Proposing Release''), at n.446 and accompanying text. In the
Investment Company Reporting Modernization Proposing Release, we
requested comment on whether the definitions of the type of funds
listed in proposed Form N-CEN were appropriate and if any different
definitions should be used. We did not receive any comments on the
proposed definitions of ETF and ETMF in proposed Form N-CEN, and are
adopting the definitions of ETF and ETMF, as proposed. See
Investment Company Reporting Modernization Adopting Release, supra
footnote 120.
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[[Page 82223]]
Many commenters generally supported enhancing prospectus disclosure
requirements,\907\ noting, for example, that enhanced disclosures will
improve shareholder and market participant knowledge regarding fund
redemption procedures and liquidity risk management.\908\ Several
commenters expressed concerns with the proposed requirements to
disclose the number of days or the methods in which a fund will pay
redemption proceeds \909\ and include lines of credit agreements as
exhibits to the fund registration statement.\910\ We discuss the
comments received in response to the proposal, as well as the
amendments to Form N-1A and modifications to the proposal, in more
detail below.
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\907\ See, e.g., CFA Comment Letter; LPL Comment Letter; Charles
Schwab Comment Letter; Vanguard Comment Letter.
\908\ See J.P. Morgan Comment Letter.
\909\ See, e.g., Fidelity Comment Letter; Federated Comment
Letter; NYC Bar Comment Letter; Vanguard Comment Letter.
\910\ See, e.g., Fidelity Comment Letter; Invesco Comment
Letter; T. Rowe Comment Letter; Voya Comment Letter.
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a. Timing of the Redemption of Fund Shares
Form N-1A requires funds to describe their procedures for redeeming
fund shares.\911\ Disclosure regarding other important redemption
information, such as the timing of payment of redemption proceeds to
fund shareholders, varies across funds as today there are no specific
requirements for this disclosure under the form. Some funds disclose
that they will redeem shares at a price based on the next calculation
of net asset value after the order is placed but may delay payment for
up to seven days (consistent with section 22(e) of the Act), and others
provide no specific time periods for the payment. Some funds disclose
differences in the timing of payment of redemption proceeds based on
the distribution channel or payment method through which the fund
shares are redeemed, while others do not.
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\911\ See Item 11(c) of Form N-1A, which requires a fund to
describe procedures for redeeming fund shares, including (1) any
restrictions on redemptions; (2) any redemption charges; (3) if the
fund has reserved the right to redeem in kind; (4) any procedure
that a shareholder can use to sell fund shares to the fund or its
underwriter through a broker-dealer (noting any charges that may be
imposed for such service); (5) the circumstances under which the
fund may redeem shares automatically without action by the
shareholder in accounts below a certain number or value of shares;
(6) the circumstances under which the fund may delay honoring a
request for redemption for a certain time after a shareholder's
investment; and (7) any restrictions on, or costs associated with,
transferring shares held in street name accounts.
---------------------------------------------------------------------------
We proposed amendments to Item 11 of Form N-1A that would require a
fund to disclose the number of days in which the fund would pay
redemption proceeds to redeeming shareholders.\912\ Under the proposal,
if the number of days in which the fund would pay redemption proceeds
differed by distribution channel, the fund also would be required to
disclose the number of days for each distribution channel.\913\ We also
proposed amendments to Item 11 that would require a fund to disclose
the methods that the fund uses to meet redemption requests.\914\ Under
the proposal, funds would have been required to disclose whether they
use the methods regularly to meet redemptions or only in stressed
market conditions.
---------------------------------------------------------------------------
\912\ See proposed Item 11(c)(7) of Form N-1A; see also
Proposing Release, supra footnote 9, section III.G.1.
\913\ Id.
\914\ See proposed Item 11(c)(8) of Form N-1A.
---------------------------------------------------------------------------
Some commenters expressed general support for these new disclosure
requirements under the proposal, stating that this information will
improve shareholder and market participant knowledge regarding fund
redemption procedures and liquidity risk management \915\ and provide
meaningful information about the general time taken to meet redemptions
and the fund's approaches to liquidity risk management.\916\
---------------------------------------------------------------------------
\915\ See J.P. Morgan Comment Letter.
\916\ See ICI Comment Letter I.
---------------------------------------------------------------------------
Some commenters also expressed concerns with the proposed
requirement that funds disclose the number of days in which a fund will
pay redemption proceeds for each distribution channel, stating that the
disclosure could present undue complexity to the prospectus and may
lead to shareholder confusion.\917\ In addition, commenters argued that
a fund does not always have a direct contractual relationship with the
ultimate beneficial owners of its shares, as there are often multiple
intermediaries between the mutual fund and its shareholder, and that a
fund is not in the best position to disclose to its shareholders a
precise timeframe in which an intermediary will transmit the proceeds
of a shareholder's redemption.\918\
---------------------------------------------------------------------------
\917\ See, e.g., Fidelity Comment Letter. See also e.g.,
Federated Comment Letter (stating that distribution channel level
disclosure is unnecessary and could present undue complexity in
prospectus if there are minor deviations).
\918\ See Fidelity Comment Letter.
---------------------------------------------------------------------------
We understand that in most cases, the distribution channel through
which a shareholder transacts in fund shares is unlikely to have a
material effect on the timing of the payment of redemption proceeds,
but instead that the choice of method of payment of redemption proceeds
will have the most significant effect on when an investor receives
proceeds. For example, we understand that the industry's central fund
transaction processing utility (the NSCC), typically debits or credits
the cash accounts of users of the utility (such as funds or their
transfer agents on one side of the transaction, and intermediaries on
behalf of beneficial owners, on the other side of the transaction)
regarding net purchase or redemption activities in shares of a fund on
T+1 (and to a lesser extent with respect to certain funds on T+3). Such
intermediary users of the utility would in turn update their account
records, including the beneficial owner's activity, on that date
regardless of the type of book entry securities, account structure, or
intermediary that the beneficial owner holds through. However, if the
beneficial owner wishes to receive remittance of redemption proceeds
via check (for example, instead of reinvesting them in another
investment), it may take a certain number of days for the intermediary
(or fund, as applicable) to process and mail the check to the customer.
Accordingly, in a change from the proposal, the final form amendments
do not require disclosure on timing of redemption proceeds based on
distribution channel, but instead only require a fund to disclose
typical expected payout times based on the payment method chosen
[[Page 82224]]
by the investor (e.g., check, wire, automated clearing house).\919\
---------------------------------------------------------------------------
\919\ See Item 11(c)(7) of Form N-1A.
---------------------------------------------------------------------------
Thus, under the final amendments, if the number of days a fund
expects to pay redemption proceeds differs by method of payment (e.g.,
check, wire, automated clearing house), then the fund is required to
disclose the typical number of days or estimated range of days that the
fund expects it will take to pay out redemption proceeds for each
method used.\920\ This requirement focuses on disclosing when the fund
expects to make the payment, not when the shareholder should expect to
receive the proceeds, because receipt of proceeds is unlikely to be in
the fund's control (for example, a fund cannot predict how long a
mailed check will take to arrive). We believe narrowing the disclosure
requirement to the effects of payment methods rather than the effects
of all types of distribution channels addresses comments. We also
believe that this modification will increase the quality of information
provided to fund shareholders about the timing of their redemption
proceeds and, at the same time, reduce the likelihood that disclosures
regarding such timing will be overly granular and complex for investors
and overly burdensome for registrants.\921\
---------------------------------------------------------------------------
\920\ See id. (emphasis added).
\921\ See Proposing Release, supra footnote 9, section
III.G.1.a.
---------------------------------------------------------------------------
Other commenters expressed concerns about specific aspects of the
proposed disclosure amendments. For example, some commenters stated
that requiring funds to disclose the number of days in which the fund
will pay redemption proceeds to redeeming shareholders would pressure
funds to disclose shorter redemption payment periods, thereby limiting
funds from exercising discretion in stressed markets.\922\ Other
commenters opposed a requirement to disclose the number of days or
methods used to pay redemption proceeds,\923\ arguing, for example,
that the disclosure requirement would inappropriately limit the
flexibility of a fund to meet redemptions to timing and methods
previously disclosed in its prospectus \924\ or would cause generic
disclosures because of the variety of methods available to funds to
meet redemptions.\925\ One commenter recommended that the Commission
narrow the scope of the amendments to only the ``typical'' number of
days, methods, and funding sources used for meeting redemption
requests.\926\
---------------------------------------------------------------------------
\922\ See FSR Comment Letter; NYC Bar Comment Letter.
\923\ See, e.g., Fidelity Comment Letter; Federated Comment
Letter; Invesco Comment Letter; Vanguard Comment Letter.
\924\ See, e.g., Invesco Comment Letter; NYC Bar Comment Letter;
Vanguard Comment Letter.
\925\ See Federated Comment Letter.
\926\ See ICI Comment Letter I.
---------------------------------------------------------------------------
In consideration of these comments, and in a modification to the
proposal, we are adopting amendments to Item 11 of Form N-1A to require
a fund to disclose the number of days following receipt of shareholder
redemption requests in which the fund typically expects to pay
redemption proceeds to redeeming shareholders,\927\ rather than the
number of days in which the fund will pay redemption proceeds as
proposed. Funds may wish to consider also disclosing whether payment of
redemption proceeds may take longer than the number of days that the
fund typically expects and may take up to seven days as provided in the
Investment Company Act.
---------------------------------------------------------------------------
\927\ See Item 11(c)(7) of Form N-1A (emphasis added).
---------------------------------------------------------------------------
We appreciate commenters' concerns, and believe that this
adjustment to the language in Form N-1A will give funds flexibility to
provide disclosures about redemption procedures that do not
inappropriately limit a fund's ability to meet redemptions to the exact
timing previously disclosed in its prospectus. We continue to believe
that requiring this disclosure will inform the public about a critical
aspect of a shareholder's relationship with a fund--when the
shareholder can expect redemption proceeds. Funds generally should
disclose timing that reflects their actual operational procedures for
meeting redemption rather than generic disclosures about fund
redemptions, regardless of what other funds in the industry may
disclose. We continue to believe that it is in the public interest to
inform investors on the timing of when fund shareholders should expect
redemption proceeds. We believe that this disclosure requirement will
also enhance consistency in fund disclosures regarding the timing in
which a fund will pay redemption proceeds, thereby improving the
information provided to shareholders and the ability of investors to
compare redemption procedures across funds.
b. Methods Used To Meet Shareholder Redemption Obligations
As noted above, some commenters opposed a requirement to disclose
the methods used (and number of days) to pay redemption proceeds,
arguing, for example, that the disclosure requirement would
inappropriately limit the flexibility of a fund to meet redemptions to
timing and methods previously disclosed in its prospectus or would
cause generic disclosures because of the variety of methods available
to funds to meet redemptions.\928\ Some commenters generally opposed
requirements for funds to disclose the methods used to meet redemption
requests, stating, for example, that it does not serve a purpose for
investors to know precisely how the fund meets their redemption
requests--so long as they receive their redemption proceeds within the
period prescribed by regulation.\929\ As noted above, one commenter
suggested that we narrow the scope of the disclosure requirement to
only the ``typical'' methods funds use for meeting redemption
requests.\930\
---------------------------------------------------------------------------
\928\ See, e.g., Federated Comment Letter; Invesco Comment
Letter; NYC Bar Comment Letter; Vanguard Comment Letter.
\929\ See Invesco Comment Letter.
\930\ See ICI Comment Letter I; see also footnote 926 and
accompanying text.
---------------------------------------------------------------------------
In light of these comments, in a modification to the proposal, we
are adopting amendments to Item 11 of Form N-1A to require a fund to
disclose the methods that the fund typically expects to use to meet
redemption requests, and whether those methods are used regularly, or
only in stressed market conditions.\931\ We believe requiring that the
description of the procedures for redeeming fund shares include a
description of the methods a fund typically expects to use to meet
redemption requests will improve disclosure about another critical
aspect of a shareholder's relationship with a fund--how a shareholder
can expect to receive redemption proceeds. We appreciate the concerns
expressed by commenters and believe that the modified language in the
form provides some needed flexibility for funds while at the same time
providing investors with improved information concerning redemption
procedures. Furthermore, this disclosure requirement will increase
consistency in fund disclosure documents regarding fund redemption
practices and improve the comparability of such information across
funds. Absent this amendment, disclosures concerning the methods funds
use to pay redemption proceeds will continue to vary across funds.
---------------------------------------------------------------------------
\931\ See Item 11(c)(8) of Form N-1A (emphasis added).
---------------------------------------------------------------------------
We believe that requiring specific disclosure on the methods a fund
uses to pay redemption proceeds could improve investor knowledge on how
a fund manages liquidity and its redemption obligations to
shareholders. At the foundation of the prospectus
[[Page 82225]]
disclosure framework is the provision to all investors of user-friendly
information that is key to an investment decision.\932\ Additionally,
given the increase in open-end funds pursuing alternative and fixed
income strategies with varied liquidity risks,\933\ the sources of
liquidity and methods used to meet shareholder redemptions are key
information that investors need.
---------------------------------------------------------------------------
\932\ See Enhanced Disclosure and New Prospectus Delivery Option
for Registered Open-End Management Investment Companies, Investment
Company Act Release No. 28584 (Jan. 13, 2009) [74 FR 4546 (Jan. 26,
2009)] (``N-1A Release''), at section I.
\933\ See supra section II.C.1.
---------------------------------------------------------------------------
Methods to meet redemption obligations may include, for example,
sales of portfolio assets, holdings of cash or cash equivalents, the
use of lines of credit and/or interfund lending, and in-kind
redemptions.\934\ Funds may also use redemption fees to help mitigate
dilution and address transaction costs associated with shareholder
activity. We also believe that requiring this disclosure could
encourage funds to consider their operations and ensure that the
methods they may use to meet shareholder redemption obligations in
normal and reasonably foreseeable stressed markets are viable.
---------------------------------------------------------------------------
\934\ See supra footnote 686 and accompanying text.
---------------------------------------------------------------------------
As noted above, Form N-1A requires funds to disclose whether they
reserve the right to redeem their shares in kind instead of in cash and
to describe the procedures for such redemptions.\935\ As proposed, we
are amending Form N-1A to incorporate this disclosure requirement into
Item 11(c)(8) discussed above. We understand that the use of in-kind
redemptions (outside of the ETF context) historically has been rare and
that many funds reserve the right to redeem in kind only as a tool to
manage liquidity risk under emergency circumstances or to manage the
redemption activity of a fund's large institutional investors.\936\ We
also are aware that there are often logistical issues associated with
redemptions in kind and that these issues can limit the availability of
in-kind redemptions as a practical matter. A fund should consider
whether adding relevant detail to its disclosure regarding in-kind
redemptions, including, for example, whether redemptions in kind will
be pro-rata slices of the fund's portfolio or individual securities or
a representative basket of securities, or revising its disclosure if
the fund would be practically limited in its ability to redeem its
shares in kind, would provide more accurate information to investors.
---------------------------------------------------------------------------
\935\ See Item 11(c)(3) of Form N-1A.
\936\ See supra section III.J. We note that funds also have the
ability to redeem in kind, subject to the limitations under rule
18f-1 under the Act for funds that have made an election under the
rule. An 18f-1 election commits a fund to pay in cash all requests
for redemption by any shareholder of record, limited in amount with
respect to each shareholder during any 90-day period to the lesser
of $250,000 or 1% of the fund's net asset value at the beginning of
the period.
---------------------------------------------------------------------------
One commenter expressed concerns that the proposed additional
disclosure requirements in Form N-1A runs against the Commission's goal
of clear and concise, user-friendly disclosures.\937\ We believe that
the amendments adopted today in this Release, including specific
modifications in response to commenters, respond appropriately to this
commenter's concern and are designed to provide disclosures to
investors with key information in a clear, concise, and understandable
manner. We believe that investors in an open-end fund should have
information on how the fund expects to meet redemptions and in what
time period they expect to pay redemption proceeds.
---------------------------------------------------------------------------
\937\ See Federated Comment Letter.
---------------------------------------------------------------------------
c. Credit Agreements Exhibit
We also proposed to amend Item 28 of Form N-1A to require a fund to
file as an exhibit to its registration statement any agreements related
to lines of credit for the benefit of the fund to increase Commission,
investor, and market participant knowledge concerning the arrangements
funds have made in order to strengthen their ability to meet
shareholder redemption requests and manage liquidity risk and the terms
of those arrangements.\938\ In light of concerns expressed by
commenters, we are not adopting amendments to Form N-1A to require the
filing of credit agreements as exhibits to a fund's registration
agreement.
---------------------------------------------------------------------------
\938\ See Proposing Release, supra footnote 9, at section
III.G.1 (where we also proposed to include an instruction related to
credit agreements noting that the specific fees paid in connection
with the credit agreements need not be disclosed in the exhibit
filed with the Commission to preserve the confidentiality of this
information).
---------------------------------------------------------------------------
Many commenters objected to the credit agreements exhibit
requirement,\939\ with some arguing, for example, that credit
agreements are often extremely lengthy documents that are not user-
friendly,\940\ the disclosure of which would be unnecessary in light of
the lines of credit reporting requirements in Form N-CEN as well as
information concerning lines of credit disclosed in a fund's statement
of additional information and financial statements.\941\ Other
commenters expressed concern that public disclosure of line of credit
agreements in a fund's registration statement could ultimately harm
fund shareholders, noting that public disclosure could (1) disrupt and
weaken a fund's ability to negotiate credit terms; \942\ (2) make
public proprietary and competitive information (e.g., certain
representations and warranties) that lenders and funds may wish to keep
confidential and are not easily redacted; \943\ and (3) ultimately
discourage lending banks from granting lending terms to funds out of a
concern that terms granted would become standard in other lending
agreements.\944\
---------------------------------------------------------------------------
\939\ See, e.g., Fidelity Comment Letter; CRMC Comment Letter;
Oppenheimer Comment Letter; Voya Comment Letter.
\940\ See CRMC Comment Letter; T. Rowe Comment Letter.
\941\ See, e.g., Oppenheimer Comment Letter; T. Rowe Comment
Letter; Voya Comment Letter.
\942\ See Oppenheimer Comment Letter; Fidelity Comment Letter.
\943\ See CRMC Comment Letter; Invesco Comment Letter;
Oppenheimer Comment Letter; Voya Comment Letter.
\944\ See Fidelity Comment Letter.
---------------------------------------------------------------------------
Rather than include line of credit agreements as exhibits, other
commenters suggested including a narrative discussion of lines of
credit information, similar to the data required to be disclosed in
Form N-CEN, in a fund's statement of additional information.\945\ Some
commenters did not oppose requiring the filing of line of credit
agreements as an exhibit to a fund's registration statement if, in
addition to redacting fees as proposed, certain other portions of the
agreement were permitted to be redacted.\946\
---------------------------------------------------------------------------
\945\ See ICI Comment Letter I; CRMC Comment Letter.
\946\ See FSR Comment Letter (requesting redaction of the
identity of the counterparty); Federated Comment Letter (requesting
redaction of the rate payable by the fund on any drawdowns).
---------------------------------------------------------------------------
We find the concerns expressed by commenters persuasive and have
determined to not adopt this amendment to Form N-1A. We acknowledge
that credit agreements can be lengthy, complex documents that may be of
limited value to retail investors and that the information provided in
the proposed exhibits could be, in part, duplicative of information
provided in a fund's statement of additional information and financial
statements. We believe that requiring funds to report the use of lines
of credit in response to reporting requirements in Form N-CEN is an
appropriate means to increase Commission, investor, and market
participant knowledge concerning the arrangements funds have made in
order to strengthen their ability to meet shareholder redemption
[[Page 82226]]
requests and manage liquidity risk and the terms of those arrangements.
d. Additional Disclosure Requirements
Some commenters recommended that the Commission require additional
disclosures in a fund's registration statement about a fund's specific
liquidity risk management policies and procedures \947\ and the market
impact costs associated with redemption activity.\948\ For example, one
commenter recommended requiring a fund to disclose a narrative of its
liquidity risk management program in its statement of additional
information as well as a statement in the fund prospectus about the
liquidity risk appetite of each fund.\949\ Another commenter expressed
support for the Commission requiring funds to include a discussion of
their liquidity risk management policies and procedures, similar to
what is currently required on Form N-1A for policies and procedures
regarding proxy voting (Items 17 and 27) and valuation procedures (Item
23), among others.\950\ In addition, one commenter recommended that we
consider requiring a fund to also disclose the level of ``position
concentration'' that is appropriate for the fund in terms of portfolio
liquidity in light of the fund's investment strategy and investor
profile.\951\ While another commenter recommended that, at a minimum,
funds be required to provide disclosures noting the possibility of
suspending redemptions and how the fund will handle redemption requests
in that situation.\952\
---------------------------------------------------------------------------
\947\ See, e.g., Invesco Comment Letter; J.P. Morgan Comment
Letter.
\948\ See BlackRock Comment Letter.
\949\ See Invesco Comment Letter.
\950\ See J.P. Morgan Comment Letter.
\951\ See BlackRock Comment Letter.
\952\ See CFA Comment Letter.
---------------------------------------------------------------------------
We support commenters' goals of providing useful information about
a fund's liquidity risk management practices to investors but also
remain committed to encouraging statutory prospectuses that are simple,
clear, and useful to investors \953\ and registration statements that
provide useful information, rather than boilerplate legal
representations. In the interest of balancing these two goals, we are
adopting the proposed amendments to Form N-1A substantially as proposed
without including these specific additional disclosure requirements
suggested by commenters in the text of the form. We note, however, that
nothing in Form N-1A prohibits disclosures about the features of a
fund's liquidity risk management program where relevant to
understanding disclosures under existing reporting requirements.
---------------------------------------------------------------------------
\953\ See N-1A Release, supra footnote 932.
---------------------------------------------------------------------------
2. New Form N-LIQUID
We are also adopting a new requirement that open-end investment
companies, including In-Kind ETFs to the extent applicable \954\ but
not including money market funds (i.e., registrants), file on a non-
public basis a current report to the Commission on new Form N-LIQUID
when certain significant events related to a fund's liquidity
occur.\955\ This requirement will be implemented through our adoption
of new rule 30b1-10, which requires funds to file a report on new Form
N-LIQUID in certain circumstances. The content of this report is
similar to the information that we proposed to be reported on Form N-
PORT under the proposal concerning a fund's investments in illiquid
assets, but with some modifications in response to comments. A report
on Form N-LIQUID is required to be filed, as applicable, within one
business day of the occurrence of one or more of the events specified
in the form.\956\ Form N-LIQUID will be non-public. For the same
reasons discussed previously regarding our determination to keep
information regarding a fund's highly liquid investment minimum and
specific position level disclosure of illiquid investments non-public,
we find that it is neither necessary nor appropriate in the public
interest or for the protection of investors to make the information
filed on Form N-LIQUID publicly available.\957\
---------------------------------------------------------------------------
\954\ As discussed below, some of the events required to be
reported on Form N-LIQUID are in connection with the breach of a
fund's highly liquid investment minimum. See Part D of Form N-
LIQUID. Because In-Kind ETFs are not subject to the highly liquid
investment minimum requirement under rule 22e-4(b)(1)(iii), they
would not be subject to this Part D reporting requirement on Form N-
LIQUID.
\955\ See rule 30b1-10.
\956\ Form N-LIQUID will also require a fund to report the
following general information: (1) The date of the report; (2) the
registrant's central index key (``CIK'') number; (3) the EDGAR
series identifier; (4) the Securities Act file number; and (v) the
name, email address, and telephone number of the person authorized
to receive information and respond to questions about the filing.
See Part A of Form N-LIQUID.
\957\ See supra footnote 615 and accompanying text and footnote
743 and accompanying text. Section 45(a) of the Investment Company
Act requires information in reports filed with the Commission
pursuant to the Investment Company Act to be made available to the
public, unless we find that public disclosure is neither necessary
nor appropriate in the public interest or for the protection of
investors.
---------------------------------------------------------------------------
First, a registrant is required to file Form N-LIQUID within one
business day when more than 15% of its net assets are, or become,
illiquid investments that are assets as defined in rule 22e-4.\958\ If
this occurs, the registrant will be required to report on Form N-LIQUID
general information about the registrant as well as (1) the date(s) of
the event, (2) the current percentage of the registrant's net assets
that are illiquid investments that are assets, and (3) identification
information about the illiquid investments.\959\
---------------------------------------------------------------------------
\958\ See Part A and Part B of Form N-LIQUID.
\959\ See Items A.1--A.5 and Items B.1--B.3 of Form N-LIQUID.
---------------------------------------------------------------------------
Second, if a registrant whose illiquid investments that are assets
previously exceeded 15% of net assets determines that its holdings in
illiquid investments that are assets have changed to be less than or
equal to 15% of the registrant's net assets, then the registrant also
is required to report within one business day (1) the date(s) on which
its illiquid investments that are assets fell to or below 15% of net
assets and (2) the current percentage of the registrant's net assets
that are illiquid investments that are assets.\960\
---------------------------------------------------------------------------
\960\ See Item C.1 and Item C.2 of Form N-LIQUID.
---------------------------------------------------------------------------
Lastly, a registrant also is required to notify the Commission on
Form N-LIQUID within one business day if its holdings in highly liquid
investments that are assets fall to or below the registrant's highly
liquid investment minimum for more than 7 consecutive calendar
days.\961\ If this occurs, a fund is required to report the date(s) on
which the fund's holdings in liquid investments that are assets fell
below the fund's highly liquid investment minimum.\962\
---------------------------------------------------------------------------
\961\ See Part D of Form N-LIQUID.
\962\ See Item D.1 of Form N-LIQUID.
---------------------------------------------------------------------------
As discussed above, we are modifying the 15% standard asset-
reporting requirement originally proposed by incorporating this
information into the fourth ``illiquid investment'' classification
category reported on Form N-PORT.\963\ Under the proposal, Form N-PORT
would have required a fund to report, for each portfolio asset, whether
the asset is a 15% standard asset in order to allow our staff and other
interested parties to track the extent that funds are holding 15%
standard assets and to discern the nature of those holdings and assist
these groups in tracking the fund's exposure to liquidity risk.\964\
---------------------------------------------------------------------------
\963\ See Item C.7 Form N-PORT; see also supra section III.C.6.
\964\ See Proposing Release, supra footnote 9, at section
II.G.2.b.
---------------------------------------------------------------------------
Some commenters recommended that the Commission require more
detailed reporting data from funds that hold a larger percentage of
securities that are
[[Page 82227]]
less liquid or illiquid and that funds should notify the Commission
more promptly than the Form N-PORT filing deadline when a fund's
illiquid assets exceed 15% of net assets, or if the fund otherwise
encounters indications of increased liquidity risk.\965\ Other
commenters expressed support for the addition of an early warning
notification provision, under which funds would be required to notify
the Commission when illiquid assets held at the end of a business day
exceed 15% of net assets and continue to exceed 15% of net assets three
business days after the threshold was first exceeded.\966\ Another
commenter expressed the belief that the sheer scale of Americans'
reliance on open-end funds as an investment instrument and the
potential for systemic contagion that arises when funds confront
liquidity challenges must inform any consideration of the Commission's
proposal.\967\ In the commenter's view, the reporting requirements
under the proposal with underlying factor-based analysis was largely
discretionary and lacked mandatory requirements, and thereby failed to
adequately account for the potential systemic threat to the nation's
financial stability posed by liquidity risk.\968\
---------------------------------------------------------------------------
\965\ See, e.g., Charles Schwab Comment Letter (noting that this
proposed approach could be similar to the Commission's 2015
Derivatives Proposing Release, which has proposed to enhance
requirements for funds whose aggregate exposure to derivatives
exceeds 50% of its net assets); see also, e.g., SIFMA Comment Letter
III.
\966\ See, e.g., SIFMA Comment Letter III (noting that this
early warning notification could respond to concerns raised by the
Third Avenue Fund liquidation); see also Third Avenue Temporary
Order, supra footnote 12.
\967\ See Better Markets Comment Letter.
\968\ See id.
---------------------------------------------------------------------------
We appreciate the concerns and suggestions raised by commenters and
agree that the Commission should be notified promptly when a fund
encounters indications of increased liquidity risk and believe that new
Form N-LIQUID addresses some concerns expressed by commenters that
certain liquidity events that could affect the liquidity of a
particular fund and/or indicate potential liquidity risks across the
fund industry require particular attention by Commission staff.
Pursuant to Part B of Form N-LIQUID, registrants will now be required
to report to the Commission within one business day of when their
percentage of illiquid investments that are assets exceeds (and
subsequently falls to or below) 15% of their net assets.\969\ Providing
this information more promptly than monthly reporting on Form N-PORT,
as proposed, will be the ``early warning notification'' that some
commenters recommended \970\ and will inform the Commission of
potential liquidity stress events at the earliest possible juncture.
Similarly, requiring a registrant to report when its holdings in highly
liquid investments that are assets fall below the registrant's highly
liquid investment minimum will add to this early warning system and
ensure the Commission is made aware of such breaches promptly, rather
than later in reports filed on Form N-PORT.\971\ We believe that the
information reported on Form N-LIQUID will assist Commission staff in
its monitoring efforts of liquidity, including monitoring of not only
the reporting fund but also funds that may have comparable
characteristics to the reporting fund and could be similarly affected
by market events.
---------------------------------------------------------------------------
\969\ See Part B and Part C of Form N-LIQUID; see also General
Instruction A of Form N-LIQUID.
\970\ See SIFMA Comment Letter III.
\971\ See Part D of Form N-LIQUID.
---------------------------------------------------------------------------
Form N-LIQUID also includes general filing and reporting
instructions, as well as definitions of specific terms referenced in
the form.\972\ These instructions and definitions are intended to
provide clarity to funds and to assist them in filing reports on Form
N-LIQUID.
---------------------------------------------------------------------------
\972\ See General Instructions A (Rule as to Use of Form N-
LIQUID), B (Application of General Rules and Regulations), C
(Information to Be Included in Report Filed on Form N-LIQUID), D
(Filing of Form N-LIQUID), E (Paperwork Reduction Act Information),
and F (Definitions) of Form N-LIQUID.
---------------------------------------------------------------------------
3. Amendments to Form N-CEN
We proposed several reporting items under Part C of Form N-CEN to
allow the Commission and other users to track certain liquidity risk
management practices that we expect funds to use on a less frequent
basis than the day-to-day portfolio construction techniques captured by
Form N-PORT.\973\ We are adopting these reporting requirements
substantially as proposed. Where we have received comments on specific
reporting requirements, we discuss them in more detail below.
---------------------------------------------------------------------------
\973\ See Proposing Release, supra footnote 9, at section
III.G.3.
---------------------------------------------------------------------------
a. Lines of Credit, Interfund Lending, and Interfund Borrowing
We are adopting, largely as proposed, but with a modification in
response to comment, the requirement in Form N-CEN that a management
company report information regarding the use of lines of credit,
interfund lending, and interfund borrowing.\974\ Several commenters
expressed general support for these reporting requirements on Form N-
CEN.\975\ In a modification to the proposal, if a fund reports that it
has access to a line of credit, for each line of credit the fund will
be required to report whether the line of credit is a committed or
uncommitted line of credit.\976\ The fund will be required to report
information concerning the size of the line of credit in U.S. dollars,
the name of the institution(s) with which the fund has the line of
credit, and whether the line of credit is for that fund alone or is
shared among multiple funds.\977\ If the line of credit is shared among
multiple funds, the fund is required to disclose the names and SEC File
numbers of the other funds (including any series) that may use the line
of credit.\978\ If the fund responds affirmatively to having available
a line of credit, the fund is required to disclose whether it drew on
the line of credit during the reporting period.\979\ If the fund drew
on that line of credit during the reporting period, the fund is
required to disclose the average dollar amount outstanding when the
line of credit was in use and the number of days that line of credit
was in use.\980\
---------------------------------------------------------------------------
\974\ See Item C.20 of Form N-CEN. We have modified the
numbering convention for items within Form N-CEN from the proposal
to be consistent with Form N-CEN as adopted in the Investment
Company Reporting Modernization Adopting Release and to clarify that
responses regarding lines of credit, interfund lending, and
interfund borrowing should apply to each line of credit or loan, as
applicable.
\975\ See, e.g., CFA Comment Letter; Federated Comment Letter;
Vanguard Comment Letter.
\976\ See Item C.20.a.i of Form N-CEN (emphasis added).
\977\ See Item C.20.a.ii-iv. of Form N-CEN.
\978\ See Item C.20.a.iv.1 of Form N-CEN. Under Form N-CEN,
``SEC File number'' means the number assigned to an entity by the
Commission when that entity registered with the Commission in the
capacity in which it is named in Form N-CEN. See General Instruction
E to Form N-CEN.
\979\ See Item C.20.a.v of Form N-CEN.
\980\ See Item C.20.a.vi. and vii of Form N-CEN.
---------------------------------------------------------------------------
The Proposing Release included a request for comment on whether
funds should be required to report information on uncommitted lines of
credit on Form N-CEN.\981\ In general, a committed line of credit
represents a bank's obligation, in exchange for a fee, to make a loan
to a fund subject to specified conditions. For uncommitted or standby
lines of credit, however, a bank indicates a willingness, but no
obligation, to lend to a fund.\982\ As one commenter noted, funds may
have certain tools like lines of credit from banks for temporary
liquidity management purposes ``when more typical means (e.g., use of
new or existing cash or sales of portfolio holdings) are unavailable or
otherwise
[[Page 82228]]
sub-optimal.'' \983\ One commenter suggested that funds report the
availability of uncommitted lines of credit in addition to committed
lines of credit in Form N-CEN.\984\
---------------------------------------------------------------------------
\981\ See Proposing Release, supra footnote 9, at section
III.G.3.c.
\982\ See Fortune, supra footnote 781 at 47.
\983\ ICI Comment Letter I.
\984\ See Federated Comment Letter.
---------------------------------------------------------------------------
In consideration of these comments, we are including in Form N-CEN
a requirement for funds to report the availability and use of committed
and uncommitted lines of credit.\985\ We believe that this information
will allow our staff and other potential users to assess what sources
of external liquidity are available to funds and to what extent funds
rely on dedicated external sources of liquidity, rather than relying on
the liquidity of fund portfolio investments alone, for liquidity risk
management. In addition, we believe that if funds make substantial use
of uncommitted lines of credit, the reporting of that reliance could
flag potential vulnerabilities in a fund or the fund industry,
particularly in the event of a market crisis when uncommitted lines of
credit might become unavailable. Furthermore, having funds report
information on lines of credit will also allow monitoring of whether
lines of credit are concentrated in particular financial institutions.
---------------------------------------------------------------------------
\985\ See Item C.20.a.(i) of Form N-CEN.
---------------------------------------------------------------------------
We are adopting, as proposed, the requirement that a fund report
whether it engaged in interfund lending or interfund borrowing during
the reporting period, and, if so, the average amount of the interfund
loan when the loan was outstanding and the number of days that the
interfund loan was outstanding.\986\ This information will provide some
transparency regarding the extent to which funds use interfund lending
or interfund borrowing. We understand that one reason that funds have
sought exemptive relief to engage in interfund lending and borrowing is
to meet redemption obligations if necessary.\987\
---------------------------------------------------------------------------
\986\ See Items C.20.b and c of Form N-CEN.
\987\ For example, we understand that funds may engage in
interfund lending and borrowing to pay out redemption proceeds same-
day or T+1 while the fund awaits proceeds from sales of non-traded
securities.
---------------------------------------------------------------------------
b. Additional Information Concerning ETFs
In a modification to the proposal, we are requiring that each ETF
that complies with rule 22e-4 as an ``In-Kind ETF'' under the rule,
identify itself accordingly in reports on Form N-CEN.\988\ As discussed
above, we are adopting certain tailored liquidity risk management
program requirements for ETFs, and certain ETFs that qualify as In-Kind
ETFs will not be required to classify their portfolio investments or
comply with the highly liquid investment minimum requirement of rule
22e-4.\989\ We believe that the In-Kind ETF information reported on
Form N-CEN will be helpful in understanding the volume of ETFs that
identify as In-Kind ETFs and thus are not required to classify their
portfolio investments or comply with the highly liquid investment
minimum requirement of rule 22e-4.\990\
---------------------------------------------------------------------------
\988\ See Item E.5 of Form N-CEN; see also supra section III.J
regarding the definition and treatment of ``In-Kind ETFs'' under
rule 22e-4.
\989\ Id.
\990\ ETFs that redeem in cash, or that do not qualify otherwise
as ``In-Kind ETFs'' (as defined in rule 22e-4(a)(9)) will be subject
to the full set of liquidity risk management program elements,
including the classification and highly liquid investment minimum
requirements. See rule 22e-4(b)(1)(i)-(iii).
---------------------------------------------------------------------------
4. Safe Harbors
Some commenters suggested that the Commission should include a safe
harbor and/or protection from liability as part of the final rule for
proposed liquidity-related disclosures.\991\ One commenter recommended
that the Commission provide a safe harbor for ``forward-looking
statements'' given the speculative nature of the proposed
disclosures.\992\ Another commenter recommended that the Commission
implement measures to shield from liability funds that in good faith
make forward-looking assessments of liquidity at either the asset or
portfolio level that subsequently turn out to materially differ from
actual liquidity.\993\ One commenter further suggested that the
Commission should include a provision stating that funds and their
affiliates will not face liability for errors in classification or
otherwise in implementing their liquidity risk management programs, and
related reports and (if applicable) disclosures, unless (i) the error
is material and (ii) the fund or affiliate acted knowingly or
recklessly. Commenters argued that any safe harbor provision should
also make clear that funds and managers would not face liability for
violation of rule 22e-4 based on second-guessing, either by the
Commission or by fund shareholders, of the design of the liquidity risk
management program.\994\ One commenter expressed concern that, even if
a safe harbor provision were established that protected funds and
directors from Commission enforcement actions, funds and directors
could still be subject to private litigation.\995\ We decline to
provide such a safe harbor.
