Statement on the Re-Proposal to Regulate Funds' Use of Derivatives as Well as Certain Sales Practices
Nov. 26, 2019
We thank the staff of the Division of Investment Management (the “Division”) for undertaking the challenging task of devising and presenting for Commission vote a proposal to modernize the way we regulate the use of derivatives in investment funds’ portfolios. Derivatives are essential financial tools in today’s markets. They enable portfolio managers of registered investment companies and business development companies (“funds”) to manage and hedge risk, enhance portfolio liquidity, efficiently gain or reduce exposure to certain asset classes, reduce transaction costs, reduce volatility, increase yield, and otherwise assist in portfolio management. If funds were prohibited from using derivatives, investors would incur higher costs and greater risks for the same market exposure.
We approach this rulemaking with an appreciation of the important role that derivatives play in enabling the asset management industry to serve investors. We also recognize the need for careful risk management by funds that use products such as equity options, credit default swaps, and index futures, which can be complex on their own and especially in combination with one another. With these particular thoughts in mind, we welcome commenters’ views on whether this proposal achieves an appropriate balance.
I. A Much Needed Modernization
Proposed Investment Company Act Rule 18f-4 offers a comprehensive updated framework to regulate funds’ use of derivatives. We welcome the departure from the current regime, which can only be described as an outdated patchwork of requirements and exemptions, most of which reflect interpretive positions of the SEC staff, not the Commission.
This proposal is not the Commission’s first attempt at modernizing the regulatory framework in this area. In December 2015, the Commission proposed a rule that took a more prescriptive approach to limiting funds’ use of derivatives. Comments on that proposal were extensive and largely critical. Commenters noted that its requirements would limit the ability of funds to use derivatives for non-speculative purposes, such as mitigating risk or obtaining cost-effective exposure to particular asset classes, which can provide great benefits to investors. The staff carefully studied and considered this and other feedback from commenters. Today’s proposal benefits from that review and allows funds more flexibility to use derivatives for non-speculative purposes. As evidenced by the release’s many questions, the proposal may need further refinement to ensure, among other things, that it is not overly prescriptive or expansive.
We welcome commenters’ feedback on whether today’s proposal has achieved our regulatory purposes without placing undue limits on funds’ ability to use derivatives to achieve investors’ objectives.
II. Changing Gears: Leveraged and Inverse Exchange-Traded Funds (“ETFs”)
As part of its recommendation, the Division has put forth an alternative to our historical approach to regulating leveraged and inverse, or “geared,” ETFs. Leveraged ETFs seek to provide returns that exceed the performance of a market index by a specified multiple over a period of time. Inverse ETFs seek to provide returns that have an inverse relationship to, or that are an inverse multiple of, the performance of a market index over a fixed period of time. To achieve their targeted returns, geared ETFs use derivatives extensively. Generally, the ability of these geared ETFs to maintain their targeted returns degrades over time, which is why disclosures for these products generally make clear that they are short-term trading vehicles. In addition, and in contrast to many other funds that use derivatives as part of a broader investment strategy, geared strategies (and their use of derivatives) are predicated on leverage. They are designed to serve particular niches in a portfolio, often explicitly speculative; they are developed with short-term traders, rather than buy-and-hold investors, in mind.
Because the general requirements of the proposal would severely restrict the availability of geared ETFs, the proposal includes a set of alternative conditions for these products, including a limit on leverage and new sales practice rules. It is not clear to us that the proposed conditions are the best way to address any potential concerns these products raise.
A. Market Regulation or Merit Regulation?
The first of these conditions, a hard limit on geared products’ use of leverage at three times the specified market index, is a direct mechanism to restrict investors’ access to geared products that might otherwise seek to exceed this limit. If such a cap is motivated by a desire to protect investors—a critical piece of the agency’s mission—we disagree with this blunt, overly-paternalistic approach to investor protection. The SEC protects investors not by limiting their right to access products available in public markets, but by ensuring that they have material information at the ready to make informed buy, sell, and hold decisions. Thus, wouldn’t good disclosure about the leverage in these products obviate the need for this type of cap?
If, on the other hand, this proposed limitation is intended to maintain fair, orderly, and efficient markets—another critical aspect of the agency’s mission—we support putting it out for comment. The Commission is charged with considering the effects a given product may have on how our markets operate, and the staff has raised concerns about how such highly leveraged products may affect rebalancing activity. We hope to hear feedback from commenters about whether these concerns are warranted in light of the number, size, and nature of these funds. Additional data would be helpful to augment the analysis provided in the proposal by our economists in the Division of Economic and Risk Analysis.
B. Reasonableness and Randomness
We have concerns regarding the proposal’s new sales practice rules, mandating that all broker-dealers and investment advisers require investors seeking to buy or sell geared ETFs to fill out questionnaires that contain a specified list of questions. This requirement would apply regardless of whether an investor is trading such products on her or his own initiative, or in response to a broker’s recommendation or an adviser’s advice. Under the proposal, even an investment adviser who has discretion over a client’s account could not use these products until the adviser is sure the client has the ability to understand them on her or his own.
