At an open meeting on December 11, 2015, the Securities and Exchange Commission (“SEC”) proposed a new “exemptive” rule, Rule 18f-4, which addresses investment company use of derivatives and other leveraging arrangements. It would require most funds that use derivatives to implement a derivative risk management program (including appointing a derivatives management officer). The proposed rule applies to mutual funds, ETFs, closed-end funds and BDCs.\

The rule is intended to modernize and harmonize funds’ treatment of derivatives under Section 18 of the Investment Company Act of 1940, as amended (the “1940 Act”), by updating and modifying previous guidance issued in 1979 in Investment Company Act Release 10666 and more than 30 no-action letters in which SEC staff permitted fund practices involving specific types of derivatives.1

According to the SEC, Section 18, which restricts funds’ capital structures, was designed to address abuses that existed before the enactment of the 1940 Act: excessive borrowing and levered securities issuances. The SEC views a fund’s obligation to pay money or deliver assets to a counterparty as implicating Section 18. Proposed Rule 18f-4 would clarify that the limitations of Section 18 apply to most derivatives (forwards, futures, swaps and written options) and financial commitments (reverse repurchase agreements, short sale borrowings, firm or standby commitments, and other similar agreements) and would provide that funds could enter into derivative transactions only if their portfolios satisfy certain conditions, including a portfolio-level limit on derivative investments and asset segregation requirements developed from the Release 10666 model.

Asset Segregation

Following the model described in Release 10666, most funds that use derivatives or financial commitment transactions in their portfolios would be required to abide by asset segregation requirements. A fund that uses derivatives would have to segregate by maintaining “qualifying coverage assets” (identified on the books and records of the fund at least once daily) in an amount equal to the sum of:

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The sum of these two amounts would reflect the overall exposure of the fund to the ongoing risk incurred in holding a particular derivative investment. It covers both the “mark-to-market” exposure, as well as potential future losses. The Market Coverage Amount would be reduced by the value of assets posted as variation margin (but not initial margin or the “independent amount”) or collateral with respect to a transaction, because the variation margin or collateral is a security for the mark-to-market exposure of a particular transaction. The Risk-Based Coverage Amount would be reduced by the value of assets representing initial margin or the “independent amount” because those amounts are posted to cover potential future amounts payable in a specific transaction. Thus, a fund using derivatives would receive “credit” for security posted in relation to the transaction when calculating the amount of coverage needed.

Unlike under existing practice, segregation requirements for derivative transactions would have to be satisfied exclusively in cash and cash equivalents, or, if the fund can satisfy its obligation by delivering a specific asset, the specific asset. Currently, many funds use “any liquid asset” to meet segregation requirements.

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If the fund enters into “financial commitment transactions,” it would be required to segregate assets that equal the full amount of cash or other assets that the fund is conditionally or unconditionally obligated to pay or deliver. Generally, “financial commitment transactions” include reverse repurchase agreements, short sale borrowings, firm or standby commitment agreements and comparable agreements, and can include uncalled capital commitments to private funds. For financial commitment transactions, a fund could meet the segregation requirement by identifying cash or cash equivalents, specific assets, or assets that are convertible to cash or will generate cash equal to the amount of the financial commitment obligation before the date on which the fund would be expected to pay.

A fund’s board of directors, including a majority of the independent directors, would be required to approve a fund’s policies and procedures for asset segregation.

Overall Limit — Two Alternatives

Funds would have to limit overall exposure to derivatives and other senior securities, tested immediately after their acquisition, by applying one of two alternative limitations.

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A fund’s particular limit would have to be approved by its board of directors, including a majority of its independent directors. This requirement suggests that in order to adopt the risk-based model, a board would have to gain a basic understanding of value-at-risk and the specific models used by the adviser to evaluate value-at-risk.

Derivatives Risk Management Program

Funds that have portfolio-level derivatives with notional exposure of more than 50 percent of their assets, or funds using any complex derivatives, would be required to implement a Derivatives Risk Management Program (DRMP) designed to identify and assess the risks associated with the fund’s derivative transactions, and manage and monitor these risks. The DRMP would need to address the potential risks posed by the investments, and monitor derivatives investing activity to ensure that it is consistent with a fund’s investment guidelines, relevant portfolio limitations and relevant disclosure to investors. The DRMP would be composed of policies and procedures including models (such as VaR calculation models), as well as other measurement tools that address potential leverage, market, counterparty, liquidity and operational risks. The DRMP would be reviewed periodically and updated at least annually to reflect changes in risk over time, and changes in policies, measurement tools or models. A fund would also need to segregate personnel involved in derivative risk management from personnel involved in portfolio management and appoint a derivatives risk manager. The proposal does not discuss whether the risk manager function can be outsourced in the same way that some funds use chief compliance officers who are employed by separate compliance organizations.

The fund’s board of directors, including a majority of the fund’s independent directors, would have to review and approve the DRMP and any material changes to the DRMP, and the appointment of the risk manager. The fund’s board would also have to receive regular reports from the risk manager, at least quarterly, and review the adequacy and efficacy of the program. In the adopting release, the SEC specifically suggested that boards should consider the adequacy of a fund’s DRMP in light of past experience (of the fund and markets in general) and recent compliance experience.

Reporting Changes

The Commission is also proposing amendments to its recently proposed reporting forms, Form N-PORT and Form N-CEN. As we have previously reported to you, these new forms, proposed in May 2015, are part of the Commission’s effort to modernize investment company regulation and reporting.

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The comment period for the proposed rule is 90 days from publication in the Federal Register.