---------------------------------------------------------------------------
\991\ See, e.g., ICI Comment Letter I; LSTA Comment Letter;
SIFMA Comment Letter II; T. Rowe Comment Letter.
\992\ See FSR Comment Letter.
\993\ See ICI Comment Letter I (noting that the Commission has
precedent for using its authority to shield from potential liability
certain forward-looking information that registrants are required to
provide (see, e.g., rule 175 under the Securities Act; rule 3b-6
under the Exchange Act; Item 303(c) of Reg. S-K; and Disclosure in
Management's Discussion and Analysis about Off-Balance Sheet
Arrangements and Aggregate Contractual Obligations, Securities Act
Release No. 33-8182 (Feb. 5, 2003) (regarding MD&A disclosures)).
\994\ See SIFMA Comment Letter II.
\995\ See Federated Comment Letter.
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M. Effective and Compliance Dates
We are adopting the following effective and compliance dates, as
set forth below.
1. Liquidity Risk Management Program
The compliance date for our liquidity risk management program
requirement is December 1, 2018 for larger entities, and June 1, 2019
for smaller entities. Thus all registered open-end management
investment companies, including open-end ETFs, that are not smaller
entities, will be required to adopt and implement a written liquidity
risk management program, approved by a fund's board of directors on
December 1, 2018, while smaller entities will be required to do so six
months later, on June 1, 2019.\996\
---------------------------------------------------------------------------
\996\ The compliance date in the section applies to rule 22e-4,
rule 30b1-10, and Form N-LIQUID.
---------------------------------------------------------------------------
In the Proposing Release, the Commission stated that it expected to
provide a tiered set of compliance dates based on asset size.\997\ The
Commission expected that 18 months after the effective date would
provide an adequate period of time for larger entities to prepare
internal processes, policies, and procedures and implement liquidity
risk management programs that would meet the requirements of the
rule.\998\ We believed that smaller entities would benefit from having
an additional 12 months to establish and implement a written liquidity
risk management program.\999\
---------------------------------------------------------------------------
\997\ See Proposing Release, supra footnote 9, at section III.H.
Specifically, for larger entities--namely, funds that together with
other investment companies in the same ``group of related investment
companies'' have net assets of $1 billion or more as of the end of
the most recent fiscal year--the Commission proposed a compliance
date of 18 months after the effective date to comply with the
Proposed Rule. For smaller entities (i.e., funds that together with
other investment companies in the same ``group of related investment
companies'' have net assets of less than $1 billion as of the end of
the most recent fiscal year), the proposal provided for an extra 12
months (or 30 months after the effective date) to comply with
proposed rule 22e-4.
\998\ Id.
\999\ Id.
---------------------------------------------------------------------------
Most of the commenters who discussed the proposed liquidity risk
management program compliance
[[Page 82229]]
date(s) opposed tiered compliance and requested at least 30 months to
comply. Some argued larger funds would need at least 30 months to
comply because of their size: More funds and a greater number and
variety of investments to classify would require more time.\1000\
Others cited operational limitations: A need of adequate time for (1)
all funds to properly prepare processes, policies and procedures; (2)
managers to adjust operations and develop reporting capabilities; and
(3) mutual fund boards to review, approve, and implement the
program.\1001\ The only commenter that supported tiered compliance
requested lengthier compliance dates for both larger and smaller
entities.\1002\
---------------------------------------------------------------------------
\1000\ See, e.g., Fidelity Comment Letter; FSR Comment Letter;
ICI Comment Letter I; Invesco Comment Letter.
\1001\ See, e.g., BlackRock Comment Letter; CRMC Comment Letter;
T. Rowe Comment Letter; Vanguard Comment Letter.
\1002\ See Dechert Comment Letter.
---------------------------------------------------------------------------
After evaluating the comments received, we believe that larger
entities would benefit from an additional period of time to come into
compliance with the rules over the 18 months that was proposed.
Therefore, we are providing an additional 6 months for these entities,
for a total of 24 months (i.e., December 1, 2018) to come into
compliance. We continue to believe that smaller entities may face
additional or different challenges in coming into compliance with the
rules quickly, and are therefore providing an extended compliance
period of a total of 30 months (i.e., June 1, 2019) for such smaller
entities.
2. Amendments to Form N-1A, Form N-PORT, and Form N-CEN
In the Proposing Release, the Commission expected to require all
initial registration statements on Form N-1A, and all post-effective
amendments that are annual updates to effective registration statements
on Form N-1A, filed six months or more after the effective date, to
comply with the proposed amendments to Form N-1A.\1003\ Few commenters
discussed the Form N-1A amendments. One commenter agreed that 6 months
was sufficient to comply with the amendments;\1004\ another commenter
requested 30 months to comply.\1005\ Because we do not expect that
funds will require significant amounts of time to prepare these
additional disclosures,\1006\ we are adopting a compliance date for our
amendments to Form N-1A of June 1, 2017. This will provide a six month
compliance period for these amendments, as proposed.
---------------------------------------------------------------------------
\1003\ See Proposing Release, supra footnote 9, at section
III.H.
\1004\ See ICI Comment Letter I.
\1005\ See Vanguard Comment Letter.
\1006\ See Proposing Release, supra footnote 9, at section
III.H.
---------------------------------------------------------------------------
Similar to the tiered compliance dates for the liquidity
classification requirements (discussed above), we are providing a
tiered set of compliance dates based on asset size for the additions to
Form N-PORT and Form N-CEN.\1007\ In the Proposing Release, for larger
entities, we expected that 18 months would provide an adequate period
of time for funds, intermediaries, and other service providers to
conduct the requisite operational changes to their systems and to
establish internal processes to prepare, validate, and file reports
containing the additional information requested by the proposed
amendments to Form N-PORT. Further, we believed that smaller entities
would benefit from extra time to comply and from the lessons learned by
larger investment companies during the adoption period for Form N-PORT.
For Form N-CEN, we proposed a compliance date of 18 months after the
effective date to comply with the new reporting requirements.\1008\ We
expected that 18 months would provide an adequate period of time for
funds, intermediaries, and other service providers to conduct the
requisite operational changes to their systems and to establish
internal processes to prepare, validate, and file reports containing
the additional information requested by the proposed amendments to Form
N-CEN. Multiple commenters, restating their concerns about operational
limitations, requested 30 months for all entities to comply with the
Form N-PORT and Form N-CEN amendments.\1009\
---------------------------------------------------------------------------
\1007\ Id.
\1008\ Id.
\1009\ See Cohen & Steers Comment Letter; Fidelity Comment
Letter; ICI Comment Letter I; Vanguard Comment Letter.
---------------------------------------------------------------------------
As discussed above, we are persuaded that larger entities would
benefit from extra time to comply and are therefore providing a
compliance date of December 1, 2018 for larger entities to come into
compliance with the additional liquidity-related reporting requirements
of Form N-PORT and Form N-CEN. This will result in larger funds filing
their first reports with additional liquidity-related information on
Form N-PORT, reflecting data as of December 31, no later than January
31. For smaller entities, the compliance date will be June 1, 2019.
This will provide smaller entities an additional six months to comply
with the new liquidity-related reporting requirements.
IV. Economic Analysis
A. Introduction and Primary Goals of Regulation
1. Introduction
As discussed above, the Commission is adopting regulatory changes
to require a liquidity risk management program, and to require new
disclosures regarding liquidity risk and liquidity risk management
(collectively, the ``final liquidity regulations''). Because of the
significant diversity in liquidity risk management practices that we
have observed in the fund industry, there exists the need for enhanced
comprehensive baseline regulations instead of only guidance for fund
liquidity risk management. In summary, and as discussed in greater
detail in section III above, the final liquidity regulations include
the following:
New rule 22e-4 will require that each fund stablish a
written liquidity risk management program. A fund's liquidity risk
management program broadly requires a fund to assess, manage and review
the fund's liquidity risk; to classify the liquidity of each of the
fund's portfolio investments; to determine a highly liquid investment
minimum (except for funds that hold primarily highly liquid
investments); and to limit illiquid investments to 15% of fund
investments. The final rule also provides for a tailored program for
all ETFs, but offers some exemptions for In-Kind ETFs. Finally, the
rule requires for board oversight of the liquidity risk management
program.
Amendments to Form N-1A and additional elements of new
Form N-PORT and Form N-CEN will require enhanced fund disclosure and
reporting regarding position liquidity and shareholder redemption
practices. New Form N-LIQUID will require more prompt, non-public
notification to the Commission when a fund's holdings of assets that
are illiquid investments exceed 15% of net assets, or when a fund's
holdings of highly liquid investments that are assets fall below the
fund's highly liquid investment minimum for more than 7 consecutive
calendar days.
The Commission is sensitive to the economic effects of the final
liquidity regulations, including the benefits and costs as well as the
effects on efficiency, competition, and capital formation. The economic
effects are discussed below in the context of the primary goals of the
final liquidity regulations.
2. Primary Goals
The primary goals of the final liquidity regulations are to promote
[[Page 82230]]
investor protection by reducing the risk that funds will be unable to
meet their redemption obligations, elevate the overall quality of
liquidity risk management across the fund industry, increase
transparency of funds' liquidity risks and risk management practices,
and mitigate potential dilution of non-transacting shareholders'
interests. Funds are not currently subject to requirements under the
federal securities laws or Commission rules that specifically require
them to maintain a minimum level of portfolio liquidity (with the
exception of money market funds), and follow Commission guidelines (not
rules) that generally limit their investment in illiquid assets.\1010\
Additionally, a fund today is only subject to limited disclosure
requirements concerning the fund's liquidity risk and risk
management.\1011\ As discussed in the Proposing Release, staff outreach
has shown that funds today engage in a variety of different practices--
ranging from comprehensive and rigorous to minimal and basic--for
assessing the liquidity of their portfolios, managing liquidity risk,
and disclosing information about their liquidity risk, redemption
practices, and liquidity risk management practices to investors.\1012\
We believe that the enhanced requirements for funds' assessment,
management, and disclosure of liquidity risk and enhanced limits on
illiquid investment holdings could decrease the chance that funds would
be unable to meet their redemption obligations and mitigate potential
dilution of non-redeeming shareholders' interests.
---------------------------------------------------------------------------
\1010\ See supra section II.D; infra section IV.B.1.a.
\1011\ See supra section II.D; infra section IV.B.1.c.
\1012\ See supra section II.D; infra sections IV.B.1.a,
IV.B.1.c.
---------------------------------------------------------------------------
The final liquidity regulations are also intended to lessen the
possibility of early redemption incentives (and investor dilution)
created by insufficient liquidity risk management, as well as the
possibility that investors' share value will be diluted by costs
incurred by a fund as a result of other investors' purchase or
redemption activity. When a fund experiences significant redemption
requests, it may sell portfolio securities or borrow funds in order to
obtain sufficient cash to meet redemptions.\1013\ However, sales of a
fund's portfolio investments conducted in order to meet shareholder
redemptions could result in significant adverse consequences to non-
redeeming shareholders when a fund fails to adequately manage
liquidity. For example, if a fund sells portfolio investments under
unfavorable circumstances, this could create dilution for non-redeeming
shareholders.\1014\ Funds also may borrow from a bank or use interfund
lending facilities to meet redemption requests, but there are costs
(such as interest rates) associated with such borrowings. Both selling
of portfolio investments and borrowing to meet redemption requests
could cause funds to incur costs that would be borne mainly by non-
redeeming shareholders.\1015\ These factors could result in dilution of
the value of non-redeeming shareholders' interests in a fund,\1016\
which could create incentives for early redemptions in times of
liquidity stress, and result in further dilution of non-redeeming
shareholders' interests.\1017\ There also is a potential for adverse
effects on the markets when open-end funds fail to adequately manage
liquidity. For example, the sale of less liquid portfolio investments
at discounted or even fire sale prices when a fund is facing redemption
pressures can produce significant negative price pressure on those
investments and correlated investments, which can impact other
investors holding these investments and may transmit stress to other
funds or portions of the markets.\1018\ For reasons discussed in detail
below, we believe that the liquidity risk management program
requirement, including the enhanced restrictions on holdings of assets
that are illiquid investments, should mitigate the risk of potential
shareholder dilution and decrease the incentive for early redemption in
times of liquidity stress.
---------------------------------------------------------------------------
\1013\ See supra section II.B.2; infra sections IV.C.1, IV.C.2.
\1014\ See supra footnotes 79-80 and accompanying text.
\1015\ See supra footnote 259 and accompanying text.
\1016\ See supra footnotes 79-80 and accompanying text; infra
sections IV.C.1, IV.C.2.
\1017\ See supra footnote 85 and accompanying text; infra
sections IV.C.1, IV.C.2.
\1018\ See supra footnote 89 and accompanying text.
---------------------------------------------------------------------------
Finally, the final liquidity regulations are meant to address
recent industry developments that have underscored the significance of
funds' liquidity risk management practices. In recent years, there has
been significant growth in the assets managed by funds with strategies
that focus on holding relatively less liquid investments, such as fixed
income funds (including emerging market debt funds), open-end funds
with alternative strategies, and emerging market equity funds.\1019\
There also has been considerable growth in assets managed by funds that
exhibit characteristics that could give rise to increased liquidity
risk, such as relatively high investor flow volatility.\1020\
Additionally, as discussed in detail above, standard fund redemption
and securities settlement periods have tended to become significantly
shorter over the last several decades, which has caused funds to
satisfy redemption requests within relatively short time periods (e.g.,
within T + 3, T + 2, and next-day periods).\1021\ But while fund
redemption periods have become shorter, certain funds, for example,
certain bank loan funds and emerging market debt funds, have increased
their holdings of portfolio securities with relatively long settlement
periods, which could result in a liquidity mismatch between when a fund
plans or is required to pay redeeming shareholders, and when any asset
sales that the fund has executed in order to pay redemptions will
settle.\1022\ Collectively, these industry trends have emphasized the
importance of effective liquidity risk management among funds and
enhanced disclosure regarding liquidity risk and risk management.
---------------------------------------------------------------------------
\1019\ See supra section II.C.1; infra section IV.B.3; see also
DERA Study, supra footnote 95, at 6-9. Relevant statistics from the
DERA Study were updated through 2015 using the CRSP US Mutual Fund
Database.
\1020\ See infra section IV.B.3.
\1021\ See supra footnotes 102 and 103 and accompanying text.
\1022\ See supra footnotes 104, 105, 377, and 378 and
accompanying text.
---------------------------------------------------------------------------
B. Economic Baseline
The final liquidity regulations will affect all funds and their
investors, investment advisers and other service providers, all issuers
of the portfolio securities in which funds invest, and other market
participants potentially affected by fund and investor behavior. The
economic baseline of the final liquidity regulations includes funds'
current practices regarding liquidity risk management and liquidity
risk disclosure, as well as the economic attributes of funds that
affect their portfolio liquidity and liquidity risk. These economic
attributes include industry-wide trends regarding funds' liquidity and
liquidity risk management, as well as industry developments
highlighting the importance of robust liquidity risk management by
funds.
[[Page 82231]]
1. Funds' Current Practices Regarding Liquidity Risk Management and
Liquidity Risk Disclosure
a. Funds' Current Liquidity Risk Management Requirements and Practices
Under section 22(e) of the Investment Company Act, a registered
investment company is required to make payment to shareholders for
redeemable securities tendered for redemption within seven days of
their tender.\1023\ In addition to the seven-day redemption requirement
in section 22(e), registered investment companies that are sold through
broker-dealers are required as a practical matter to meet redemption
requests within three business days because broker-dealers are subject
to rule 15c6-1 under the Exchange Act, which establishes a three-day (T
+ 3) settlement period for purchases and sales of securities (other
than certain types of securities exempted by the rule) effected by a
broker or a dealer, unless a different settlement period is expressly
agreed to by the parties at the time of the transaction. Furthermore,
rule 22c-1 under the Act, the ``forward pricing'' rule, requires funds,
their principal underwriters, and dealers to sell and redeem fund
shares at a price based on the current NAV next computed after receipt
of an order to purchase or redeem fund shares, even though cash
proceeds from purchases may be invested or fund investments may be sold
in subsequent days in order to satisfy purchase requests or meet
redemption obligations.
---------------------------------------------------------------------------
\1023\ See section 22(e) of the Act. Section 22(e) of the Act
provides, in part, that no registered investment company shall
suspend the right of redemption or postpone the date of payment upon
redemption of any redeemable security in accordance with its terms
for more than seven days after tender of the security absent
specified unusual circumstances.
---------------------------------------------------------------------------
With the exception of money market funds subject to rule 2a-7 under
the Act, the Commission has not promulgated rules requiring open-end
funds to hold a minimum level of liquid investments.\1024\ The
Commission historically has taken the position that open-end funds
should maintain a high degree of portfolio liquidity to ensure that
their portfolio securities and other assets can be sold and the
proceeds used to satisfy redemptions in a timely manner in order to
comply with section 22(e) and their other obligations.\1025\ The
Commission also has stated that open-end funds have a ``general
responsibility to maintain a level of portfolio liquidity that is
appropriate under the circumstances,'' and to engage in ongoing
portfolio liquidity monitoring to determine whether an adequate level
of portfolio liquidity is being maintained in light of the fund's
redemption obligations.\1026\ Open-end funds are also required by rule
38a-1 under the Act to adopt and implement written compliance policies
and procedures reasonably designed to prevent violations of the federal
securities laws, including policies and procedures that provide for the
oversight of compliance by certain of the fund's service providers, and
such policies and procedures should be appropriately tailored to
reflect each fund's particular compliance risks; the rule also requires
board approval and review of the service providers' compliance policies
and procedures.\1027\ An open-end fund that holds a significant portion
of its assets in securities with long settlement periods or with
infrequent trading, or an open-end fund that represents it will pay
redemptions in fewer than seven days, for instance, may be subject to
relatively greater liquidity risks than other open-end funds.
---------------------------------------------------------------------------
\1024\ See supra footnotes 61-62 and accompanying text.
\1025\ See Restricted Securities Release, supra footnote 37.
\1026\ See supra footnote 64 and accompanying text.
\1027\ See Rule 38a-1 Adopting Release, supra footnote 65.
---------------------------------------------------------------------------
Additionally, long-standing Commission guidelines generally limit
an open-end fund's aggregate investment in ``illiquid assets'' to no
more than 15% of the fund's net assets (the ``15% guideline'').\1028\
Under the 15% guideline, a portfolio security or other asset is
considered illiquid if it cannot be sold or disposed of in the ordinary
course of business within seven days at approximately the value at
which the fund has valued the investment.\1029\ The 15% guideline has
generally limited funds' exposure to particular types of securities
that cannot be sold within seven days and that the Commission and staff
have indicated may be illiquid, depending on the facts and
circumstances. Depositors of UITs are currently required to consider
which of their restricted securities are illiquid.\1030\
---------------------------------------------------------------------------
\1028\ See supra footnote 38 and accompanying text.
\1029\ See supra footnote 39 and accompanying text.
\1030\ See Rule 144A Release, supra footnote 37 at n.61
(discussing liquidity requirements for UITs prior to the adoption of
rule 22e-4).
---------------------------------------------------------------------------
As noted in the Proposing Release, staff outreach has shown that
funds currently employ a diversity of practices with respect to
assessing portfolio investments' liquidity, as well as managing
liquidity risk. Section II.D.3 above provides an overview of these
practices, which include, among others: Assessing the ability to sell
particular investments within various time periods, taking into account
relevant market, trading, and other factors; monitoring initial
liquidity determinations for portfolio investments (and modifying these
determinations, as appropriate); holding certain amounts of the fund's
portfolio in highly liquid investments or cash equivalents;
establishing committed back-up lines of credit or interfund lending
facilities; and conducting stress testing relating to the extent the
fund has liquid investments to cover possible levels of
redemptions.\1031\ Some commenters indicated that they view in-kind
redemptions as an important liquidity risk management tool.\1032\
Another commenter noted that ETFs are often used to help manage
liquidity risk because they can allow funds to maintain market exposure
while ensuring sufficient liquidity.\1033\ As noted in the Proposing
Release, the staff has observed that some of the funds with relatively
more thorough liquidity risk management practices have appeared to be
able to meet periods of high redemptions without significantly altering
the risk profile of the fund or materially affecting the fund's
performance, and thus with few dilutive impacts. It therefore appears
that these funds have generally aligned their portfolio liquidity with
their liquidity needs, and that their liquidity risk management permits
them to efficiently meet redemption requests. Other funds, however,
employ portfolio investment liquidity assessment and liquidity risk
management practices that are substantially less rigorous.\1034\ As
discussed above in section II.D.3, some funds do not take different
market conditions into account when
[[Page 82232]]
evaluating portfolio investment liquidity, and do not conduct ongoing
liquidity monitoring. Likewise, some funds do not have independent
oversight of their liquidity risk management outside of the portfolio
management process. As a result, funds' procedures for assessing the
liquidity of their portfolio securities, as well as the
comprehensiveness and independence of their liquidity risk management,
vary significantly.
---------------------------------------------------------------------------
\1031\ See also, e.g., Nuveen FSOC Notice Comment Letter, supra
footnote 85 (discussing stress tests of a fund's ability to meet
redemptions over certain periods); BlackRock FSOC Notice Comment
Letter, supra footnote 85 (discussing several overarching principles
that provide the foundation for a prudent market liquidity risk
management framework for collective investment vehicles, including
an independent risk management function, compliance checks to ensure
portfolio holdings do not exceed regulatory limits, a risk
management function that is independent from portfolio management,
and measuring levels of liquid assets into ``tiers of liquidity'');
Invesco FSOC Notice Comment Letter, supra footnote 248, at 11
(discussing liquidity analysis).
\1032\ See BlackRock Comment Letter; Invesco Comment Letter.
\1033\ See BlackRock Comment Letter.
\1034\ See infra section IV.C.1.b, where the potential
consequences of less rigorous liquidity risk management are
discussed in the context of risk management program benefits.
---------------------------------------------------------------------------
A fund may meet redemption requests in a variety of ways, including
by using cash, borrowing under a line of credit, or by selling
portfolio investments. The fund's portfolio liquidity as well as its
value will be affected by the choice of which investments are sold.
Subsequent portfolio transactions after redemptions are met will also
affect portfolio liquidity and value. For example, a fund facing a
large redemption request might lessen the impact on portfolio value of
selling investments by selling the most liquid portion of the portfolio
or using some of its cash or a line of credit.\1035\ That choice
benefits non-redeeming investors by minimizing transaction costs and
the loss in fund value due to the price impact of selling, but it also
could increase the liquidity risk of the fund portfolio and the fund
may incur transaction costs if it subsequently engages in portfolio
transactions such as rebalancing towards its previous portfolio
allocation.\1036\ If the fund instead were to sell a ``strip'' of the
portfolio (i.e., a cross-section or representative selection of the
fund's portfolio investments), the immediate impact on fund value may
be greater, but the liquidity of the fund portfolio would be unchanged
as a result of the sale. Funds also could choose to meet redemptions by
selling a range of investments in between their most liquid, on one end
of the spectrum, and a perfect pro rata strip of investments, on the
other end of the spectrum.\1037\ All of the above ways by which a fund
may meet redemptions potentially occur in conjunction with other
strategic portfolio management decisions, such as opportunistically
paring back or eliminating holdings in a particular investment or
sector while meeting redemptions.
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\1035\ We note that in some instances, selling only the most
liquid investments to meet a large redemption could be inconsistent
with the fund's investment mandate. For example, if a fund's
investment mandate required it to hold a certain percentage of its
portfolio in equities, the fund might not be able to sell a large
portion of its equity holdings to meet redemption requests and still
hold the required percentage of its portfolio in equities.
\1036\ See, e.g., supra footnote 71 (discussing recent
circumstances in which, during a year of heavy redemptions that
caused a high yield bond fund's assets to shrink 33% in this period,
the fund's holdings of lower quality bonds grew to 47% of assets,
from 35% before the redemptions).
\1037\ See, e.g., Hao Jiang, Dan Li, and Ashley Wang, Dynamic
Liquidity Management by Corporate Bond Mutual Funds (May 6, 2016)
(unpublished working paper), available at http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2776829. The study presents preliminary
evidence consistent with the notion that corporate bond funds tend
to sell proportional ``strips'' of their portfolios during periods
of high market volatility and disproportionately sell more liquid
assets during periods of lower market volatility.
---------------------------------------------------------------------------
Staff analysis of the impact of large redemptions on U.S. equity
fund portfolio liquidity is consistent with the hypothesis that the
average U.S. equity fund does not sell a strip of its portfolio
investments to meet large redemptions, but instead appears--based on
changes in funds' portfolio liquidity following net outflows--to
disproportionately sell the more liquid portion of its portfolio for
this purpose.\1038\ Similarly, staff analysis shows that after a U.S.
municipal bond fund encounters net outflows, the typical U.S. municipal
bond fund will experience an increase in its holdings of municipal
bonds (and a decrease in its holdings of cash and cash equivalents),
potentially decreasing the fund's overall portfolio liquidity.\1039\
---------------------------------------------------------------------------
\1038\ DERA Study, supra footnote 95, at 43-46. The DERA Study
analyzes U.S. equity mutual fund liquidity management trends using
the Amihud liquidity measure. See Proposing Release, supra footnote
9, at n.621. We respond to comments on this result and other aspects
of the DERA study in section IV.C.1.f.
\1039\ DERA Study, supra footnote 95, at 47-49.
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b. Funds' Current Liquidity Risk Disclosure Requirements and Practices
Items 4 and 9 of Form N-1A require a fund to disclose the principal
risks of investing in the fund.\1040\ A fund currently must disclose
the risks to which the fund's portfolio as a whole is expected to be
subject and the circumstances reasonably likely to adversely affect the
fund's NAV, yield, or total return.\1041\ Some funds currently disclose
that liquidity risk is a principal risk of investing in the fund, but
often do so in a generic way.
---------------------------------------------------------------------------
\1040\ Item 4(b)(1)(i) and Item 9(c) of Form N-1A.
\1041\ Id.
---------------------------------------------------------------------------
Item 11 of Form N-1A requires a fund to describe its procedure for
redeeming fund shares, including restrictions on redemptions, any
redemption charges, and whether the fund has reserved the right to
redeem in kind.\1042\ Disclosure regarding other redemption
information, such as the timing of payment of redemption proceeds to
fund shareholders, varies across funds as there are currently no
specific requirements for this disclosure. Some funds disclose that
they will redeem shares within a specific number of days after
receiving a redemption request, other funds disclose that they will
honor such requests within seven days (as required by section 22(e) of
the Act), and others provide no specific time periods. Additionally,
some funds disclose differences in the timing of payment of redemption
proceeds based on the payment method by which the fund shares are
redeemed, while others do not.
---------------------------------------------------------------------------
\1042\ Item 11(c) of Form N-1A.
---------------------------------------------------------------------------
Funds are not currently required to disclose information about the
liquidity of their portfolio investments. However, some funds
voluntarily disclose in their registration statements any specific
limitations applicable to the fund's investment in 15% guideline
assets, as well as types of assets considered by the fund to be subject
to the 15% guideline.
Form N-1A does not currently require funds to disclose information
about liquidity risk management practices such as the establishment (or
use) of committed back-up lines of credit. A fund is, however, required
to disclose information regarding the amount and terms of unused lines
of credit for short-term financing, as well as information regarding
related party transactions in its financial statements or notes
thereto.\1043\
---------------------------------------------------------------------------
\1043\ See Sec. Sec. 210.5-02.19(b) and 210.4-08(k) of
Regulation S-X.
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2. Fund Industry Developments Regarding Funds' Liquidity Risk
Management
a. Overview
Below we discuss the size and growth of the U.S. fund industry
generally, as well as the growth of various investment strategies
within the industry. We show that the fund industry has grown
significantly in the past two decades, and during this period, funds
with international strategies, fixed income funds, and funds with
alternative strategies have grown particularly quickly. We also
determine the types of funds that demonstrate notably volatile and
unpredictable flows. Because volatility and predictability in a fund's
flows can affect the extent to which the fund is able to meet expected
and reasonably foreseeable redemption requests without diluting the
interests of fund shareholders, assessing trends regarding these
factors can provide information about sectors of the fund industry that
could be particularly susceptible to liquidity risk.
While we believe that these trends are relevant from the
perspective of addressing potential liquidity risk in the fund industry
(and in funds' underlying portfolio investments), we emphasize
[[Page 82233]]
that liquidity risk is not confined to certain types of funds or
investment strategies. Although we recognize that certain fund
characteristics could make a fund relatively more prone to liquidity
risk, we believe that all types of funds entail liquidity risk to some
extent.\1044\ Thus, while in this section we discuss certain types of
funds and strategies that are generally considered to exhibit increased
liquidity risk, we are not asserting that only these types of funds and
strategies involve liquidity risk, or that a fund of the type and with
the strategy discussed below necessarily demonstrates greater liquidity
risk than a fund that does not have these same characteristics.
---------------------------------------------------------------------------
\1044\ See supra section III.A.2.
---------------------------------------------------------------------------
b. Size and Growth of the U.S. Fund Industry and Various Investment
Strategies Within the Industry
Open-end funds and ETFs manage a significant and growing amount of
assets in U.S. financial markets. As of the end of 2015, there were
10,633 open-end funds (excluding money market funds, but including
ETFs), as compared to 5,279 at the end of 1996.\1045\ The assets of
these funds were approximately $15.0 trillion in 2015, having grown
from about $2.63 trillion in 1996.\1046\ Within these figures, the
number of ETFs and ETFs' assets have increased notably in the past
decade. There were 1,594 ETFs in 2015, as opposed to a mere 119 in
2003, and ETFs' assets have increased from $151 billion in 2003 to $2.1
trillion in 2015.\1047\
---------------------------------------------------------------------------
\1045\ See 2016 ICI Fact Book, supra footnote 11, at 22, 176,
183. Specifically, as of the end of 2015, there were 9,039 open-end
mutual funds (including funds that invest in other funds) and 1,594
ETFs. There were approximately 50 ETFs that invest in other ETFs,
which are not included in our figures.
\1046\ See 2016 ICI Fact Book, supra footnote 11, at 174, 182.
\1047\ See 2016 ICI Fact Book, supra footnote 11, at 182, 183.
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U.S. equity funds represent the greatest percentage of U.S. open-
end fund industry assets.\1048\ Open-end U.S. equity funds, excluding
ETFs, money market funds and variable annuities, held 44.7% of U.S.
fund industry assets as of the end of 2015. The investment strategies
with the next-highest percentages of U.S. fund industry assets are
foreign equity funds (16.7%), general bond funds (13.2%), and mixed
strategy funds (12.3%).\1049\ Funds with alternative strategies \1050\
only represent a small percentage of the U.S. fund industry assets, but
as discussed below, the number of alternative strategy funds and the
assets of this sector have grown considerably in recent years.\1051\
---------------------------------------------------------------------------
\1048\ DERA Study, supra footnote 95, at Table 1.
\1049\ Id. The figure for general bond funds does not include
assets attributable to foreign bond funds (1.9%), U.S. corporate
bond funds (0.8%), U.S. government bond funds (1.4%), and U.S.
municipal bond funds (4.7%). The figure for mixed strategy funds
includes assets of, among others, target date funds, convertible
securities funds, and flexible portfolio funds.
\1050\ Alternative funds are funds that seek total returns
through the use of alternative investment strategies, including but
not limited to equity market neutral, long/short equity, global
macro, event driven, credit focus strategies.
\1051\ DERA Study, supra footnote 95, at 7-8.
---------------------------------------------------------------------------
While the overall growth rate of funds' assets has been generally
high (about 7.2% per year, between the years 2000 and 2015 \1052\), it
has varied significantly by investment strategy.\1053\ U.S. equity
funds' assets grew substantially in terms of dollars from the end of
2000 to 2015,\1054\ but this sector's assets as a percentage of total
U.S. fund industry assets decreased from about 65% to about 45% during
that same period.\1055\ Like U.S. equity funds, the assets of U.S.
corporate bond funds, government bond funds, and municipal bond funds
also increased in terms of dollars from 2000 to 2015, but each of these
sectors' assets as a percentage of the fund industry decreased during
this period.\1056\ On the other hand, the assets of foreign equity
funds, general bond funds, and foreign bond funds increased steadily
and substantially as a percentage of the fund industry over the same
period.\1057\ For example, foreign equity funds increased steadily from
10.6% of total industry assets in 2000 to 16.7% in 2015. And within
these three investment strategies, certain investment subclasses
(emerging market debt and emerging market equity) have grown
particularly quickly from 2000 to 2015.\1058\ The overall growth rate
of funds' assets between the years 2000 and 2015 was greater for index
funds (12.3%) than actively managed funds (4.9%).\1059\
---------------------------------------------------------------------------
\1052\ DERA Study, supra footnote 95, at Table 2.
\1053\ The figures in this paragraph and the following
paragraph, discussing the variance in growth rate of funds' assets
by investment strategy, exclude ETF assets.
\1054\ U.S. equity funds held about $5.6 trillion as the end of
2015, compared to about $2.9 trillion at the end of 2000. DERA
Study, supra footnote 95, at Table 2.
\1055\ DERA Study, supra footnote 95, at Table 2.
\1056\ Id. U.S. corporate bond funds held about $95 billion at
the end of 2015, as opposed to $66 billion in 2000; these funds'
assets as a percentage of the U.S. fund industry decreased from 1.5%
in 2000 to 0.8% in 2015. U.S. government bond funds held about $174
billion at the end of 2015, as opposed to $91 billion in 2000; these
funds' assets as a percentage of the U.S. fund industry decreased
from 2.1% in 2000 to 1.4% in 2015. U.S. municipal bond funds held
about $592 billion at the end of 2015, as opposed to $278 billion in
2000; these funds' assets as a percentage of the U.S. fund industry
decreased from 6.3% in 2000 to 4.7% in 2015.
\1057\ Id. Foreign equity funds held about $2.1 trillion in
2015, as opposed to $465 billion in 2000. U.S. general bond funds
held about $1.7 trillion at the end of 2015, as opposed to $240
billion in 2000; these funds' assets as a percentage of the U.S.
fund industry increased from 5.4% in 2000 to 13.2% in 2015. Foreign
bond funds held about $244 billion at the end of 2015, as opposed to
$19 billion in 2000; these funds' assets as a percentage of the U.S.
fund industry increased from 0.4% in 2000 to 1.9% in 2015.
\1058\ DERA Study, supra footnote 95, at 9. Emerging market debt
and emerging market equity funds held about $289 billion at the end
of 2015, as opposed to $20 billion in 2000. The assets of emerging
market debt funds and emerging market equity funds grew by an
average of 18.1% and 19.8%, respectively, each year from 2000
through 2015.
These investment subclasses represent a small portion of the
U.S. mutual fund industry (the combined assets of these investment
subclasses as a percentage of the U.S. fund industry was 2.3% at the
end of 2015).
\1059\ See 2016 ICI Fact Book, supra footnote 11, at 174, 218.
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The assets of funds with alternative strategies \1060\ also have
grown rapidly in recent years. From 2005 to 2015, the assets of
alternative strategy funds grew from $366 million to $310 billion, and
from the end of 2011 to the end of 2013, the assets of alternative
strategy funds grew by an average rate of almost 80% each year.
However, as discussed above, funds with alternative strategies remain a
relatively small portion of the U.S. fund industry as a percentage of
total assets.\1061\
---------------------------------------------------------------------------
\1060\ See supra footnote 95 for a discussion of the primary
investment strategies practiced by ``alternative strategy'' funds.
\1061\ See supra footnote 1051 and accompanying text.
---------------------------------------------------------------------------
c. Significance of Fund Industry Developments
The industry developments discussed above are notable for several
reasons. The growth of funds generally over the past few decades
demonstrates that investors have increasingly come to rely on
investments in funds to meet their financial needs.\1062\ These trends
also demonstrate growth in particular types of funds that may entail
increased liquidity risk. In particular, there has been significant
growth in high-yield bond funds, emerging market debt funds, and funds
with alternative strategies. Commissioners and Commission staff have
previously spoken about the need to focus on potential liquidity risks
relating to fixed income assets and fixed income funds,\1063\ and
within this sector, funds that invest in high-yield bonds could be
subject to greater liquidity risk as they invest in lower-rated bonds
that tend to be less liquid than investment grade
[[Page 82234]]
fixed income securities.\1064\ Emerging market debt funds may invest in
relatively illiquid securities with lengthy settlement periods.\1065\
Likewise, funds with alternative strategies may hold portfolio
investments that are relatively illiquid.\1066\ Moreover, Commission
staff economists have found that both foreign bond funds (including
emerging market debt funds) and alternative strategy funds have
historically experienced relatively more volatile and unpredictable
flows than the average mutual fund,\1067\ which could increase these
funds' liquidity risks by making it more likely that a fund may need to
sell portfolio investments in a manner that creates a market impact in
order to pay redeeming shareholders.
---------------------------------------------------------------------------
\1062\ See supra footnote 21 and accompanying text.
\1063\ See supra footnote 93 and accompanying text.
\1064\ The Commission and Commission staff have cautioned that
high yield securities may be considered to be illiquid, depending on
the facts and circumstances. See Interval Fund Proposing Release,
supra footnote 41; see also SEC Investor Bulletin, What Are High-
Yield Corporate Bonds?, SEC Pub. No. 150 (June 2013), available at
http://www.sec.gov/investor/alerts/ib_high-yield.pdf (noting that
high-yield bonds may be subject to more liquidity risk than, for
example, investment-grade bonds). But see Who Owns the Assets?,
supra footnote 378 (discussing the liquidity characteristics of
high-yield bond funds in depth, and noting that these funds have
weathered multiple market environments, and are generally managed
with multiple sources of liquidity).
