SEC Proposes New Rules and Amendments to Update the Approach to the Regulation of Funds’ Use of Derivatives and Other Transactions

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The U.S. Securities and Exchange Commission on November 25, 2019 approved for publication a three-part rule proposal related to the use of derivatives and certain other transactions by registered investment companies (i.e., open-end funds other than money market funds; closed-end funds; and exchange-traded funds) and business development companies (collectively, funds).1 The proposal includes: (1) new Rule 18f‑4 under the Investment Company Act of 1940; (2) new rules relating to leveraged/inverse funds and vehicles, including sales practices rules under the Securities Exchange Act of 1934 and the Advisers Act of 1940 and a related rule amendment under the 1940 Act relating to leveraged/inverse exchange-traded funds; and (3) related fund reporting form amendments.

Proposed Rule 18f-4 is a re-proposal of a 2015 SEC rulemaking effort that would have permitted a fund to enter into derivatives transactions and “financial commitment transactions” subject to certain conditions.2 The 2015 proposed rulemaking was the first significant SEC or staff action relating to funds’ use of derivatives since the SEC’s issuance of a Concept Release in 2011.3 Similar to the 2015 proposal, if adopted, proposed Rule 18f-4 and the related items discussed in this OnPoint would represent perhaps the most significant change to the way the SEC regulates funds’ use of derivatives, as well as the obligations of the boards of such funds, since Release 106664 was published. While presented as an “exemptive” rule, proposed Rule 18f-4 in fact would place restrictions on the manner in which many funds currently use derivatives based on existing SEC and no-action guidance.

Proposed Rule 18f-4 under the 1940 Act

Rule 18f-4 would provide an exemption from the applicable restrictions on issuing “senior securities” under Sections 18 and 61 of the 1940 Act, allowing funds to enter certain transactions that create leverage, subject to the conditions outlined below. The proposing release states that Rule 18f-4 is designed to address the investor protection purposes and concerns underlying Section 18 and to provide an “updated and more comprehensive approach” to the regulation of funds’ use of these types of transactions.

Rule 18f-4 would treat separately a fund’s “derivatives transactions” (i.e., transactions in derivatives instruments involving a potential future payment or delivery obligation and short sale borrowings), reverse repurchase agreements and other “similar financing transactions,” and unfunded commitment agreements, and would subject each category of fund transactions to different conditions.

Conditions to Enter Into Derivatives Transactions

Rule 18f-4 would permit funds to enter into derivatives transactions subject to the following conditions:

  1. Fund Derivatives Risk Management Program. A fund would be required to adopt and implement a written derivatives risk management program “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.” The program would be required to include elements relating to risk identification and assessment, risk guidelines, weekly or more frequent stress testing, backtesting, internal reporting and escalation of material risks, and program review and otherwise would allow “principals-based” tailoring of the program to the fund’s particular risks.
  2. Limit on Fund Leverage Risk. A fund would be required to comply with an outer limit on fund leverage risk. Under this condition, a fund’s value at risk (VaR)5 could not exceed 150% of the VaR of a “designated reference index.” If the fund’s derivatives risk manager was not able to identify an appropriate designated reference index, the fund’s VaR could not exceed 15% of the value of the fund’s net assets. The fund would be required to determine its compliance with the applicable VaR test at least once each business day. If the fund were to determine that it was not in compliance with the applicable VaR test and did not come back into compliance within three business days, the derivatives risk manager and fund would be subject to certain remediation requirements. The fund also would be required to disclose the designated reference index for performance comparison purposes.
  3. Board Oversight and Reporting. The derivatives risk manager responsible for administering a fund’s derivatives risk management program would need to be approved by the fund’s board, including a majority of directors who are not interested persons of the fund. The derivatives risk manager would need to report to the board periodically regarding the program’s implementation and effectiveness, as well as risk guideline non-compliance, stress testing and backtesting. The limit on fund leverage risk also would require the derivatives risk manager to report on a fund’s failure to return to compliance with the VaR test within three business days.
  4. Exception for Limited Derivatives Users. A fund would not be required to adopt a derivatives risk management program or comply with the limit on fund leverage risk requirements discussed above, if the fund either: limits its derivatives exposure6 to 10% of its net assets; or uses derivatives transactions solely to hedge certain currency risks. Such a fund also would be required to adopt and implement policies and procedures “reasonably designed to manage the fund’s derivatives risks.”
  5. Alternative Conditions for Leveraged/Inverse Funds. A fund that is a “leveraged/inverse investment vehicle” as defined in the proposed Exchange Act and Advisers Act sales practices rules (discussed below) would not be required to comply with the limit on fund leverage risk requirements discussed above. However, these funds will be subject to alternative conditions. The proposing release notes that most registered investment companies that are leveraged/inverse investment vehicles (leveraged/inverse funds) could not satisfy the limit on fund leverage, because those funds provide leveraged or inverse market exposure exceeding 150% of the return or inverse return of the relevant index. The proposing release notes, however, that certain investors who are capable of evaluating leveraged/inverse funds’ characteristics and their unique risks may want to use such leveraged/inverse funds.

