SEC Commissioners issued recommendations on the agency's "re-proposal" to update the regulation on the use of derivatives by SEC-registered investment companies and business development companies ("registered funds") (see here and here).

As previously covered, proposed Rule 18f-4 under the Investment Company Act of 1940 provides a conditional exemption from Section 18 under the ICA for registered funds when entering into derivatives transactions.

In addition, the proposal creates Rule 15l-2 under the Securities Exchange Act and Rule 211(h)-1 under the Investment Advisers Act in order to address sales practices with respect to leveraged or inverse funds and exchange-listed commodity or currency pools (a/k/a "leveraged investment vehicles"). The proposed rules would require broker-dealers and investment advisers to comply with "due diligence and approval" requirements prior to approving orders to buy and sell shares of leveraged investment vehicles, and include a determination as to whether there is a "reasonable basis" to believe that a retail customer or client can assess the risks associated with these products. The proposal would also amend ICA Rule 6c-11 to permit certain leveraged or inverse exchange-traded funds ("ETFs") to operate without receiving exemptive orders.

"Modernization" of Regulatory Framework

SEC Commissioners Hester M. Peirce and Elad L. Roismancommended the Division of Investment Management for providing an updated framework concerning funds' use of derivatives and "welcome[d]" the departure from the current regime and its "outdated patchwork" of requirements and exemptions. Commissioners Robert J. Jackson Jr. and Allison Herren Lee also expressed approval of "establishing a systematic approach" to limiting fund risk-taking.

Ms. Peirce and Mr. Roisman added that the "re-proposal" has been revised to address criticism by commenters on the 2015 proposal (see previous coverage) for limiting funds' ability use derivatives for non-speculative purposes. Proposed Rule 18f-4 is intended to allow funds somewhat greater freedom.

Leveraged and Inverse ETFs

Ms. Peirce and Mr. Roisman cautioned that the proposed Rule's alternative conditions for leveraged and inverse (a/k/a "geared") ETFs may not be "the best way" to address risks associated with those products.

Specifically, Ms. Peirce and Mr. Roisman raised several concerns with the proposed alternative approach, arguing that:

  • restricting investors' ability to use geared products is a "blunt, over-paternalistic approach" to implementing investor protection;
  • the requirement that broker-dealers and investment advisers have investors complete questionnaires before buying geared ETFs lacks a "rationale," since Regulation Best Interest already will require broker-dealers to advise customers according to what is in their best interests;
  • applying the proposed sales rules when an investor buys geared ETFs without the input of a financial advisor places a barrier between the investor and financial product; and
  • despite the "enumerated" questions required to determine whether an investor can transact in geared ETFs, the proposal does not tell the broker-dealer how to assess the investor's answer to the questions.

Ms. Peirce and Mr. Roisman supported the Division of Investment Management's recommendation to allow ETF sponsors to "rely" on Rule 6c-11 in order to establish new leveraged and inverse ETFs.

Investor Protections

Mr. Jackson and Ms. Lee called on commenters to provide feedback on ways to strengthen the investors protections included in the proposal.

According to Mr. Jackson and Ms. Lee, the proposal should address three critical areas. Specifically, they called for feedback on:

  • if the proposed "best interest" requirements for brokers selling leveraged and inverse ETFs will sufficiently "protect ordinary investors" from the associated risks;
  • whether requiring a fund board to approve the hire of a risk manager to oversee its use of derivatives – without requiring the board to approve the fund’s derivatives risk management program – is adequate; and
  • the reliability of using VaR ("value at risk") to assess the degree of financial risk in a fund over a specified period of time.


Interesting that Ms. Peirce and Mr. Roisman - who conceded to the adoption of Regulation Best Interest (perhaps as an attempt at compromise) - now object to the addition of further rules that are effectively supplementary to Regulation Best Interest. Having crossed the line in redefining the role of the SEC from a disclosure regulator to a suitability regulator, Ms. Peirce and Mr. Roisman may find it difficult to justify any particular stopping point in a broker-dealer's suitability obligations. If that direction is to be reversed, the regulators (or perhaps Congress) must state in some fashion that investors must accept some level of responsibility (but which investors and how much responsibility and how is such acceptance to be manifest?).

Reality is, the current logic of regulation dictates that small investors will have to take any advice or direction from a robe-adviser, and these investors will be generally directed into lower-risk, lower-reward, plain-vanilla products. This is not necessarily a bad thing; we should just acknowledge that is the way the rules are driving the market. On the other hand, regulators should not complain that retail investors are denied opportunities to invest in small startups; such investments are inherently risky, and firms that put their clients into them will share more of the downside risk through the possibility of litigation or enforcement action. In this respect the comments of Commissioners Jackson and Lee are telling; ultimately, their message is that any broker that puts an "ordinary investor" in a risky product is at legal risk.