The Securities and Exchange Commission (the “SEC”) recently re-proposed Rule 18f-4 (the “Proposed Rule”) under the Investment Company Act of 1940, as amended (the “1940 Act”), which would apply to the use of derivatives and other financial instruments by registered investment companies and business development companies (collectively, “funds”) (the “2019 Release”).1 An initial version of the Proposed Rule was proposed on December 11, 2015 (the “2015 Release”).2 Both versions of the Proposed Rule would permit a fund to enter into “derivatives transactions”3 and certain other transactions, provided that the fund complies with the Proposed Rule’s requirements. If adopted, the Proposed Rule would supersede the guidance provided by the SEC in an interpretive release (“Release 10666”),4 as well as the guidance provided by the SEC staff through numerous no-action letters concerning a fund’s use of derivatives and financial commitment transactions since Release 10666 was issued.
The 2019 Release also includes proposals for new sales practice rules, Rule 15l-5 under the Securities Exchange Act of 1934, as amended, and Rule 211(h)-1 under the Investment Advisers Act of 1940, as amended (collectively, the “Proposed Sales Practice Rules”), which would require brokers, dealers and registered advisers to exercise due diligence in approving certain clients to transact in shares of certain leveraged or inverse funds and commodity or currency pools. The 2019 Release also includes amendments to Rule 6c-11 under the 1940 Act (which permits most exchange-traded funds (“ETFs”) to operate without obtaining an exemptive order) to cover certain leveraged or inverse ETFs.
Re-Proposed Rule 18f-4
The Proposed Rule would permit a fund to enter into certain derivatives and financial commitment transactions notwithstanding the limitations of Section 18 of the 1940 Act, provided certain conditions are met.5
For derivatives transactions, the Proposed Rule would require a fund to:
- adopt and implement a written derivatives risk management program (“DRMP”) (unless the limited usage exception discussed below applies) and designate a derivatives risk manager (“DRM”);
- comply with an absolute or relative value-at-risk (“VaR”) limitation (unless a limited usage exception applies) and provide reporting to the SEC if certain events occur with respect to the applicable VaR limitation on Form N-RN;
- maintain a variety of additional written records pertaining to the fund’s use of derivatives transactions; and
- comply with certain additional reporting and disclosure requirements.
A fund’s board would also be required to approve the designation of the DRM and receive certain reports with respect to the DRMP. Each of the foregoing requirements is summarized below.
Unfunded commitment transactions would be subject to different requirements under the Proposed Rule, which also are discussed below.
- Derivatives Risk Management Program: Unless the fund is a “limited derivatives user,” a fund would be required to adopt and implement a DRMP that includes policies and procedures reasonably designed to manage the fund’s derivatives risks and to reasonably segregate the functions associated with the program from the portfolio management of the fund. While the program must cover certain general elements, it must be tailored based on how a fund uses derivatives and how such use may affect the fund’s investment portfolio and overall risk profile. As proposed, the Proposed Rule would require a fund’s program to include the following elements: risk identification and assessment, risk guidelines, stress testing, backtesting, internal reporting and escalation, and periodic review of the program by the DRM.
- Limits on the Fund’s Leverage Risk: Unless the fund is a limited derivatives user, the fund would be required to comply with a Relative VaR Limit or an Absolute VaR Limit (each as defined below), which would have to be measured at least once each business day. VaR is an estimate of an instrument or portfolio’s potential losses over a given time horizon and at a specified confidence level.
- The “Relative VaR Limit” would limit the VaR of the fund’s portfolio to 150% of the VaR of a designated reference index for that fund as selected by the DRM. The designated reference index must be unleveraged, reflect the markets or asset classes in which the fund invests, and cannot be administered by an organization that is an affiliated person of the fund, its investment adviser, or principal underwriter, or created at the request of the fund or its investment adviser, unless the index is widely recognized and used.
- The “Absolute VaR Limit” would limit the VaR of the fund’s portfolio to 15% of the fund’s net assets. This limit would apply if the DRM is unable to identify an appropriate reference index for the fund.
- Board Oversight and Reporting: Unless the fund is a limited derivatives user, the fund’s board of directors, including a majority of its independent directors, must approve the designation of the DRM. Under the Proposed Rule, the DRM must have relevant derivatives risk management experience and could consist of one or more officers of the fund’s adviser, but could not be a third party, a fund’s portfolio manager, or, if the DRM consists of multiple persons, represent a majority of the fund’s portfolio managers. The fund’s board also would be required, initially and at least annually thereafter, to receive written reports prepared by the DRM regarding the DRMP’s adequacy and effectiveness of its implementation. Under the Proposed Rule, the board would not be required to approve the DRMP or any material changes thereto.
