SEC Proposes to Modernize Regulation of the Use of Derivatives by Registered Funds and Business Development Companies

The Securities and Exchange Commission has voted to propose a new rule designed to enhance the regulation of the use of derivatives by registered investment companies, including mutual funds, exchange-traded funds (ETFs) and closed-end funds, as well as business development companies. The proposed rule would provide an updated and more comprehensive approach to the regulation of funds’ derivatives use.

“The Commission’s proposal recognizes the extensive changes that have taken place in our capital markets and the fund industry over the past several decades, including the importance of derivatives in effective portfolio management,” said SEC Chairman Jay Clayton. “Funds frequently use derivatives to gain exposure to certain asset classes more efficiently and to mitigate risks, but in certain cases derivatives can heighten risks to investors and markets, including risks related to leverage. By standardizing the framework for funds’ derivatives risk management, the proposal would benefit investors, funds and our markets, including by providing for more-effective risk management across funds and enhanced investor protections.”

The Investment Company Act limits the ability of registered funds and business development companies to obtain leverage, including by engaging in transactions that involve potential future payment obligations. Leverage is commonly thought of in terms of purchasing securities with borrowed funds. However, derivatives, such as forwards, futures, swaps and written options, can also create future payment obligations. The proposed rule would permit these funds to use derivatives that create such obligations, provided that they comply with certain conditions designed to protect investors. 

These conditions include adopting a derivatives risk management program and complying with a limit on the amount of leverage-related risk that the fund may obtain, based on value-at-risk.  A streamlined set of requirements would apply to funds that use derivatives in a limited way. The proposed rule would also permit a fund to enter into reverse repurchase agreements and similar financing transactions, as well as “unfunded commitments” to make certain loans or investments, subject to conditions tailored to these transactions.

Certain registered investment companies that seek to provide leveraged or inverse exposure to an underlying index—including leveraged ETFs—would not be subject to the proposed limit on fund leverage risk but instead would be subject to alternative requirements under the Commission’s proposal. These funds would have to limit the investment results they seek to 300% of the return (or inverse of the return) of their underlying index (i.e., three times leveraged). Sales of these funds also would be subject to proposed new sales practices rules. Under these new rules, a broker, dealer, or investment adviser that is registered with the Commission would have to exercise due diligence in approving a retail customer or client’s account to buy or sell shares of these funds, as well as shares of exchange-listed commodity or currency pools that have similar investment strategies. These proposed new rules are designed to help ensure that retail investors in these products are limited to those who are capable of evaluating their characteristics—including that the funds would not be subject to all of the leverage-related requirements under the proposed rule applicable to registered investment companies generally—and the unique risks they present.

The proposal will be published on SEC.gov and in the Federal Register. The comment period for the proposal will be 60 days after publication in the Federal Register.

*  *  *

FACT SHEET

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

Highlights

The Commission voted to propose new rules, and rule and form amendments, designed to provide an updated, comprehensive approach to the regulation of funds’ use of derivatives and certain other transactions. Proposed new rule 18f-4, an exemptive rule under the Investment Company Act of 1940 (the “Act”),would permit mutual funds, exchange-traded funds (“ETFs”), registered closed-end funds, and business development companies (collectively, “funds”)to enter into derivatives transactions and certain other transactions notwithstanding the restrictions under section 18 of the Act.

The Commission also proposed new sales practice rules—rule 15l-2 under the Securities Exchange Act of 1934 and rule 211(h)-1 under the Investment Advisers Act of 1940—designed to address specific considerations raised by certain leveraged or inverse funds and exchange-listed commodity or currency pools (“leveraged investment vehicles”). In connection with these proposed new rules, the Commission proposed to amend rule 6c-11 under the Act to allow certain leveraged or inverse ETFs to operate without obtaining an exemptive order.

Finally, the Commission proposed new reporting requirements and amendments to certain disclosure forms.

Proposed Rule 18f-4 Under the Investment Company Act

The development of staff guidance and industry practice on an instrument-by-instrument basis, together with growth in the volume and complexity of derivatives markets over past decades, has resulted in situations in which different funds may treat the same kind of derivative differently, based on their own view of our staff’s guidance or observation of industry practice. Where there is no specific guidance, or where the application of existing guidance is unclear or applied inconsistently, funds may take approaches that may not address the purposes and concerns underlying section 18.