We struggle with the rationale for adding such a prescriptive requirement into our regulatory regimes that govern broker-dealers and investment advisers—regimes we comprehensively updated and clarified, after years of deliberation, only a handful of months ago. Regulation Best Interest will require broker-dealers to make recommendations that are in the best interest of a customer, “based on [the customer’s] investment profile and the potential risks, rewards, and costs associated with the recommendation.” Similarly, we recently stated that an investment adviser must base its advice to a client on a reasonable understanding of the client’s objectives, requiring the adviser to make “a reasonable inquiry into the client’s financial situation, level of financial sophistication, investment experience, and financial goals.” Each of these Commission actions was principles-based, allowing broker-dealers and advisers flexibility in gathering the information they need from customers or clients to carry out their responsibilities. In contrast, the Commission now proposes a requirement that would micromanage broker-dealers and advisers, and do so in a way that appears neither necessary nor sufficient for them to meet their existing regulatory obligations.
This new sales practice requirement would also apply in situations where investors attempt to trade geared products on their own, without the input of a financial professional. Apart from a similar FINRA requirement with respect to options trading, we can think of little precedent for placing such a barrier between an investor and a financial product. The most ready analogy would be our accredited investor standard, the product of a rule that is on the Commission’s agenda to be reconsidered in the near term. The accredited investor standard is a set of criteria which an investor must meet to have the chance to buy certain securities offered in private markets, where investors may not have the benefit of particular disclosures required by the federal securities laws and SEC rules. To our knowledge, the Commission has not established a similar hurdle for investors attempting to buy or sell securities available in our public markets. Why would we introduce such a thing now, with respect to such a narrow subset of products?
Even if the proposed sales practice requirement were appropriate, the proposal’s enumerated questions for determining whether an investor makes the cut to transact in geared products may not be. A few questions aim to gauge the investor’s ability to understand complex financial products (albeit mostly through the investor’s self-identification). Others aim to obtain information about the investor’s income and wealth. The release does not specify how we expect brokerage or advisory firms to assess investors’ answers to these questions. Yet, the proposed rules would direct them to make a “reasonable” determination as to whether the investor is suited for trading geared products. By providing so little information about the result we are aiming to achieve, we worry that such a requirement will either become a meaningless check-the-box exercise or a regulatory deterrent for brokers and advisers to offer these ETFs on their menus at all.
Nevertheless, we understand that these sales practice recommendations are part of a proposal. We hope that commenters will provide us with feedback on whether this proposed course is in fact the optimal approach and alert us to any unintended consequences of the new requirements. For example, would this additional information be helpful or necessary when registered representatives of broker-dealers make a recommendation to satisfy requirements under Regulation Best Interest? Do financial professionals need us to specify the exact questions they should ask in order to understand their customers’ or clients’ best interests? How about when broker-dealers make a general suitability determination under FINRA rules when considering products to make available for self-directed accounts? More broadly, is making access to an asset class a matter of privilege an appropriate approach to investor protection? Shouldn’t the presumption of our rules instead be that investors have a right to access the full range of asset classes available in our public markets?
We welcome the Division’s recommendation to allow ETF sponsors to rely on Rule 6c-11 in devising new leveraged and inverse ETFs, rather than having to queue for exemptive relief, as they currently have to do. Waiting in those queues carries with it an air of hopelessness in light of the Commission’s current moratorium on consideration of such applications. The proposed change would create a playing field that is uniform and fair. We also believe the enhancement in competition that likely would result from such a development could improve product offerings for investors.
Again, our sincere thanks go to the agency’s staff who worked so diligently to devise this comprehensive recommendation. In particular, we commend Dalia Blass, Sarah ten Siethoff, Brian Johnson, Amanda Wagner, Thoreau Bartmann, Dennis Sullivan, John Lee, Sirimal Mukerjee, Joel Cavanaugh, Asaf Barouk, Penelope Saltzman, Tim Dulaney, Michael Spratt, Ed Bartz, Asen Parachkevov, Jackie Rivas, Emily Westerberg Russell, Lourdes Gonzalez, Kelly Shoop, Alicia Goldin, Brandon Hill, Narahari Phatak, Alex Schiller, Wu Mi, Christian Jauregui, Rooholah Hadadi, Adam Large, Marie-Louise Huth, Robert Bagnall, and Cathy Ahn.
We also thank commenters in advance for any feedback they share.
 The Commission issued a statement in 1979 that purported to apply uniform requirements to many trading practices involving leverage and financial commitments. See Securities Trading Practices of Registered Investment Companies, Investment Company Act Release No. 10666 (Apr. 18, 1979) [44 FR 25128 (Apr. 27, 1979)]. However, over the next four decades, the Commission remained largely silent as the demand for derivatives products grew and new products came to market. During this time, the agency’s staff issued no-action letters (and other less formal staff guidance) that granted relief to certain market participants from the Commission’s 1979 requirements on an instrument-by-instrument basis. The result has been that disparate industry practices have proliferated for managing risk associated with derivatives in fund portfolios. Today different funds may treat the same kind of derivative differently, based on their own particular interpretations of the staff’s guidance. Not only does such a non-uniform approach disadvantage certain market participants, it raises questions of how the variety of outcomes could provide the types of investor protections contemplated by the Investment Company Act of 1940 (the “Act”) and the Commission’s 1979 order. We note, however, that there are questions about whether the derivatives transactions described in this release are of the type to raise concerns under Section 18 of the Act. We look forward to comment on this question.