\1065\ See, e.g., supra footnote 377 and accompanying text
(discussing the settlement cycles associated with transactions in
certain foreign securities); see also Reuters, Fitch: Close Look at
EM Corporate Bond Trading Reveals Liquidity Risks (Apr. 16, 2015),
available at http://www.reuters.com/article/2015/04/16/idUSFit91829620150416. But see Who Owns the Assets?, supra footnote
378 (discussing the liquidity characteristics of emerging market
debt funds in depth, and noting that these funds tend to hold a
portion of their assets in developed market government bonds
(providing further liquidity), generally establish limits on less
liquid issuers, and generally maintain allocations to cash for
liquidity and rebalancing purposes).
\1066\ See supra footnotes 99-100 and accompanying text.
\1067\ DERA Study, supra footnote 95, at 16-24.
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One commenter has argued that flow volatility, which staff
economists have used as a measure of liquidity risk, does not
necessarily translate into liquidity risk.\1068\ In this commenter's
view, for example, a fund with volatile but predictable flows may have
less liquidity risk than a fund with less volatile but less predictable
flows. Likewise, a U.S. equity fund could have much greater flow
volatility than a foreign bond mutual fund without having greater
liquidity risk because the equity fund's assets are more liquid.
However, differences in average flow volatility between fund categories
persist after accounting for predictability, and the analysis suggests
that changes in flow volatility may influence the management of fund
liquidity.\1069\ Flow volatility is not the sole determinant of
liquidity risk for a fund, but it is an important determinant, which
makes it useful in helping understand differences in potential
liquidity risk within and between fund categories.
---------------------------------------------------------------------------
\1068\ ICI Comment Letter II.
\1069\ DERA Study, supra footnote 95, at 23-24, 37.
---------------------------------------------------------------------------
The same commenter has also suggested that the same approach of
measuring liquidity risk does not consider the usage of derivatives in
managing volatile flows, noting that they are often more liquid than
their underlying assets.\1070\ We acknowledge that derivatives could
play a role in managing fund flows. As is the case for corporate bond
holding data, data on fund holdings of derivatives is limited so our
analysis of holdings level data was necessarily limited to U.S. equity
funds.
---------------------------------------------------------------------------
\1070\ ICI Comment Letter II.
---------------------------------------------------------------------------
C. Benefits and Costs, and Effects on Efficiency, Competition, and
Capital Formation
Taking into account the goals of the final liquidity regulations
and the economic baseline, as discussed above, this section discusses
the benefits and costs of the final liquidity regulations, as well as
the potential effects of the final liquidity regulations on efficiency,
competition, and capital formation. This section also discusses
reasonable alternatives to rule 22e-4 and the disclosure and reporting
requirements regarding funds' liquidity risk and liquidity risk
management.
1. Rule 22e-4
a. Summary of Rule 22e-4's Requirements
Rule 22e-4 will require each fund to establish a written liquidity
risk management program. The rule specifies that a fund's liquidity
risk management program shall include the following required program
elements: (i) Assessment, management, and periodic review of the fund's
liquidity risk; (ii) classification of the liquidity of each of the
fund's portfolio investments based on asset class, so long as the fund
or its adviser does not have information about any market, trading, or
investment-specific considerations that are reasonably expected to
significantly affect the liquidity characteristics of an investment
that would suggest a different classification for that investment;
\1071\ (iii) determining and periodically reviewing a highly liquid
investment minimum and adopting and implementing policies and
procedures for responding to a shortfall of the fund's assets that are
highly liquid investments below its highly liquid investment minimum;
(iv) prohibiting the fund's acquisition of ``illiquid investments''
(that is, any investment that the fund reasonably expects cannot be
sold or disposed of in current market conditions in seven calendar days
or less without the sale or disposition significantly changing the
market value of the investment) if, following the acquisition, the fund
would hold more than 15% of its net assets in assets that are illiquid
investments; (v) requiring a fund whose illiquid investments that are
assets exceed 15% of its net assets to conduct certain board reporting;
and (vi) for funds that engage in, or reserve the right to engage in,
redemptions in kind, establishing policies and procedures regarding how
and when it will engage in such redemptions in kind.\1072\ A fund's
board, including a majority of the fund's independent directors, will
be required to provide general oversight of the fund's liquidity risk
management program, but the board would not have to approve the fund's
highly liquid investment minimum.\1073\ The fund will be required to
designate the fund's adviser or officer(s) responsible for
administering the program, and such designation is required to be
approved by the fund's board of directors.\1074\ The fund's board will
also be required to review, at least annually, a written report
prepared by the fund's investment adviser or officer(s) administering
the liquidity risk management program reviewing the adequacy and
effectiveness of the implementation of the fund's liquidity risk
management program, including the fund's highly liquid investment
minimum, and the effectiveness of its implementation.\1075\
---------------------------------------------------------------------------
\1071\ Rule 22e-4 (b)(1)(ii).
\1072\ Proposed rule 22e-4(b)(2)(iv).
\1073\ Proposed rule 22e-4(b)(3)(i).
\1074\ Proposed rule 22e-4(b)(3)(iii).
\1075\ Rule 22e-4(b)(3)(ii).
---------------------------------------------------------------------------
Rule 22e-4 also includes certain recordkeeping requirements. A fund
will be required to keep a written copy of its liquidity risk
management policies and procedures, as well as copies of any materials
provided to the fund's board in connection with the approval of the
initial liquidity risk management program and annual board reporting
requirement.\1076\ A fund will also be required to keep a written
record of how its highly liquid investment minimum, and any adjustments
thereto, were determined.\1077\
---------------------------------------------------------------------------
\1076\ Rule 22e-4(c)(1) and (2).
\1077\ Rule 22e-4(c)(3).
---------------------------------------------------------------------------
[[Page 82235]]
In addition, two types of funds are subject to tailored
requirements by the final rule. First, funds that primarily hold highly
liquid assets do not have to establish a highly liquid investment
minimum as part of their liquidity risk management programs.\1078\
Second, ETFs are required to assess and manage liquidity risk with
respect to certain additional factors tailored to the specific risks of
ETFs.\1079\ However, an ETF that meets the final rule's definition of
an ``In-Kind ETF'' is not required to establish a highly liquid
investment minimum or to classify its individual portfolio
holdings.\1080\
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\1078\ Rule 22e-4(b)(1)(iii)(A).
\1079\ Rule 22e-4(b)(1)(iii)(D)-(E).
\1080\ See infra footnote 846 and accompanying text for the
definition of ``In-Kind ETF.''
---------------------------------------------------------------------------
In addition to the special treatment of In-Kind ETFs and primarily
highly liquid funds, the final rules differ from the proposed version
in several ways that may have economic consequences: (1) It integrates
the definition of illiquid investments subject to the 15% illiquid
investment limit as a part of the portfolio classification process,
requiring the consideration of market, trading, and investment-specific
factors and market depth in determining whether an investment is
illiquid, as well as the periodic review of this assessment at least
monthly; (2) it reduces the number of categories used to classify
portfolio investment liquidity from six to four and requires fewer
long-term liquidity projections; (3) it simplifies portfolio position
classification by allowing them to be based on asset classes, with
customized exceptions for individual positions where necessary; \1081\
(4) it does not prohibit the acquisition of less liquid investments if
a fund goes below its highly liquid investment minimum, but instead
requires that a fund report to its board if it goes below its highly
liquid investment minimum, and, if the shortfall lasts more than 7
consecutive calendar days, also requires reporting to the Commission;
(5) it requires that a fund's board approve and annually review a
report concerning its liquidity risk management program, but generally
does not require the board to approve the highly liquid investment
minimum (except in some circumstances) or material changes to these
programs; (6) it requires that a fund assess its liquidity risk with
respect to several factors, where applicable, in both stressed and
normal market conditions, whether its strategy is appropriate for an
open-ended fund, and whether its strategy involves a concentrated
portfolio or large positions in particular issuers; \1082\ (7) it
requires that principal underwriters or depositors of UITs to
determine, on or before the date of the initial deposit of portfolio
securities into a UIT, that the portion of the illiquid investments
that the UIT holds or will hold at the date of deposit that are assets
is consistent with the redeemable nature of the securities that it
issues; and (8) requires that In-Kind ETFs offer daily transparency by
posting on the ETF's Web site on each day that the national securities
exchange on which the fund's shares are listed is open for business,
before commencement of trading of fund shares on the exchange, the
identities and quantities of the securities, assets or other positions
held by the fund, or its respective master fund, that will form the
basis for the fund's calculation of net asset value at the end of the
business day.
---------------------------------------------------------------------------
\1081\ See supra footnote 408 and accompanying text.
\1082\ Rule 22e-4(b)(1)(iii)(A)-(C).
---------------------------------------------------------------------------
b. Benefits
Rule 22e-4, as adopted, should produce the same broad benefits for
current and potential fund investors as discussed in the proposal.
Where appropriate, we discuss below any changes in these benefits due
to differences between the proposed and final rules. Specifically, the
liquidity risk management program requirements are likely to improve
investor protection by decreasing the chance that some funds may be
unable to meet their redemption obligations, would meet such
obligations by diluting the fund's shares, or would meet such
obligations through methods that would have other adverse impacts on
non-redeeming investors (e.g., increased risk exposure and decreased
liquidity). To the extent that some funds do not currently meet the
liquidity risk management standards required by the rule--either by
meeting the rule's minimum baseline requirements for fund assessment
and management of liquidity risk or via alternative liquidity risk
management approaches--investor protection will be enhanced by imposing
these minimum requirements on funds.
We believe that the liquidity risk management program requirement
should promote improved alignment of the liquidity of the fund's
portfolio with the fund's expected (and reasonably foreseeable) levels
of redemptions. As discussed above, rule 22e-4 will require each fund
to classify the liquidity of its portfolio investments in assessing its
liquidity risk, and to determine a highly liquid investment minimum to
increase the likelihood that the fund will hold adequate liquid
investments to meet redemption requests without significant dilution.
Each fund will have flexibility to determine the particular investments
that it holds in connection with its highly liquid investment minimum.
Assets eligible for inclusion in a fund's highly liquid investment
minimum could include a broad variety of securities, as well as cash
and cash equivalents. While one fund may conclude that it is
appropriate to hold a significant portion of its assets that are highly
liquid investments in cash and cash equivalents, another could decide
it is appropriate to hold assets that are convertible to cash within
longer periods (but not exceeding three business days) as the majority
of its highly liquid investments. The highly liquid investment minimum
requirement should allow funds to continue to meet a wide variety of
investors' investment needs by obliging funds to maintain appropriate
liquidity in their portfolios. The proposed rule would have required
funds to set a firm three-day liquid asset minimum, prohibiting the
acquisition of relatively less liquid assets until a fund was back
above its minimum, instead of allowing them to operate below the
minimum with board notification, so the final rule should mitigate any
unfavorable market effects related to the systematic purchase or sale
of investments once a strict minimum was exceeded. In extreme cases--
for example, if investments that the fund sought to purchase were
trading at fire sale prices due to a market event--a fund could go
below its minimum to trade opportunistically. However, that might cause
the fund to operate below its highly liquid investment minimum for more
than 7 consecutive calendar days, requiring reporting to the fund's
board and the Commission within one business day, so funds may be
hesitant to take advantage of attractive market prices when they are
close to their minimum under the final rule. The ability to deviate
from the minimum for up to 7 consecutive calendar days with required
reporting at the next regular board meeting, or for longer periods
provided the fund reports to the board and the Commission, could also
reduce the likelihood that funds set artificially low minimums, which
would be less protective of investors than a minimum with some
flexibility built in such as the one we are adopting. The limitation on
the acquisition of assets that are illiquid investments to no more than
15% of net assets, along with the corresponding enhancements to how
investment illiquidity is assessed, complements the
[[Page 82236]]
highly liquid investment minimum requirement by increasing the
likelihood that a fund's portfolio is not overly concentrated in
investments whose liquidity is limited. Furthermore, the additional
board reporting requirements triggered when a fund's illiquid
investments that are assets exceed 15% of net assets decreases the
likelihood that a fund's portfolio is overly concentrated in
investments classified as illiquid for an extended period of time
without board oversight.
We believe that the rule also will decrease the probability that a
fund will need to meet redemption requests through activities that can
materially affect the fund's NAV or risk profile or dilute the
interests of fund shareholders. For example, when a fund is
insufficiently liquid or does not effectively manage liquidity and is
faced with significant redemptions, or both, it may be forced to sell
portfolio investments under unfavorable circumstances, which could
create significant negative price pressure on those investments.\1083\
This, in turn, could disadvantage non-redeeming shareholders by
decreasing the value of those shareholders' interests in the
fund.\1084\ Even if a fund were to sell the most liquid portion of its
portfolio to meet redemption requests, which would minimize the loss in
fund value due to the price impact of selling, these asset sales could
decrease the liquidity of the fund portfolio, potentially creating
increased liquidity risk for non-redeeming shareholders. As discussed
above, staff analysis is consistent with the hypothesis that U.S.
equity funds may disproportionally sell more liquid assets, especially
when facing significant outflows, as opposed to selling a pro rata
``strip'' of the fund's portfolio assets, which minimizes price impact
on a fund in the short term, but ultimately decreases the liquidity of
the fund's portfolio.\1085\ Short-term borrowings by a fund to meet
redemption requests could also disadvantage non-redeeming shareholders
by leveraging the fund, which requires the fund to pay interest on the
borrowed funds (although, in some instances, the costs of borrowing may
be less than the costs of selling assets to meet redemptions) and
magnifies any gains or losses to non-redeeming shareholders. Moreover,
the costs of borrowing (that is, the costs associated with maintaining
a committed line of credit, as well as interest expenses associated
with drawing on a credit line) could be passed on to fund shareholders
in the form of fund operating expenses, which adversely affect a fund's
NAV. To the extent that the program requirement results in liquidity
risk assessment and management that enhance funds' ability to meet
redemption obligations, it will be less likely that a fund takes
actions to pay redemptions that cause dilution or have other adverse
impacts on non-redeeming shareholders.
---------------------------------------------------------------------------
\1083\ See Coval & Stafford, supra footnote 86 (discussing how
mutual fund fire sales impact asset prices).
\1084\ While the impact of fire sales on asset prices may be
short lived in some instances, Coval and Stafford show that the
impact of fire sales can often take many months to dissipate. Id.
\1085\ See supra footnote 1038 and accompanying text.
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The potential negative consequences of asset sales undertaken to
pay fund redemptions could create early redemption incentives in times
of liquidity stress, or a ``first-mover advantage.'' \1086\ For
example, academic studies have suggested that an incentive exists for
market participants to front-run trades conducted by a fund in response
to significant changes in fund flows.\1087\ This suggests that
sophisticated fund investors could anticipate that significant fund
outflows could lead a fund to conduct trades that would disadvantage
non-redeeming shareholders, which could create an incentive to redeem
ahead of such trades. If investors' redemptions are motivated by a
first-mover advantage, this could lead to increasing levels of
redemptions, and as the level of outflows from a fund increases, the
incentive to redeem also increases. Any negative effects on non-
redeeming shareholders thus could be magnified by a first-mover
advantage to the extent that this dynamic produces growing redemptions
and decreasing portfolio liquidity. The first-mover advantage is more
commonly discussed with respect to money market funds, especially
institutional prime money market funds that operated under a fixed NAV
prior to the 2014 reform (that will become effective October 14, 2016),
but the incentives that have been argued to create the first-mover
advantage among those funds could in theory exist (in possibly weaker
form) among other open-end funds. We agree with commenters that the
empirical support for the existence of a first-mover advantage is not
conclusive and that the mutual fund industry has been able to
successfully navigate periods of historical market stress.\1088\ While
we understand that fund investors may not have historically been
motivated to redeem on account of a perceived (or actual) first-mover
advantage during previous periods of stress, we cannot predict how
investors may behave in the future. To the extent that economic
incentives exist to redeem fund shares prematurely, such redemptions
could lead to investor dilution as discussed above, and the possibility
of protecting against this potential dilution could be one benefit of
rule 22e-4.
---------------------------------------------------------------------------
\1086\ See supra footnote 85 and accompanying text (discussing
the possibility of a first-mover advantage with respect to the
timing of shareholder redemption from funds, but also arguments that
such a first-mover advantage does not exist in funds, as well as
arguments that even if incentives to redeem ahead of other
shareholders do exist, this does not necessarily imply that
investors will in fact redeem en masse in times of market stress).
\1087\ See Coval & Stafford, supra footnote 86; Dyakov &
Verbeek, supra footnote 86.
\1088\ See, e.g., Comment Letter of Wellington Management Group
LLP on the Notice Seeking Comment on Asset Management Products and
Activities, Docket No. FSOC-2014-0001 (Mar. 25, 2015), at 4; ICI
FSOC Notice Comment Letter, supra footnote 68, at 7; Nuveen FSOC
Notice Comment Letter, supra footnote 85, at 10; Dechert Comment
Letter; Vanguard Comment Letter; Comment Letter of the Independent
Trustees of Fidelity Fixed Income and Asset Allocation Funds (Jan.
13, 2016) (all arguing that evidence shows that fund shareholders'
redemptions are largely driven by other concerns rather than a
theoretical first-mover advantage).
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The program requirement aims to promote a minimum baseline for
liquidity risk management in the fund industry. This should promote
investor protection by elevating the overall quality of liquidity risk
management across the fund industry, reducing the likelihood that funds
will meet redemption obligations only through activities that could
significantly dilute shareholders or adversely affect fund risk
profiles. Shareholders in funds that already engage in strong liquidity
risk management practices may be less likely to benefit from the
program requirement, or may benefit less, than shareholders in funds
that do not employ equally rigorous practices. We cannot quantify the
total benefits to fund operations and investor protection that we
discuss above, but to the extent that staff outreach has noted that
some funds currently have no (or very limited) formal liquidity risk
management programs in place, rule 22e-4 would enhance current
liquidity risk management practices.
Finally, to the extent that the program requirement results in
funds less frequently needing to sell portfolio investments in
unfavorable market conditions in order to meet redemptions, the
requirement also could lower potential spillover risks that funds could
pose to the financial markets generally. If, as a result of the program
requirement, a fund was prepared to meet redemption requests in other
ways, the rule could decrease the
[[Page 82237]]
risk that the fund might indirectly transmit stress to other market
sectors and participants. The rule should help ensure that all funds,
not just those with liquidity risk management practices currently in
place, operate in a manner that lessens the chance of spillover risks.
We are unable to quantify this potential benefit because we cannot
predict the extent to which funds would enhance their current liquidity
risk management practices as a result of rule 22e-4, or predict the
precise circumstances that could entail negative spillover effects in
light of less-comprehensive liquidity risk management by funds.\1089\
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\1089\ The ability of the Commission to perform such analysis is
limited by difficulties in both gathering data about funds'
liquidity risk management practices and quantifying such data.
---------------------------------------------------------------------------
Commenters generally did not disagree with the benefits of the
proposed rule, with any exceptions noted in the above discussion of
rule 22e-4's benefits. As discussed above, the final rule differs from
the proposal in several key respects, but it largely preserves the
proposed rule's benefits. First, funds that primarily hold assets that
are highly liquid investments are not required to establish a highly
liquid investment minimum, so any benefits that might have accrued to
shareholders of these funds under the proposed rule may be diminished.
However, these funds are less likely to be exposed to the liquidity
risks discussed above to the same degree as other funds, so any loss in
benefits should be negligible and is likely to be less than the costs
of establishing a minimum. Similarly, In-Kind ETFs are exempt from
certain aspects of the final rule, because the benefits of those
aspects of the final rule would have been insignificant for In-Kind
ETFs. The final rule instead achieves benefits with respect to ETFs by
replacing these less-apposite requirements with new tailored
requirements for ETFs that are designed to promote the proper
management of ETF liquidity, focused on preventing the arbitrage
mechanism that keeps ETFs priced properly from being adversely impacted
by a lack of liquidity. In addition, the new requirement for daily
transparency will permit the sophisticated authorized participants that
directly interact with the ETF to effectively evaluate the liquidity of
the ETF's holdings. Since nearly all In-Kind ETFs already provide daily
transparency as a matter of course, we believe no additional costs
arise for In-Kind ETFs.\1090\
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\1090\ We note that ETMFs are not required to provide such daily
transparency under their orders, and thus would need to choose to
provide such daily transparency if they wished to take advantage if
this provision. Choosing to take advantage of this provision is
within the discretion of ETFs that could potentially qualify as In-
Kind. As discussed in the PRA section below, we estimate that not
all ETFs would qualify as In-kind, either because of their use of
cash for redemptions or because of their choice not to provide daily
transparency of holdings.
---------------------------------------------------------------------------
Second, modifications to the proposal allow funds to classify
portfolio investments via assignments to asset classes as a default,
but require them to classify specific investments separately if they
merit special attention,\1091\ which preserves the benefits of
investment liquidity classification without imposing the additional
cost of individually classifying each portfolio position in all cases.
Third, the rule's simplification of classification categories from six
to four, with shorter-term horizons, still provides a reasonably
nuanced view of a fund portfolio's position-level liquidity while
responding to commenters' concerns that the proposed rule's more
detailed classification would have required too much precision at long-
term horizons and would not accurately reflect a fund's actual
liquidity profile. Fourth, the final rule should preserve the benefits
of board oversight of a fund's liquidity risk management program
without requiring that board members approve the highly liquid
investment minimum (except in certain circumstances). The modifications
to the board's role make the board's involvement in the liquidity risk
management more consistent with the board's historical duty to provide
oversight (instead of day-to-day management).
---------------------------------------------------------------------------
\1091\ See supra footnote 1064 and accompanying text.
---------------------------------------------------------------------------
Changes to the final rule could also provide additional benefits
relative to the proposal. While the final rule clarifies that the
factors a fund should consider in devising a liquidity risk management
program may be considered as appropriate, it also requires that funds
consider two additional factors--whether a given strategy is
appropriate in an open-ended fund or involves a concentrated portfolio
or concentrated positions in particular issuers--which could improve
the risk management program's effectiveness for funds that do not
already consider these factors. The final rule also more precisely
specifies criteria for both the initial and ongoing assessment of
whether investments should be classified as illiquid under the 15%
illiquid investment limit by tying it to the same criteria used in
assigning investments to other liquidity categories (including
considering relevant market, trading, and investment-specific
considerations, and market depth), which should reduce a firm's
compliance burdens relative to the proposed rule while at the same time
providing a more precise picture of how exposed to illiquid investments
a given fund is. Finally, while UITs were not subject to rule 22e-4
under the proposal, the final rule requires that the principal
underwriter or depositor of a UIT will be required to determine, on or
before the date of the initial deposit of portfolio securities into the
UIT, that the portion of illiquid investments the UIT holds or will
hold at the date of deposit that are assets is consistent with the
redeemable nature of the securities it issues. This enhancement of the
final rule over the proposal could benefit investors by reducing the
likelihood that a UIT could be created that holds an excessive amount
of illiquid securities, which in turn would reduce the liquidity risk
associated with UITs.
c. Costs
One-Time and Ongoing Costs Associated With Program Establishment and
Implementation
Funds will incur one-time costs to establish and implement a
liquidity risk management program in compliance with rule 22e-4, as
well as ongoing program-related costs. As discussed above, funds today
employ a range of different practices, with varying levels of quality,
for assessing the liquidity of their portfolio investments and managing
fund liquidity risk. Accordingly, funds whose practices regarding
portfolio investment liquidity classification and liquidity risk
assessment and management most closely align with the liquidity risk
management program requirements would incur relatively lower costs to
comply with rule 22e-4. Funds whose practices for classifying the
liquidity of their portfolio investments and for assessing and managing
liquidity risk are less thorough or not closely aligned with the rule,
on the other hand, may incur relatively higher initial compliance
costs.
Some commenters suggested that the estimates of costs in the rule
proposal were significantly understated and that the true costs of
compliance with the rule requirements would likely exceed the expected
benefits.\1092\ Another
[[Page 82238]]
commenter suggested that costs were underestimated because other fund
systems would also have to be modified to ensure compliance with the
entirety of the requirements of the rule.\1093\ For example, if funds
are required to maintain or target a certain level of fund liquidity,
then the trade order management system would have to be modified to
ensure accurate monitoring of such limitations. We have revised the
discussion of costs to both reflect new information on the potential
costs of compliance and changes in the rule that are designed to lessen
the potential costs. Specifically, we use estimates provided by
commenters to approximate costs for each fund complex under the
proposed rule and then qualitatively discuss how changes to the
proposed rule affect these estimates. Because most changes to the final
rule reduce requirements for some segment of funds relative to the
proposal, the estimates below can generally be considered an upper
bound on fund costs except where explicitly noted.
---------------------------------------------------------------------------
\1092\ See CFA Comment Letter; Cohen & Steers Comment Letter;
Dechert Comment Letter; Dodge & Cox Comment Letter; Federated
Comment Letter; FSR Comment Letter; ICI Comment Letter I; Invesco
Comment Letter; LSTA Comment Letter; MFDF Comment Letter; SIFMA
Comment Letter I; T. Rowe Comment Letter; Vanguard Comment Letter;
Voya Comment Letter.
\1093\ See Federated Comment Letter.
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Staff estimates of the one-time costs in the proposal, which ranged
from $1.3 million to $2.25 million per fund complex, were partly based
on estimates from another Commission rulemaking.\1094\ Some commenters
expressed concern about the calculation of this estimate because it was
based on assumptions driven by analysis performed with respect to money
market fund reform.\1095\ While some of the large scale system
modifications required by rule 22e-4 will be similar to those required
for money market funds due to regulatory reform, and we attempted to
adjust our estimates for differences between the two rules, one
commenter suggested that the process of classifying portfolio assets
was more akin to a fund's costs in analyzing the value of its
assets.\1096\ We acknowledge that could be an informative approach to
estimating costs, but absent concrete estimates associated with that
approach, which the commenter did not provide, we have updated our
estimates based on the limited quantitative information available from
commenters.\1097\ One commenter estimated that there would be $2
million in initial implementation costs and more than $650,000 in
annual recurring costs for automating a classification process that
would have to manage 63,000 different portfolio positions.\1098\
Another commenter estimated the costs of building a system to classify
the liquidity of its investments, which is not currently commercially
available, in the millions of dollars to manage their 44,000 different
portfolio positions.\1099\ We use the former as a basis for our
analysis because it is comparable in magnitude to the latter.\1100\
Because there are likely to be economies of scale in developing the
policies, procedures, and systems required to comply with rule 22e-4,
we approximate the cost per fund complex by assuming fixed costs
constitute 30% of the commenter's estimates, and extrapolate using the
number of funds per complex to scale variable costs up or down.\1101\
In addition, because the process of classifying assets under the
proposal would likely constitute a majority of a fund's costs, we
assume the classification process constitutes approximately 75% of a
fund's cost of complying with proposed rule 22e-4. This method results
in one-time costs for funds under the proposed rule that range from
approximately $0.8 million to $10.2 million, that the average cost per
fund complex is $1 million, and the aggregate cost is approximately
$855 million. The estimated range of costs using this approach is wider
than our approach in the proposal, but the estimated aggregate cost is
lower than our initial estimate of $1.3 billion. While these estimates
would change if we varied our assumption that fixed costs comprise 30%
of the commenter's estimate--for example, increasing this percentage
would compress the range of costs and the aggregate may increase or
decrease--they are of the same order of magnitude as our estimates in
the proposal.
---------------------------------------------------------------------------
\1094\ See Proposing Release, supra footnote 9, at n.702 and
accompanying text.
\1095\ See FSR Comment Letter; SIFMA Comment Letter I.
\1096\ See Dechert Comment Letter.
\1097\ As in the proposal, the estimates assume that each fund
would not bear all of the costs (particularly, the costs of systems
modification) on an individual basis, but instead that these costs
would likely be allocated among the multiple users of the systems,
that is, each of the members of a fund complex. Accordingly, we
expect that, in general, funds within large fund complexes would
incur fewer costs on a per fund basis than funds within smaller fund
complexes, due to economies of scale in allocating costs among a
group of users.
\1098\ See Invesco Comment Letter.
\1099\ See T. Rowe Comment Letter.
\1100\ We estimate that there were 146 funds in the second
commenter's fund complex as of December 31, 2015, which implies an
estimated cost of approximately $4 million using our estimation
procedure, in line with the commenter's statement that its cost
would be ``in the millions.'' See supra footnote 1094 for discussion
of the estimation procedure.
\1101\ We use CRSP U.S. Mutual Fund Database to obtain the
number of funds for each complex. As of December 31, 2015, there
were 7551 mutual funds (excluding money market funds and annuities),
1484 ETFs (excluding non-40-act ETFs, ETNs, and Commodity ETFs), and
847 fund complexes (334 of them with only one fund). The commenter,
Invesco, consisted of 87 funds as of that date, and we assume the
fixed cost component of their estimate is $0.6 million (30% of $2
million). The remaining $1.4 million is assumed to be a variable
cost that scales linearly with the number of funds. To arrive at a
total cost of 22e-4, each of these estimates is scaled so that the
classification process constitutes 75% of the total costs of
proposed rule 22e-4.
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These estimated one-time costs are attributable to the following
activities, as applicable to each of the funds within the complex: (i)
Developing policies and procedures relating to each of the required
program elements,\1102\ and the related recordkeeping requirements of
the rule; (ii) planning, coding, testing, and installing any system
modifications relating to each of the required program elements; (iii)
integrating and implementing policies and procedures relating to each
of the required program elements (including classifying the liquidity
of each of the fund's portfolio investments pursuant to rule 22e-
4(b)(1)(ii)), as well as the recordkeeping requirements of the rule;
(iv) preparing training materials and administering training sessions
for staff in affected areas; and (v) costs associated with educating
the fund's board and obtaining approval of the program. These
activities are likely to cut across many different functional groups
within a fund or fund complex, including legal, compliance, risk,
portfolio management, accounting, and technology staff. To the extent
that some of the systems needed to support the required program
elements are developed by third parties, fund complexes may be able to
implement their liquidity risk management programs for less than our
estimated cost of developing these
[[Page 82239]]
programs themselves, but the final rule emphasizes that it is
ultimately each fund's responsibility to classify its positions, so
these potential cost reductions may be limited. For example, we
understand that third parties have already developed programs that
include certain market, trading, and investment-specific factors which
could be useful in classifying the liquidity of portfolio investments,
and are currently available for purchase.\1103\
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\1102\ Specifically, a fund would be required, where applicable,
to establish policies and procedures relating to: (i) Assessment,
management, and periodic review of the fund's liquidity risk; (ii)
classification of the liquidity of each of the fund's portfolio
investments, as well as at-least-monthly reviews of the fund's
liquidity classifications; (iii) the requirements to determine and
periodically review a highly liquid investment minimum, and to adopt
and implement policies and procedures for responding to a shortfall
of the fund's highly liquid investments below its highly liquid
investment minimum; (iv) the requirement to limit the fund's
acquisition of illiquid investments over 15% of the fund's net
assets; and (v) for funds that engage in, or reserve the right to
engage in, redemptions in kind, the requirement to establish
policies and procedures regarding how it will engage in such
redemptions in kind. The final rule also provides for a tailored
program for ETFs that redeem in kind, excluding them from the
classification and highly liquid investment minimum requirements,
but requiring them to consider additional factors as part of their
liquidity risk assessment and management that reflect potential
liquidity-related concerns that could arise from the structure and
operation of ETFs. The final rule also provides an exclusion from
the highly-liquid investment minimum requirement for funds that
primarily hold highly liquid investments. The rule also provides for
board oversight of the liquidity risk management program.
\1103\ See supra footnote 323 and accompanying text (discussing
Commission guidance on a fund's use of third-party service providers
to obtain data to inform or supplement its consideration of the
liquidity classification factors). We understand, based on staff
outreach, that annual costs to subscribe to the liquidity
classification services provided by third-party data and analytics
providers currently range from $50,000-$500,000.
---------------------------------------------------------------------------
We have also revised our estimates of the ongoing costs of
complying with rule 22e-4 using the same approach and based on the same
commenter's estimate as above for one-time costs. While our analysis in
the proposal assumed ongoing costs ranged from 10% to 25% of the one-
time costs resulting from the rule, we've reduced the low end of the
range to 5% to reflect changes from the Proposing Release, discussed
below, that should lower some funds' compliance burdens, and increased
the high end of the range to 32.5% to reflect the commenter's estimate
that ongoing costs for their fund under the proposed rule would be
$0.65 million (compared to one-time costs of $2 million). We again
extrapolate from the commenter's estimate as above to arrive at a
minimum and maximum cost estimate for each fund, which implies a range
of ongoing costs across all funds of $40,000 to $3.3 million per fund
complex. These costs are attributable to the following activities, as
applicable to each of the funds within the complex: (i) Classification
of the liquidity of each of the fund's portfolio investments, as well
as at-least-monthly reviews of the fund's liquidity classifications
(rule 22e-4(b)(1)(ii)); (ii) periodic review of the fund's liquidity
risk (rule 22e-4(b)(1)(i)); (iii) periodic review of the adequacy of
the fund's highly liquid investment minimum (rule 22e-
4(b)(1)(iii)(A)(2)); (iv) systems maintenance; (v) additional staff
training; (vi) approval, annual review, and general oversight by the
board of the fund's liquidity risk management program (rule 22e-
4(b)(2)); and (viii) recordkeeping relating to the fund's liquidity
risk management program (rule 22e-4(b)(3)).\1104\ Relative to the
proposed rule, the final rule reduces the responsibilities of a fund's
board, which is not required to approve the fund's highly liquid
investment minimum or material changes to the fund's liquidity risk
management program, which should reduce the board-related costs
embedded in the above estimates of rule 22e-4's one-time and ongoing
costs.
---------------------------------------------------------------------------
\1104\ As discussed in greater detail below, we anticipate that,
depending on the personnel (and/or third-party service providers)
involved in the activities associated with administering a liquidity
risk management program, certain of the estimated ongoing costs
associated with these activities could be borne by the fund, and
others could be borne by the adviser.
---------------------------------------------------------------------------
The original classification scheme would have mandated significant
micro-level analysis of instruments not currently conducted by fund
advisers according to many commenters.\1105\ Such an analysis would
have required entirely new systems for many fund complexes and would
have required funds to incur significant expenses (especially for
smaller fund complexes).\1106\ The new classification system lowers the
potential costs of compliance with the liquidity classification
requirement by (i) reducing the number of classification categories
reduced from six to four, (ii) only requiring ``days-to-cash''
estimates out to 7 days, (iii) allowing funds to generally classify
based on asset class (subject to an exception process), (iv) changing
the process for considering position size to reduce complexity, and (v)
simplifying the classification factors to be considered into a single
requirement that funds consider market, trading, and investment-
specific data when classifying an investment. As a whole, these changes
should lower the potential costs of compliance with the classification
requirement relative to the proposal estimates above without
significantly reducing the potential benefits of the requirement.
---------------------------------------------------------------------------
\1105\ See Credit Suisse Comment Letter; Dechert Comment Letter;
Federated Comment Letter; Fidelity Comment Letter; Oppenheimer
Comment Letter; SIFMA Comment Letter I; Wellington Comment Letter.
\1106\ See Dechert Comment Letter; ICI Comment Letter I; SIFMA
Comment Letter I; T. Rowe Comment Letter.
---------------------------------------------------------------------------
Specifically with respect to position size, commenters argued that
evaluating ``days-to-cash'' was inherently biased against large funds
and could lead to ``plain vanilla'' funds that generally invest in only
highly-liquid securities (e.g., S&P 500 funds) being classified as
highly illiquid if they manage a large amount of assets.\1107\ The rule
now only requires a fund to determine whether trading varying portions
of a position in a particular portfolio investment or asset class, in
sizes that the fund reasonably anticipates trading, is reasonably
expected to significantly affect its liquidity. This change should
prevent large ``plain vanilla'' funds from appearing to be very
illiquid under the classification scheme while still maintaining the
idea that position size is an important consideration in the evaluation
of liquidity. Relative to the proposed rule, this should reduce the
costs associated with determining how position size affects the number
of days required to liquidate an investment and eliminate the cost of
classifying separate portions of a position into separate liquidity
buckets.
---------------------------------------------------------------------------
\1107\ See Dodge & Cox Comment Letter; Oppenheimer Comment
Letter; Vanguard Comment Letter; ICI Comment Letter I; ICI Comment
Letter II; Invesco Comment Letter.
---------------------------------------------------------------------------
The classification process has also been revised in response to
commenter concerns about the need to evaluate whether an investment can
be sold for cash without materially affecting the security's price,
which investors could interpret as an indication that they can redeem
out of funds at a known or protected NAV.\1108\ One commenter expressed
concern that if investors were given estimates of liquidity that are
speculative or stale, or both, which might fail to predict liquidity
with accuracy during periods of market stress, then funds could be
potentially subject to significant litigation costs.\1109\ The value
impact component of the rule has been modified so that determinations
of market impact can be based on a reasonable expectation that an
investment can be converted to cash (or in some cases, sold or disposed
of) without the conversion (or in some cases, sale or disposition)
significantly changing the market value, rather than a price ``that
does not materially affect the value of that asset immediately prior to
sale.'' This modification in the definition should relieve funds of the
need to develop precise security-by-security expectations of forward
looking liquidity while still emphasizing the need to consider the
potential market impact of buying or selling an investment, reducing
compliance costs relative to the proposed rule.
