SEC Adopts New Rules Regarding Use of Derivatives by Registered Investment Companies and Business Development Companies

Kramer Levin Naftalis & Frankel LLP

On Oct. 28, 2020, the Securities and Exchange Commission (SEC) voted to adopt a new rule (Rule 18f-4) and other related amendments, significantly altering the regulatory framework for derivatives use by registered investment companies (RICs), including mutual funds (other than money market funds), exchange-traded funds (ETFs) and closed-end funds, and business development companies (BDCs) (each, a fund). The new rule is largely adopted as proposed, with some key modifications noted below.

Rule 18f-4

New Rule 18f-4 provides certain exemptions from Section 18 of the Investment Company Act of 1940 (the 1940 Act), subject to certain conditions. In order to avail itself of Rule 18f-4, a fund is generally required to implement a written derivatives risk management program, which must include risk guidelines, stress testing, backtesting (no less than weekly), internal reporting and escalation, and program review elements. Such program is to be administered by a derivatives risk manager (who must be an officer or officers of the fund’s investment adviser other than the fund’s portfolio manager) approved by the fund’s board of directors, who will report to the board periodically (at least annually) on the program’s implementation and effectiveness.

A fund is generally required to comply with an outer limit on fund leveraged risk based on value-at-risk (VaR), based on a relative test that compares the fund’s VaR to that of a “designated reference portfolio” for the fund, generally chosen as an index that meets certain requirements or the fund’s own securities portfolio, excluding derivative transactions. If the fund’s investment objective is to track the performance of an unleveraged index, it must use that index as a designated reference portfolio. The fund’s VaR is generally not permitted to exceed 200% of the VaR of the designated reference portfolio (or 250% in the case of a closed-end company that has issued preferred stock) or 20% of the fund’s net assets (or 25% in the case of a closed-end company that has issued preferred stock). The allowances for closed-end funds are new to the final rule, and the VaR limits generally are more flexible than those under the proposed rule, which had a lower 150% relative VaR limit and a 15% net asset limit.

A fund may be exempted from the VaR and written program requirements provided that the fund (i) adopts and implements written policies and procedures reasonably designed to manage derivatives risk, and (ii) has derivatives exposure limited to 10% or less of its net assets, excluding certain currency and interest rate hedging transactions. In addition, unlike in the proposed rule, such fund need not comply with the board oversight and reporting requirements. The proposed rule was also modified to clarify that the calculation of derivatives exposure will exclude, for this purpose, currency or interest rate derivatives that hedge currency or interest rate risks associated with one or more specific equity or fixed-income investments held by the fund or the funds borrowing (provided such transactions are entered into and maintained by the fund for hedging purposes). 

Leveraged and inverse funds will generally be subject to Rule 18f-4, including the requirement to comply with the 200% relative VaR limit. This effectively limits leveraged or inverse funds’ targeted daily return to 200% (or inverse of return) of the underlying index. Such funds may seek an exemption to this requirement if they satisfy certain conditions.

Funds may enter into reverse repurchase agreements and similar financing transactions (as well as “unfunded commitments” to make certain loans or investments), provided the fund complies with the asset coverage requirements of Section 18 and treats the reverse repurchase agreements or similar transactions as derivatives transactions for purposes of this section. Unfunded commitments will not be considered for purposes of computing asset coverage. Funds may also invest in securities on a when-issued or forward-settling basis, or with a non-standard settlement cycle, subject to certain conditions.

Reporting Requirements

In connection with the new rule and amendment, funds will be required to make confidential reports to the SEC on a current basis on Form-RN if the fund is out of compliance with the VaR limits (described above) for more than five business days. Funds currently required to file reports on Forms N-PORT and N-CEN will be required to provide certain information regarding a fund’s derivatives use, including VaR and (for funds relying on the limited derivatives user exception to Rule 18f-4) other derivatives exposure information.

The SEC is rescinding the 1979 General Statement of Policy (Release 10666), which had provided guidance on how funds may enact certain trading practices in light of the Section 18 restrictions. Some but not all staff letters and guidance addressing fund derivatives usage covered by Rule 18f-4 will be withdrawn as well.

Compliance Dates

The new rule and amendment will be effective 60 days after publication in the Federal Register. However, given the dramatic revisions to the regulatory framework governing fund derivatives usage, compliance with the provisions of Rule 18f-4 and related reporting requirements will be required beginning 18 months after the effective date. The rescission of Release 10666 and withdrawal of staff letters and guidance will be effective concurrently with this compliance date.

The full text of the SEC release may be found here.

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DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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