 See Use of Derivatives by Registered Investment Companies and Business Development Companies, Investment Company Act Release No. 31933 (Dec. 11, 2015) [80 FR 80883 (Dec. 28, 2015)].
 See U.S. Department of the Treasury, “A Financial System that Creates Economic Opportunities: Asset Management and Insurance” (Oct. 2017), at 36, https://www.treasury.gov/press-center/press-releases/Documents/A-Financial-System-That-Creates-Economic-Opportunities-Asset_Management-Insurance.pdf.
 See Use of Derivatives by Registered Investment Companies and Business Development Companies; Required Due Diligence by Broker-Dealers and Registered Investment Advisers Regarding Retail Customers’ Transactions in Certain Leveraged/Inverse Investment Vehicles, Investment Company Act Release No. 337-4 (Nov. 26, 2019) (“Re-Proposing Release”), at Section II.G.
 See Proposed Rule 18f-4(c)(4)(iii).
 See Re-Proposing Release, at Section III.E.4.
 See Proposed rule 15l-2(a) under the Securities Exchange Act of 1934 (the “Exchange Act”); proposed rule 211(h)-1(a) under the Investment Advisers Act of 1940 (the “Advisers Act”).
 See Re-Proposing Release, Section II.G.2 (“The proposed sales practices rules are designed to establish a single, uniform set of enhanced due diligence and approval requirements for broker-dealers and investment advisers with respect to retail investors that engage in leveraged/inverse investment vehicle transactions, including transactions where no recommendation or investment advice is provided by a firm.”).
 See “SEC Adopts Rules and Interpretations to Enhance Protections and Preserve Choice for Retail Investors in Their Relationships With Financial Professionals” (June 5, 2019), https://www.sec.gov/news/press-release/2019-89; see also Chairman Jay Clayton, “Public Comments from Retail Investors and Other Interested Parties on Standards of Conduct for Investment Advisers and Broker-Dealers” (June 1, 2017), https://www.sec.gov/news/public-statement/statement-chairman-clayton-2017-05-31, comments available at https://www.sec.gov/comments/ia-bd-conduct-standards/iabdconductstandards.htm.
 See Exchange Act rule 15l-1(a)(ii)(B) (the “Care Obligation” of Regulation Best Interest).
 See Commission Interpretation Regarding Standard of Conduct for Investment Advisers, Release No. IA-5248 (June 5, 2019), at 11-12.
 Note that the Re-Proposing Release states: “Compliance with the proposed rules would not supplant or by itself satisfy other broker-dealer or investment adviser obligations, such as a broker-dealer’s obligations under Regulation Best Interest or an investment adviser’s fiduciary duty under the Advisers Act.” Re-Proposing Release, at 183.
 See FINRA rule 2360(b)(16), (17) (requiring broker-dealers to approve customer accounts for options trading).
 See Regulatory Flexibility Agenda of the Securities and Exchange Commission (Fall 2019), available at https://www.reginfo.gov/public/do/eAgendaViewRule?pubId=201910&RIN=3235-AM19 (noting that the SEC staff “is considering recommending that the Commission propose amendments to expand the definition of accredited investor under Regulation D of the Securities Act of 1933”).
 See Regulation D Revisions; Exemption for Certain Employee Benefit Plans, Release No. 33-6683 (Jan. 16, 1987) [52 FR 3015 (Jan. 30, 1987)] (Proposing Release) (stating that the accredited investor definition is “intended to encompass those persons whose financial sophistication and ability to sustain the risk of loss of investment or fend for themselves render the protections of the Securities Act’s registration process unnecessary”).
 See Proposed Exchange Act rule 15l-2(b); proposed Advisers Act rule 211(h)-1(b).
 See Investment Company Act Rule 6c-11(c)(4); see also Exchange-Traded Funds, Investment Company Act Release No. 33646 (Sept. 25, 2019) [84 FR 57162], at 30.
 Between 2006 and 2008, the Commission issued a few orders to allow certain sponsors to operate leveraged and inverse ETFs. In 2010, the Commission issued a press release announcing a moratorium on new exemptive orders for such products. See “SEC Staff Evaluating the Use of Derivatives by Funds” (Mar. 25, 2010), https://www.sec.gov/news/press/2010/2010-45.htm (noting that, pending staff review of the use of derivatives by investment companies, the staff “determined to defer consideration of exemptive requests under the Investment Company Act to permit ETFs that would make significant investments in derivatives,” specifically “new and pending exemptive requests from certain actively-managed and leveraged ETFs that particularly rely on swaps and other derivative instruments to achieve their investment objectives.”). While the staff subsequently lifted the moratorium for actively-managed, the moratorium on leveraged ETFs has continued. See Derivatives Use by Actively-Managed ETFs (Dec. 6, 2012), https://www.sec.gov/divisions/investment/noaction/2012/moratorium-lift-120612-etf.pdf.