---------------------------------------------------------------------------
\1108\ See ICI Comment Letter II.
\1109\ See Dodge & Cox Comment Letter.
---------------------------------------------------------------------------
Commenters also expressed concern about the use of third-party
vendors in the process of liquidity classification.\1110\ If only a few
vendors were able to provide the necessary data, such data would likely
cause significant expenses for the funds, and those expenses would
likely be passed on, at least in part, to fund investors through
[[Page 82240]]
higher fees. Another commenter suggested that the cost of third-party
liquidity data should be included in any estimate of the potential
costs of the classification system because of the strong likelihood
that all funds would need to subscribe to a third-party vendor to
ensure compliance with the rule.\1111\ As discussed in the proposal, we
believe outsourcing program functions to vendors should, if anything,
reduce compliance costs, and we noted that liquidity classification
services already exist.\1112\ In addition, our updated estimate of
costs above is based on a large investment manager's estimate of
constructing an internal system from scratch, so we would expect the
cost of a vendor-based solution, which would be partially amortized
across all of its clients, to be lower. The changes made to the
classification system from the proposal could also lessen the costs
associated with third-party vendors relative to the proposed rule. In
particular, to the extent that requiring less precision via fewer
classification categories and shorter time horizons, allowing funds to
generally classify according to asset class (subject to an exception
process), and requiring a simpler position size evaluation criterion
reduce the scope and intensity of the investment classification
process, funds may not rely as much on vendors to comply with the rule,
and vendors themselves may experience reduced costs in developing
programs, leading to lower prices if they pass on some of the savings
to funds.
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\1110\ See Dechert Comment Letter; Federated Comment Letter; ICI
Comment Letter I; ICI Comment Letter II; MFDF Comment Letter; Nuveen
Comment Letter; SIFMA Comment Letter I; T. Rowe Comment Letter;
Wells Fargo Comment Letter.
\1111\ See Interactive Data Comment Letter.
\1112\ See Proposing Release, supra footnote 9, at n.705 and
accompanying text.
---------------------------------------------------------------------------
If all funds use a small number of third-party vendors, there could
be other indirect, but potentially large, costs. According to one
commenter, the vendors could become de facto liquidity ``rating
agencies'' and their ``upgrades'' and ``downgrades'' of asset liquidity
could have systemic effects on the market.\1113\ For example, if a
vendor were to remove a widely-held investment from the highly liquid
investment category, then many funds could simultaneously attempt to
sell that investment, which could harm both fund investors and the
wider market. Given the data limitations and difficulties in estimating
liquidity for many less liquid investments, that potential effect might
be driven by error-prone modeling instead of true changes in liquidity.
We emphasize above that while third-party products can serve as a
useful input to the classification process, it is the fund's
responsibility to determine the liquidity of each investment, which
should lessen the potential for systemic issues by reducing fund
reliance on third-party vendors and allowing more of the necessary
liquidity analysis to be performed within each fund complex.\1114\
---------------------------------------------------------------------------
\1113\ See ICI Comment Letter II.
\1114\ See supra section III.C.1.b. (providing guidance on the
appropriate use of data vendors).
---------------------------------------------------------------------------
Several additional components of the final rule will affect costs
relative to the proposal. First, by excluding any fund that primarily
holds assets that are highly liquid investments from the requirement to
have a highly liquid investment minimum, the final rule avoids imposing
any potential costs related to the minimum on some funds that would
benefit less from having a minimum. It is possible that some funds that
do not qualify as primarily highly liquid funds will incur the costs of
establishing a minimum without a significant benefit. Second, whereas
funds may currently use back-office operations to limit their
acquisition of illiquid assets under exiting Commission guidelines, the
final rule's enhanced illiquid investment standard may require funds to
incur direct costs associated with a shift of these operations to other
business functions (we also discuss indirect costs associated with the
enhanced illiquid investment limit below).\1115\ Third, the final rule
does not require In-Kind ETFs to establish a highly liquid investment
minimum or classify the liquidity of their portfolios, which will
reduce their costs relative to other funds, but it also requires them--
as it does all ETFs--to consider several additional factors as part of
their liquidity risk programs, which may increase their implementation
costs. Finally, principal underwriters or depositors of UITs, which had
no liquidity risk requirements under the proposed rule, will now have
to incur a one-time cost on or before the date of the initial deposit
of the portfolio securities into the UITs to assess whether the amount
of illiquid investments they expect the UITs to hold is compatible with
the redeemable nature of the securities they issue. This cost should be
comparable in magnitude to incurring a fraction of the ongoing costs of
an open-ended fund under rule 22e-4 because it involves an analysis
that is similar to complying with the rule's 15% illiquid investment
limit without having to establish all of the systems and processes that
are required to perform that task on a continuing basis. Assuming that
this activity accounts for 20% of an open-ended fund's ongoing costs,
we estimate that it would cost a UIT $8,000 to $52,000, and note that
it will only be incurred by UITs that are launched after the rule's
compliance date.\1116\ UITs are already required to consider which of
their restricted securities are illiquid, so this estimate should be
considered an upper bound on the costs imposed on UITs by the rule.
Finally, the rule's provision requiring board oversight when a fund's
holding of illiquid assets exceed 15% of its net assets may impose
additional costs on the fund to hold a special board meeting, including
the cost of preparing materials for the board's deliberation, the cost
of board members' time, as well as the cost of consultations with
outside counsel.
---------------------------------------------------------------------------
\1115\ See supra section III.C.4.a.
\1116\ These figures are based on the same comment letter used
to estimate one-time and ongoing costs for open-ended funds. We
assume the costs associated with launching a UIT under rule 22e-4
are equivalent to 20% of the ongoing costs of a one fund complex.
Under the assumptions above that ongoing costs for open-ended funds
are 5% to 32.5% of their initial costs, fund complexes with one fund
have estimated ongoing costs of approximately $40,000 to $260,000.
Multiplying that range by 20% produces the UIT estimate.
---------------------------------------------------------------------------
Depending on the personnel (and/or third-party service providers)
involved with respect to the activities associated with establishing
and implementing a liquidity risk management program, certain of the
estimated one-time costs could be borne by the fund, and others could
be borne by the fund's adviser or other service providers. This cost
allocation would be dependent on the facts and circumstances of a
particular fund's liquidity risk management program, and thus we cannot
specify the extent to which the estimated costs would typically be
allocated to the fund as opposed to the adviser. Estimated costs that
are allocated to the fund would likely be borne by fund shareholders in
the form of fund operating expenses.
Certain elements of the program requirement may entail marked
variability in related compliance costs, depending on a fund's
particular circumstances and sources of potential liquidity risk. The
process of classifying the liquidity of each of a fund's portfolio
investments could give rise to varying costs depending on the fund's
particular investment strategy. For example, a U.S. large cap equity
fund would likely incur relatively few costs to obtain the data
necessary to classify its portfolio positions, specifically given that,
relative to the proposed rule, the final rule allows such a fund to
generally classify its positions based on asset classes (subject to an
exception process). On the other hand, funds that hold investments for
which relevant market,
[[Page 82241]]
trading, and other investment-specific data is less readily available,
for which a general asset-class-based classification is more difficult
to apply, or funds that require more exceptions to their asset-class-
based classification would incur relatively greater costs associated
with the classification of their portfolio positions' liquidity. In
addition, funds with multiple sub-advisers may incur relatively more
costs to coordinate the process of classifying position liquidity as
well as monitoring whether the fund is compliant with its highly liquid
investment minimum and the 15% illiquid investment limit.
Certain factors that the rule's guidance suggests a fund should
consider in assessing its liquidity risk also could entail relatively
greater costs, depending on the fund's circumstances. For instance, a
fund with a relatively short operating history could incur greater
costs in assessing the fund's cash flow projections than a similarly
situated fund with a relatively long operating history. This is because
the newer fund could find it appropriate to assess redemption activity
in similar funds during normal and stressed periods (to predict its
future cash flow patterns), which could entail additional costs to
gather and analyze relevant data about these comparison funds. Also, a
fund whose shares are held largely through omnibus accounts may wish to
periodically request shareholder information from financial
intermediaries in order to determine how the fund's ownership
concentration may affect its cash flow projections. These data
requests, and related analyses, could cause a fund to incur costs that
another fund, whose shares are largely held directly, would not. A fund
that deems it appropriate to establish and implement additional
liquidity risk management policies and procedures beyond those
specifically required under the rule also would incur additional
related costs. While we recognize that, as described above, the costs
to establish and implement a liquidity risk management program in
compliance with rule 22e-4 will depend to some degree on the level of
liquidity risk facing the fund, we are unable to quantify the various
ways in which a fund's individual risks and circumstances could affect
the costs associated with establishing a liquidity risk management
program.
Commenters suggested that the proposed three-day liquid asset
minimum requirement could have had a number of unintended consequences.
As discussed above, if third-party vendors become de facto ``rating
agencies'' for liquidity, then a liquidity minimum could force many
funds to sell the same investments simultaneously after a liquidity
``downgrade,'' which could have a systemic impact on funds and the
overall market.\1117\ Similarly, if a fund were forced into predictable
trading behavior during a market downturn because of the highly liquid
investment minimum requirement, the liquidity and performance of that
fund would be negatively impacted.\1118\ It is possible that the
proposed three-day liquid asset minimum requirements could have created
these types of unintended consequences by prohibiting a fund from
acquiring less liquid assets if it was below its three-day liquid asset
minimum, but the final rule does not include this prohibition. Instead,
as discussed above, a fund is only required to report to its board and,
possibly, the Commission when it is below its highly liquid investment
minimum. This requirement should provide fund management the
flexibility to avoid forced, predictable trading behavior while
maintaining the emphasis on effective liquidity risk management the
minimum is designed to provide. While fund liquidity may vary more
under this approach, the reporting requirements surrounding any
shortfall, including a requirement to provide the fund's board with an
explanation of how the fund plans to restore its minimum if a shortfall
lasts more than 7 consecutive calendar days, should help provide
oversight to prevent a fund from continually failing to meet its
liquidity minimum. As a whole, this approach should result in lower
costs for funds compared to the proposed three-day liquid asset minimum
and, because we anticipate that lengthy breaches of the minimum will be
relatively rare, it should not significantly decrease the benefits of
having a highly liquid investment minimum.
---------------------------------------------------------------------------
\1117\ ICI Comment Letter II.
\1118\ ICI Comment Letter II.
---------------------------------------------------------------------------
One commenter suggested that investor choice could be negatively
impacted because of the implementation and on-going costs of the
liquidity risk management program.\1119\ The commenter asserted that
the costs could overwhelm small fund complexes and force them to either
cease operations or consolidate with a larger complex.\1120\ Most of
the changes made to the rule since its proposal--exclusions for funds
that primarily hold assets that are highly liquid investments and In-
Kind ETFs, a reduction in the number of investment classification
categories, and the ability to generally classify investments based on
asset classes (subject to an exception process)--should decrease the
estimated implementation and on-going costs compared to the proposal.
Yet it remains possible that some fund complexes will still find the
costs burdensome. While investor choice may be harmed if a fund is
closed because the costs of the rule are burdensome, remaining funds
will be better positioned to avoid the negative consequences of
inadequate liquidity management if that fund exited because it was
unable to provide a minimum acceptable baseline of liquidity. To the
extent that there are funds that are currently able to provide
effective liquidity risk management, but would be forced to cease
operations because of the costs of complying with the rule (even after
changes from the proposal that increase flexibility and decrease
implementation and on-going costs), investor choice may be negatively
affected.
---------------------------------------------------------------------------
\1119\ Charles Schwab Comment Letter.
\1120\ Id.
---------------------------------------------------------------------------
A fund may incur costs if it reallocates its portfolio to
correspond with its initial or subsequently modified highly liquid
investment minimum, or if the rule's definition of an illiquid
investment results in the fund holding more than 15% of its net assets
in assets that are illiquid investments. While we are unable to
anticipate how many funds may reallocate their portfolios for these two
reasons, or the extent of such reallocation by any fund that does so,
we anticipate that the transaction-related costs of any such
reallocation will not be significant for most funds. This is because
some funds may not need to reallocate their portfolios at all to
correspond with their highly liquid investment minimum or the 15%
illiquid investment limit, and those that do so would be able to
gradually adjust their portfolios in order to buy and sell portfolio
positions during times that are financially advantageous given the
delayed compliance date. Thus, while a fund may reallocate its
portfolio to comply with its highly liquid investment minimum and the
15% illiquid investment limit by the time of the compliance date, a
fund would not be required to conduct transactions in portfolio
investments in any particular timeframe prior to the compliance date.
If a fund wishes to reallocate its portfolio by the compliance date, we
anticipate that the compliance date would provide sufficient time to do
so with relatively few associated transaction costs. Along with the
transaction-related costs associated with any portfolio reallocation,
we recognize that this reallocation in turn could affect
[[Page 82242]]
the performance and/or risk profiles of funds that modify their
composition, which in turn could result in costs associated with
decreased investment options available to investors and any changes to
the market for relatively less liquid investments; these costs are
discussed below. Finally, it is worth noting that, because the rule
excludes both In-Kind ETFs and funds that primarily hold assets that
are highly liquid investments from the requirement of having a highly
liquid investment minimum, these funds will not incur any of the costs
associated with transactions, reduced fund performance, or altered risk
profiles associated with a minimum, though they will still incur these
costs as they apply to the rule's 15% illiquid investment limit.
Potential for Decreased Investment Options and Adverse Effects
We recognize that the rule requires a fund to determine the
liquidity profile of its current portfolio and evaluate its potential
liquidity needs, which could result in a fund concluding that its
current portfolio lacks sufficient liquidity. This could lead a fund to
modify its portfolio composition to meet its appropriate highly liquid
investment minimum (e.g., one commenter stated that funds may decrease
their holdings of long-term municipal bonds) or to comply with the more
specific 15% illiquid investment limit.\1121\ The rule could therefore
result in certain funds increasing their investments in relatively more
liquid investments or altering the way in which their portfolios are
managed, which in turn could affect the performance, tracking error,
and/or risk profiles of these funds.\1122\ This is most likely to
affect funds that currently hold investments with relatively lower
liquidity. Such modifications to funds' portfolio compositions could in
turn decrease certain investment options available to investors or
reduce investor returns. However, because these portfolio composition
shifts are most likely to occur if a fund needs to adjust its existing
liquidity level to comply with the rule, we anticipate that the
potential for decreased yield is most likely to affect funds currently
holding portfolios whose liquidity levels have the potential to create
redemption-related liquidity risk for fund investors. Thus, the
potential for decreased investment options for certain investors, and
any related decrease in investment yield, has the potential offsetting
benefit of decreased liquidity risk in the funds in which these
investors hold shares. However, there could be other reasons funds may
choose to invest in more liquid investments as a result of the rule
even if this reallocation is not required, including the possibility
that they do not want to appear less liquid than their peer funds in
their publicly disclosed liquidity profile, or because increased
disclosure requirements regarding the timing of a fund's redemption
payments may result in funds holding more liquid investments.\1123\
---------------------------------------------------------------------------
\1121\ GFOA Comment Letter.
\1122\ See, e.g., supra footnote 767 (discussing how index funds
that use full replication strategies might need to move towards
other techniques for tracking an index if full replication requires
them to exceed the 15% illiquid asset limit).
\1123\ See infra section IV.c.2.a (discussing the effects of the
rule's disclosure requirements).
---------------------------------------------------------------------------
We cannot quantify the number of funds that would need to
significantly modify their portfolios' risk profile as a result of the
rule because we lack the information necessary to provide a reasonable
estimate. Such an estimate would depend on the number of funds that
might need to modify their current portfolio composition as a result of
the rule, as well as the availability of relatively liquid investments
that can act as adequate substitutes to existing investments for those
affected funds. We are unable to quantify the total potential costs
discussed in this section because: (1) We cannot anticipate the highly
liquid investment minimum that each fund would determine to be
appropriate based on its liquidity risk or the extent to which fund
holdings exceed the rule's more specific 15% illiquid investment limit
relative to the current 15% guideline; (2) we cannot determine what
relatively more liquid investments funds would purchase as substitutes;
(3) we are unable to estimate the resulting changes to funds' yields
and risk profiles, nor how investors would react to these changes. In-
Kind ETFs and funds that primarily hold assets that are highly liquid
investments will not be subject to the highly liquid investment
minimum, so this may reduce the aggregate costs associated with
decreased investment options relative to the proposed rule. Commenters
did not specifically object to our assessment of the rule's impact on
investment options in the proposed rule.
Market for Relatively Less Liquid Investments
As discussed above, the rule could result in certain funds
increasing their investments in relatively more liquid investments,
which would effectively mean that these funds would decrease their
investments in relatively less liquid investments. If funds decrease
their investments in relatively less liquid investments, the market for
those investments could become even less liquid. This could discourage
new issuances of similar investments and decrease the liquidity of
relatively less liquid investments that are still outstanding. The
impact of decreased investment by funds in relatively less liquid
markets will depend on how much current investment in those markets is
driven by the funds, which varies between markets. Further, these
market effects could be partially offset if other opportunistic
investors with greater capacity to hold less liquid investments are
attracted to the market by any lower prices for these investments that
result if funds decrease their holdings of less liquid
investments.\1124\ In addition, if the rule leads funds to better
assess the liquidity risk associated with certain investments, any
decrease in the prices of these investments could reflect more
efficient pricing of the investments (that is, risk would be better
reflected in asset prices than it is currently). Because funds
currently are not required to report or disclose information concerning
the liquidity of their investments, and because we cannot anticipate
the highly liquid investment minimum that each fund would determine to
be appropriate based on its liquidity risk or the extent to which the
more specific 15% illiquid investment limit will apply to current fund
holdings, it is difficult to predict the extent to which the rule could
lead funds to modify their portfolio holdings, or whether such
modifications would discourage the issuance of certain investment. As a
result, we cannot quantify the potential costs discussed in this
section. Commenters did not specifically object to our assessment of
the costs related to decreased investment in illiquid assets in the
proposed rule.
---------------------------------------------------------------------------
\1124\ Relatively less liquid investments have a higher expected
return compared to relatively more liquid investments, thereby
compensating longer-term investors for holding relatively less
liquid investments. See Yakov Amihud & Haim Mendelson, Asset Pricing
and the Bid-Ask Spread, 17 J. Fin. Econ. 223 (1986), available at
http://pages.stern.nyu.edu/~lpederse/courses/LAP/papers/
TransactionCosts/AmihudMendelson86.pdf.
---------------------------------------------------------------------------
d. Effects on Efficiency, Competition, and Capital Formation
The liquidity risk management program requirement would require a
fund to assess its liquidity risk and to determine its highly liquid
investment minimum based on this risk assessment. For funds that do not
already engage in liquidity risk management practices that meet the
rule's requirements, the requirements should improve the
[[Page 82243]]
alignment between fund portfolio liquidity and fund liquidity needs.
This improved alignment could enhance funds' ability to meet
redemptions in a manner that mitigates potential dilution of
shareholders' interests, and thus this improved alignment could be
viewed as increasing efficiency to the extent that dilution is
perceived as a drag on the ability of a fund's NAV to reflect the
performance of its portfolio. Additionally, the requirement for each
fund to classify the liquidity of its portfolio investments and
publicly report the aggregated percentage of its portfolio assigned to
each of the four classifications categories could increase allocative
efficiency by assisting investors in making investment choices that
better match their risk tolerances. However, this potential efficiency
gain will only hold to the extent that these portfolio-level
classification aggregates, which are based on non-public subjective
assessments of investment liquidity, are comparable across funds.
Furthermore, this potential efficiency gain will only be achieved if
this classification sufficiently contrasts the tradeoff between
portfolio liquidity and performance across funds.
By enhancing funds' liquidity risk assessment and risk management,
the program requirement also could promote pricing efficiency in the
sense that it could decrease the likelihood that a fund would be forced
to sell portfolio investments under unfavorable circumstances in order
to meet redemptions, potentially creating significant negative price
pressure on those investments. If a fund's asset sales were to cause
temporary changes in market prices unrelated to an investment's
fundamentals, this could create a temporary pricing inefficiency. By
decreasing the likelihood that these types of price movements would
occur, the program requirement could decrease pricing inefficiency.
However, the program requirement could negatively affect the efficient
pricing of investments with lower liquidity if it indirectly
discourages funds from investing in them (for example, if a fund were
to decrease its holdings in investments that have lower liquidity if it
determines, as a result of the fund's liquidity risk assessment, that
its appropriate highly liquid investment minimum or the more specific
15% illiquid investment limit do not correspond with the fund's current
portfolio composition). But as discussed above, this market effect
could be partially offset if other investors are incentivized to buy
relatively less liquid investments on account of any lower prices for
these investments that result if funds decrease their holdings of these
investments.\1125\ Alternatively, any price decreases experienced as a
result of decreased mutual fund investment could be considered
efficient price adjustments given the reduction in liquidity of the
investments.
---------------------------------------------------------------------------
\1125\ See supra section IV.C.1.c.
---------------------------------------------------------------------------
If the liquidity risk management program requirement results in a
material decrease in funds' investment in relatively less liquid
investments, competition for these investments would initially be
negatively affected. Under this scenario, the relatively less liquid
investments in which funds formerly would have invested may become less
liquid, since the number of current or potential market participants
would be reduced. However, because this reduction in demand and
liquidity results in larger illiquidity discounts and higher expected
returns, some investors might become willing to invest in these assets,
which in turn would partially offset the initial reduction in
competition. As a corollary, if the liquidity risk management program
requirement results in a material increase in funds' investment in
highly liquid investments, competition for these investments would be
positively affected. However, as funds increase their investments, the
liquidity of those investments should increase and their liquidity
premium decrease, which in turn could lead some investors to reduce
their demand for these investments, partially offsetting the initial
increase in competition. Relative to the proposal, the competitive
effects of fund demand for highly liquid investments relative to lower
liquidity investments should, if anything, be reduced because the rule
only requires a fund to consider stressed conditions that are
reasonably foreseeable in determining its minimum.
The size of a fund, or the family of funds to which a fund belongs,
could have certain competitive effects with respect to the fund's
implementation of its liquidity risk management program. If there are
economies of scale in creating and administering multiple liquidity
risk management programs, funds in large families would have a
competitive advantage. For a fund in a smaller complex, however, a
greater portion of the fund's (and/or adviser's \1126\) resources may
be needed to create and administer a liquidity risk management program,
which may increase barriers to entry in the fund industry, and lead to
an adverse effect on competition. The size of a fund family also could
produce competitive advantages or disadvantages with respect to a
fund's use of products developed by third parties to assist in
classifying the liquidity of their portfolio investments, or to assess
the fund's liquidity risk. Funds in a large complex also could receive
relatively more favorable pricing for third-party liquidity risk
management tools, if the fund complex were to purchase discounted bulk
services from the developer or receive relationship-based pricing
discounts. To the extent that they choose to use liquidity risk
management tools such as committed lines of credit and interfund
lending,\1127\ funds in larger complexes likewise could receive more
favorable rates on committed lines of credit than funds in smaller
complexes, and could have opportunities to establish interfund lending
arrangements more easily than funds in smaller complexes.
---------------------------------------------------------------------------
\1126\ See supra footnote 446 and accompanying text.
\1127\ See supra footnote 258 and accompanying text (discussing
and providing guidance on the use of these tools).
---------------------------------------------------------------------------
Any changes in certain investments' or asset classes' liquidity
that could indirectly result from the liquidity risk management program
requirement (for example, as discussed above, if the number of buyers
and sellers for certain investments becomes significantly reduced as a
result of the program requirement) could also affect capital formation
among issuers of these investments. Because lower asset liquidity
implies higher illiquidity premiums and larger asset price discounts
some firms and other issuers of securities could be discouraged from
issuing new securities in asset classes that are associated with lower
liquidity. If changes in liquidity are not equal across all asset
classes, firms and other entities may begin to shift their capital
structure (e.g., begin to issue equity instead of debt) or to change
the terms of certain securities that they issue in order to increase
their liquidity (e.g., by standardizing the terms of certain debt
securities, or modifying the securities' terms to promote electronic
trading).\1128\
---------------------------------------------------------------------------
\1128\ See GFOA Comment Letter (discussing these types of
effects on municipal bond issuers).
---------------------------------------------------------------------------
Commenters did not specifically object to our assessment of the
proposed rule's effects on efficiency, competition, and capital
formation. With the exception of the potential efficiency changes due
to modifications reflected in the adoption of a highly liquid
investment minimum and the more specific 15% illiquid investment limit
discussed above, our assessment of the
[[Page 82244]]
final rule's effects largely corresponds with those of the proposed
rule.
e. Reasonable Alternatives
The Commission considered various alternatives to the individual
elements of rule 22e-4. Those alternatives are outlined above in the
sections discussing the rule elements.\1129\ The following discussion
addresses economically significant alternatives to rule 22e-4, which
involve broader issues than the more granular alternatives to the
individual rule elements discussed above.
---------------------------------------------------------------------------
\1129\ See supra sections III.A.3, III.B.1.b, III.B.2.j,
III.B.3.b, III.C.1.c, III.C.1.d, III.C.2.a, III.C.2.b, III.C.3.a,
III.C.3.a, III.C.6.a, III.C.6.b, II.C.5.c, III.D.4, and III.E.
---------------------------------------------------------------------------
Liquidity Risk Management Program and Scope
The Commission considered, but ultimately decided against,
excluding certain types of funds from rule 22e-4.\1130\ For example,
the rule could have carved out funds with investment strategies that
historically have entailed relatively little liquidity risk, or funds
with relatively low asset levels. We are not excluding any subset of
open-end funds, other than money market funds, from the scope of the
rule, although we have tailored the rule for certain kinds of
investment companies that present different liquidity risks (In-Kind
ETFs, funds that primarily hold assets that are highly liquid
investments, and UITs). Some funds with investment strategies that
historically have involved little liquidity risk invest in assets that
have lower liquidity, or in more liquid assets that can experience
episodes of lower liquidity.\1131\ To the extent that these types of
investments create potential liquidity risk for a fund, excluding funds
with investment strategies that have historically involved little
liquidity risk could expose investors to more potential liquidity risk
than they would face under the rule. Furthermore, investors in small
funds could suffer from insufficient liquidity risk management just as
investors in larger funds could. Indeed, staff analysis suggests that
funds with relatively low total assets can experience greater flow
volatility, including more volatility in unexpected flows, than funds
with higher assets, which could indicate increased liquidity
risk.\1132\ The program requirement permits a fund to customize and
calibrate its liquidity risk management program to reflect the
liquidity risks that it typically faces (and that it could face in
stressed market conditions). This flexibility is meant to result in
programs whose scope, and related costs and burdens beyond the fixed
cost of establishing a minimum liquidity risk management program, are
appropriate to manage the actual liquidity risks facing a particular
fund. For example, funds that primarily hold assets that are highly
liquid investments are not required to adopt a highly liquid investment
minimum because any benefits associated with this requirement as
applied to these funds are less likely to justify the associated
burdens.
---------------------------------------------------------------------------
\1130\ See section III.A.2 for more detailed discussion of rule
22e-4's scope.
\1131\ See Proposing Release, supra footnote 9, at n.123-124
(discussing liquidity issues in microcap stocks as well as treasury
bonds during the ``Flash Crash'').
\1132\ DERA Study, supra footnote 95, at 16-24. See infra
footnote 1159 and accompanying paragraph regarding comments on small
funds.
---------------------------------------------------------------------------
Instead of adopting rule 22e-4, the Commission could issue guidance
surrounding the assessment and management of liquidity risk, which
would give funds more flexibility in managing liquidity risk and could
reduce costs relative to the requirements of the rule. However, on
account of the significant diversity in liquidity risk management
practices that we have observed in the fund industry, we believe that
the need exists for an enhanced comprehensive baseline requirement
instead of only guidance for fund liquidity risk management.
Commenters suggested the rule could have also taken a purely
principles-based approach instead of a prescriptive approach.\1133\ The
final rule is not a purely prescriptive rule; while it does specify
certain standards, it provides funds with a substantial degree of
flexibility in implementing those standards. That said, a purely
principles-based approach that specified few or no requirements could
give funds more flexibility in tailoring risk management programs to
their needs and could reduce compliance costs, but it would be less
certain to create a comprehensive baseline for fund liquidity risk
management, which in turn would diminish the comparability (and thus
the value) of information reported to the Commission and to the public
about funds' liquidity. Under a purely principles-based approach, an
investor with investments in multiple funds would be aware that those
funds are all generally required to manage liquidity risk, but may not
have sufficient clarity about how each of the funds may have chosen to
interpret and implement general principles so as to permit the investor
to understand how this variation across funds affects the liquidity
risk to which the investor is exposed. Finally, funds are not
prohibited from developing or maintaining their own, tailored risk
management programs to the extent that they are supplemental to the
baseline that the Commission's program requires.
---------------------------------------------------------------------------
\1133\ AIMA Comment Letter; CFA Comment Letter; Cohen & Steers
Comment Letter; Dodge & Cox Comment Letter; Eaton Vance Comment
Letter I; FSR Comment Letter; ICI Comment Letter I; ICI Comment
Letter III; LSTA Comment Letter; MFDF Comment Letter; Nuveen Comment
Letter; NYC Bar Comment Letter; Oppenheimer Comment Letter; State
Street Comment Letter; Vanguard Comment Letter; Wellington Comment
Letter; Wells Fargo Comment Letter; Dechert Comment Letter.
---------------------------------------------------------------------------
The Commission considered proposing liquidity requirements similar
to those imposed on money market funds--that is, the requirement to
hold a specified minimum level of highly liquid investment holdings,
and the ability to impose redemption fees and gates.\1134\ The
requirements imposed on money market funds, and the tools available to
these funds to manage heavy redemptions, are specifically tailored to
the assets held by money market funds and the behavior of money market
fund investors.\1135\ Imposing similar regulatory requirements on funds
that are not money market funds would ignore significant differences
between money market funds and other funds. We discuss the costs and
benefits of requiring funds to hold a specified minimum level of highly
liquid investments below (similar to the portfolio liquidity
requirements applicable to money market funds). With respect to
redemption fees, funds are already permitted to use them under existing
regulations (up to a maximum fee of two percent), although those fees
are largely used by certain funds to recoup costs incurred as a result
of excessive short-term trading of mutual fund shares, rather than
mitigating dilution arising from shareholder transaction activity
generally, and are viewed as unpopular with investors and
intermediaries. Redemption gates would allow funds to limit the
potential dilution shareholders face in circumstances where they face
extreme redemptions, but they would also impose constraints on
shareholders' access to their assets in those situations, and
commenters were not in favor of extending rule 22e-3 to permit funds to
make broader use of suspensions of redemptions.\1136\ In addition,
funds that are not money market funds have not demonstrated the same
risk of significant redemptions during times of
[[Page 82245]]
market stress that money market funds may face and which redemption
gates are meant to prevent, implying that the benefits of gates are
less applicable to funds that are not money market funds.\1137\
---------------------------------------------------------------------------
\1134\ See supra footnotes 153-155 and accompanying text.
\1135\ See 2014 Money Market Fund Reform Adopting Release, supra
footnote 43, at section II.
\1136\ See ICI Comment Letter I.
\1137\ See 2014 Money Market Fund Reform Adopting Release, supra
footnote 43, at section III.A.1.
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Classifying Portfolio Investment Liquidity
The Commission considered multiple alternatives to the rule's
requirement that funds classify the liquidity of their portfolio
investments, which establishes one component of a uniform baseline for
fund liquidity risk management. As discussed above, commenters raised
three primary structural alternatives to the proposed classification
requirement: (i) A ``principles-based'' liquidity classification
approach, where each fund would have to classify the liquidity of its
portfolio assets, but the Commission would not require any specific
classification scheme; \1138\ (ii) a simplified version of the proposed
classification system, with fewer classification categories based on
shorter time projections than the proposal; \1139\ and (iii) an
approach with new classification categories based on qualitative
distinctions in the market- and trading-related characteristics of
different asset classes under different market conditions, which
generally would rely on the Commission mapping different asset classes
to each of these new classification categories.\1140\
---------------------------------------------------------------------------
\1138\ See, e.g., AIMA Comment Letter; LSTA Comment Letter;
Street Comment Letter; Wellington Comment Letter.
\1139\ See, e.g., Eaton Vance Comment Letter I; Interactive Data
Comment Letter; Markit Comment Letter; Wells Fargo Comment Letter.
Commenters generally suggested three, four, or five classification
categories.
\1140\ See, e.g., BlackRock Comment Letter; MFS Comment Letter;
Nuveen Comment Letter; CSRC Comment Letter.
---------------------------------------------------------------------------
A purely principles-based approach to classifying assets, as
suggested by several commenters, would have the benefit of allowing
each fund to tailor its classification scheme to the liquidity factors
most relevant to the assets it invests in rather than imposing a one-
size-fits-all approach that may be less applicable to some funds.
However, as discussed above, this approach would not provide a uniform
methodology for funds' liquidity assessment procedures and would not
promote reasonably comparable reporting to the Commission and
disclosure to the public about funds' portfolio liquidity.\1141\
Instead, also as discussed above, we are largely adopting commenters'
suggested approach of reducing the number of liquidity classifications
from six to four.\1142\
---------------------------------------------------------------------------
\1141\ See supra section III.C.6.
\1142\ The Commission also could have, as described in the
Proposing Release, required funds to classify each portfolio
position as ``liquid'' or ``illiquid,'' but commenters did not
support such an alternative, and we continue to believe that a two-
category approach would be insufficiently nuanced to capture the
full spectrum of portfolio position liquidity. See also supra
section III.C.1.a for a more detailed discussion of commenter
suggestions with respect to the number of liquidity classification
categories.
---------------------------------------------------------------------------
The Commission considered but is not adopting commenters'
alternative of having the Commission establish a fixed classification
schema to which all funds must adhere--for example, an enumeration of
asset classes and a mapping of those classes to a liquidity
classification.\1143\ This approach would have the benefit of producing
liquidity classifications that are objectively comparable across funds,
but the Commission may not be able to respond as quickly as market
participants to dynamic market conditions that might necessitate
changes to asset class liquidity classifications, and would be unable
to account for determinants of investment liquidity that are fund-
specific.
---------------------------------------------------------------------------
\1143\ For examples suggesting this approach see, e.g., AFR
Comment Letter; BlackRock Comment Letter; SRC Comment Letter.
---------------------------------------------------------------------------
Relatedly, some commenters also suggested classification categories
based on alternatives to the ``days-to-cash'' criterion of the proposed
and final rule, including, in whole or in part, on the fraction of
average daily trading volume (``ADTV'') that each position size
corresponds to, the expected behavior of bid-ask spreads in a given
asset, or more qualitative liquidity buckets (e.g., ``converted to cash
quickly under most circumstances'').\1144\ Some of these more specific
criteria may be appropriate for particular assets (e.g., ADTV is a
reasonable measure for exchange-traded securities), but do not apply to
all assets (e.g., bid-ask spreads are not readily available for some
asset classes). Also, more qualitative criteria make it more difficult
to compare classifications across funds relative to the ``days-to-
cash'' approach in the final rule.
---------------------------------------------------------------------------
\1144\ See Nuveen Comment Letter; BlackRock Comment Letter;
Dodge & Cox Comment Letter; SIFMA Comment Letter I.
---------------------------------------------------------------------------
Highly Liquid Investment Minimum
The final rules require funds that do not primarily hold assets
that are highly liquid investments to establish a highly liquid
investment minimum as part of their liquidity risk management program
and provides some flexibility by not prohibiting the acquisition of
less liquid investments, but instead requiring a fund to report to the
board and, in some cases, the Commission if it goes below its minimum.
The first type of alternative the Commission considered with respect to
this requirement concerns which investments satisfy a minimum, which
could have varied along a spectrum from more liquid (e.g., only cash
would qualify as a highly liquid investment) to less liquid (e.g.,
investments reasonably expected to convert to cash in the 7-day
timeframe associated with open-ended fund redemption and settlement
requirements would qualify). While there are various marginal benefits
and costs associated with defining investments that satisfy the minimum
at points along that spectrum--for example, cash is more liquid but
does not provide any yield--the final rule aligns the definition of
what investments are subject to the minimum with the definition of the
first (most liquid) category of investments in the liquidity risk
management program's liquidity classification requirement.\1145\ This
consistency in treatment means that fund advisers, investors, and the
Commission can focus on a smaller number of clearly-defined concepts
when broadly evaluating fund liquidity.
---------------------------------------------------------------------------
\1145\ See the Proposing Release, supra footnote 9 at n.730 and
associated text for a further discussion of cash and ``seven day
liquid assets'' as alternatives for a minimum. We did not receive
explicit comments on the merits of which types of investments should
satisfy a minimum.
---------------------------------------------------------------------------
The Commission also considered whether to make the highly liquid
investment minimum purely a target instead of a minimum. The proposed
rule would have precluded funds from acquiring less liquid investments
anytime they were below their highly liquid investment minimum.
Commenters suggested this could lead to several potential costs, as
discussed above regarding the rule's costs and benefits, including the
possibility that it could lead to herding behavior among funds.\1146\
Some commenters instead suggested that a target or range be used
instead of a minimum, which could provide funds more flexibility in
returning to their target without incurring unnecessary trading costs,
as well as the ability to trade more opportunistically during periods
of market stress.\1147\ However, a target
[[Page 82246]]
might have been interpreted as an ``average'' level of highly liquid
investments funds should hold and, without further requirements such as
board reporting, may not have provided a sufficient incentive to fund
managers to ensure that the percentage of a fund's investments invested
in relatively liquid investments is at (or above) the level deemed
appropriate by the fund. The final rules strike a balance: Funds are
not prohibited from acquiring less liquid investments if they go below
their highly liquid investment minimum, but they must report any
shortfall to their boards (and the Commission where required). This
should reduce concerns regarding herding behavior,\1148\ but does make
it more burdensome for a fund to buy any assets that are not highly
liquid investments opportunistically if the fund is at or below its
highly liquid investment minimum, insofar as funds may not want to
trigger their reporting obligation to their board, the Commission, or
both.