Proposed rule 18f-4 would impose a uniform set of conditions and provide certain exemptions from the Act. The conditions include the following:

• Derivatives Risk Management Program. The proposed rule would generally require a fund to implement a written derivatives risk management program. The program would institute a standardized risk management framework for funds, while requiring principles-based tailoring by each fund to the fund’s particular risks. The program would have to include risk guidelines as well as stress testing, backtesting, internal reporting and escalation, and program review elements. A derivatives risk manager approved by the fund’s board of directors would administer the program. The fund’s derivatives risk manager would have to report to the fund’s board on the derivatives risk management program’s implementation and effectiveness to facilitate the board’s oversight of the fund’s derivatives risk management.
• Limit on Fund Leverage Risk. A fund relying on the proposed rule would generally have to comply with an outer limit on fund leverage risk based on value-at-risk, or “VaR.” This outer limit would be based on a relative VaR test that compares the fund’s VaR to the VaR of a “designated reference index” for that fund. The fund’s VaR would not be permitted to exceed 150% of the VaR of the fund’s designated reference index. If the fund’s derivatives risk manager is unable to identify an appropriate designated reference index, the fund would be required to comply with an absolute VaR test, under which the VaR of its portfolio would not be permitted to exceed 15% of the value of the fund’s net assets. 
• Exception for Limited Users of Derivatives. The proposed rule would provide an exception from the program requirement and the VaR-based limit on fund leverage risk for a fund that either: (1) limits its derivatives exposure to 10% of its net assets, or (2)uses derivatives only to hedge certain currency risks.
• Alternative Conditions for Certain Leveraged or Inverse Funds. The proposed rule includes a set of alternative conditions for certain leveraged or inverse funds. Such a fund would be excepted from the proposed limit on fund leverage risk, provided that, among other things, it: (1) limits the investment results it seeks to 300% of the return (or inverse of the return) of the underlying index, (2) discloses in its prospectus that it is not subject to the proposed limit on fund leverage risk, and (3) is a fund to which the new proposed sales practices rules would apply, prohibiting a retail investor from trading through a broker-dealer or investment adviser unless the broker-dealer or investment adviser were to approve the investor’s account for such trading, as discussed below.
• Reverse Repurchase Agreements and Unfunded Commitment Agreements. The proposed rule would also permit a fund to enter into reverse repurchase agreements and similar financing transactions, as well as “unfunded commitments” to make certain loans or investments, subject to conditions tailored to these transactions.

Proposed Sales Practice Rules and Amendments to Rule 6c-11

The proposed sales practice rules would establish a set of due diligence and approval requirements for broker-dealers and SEC-registered investment advisers with respect to trades in shares of certain leveraged investment vehicles.

Under the proposed rules, a firm would have to exercise due diligence in determining whether to approve a retail customer or client’s account to buy or sell leveraged investment vehicles. A broker-dealer or investment adviser could only approve the account if it had a reasonable basis to believe that the customer or client is capable of evaluating the risks associated with these products.

The proposed amendments to Investment Company Act rule 6c-11 would permit certain leveraged or inverse ETFs to rely on rule 6c-11. The Commission proposed to rescind the exemptive orders previously issued to the sponsors of leveraged or inverse ETFs in connection with any adoption of the proposed amendments.

Reporting Requirements

The proposal would require a fund to report confidentially to the Commission on a current basis on Form N-LIQUID (to be renamed “Form N-RN”) if the fund is out of compliance with the VaR-based limit on fund leverage risk for more than three consecutive business days. The proposal also would amend Forms N-PORT and N-CEN to require funds that are currently required to file these forms to provide certain information regarding a fund’s derivatives exposure and, as applicable, information regarding the fund’s VaR. This information would be publicly available.

Review of Relevant Staff Guidance

In view of the proposal’s updated, comprehensive approach to the regulation of funds’ derivatives use, the Commission proposed to rescind a 1979 General Statement of Policy (Release 10666), which provides Commission guidance on how funds may use certain derivatives and derivatives-like transactions in light of section 18’s restrictions. In addition, staff in the Division of Investment Management is reviewing its no-action letters and other guidance addressing funds’ use of derivatives and other transactions covered by proposed rule 18f-4 to determine which letters and staff guidance, or portions thereof, should be withdrawn in connection with any adoption of the proposal. 

What’s Next?

The proposal will be published on SEC.gov and in the Federal Register. The public comment period will remain open for 60 days after publication in the Federal Register.

The Commission also approved for use two short-form tear sheets to gather information. Funds are encouraged to submit additional feedback on proposed rule 18f-4 in light of their current risk management practices. Broker-dealers and investment advisers are encouraged to submit additional feedback on the proposed sales practice rules. While any commenter could use these tear sheets, they are particularly aimed at smaller funds, advisers, and broker-dealers, and are designed to help these smaller entities provide feedback on how the proposal would affect them.