- Recordkeeping: The Proposed Rule would require a fund entering into transactions pursuant to the Proposed Rule to maintain certain additional written records, including records documenting the DRMP and its implementation.
- Reporting and Disclosure Requirements: A fund would also be required to file certain reports, including on Form N-RN, and make certain disclosures regarding its use of derivatives.
Other Aspects of the Proposed Rule
- Exception for Limited Derivatives Users: The Proposed Rule would provide an exception from the DRMP requirements and the Absolute VaR Limit and Relative VaR Limit requirements for those funds that qualify as a limited derivatives user. A fund is “limited derivatives user” if: (a) its derivatives exposure (the aggregate notional amounts of derivatives investments plus the value of short sales) does not exceed 10% of the fund’s net assets, or (b) the fund limits its use of derivatives transactions to currency derivatives to hedge the currency risks associated with foreign currency-denominated equity or fixed income investments. With respect to the latter, the notional amounts of the derivatives can only exceed the value or principal value of the instrument being hedged by a “negligible” amount. A fund that relies on the limited user exception would, however, be required to adopt policies and procedures that are reasonably designed to manage its derivatives risks.
- Treatment of Reverse Repurchase and Unfunded Commitment Agreements: As proposed, the Proposed Rule would also enable a fund to engage in reverse repurchase agreements (“reverse repos”) and other similar financing transactions so long as the reverse repo or other transaction are subject to the relevant asset coverage requirements of Section 18 of the 1940 Act. Unfunded commitments would be treated similarly to reverse repos and would not be subject to the VaR limitations discussed above. Instead, a fund would be required to form a “reasonable belief” at the time the fund enters into an unfunded commitment agreement that the fund will have sufficient cash and cash equivalents to meet its obligations under the commitment as they come due. A fund would also be required to document the basis for its reasonable belief and retain this documentation as part of the fund’s records.
- Leveraged/Inverse Funds and ETFs: As proposed, the Proposed Rule would provide an exception from the VaR limitations discussed above for certain leveraged/inverse funds6 that: (i) disclose that they are not subject to such VaR limitations in their prospectuses; and (ii) do not seek to obtain investment results exceeding 300% of the return or inverse of the return of an underlying index.
Proposed Sales Practice Rules
The Proposed Sales Practice Rules would require registered broker-dealers and registered investment advisers to exercise additional due diligence on retail clients (i.e., customers that are natural persons or their legal representatives) before approving their accounts to invest in shares of leveraged/inverse funds, and specifies the information a registered broker-dealer or investment adviser must obtain before forming a reasonable basis to believe that the customer or client is capable of evaluating the risk associated with these products.
The Proposed Rule generally is a positive step towards simplifying funds’ compliance obligations under Section 18 with respect to their use of derivatives and financial commitment transactions. The version of the Proposed Rule included in the 2019 Release represents a substantial improvement over the version included in the 2015 Release. In this regard, the Proposed Rule omits duplicative asset segregation requirements and an aggregate notional limitation, reflecting the SEC’s willingness to consider and make modifications in response to thoughtful industry comments. The Proposed Rule, however, leaves many questions unanswered regarding how derivatives should be treated for purposes of compliance with other 1940 Act limitations, such as diversification, industry concentration, and securities-related issuer restrictions.
Comments on the proposals contained in the 2019 Release are due 60 days after it is published in the Federal Register, which has not occurred as of the date of this client memorandum.
1 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, SEC Rel. No. IC-33704 (Nov. 25, 2019), available at https://www.sec.gov/rules/proposed/2019/34-87607.pdf.
2 Use of Derivatives by Registered Investment Companies and Business Development Companies, SEC Rel. No. IC-31933 (Dec. 11, 2015).
3 “Derivatives transaction” is defined in the Proposed Rule as 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 any payment or delivery of cash or other assets during the life of the instrument or at maturity or early termination, whether as a margin or settlement payment or otherwise.
4 Securities Trading Practices of Registered Investment Companies, SEC Rel. No. IC-10666 (Apr. 18, 1979).
5 The Proposed Rule, if adopted as proposed, generally does not apply different limitations to different types of derivatives transactions.
6 The definition for leveraged and inverse funds is similar the definition contained in the current version of Rule 6c-11, although it would also include funds that are not ETFs.