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\1146\ For example, any market event that increases the value of
the less liquid portion of many funds' portfolios could place them
below the minimum, and could indirectly result in some funds selling
less liquid investments at the same time to bring their allocations
back in line with their minimums.
\1147\ For comments discussing the costs and benefits of a
target vs. a minimum, see, e.g., Blackrock Comment Letter; Federated
Comment Letter; Invesco Comment Letter; PIMCO Comment Letter.
\1148\ For example, if an asset ceased to be a highly liquid
investment, it could indirectly lead funds to sell that asset in
order to meet their minimum. Coordinated selling could produce
further downward pressure on the value of the investment. Some funds
could be interested in purchasing such an investment if they viewed
it to be undervalued and thus good for fund investors--which could
also help counteract the downward pricing pressure caused by funds
exiting their positions--but if such a purchase would cause them to
violate their minimum, it would have been prohibited under the
proposed rule.
---------------------------------------------------------------------------
Some commenters were generally opposed to a highly liquid
investment minimum,\1149\ and the final rule could have excluded this
requirement altogether. Doing so would still require that funds manage
liquidity risk appropriately but would provide even more flexibility in
how that is achieved. However, the highly liquid investment minimum
requires funds to directly consider the assets they need to have on
hand to meet redemptions in a flexible manner to reduce dilution that
may result from forced sales, and funds have flexibility in setting a
minimum that is appropriate to the needs of their fund as well as
adjusting the minimum dynamically to adapt to changing market
conditions.\1150\ We note that the final rule does not require funds
that primarily hold assets that are highly liquid investments to
establish a minimum.
---------------------------------------------------------------------------
\1149\ See, e.g., Invesco Comment Letter; Blackrock Comment
Letter.
\1150\ See supra footnote 638 and accompanying text.
---------------------------------------------------------------------------
The Commission also considered requiring a uniform highly liquid
investment minimum for all funds. This alternative approach would have
the advantage of being simple for investors to understand, easy for
funds to apply, and simple for our examination staff to verify.
However, this alternative would fail to account for notable differences
between funds with respect to investment strategy, fund flow patterns,
and other characteristics that contribute to funds' liquidity risk,
which in turn would make it reasonable for funds' portfolios to have
varying liquidity profiles. We believe that the fund-specific highly
liquid investment minimum requirement will promote alignment of a
fund's liquidity needs with the liquidity of fund investments, while
still permitting funds reasonable flexibility in implementation. In
light of the significant diversity within the fund industry, we believe
that flexibility is appropriate to help minimize the potential costs to
investors of the requirement. This approach still includes elements
that will help our staff to assess whether funds are holding an
appropriate level of assets that are highly liquid investments. Each
fund will be required to maintain a written record of how its highly
liquid investment minimum was determined, as well as copies of
materials submitted to the fund's board in connection with the highly
liquid investment minimum.\1151\ One benefit of a Commission-determined
uniform highly liquid investment minimum would be to ensure that funds
do not set their minimum at an artificially low level (e.g., 0) that is
divorced from their liquidity risk. We believe that the requirement for
a fund to consider certain specified factors in determining its
minimum, as well as the recordkeeping and board review requirements
discussed above, will help promote funds' establishing realistic
minimums, and discourage inappropriately low or zero minimums.
---------------------------------------------------------------------------
\1151\ See proposed rule 22e-4(c)(2)-(3).
---------------------------------------------------------------------------
Instead of requiring funds to determine and invest their assets in
compliance with a highly liquid investment minimum, we could require
funds to conduct stress tests of their own design assessing the extent
to which the fund has a level of highly liquid investments necessary to
cover possible levels of redemptions. This would have the benefit of
granting a fund flexibility in determining whether its portfolio
liquidity profile is appropriate given its liquidity needs. However,
because the quality and comprehensiveness of funds' liquidity risk
management currently varies significantly, we believe that requiring
funds to have a highly liquid investment minimum is important in
reducing the risk that funds will be unable to meet their redemption
obligations, in minimizing dilution, and in elevating the overall
quality of liquidity risk management across the fund industry. Also, we
believe that it would be difficult to determine, depending on the level
of discretion a fund would have in developing stress scenarios, whether
these scenarios would accurately depict liquidity risk and lead funds
to determine the appropriate level of portfolio liquidity they should
hold. For example, if a fund's liquidity needs were generally high
during normal periods, but were not correspondingly extreme during
stress events, basing this fund's portfolio liquidity on the results of
stress testing alone could cause a fund to hold too little liquidity
during non-stressed periods. Therefore, we do not believe that a
general stress testing requirement would be an adequate substitute for
the highly liquid investment minimum requirement.
15% Illiquid Investment Limit
Instead of the adopted illiquid investment definition, the
Commission could have codified a definition of illiquid investments
that reflects the current 15% guideline. This approach would have had
the benefit of already being accepted and understood by the industry,
and would have entailed few additional implementation costs for funds.
However, it would not have been harmonized with the rule's requirements
with respect to other liquidity classifications, particularly the
requirement that funds review at least monthly whether their
investments are illiquid with respect to relevant market, trading, and
investment-specific factors, and also incorporate market depth
considerations into this process.\1152\ To the extent that the rule's
liquidity classification requirement results in funds more accurately
assessing the amount of illiquid investments in their portfolios, funds
may improve on their liquidity risk management under the rule as
adopted than under a codification of the 15% guideline.
---------------------------------------------------------------------------
\1152\ See supra sections III.C.1.b and III.C.3.b.
---------------------------------------------------------------------------
f. Comments on the DERA Study
We received substantial comments on the DERA Study from one
commenter. The Commission has carefully considered these comments and
adjusted our analysis where appropriate. In terms of broader concerns,
the commenter suggested that the analysis in the DERA Study does not
provide a strong basis for the specifics
[[Page 82247]]
of the rule.\1153\ For example, the commenter asserts that the DERA
Study's analysis does not provide a justification for funds sorting
their assets into six liquidity categories and does not apply this
classification in the DERA Study. The DERA Study's analysis was not
designed to justify each policy choice made in the rule. Rather, the
analysis in the DERA Study makes certain findings and reports certain
empirical results designed to inform the Commission more generally
about the current state of fund liquidity.
---------------------------------------------------------------------------
\1153\ ICI Comment Letter II.
---------------------------------------------------------------------------
With respect to the proposal's interpretation of the DERA Study's
results, the commenter expressed the concern that the results in the
DERA Study provide only indirect evidence on the selling behavior of
funds in response to redemptions. While a direct test would be
preferable, such a test would require data on both daily fund flows and
fund daily transactions, neither of which are available in sufficient
detail for analysis. The commenter states that the DERA Study itself
only shows that fund liquidity tends to decrease following outflows and
that other endogenous factors, such as broad changes in market
conditions due to macroeconomic events, could be causing changes in
both fund liquidity and fund flows.\1154\ To demonstrate its concerns
about endogeneity, the commenter uses a vector autoregression (VAR) to
present evidence that a proxy for market returns causes changes to both
the Amihud liquidity of the S&P 500 and net U.S. equity mutual fund
flows in a manner consistent with its alternative hypothesis that a
fund's average Amihud liquidity may decrease due to an increase in
market volatility rather than because of fund managers' trading
behavior.\1155\ The analysis performed in the DERA Study does control
for broad changes in market liquidity at the fund class-level.\1156\ To
the extent that broad market effects drive variation in fund liquidity
within a fund class in a way that is also correlated with fund flows,
we acknowledge the commenter's concern about endogeneity and have
modified our interpretation in the discussion above, but we also note
that there is anecdotal evidence that supports this
interpretation.\1157\ With respect to the Amihud liquidity measure used
in the study, the commenter states that the DERA Study's conclusion
that a ``10% outflow increases the impact of selling $10 million of the
asset-weighted average equity portfolio holding by 11 basis points'' is
a key result supporting the proposal's hypothesis that funds sell their
more liquid assets first to meet redemptions. We disagree that the
specific economic interpretation of the Amihud measure cited by the
commenter is necessary to support the hypothesis that funds tend to
sell their more liquid assets: To the extent that the Amihud measure
reflects the liquidity of underlying fund assets, a decline in the
average Amihud liquidity of a fund's portfolio is consistent with the
fund disproportionately selling its more liquid assets.
---------------------------------------------------------------------------
\1154\ ICI Comment Letter II.
\1155\ ICI Comment Letter II.
\1156\ DERA Study, supra footnote 95, at 43-44. The model
includes Lipper class fixed effects, year-quarter fixed effects, and
interactions of those fixed effects. The year-quarter and
interaction fixed effects should capture any broad changes in
liquidity within different fund styles over time, which could be
related to macroeconomic events.
\1157\ See, e.g., supra footnote 71.
---------------------------------------------------------------------------
The commenter concludes that the analysis in the DERA Study does
not demonstrate that funds are managing portfolios and redemptions in a
manner that harms the interests of non-redeeming shareholders.\1158\ We
acknowledge that the analysis does not establish a direct link between
redemptions and quantifiable harm to non-redeeming shareholders; as
discussed above, it was designed to inform the Commission more
generally about the current state of fund liquidity. The commenter also
states the DERA Study's finding that municipal bond funds hold less
cash following redemptions implies that a 40% outflow would be required
to deplete the average municipal bond fund's cash holdings. We
acknowledge the commenter's interpretation of the analysis, but note
that the results do not imply that all municipal bond funds would
necessarily require outflows of a similar magnitude to deplete a
significant portion of their cash holdings.
---------------------------------------------------------------------------
\1158\ ICI Comment Letter II.
---------------------------------------------------------------------------
The commenter makes several statements regarding results related to
the volatility of fund flows. First, the commenter provides evidence
that flow volatility declines with fund size, notes that the DERA
Study's use of simple averages to calculate average flow volatility in
a given fund category overstates the highly volatile flows of small
funds, and shows that asset-weighted flow volatility measures are
significantly smaller for all fund categories.\1159\ We acknowledge
that the simple average will overstate smaller funds relative to an
asset-weighted average, but the opposite view holds too: Asset-weighted
averages will understate flow volatility for small funds, and the rule
is concerned with the potential liquidity risk problems at all funds.
The commenter also states that the relatively higher flow volatility of
alternative funds may simply be attributable to the fact that they are
generally smaller in size (because small funds generally tend to have
more volatile flows as a percentage of their assets) and that, as they
have grown, the volatility of their flows has, if anything, decreased.
We acknowledge that the flow volatility of alternative funds may be a
function of their smaller size, but also note that small funds are also
subject to the rule and that other fund categories, such as foreign
bond funds, exhibit higher flow volatility despite being relatively
larger in size. The commenter also notes that, as the DERA Study
acknowledged, the predictability of fund flows is likely understated.
The purpose of analyzing the predictability of flows in the analysis
was to determine, using a simple model of fund flows, the extent which
flow volatility was predictable and whether, after accounting for
predictability, the unexpected component of flow volatility varied
across fund types in the same way as total flow volatility. While fund
managers may be able to predict a larger fraction of flow volatility,
the evidence in the DERA Study supports the notion that unexpected flow
volatility varies proportionally with total flow volatility, and the
relative ranking of unexpected flow volatility by fund type is not
likely to change with a better model of flows. The commenter also
states that the DERA Study provides evidence that funds already
successfully manage volatile flows.\1160\ The proposal acknowledged
that this evidence supports the view that funds do manage volatile
flows by holding larger amounts of cash and liquid assets, and this
evidence provides support for the rule's inclusion of flow volatility
as a factor for funds to consider when managing risk.\1161\ Finally,
the commenter points out that, while the DERA Study finds smaller funds
have more volatile flows, small funds may find it easier to trade
assets with minimal price effects. We agree that small funds may have
less price impact, but note that any fixed trading costs incurred via
smaller trades will involve larger proportional trading costs.
---------------------------------------------------------------------------
\1159\ ICI Comment Letter II.
\1160\ ICI Comment Letter II.
\1161\ See Proposing Release, supra footnote 9, at n.631 and
accompanying discussion.
---------------------------------------------------------------------------
The commenter also provides evidence on the relationship between
fund flows and holdings of short-term
[[Page 82248]]
assets for alternative strategy and high-yield bond funds. It finds no
relationship between the two, asserting that the lack of a relationship
shows funds are not systematically selling short-term assets to meet
redemptions. However, this result is at the aggregate level, and does
not necessarily preclude a relationship between the two quantities at
the fund level for some funds. It also provides a fund-level analysis
across high-yield bond funds in 5 separate months and also does not
find a relationship between the two in four of the months. In one of
the months, it does find statistically significant evidence that a
decrease in short-term assets is associated with outflows, consistent
with the DERA Study's finding. The commenter's inability to find a
relationship is not evidence that there is no relationship per se: It
is possible the commenter's test simply had low statistical power. To
the extent that the commenter's evidence does support the claim that
funds do not sell short-term assets in response to fund flows, the DERA
Study used a different measure of liquidity and did not claim any
evidence found using another measure, such as the short-term asset
ratio used by the commenter, would produce the same result. More
specifically, while funds may not sell their most liquid investments
(which would be reflected in the short-term asset ratio used by the
commenter), they could still be disproportionately selling their more
liquid investments.
With respect to the liquidity measure used in the DERA Study, the
commenter points out that it only uses a single measure of market
liquidity (Amihud illiquidity) and claims that the measure is not
sufficient to support the interpretations the proposal draws from the
study.\1162\ We acknowledge that the use of alternative measures could
alter some of the results and interpretations in the DERA Study, but
also emphasize that the DERA Study was intended to generally inform the
Commission about the current state of fund liquidity, not to justify
each policy choice made in the rule.
---------------------------------------------------------------------------
\1162\ ICI Comment Letter II.
---------------------------------------------------------------------------
The commenter stated that the academic studies used in support of
the DERA Study and the proposal are either (1) theoretical and ignore
important institutional details or (2) based on empirical fund-level
results which by their design cannot provide any commentary on market-
wide concerns. With respect to the theoretical study cited in the
proposal, it shows one mechanism by which mutual fund shareholders may
have a first-mover incentive using a simplified model of the world for
tractability; it is possible that in a model which captures more
institutional details as proposed by the commenter--taxes, longer
investor horizons, and reinvestment risk--this incentive is reduced or
eliminated, but we are not aware of any other studies that reach such a
conclusion. With respect to any empirical studies, the primary goal of
the rule is to improve the fund-level management of liquidity and
redemptions, which makes the cited fund-level academic studies relevant
for the discussion. The commenter also points out that one of the
empirical studies (Coval and Stafford), which provides evidence of
negative price pressure due to forced selling by mutual funds, also
states that the ex-ante probability of an equity mutual fund being
affected by this risk is small because less than one percent of stocks
are affected in a given quarter. The proposal did not claim that forced
selling by mutual funds was a pervasive phenomenon, but did highlight
that it is a possible risk that funds and their shareholders face.
2. Disclosure and Reporting Requirements Regarding Liquidity Risk and
Liquidity Risk Management
a. Disclosure and Reporting Requirements
We are adopting amendments to Form N-1A as well as adopting new
items to Form N-PORT, Form N-CEN, and adopting Form N-LIQUID, to
enhance fund disclosure and reporting regarding liquidity and
redemption practices. Specifically, amendments to Form N-1A will
require a fund to disclose: (i) The number of days in which the fund
typically expects to pay redemption proceeds to redeeming shareholders
\1163\ and (ii) the methods the fund typically expects to use to meet
redemption requests in stressed and non-stressed market
conditions.\1164\
---------------------------------------------------------------------------
\1163\ Item 11(c)(7) of Form N-1A.
\1164\ Item 11(c)(8) of Form N-1A.
---------------------------------------------------------------------------
New items on Form N-PORT will require a fund to confidentially
disclose monthly: (i) The fund's highly liquid investment minimum and
the number of days a fund's holdings in assets that are highly liquid
investments fell below that minimum during a given reporting period;
\1165\ (ii) the liquidity classification of each investment as
determined pursuant to rule 22e-4(b)(2)(i) including the determination
of whether the investment qualifies as an illiquid investment, and
(iii) the percentage of the fund's highly liquid investments that the
fund has segregated to cover, or pledged to satisfy margin requirements
in connection with, derivatives transactions in each of the other
liquidity classification categories.\1166\ Once per quarter, funds will
be required to publicly disclose (with a 60-day delay): (i) The
aggregated percentage of their portfolios invested in each of the four
liquidity classification categories, but funds will not be required to
publicly disclose the liquidity classification of each individual
position; \1167\ and (ii) the percentage of the fund's highly liquid
investments that it has segregated to cover, or pledged to satisfy
margin requirements in connection with, derivatives transactions in
each of other liquidity classification categories.\1168\
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\1165\ Item B.7 of Form N-PORT.
\1166\ Item C.7 of Form N-PORT.
\1167\ Item B.8 of Form N-PORT.
\1168\ Item B.8.b of Form N-PORT.
---------------------------------------------------------------------------
New items on Form N-CEN will require a fund to disclose certain
information regarding the use of committed lines of credit and
interfund borrowing and lending.\1169\ We have also adopted a new item
on Form N-CEN that will require an ETF to report whether it qualifies
as an In-Kind ETF.\1170\
---------------------------------------------------------------------------
\1169\ Item C.20 of Form N-CEN.
\1170\ Item E.5 of Form N-CEN.
---------------------------------------------------------------------------
The final form amendments differ from the proposal in several ways
that may have potential economic consequences. In response to
commenters' suggestions, the rule does not require funds to file credit
agreements as part of Form N-1A. While Form N-PORT requires funds to
report position-level liquidity classifications to the Commission,
these classifications will not be publicly released. Instead, a fund
will only be required to publicly disclose the aggregate percentage of
the fund's holdings invested in each of the four liquidity
classification categories and the percentage in each of the four
liquidity classification categories of the fund's highly liquid
investments that are segregated to cover derivatives transactions. The
adopted rule also incorporates commenters' suggestions that the
Commission be notified more quickly if a fund's assets that are
illiquid investments exceed 15% of its net assets by requiring funds to
file Form N-LIQUID indicating such a breach immediately after it
occurs. With respect to the highly liquid investment minimum, a fund is
required to report any decline below the minimum that lasts more than 7
consecutive calendar days to the Commission by filing Form N-LIQUID,
whereas the proposal would have required that a fund not purchase
[[Page 82249]]
less liquid investments while below its minimum. Any significant
economic effects of these changes are discussed below.
b. Benefits
The disclosure and reporting requirements will promote investor
protection by improving the availability of information regarding
funds' liquidity risks and risk management practices, as well as funds'
redemption practices. As discussed above, funds' disclosures to
shareholders regarding their redemption practices are currently varied
in content and comprehensiveness.\1171\ To the extent that the
requirement for funds to disclose the number of days in which the fund
will pay redemption proceeds to redeeming shareholders fosters
competition among funds to minimize the timing of redemptions, and
assuming funds are able to meet redemptions in the time advertised,
such competition could potentially be to the benefit of investors.
Relative to the proposal, final Form N-1A requires that funds disclose
estimated payment times for each payment method, which should reduce
any potential investor confusion associated with the complexity of
estimates based on funds' distribution channels under the
proposal.\1172\
---------------------------------------------------------------------------
\1171\ See supra section III.G.1.a.
\1172\ See Fidelity Comment Letter.
---------------------------------------------------------------------------
While some funds voluntarily include disclosure regarding fund
limitations on illiquid asset holdings that track the 15% guideline, a
fund is not currently required to disclose information about the
liquidity of its portfolio investments. In light of the relatively few
disclosure requirements regarding funds' liquidity risks, liquidity
risk management practices, and redemption practices, as well as the
current inconsistency in funds' liquidity-related disclosures, we
believe that the disclosure and reporting requirements would increase
shareholders' and the Commission's understanding of particular funds'
liquidity-related risks and redemption policies. This in turn should
assist investors in making investment choices that better match their
risk tolerances.
We note that, while Form N-PORT and Form N-CEN are designed
primarily to assist the Commission and its staff, we believe that the
information in these forms (including the liquidity-related information
to be included in these forms) also will be valuable to investors and
other potential users.\1173\ In particular, we believe that both
sophisticated institutional investors and third-party users that
provide services to retail investors may find the publically disclosed
liquidity-related information to be useful. And we believe that
individual investors could benefit indirectly from the information
collected on reports on Form N-PORT through analyses prepared by third-
party service providers.
---------------------------------------------------------------------------
\1173\ See Investment Company Reporting Modernization Adopting
Release, supra footnote 120.
---------------------------------------------------------------------------
The liquidity-related information that funds will be required to
provide on Form N-PORT and Form N-CEN will enhance investor protection
by improving the Commission's ability to monitor funds' liquidity using
relevant and targeted data. This monitoring will permit us to analyze
liquidity trends in individual funds, and, to the extent that liquidity
profiles are comparable across funds, among certain types of funds and
the fund industry as a whole, as well as to better understand funds'
liquidity risk management practices. As discussed in our release
adopting rules and forms to modernize investment company reporting, the
information we receive on these reports will facilitate the oversight
of funds and will assist the Commission, as the primary regulator of
such funds, to better effectuate its mission to protect investors,
maintain fair, orderly, and efficient markets, and facilitate capital
formation.\1174\ Some commenters supported the reporting of asset-level
liquidity classifications if such information was only provided to the
Commission (i.e., made non-public),\1175\ although some did object to
the disclosure regardless of whether or not it was made public.\1176\
---------------------------------------------------------------------------
\1174\ See id.
\1175\ See CFA Comment Letter; Dechert Comment Letter; State
Street Comment Letter; Interactive Data Comment Letter; Nuveen
Comment Letter; Oppenheimer Comment Letter; Charles Schwab Comment
Letter; T. Rowe Comment Letter; Voya Comment Letter; Wellington
Comment Letter.
\1176\ See Federated Comment Letter; Fidelity Comment Letter;
Invesco Comment Letter; SIFMA Comment Letter I.
---------------------------------------------------------------------------
Form N-LIQUID will complement rule 22e-4's enhanced focus on the
limits on illiquid investments and the highly liquid investment minimum
discussed above by requiring reporting to the SEC every time: (1) A
fund's assets that are illiquid investments exceed 15% of its net
assets (as well as additional reporting when the fund's assets that are
illiquid investments fall back to or below 15% of its net assets); and
(2) a fund's investments in highly liquid investments that are assets
fall below its highly liquid investment minimum for more than 7
consecutive calendar days. This enhanced reporting could produce
significant benefits. For example, the SEC's market monitoring capacity
could be enhanced, in that multiple close-in-time filings by similar
types of funds may be an indication of market stress in a market
segment. Similarly, multiple close-in-time filings by the same fund may
be an indication that the fund is failing to adequately manage its
liquidity.
Form N-PORT as adopted does not require that the asset-level
liquidity classifications be publicly disclosed in order to address
commenter concerns about the potential costs of such disclosure (which
are discussed in the costs section below). This change reduces some of
the proposal's potential public disclosure benefits. Under the
proposal, investors--by their own efforts or via third-party products--
could have compared how assets were classified according to different
funds' subjective approaches and resolved discrepancies across funds to
arrive at more directly comparable fund liquidity profiles. Under the
form as adopted, a fund will publicly disclose a new aggregate
liquidity profile by reporting the percentage of its portfolio assigned
to each of the four liquidity classification categories on Form N-PORT.
This will provide a useful snapshot of fund liquidity to investors and
will increase the amount of information available to investors about
fund liquidity, but this snapshot may not be as informative as
liquidity profiles under the proposed rule. The final form requires
funds to confidentially report their investment liquidity
classifications to the Commission via Form N-PORT. This maintains a
major benefit of the proposal, allowing the Commission to monitor
funds' liquidity levels and take action when significant aberrations
are discovered.
Similarly, the final form amendments do not require the public
disclosure of a fund's highly liquid investment minimum in order to
address commenter concerns, but it is not likely that this change will
significantly reduce the benefits of reporting this minimum: The
primary investor protection benefit of reporting the minimum via Form
N-PORT is to encourage funds' holding of highly liquid investments that
correspond to the liquidity risks of their strategies. By
confidentially reporting the minimum, a fund will give the Commission
the capability to monitor whether the minimum is an outlier relative to
other funds with similar investment strategies. The oversight role of
the fund's board under rule 22e-4 is yet another safeguard in this
respect.
Finally, Form N-PORT's requirement that funds disclose the
percentage of the fund's highly liquid investments that it
[[Page 82250]]
has segregated to cover or pledged to satisfy margin requirements in
connection with derivatives transactions that are classified as
moderately liquid investments, less liquid investments, and illiquid
investments, should more accurately reflect the amount of highly liquid
investments that are available to manage a fund's liquidity risk. For
example, without such a disclosure, investors might assume a fund whose
highly liquid investments are all segregated to cover derivatives
positions that are not highly liquid is better prepared to handle
redemption requests than it actually is.
Because we cannot predict the extent to which the requirements will
enhance investors' awareness of funds' portfolio liquidity and
liquidity risk, influence investors' investments in certain funds, or
increase the Commission's ability to protect investors, we are unable
to quantify the potential benefits discussed in this section.
c. Costs
Funds will incur one-time and ongoing annual costs to comply with
the disclosure and reporting requirements regarding liquidity and
shareholder redemption practices. Commenters' responses to the
estimates of these costs are discussed in the PRA discussion below, and
we have updated all estimates in this section to reflect changes in the
PRA.\1177\
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\1177\ See infra section V.
---------------------------------------------------------------------------
We estimate that the one-time costs to comply with the amendments
to Form N-1A will be approximately $324 per fund (plus printing
costs).\1178\ We estimate that each fund will incur an ongoing cost
associated with compliance with the amendments to Form N-1A of
approximately $81 each year to review and update the disclosure
regarding redemptions.
---------------------------------------------------------------------------
\1178\ This estimate is based on the following calculation: 1 (1
hour to update registration statement disclosure about redemption
procedures) x $324 (blended rate for a compliance attorney ($340)
and a senior programmer ($308)) = $324. This figure incorporates the
costs we estimated for each fund to update its registration
statement to include the required disclosure about: (i) The number
of days in which the fund will pay redemption proceeds to redeeming
shareholders; and (ii) the methods the fund uses to meet redemption
requests in stressed and non-stressed market conditions. The costs
associated with these activities are all paperwork-related costs and
are discussed in more detail infra at section V.F.
---------------------------------------------------------------------------
The amendments to Form N-PORT will require funds to report on Form
N-PORT the liquidity classification of each portfolio investment, and
we estimate that the average one-time compliance costs associated with
this reporting will be $15,576 per fund.\1179\ Furthermore, we estimate
that 9,347 funds will be required to file, on a monthly basis,
additional information on Form N-PORT as a result of the
amendments.\1180\ Assuming that 35% of funds (3,271 funds) will choose
to license a software solution to file reports on Form N-PORT in
house,\1181\ we estimate an upper bound on the initial annual costs to
file the additional information associated with the amendments for
funds choosing this option of $783 per fund \1182\ with annual ongoing
costs of $261 per fund.\1183\ We further assume that 65% of funds
(6,076 funds) will choose to retain a third-party service provider to
provide data aggregation and validation services as part of the
preparation and filing of reports on Form N-PORT,\1184\ and we estimate
an upper bound on the initial costs to file the additional information
associated with the amendments for funds choosing this option of $1,044
per fund \1185\ with annual ongoing costs of $131 per fund.\1186\
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\1179\ This estimate is based on the following calculation: (i)
Project planning and systems design (24 hours x $264 (hourly rate
for a senior systems analyst) = $6,336) and (ii) systems
modification integration, testing, installation and deployment (30
hours x $308 (hourly rate for a senior programmer) = $9,240). $6,336
+ $9,240 = $15,576. Estimates for drafting, integrating,
implementing policies and procedures are addressed in the discussion
of rule 22e-4. This figure incorporates the costs that we estimated
associated with preparing the section of the fund's report on Form
N-PORT that will incorporate the information that will be required
under Item C.7. The costs associated with these activities are all
paperwork-related costs and are discussed in more detail infra at
section V.E. As discussed in section V.E infra, we believe that any
external annual costs associated with filing Form N-PORT will be
only incrementally affected by compliance with Item C.7 of Form N-
PORT, and thus Item C.7 does not affect our previous estimates of
these costs.
\1180\ There were 10,633 open-end funds (excluding money market
funds, and including ETFs) as of the end of 2015. See 2016 ICI Fact
Book, supra footnote 11, at 22, 176, 183. As discussed in note 1253,
infra, we assume that 75% of ETFs, or 1,196 ETFs, will identify as
In-Kind ETFs, which are exempt from the classification requirement,
thereby reducing the total number of funds filing classification
information to 9,347.
\1181\ This assumption tracks the assumption made in the
Investment Company Reporting Modernization Adopting Release that 35%
of funds will choose to license a software solution to file reports
on Form N-PORT. See Investment Company Reporting Modernization
Adopting Release, supra footnote 120.
\1182\ This estimate is based upon the following calculations:
$783 in internal costs = ($783 = 3 hours x $261 (blended hourly rate
for senior programmer ($308), senior database administrator ($312),
financial reporting manager ($266), senior accountant ($192),
intermediate accountant ($157), senior portfolio manager ($306), and
compliance manager ($283)). We do not anticipate any change to
external annual costs as a result of the amendments. See infra at
section V.E. The hourly wage figures in this and subsequent
footnotes are from SIFMA's Management & Professional Earnings in the
Securities Industry 2013, modified by Commission staff to account
for an 1800-hour work-year and multiplied by 5.35 to account for
bonuses, firm size, employee benefits, and overhead.
\1183\ This estimate is based upon the following calculations:
$261 in internal costs ($261 = 1 hour x $261 (blended hourly rate
for senior programmer ($308), senior database administrator ($312),
financial reporting manager ($266), senior accountant ($192),
intermediate accountant ($157), senior portfolio manager ($306), and
compliance manager ($283)). We do not anticipate any change to
external annual costs as a result of the amendments. See infra at
section V.E.
\1184\ This assumption tracks the assumptions made in the
Investment Company Reporting Modernization Adopting Release that 65%
of funds will choose to retain a third-party service provider to
provide data aggregation and validation services as part of the
preparation and filing of reports on Form N-PORT. See Investment
Company Reporting Modernization Adopting Release, supra footnote
120.
\1185\ This estimate is based upon the following calculations:
$1,044 in internal costs ($1,044 = 4 hours x $261 (blended hourly
rate for senior programmer ($308), senior database administrator
($312), financial reporting manager ($266), senior accountant
($192), intermediate accountant ($157), senior portfolio manager
($306), and compliance manager ($283)). We do not anticipate any
change to external annual costs as a result of the amendments.
\1186\ This estimate is based upon the following calculations:
$130.5 in internal costs ($130.5 = (0.5 hours x $261 (blended hourly
rate for senior programmer ($308), senior database administrator
($312), financial reporting manager ($266), senior accountant
($192), intermediate accountant ($157), senior portfolio manager
($306), and compliance manager ($283)). We do not anticipate any
change to external annual costs as a result of the amendments.
---------------------------------------------------------------------------
Likewise, compliance with the amendments to Form N-CEN will involve
ongoing costs as well as one-time costs. We estimate that 10,633 funds
will be required to file responses on Form N-CEN as a result of the
amendments to the form. We estimate that the one-time and ongoing
annual compliance costs associated with providing additional responses
to Form N-CEN as a result of the amendments will be approximately $162
per fund.\1187\
---------------------------------------------------------------------------
\1187\ This estimate is based on the following calculation: 0.5
hour x $324 (blended hourly rate for a compliance attorney ($340)
and a senior programmer ($308)) = $162. This figure incorporates the
costs that we estimated associated with preparing the section of the
fund's report on Form N-CEN that will incorporate the information
that will be required under Item C.20. We do not estimate any
additional costs in connection with proposed Item E.5 of Form N-CEN
because the new item only requires a yes or no response. We do not
estimate any change to the external costs associated with Form N-
CEN. The costs associated with these activities are all paperwork-
related costs and are discussed in more detail infra at section V.E.
---------------------------------------------------------------------------
Based on these estimates, staff further estimates that the total
one-time costs to comply with the disclosure and reporting requirements
will be approximately $55 million for all funds that would file reports
on Form N-PORT in house \1188\ and approximately
[[Page 82251]]
$103 million for all funds that will use a third-party service provider
to prepare and file reports on Form N-PORT.\1189\ In addition, staff
estimates that the total ongoing annual costs associated with the
disclosure and reporting requirements would be approximately $1.6
million for all funds that file reports on Form N-PORT in house \1190\
and approximately $2.3 million for all funds that use a third-party
service provider to prepare and file reports on Form N-PORT.\1191\
---------------------------------------------------------------------------
\1188\ This estimate assumes that 35% of funds (3,271 funds)
would choose to file reports on proposed Form N-PORT in house (see
infra section V.D) and is based on the following calculation: 3,271
funds x $16,845 ($324 + $15,576 + $783 + $162) = $55,099,995.
\1189\ This estimate assumes that 65% of funds (6,076) would
choose to file reports on proposed Form N-PORT with the assistance
of third-party service providers (see infra section V.D) and is
based on the following calculation: 6,076 funds x $17,106 ($324 +
$15,576 + $1,044 + $ 162) = $103,850,526.
\1190\ This estimate is based on the following calculation:
3,271 funds x $502.63 ($79.63 + $261 + $162) = $1,644,102.73.
\1191\ This estimate is based on the following calculation:
6,071 funds x $372.63 ($79.63 + $131 + $162) = $2,262,236.73
---------------------------------------------------------------------------
Commenters expressed concern that it was not appropriate to require
public disclosure of liquidity classifications by position via Form N-
PORT, arguing that reporting position-level liquidity classifications
creates significant costs which outweigh the potential benefits. For
example, they suggested this disclosure could create potential
litigation exposures, create investor confusion surrounding the
perceived precision of the classifications, stifle innovation in
liquidity risk management, or facilitate predatory trading and/or
first-mover incentives, particularly during times of stress.\1192\ We
agree that funds could have encountered costs related to the above
concerns if they were required to follow the disclosure regime
contemplated in the original proposal. While investors already have
access to fund portfolio positions, to the extent that position-level
liquidity classifications could have been valuable to professional
traders, predatory trading opportunities could have increased under the
proposal. The final form mitigates these costs by requiring that a
fund's most competitively-sensitive information--its individual
position liquidity classifications--be filed confidentially with the
Commission.
---------------------------------------------------------------------------
\1192\ See, e.g., Federated Comment Letter; Dodge & Cox Comment
Letter; PIMCO Comment Letter; Invesco Comment Letter.
---------------------------------------------------------------------------
The costs of the adopted form amendments differ from the proposal
in several ways. First, as discussed above, the Form N-PORT only
requires that funds publicly disclose an aggregate liquidity profile,
which should significantly mitigate many of the potential costs
associated with the potential front running of mutual funds by
sophisticated investors. Second, Form N-PORT requires a fund to
disclose the percentage of the fund's highly liquid investments that it
has segregated to cover or pledged to satisfy margin requirements in
connection with derivatives transactions that are classified as
moderately liquid investments, less liquid investments, and illiquid
investments. By contrast, the proposed rules required a fund to pair
each segregated asset with the derivative it was covering. The final
rule's approach should lower costs relative to the proposal. We also
are not requiring funds to file credit agreements as exhibits to Form
N-1A. Many commenters objected to the proposed requirement to file line
of credit agreements \1193\ with some arguing that such filings would
be unnecessary because lines of credit are often already disclosed
under existing requirements of Form N-1A, in a fund's statement of
additional information, in footnotes to fund financial statements, and
potentially in Form N-CEN.\1194\ In addition, commenters stated that
public disclosure of line of credit agreements could (1) weaken their
ability to negotiate credit terms; \1195\ (2) make public proprietary
and competitive information; \1196\ and (3) discourage lending banks
from granting certain lending terms to funds (out of a concern that
terms granted would become standard in other lending agreements).\1197\
Removing the requirement to file credit agreements as exhibits to Form
N-1A should, if anything, lead to a reduction in the costs associated
with filing that form, vis-[agrave]-vis the proposed rule.
---------------------------------------------------------------------------
\1193\ Fidelity Comment Letter; CRMC Comment Letter; Invesco
Comment Letter; Oppenheimer Comment Letter; T. Rowe Comment Letter;
Voya Comment Letter.
\1194\ Oppenheimer Comment Letter; T. Rowe Comment Letter; Voya
Comment Letter.
\1195\ Oppenheimer Comment Letter; Fidelity Comment Letter.
\1196\ CRMC Comment Letter; Invesco Comment Letter; Oppenheimer
Comment Letter; Voya Comment Letter.
\1197\ Fidelity Comment Letter.