Accordingly, as discussed below, broker-dealers and investment advisers would be required under the sales practices rules to approve retail investors’ accounts to purchase or sell shares in leveraged/inverse investment vehicles.

The alternative conditions to which leveraged/inverse funds would be subject would require that a leveraged/inverse fund: discloses in its prospectus that it is not subject to the limit on fund leverage risk; and does not seek or obtain, directly or indirectly, investment results exceeding 300% of the return (or inverse return) of the underlying index.

Transactions entered into in compliance with the above conditions would not be considered for purposes of computing a fund’s “asset coverage,” as defined in Section 18(h) of the 1940 Act, meaning these transactions would not be considered indebtedness for purposes of Section 18.

Conditions to Enter Into Reverse Repurchase Agreements, Similar Financing Transactions and Unfunded Commitments

Rule 18f-4 would permit funds to enter into reverse repurchase agreements and similar financing transactions as well as “unfunded commitment agreements”7 to make certain loans or investments, subject to the following conditions, which the proposing release states are “tailored to those transactions”:

  1. A fund would be permitted to enter reverse repurchase agreements and similar financing transactions8 if the fund: complies with the asset coverage requirements under Section 18 of the 1940 Act; and combines the aggregate amount of indebtedness associated with such transactions with the aggregate amount of any other senior securities representing indebtedness when calculating the asset coverage ratio.
  2. A fund would be permitted to enter into an unfunded commitment agreement if the fund reasonably believes, at the time it enters such agreement, that it will have sufficient cash and cash equivalents to meet its obligations with respect to all of its unfunded commitment agreements as they come due, subject to certain limitations. Such transactions will not be considered for purposes of computing asset coverage as defined in Section 18(h).

Other Requirements

Rule 18f-4 would require funds to maintain certain records. The proposing release states that these requirements are designed to provide the SEC staff and the fund’s compliance personnel with “the ability to evaluate the fund’s compliance with the proposed rule’s requirements.”

Asset Segregation

Rule 18f-4 would not subject any of the transactions to which it would apply to an asset segregation requirement similar to the requirement under Release 10666 (the asset segregation currently required for certain transactions under the SEC’s prior guidance relating to the use of transactions that create leverage). With respect to derivatives transactions, the proposing release states that the SEC believes that “the proposed VaR-based tests would be a more direct and effective method of limiting fund leverage risk consistent with Section 18.” The proposing release also states that the SEC believes that “the proposed rule’s requirements, in their totality, would appropriately address the asset sufficiency risks underlying Section 18.”

Rescinding Prior Guidance

As a related matter, the SEC is also proposing to rescind Release 10666. The proposing release notes that the staff of the SEC’s Division of Investment Management is reviewing certain of its no-action letters and other guidance addressing derivatives transactions and other relevant transactions that have constituted a 30+ year patchwork of guidance for the industry in this area, to determine whether all or portions of such guidance also should be withdrawn in connection with the adoption of the proposal.

Proposed Transition Period

The proposing release states that the SEC would expect to provide a one-year transition period after the publication of any final rule in the Federal Register, while funds prepare to come into compliance with Rule 18f-4 before Release 10666 is withdrawn.

