On November 25, 2019, the U.S. Securities and Exchange Commission (the SEC) issued a release (the Proposing Release)

  • reproposing new Rule 18f-4 (the Proposed Rule) under the Investment Company Act of 1940, as amended (the Act), intended to address the investor protection purposes and concerns underlying Section 18 of the Act with regard to the incurrence of leverage or other obligations arising from the use of derivatives by mutual funds (excluding money market funds), exchange traded funds (ETFs), registered closed-end funds and companies electing to be treated as business development companies (BDCs) under the Act (collectively, Funds)
  • proposing new Rule 15l-2 under the Securities Exchange Act of 1934, as amended (the Exchange Act), and new Rule 211(h)-1 under the Investment Advisers Act of 1940, as amended (the Advisers Act) (collectively, the sales practices rules), that would require a broker, dealer or investment adviser that is registered (or required to be registered) with the SEC to exercise due diligence in approving a retail customer’s or client’s account to buy or sell shares of certain “leveraged/inverse investment vehicles” (described below)
  • proposing amendments to Forms N-PORT, N-LIQUID (proposed to be renamed Form N-RN) and N-CEN, intended to provide the SEC with information regarding Funds’ derivatives exposure, and for Funds subject to the limit on fund leverage risk, certain additional information, including value at risk (VaR)-related information

The SEC first proposed Rule 18f-4 in December 2015 (the 2015 Proposal). Under the 2015 Proposal, a Fund would have been prohibited from investing in a derivatives transaction unless the Fund (i) complied with one of two alternative portfolio limitations, (ii) maintained certain qualifying assets and segregated those assets on its books and records and (iii) depending on the extent to which the Fund used derivatives, adopted a written derivatives risk management program including certain specified elements.

Reproposed Rule 18f-4 Under the Act

Unlike the 2015 Proposal, the Proposed Rule does not propose specific asset segregation requirements but does propose certain other new requirements, including that, generally, Funds establish risk management programs and comply with certain proposed VaR-based limitations on Fund leverage risk, discussed further below. As discussed below, there are exceptions for limited derivatives users that meet certain requirements. Like the 2015 Proposal, the Proposing Release contemplates that the Proposed Rule would supersede and rescind the confusing and at times inconsistent prior guidance under Investment Company Act Release No. 10666 (discussed below) and certain related no-action letters and other SEC guidance. The Proposing Release includes a list of no-action letters anticipated to be rescinded (in whole or in part) in connection with the final rule, but additional no-action letters and other staff guidance also may be withdrawn (in whole or in part).

Limitations on Derivatives Transactions

The Proposed Rule defines derivatives transactions broadly to include (1) any swap, security-based swap, futures contract, forward contract, option, any combination of the foregoing or any similar instrument under which a Fund is, or may be, required to make a payment or delivery of cash or other assets during the life of the instrument, at maturity or upon its early termination, whether as margin, settlement payment or otherwise and (2) any short sale borrowing.

Under the Proposed Rule, a Fund may invest in a derivatives transaction, notwithstanding the restrictions regarding issuing senior securities set forth in Section 18 of the Act, only if the Fund satisfies the following conditions:

  • Board oversight and reporting. The designation of a derivatives risk manager responsible for administering a Fund’s derivatives risk management program must be approved by the Fund’s board of directors. It is proposed that the derivatives risk manager have a direct reporting line to the Fund’s board and report to the board regarding the implementation and effectiveness of the Fund’s derivatives risk management program as well as the results of the Fund’s stress testing and backtesting.
  •  Derivatives risk management program. A Fund that engages in derivatives transactions (including short sale borrowings) would generally be required to adopt and implement a written derivatives risk management program that includes policies and procedures reasonably designed to manage the Fund’s derivatives risk and to reasonably segregate the functions associated with the derivatives risk management program from the Fund’s portfolio management. The program must provide for
    • identification and assessment of the Fund’s derivatives risks, defined to include leverage, market, counterparty, liquidity, operational and legal risks and any other risks the derivatives risk manager (or in the case of a Fund that is a limited derivatives user (as defined in the Proposed Rule, a Limited Derivatives User), the Fund’s investment adviser), deems material, taking into account the Fund’s derivatives transactions and other investments
    • risk guidelines establishing quantitative or otherwise measurable criteria, metrics or thresholds of the Fund’s derivatives risks; the guidelines are required to specify levels of the given criterion, metric or threshold that the Fund does not normally anticipate to exceed, and the measures to be taken if they are exceeded
    • stress testing of the Fund’s portfolio at least weekly (or more frequently if necessitated by the Fund’s strategy or investments or current market conditions) to evaluate the Fund’s potential portfolio losses in response to extreme but plausible market changes or changes in market risk factors that would have a significant adverse effect on the Fund’s portfolio
    • internal reporting and escalation of material risks to the Fund’s portfolio management function and board of directors, as appropriate
    • backtesting the results of the required VaR calculation model (described below) used by the Fund for the relative VaR test or the absolute VaR test for that day, estimated over a one-trading-day time horizon, and identifying as an exception any instance in which the Fund experiences a loss exceeding the corresponding VaR calculation’s estimated loss
    • periodic reviews (on or before the implementation of the program, and at least annually thereafter, the frequency to be determined by the Fund’s board) of the program’s effectiveness, and updates to the program to reflect changes in risks over time
    • at or prior to implementation of the risk management program, and at least annually thereafter, a written report from the derivatives risk manager to the Fund’s board, representing that the program is reasonably designed to manage the Fund’s derivatives risks, which must be based on the derivatives risk manager’s reasonable belief after due inquiry. The written report must include the basis for the representation along with other information reasonably necessary to evaluate the adequacy of the Fund’s program. Reports following the implementation of the program must address the effectiveness of its implementation. The written reports must also include the derivatives risk manager’s basis for the selection of the designated reference index or, if applicable, an explanation of why the derivatives risk manager was unable to identify an appropriate designated reference index for the Fund
    • regular reports to the Fund’s board of directors at a frequency determined by the board regarding the derivatives risk manager’s analysis of any exceedances as well as the results of any stress testing and backtesting of the Fund’s guidelines
    • written records documenting the results of any stress testing, backtesting, internal reporting or escalation of material risks under the program, and any periodic reviews of the program
  • Limitation on fund leverage risk. The Proposed Rule would generally require that a Fund engaging in derivatives transactions (other than a Fund that qualifies as a Limited Derivatives User) comply with an outer limit on fund leverage risk based on VaR. The outer limit would be based on a relative VaR test comparing the Fund’s VaR to the VaR of an unleveraged “designated reference index” for the particular Fund that reflects the markets or the asset classes in which the Fund invests, in addition to other requirements. A Fund would satisfy the proposed relative VaR test if the VaR of its entire portfolio does not exceed 150% of the VaR of its designated reference index. If a Fund’s derivatives risk manager is unable to identify an appropriate designated reference index, the Fund must comply with an absolute VaR test whereby the VaR of the Fund’s portfolio must not exceed 15% of the value of the Fund’s net assets. 

Exceptions for Limited Derivatives Users

Under the Proposed Rule, if a Fund is a Limited Derivatives User, the Fund would be exempt from the requirements to adopt a derivatives risk management program and impose a VaR-based limit on Fund leverage risk. Under the Proposed Rule, a Limited Derivatives User is a Fund that either (i) limits its derivatives exposure to 10% of its net assets or (ii) limits its use of derivatives transactions solely to hedging certain currency risks and, in either case, that adopts and implements policies and procedures reasonably designed to manage the Fund’s derivatives risks.

Leveraged/Inverse Funds — Alternative Provisions

Leveraged/inverse vehicles are registered investment companies (or any separate series thereof) or certain exchange-listed commodity- or currency-based trusts or Funds that seek, directly or indirectly, to provide investment returns that correspond to the performance of a market index by a specified multiple, or to provide investment returns that have an inverse relationship to the performance of a market index, over a predetermined period of time. They are structured as ETFs and rely on SEC exemptive relief to operate; however, the SEC last granted such relief in 2009.

Under the Proposed Rule, a Fund need not comply with the proposed VaR-based leverage test if it (i) meets the definition of a “leveraged/inverse investment vehicle” under the proposed sales practice rules, including disclosing in its prospectus that it is not subject to the condition of the Proposed Rule limiting fund leverage risk and (ii) does not seek to obtain, directly or indirectly, investment results exceeding 300% of the return (or inverse of the return) of an underlying index. The prospectus disclosure requirement is intended to provide both investors and the market with the information that these Funds are not subject to the Proposed Rule’s leverage risk limitation.

The Proposed Rule would except leveraged/inverse Funds from the limit on fund leverage risk if the Fund complies with the sales practice rules requiring that broker-dealers and investment advisers exercise due diligence on retail investors prior to approving such investors’ accounts to invest in these Funds.

Recordkeeping Requirements

The Proposed Rule would require that a Fund comply with certain recordkeeping requirements intended to allow the SEC staff and the Fund’s board of directors and compliance personnel the ability to evaluate Fund compliance with the Proposed Rule requirements. Records required to be maintained include the Fund’s written policies and procedures, stress testing and back testing results, records documenting internal reporting or escalation of material risks, records documenting the reviews of backtesting the results of the VaR calculation model used by the Fund for its VaR test and records documenting the periodic reviews of the derivatives risk management program.