---------------------------------------------------------------------------
The requirement to file Form N-LIQUID in three circumstances--if
more than 15% of a fund's net assets are, or become, illiquid
investments that are assets; if the fund's illiquid investments that
are assets previously exceeded 15% of net assets and the fund
determines that its illiquid investments that are assets have changed
to be less than or equal to 15% of net assets; or if a fund's holdings
in highly liquid investments that are assets fall below the fund's
highly liquid investment minimum for more than 7 consecutive calendar
days--may impose small incremental costs on funds. The adopted rule's
liquidity risk management framework should help encourage funds to
avoid exceeding the 15% illiquid investment limit, but in cases where
they must file Form N-LIQUID, there will be incidental costs associated
with filing the form itself. There will be similar incidental costs
associated with filing Form N-LIQUID should a fund breach its highly
liquid investment minimum for more than 7 consecutive calendar days. We
estimate these costs as $1,745 per filing, and estimate the total
number of filings to be roughly 90 per year, for an aggregate cost of
$157,050.\1198\ Finally, any potential indirect costs associated with
filing the form, such as spillover effects or investor flight due to a
breach, should be limited because Form N-LIQUID filings will not be
publicly disclosed. Because Form N-LIQUID filings will be triggered by
events that are part of a fund's periodic review of its investment
classifications under rule 22e-4, the monitoring costs associated with
Form N-LIQUID are included in our estimates of the compliance costs for
rule 22e-4 above.
---------------------------------------------------------------------------
\1198\ See infra footnotes 1280-1287 and surrounding discussion
for more details on these estimates.
---------------------------------------------------------------------------
d. Effects on Efficiency, Competition, and Capital Formation
We believe the final rules' disclosure requirements could increase
informational efficiency by providing additional information about the
aggregate liquidity profile of funds' portfolios to investors and
third-party service providers. To the extent that aggregate liquidity
profiles--the percentages a fund holds in each of the four liquidity
classification categories--are comparable across funds, this could
assist investors in evaluating the risks associated with certain funds,
which could increase allocative efficiency by assisting investors in
making more informed investment choices that better match their risk
tolerances. However, because each fund has discretion in how it defines
both the asset type and liquidity classification of its portfolio
positions, the publicly disclosed aggregation of these classifications
may not be directly comparable across funds; in this case, allocative
efficiency may not be enhanced, and, if fund liquidity profiles are
misinterpreted as being comparable, efficiency could be reduced.
Enhanced disclosure regarding funds' liquidity and liquidity risk
[[Page 82252]]
management practices could positively affect competition by permitting
investors to choose whether to invest in certain funds based on this
information. However, if investors were to move their assets among
funds as a result of the disclosure requirements (for example, if the
disclosure made clear that a certain fund was able to generate higher
returns than its peers only because of high exposures to relatively
less liquid positions, which then led investors with limited risk
tolerance to move assets out of this fund), this could negatively
affect the competitive stance of certain funds.
Increased investor awareness of funds' portfolio liquidity and
liquidity risk management practices also could promote capital
formation if investors find certain funds' liquidity profiles or risk
management practices, or both, attractive, and this awareness promotes
increased investment in these funds (assuming these investments consist
of assets that were not otherwise invested in the capital markets) and
in turn in the assets in which the funds invest. On the other hand,
disclosure which reveals liquidity risk could negatively impact capital
formation if the disclosure causes investors to perceive that some
funds pose too great an investment risk. Investors could consequently
decide not to invest in these funds or to decrease their investment in
these funds. If these foregone investments are not reinvested elsewhere
in capital markets, capital formation would be negatively affected.
Conversely, to the extent that investors assume that funds investing in
relatively less liquid investments could obtain a liquidity risk
premium in the form of higher returns over some period of time, the
potential for higher returns could draw certain investors to funds
investing in relatively less liquid asset classes, which could
positively affect capital formation. If investors shift their invested
investments between funds based on liquidity, there could be capital
formation effects stemming from increased (or decreased) investment in
the funds' portfolio investments, even if the total capital invested in
funds remains constant. For example, if fund investors move assets from
an investment strategy that entails relatively high liquidity risk to
one whose investment strategy involves relatively low liquidity risk,
less liquid portfolio asset classes could experience an adverse impact
on capital formation while the more liquid portfolio asset classes
could experience a positive impact on capital formation, although the
total capital invested in funds would remain constant.
Relative to the proposal, the final disclosure and reporting
requirements do not significantly alter our assessment of the
requirements' impact on efficiency, competition, and capital formation.
The exclusion of individual portfolio position classification from
public disclosure requirements reduces the potential efficiency and
capital formation gains that might accrue from better informed
investors: position-level data could have been used (directly or via
third-party vendor applications) to construct a detailed breakdown of a
fund's liquidity profile, but any public analysis is now limited to an
aggregate liquidity profile for each fund to address the concerns of
commenters regarding the potential costs of disclosing position-level
liquidity data publicly. At the same time, to the extent position-level
liquidity classifications could be valuable to professional traders,
requiring less public disclosure may reduce any potential
inefficiencies that could have resulted from predatory trading or front
running associated with the disclosure of individual investment
classifications.
In addition, while we are also imposing a new filing requirement
via Form N-LIQUID, this form will be filed confidentially with the
Commission and will only be necessary when a fund breaches the 15%
illiquid investment limit, returns to compliance with the 15% illiquid
investment limit, or breaches its highly liquid investment minimum for
longer than 7 consecutive calendar days. Requiring notice to the
Commission of these events may itself provide an incentive for funds to
manage their liquidity in such a way as to avoid triggering the
reporting obligation; where a reporting obligation is triggered, Form
N-LIQUID will provide the Commission with timely information that may
prompt the Commission to inquire further into the circumstances that
gave rise to the requirement to file Form N-LIQUID. As discussed above,
for example, if a number of similarly-situated funds each file a report
in close temporal proximity to one another, or if a single fund files a
series of reports, such information is likely to be of value to the
Commission in taking appropriate action to protect investors, if
required. If Form N-LIQUID provides an early warning of potential fund
liquidity issues that is sufficiently timely and clear to permit
Commission involvement when needed to respond to the potential for
disruptive fund closures and associated negative consequences,
including fund shareholder dilution and any spillover effects, Form N-
LIQUID could enhance efficiency to the extent that negative price
pressure on investments due to fire sales is avoided and, to the extent
mutual fund investors associate this with lower liquidity risk in the
mutual fund industry, Form N-LIQUID may promote capital formation.
e. Reasonable Alternatives
The following discussion addresses significant alternatives to the
disclosure and reporting requirements. More detailed alternatives to
the individual elements of the requirements are discussed in detail
above.\1199\
---------------------------------------------------------------------------
\1199\ See supra sections III.G.1.a, III.G.1.b, III.G.2.d, and
III.G.3.c.
---------------------------------------------------------------------------
The Commission considered requiring each fund to disclose
information about the liquidity of its portfolio positions in the
fund's prospectus or on the fund's Web site, in addition to in reports
filed on Form N-PORT. For example, we could have required a fund to
disclose its highly liquid investment minimum, or the percentage of the
fund's portfolio invested in each of the liquidity categories specified
under rule 22e-4(b)(2)(i), in its prospectus or on its Web site. This
additional disclosure could further increase transparency with respect
to funds' portfolio liquidity and liquidity-related risks. But this
additional disclosure could inappropriately emphasize risks relating to
a fund's portfolio liquidity over other significant risks associated
with an investment in the fund. In addition, funds are not precluded
from voluntarily disclosing any of the information contained in the
rule's required disclosure forms on their Web sites, so it is likely
more efficient to allow investor demand for this information to drive
whether or not funds publicly disclose this information of their own
volition.
Conversely, the Commission also considered both limiting and
expanding the enhancements to funds' liquidity-related disclosures on
Form N-PORT. As discussed above, we are sensitive to the possibility
that any amendments to the form could facilitate front-running,
predatory trading, and other activities that could be detrimental to a
fund and its investors. We likewise carefully considered costs and
benefits with respect to the new liquidity-related disclosures required
under Form N-PORT and concluded that these disclosures appropriately
balance related costs with the benefits that could arise from the
ability of the Commission, and members of the public, to monitor and
analyze the liquidity of individual funds, as well as liquidity trends
within the fund industry.
[[Page 82253]]
In response to the proposal, which would have required that certain
position-level data be reported publicly (albeit with a 60 day delay)
commenters suggested that the Commission require (1) no reporting of
any kind, or (2) no public disclosure, in light of potential negative
competitive effects of public reporting and the limited benefits of
stale data in understanding current fund liquidity levels.\1200\ The
Commission considered these alternatives, but rejected the first
alternative because it would have provided no useful information to
investors to permit them to better understand their funds' liquidity
profiles, and no useful information to the Commission to enable the
Commission to better monitor funds' liquidity. With regard to the
second alternative, providing no information to investors would have
the same defect of not permitting investors the opportunity to assess
and make investment decisions based on better information about funds'
liquidity. However, recognizing commenters' concern about voluminous,
stale data, the final form provides investors with aggregated
information--the percentage of the funds' portfolio falling into each
of the four liquidity categories--and reserves the more detailed data
for confidential submission to the Commission. We believe the approach
in the final form strikes an appropriate balance, by mitigating many of
the concerns expressed by commenters while preserving significant
benefits for investors (both directly, and through the Commission's
improved ability to monitor funds).
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\1200\ See supra section III.C.6.
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V. Paperwork Reduction Act Analysis
A. Introduction
New rule 22e-4 contains ``collections of information'' within the
meaning of the Paperwork Reduction Act of 1995 (``PRA'').\1201\ In
addition, the amendments to Form N-1A will impact the collections of
information burden under those rules and form. The new reporting
requirements on Form N-CEN and Form N-PORT will impact the collections
of information burdens associated with these forms described in the
Investment Company Reporting Modernization Adopting Release.\1202\ New
rule 30b1-10 and new Form N-LIQUID also contain a collection of
information within the meaning of the PRA.\1203\
---------------------------------------------------------------------------
\1201\ 44 U.S.C. 3501 through 3521.
\1202\ See Investment Company Reporting Modernization Adopting
Release, supra footnote 120.
\1203\ See rule 30b1-10 requiring certain funds to file Form N-
LIQUID.
---------------------------------------------------------------------------
The titles for the existing collections of information are: ``Form
N-1A under the Securities Act of 1933 and under the Investment Company
Act of 1940, Registration Statement of Open-End Management Investment
Companies'' (OMB Control No. 3235-0307). In the Investment Company
Reporting Modernization Adopting Release, we submitted new collections
of information for Form N-CEN and Form N-PORT.\1204\ The titles for
these new collections of information are: ``Form N-CEN Under the
Investment Company Act, Annual Report for Registered Investment
Companies'' and ``Form N-PORT Under the Investment Company Act, Monthly
Portfolio Investments Report.''
---------------------------------------------------------------------------
\1204\ See Investment Company Reporting Modernization Adopting
Release, supra footnote 120.
---------------------------------------------------------------------------
We are submitting new collections of information for new rule 22e-
4, new rule 30b1-10, and new Form N-LIQUID under the Investment Company
Act of 1940. The titles for these new collections of information will
be: ``Rule 22e-4 Under the Investment Company Act of 1940, Liquidity
risk management programs,'' ``Rule 30b1-10 Under the Investment Company
Act of 1940, Current report for open-end management investment
companies,'' and ``Form N-LIQUID, Current Report, Open-end Management
Investment Company Liquidity.'' The Commission is submitting these
collections of information to the OMB for review in accordance with 44
U.S.C. 3507(d) and 5 CFR 1320.11. An agency may not conduct or sponsor,
and a person is not required to respond to, a collection of information
unless it displays a currently valid control number.
The Commission is adopting new rule 22e-4, new rule 30b1-10, new
Form N-LIQUID, and amendments to Form N-1A. The Commission also is
adopting new items to Form N-CEN and Form N-PORT. The new rules and
amendments are designed to promote effective liquidity risk management
throughout the open-end fund industry and enhance disclosure and
Commission oversight of fund liquidity and shareholder redemption
practices. We discuss below the collection of information burdens
associated with these reforms. In the Proposing Release, the Commission
solicited comment on the collection of information requirements and the
accuracy of the Commission's statements in the Proposing Release.
B. Rule 22e-4
Rule 22e-4 requires a ``fund'' and an In-Kind ETF, each within the
meaning of rule 22e-4,\1205\ to establish a written liquidity risk
management program that is reasonably designed to assess and manage the
fund's or In-Kind ETF's liquidity risk. This program includes policies
and procedures that incorporate certain program elements, including:
(i) For funds, the classification of the liquidity of a fund's
portfolio positions; (ii) for funds and In-Kind ETFs, the assessment,
management, and periodic review of liquidity risk (with such review
occurring no less frequently than annually); (iii) for funds that do
not primarily hold assets that are highly liquid investments, the
determination of and periodic review of the fund's highly liquid
investment minimum and establishment of policies and procedures for
responding to a shortfall of the fund's highly liquid investment
minimum, which includes reporting to the fund's board of directors; and
(iv) for funds and In-Kind ETFs, the establishment of policies and
procedures regarding redemptions in kind, to the extent that the fund
engages in or reserves the right to engage in redemptions in kind. The
rule also requires board approval and oversight of a fund's or In-Kind
ETF's liquidity risk management program and recordkeeping. Rule 22e-4
also requires a limited liquidity review, under which a UIT's principal
underwriter or depositor determines, on or before the date of the
initial deposit of portfolio securities into the UIT, that the portion
of the illiquid investments that the UIT holds or will hold at the date
of deposit that are assets is consistent with the redeemable nature of
the securities it issues and retains a record of such determination for
the life of the UIT and for five years thereafter.
---------------------------------------------------------------------------
\1205\ The term ``funds'' is defined under rule 22e-4(a)(4) to
mean an open-end management investment company that is registered or
required to be registered under section 8 of the Act and includes a
separate series of such an investment company, but does not include
a registered open-end management investment company that is
regulated as a money market fund under Sec. 270.2a-7 or an In-Kind
ETF, as defined under rule 22e-4(a)(9).
---------------------------------------------------------------------------
The requirements under rule 22e-4 that a fund and In-Kind ETF adopt
a written liquidity risk management program, report to the board,
maintain a written record of how the highly liquid investment minimum
was determined and written policies and procedures for responding to a
shortfall of the fund's highly liquid investment
[[Page 82254]]
minimum, which includes reporting to the fund's board of directors (for
funds that do not primarily hold highly liquid investments), establish
written policies and procedures regarding how the fund will engage in
redemptions in kind, and retain certain other records are all
collections of information under the PRA. In addition, the requirement
under rule 22e-4 that the principal underwriter or depositor of a UIT
assess the liquidity of the UIT on or before the date of the initial
deposit of portfolio securities into the UIT and retain a record of
such determination for the life of the UIT, and for five years
thereafter, is also a collection of information under the PRA. The
respondents to rule 22e-4 will be open-end management investment
companies (including, under certain circumstances, In-Kind ETFs but
excluding money market funds), and the principal underwriters or
depositors of UITs under certain circumstances.
1. Preparation of Written Liquidity Risk Management Program
We believe that some open-end funds regularly monitor the liquidity
of their portfolios as part of the portfolio management function, but
they may not have written policies and procedures regarding liquidity
management. Rule 22e-4 requires funds and In-Kind ETFs to have a
written liquidity risk management program. We believe such a program
will minimize dilution of shareholder interests by promoting stronger
and more effective liquidity risk management across open-end funds and
will reduce the risk that a fund or In-Kind ETF will be unable to meet
redemption obligations.
In the Proposing Release, we estimated that funds within 867 fund
complexes would be subject to rule 22e-4.\1206\ Compliance with rule
22e-4 would have been mandatory for all such funds. We further
estimated that a fund complex would incur a one-time average burden of
40 hours associated with documenting the liquidity risk management
programs adopted by each fund within the complex. Under the proposal,
rule 22e-4 would have required fund boards to approve the liquidity
risk management program and any material changes to the program, and we
estimated a one-time burden of nine hours per fund complex associated
with fund boards' review and approval of the funds' liquidity risk
management programs and preparation of board materials. Amortized over
a 3-year period, we estimated this would be an annual burden per fund
complex of about 16 hours. Accordingly, we estimated that the total
burden for initial documentation and review of funds' written liquidity
risk management program would be 42,483 hours.\1207\ We also estimated
that it would cost a fund complex approximately $38,791 to document,
review and initially approve these policies and procedures, for a total
cost of approximately $33,631,797.\1208\
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\1206\ See Proposing Release, supra footnote 9, at n.819 and
accompanying text. This estimate excluded ETFs and UITs. See also
2016 ICI Fact Book, supra footnote 11, at Fig. 1.8.
\1207\ This estimate was based on the following calculation: (40
+ 9) hours x 867 fund complexes = 42,483 hours.
\1208\ These estimates were based on the following calculations:
20 hours x $301 (hourly rate for a senior portfolio manager) =
$6,020; 20 hours x $455.5 (blended hourly rate for assistant general
counsel ($426) and chief compliance officer ($485)) = $9,110; 5
hours x $4,465 (hourly rate for a board of 8 directors) = $22,325; 4
hours (for a fund attorney's time to prepare materials for the
board's determinations) x $334 (hourly rate for a compliance
attorney) = $1,336. $6,020 + $9,110 + $22,325 + $1,336 = $38,791;
$38,791 x 867 fund complexes = $33,631,797. The hourly wages used
are from SIFMA's Management & Professional Earnings in the
Securities Industry 2013, modified to account for an 1800-hour work-
year and multiplied by 5.35 to account for bonuses, firm size,
employee benefits, and overhead. The staff previously estimated in
2009 that the average cost of board of director time was $4,000 per
hour for the board as a whole, based on information received from
funds and their counsel. Adjusting for inflation, the staff
estimates that the current average cost of board of director time is
approximately $4,465.
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We did not receive any comments on the estimated hour and costs
burdens associated with the overall preparation of written liquidity
risk management programs under rule 22e-4 discussed above. We did,
however, receive comments on the costs associated with the
classification of the liquidity of a fund's portfolio positions, which
we address below in connection with Form N-PORT. The Commission has
modified the estimated increase in annual burden hours and total time
costs that will result from the new written liquidity risk management
requirements of rule 22e-4 based on certain modifications made to rule
22e-4 and updates to the industry data figures that were utilized in
the Proposing Release. Based upon our review of industry data, we
estimate that funds within 873 fund complexes would be subject to rule
22e-4,\1209\ updated from 867 in our proposal. Compliance with rule
22e-4 will be mandatory for all such funds and In-Kind ETFs, with
certain program elements applicable to certain funds within a fund
complex based upon whether the fund is an In-Kind ETF or does not
primarily hold assets that are highly liquid investments, as noted
above. We discuss mandatory compliance with rule 22e-4 with respect to
principal underwriters and depositors of UITs in section V.B.5. below.
---------------------------------------------------------------------------
\1209\ See 2016 ICI Fact Book, supra footnote 11, at Fig. 1.8.
---------------------------------------------------------------------------
The Commission continues to estimate that a fund complex will incur
a one-time average burden of 40 hours associated with documenting the
liquidity risk management programs adopted by each fund within a fund
complex. In light of the requirement that a fund subject to the highly
liquid investment minimum requirement adopt and implement policies and
procedures for responding to a shortfall of the fund's highly liquid
investment minimum, and responding to any potential excesses of the 15%
illiquid asset limit, both of which include reporting to the fund's
board of directors, we estimate a one-time burden of 10 hours, rather
than 9 hours, per fund complex associated with fund boards' review and
approval of the funds' liquidity risk management programs and
preparation of board materials. Amortized over a 3-year period, we
estimate this will be an annual burden per fund complex of about 16.67
hours. Accordingly, we estimate that the total burden for initial
documentation and review of funds' written liquidity risk management
program will be 43,650 hours.\1210\ We also estimate that it will cost
a fund complex approximately $41,467.5 to document, review, and
initially approve these policies and procedures, for a total cost of
approximately $36,201,127.5.\1211\
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\1210\ This estimate is based on the following calculation: (40
+10) hours x 873 fund complexes = 43,650 hours.
\1211\ These estimates are based on the following calculations:
20 hours x $306 (hourly rate for a senior portfolio manager) =
$6,120; 20 hours x $463 (blended hourly rate for assistant general
counsel ($433) and chief compliance officer ($493)) = $9,260; 5.5
hours x $4,465 (hourly rate for a board of 8 directors) = $24,557.5;
4.5 hours (for a fund attorney's time to prepare materials for the
board's determinations) x $340 (hourly rate for a compliance
attorney) = $1,530. $6,120 + $9,260 + $24,557.5 + $1,530 =
$41,467.5; $41,467.5 x 873 fund complexes = $36,201,127.5. The
hourly wages used are from SIFMA's Management & Professional
Earnings in the Securities Industry 2013, modified by Commission
staff to account for an 1800-hour work-year and inflation, and
multiplied by 5.35 to account for bonuses, firm size, employee
benefits, and overhead. The staff previously estimated in 2009 that
the average cost of board of director time was $4,000 per hour for
the board as a whole, based on information received from funds and
their counsel. Adjusting for inflation, the staff estimates that the
current average cost of board of director time is approximately
$4,465.
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2. Reporting Regarding the Highly Liquid Investment Minimum
Rule 22e-4 requires any fund that does not primarily hold assets
that are highly liquid investments to determine
[[Page 82255]]
a highly liquid investment minimum for the fund, which must be reviewed
at least annually, and may not be changed during any period of time
that a fund's assets that are highly liquid investments are below the
determined minimum without approval from the fund's board of
directors.\1212\ The fund's investment adviser or officers designated
to administer the liquidity risk management program must provide a
written report to the fund's board at least annually that describes a
review of the adequacy and effectiveness of the fund's liquidity risk
management program, including, if applicable, the operation of the
highly liquid investment minimum.\1213\ In addition, the fund must
adopt and implement policies and procedures for responding to a
shortfall of the fund's assets that are highly liquid investments below
its highly liquid investment minimum, which must include reporting to
the fund's board of directors with a brief explanation of the causes of
the shortfall, the extent of the shortfall, and any actions taken in
response, and, if the shortfall lasts more than 7 consecutive calendar
days, an explanation of how the fund plans to come back into compliance
with its minimum within a reasonable period of time.\1214\
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\1212\ See rule 22e-4(b)(1)(iii)(A).
\1213\ See rule 22e-4(b)(3)(iii).
\1214\ See rule 22e-4(b)(1)(iii)(A)(3).
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Similar to the highly liquid investment minimum, in the Proposing
Release, we proposed that funds be required to establish a three-day
liquid asset minimum as part of a fund's liquidity risk management
program, subject to board review, and we estimated that, for each fund
complex, compliance with this reporting requirement would entail: (i)
Five hours of portfolio management time, (ii) five hours of compliance
time, (iii) five hours of professional legal time and (iv) 2.5 hours of
support staff time, requiring an additional 17.5 burden hours at a time
cost of approximately $5,193 per fund complex to draft the required
report to the board.\1215\ We estimated that the total burden for
preparation of the board report would be 15,173 hours, at an aggregate
cost of $4,502,331.\1216\
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\1215\ This estimate was based on the following calculation: 5
hours x $301 (hourly rate for a senior portfolio manager) = $1,505;
5 hours x $283 (hourly rate for compliance manager) = $1,415; 5
hours x $426 (hourly rate for assistant general counsel) = $2,130;
and 2.5 hours x $57 (hourly rate for general clerk) = $143. $1,505 +
$1,415 + $2,130 + $143 = $5,193. The hourly wages used were from
SIFMA's Management & Professional Earnings in the Securities
Industry 2013, modified to account for an 1800-hour work-year and
multiplied by 5.35 to account for bonuses, firm size, employee
benefits, and overhead. The hourly wage used for the general clerk
was from SIFMA's Office Salaries in the Securities Industry 2013,
modified to account for an 1800-hour work-year and multiplied by
2.93 to account for bonuses, firm size, employee benefits, and
overhead.
Because, under the proposal, each fund within a fund complex
would be required to determine its own three-day liquid asset
minimum, this estimate assumed that the report at issue would
incorporate an assessment of the three-day liquid asset minimum for
each fund within the fund complex.
\1216\ These estimates were based on the following calculations:
867 fund complexes x 17.5 hours = 15,173 hours; and $5,193 x 867
fund complexes = $4,502,331.
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We received several comments addressing, in general, the potential
costs associated with a fund establishing and implementing a liquid
asset minimum. To minimize the costs of implementing a liquid asset
minimum, one commenter recommended that funds that have demonstrated a
history of investing in only three-day liquid assets be excluded from
the proposed three-day liquid asset minimum requirements and thus not
incur the costs of related board reporting requirements.\1217\ Other
commenters characterized the program requirements under the proposal as
a one-size-fits-all approach to liquidity risk management and expressed
the belief that such requirements were expensive and unsuitable for
many funds.\1218\
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\1217\ See CFA Comment Letter.
\1218\ See, e.g., Dechert Comment Letter; Federated Comment
Letter.
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As discussed above, the Commission has modified the proposed three-
day liquid asset minimum requirement to a highly liquid investment
minimum requirement that is tailored to apply only to funds that do not
primarily hold highly liquid investments, thereby potentially reducing
the number of funds required to establish, maintain, and report a
highly liquid investment minimum. In addition, the final rule retains a
role for the board in overseeing the fund's liquidity risk management
program, but eliminates certain of the more specific and detailed
approval requirements originally proposed.\1219\ Unlike the proposal,
however, rule 22e-4 requires a fund that is subject to the highly
liquid investment minimum requirement to also adopt and implement
policies and procedures to respond to a shortfall of assets that are
highly liquid investments below the fund's highly liquid investment
minimum, which includes reporting to the fund's board of directors.
---------------------------------------------------------------------------
\1219\ See supra section III.H.3.
---------------------------------------------------------------------------
In light of these modifications, we estimate that the burdens
associated with board reporting will decrease overall in comparison to
the proposal due to the elimination of certain board oversight
requirements originally proposed and the potential reduction in the
number of funds that would require board oversight of a highly liquid
investment minimum. Therefore, we have modified the estimated annual
burden hours and total costs that will result from the highly liquid
investment minimum requirement under rule 22e-4.\1220\ We estimate
that, for each fund complex, compliance with the reporting requirement
would entail: (i) 4 Hours, rather than five hours, of portfolio
management time; (ii) 4 hours, rather than five hours, of compliance
time; (iii) 4 hours, rather than five hours, of professional legal
time; and (iv) 2 hours, rather than 2.5 hours, of support staff time,
requiring an additional 14 burden hours at a time cost of approximately
$4,224 per fund complex to draft the required report to the
board.\1221\ We estimate that fund complexes will have at least one
fund that will be subject to the highly liquid investment minimum
requirement. Thus, we estimate that 873 fund complexes will be subject
to this requirement under rule 22e-4 and that the total burden for
preparation of the board report associated will be 12,222 hours, at an
aggregate cost of $3,687,552.\1222\
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\1220\ Under the proposal, because each fund within a fund
complex would have been required to determine its own three-day
liquid asset minimum, the estimate under the proposal assumed that
the report at issue would incorporate an assessment of the three-day
liquid asset minimum for each fund within the fund complex. As
adopted, rule 22e-4 only requires the assessment of the highly
liquid investment minimum for funds that do not primarily hold
assets that are highly liquid investments.
\1221\ The estimate is based on the following calculation: 4
hours x $306 (hourly rate for a senior portfolio manager) = $1,224;
4 hours x $288 (hourly rate for compliance manager) = $1,152; 4
hours x $433 (hourly rate for assistant general counsel) = $1,732;
and 2 hours x $58 (hourly rate for general clerk) = $116. $1,224 +
$1,152 + $1,732 + $116 = $4,224. The hourly wages used are from
SIFMA's Management & Professional Earnings in the Securities
Industry 2013, modified by Commission staff to account for an 1800-
hour work-year and inflation, and multiplied by 5.35 to account for
bonuses, firm size, employee benefits, and overhead. The hourly wage
used for the general clerk is from SIFMA's Office Salaries in the
Securities Industry 2013, modified by Commission staff to account
for an 1800-hour work-year and inflation, and multiplied by 5.35 to
account for bonuses, firm size, employee benefits, and overhead.
\1222\ These estimates are based on the following calculations:
873 fund complexes x 14 hours =12,222 hours; and $4,224 x 873 fund
complexes = $3,687,552.
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3. Recordkeeping
Final rule 22e-4 requires a fund or In-Kind ETF to maintain a
written copy of the policies and procedures adopted pursuant to its
liquidity risk management program for five years in
[[Page 82256]]
an easily accessible place.\1223\ The rule also requires a fund to
maintain copies of materials provided to the board in connection with
its initial approval of the liquidity risk management program and any
written reports provided to the board, for at least five years, the
first two years in an easily accessible place.\1224\ If applicable, a
fund must also maintain a written record of how its highly liquid
investment minimum and any adjustments to the minimum were determined,
as well as any reports to the board regarding a shortfall in the fund's
highly liquid investment minimum, for five years, the first two years
in an easily accessible place.\1225\ The retention of these records
would be necessary to allow the staff during examinations of funds to
determine whether a fund is in compliance with the liquidity risk
management program requirements.
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\1223\ See rule 22e-4(b)(4)(i).
\1224\ See rule 22e-4(b)(4)(ii).
\1225\ See rule 22e-4(b)(4)(iii).
---------------------------------------------------------------------------
Under the proposal, the recordkeeping requirements were
substantially similar to those being adopted. In the Proposing Release,
we estimated that the burden to retain these records would be five
hours per fund complex, with 2.5 hours spent by a general clerk and 2.5
hours spent by a senior computer operator, with an estimated time cost
per fund complex of $361.\1226\ We also estimated that the total burden
for recordkeeping related to the liquidity risk management program
would be 4,335 hours, at an aggregate cost of $312,987.\1227\
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\1226\ This estimate was based on the following calculations:
2.5 hours x $57 (hourly rate for a general clerk) = $143; 2.5 hours
x $87 (hour rate for a senior computer operator) = $218. $143 + $218
= $361.
\1227\ This estimate was based on the following calculations:
867 fund complexes x 5 hours = 4,335 hours. 867 fund complexes x
$361 = $312,987.
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We did not receive any comments on the estimated hour and cost
burdens associated with the recordkeeping requirements of rule 22e-4.
The Commission has modified the estimated increase in annual burden
hours and total time costs that will result from these requirements in
light of modifications to change those subject to the requirements to
funds and In-Kind ETFs and to require them to maintain reports to
boards concerning a shortfall of the fund's highly liquid investment
minimum and the new requirement to retain records submitted to the
board related to shortfalls of the minimum. We believe that, on an
annual basis, the burden to retain records in connection with rule 22e-
4 will be four hours, rather than five hours per fund complex, with 2
hours, rather than 2.5 hours, spent by a general clerk, and 2 hours,
rather than 2.5 hours, spent by a senior computer operator, with an
estimated time cost per fund complex of $292, rather than $361, based
on updated data concerning funds and fund personnel salaries.\1228\ In
addition, we estimate that the total burden for recordkeeping related
to the liquidity risk management program requirement of rule 22e-4 will
be 3,492 hours, rather than 4,335 hours, at an aggregate cost of
$254,916, rather than $312,987.\1229\
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\1228\ This estimate is based on the following calculations: 2
hours x $58 (hourly rate for a general clerk) = $116; 2 hours x $88
(hour rate for a senior computer operator) = $176. $116 + $176 =
$292.
\1229\ This estimate is based on the following calculations: 873
fund complexes x 4 hours = 3,492 hours. 873 fund complexes x $292 =
$254,916.
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4. Estimated Total Burden for Open-End Funds
Amortized over a three-year period, we estimate that the hour
burdens and time costs associated with rule 22e-4 for open-end funds,
including the burden associated with (1) funds' initial documentation
and review of the required written liquidity risk management program,
(2) reporting to a fund's board regarding the fund's highly liquid
investment minimum, and (3) recordkeeping requirements will result in
an average aggregate annual burden of 26,190 hours, rather than 28,611
hours as proposed, and average aggregate time costs of $14,780,326.5,
rather than $14,431,215 as proposed.\1230\ We continue to estimate that
there are no external costs associated with this collection of
information.
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\1230\ These estimates are based on the following calculations:
43,650 hours (year 1) + (2 x 12,222 hours) (years 2 and 3) + (3 x
3,492 hours) (years 1, 2 and 3) / 3 = 26,190 hours; $36,201,127.5
(year 1) + (2 x $3,687,552) (years 2 and 3) + (3 x $254,916) (years
1, 2 and 3) / 3 = $14,780,326.5.
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5. UIT Liquidity Determination
As discussed above, we recognize that UITs may in some
circumstances be subject to liquidity risk (particularly where the UIT
is not a pass-through vehicle and the sponsor does not maintain an
active secondary market for UIT shares). We believe that UITs may not
have written policies and procedures regarding liquidity management and
are adopting a new requirement under rule 22e-4 with respect to UITs.
On or before the date of initial deposit of portfolio securities into a
registered UIT, the UIT's principal underwriter or depositor is
required to determine that the portion of the illiquid investments that
the UIT holds or will hold at the date of deposit that are assets is
consistent with the redeemable nature of the securities it issues, and
maintain a record of that determination for the life of the UIT and for
five years thereafter. The retention of these records would be
necessary to allow the staff during examinations to determine whether a
UIT is in compliance with the liquidity risk assessment required under
rule 22e-4. This assessment would occur on or before the initial
deposit of portfolio securities of a new UIT and thus would only need
to occur once. Maintenance of the records would be required for the
life of the UIT and for five years thereafter.
We estimate that 1615 newly registered UITs will be subject to the
UIT liquidity determination requirement under rule 22e-4 each
year.\1231\ Compliance with rule 22e-4(c) will be mandatory for all
principal underwriters or depositors of such UITs. We estimate that the
principal underwriter or depositor of a UIT will incur a one-time
average burden of 10 hours to document its determination that the
portion of the illiquid investments that the UIT holds or will hold at
the date of deposit that are assets is consistent with the redeemable
nature of the securities it issues. Amortized over a 3 year period, we
estimate this would be an annual burden per UIT of about 3 hours.
Accordingly, we estimate that the total burden for the initial
documentation and review of funds' written liquidity risk management
program would be 16,150 hours.\1232\ We also estimate that it will cost
the principal underwriter or depositor of a UIT approximately $2,466 to
perform and document this review, for a total cost of approximately
$3,982,590.\1233\
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\1231\ This estimate is based upon staff review of new UIT
registration statements and semi-annual reporting on Form N-SAR
filed with the Commission and Monthly Unit Investment Trust Data
released by the Investment Company Institute, available at https://www.ici.org/research/stats, for the months of January through
December of 2015.
\1232\ This estimate is based on the following calculation: 10
hours x 1615 new UITs = 16,150 hours.
\1233\ These estimates are based on the following calculations:
5 hours x $308 (hourly rate for a senior programmer) = $1540; 2
hours x $463 (blended hourly rate for assistant general counsel
($433) and chief compliance officer ($493)) = $926. $1,540 + $926 =
$2,466; $2,466 x 1615 estimated new UITs = $3,982,590. The hourly
wages used are from SIFMA's Management & Professional Earnings in
the Securities Industry 2013, modified by Commission staff to
account for an 1800-hour work-year and inflation, and multiplied by
5.35 to account for bonuses, firm size, employee benefits, and
overhead.
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We estimate that the burden to retain these records will be two
hours per UIT, with 1 hour spent by a general clerk and 1 hour spent by
a senior computer operator, with an estimated time cost
[[Page 82257]]
per UIT of $146.\1234\ We also estimate that the total burden for
recordkeeping related to the liquidity risk management program will be
3,230 hours, at an aggregate cost of $235,790.\1235\ We estimate that
there are no external costs associated with this collection of
information.
---------------------------------------------------------------------------
\1234\ This estimate is based on the following calculations: 1
hour x $58 (hourly rate for a general clerk) = $58; 1 hours x $88
(hour rate for a senior computer operator) = $88. $58 + 88 = $146.
\1235\ This estimate is based on the following calculations:
1615 UITs x 2 hours = 3,230 hours. 1615 UITs x $146 = $235,790.
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C. Form N-PORT
Today, the Commission is adopting Form N-PORT, which will require
funds to report information within thirty days after the end of each
month about their monthly portfolio holdings to the Commission in a
structured data format.\1236\ Preparing a report on Form N-PORT is
mandatory and a collection of information under the PRA, and the
information required by Form N-PORT will be data-tagged in XML format.
Except for certain reporting items specified in the form, responses to
the reporting requirements will be kept confidential for reports filed
with respect to the first two months of each quarter; the third month
of the quarter will not be kept confidential, but made public sixty
days after the quarter end.
---------------------------------------------------------------------------
\1236\ See Investment Company Reporting Modernization Adopting
Release, supra footnote 120.
---------------------------------------------------------------------------
In the Investment Company Reporting Modernization Adopting Release,
we estimate that, for the 35% of funds that would file reports on Form
N-PORT in house, the per fund average aggregate annual hour burden will
be 144 hours per fund, and the average cost to license a third-party
software solution will be $4,805 per fund per year.\1237\ For the
remaining 65% of funds that would retain the services of a third party
to prepare and file reports on Form N-PORT on the fund's behalf, we
estimate that the average aggregate annual hour burden will be 125
hours per fund, and each fund will pay an average fee of $11,440 per
fund per year for the services of third-party service provider. In sum,
we estimate that filing reports on Form N-PORT will impose an average
total annual hour burden of 144 hours on applicable funds, and all
applicable funds will incur on average, in the aggregate, external
annual costs of $103,787,680, or $9,118 per fund.\1238\
---------------------------------------------------------------------------
\1237\ See id. at n. 1426 and accompanying text.
\1238\ See id. at n. 1499 and accompanying text.
---------------------------------------------------------------------------
Today, we are also adopting amendments to Form N-PORT concerning
liquidity information that require a fund to report information about
the fund's highly liquid investment minimum (if applicable),\1239\ the
liquidity classification for each portfolio investment among four
liquidity categories (with the fourth category covering investments
that qualify as ``illiquid investments'' under the 15% illiquid
investment limit),\1240\ certain information on the percentage of the
fund's highly liquid investments that is segregated to cover, or
pledged to satisfy margin requirements in connection with, fund's
derivatives transactions in each of the other liquidity
categories,\1241\ and the aggregate percentage of the fund representing
each of the four liquidity categories.\1242\ Unlike the proposal, the
amendments adopted today will not require funds to indicate the dollar
amount attributable to different classifications for different portions
within a given holding.\1243\ We believe that requiring funds to report
information about the liquidity of portfolio investments will enhance
the Commission's ability to assess liquidity risk in the open-end fund
industry and assist in our regulatory oversight efforts. Moreover, we
believe that this information will help investors and other potential
users of information on Form N-PORT better understand the liquidity
risks in funds.
---------------------------------------------------------------------------
\1239\ See Item B.7 of Form N-PORT.
\1240\ See Item C.7.a of Form N-PORT.
\1241\ See Item C.7.b of Form N-PORT. The fourth classification
category incorporates data that, under the proposal, would have been
reported as a 15% standard asset in response to proposed Item C.7 of
proposed Form N-PORT.
\1242\ See Item C.7.c of Form N-PORT.
\1243\ See supra section III.C
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1. Liquidity Classification
Under rule 22e-4(b)(1)(ii), an open-end management investment
company (other than a money market fund or an In-Kind ETF) is required
as part of its liquidity risk management program to classify the
liquidity of each of its portfolio investments (including each of the
fund's derivatives transactions) as a highly liquid investment,
moderately liquid investment, less liquid investment, or illiquid
investment.
Under the proposal, all open-end funds would be required to
classify portfolio assets under a days-to-cash framework and report
such classifications on Form N-PORT.\1244\ In the Proposing Release, we
estimated that 8,734 funds would be required to file, on a monthly
basis, additional information on Form N-PORT as a result of the
proposed amendments to N-PORT to require funds provide additional
liquidity information.\1245\ We stated our expectation that funds would
incur a one-time internal burden to initially classify a fund's
portfolio securities and program existing systems to conduct the
ongoing classifications and reviews required under the proposal for
reporting purposes. We estimated that each fund would incur an average
one-time burden of 54 hours at a time cost of $15,330.\1246\ Amortized
over a three-year period, we estimated that this would result in an
average annual hour burden of approximately 18 burden hours and a time
cost of $5,110.\1247\
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\1244\ See id.; see also Proposing Release, supra footnote 9, at
section III.B.
\1245\ See Proposing Release, supra footnote 9, at n.850 and
accompanying text. This was based on estimates that there were 8,734
open-end funds (excluding money market funds, and including ETFs
(for purposes of these calculations, we excluded non-1940 Act ETFs))
as of the end of 2014.
\1246\ See Proposing Release, supra footnote 9, n.851 and
accompanying text. We estimated that these systems modifications
would include the following costs: (i) Project planning and systems
design (24 hours x $260 (hourly rate for a senior systems analyst) =
$6,240) and (ii) systems modification integration, testing,
installation and deployment (30 hours x $303 (hourly rate for a
senior programmer) = $9,090. $6,240 + $9,090 = $15,330.
\1247\ $15,330 / 3 = $5,110. See Proposing Release, supra
footnote 9, at n.852 and accompanying text.
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Many commenters expressed concerns over the operational costs
associated with the assignment of liquidity classifications and the
reporting of this information on Form N-PORT. Several commenters
expressed the belief that the liquidity classification requirement
could impose significant direct costs to a fund and its shareholders
(e.g., new operational systems, trade order management systems, and
other processes to handle complex classification schemes), which
commenters anticipated to be in excess of the Commission's estimates
under the proposal.\1248\ One commenter estimated that the costs
associated with building a liquidity classification system could range
in the millions of dollars for fund complexes that have large numbers
of portfolio positions.\1249\ Another commenter estimated $2 million in
initial implementation costs and more than $650,000 in annual recurring
costs in connection with automating the classification process for over
63,000 portfolio positions.\1250\ This commenter also expressed the
belief that substantial resources, including additional investment
professionals and
[[Page 82258]]
compliance personnel, and additional expenses associated with third-
party service providers would increase costs associated with the
classification requirement.\1251\ Some commenters also expressed
concern that the costs of diverting resources and key personnel were
not considered in the Commission's cost estimates.\1252\
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\1248\ See, e.g., CFA Comment Letter; Federated Comment Letter;
ICI Comment Letter; Voya Comment Letter.
\1249\ See T. Rowe Comment Letter (noting that its fund complex
has just under 44,000 portfolio positions combined as of December
31, 2015).
\1250\ See Invesco Comment Letter.
\1251\ Id.
\1252\ See, e.g., Dechert Comment Letter; ICI Comment Letter I;
Nuveen Comment Letter; Wells Fargo Comment Letter.
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As discussed above, we are adopting a liquidity classification
requirement under rule 22e-4 with a number of modifications to address
commenters' concerns. Unlike the proposal which would have applied to
all open-end funds, In-Kind ETFs are not subject to the classification
requirements under rule 22e-4(b)(ii). The classification categories
have been reduced from six to four and the timeframe for projections
substantially reduced, with the fourth category designated for those
investments that qualify as ``illiquid investments'' harmonized with
the codified 15% illiquid investment limit. Furthermore, a fund may
classify portfolio investments based on asset class, rather than
position-by-position, so long as the fund or its adviser does not have
information about any market, trading, or investment-specific
considerations that are reasonably expected to significantly affect the
liquidity characteristics of an investment and would suggest a
different classification for that investment.
We believe that these modifications to the liquidity classification
requirements will reduce the number of funds subject to the liquidity
classification requirements and will address some of the costs
commenters anticipate funds and fund shareholders would bear to
establish new operational, trade, and other systems to process and
report fund liquidity classification information. However, we
recognize, as discussed above, that several commenters suggested that
implementation of liquidity classification systems would be more costly
than we estimated. Accordingly, we believe, on balance, that the per
fund estimates that we proposed are reasonable and are not reducing
them, despite having adopted some modifications to rule 22e-4 that we
believe reduce the burden relative to the proposal.
We estimate that 9,347 funds, rather than 8,734 funds, will be
required to file, on a monthly basis, additional information on Form N-
PORT as a result of the modifications to Form N-PORT to require
additional liquidity information.\1253\ We continue to expect that
funds will incur a one-time internal burden to initially classify a
fund's portfolio securities and program new and/or existing systems to
conduct the ongoing classifications and reviews required under rule
22e-4 for reporting purposes. We continue to estimate that each fund
will incur an average one-time burden of 54 hours, at a time cost of
$15,576, rather than $15,330 based on updated data concerning funds and
fund personnel salaries.\1254\ Amortized over a three-year period, we
estimate that this will result in an average annual hour burden of
approximately 18 burden hours, and a time cost of $5,192, rather than
$5,110.\1255\
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\1253\ This is based on estimates that there are 9,039 open-end
mutual funds (excluding money market funds) and 1,594 ETFs as of the
end of 2015. See supra footnote 1045 and accompanying text. Based on
staff experience, we estimate that more than 75% of ETFs or 1,196
ETFs will identify as In-Kind ETFs and thus will not be subject to
the classification requirement. 9,039 + (1,594 - 1,196) = 9,437.
\1254\ We estimate that these systems modifications will include
the following costs: (i) Project planning and systems design (24
hours x $264 (hourly rate for a senior systems analyst) = $6,336)
and (ii) systems modification integration, testing, installation and
deployment (30 hours x $308 (hourly rate for a senior programmer) =
$9,240. $6,336 + $9,240 = $15,576.
\1255\ $15,576 / 3 = $5,192.
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2. Reporting on Form N-PORT
In addition to the classification and review of securities, we
estimated in the Proposing Release that 8,734 \1256\ funds would be
required to file, on a monthly basis, additional information on Form N-
PORT. We estimated that each fund that files reports on Form N-PORT in
house (35%, or 3,057 funds) would require an average of approximately 3
burden hours to compile (including review of the information), tag, and
electronically file the additional information in light of the proposed
additions regarding liquidity information for the first time and an
average of approximately 1 burden hours for subsequent filings.
Therefore, we estimated the per fund average annual hour burden
associated with the incremental changes to Form N-PORT as a result of
the proposed additions for these funds would be an additional 14 hours
for the first year \1257\ and an additional 12 hours for each
subsequent year.\1258\ Amortized over three years, we estimated that
the average annual hour burden would be an additional 12.67 hours per
fund.\1259\
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\1256\ See Proposing Release, supra footnote 9, at section V.E.
There were 8,734 open-end funds (excluding money market funds, and
including ETFs) as of the end of 2014. See 2016 ICI Fact Book, supra
footnote 11, at 177, 184.
\1257\ The estimate was based on the following calculation: (1
filing x 3 hours) + (11 filings x 1 hour) = 14 burden hours in the
first year.
\1258\ This estimate was based on the following calculation: 12
filings x 1 hour = 12 burden hours in each subsequent year.
\1259\ The estimate was based on the following calculation: (14
+ (12 x 2)) / 3 = 12.67.
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In the Proposing Release, we also estimated that 65% of funds
(5,677) would retain the services of a third party to provide data
aggregation, validation and/or filing services as part of the
preparation and filing of reports on proposed Form N-PORT on the fund's
behalf.\1260\ For these funds, we estimated that each fund would
require an average of approximately 4 hours to compile and review the
information with the service provider prior to electronically filing
the report for the first time and an average of 0.5 burden hours for
subsequent filings.
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\1260\ Proposing Release, supra footnote 9.
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Therefore, in the Proposing Release, we estimated that the per-fund
average annual hour burden associated with the incremental changes to
proposed Form N-PORT as a result of the proposed additions related to
liquidity information for these funds would be an additional 9.5 hours
for the first year \1261\ and an additional 6 hours for each subsequent
year.\1262\ Amortized over three years, we estimated that the average
aggregate annual hour burden would be an additional 7.17 hours per
fund.\1263\ In sum, we estimated that the proposed additions to Form N-
PORT would impose an average total annual hour burden of an additional
79,436.28 hours on applicable funds.\1264\ We did not anticipate any
change to the total external annual costs of $97,674,221 associated
with Form N-PORT.\1265\
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\1261\ The estimate was based on the following calculation: (1
filing x 4 hours) + (11 filings x 0.5 hour) = 9.5 burden hours in
the first year.
\1262\ This estimate was based on the following calculation: 12
filings x 0.5 hour = 6 burden hours in each subsequent year.
\1263\ The estimate was based on the following calculation: (9.5
+ (6 x 2)) / 3 = 7.17.
\1264\ The estimate was based on the following calculation:
(3,057 funds x 12.67 hours) + (5,677 funds x 7.17 hours) = 79,436.28
hours.
\1265\ See Proposing Release, supra footnote 9; see also
Investment Company Reporting Modernization Adopting Release, supra
footnote 120.
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As discussed in section V.E.2 above, many commenters expressed
concerns over the operational costs associated with the assignment of
liquidity classifications and the reporting of this information on Form
N-PORT. In addition, one commenter recommended that estimated costs to
purchase third-party liquidity assessment data be included in the total
estimated costs to comply with proposed rule given the
[[Page 82259]]
likelihood that many funds will subscribe to such services to
operationally comply with the rule 22e-4.\1266\
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\1266\ See Interactive Data Comment Letter.
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The Commission has modified the estimated increase in annual burden
hours and total time costs that will result from Form N-PORT and the
liquidity related amendments to Form N-PORT in consideration of
commenters' concerns that the Commission underestimated the operational
requirements for reporting and to reflect updates to the industry data
figures that were utilized in the Proposing Release. We estimate that
9,347 funds would be required to file, on a monthly basis, additional
information on Form N-PORT as a result of the additional liquidity-
related reporting items adopted today.\1267\
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\1267\ See footnote 1253 and accompanying text.
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We estimate that each fund that files reports on Form N-PORT in
house (35%, or 3,271) will require an average of approximately 6 burden
hours, rather than 3 burden hours, to compile (including review of the
information), tag, and electronically file the additional liquidity
information required on Form N-PORT for the first time and an average
of approximately 2 burden hours, rather than 1 burden hour, for
subsequent filings. Therefore, we estimate the per fund average annual
hour burden associated with the incremental changes to Form N-PORT as a
result of the added liquidity information for these funds would be an
additional 28 hours, rather than 14 hours for the first year \1268\ and
an additional 24 hours for each subsequent year.\1269\ Amortized over
three years, the average annual hour burden would be an additional
25.33 hours per fund.\1270\
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\1268\ The estimate is based on the following calculation: (1
filing x 6 hours) + (11 filings x 2 hour) = 28 burden hours in the
first year.
\1269\ This estimate is based on the following calculation: 12
filings x 2 hour = 24 burden hours in each subsequent year.
\1270\ The estimate is based on the following calculation: (28 +
(24 x 2)) / 3 = 25.33.
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We further estimate that 65% of funds (9,076) will retain the
services of a third party to provide data aggregation, validation and/
or filing services as part of the preparation and filing of reports on
Form N-PORT on the fund's behalf. For these funds, we estimate that
each fund will require an average of approximately 8 hours, rather than
4 hours, to compile and review the added liquidity-related information
with the service provider prior to electronically filing the report for
the first time and an average of 1 burden hour, rather than 0.5 burden
hours, for subsequent filings. Therefore, we estimate the per fund
average annual hour burden associated with the liquidity-related
changes to Form N-PORT for these funds would be an additional 19 hours,
rather than 9.5 hours, for the first year \1271\ and an additional 12
hours, rather than 6 hours, for each subsequent year.\1272\ Amortized
over three years, the average aggregate annual hour burden would be an
additional 14.33 hours per fund, rather than 7.17 hours per fund.\1273\
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\1271\ The estimate is based on the following calculation: (1
filing x 8 hours) + (11 filings x 1 hour) = 19 burden hours in the
first year.
\1272\ This estimate is based on the following calculation: 12
filings x 1 hour = 12 burden hours in each subsequent year.
\1273\ The estimate is based on the following calculation: (19 +
(12 x 2)) / 3 = 14.33.
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In sum, we estimate that the adopted additional liquidity reporting
information on Form N-PORT will impose an average total annual hour
burden of an additional 169,923.51 hours, rather than 79,436.28 hours,
on applicable funds.\1274\ As we stated in the Proposing Release, we
believe that the changes to Form N-PORT associated with reporting
liquidity classifications will not result in third party service
providers charging additional fees above those estimated in the
Investment Company Modernization Proposing Release. Therefore, we have
revised our estimates of number of funds affected as discussed
previously, but are continuing to estimate the same external costs for
hiring third party service providers as in the Investment Company
Modernization Adopting Release. Accordingly, we estimate that the total
external annual cost burden of compliance with the information
collection requirements of Form N-PORT will be $103,787,680, or $9,118
per fund.\1275\
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\1274\ The estimate is based on the following calculation:
(3,271 funds x 25.33 hours) + (6,076 funds x 14.33 hours) =
169,923.51 hours.
\1275\ See Investment Company Reporting Modernization Adopting
Release, supra footnote 120.
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D. Form N-LIQUID and Rule 30b1-10
As discussed above, we are adopting a new requirement that open-end
investment companies, including In-Kind ETFs but not including money
market funds, file a current report on Form N-LIQUID on a non-public
basis when certain events related to their liquidity occur.\1276\
Similar to Form 8-K under the Exchange Act,\1277\ or Form N-CR under
the Investment Company Act for money market funds,\1278\ Form N-LIQUID
requires disclosure, by means of a current report filed with the
Commission, of certain specific reportable events. The information
reported on Form N-LIQUID concerns events under which more than 15% of
a fund's or In-Kind ETF's net assets are, or become, illiquid
investments that are assets as defined in rule 22e-4 and when holdings
in illiquid investments are assets that previously exceeded 15% of a
fund's net assets have changed to be less than or equal to 15% of the
fund's net assets.\1279\ The information reported on Form N-LIQUID also
regards events under which a fund's holdings in assets that are highly
liquid investments fall below the fund's highly liquid investment
minimum for more than 7 consecutive calendar days. A report on Form N-
LIQUID is required to be filed, as applicable, within one business day
of the occurrence of one or more of these events.\1280\
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\1276\ This requirement will be implemented through our adoption
of new rule 30b1-10, which requires funds to file a report on new
Form N-LIQUID in certain circumstances. See rule 30b1-10; Form N-
LIQUID. For purposes of the PRA analysis, therefore, the burden
associated with the requirements of rule 30b1-10 is included in the
collection of information requirements of Form N-LIQUID.
\1277\ 17 CFR 249.308.
\1278\ 17 CFR 270.30b1-8.
\1279\ See Item C.1 and Item C.2 of Part A of Form N-LIQUID.
\1280\ See General Instruction A.2 of Form N-LIQUID.
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This reporting requirement on Form N-LIQUID is a collection of
information under the PRA. The information provided on Form N-LIQUID
will enable the Commission to receive information on fund liquidity
events more uniformly and efficiently and will enhance the Commission's
oversight of funds when significant liquidity events occur and its
ability to respond to market events. The Commission will be able to use
the information provided on Form N-LIQUID in its regulatory, disclosure
review, inspection, and policymaking roles. This collection of
information will be kept confidential.
The staff estimates that the Commission will receive, in the
aggregate, an average of 30 reports \1281\ per year filed in response
to an event specified on Part B (``Above 15% Illiquid Investments''),
an average of 30 reports \1282\ per year filed in response to an event
specified on Part C (``At or Below 15% Illiquid Investments''), and
[[Page 82260]]
an average of 30 reports \1283\ per year filed in response to an event
specified on Part D (``Highly Liquid Investments Below the Highly
Liquid Investment Minimum'') of the form.
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\1281\ Commission staff estimates this figure based, in part, by
reference to the total of 28 Form N-CR filings received by the
Commission from mid-July 2015 to mid-July 2016. We recognize that
the circumstances under which money market funds report events on
Form N-CR are not the same as the liquidity events reported on Form
N-LIQUID and that reported occurrences may be less than or more than
30. We believe, however, that Form N-CR provides a helpful guidepost
for estimation purposes and believe an estimation of 30 reports is
appropriate for purposes of this PRA.
\1282\ See id.
\1283\ See id.
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When filing a report on Form N-LIQUID,\1284\ staff estimates that a
fund will spend on average approximately 4 hours \1285\ of an in-house
attorney's time and one \1286\ hour of an in-house accountant's time to
prepare, review, and submit Form N-LIQUID, at a total time cost of
$1,745.\1287\ Accordingly, in the aggregate, staff estimates that
compliance with new rule 30b1-10 and Form N-LIQUID will result in a
total annual burden of approximately 450 burden hours and total annual
time costs of approximately $157,050.\1288\ Given an estimated 10,633
funds will be required to comply with new rule 30b1-10 and Form N-
LIQUID,\1289\ this would result in an annual burden of approximately
0.04 burden hours and annual time costs of approximately $15 on a per-
fund basis. Staff estimates that there will be no external costs
associated with this collection of information.
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\1284\ For purposes of this estimate, the staff expects that it
would take approximately the same amount of time to prepare and file
a report on Form N-LIQUID, regardless under which Part of Form N-
LIQUID it is filed.
\1285\ This estimate is derived in part from our current PRA
estimate for Form N-CR and Form 8-K.
\1286\ Id.
\1287\ This estimate is based on the following calculations: (4
hours x $386/hour for an attorney = $1,544), plus (1 hour x $201/
hour for a senior accountant = $201), for a combined total of 5
hours at total time costs of $1,745.
\1288\ This estimate is based on the following calculations: (30
reports filed per year with respect to Part B) + (30 reports filed
per year with respect to Part C) + (30 reports filed per year with
respect to Part D) = 90 reports filed per year. 90 reports filed per
year x 5 hours per report = approximately 450 total annual burden
hours. 90 reports filed per year x $1,745 in costs per report =
$157,050 total annual costs.
\1289\ This estimate is based on the number of funds the staff
estimates will be required to file reports on Form N-PORT with the
Commission. For purposes of this PRA, the staff assumes that the
universe of funds affected by rule 30b1-9 for Form N-PORT would be
similar to the universe of funds affected by rule 30b1-10 for Form
N-LIQUID.
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E. Form N-CEN
On May 20, 2015, we proposed to amend rule 30a-1 to require all
funds to file reports with certain census-type information on proposed
Form N-CEN with the Commission on an annual basis. Proposed Form N-CEN
would have been a collection of information under the PRA, and was
designed to facilitate the Commission's oversight of funds and its
ability to monitor trends and risks. The collection of information
under Form N-CEN would be mandatory for all funds, and responses would
not be kept confidential.
In the Investment Company Reporting Modernization Proposing
Release, we estimated that the average annual hour burden per response
for proposed Form N-CEN for the first year would be 32.37 hours and
12.37 hours in subsequent years.\1290\ Amortizing the burden over three
years, we estimated that the average annual hour burden per fund per
year would be 19.04 and the total average annual hour burden would be
59,900 hours.\1291\ We also estimated that all applicable funds would
incur, in the aggregate, external annual costs of $1,748,637, which
would include the costs of registering and maintaining LEIs for funds.
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\1290\ Investment Company Reporting Modernization Proposing
Release, supra footnote 120.
\1291\ Id. at n.765 and accompanying text.
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We are adopting, substantially as proposed, amendments to Form N-
CEN to enhance the reporting of a fund's liquidity risk management
practices. Specifically, the amendments to Form N-CEN will require a
fund to report information about lines of credit, but in a modification
to the proposal, funds will report about both committed and uncommitted
lines of credit.\1292\ As proposed, funds will be required to report
information such as the size of the line of credit, the number of days
that the line of credit was used, and the identity of the institution
with whom the line of credit is held.\1293\ The amendments to Form N-
CEN also will require a fund to report whether it engaged in interfund
lending or interfund borrowing.\1294\ In addition, amendments to Form
N-CEN will require an ETF to report whether it qualifies as an ``In-
Kind ETF'' for purposes of rule 22e-4.\1295\
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\1292\ See Item C.20.a. of Form N-CEN.
\1293\ See Id.
\1294\ See Item C.20.b. of Form N-CEN.
\1295\ See Item E.5 of Form N-CEN. We do not estimate any change
in burden as a result of Item E.5 of Form N-CEN because the item
only requires a yes or no response. In the Proposing Release, we
also proposed to add to Form N-CEN a requirement for funds to report
whether the fund required that an authorized participant post
collateral to the fund or any of its designated service providers in
connection with the purchase or redemption of fund shares during the
reporting period. We are adopting this requirement in the Reporting
Modernization Release. See supra footnote 898.
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In the Proposing Release, we estimated that 8,734 funds would be
required to file responses on Form N-CEN as a result of the proposed
amendments to the form. We estimated that the average annual hour
burden per additional response to Form N-CEN as a result of the
proposed amendments would be 0.5 hour per fund per year for a total
average annual hour burden of 4,367 hours.\1296\ We did not estimate
any change to the external costs associated with proposed Form N-CEN.
---------------------------------------------------------------------------
\1296\ This estimate was based on the following calculation:
8,734 funds x 0.5 hours = 4,367 hours.
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We did not receive any comments on these estimated hour and cost
burdens. The Commission has modified the estimated increase in annual
burden hours and total time costs that will result from the amendments
based on the modifications to the proposal to require funds to report
information on uncommitted lines of credit in addition to committed
lines of credit as well as in light of updated data concerning funds
and fund personnel salaries. We estimate that 10,633 funds, rather than
8,734 funds will be required to file responses on Form N-CEN as a
result of the amendments to the form based on updates to the industry
data figures that were utilized in the Proposing Release.\1297\ We
estimate that the average annual hour burden per additional response to
Form N-CEN as a result of the adopted additions to Form N-CEN will be
one hour per fund per year, instead of 0.5 hour per fund per year, for
a total average annual hour burden of 10,633, rather than 4,367
hours.\1298\ We do not estimate any change to the external costs
associated with proposed Form N-CEN.
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\1297\ See 2016 ICI Fact Book, supra footnote 11, at 22, 176,
183.
\1298\ This estimate is based on the following calculation:
10,633 funds x 1 hour = 10,633 hours.
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F. Form N-1A
Form N-1A is the registration form used by open-end investment
companies. The respondents to the amendments to Form N-1A adopted today
are open-end management investment companies registered or registering
with the Commission. Compliance with the disclosure requirements of
Form N-1A is mandatory, and the responses to the disclosure
requirements are not confidential. We currently estimate for Form N-1A
a total hour burden of 1,579,974 hours, and the total annual external
cost burden is $124,820,197.\1299\
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\1299\ These estimates are based on the last time the rule's
information collections were submitted for PRA renewal in 2014.
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We are adopting amendments to Form N-1A that require funds to
disclose additional information concerning the procedures for redeeming
a fund's shares. Funds will be required to describe the number of days
following receipt of shareholder redemption requests in which the fund
reasonably
[[Page 82261]]
expects to pay redemption proceeds to redeeming shareholders.\1300\
Funds also will be required to describe the methods used to meet
redemption requests in stressed and non-stressed market
conditions.\1301\ Funds, however, will not be required to file as
exhibits to their registration statements credit agreements as
originally proposed. Overall, we believe that requiring funds to
provide this additional disclosure regarding redemption procedures will
provide Commission staff, investors, and market participants with
improved information about the procedures funds use to meet their
redemption obligations.
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\1300\ See Item 11(c)(7) of Form N-1A.
\1301\ See Item 11(c)(8) of Form N-1A.
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Form N-1A generally imposes two types of reporting burdens on
investment companies: (i) The burden of preparing and filing the
initial registration statement; and (ii) the burden of preparing and
filing post-effective amendments to a previously effective registration
statement (including post-effective amendments filed pursuant to rule
485(a) or 485(b) under the Securities Act, as applicable). In the
Proposing Release, we estimated that each fund would incur a one-time
burden of an additional 2 hours,\1302\ at a time cost of an additional
$637,\1303\ to draft and finalize the required disclosure and amend its
registration statement in response to the proposed Form N-1A disclosure
requirements. In aggregate, we estimated that funds would incur a one-
time burden of an additional 17,468 hours,\1304\ at a time cost of an
additional $5,563,558,\1305\ to comply with the Form N-1A disclosure
requirements originally proposed. We estimated that amortizing the one-
time burden over a three-year period would result in an average annual
burden of an additional 5,823 hours at a time cost of an additional
$1,854,519.\1306\
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\1302\ This estimate was based on the following calculation: 1
hour to update registration statement to include swing pricing-
related disclosure statements + 1 hour to update registration
statement disclosure about redemption procedures = 2 hours.
\1303\ This estimate was based on the following calculation: 2
hours x $318.5 (blended rate for a compliance attorney ($334) and a
senior programmer ($303)) = $637.
\1304\ This estimate was based on the following calculations: 2
hours x 8,734 funds = 17,468 hours.
\1305\ This estimate was based on the following calculation:
17,468 hours x $318.50 (blended rate for a compliance attorney
($334) and a senior programmer ($303)) = $5,563,558.
\1306\ This estimate was based on the following calculation:
17,468 hours / 3 = 5,823 average annual burden hours; $5,563,558
burden costs / 3 = $1,854,519 average annual burden cost.
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In the Proposing Release, we also estimated that each fund would
incur an ongoing burden of an additional 0.25 hours, at a time cost of
an additional $80,\1307\ each year to review and update the proposed
disclosure in response to Item 11 and Item 28 of Form N-1A regarding
the pricing and redemption of fund shares and the inclusion of credit
agreements as exhibits, respectively. In aggregate, we estimated that
funds would incur an annual burden of an additional 2,184 hours,\1308\
at a time cost of an additional $695,604,\1309\ to comply with the
proposed Form N-1A disclosure requirements.
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\1307\ This estimate was based on the following calculations:
0.25 hours x $318.50 (blended hourly rate for a compliance attorney
($334) and a senior programmer ($303)) = $79.63.
\1308\ This estimate was based on the following calculation:
0.25 hours x 8,734 funds = 2,183.5 hours.
\1309\ This estimate was based on the following calculation:
2,184 hours x $318.50 (blended hourly rate for a compliance attorney
($334) and a senior programmer ($303)) = $695,604.
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In the Proposing Release, we further estimated that amortizing
these one-time and ongoing hour and cost burdens over three years would
result in an average annual increased burden of approximately 0.50
hours per fund,\1310\ at a time cost of $265.42 per fund.\1311\
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\1310\ This estimate was based on the following calculation: 1
burden hour (year 1) + 0.25 burden hour (year 2) + 0.25 burden hour
(year 3) / 3 = 0.50 hours.
\1311\ This estimate was based on the following calculation:
$637 (year 1 monetized burden hours) + $79.63 (year 2 monetized
burden hours) + $79.63 (year 3 monetized burden hours) / 3 =
$265.42.
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In total, we estimated in the Proposing Release that funds would
incur an average annual increased burden of approximately 8,007
hours,\1312\ at a time cost of approximately $2,550,123,\1313\ to
comply with the proposed Form N-1A disclosure requirements. We did not
estimate any change to the external costs associated with the proposed
amendments to Form N-1A.
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\1312\ This estimate was based on the following calculation:
5,823 hours + 2,184 hours = 8,007 hours.
\1313\ This estimate was based on the following calculation:
$1,854,519 + $695,604 = $2,550,123.
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One commenter stated that the cost estimates under the proposal
were overly optimistic, including as an example our estimated $637 cost
per fund to implement the proposed Form N-1A disclosure
requirements.\1314\ As discussed above, our amendments to Form N-1A
include several modifications or clarifications from the proposal that
address concerns raised by commenters and that are intended, in part,
to decrease implementation burdens relative to the proposal. For
example, we are not adopting the proposed requirement that funds file
credit agreements as exhibits to their registration statements.
Furthermore, instead of a requirement for funds to disclose the exact
number of days in which a fund would pay redemption proceeds, including
the number of days that apply for each distribution channel of the
fund, funds are required to disclose the number of days a fund
reasonably expects to pay redemption proceeds and are not required to
account for all distribution channels, only varied payment methods, if
applicable. We believe that these modifications will increase the
quality of information provided to fund shareholders about the timing
of their redemption proceeds and, at the same time, reduce the
likelihood that disclosures regarding such timing will be overly
granular and complex for investors and overly burdensome for
registrants.
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\1314\ See FSR Comment Letter (noting that changes to a fund's
disclosure typically involve a number of stakeholders and several
rounds of drafting and review, such that costs associated with even
modest changes to fund disclosure can have a serious cost
component). With the exception of this comment, we did not receive
comments on the estimated hour and costs burdens associated with the
disclosure amendments to Form N-1A under the proposal.
---------------------------------------------------------------------------
We believe that certain modifications from and clarifications to
the proposal that we are adopting today as well as the removal of the
swing pricing disclosure requirements from this Release will generally
reduce the estimated burden hours and costs associated with the adopted
amendments to Form N-1A relative to the proposal. Furthermore, we have
considered the concern expressed by one commenter that the burdens and
costs estimated in the proposal were overly optimistic and believe that
any possible underestimates in burdens and costs expressed in the
proposal have been offset by the adopted modifications that reduce such
burdens. For these reasons, we believe that the amendments to Form N-1A
adopted today, including modifications from the proposal, will reduce
the estimated burden hours and costs stated in the Proposing Release.
We estimate that each fund will incur a one-time burden of an
additional hour, rather than 2 hours, to draft and finalize the
required disclosure and amend its registration statement,\1315\ but at
a time cost of an additional $324, rather than $637,\1316\ based on
updated data concerning funds and fund personnel salaries and the
removal of the swing pricing disclosure requirement. In
[[Page 82262]]
aggregate, we estimate that funds will incur a one-time burden of an
additional 11,114 hours,\1317\ rather than 17,468 hours, at a time cost
of an additional $3,600,936,\1318\ rather than $5,563,558, to comply
with the Form N-1A disclosure requirements as adopted. We estimate that
amortizing the one-time burden over a three-year period will result in
an average annual burden of an additional 3,705 hours, rather than
5,823 hours at a time cost of an additional $1,200,312, rather than
$1,854,519.\1319\
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\1315\ This estimate is based on the following calculation: 1
hour to update registration statement disclosure about redemption
procedures = 1 hour.
\1316\ This estimate is based on the following calculation: 1
hour x $324 (blended rate for a compliance attorney ($340) and a
senior programmer ($308)) = $324.
\1317\ This estimate was based on the following calculations: 1
hour x 11,114 funds (including money market funds and ETFs) = 11,114
hours.
\1318\ This estimate is based on the following calculation:
11,114 hours x $324 (blended rate for a compliance attorney ($340)
and a senior programmer ($308)) = $3,600,936.
\1319\ This estimate is based on the following calculation:
11,114 hours / 3 = 3,704.67 average annual burden hours; $3,600,936
burden costs / 3 = $1,200,312 average annual burden cost.
---------------------------------------------------------------------------
In addition, we estimate that each fund will incur an ongoing
burden of an additional 0.25 hours, but at a time cost of an additional
$81,\1320\ each year to review and update disclosures required in
response to the amendments to Form N-1A. In aggregate, we estimate that
funds will incur an annual burden of an additional 2,778.50
hours,\1321\ at a time cost of an additional $900,234,\1322\ to comply
with the Form N-1A disclosure requirements adopted today.
---------------------------------------------------------------------------
\1320\ This estimate is based on the following calculations:
0.25 hours x $324 (blended hourly rate for a compliance attorney
($340) and a senior programmer ($308)) = $81.
\1321\ This estimate is based on the following calculation: 0.25
hours x 11,114 funds = 2,778.50 hours.
\1322\ This estimate is based on the following calculation:
2,778.50 hours x $324 (blended hourly rate for a compliance attorney
($340) and a senior programmer ($308)) = $900,234.
---------------------------------------------------------------------------
Furthermore, we estimate that amortizing these one-time and ongoing
hour and cost burdens over three years will result in an average annual
increased burden of approximately 0.50 hours per fund,\1323\ at a time
cost of $162 per fund.\1324\
---------------------------------------------------------------------------
\1323\ This estimate is based on the following calculation: 1
burden hour (year 1) + 0.25 burden hour (year 2) + 0.25 burden hour
(year 3) / 3 = 0.50 hours.
\1324\ This estimate is based on the following calculation: $324
(year 1 monetized burden hours) + $81 (year 2 monetized burden
hours) + $81 (year 3 monetized burden hours) / 3 = $162.
---------------------------------------------------------------------------
In total, we estimate that funds will incur an average annual
increased burden of approximately 6,483.17 hours,\1325\ at a time cost
of approximately $3,300,858,\1326\ to comply with the Form N-1A
disclosure requirements adopted today. We do not estimate any change to
the external costs associated with these amendments to Form N-1A.
---------------------------------------------------------------------------
\1325\ This estimate is based on the following calculation:
3,704.67 hours + 2,778.50 hours = 6,483.17 hours.
\1326\ This estimate is based on the following calculation:
$1,200,312 + $900,234 = $2,100,546.
---------------------------------------------------------------------------
VI. Final Regulatory Flexibility Act Analysis
This Final Regulatory Flexibility Analysis has been prepared in
accordance with section 3 of the Regulatory Flexibility Act
(``RFA'').\1327\ It relates to: new rule 22e-4; new Rule 30b-10, Form
N-LIQUID; and amendments to Form N-1A, Form N-PORT, and Form N-CEN. We
prepared an Initial Regulatory Flexibility Analysis (``IRFA'') in
conjunction with the Proposing Release in September 2015.\1328\ The
Proposing Release included, and solicited comment, on the IRFA. In the
Proposing Release, we also proposed amendments to rule 22c-1, rule 31a-
2, and Form N-1A as well as additions to Form N-CEN regarding the use
of swing pricing.\1329\
---------------------------------------------------------------------------
\1327\ 5 U.S.C. 604.
\1328\ See Proposing Release, supra footnote 9, at section VI.
\1329\ See Proposing Release, supra footnote 9, at section
III.G.1.b.
---------------------------------------------------------------------------
A. Need for the Rule
With the exception of money market funds, open-end funds (including
both in-kind and other ETFs) and UITs are not currently subject to
requirements under the federal securities laws or Commission rules that
specifically require them to manage their liquidity risk,\1330\
although there are guidelines stating that such entities should limit
their investments in illiquid assets.\1331\ In addition, funds are only
subject to limited disclosure and reporting requirements concerning a
fund's liquidity risk and risk management.\1332\ We understand that
funds today engage in a variety of different practices, with varying
levels of comprehensiveness, for classifying the liquidity of their
portfolio investments, assessing and managing liquidity risk, and
disclosing information about their liquidity risk, redemption
practices, and liquidity risk management practices to investors.\1333\
---------------------------------------------------------------------------
\1330\ See supra sections II.D and IV.B.1.a.
\1331\ See id.
\1332\ See supra sections II.D and IV.B.1.c.
\1333\ See supra sections II.D, IV.B.1.a and IV.B.1.c.
---------------------------------------------------------------------------
The Commission is adopting a new rule, amendments to current rules,
a new form and amendments to current forms to promote effective
liquidity risk management throughout the open-end fund industry and
thereby reduce the risk that funds will be unable to meet redemption
obligations and mitigate dilution of the interests of fund
shareholders. The changes also seek to enhance disclosure regarding
fund liquidity and redemption practices. Specifically, a primary
objective of these liquidity regulations is to promote shareholder
protection by elevating the overall quality of liquidity risk
management across the fund industry, as well as by increasing
transparency of funds' liquidity risks and risk management. The
liquidity regulations are also intended to lessen the possibility of
investor dilution created by insufficient liquidity risk management.
Finally, the liquidity regulations are meant to address recent industry
developments that have underscored the significance of funds' liquidity
risk management practices. Each of these objectives is discussed in
detail in section III above.