Reverse Repurchase Agreements and Unfunded Commitment Agreements

The Proposed Rule does not classify reverse repurchase agreements and unfunded commitment agreements as a “derivatives instrument” but notes that they still implicate Section 18 of the Act. The Proposed Rule would permit Funds to enter into reverse repurchase agreements and similar financing transactions if they meet the asset coverage requirements of Section 18 of the Act. It also permits the Fund to enter into unfunded commitment agreements to make certain loans subject to conditions tailored to these transactions. Under the Proposed Rule, a Fund would be able to enter into unfunded commitment agreements if the Fund reasonably believes that it will have sufficient cash and cash equivalents to meet its obligations under those agreements as they come due.

Anticipated Rescission of Prior SEC Guidance

The SEC has proposed to rescind Investment Company Act Release No. 10666, which provides guidance on the use of certain derivative and similar transactions. In addition, the SEC has indicated that it will review no-action letters and other guidance regarding the use of derivatives by Funds and may withdraw certain such letters and SEC staff guidance.

Additional Proposals

  •  Proposed amendments to Rule 6c-11 under the 1940 Act would permit leveraged/inverse ETFs that satisfy certain conditions to rely on Rule 6c-11 to operate without obtaining an exemptive order — avoiding the expense and delay of the application process. The SEC is proposing to rescind the exemptive orders previously issued to sponsors of leveraged/inverse ETFs.
  • Proposed new Rule 15l-2 under the Exchange Act and proposed new Rule 211(h)-1 under the Advisers Act are intended to address investor protection concerns implicated by leveraged/inverse funds by requiring broker-dealers and investment advisers that are registered (or required to be registered) with the SEC to exercise due diligence of retail investors prior to approving retail investor accounts to invest in such leveraged/inverse funds. It is contemplated that the sales practices rules would not apply to a position in a leveraged/inverse investment vehicle that was established prior to the rules’ compliance date but would apply if the retail client or retail account is increasing an existing position or establishing a new position in a leveraged/inverse investment vehicle.

Proposed amendments to Forms N-PORT, N-LIQUID and N-CEN

  • Form N-PORT is proposed to be amended to require Funds to provide information about their derivatives exposure, and if the Fund is subject to the limit on fund leverage risk under the Proposed Rule, the Fund would also be required to report VaR-related information.
  • Form N-LIQUID is proposed to be retitled Form N-RN and to be amended to add new current reporting requirements for Funds subject to the proposed VaR-based limit on fund leverage risk under the Proposed Rule. The amendments would require that a Fund that has determined it is not in compliance with the applicable VaR test, and does not come into compliance within three business days after such determination, file a nonpublic report on Form N-RN that provides certain information regarding the Fund’s VaR test breaches. Funds subject to the VaR test would be subject to the Form N-RN requirements even if they are not currently required to file Form N-LIQUID. A Fund would be required to provide certain information regarding (1) the Fund’s exposure to derivatives; (2) the Fund’s VaR and, if applicable, the Fund’s designated reference index, and the Fund’s backtesting results; (3) certain breaches, which would be required to be reported to the SEC in a nonpublic current report; and (4) certain identifying information about the Fund, such as whether the Fund is a Limited Derivatives User or a “leveraged/inverse fund.”
  • Form N-CEN is proposed to be modified to require a Fund to specify whether it relied on the Proposed Rule during the relevant reporting period and whether it relied on any exceptions from requirements of the Proposed Rule. In particular, the Proposed Rule would require the Fund to indicate whether it is a Limited Derivatives User and, if so, the particular exception relied on, or whether the Fund is a leveraged/inverse Fund excepted under the Proposed Rule from the limit on fund leverage risk. A Fund would also be required to identify whether it entered into reverse repurchase agreements or similar financing transactions, or unfunded commitment agreements.

Comment Period

Comments should be submitted on or before 60 days after publication in the Federal Register. The SEC has requested comments on 255 specific items, including

  • whether money market funds should be included in the defined term Funds, and why or why not
  • whether the definition of “derivatives transaction” is sufficiently clear
  • whether the proposed risk manager requirement raises any particular issues for Funds with smaller investment advisers, and, if so, how to mitigate the challenges (e.g., authorizing the use of third parties not employed by the adviser to administer the program)
  • whether a Fund should publicly disclose (in its prospectus, website, Form N-PORT or Form N-CEN) the guidelines it uses and the quantitative levels selected) or whether this information should be reported to the SEC confidentially

Proposed Transition Periods

The SEC has proposed a one-year transition period (from the publication of any final rule in the Federal Register) to allow Funds time to come into compliance with the Proposed Rule in its final form. A one-year transition period for the sales practices rules is also proposed to allow broker-dealers and investment advisers time to bring their operations into compliance with the new rules. The SEC has also proposed a one-year delay for the effective date of the proposed amendments to Rule 6c-11. In connection with the adoption of the Proposed Rule, the SEC has proposed withdrawing certain no-action letters (including, but not limited to, those listed in the Proposing Release) and other SEC staff guidance that would be superseded by or be inconsistent with the final rule. Finally, a one-year transition period is proposed prior to the withdrawal of Release 10666.