B. Significant Issues Raised by Public Comment
In the Proposing Release, we requested comment on the IRFA,
requesting in particular comment on the number of small entities that
would be subject to the proposed liquidity regulations and whether the
proposed liquidity regulations would have any effects that have not
been discussed. We requested that commenters describe the nature of any
effects on small entities subject to the proposed liquidity regulations
and provide empirical data to support the nature and extent of such
effects. We also requested comment on the estimated compliance burdens
of the proposed liquidity regulations and how they would affect small
entities. We received a number of comments related to the impact of our
proposal on small entities, with some commenters expressing concern
that liquidity risk management programs, as proposed, would require
building entirely new systems and/or maintaining parallel system, which
certain of the commenters believed could generate disproportionate
burdens on small funds.\1334\ We discuss these costs in detail in
section V., above, and conclude that such costs are justified by the
benefits of liquidity risk management programs.
---------------------------------------------------------------------------
\1334\ See Dechert Comment Letter; ICI Comment Letter I; SIFMA
Comment Letter I; T. Rowe Comment Letter.
---------------------------------------------------------------------------
C. Small Entities Subject to the Rule
An investment company is a small entity if, together with other
investment companies in the same group of related investment companies,
it has net assets of $50 million or less as of the end of its most
recent fiscal year.\1335\ Commission staff estimates that, as of
[[Page 82263]]
December 31, 2015, there were 78 small open-end investment companies
(within 76 fund complexes) that would be considered small entities;
this number includes open-end ETFs.
---------------------------------------------------------------------------
\1335\ See rule 0-10(a) under the Act.
---------------------------------------------------------------------------
D. Projected Reporting, Recordkeeping, and Other Compliance
Requirements
1. New Rule 22e-4
Rule 22e-4 generally requires each registered open-end fund (but
not including money market funds), including each small entity, to
establish a written liquidity risk management program.\1336\ A fund's
board will be required to approve the fund's liquidity risk management
program, as well as the fund's designation of the fund's investment
adviser or officers as responsible for administering the fund's
liquidity risk management program, and review a report on the program's
effectiveness no less than annually. In addition, for funds that do not
primarily hold assets that are highly liquid investments, the new rule
requires the determination of and periodic review of the fund's highly
liquid investment minimum and establishment of policies and procedures
for responding to a shortfall of the fund's highly liquid investment
minimum, which includes reporting to the fund's board of directors. The
new rule also requires a fund's liquidity risk management program to
incorporate certain specified elements.\1337\ Rule 22e-4 includes
tailored liquidity risk management program requirements for ETFs,
intended to target ETFs' unique risks while eliminating requirements
that are largely inapplicable to ETFs that redeem in kind.\1338\ The
rule also includes liquidity-related requirements for UITs, intended to
recognize the unmanaged structure of UITs while requiring that
principal underwriters or depositors of UITs to determine, on or before
the date of the initial deposit of portfolio securities into a UIT,
that the portion of the illiquid investments that the UIT holds or will
hold at the date of deposit that are assets is consistent with the
redeemable nature of the securities that it issues.\1339\ Rule 22e-4
also includes certain recordkeeping requirements.\1340\ We estimate
that 76 fund complexes are small fund groups that have funds that would
be required to comply with the proposed liquidity risk management
program requirement.\1341\ As discussed above, we estimate that a fund
complex would incur one-time costs ranging from $0.8 million to $10.2
million, depending on the fund's particular circumstances and current
liquidity risk management practices, to establish and implement a
liquidity risk management program.\1342\ We further estimate that a
fund complex would incur ongoing annual costs associated with proposed
rule 22e-4 that would range from $40,000 to $3.3 million.\1343\
Finally, we estimate that any UITs launched after the rule's compliance
date will incur one-time costs associated with rule 22e-4 of $8,000 to
$52,000.\1344\
---------------------------------------------------------------------------
\1336\ See supra footnote 113.
\1337\ See id. and accompanying and preceding text.
\1338\ See id.
\1339\ See supra section III.K.
\1340\ See supra section III.I.
\1341\ Commission staff estimate as of December 31, 2015.
\1342\ See supra paragraph accompanying footnote 1101.
\1343\ See supra paragraph accompanying footnote 1104.
\1344\ See supra footnote 1116 and accompanying text.
---------------------------------------------------------------------------
2. Disclosure and Reporting Requirements Regarding Liquidity Risk and
Liquidity Risk Management
New Form N-LIQUID, along with amendments to Form N-1A, Form N-PORT,
and Form N-CEN are intended to enhance fund disclosure and reporting
regarding a fund's redemption practices, portfolio liquidity, and
certain liquidity risk management practices. New Form N-LIQUID will
require a fund to confidentially notify the Commission if the fund's
illiquid investment holdings exceed 15% of its net assets or if its
highly liquid investments decline below its minimum for more than a
brief period of time.\1345\ The amendments to Form N-1A require funds
to disclose additional information concerning the procedures for
redeeming a fund's shares.\1346\ The amendments to Forms N-PORT and N-
CEN require reporting of certain information regarding the liquidity of
a fund's holdings and the fund's liquidity risk management practices.
We estimate that 78 funds are small entities that would be required to
comply with the proposed disclosure and reporting requirements.\1347\
---------------------------------------------------------------------------
\1345\ See supra section III.L.2.
\1346\ See supra section III.L.1.
\1347\ Commission staff estimate as of December 31, 2015.
---------------------------------------------------------------------------
As discussed above, for each fund, including a fund that is a small
entity, when filing a report on Form N-LIQUID, staff estimates that a
fund will spend on average approximately 4 hours \1348\ of an in-house
attorney's time and one \1349\ hour of an in-house accountant's time to
prepare, review, and submit Form N-LIQUID, at a total time cost of
$1,745.\1350\ Staff estimates that there will be no external costs
associated with this collection of information.
---------------------------------------------------------------------------
\1348\ See supra footnote 1285 and accompanying text.
\1349\ Id.
\1350\ See supra footnote 1287 and accompanying text.
---------------------------------------------------------------------------
As discussed above, we estimate that each fund, including funds
that are small entities, would incur a one-time burden of an additional
1 hour,\1351\ at a time cost of an additional $324 (plus printing
costs), to comply with the amendments to Form N-1A.\1352\ We also
estimate that each fund, including small entities, would incur an
ongoing burden of an additional 0.25 hours, at a time cost of
approximately an additional $81 each year associated with compliance
with the amendments to Form N-1A.\1353\ We do not estimate any change
to the external costs associated with the proposed amendments to Form
N-1A.
---------------------------------------------------------------------------
\1351\ See supra footnote 1302 and accompanying text.
\1352\ See supra footnote 1303 and accompanying text.
\1353\ See supra footnote 1307 and accompanying text.
---------------------------------------------------------------------------
We also estimate that each fund that files reports on Form N-PORT
(35% of funds) in house will require an average of approximately 6
burden hours to compile (including review of the information), tag, and
electronically file the additional liquidity information required on
Form N-PORT for the first time and an average of approximately 2 burden
hours, rather than 1 burden hour, for subsequent filings. Therefore, we
estimate the per fund average annual hour burden associated with the
incremental changes to Form N-PORT as a result of the added liquidity
information for these funds would be an additional 28 hours for the
first year and an additional 24 hours for each subsequent year.\1354\
Amortized over three years, the average annual hour burden would be an
additional 25.33 hours per fund.\1355\ We further estimate that 65% of
funds will retain the services of a third party to provide data
aggregation, validation and/or filing services as part of the
preparation and filing of reports on Form N-PORT on the fund's behalf.
For these funds, we estimate that each fund will require an average of
approximately 8 hours to compile and review the added liquidity-related
information with the service provider prior to electronically filing
the report for the first time and an average of 1 burden hour for
subsequent filings. Therefore, we estimate the per fund
[[Page 82264]]
average annual hour burden associated with the liquidity-related
changes to Form N-PORT for these funds would be an additional 19 hours
for the first year \1356\ and an additional 12 hours for each
subsequent year.\1357\ Amortized over three years, the average
aggregate annual hour burden would be an additional 14.33 hours per
fund.\1358\ We further estimate that the total external annual cost
burden of compliance with the information collection requirements of
Form N-PORT will be $9,118 per fund.\1359\
---------------------------------------------------------------------------
\1354\ See supra footnote 1269 and accompanying paragraph.
\1355\ See supra footnote 1270 and accompanying text.
\1356\ See supra footnote 1271 and accompanying text.
\1357\ See supra footnote 1272 and accompanying text.
\1358\ See supra footnote 1273 and accompanying text.
\1359\ See supra footnote 1275 and accompanying text.
---------------------------------------------------------------------------
As discussed above, we also estimate that the average annual hour
burden per additional response to Form N-CEN as a result of the adopted
additions to Form N-CEN will be one hour per fund per year.\1360\ We do
not estimate any change to the external costs associated with proposed
Form N-CEN.\1361\
---------------------------------------------------------------------------
\1360\ See supra footnote 1298 and accompanying paragraph.
\1361\ Id.
---------------------------------------------------------------------------
E. Agency Action To Minimize Effect on Small Entities
The Regulatory Flexibility Act directs the Commission to consider
significant alternatives that would accomplish the stated objective,
while minimizing any significant impact on small entities. Alternatives
in this category would include: (i) Establishing different compliance
or reporting standards that take into account the resources available
to small entities; (ii) clarifying, consolidating, or simplifying the
compliance requirements under the rules and amendments for small
entities; (iii) using performance rather than design standards; and
(iv) exempting small entities from coverage of the rules and
amendments, or any part of the rules and amendments.
The Commission does not presently believe that these rules and
amendments would require the establishment of special compliance
requirements or timetables for small entities. These rules and
amendments are specifically designed to reduce any unnecessary burdens
on all funds (including small funds). To establish special compliance
requirements or timetables for small entities may in fact disadvantage
small entities by encouraging larger market participants to focus
primarily on the needs of larger entities when making the operational
changes envisioned by certain of the rules and amendments, and possibly
ignoring the needs of smaller funds.
With respect to further clarifying, consolidating, or simplifying
the compliance requirements of the rules and amendments, using
performance rather than design standards, and exempting small entities
from coverage of these rules and amendments or any part of the rules
and amendments, we believe additional such changes would be
impracticable. Small entities are as vulnerable to the risks of being
unable to meet redemption obligations and of dilution of the interests
of fund shareholders as larger funds. We believe that the rules and
amendments are necessary to help mitigate these risks. Exempting small
funds from coverage under these rules and amendments or any part of the
rules and amendments could compromise the effectiveness of the rules
and amendments or any part of the rules and amendments.
VII. Statutory Authority and Text of Amendments
The Commission is adopting new rule 22e-4 under the authority set
forth in sections 22(c), 22(e), 34(b) and 38(a) of the Investment
Company Act [15 U.S.C. 80a-22(c), 80a-22(e), 80a-35(b), and 80a-37(a)],
the Investment Advisers Act, particularly, section 206(4) thereof [15
U.S.C. 80b-6(4)], the Exchange Act, particularly section 10(b) thereof
[15 U.S.C. 78a et seq.], the Securities Act, particularly section 17(a)
thereof [15 U.S.C. 77a et seq.]. The Commission is adopting amendments
to Form N-1A, Form N-PORT, and Form N-CEN under the authority set forth
in the Securities Act, particularly section 19 thereof [15 U.S.C. 77a
et seq.], the Trust Indenture Act, particularly, section 19 thereof [15
U.S.C. 77aaa et seq.], the Exchange Act, particularly sections 10, 15,
and 23, and 35A thereof [15 U.S.C. 78a et seq.], and the Investment
Company Act, particularly, sections 8, and 38 thereof [15 U.S.C. 80a et
seq.].
List of Subjects in 17 CFR Parts 270 and 274
Investment companies, Reporting and recordkeeping requirements,
Securities.
For the reasons set out in the preamble, title 17, chapter II of
the Code of Federal Regulations is amended as follows:
PART 270--RULES AND REGULATIONS, INVESTMENT COMPANY ACT OF 1940
0
1. The authority citation for part 270 continues to read, in part, as
follows:
Authority: 15 U.S.C. 80a-1 et seq., 80a-34(d), 80a-37, 80a-39,
and Pub. L. 111-203, sec. 939A, 124 Stat. 1376 (2010), unless
otherwise noted.
* * * * *
0
2. Section 270.22e-4 is added to read as follows:
Sec. 270.22e-4 Liquidity risk management programs.
(a) Definitions. For purposes of this section:
(1) Acquisition (or acquire) means any purchase or subsequent
rollover.
(2) Business day means any day, other than Saturday, Sunday, or any
customary business holiday.
(3) Convertible to cash means the ability to be sold, with the sale
settled.
(4) Exchange-traded fund or ETF means an open-end management
investment company (or series or class thereof), the shares of which
are listed and traded on a national securities exchange, and that has
formed and operates under an exemptive order under the Act granted by
the Commission or in reliance on an exemptive rule adopted by the
Commission.
(5) Fund means an open-end management investment company that is
registered or required to register under section 8 of the Act (15
U.S.C. 80a-8) and includes a separate series of such an investment
company, but does not include a registered open-end management
investment company that is regulated as a money market fund under Sec.
270.2a-7 or an In-Kind ETF.
(6) Highly liquid investment means any cash held by a fund and any
investment that the fund reasonably expects to be convertible into cash
in current market conditions in three business days or less without the
conversion to cash significantly changing the market value of the
investment, as determined pursuant to the provisions of paragraph
(b)(1)(ii) of this section.
(7) Highly liquid investment minimum means the percentage of the
fund's net assets that the fund invests in highly liquid investments
that are assets pursuant to paragraph (b)(1)(iii) of this section.
(8) Illiquid investment means any investment that the fund
reasonably expects cannot be sold or disposed of in current market
conditions in seven calendar days or less without the sale or
disposition significantly changing the market value of the investment,
as determined pursuant to the provisions of paragraph (b)(1)(ii) of
this section.
(9) In-Kind Exchange Traded Fund or In-Kind ETF means an ETF that
meets redemptions through in-kind transfers
[[Page 82265]]
of securities, positions, and assets other than a de minimis amount of
cash and that publishes its portfolio holdings daily.
(10) Less liquid investment means any investment that the fund
reasonably expects to be able to sell or dispose of in current market
conditions in seven calendar days or less without the sale or
disposition significantly changing the market value of the investment,
as determined pursuant to the provisions of paragraph (b)(1)(ii) of
this section, but where the sale or disposition is reasonably expected
to settle in more than seven calendar days.
(11) Liquidity risk means the risk that the fund could not meet
requests to redeem shares issued by the fund without significant
dilution of remaining investors' interests in the fund.
(12) Moderately liquid investment means any investment that the
fund reasonably expects to be convertible into cash in current market
conditions in more than three calendar days but in seven calendar days
or less, without the conversion to cash significantly changing the
market value of the investment, as determined pursuant to the
provisions of paragraph (b)(1)(ii) of this section.
(13) Person(s) designated to administer the program means the fund
or In-Kind ETF's investment adviser, officer, or officers (which may
not be solely portfolio managers of the fund or In-Kind ETF)
responsible for administering the program and its policies and
procedures pursuant to paragraph (b)(2)(ii) of this section.
(14) Unit Investment Trust or UIT means a unit investment trust as
defined in section 4(2) of the Act (15 U.S.C. 80a-4).
(b) Liquidity Risk Management Program. Each fund and In-Kind ETF
must adopt and implement a written liquidity risk management program
(``program'') that is reasonably designed to assess and manage its
liquidity risk.
(1) Required program elements. The program must include policies
and procedures reasonably designed to incorporate the following
elements:
(i) Assessment, management, and periodic review of liquidity risk.
Each fund and In-Kind ETF must assess, manage, and periodically review
(with such review occurring no less frequently than annually) its
liquidity risk, which must include consideration of the following
factors, as applicable:
(A) The fund or In-Kind ETF's investment strategy and liquidity of
portfolio investments during both normal and reasonably foreseeable
stressed conditions, including whether the investment strategy is
appropriate for an open-end fund, the extent to which the strategy
involves a relatively concentrated portfolio or large positions in
particular issuers, and the use of borrowings for investment purposes
and derivatives;
(B) Short-term and long-term cash flow projections during both
normal and reasonably foreseeable stressed conditions;
(C) Holdings of cash and cash equivalents, as well as borrowing
arrangements and other funding sources; and
(D) For an ETF:
(1) The relationship between the ETF's portfolio liquidity and the
way in which, and the prices and spreads at which, ETF shares trade,
including, the efficiency of the arbitrage function and the level of
active participation by market participants (including authorized
participants); and
(2) The effect of the composition of baskets on the overall
liquidity of the ETF's portfolio.
(ii) Classification. Each fund must, using information obtained
after reasonable inquiry and taking into account relevant market,
trading, and investment-specific considerations, classify each of the
fund's portfolio investments (including each of the fund's derivatives
transactions) as a highly liquid investment, moderately liquid
investment, less liquid investment, or illiquid investment. A fund must
review its portfolio investments' classifications, at least monthly in
connection with reporting the liquidity classification for each
portfolio investment on Form N-PORT in accordance with Sec. 270.30b1-
9, and 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.
Note to paragraph (b)(1)(ii)introductory text: If an investment
could be viewed as either a highly liquid investment or a moderately
liquid investment, because the period to convert the investment to
cash depends on the calendar or business day convention used, a fund
should classify the investment as a highly liquid investment. For a
discussion of considerations that may be relevant in classifying the
liquidity of the fund's portfolio investments, see Investment
Company Act Release No. IC-32315 (Oct. 13, 2016).
(A) The fund may generally classify and review its portfolio
investments (including the fund's derivatives transactions) according
to their asset class, provided, however, that the 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.
(B) In classifying and reviewing its portfolio investments or asset
classes (as applicable), the fund must determine whether trading
varying portions of a position in a particular portfolio investment or
asset class, in sizes that the fund would reasonably anticipate
trading, is reasonably expected to significantly affect its liquidity,
and if so, the fund must take this determination into account when
classifying the liquidity of that investment or asset class.
(C) For derivatives transactions that the fund has classified as
moderately liquid investments, less liquid investments, and illiquid
investments, identify the percentage of the fund's highly liquid
investments that it has segregated to cover, or pledged to satisfy
margin requirements in connection with, derivatives transactions in
each of these classification categories.
Note to paragraph (b)(1)(ii)(C): For purposes of calculating
these percentages, a fund that has segregated or pledged highly
liquid investments and non-highly liquid investments to cover
derivatives transactions classified as moderately liquid, less
liquid, or illiquid investments first should apply segregated or
pledged assets that are highly liquid investments to cover these
transactions, unless it has specifically identified segregated non-
highly liquid investments as covering such derivatives transactions.
(iii) Highly liquid investment minimum. (A) Any fund that does not
primarily hold assets that are highly liquid investments must:
(1) Determine a highly liquid investment minimum, considering the
factors specified in paragraphs (b)(1)(i)(A) through (D) of this
section, as applicable (but considering those factors specified in
paragraphs (b)(1)(i)(A) and (B) only as they apply during normal
conditions, and during stressed conditions only to the extent they are
reasonably foreseeable during the period until the next review of the
highly liquid investment minimum). The highly liquid investment minimum
determined pursuant to this paragraph may not be changed during any
period of time that a fund's assets that are highly liquid investments
are below the determined minimum without approval from the fund's board
of directors, including a majority of directors who are not interested
persons of the fund;
[[Page 82266]]
(2) Periodically review, no less frequently than annually, the
highly liquid investment minimum; and
(3) Adopt and implement policies and procedures for responding to a
shortfall of the fund's highly liquid investments below its highly
liquid investment minimum, which must include requiring the person(s)
designated to administer the program to report to the fund's board of
directors no later than its next regularly scheduled meeting with a
brief explanation of the causes of the shortfall, the extent of the
shortfall, and any actions taken in response, and if the shortfall
lasts more than 7 consecutive calendar days, must include requiring the
person(s) designated to administer the program to report to the board
within one business day thereafter with an explanation of how the fund
plans to restore its minimum within a reasonable period of time.
(B) For purposes of determining whether a fund primarily holds
assets that are highly liquid investments, a fund must exclude from its
calculations the percentage of the fund's assets that are highly liquid
investments that it has segregated to cover all derivatives
transactions that the fund has classified as moderately liquid
investments, less liquid investments, and illiquid investments, or
pledged to satisfy margin requirements in connection with those
derivatives transactions, as determined pursuant to paragraph
(b)(1)(ii)(C) of this section.
(iv) Illiquid investments. No fund or In-Kind ETF may acquire any
illiquid investment if, immediately after the acquisition, the fund or
In-Kind ETF would have invested more than 15% of its net assets in
illiquid investments that are assets. If a fund or In-Kind ETF holds
more than 15% of its net assets in illiquid investments that are
assets:
(A) It must cause the person(s) designated to administer the
program to report such an occurrence to the fund's or In-Kind ETF's
board of directors within one business day of the occurrence, with an
explanation of the extent and causes of the occurrence, and how the
fund or In-Kind ETF plans to bring its illiquid investments that are
assets to or below 15% of its net assets within a reasonable period of
time; and
(B) If the amount of the fund's or In-Kind ETF's illiquid
investments that are assets is still above 15% of its net assets 30
days from the occurrence (and at each consecutive 30 day period
thereafter), the fund or In-Kind ETF's board of directors, including a
majority of directors who are not interested persons of the fund or In-
Kind ETF, must assess whether the plan presented to it pursuant to
paragraph (b)(1)(iv)(A) continues to be in the best interest of the
fund or In-Kind ETF.
(v) Redemptions in Kind. A fund that engages in, or reserves the
right to engage in, redemptions in kind and any In-Kind ETF must
establish policies and procedures regarding how and when it will engage
in such redemptions in kind.
(2) Board oversight. A fund or In-Kind ETF's board of directors,
including a majority of directors who are not interested persons of the
fund or In-Kind ETF, must:
(i) Initially approve the liquidity risk management program;
(ii) Approve the designation of the person(s) designated to
administer the program; and
(iii) Review, no less frequently than annually, a written report
prepared by the person(s) designated to administer the program that
addresses the operation of the program and assesses its adequacy and
effectiveness of implementation, including, if applicable, the
operation of the highly liquid investment minimum, and any material
changes to the program.
(3) Recordkeeping. The fund or In-Kind ETF must maintain:
(i) A written copy of the program and any associated policies and
procedures adopted pursuant to paragraphs (b)(1) through (b)(2) of this
section that are in effect, or at any time within the past five years
were in effect, in an easily accessible place;
(ii) Copies of any materials provided to the board of directors in
connection with its approval under paragraph (b)(2)(i) of this section,
and materials provided to the board of directors under paragraph
(b)(2)(iii) of this section, for at least five years after the end of
the fiscal year in which the documents were provided, the first two
years in an easily accessible place; and
(iii) If applicable, a written record of the policies and
procedures related to how the highly liquid investment minimum, and any
adjustments thereto, were determined, including assessment of the
factors incorporated in paragraphs (b)(1)(iii)(A) through (B) of this
section and any materials provided to the board pursuant to paragraph
(b)(1)(iii)(A)(3) of this section, for a period of not less than five
years (the first two years in an easily accessible place) following the
determination of, and each change to, the highly liquid investment
minimum.
(c) UIT liquidity. On or before the date of initial deposit of
portfolio securities into a registered UIT, the UIT's principal
underwriter or depositor must determine that the portion of the
illiquid investments that the UIT holds or will hold at the date of
deposit that are assets is consistent with the redeemable nature of the
securities it issues, and must maintain a record of that determination
for the life of the UIT and for five years thereafter.
0
3. Section 270.30b1-10 is added to read as follows:
Sec. 270.30b1-10 Current report for open-end management investment
companies.
Every registered open-end management investment company, or series
thereof but not a fund that is regulated as a money market fund under
Sec. 270.2a-7, that experiences any event specified on Form N-LIQUID,
must file with the Commission a current report on Form N-LIQUID within
the period specified in that form.
PART 274--FORMS PRESCRIBED UNDER THE INVESTMENT COMPANY ACT OF 1940
0
4. The general authority citation for part 274 continues to read, in
part, as follows, and the sectional authorities for Sec. Sec. 274.101
and 274.130 are removed:
Authority: 15 U.S.C. 77f, 77g, 77h, 77j, 77s, 78c(b), 78l, 78m,
78n, 78o(d), 80a-8, 80a-24, 80a-26, 80a-29, and Pub. L. 111-203,
sec. 939A, 124 Stat. 1376 (2010), unless otherwise noted.
* * * * *
Sec. 274.11A [Amended]
0
5. Amend Form N-1A (referenced in Sec. 274.11A) by:
0
a. In General Instruction A. Definitions, revising the definition of
Exchange-Trade Fund;
0
b. In Item 11 removing paragraph (c)(3) and redesignating paragraphs
(c)(4), (c)(5), (c)(6) and (c)(7) as paragraphs (c)(3), (c)(4), (c)(5)
and (c)(6), respectively; and
0
c. In Item 11 adding new paragraph (c)(7) and paragraph (c)(8);
The revisions and additions read as follows:
Note: The text of Form N-1A does not, and this amendment will
not, appear in the Code of Federal Regulations.
Form N-1A
* * * * *
General Instructions
A. Definitions * * *
``Exchange-Traded Fund'' means a Fund or Class, the shares of which
are listed and traded on a national securities exchange, and that has
formed and operates under an exemptive order granted by the Commission
or in reliance on an exemptive rule adopted by the Commission.
* * * * *
[[Page 82267]]
Item 11. Shareholder Information
(a) * * *
(c) * * *
(7) The number of days following receipt of shareholder redemption
requests in which the fund typically expects to pay out redemption
proceeds to redeeming shareholders. If the number of days differs by
method of payment (e.g., check, wire, automated clearing house), then
disclose the typical number of days or estimated range of days that the
fund expects it will take to pay out redemptions proceeds for each
method used.
(8) The methods that the fund typically expects to use to meet
redemption requests, and whether those methods are used regularly, or
only in stressed market conditions (e.g., sales of portfolio assets,
holdings of cash or cash equivalents, lines of credit, interfund
lending, and/or ability to redeem in kind).
* * * * *
Sec. 274.101 [Amended]
0
6. Effective June 1, 2018, amend Form N-CEN [(referenced in Sec.
274.101), as published elsewhere in this issue by:
0
a. In Part C, adding Item C.20; and
0
b. In Part E, adding Item E.5.
The additions read as follows:
Form N-Cen
Annual Report for Registered Investment Companies
* * * * *
Part C. Additional Questions for Management Investment Companies
* * *
Item C.20. Lines of credit, interfund lending, and interfund borrowing.
For open-end management investment companies, respond to the following:
a. Does the Fund have available a line of credit? [Yes/No] If yes,
for each line of credit, provide the information requested below:
i. Is the line of credit a committed or uncommitted line of credit?
[committed/uncommitted]
ii. What size is the line of credit? [insert dollar amount]
iii. With which institution(s) is the line of credit? [list
name(s)]
iv. Is the line of credit just for the Fund, or is it shared among
multiple funds? [sole/shared]
1. If shared, list the names of other funds that may use the line
of credit. [list names and SEC File numbers]
v. Did the Fund draw on the line of credit this period? [Yes/No]
vi. If the Fund drew on the line of credit during this period, what
was the average amount outstanding when the line of credit was in use?
[insert dollar amount]
vii. If the Fund drew on the line of credit during this period,
what was the number of days that the line of credit was in use? [insert
amount]
b. Did the Fund engage in interfund lending? [Yes/No] If yes, for
each loan provide the information requested below:
i. What was the average amount of the interfund loan when the loan
was outstanding? [insert dollar amount.]
ii. What was the number of days that the interfund loan was
outstanding? [insert amount]
c. Did the Fund engage in interfund borrowing? [Yes/No] If yes, for
each loan provide the information requested below:
i. What was the average amount of the interfund loan when the loan
was outstanding? [insert dollar amount.]
ii. What was the number of days that the interfund loan was
outstanding? [insert amount]
* * * * *
Part E. Additional Questions for Exchange-Traded Funds and Exchange-
Traded Managed Funds
* * * * *
Item E.5
* * * * *
In-Kind ETF. Is the Fund an ``In-Kind Exchange-Traded Fund'' as
defined in rule 22e-4 under the Act? [Y/N]
* * * * *
Sec. 274.150 [Amended]
0
7. Amend Form N-PORT (referenced in Sec. 274.150), as published
elsewhere in this issue by:
0
a. In the General Instructions E. Definitions, adding definitions of
``Highly Liquid Investment Minimum'' and ``Illiquid Investment'' in
alphabetical order;
0
b. In the General Instructions, revising the second paragraph of F.
Public Availability;
0
c. In Part B, adding Item B.7 and Item B.8; and
0
d. In Part C, adding Item C.7.
The revisions and additions read as follows:
Form N-Port
Monthly Portfolio Investments Report
* * * * *
E. Definitions
* * * * *
``Highly Liquid Investment Minimum'' has the meaning defined in
rule 22e-4(a)(7).
``Illiquid Investment'' has the meaning defined in rule 22e-
4(a)(8).
* * * * *
F. Public Availability
* * * * *
The SEC does not intend to make public the information reported on
Form N-PORT for the first and second months of each Fund's fiscal
quarter that is identifiable to any particular Fund or adviser, or any
information reported with regards to a Fund's Highly Liquid Investment
Minimum (Item B.7 of this Form), country of risk and economic exposure
(Item C.5.b), delta (Items C.9.f.5, C.11.c.vii, or C.11.g.iv),
liquidity classification for portfolio investments (Item C.7), or
miscellaneous securities (Part D of this Form), or explanatory notes
related to any of those topics (Part E) that is identifiable to any
particular Fund or adviser. However, the SEC may use information
reported on this Form in its regulatory programs, including
examinations, investigations, and enforcement actions.
* * * * *
Part B. Information About the Fund
* * * * *
Item B.7 Highly Liquid Investment Minimum Information.
a. If applicable, provide the Fund's current Highly Liquid
Investment Minimum.
b. If applicable, provide the number of days that the Fund's
holdings in Highly Liquid Investments fell below the Fund's Highly
Liquid Investment Minimum during the reporting period.
c. Did the Fund's Highly Liquid Investment Minimum change during
the reporting period? [Y/N]
1. If yes, provide any Highly Liquid Investment Minimums set by the
fund during the reporting period.
Item B.8 Liquidity aggregate classification information. For portfolio
investments of open-end management investment companies, provide the
following information:
a. The aggregate percentage of investments that are assets
(excluding any investments that are reflected as liabilities on the
Fund's balance sheet) compared to total investments that are assets of
the Fund for each of the following categories as specified in rule 22e-
4:
1. Highly Liquid Investments
2. Moderately Liquid Investments
3. Less Liquid Investments
4. Illiquid Investments
b. Derivatives Transactions. The percentage of the Fund's highly
[[Page 82268]]
liquid investments that it has segregated to cover or pledged to
satisfy margin requirements in connection with derivatives transactions
that are classified as:
1. Moderately Liquid Investments
2. Less Liquid Investments
3. Illiquid Investments
* * * * *
Part C. Schedule of Portfolio Investments
* * * * *
Item C.7. Liquidity classification information. For portfolio
investments of open-end management investment companies, provide the
liquidity classification for each portfolio investment among the
following categories as specified in rule 22e-4:
1. Highly Liquid Investments
2. Moderately Liquid Investments
3. Less Liquid Investments
4. Illiquid Investments
* * * * *
0
8. Section 274.223 is added to subpart C to read as follows:
Sec. 274.223 Form N-LIQUID, Current report, open-end investment
company liquidity.
This form shall be used by registered open-end management
investment companies, or series thereof, but not including a company or
series thereof that is regulated as a money market fund under Sec.
270.2a-7 of this chapter, to file reports pursuant to Sec. 270.30b1-10
of this chapter.
Note: The text of Form N-LIQUID will not appear in the Code of
Federal Regulations.
United States Securities and Exchange Commission
Washington, DC 20549
Form N-LIQUID
Current Report
Open-End Management Investment Company Liquidity
Form N-LIQUID is to be used by a registered open-end management
investment company, or series thereof (``fund''), under the Investment
Company Act of 1940 [15 U.S.C. 80a] (``Act'') but not including a fund
that is regulated as a money market fund under rule 2a-7 under the Act
(17 CFR 270.2A-7), to file current reports with the Commission pursuant
to [rule 30b1-10] under the Act [(17 CFR 270.30b1-10)]. The Commission
may use the information provided on Form N-LIQUID in its regulatory,
disclosure review, inspection, and policymaking roles.
General Instructions
A. Rules as to Use of Form N-LIQUID
(1) Form N-LIQUID is the reporting form that is to be used for
current reports of open-end management investment companies
(``registrants'') required by section 30(b) of the Act and rule 30b1-10
under the Act. The Commission does not intend to make public
information reported on Form N-LIQUID that is identifiable to any
particular registrant, although the Commission may use Form N-LIQUID
information in an enforcement action.
(2) Unless otherwise specified, a report on this Form N-LIQUID is
required to be filed, as applicable, within one business day of the
occurrence of the event specified in Parts B-D of this form. If the
event occurs on a Saturday, Sunday, or holiday on which the Commission
is not open for business, then the one business day period shall begin
to run on, and include, the first business day thereafter.
B. Application of General Rules and Regulations
The General Rules and Regulations under the Act contain certain
general requirements that are applicable to reporting on any form under
the Act. These general requirements should be carefully read and
observed in the preparation and filing of reports on this form, except
that any provision in the form or in these instructions shall be
controlling.
C. Information To Be Included in Report Filed on Form N-LIQUID
Upon the occurrence of the event specified in Parts B-D of Form N-
LIQUID, a registrant must file a report on Form N-LIQUID that includes
information in response to each of the items in Part A of the form, as
well as each of the items in the applicable Parts B-D of the Form.
D. Filing of Form N-LIQUID
A fund must file Form N-LIQUID in accordance with rule 232.13 of
Regulation S-T (17 CFR part 232). Form N-LIQUID must be filed
electronically using the Commission's Electronic Data Gathering,
Analysis and Retrieval System (``EDGAR'').
E. Paperwork Reduction Act Information
A registrant is not required to respond to the collection of
information contained in Form N-LIQUID unless the form displays a
currently valid Office of Management and Budget (``OMB'') control
number. Please direct comments concerning the accuracy of the
information collection burden estimate and any suggestions for reducing
the burden to the Secretary, Securities and Exchange Commission, 100 F
Street, NE., Washington, DC 20549-1090. The OMB has reviewed this
collection of information under the clearance requirements of 44 U.S.C.
3507.
F. Definitions
References to sections and rules in this Form N-LIQUID are to the
Investment Company Act (15 U.S.C. 80a), unless otherwise indicated.
Terms used in this Form N-LIQUID have the same meaning as in the
Investment Company Act or rule 22e-4 under the Investment Company Act,
unless otherwise indicated. In addition, as used in this Form N-LIQUID,
the term registrant means the registrant or a separate series of the
registrant.
United States Securities and Exchange Commission
Washington, DC 20549
Form N-LIQUID
Current Report
Open-End Management Investment Company Liquidity
Part A. General Information
Item A.1. Report for [mm/dd/yyyy].
Item A.2. CIK Number of registrant.
Item A.3. EDGAR Series Identifier.
Item A.4. Securities Act File Number.
Item A.5. Provide the name, email address, and telephone number of the
person authorized to receive information and respond to questions about
this Form N-LIQUID.
Part B. Above 15% Illiquid Investments
If more than 15 percent of the registrant's net assets are, or
become, illiquid investments that are assets as defined in rule 22e-4,
then report the following information:
Item B.1. Date(s) on which the registrant's illiquid investments that
are assets exceeded 15 percent of its net assets.
Item B.2. The current percentage of the registrant's net assets that
are illiquid investments that are assets.
Item B.3. Identification of Illiquid investments. For each investment
that is an asset that is held by the registrant that is considered
illiquid, disclose (1) the name of the issuer, the title of the issue
or description of the investment, the CUSIP (if any), and at least one
other identifier, if available (e.g., ISIN, Ticker, or other unique
identifier (if ticker and ISIN are not
[[Page 82269]]
available)) (indicate the type of identifier used), and (2) the
percentage of the fund's net assets attributable to that investment.
Part C. At or Below 15% Illiquid Investments
If a registrant that has filed part B of Form N-LIQUID determines
that its holdings in illiquid investments that are assets have changed
to be less than or equal to 15 percent of the registrant's net assets,
then report the following information:
Item C.1. Date(s) on which the registrant's illiquid investments that
are assets fell to or below 15 percent of net assets.
Item C.2. The current percentage of the registrant's net assets that
are illiquid investments that are assets.
Part D. Assets That Are Highly Liquid Investments Below the Highly
Liquid Investment Minimum
If a registrant's holdings in assets that are highly liquid
investments fall below its highly liquid investment minimum for more
than 7 consecutive calendar days, then report the following
information:
Item D.1. Date(s) on which the registrant's holdings of assets that are
highly liquid investments fell below the fund's highly liquid
investment minimum.
Signatures
Pursuant to the requirements of the Investment Company Act of 1940,
the registrant has duly caused this report to be signed on its behalf
by the undersigned hereunto duly authorized.
-----------------------------------------------------------------------
(Registrant)
Date-------------------------------------------------------------------
-----------------------------------------------------------------------
(Signature)*
* Print name and title of the signing officer under his/her
signature.
By the Commission.
Dated: October 13, 2016.
Brent J. Fields,
Secretary.
[FR Doc. 2016-25348 Filed 11-17-16; 8:45 am]
BILLING CODE 8011-01-P