Proposed Rules Relating to Leveraged/Inverse Vehicles and Funds

Proposed New Exchange Act and Advisers Act Sales Practices Rules

The SEC proposed Rule 15l-2 under the Exchange Act and Rule 211(h)-1 under the Advisers Act – new “sales practices” rules that would require broker-dealers and investment advisers (jointly, firms) and their associated persons who are natural persons to exercise due diligence. Such due diligence must determine "at a minimum" certain information about a customer or client who is a natural person (or the legal representative9 of a natural person – together, a “retail10 investor”). Such due diligence must be performed before either: accepting or placing the retail investor’s order to buy or sell shares of a leveraged/inverse investment vehicle;11 or approving the retail investor’s account to engage in such transactions. The proposed sales practices rules also would require firms to adopt written policies and procedures, and to maintain certain records.

The proposed sales practices rules would allow a firm to approve the purchase or sale of shares of leveraged/inverse investment vehicles in a retail investor’s account if the firm had a reasonable basis to believe that the retail investor is capable of evaluating the risks associated with these products. The SEC analogized its proposed new sales practices rules to FINRA’s existing options account approval process. As with options accounts, there would be no requirement for transaction-by-transaction approval. Significantly, the proposed sales practices rules would apply without regard to whether a recommendation or investment advice is provided to the retail investor, including to self-directed brokerage transactions. As with Regulation Best Interest, the SEC does not propose in Exchange Act Rule 15l-1 to exclude sophisticated or high net worth investors from the scope of covered customers. Proposed Advisers Act Rule 211(h)-1 effectively imports the definition of “retail customer” from Regulation Best Interest (and "retail investor" from Form CRS) and applies this definition to investment advisers' placement or approval of a retail investor’s transaction in a leveraged/inverse investment vehicle, “to establish a single, uniform set of enhanced due diligence and approval requirements” for firms.

The proposal also would require firms to maintain certain records (including written approvals) for at least six years after an account closing, which is inconsistent with the recordkeeping rules governing investment advisers.12 The proposal further states that “[c]ompliance 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.”

If the new sales practices rules are adopted, the SEC proposes to provide a one-year compliance period following the rules’ publication in the Federal Register. The proposed sales practices rules would apply not only to new accounts and transactions established after the rules’ compliance date, but also to pre-existing accounts, even if the retail investor was already investing in leveraged/inverse investment vehicles.

Proposed Amendments to Rule 6c-11 under the 1940 Act

Rule 6c-11 under the 1940 Act generally permits ETFs to operate without obtaining an SEC exemptive order, subject to certain conditions.13 Currently, Rule 6c-11(c)(4) excludes leveraged/inverse ETFs from relying on the rule, in order to allow the SEC to consider Section 18 issues raised by ETFs as part of the SEC’s broader consideration of derivatives use by registered funds and BDCs. In connection with the other rule proposals, the SEC is proposing to remove this provision “because the proposed sales practices rules and Rule 18f-4 are designed to address these issues.”

The SEC also is proposing to rescind the exemptive orders previously issued to the sponsors of leveraged/inverse ETFs. The proposing release states that this “would promote a level playing field by allowing any sponsor (in addition to sponsors currently granted exemptive orders) to form and launch a leveraged/inverse ETF subject to the conditions in Rule 6c-11 and proposed Rule 18f-4, with transactions in the fund subject to the proposed sales practices rules.” The SEC proposes to delay the effective date of the amendments to Rule 6c-11 for one year following the publication of any final rule in the Federal Register. The SEC also proposes to rescind the exemptive orders noted above on the effective date of the amendments to Rule 6c-11.

Proposed Fund Reporting and Disclosure Form Amendments

The SEC is proposing to amend Forms N-PORT, N-LIQUID (which would be re-titled as Form N-RN), and N-CEN “to enhance the Commission’s ability to oversee funds’ use of and compliance with the proposed rules effectively, and for the Commission and the public to have greater insight into the impact that funds’ use of derivatives would have on their portfolios.”

The proposed amendments to Form N-PORT would add new reporting item regarding funds’ derivatives exposure as of the end of the reporting period, as well as a new reporting item requiring that a fund (other than BDCs, which are not required to file Form N-CEN or Form N-PORT) subject to the proposed VaR-based limit on fund leverage risk report: the fund’s highest daily and median VaR and VaR ratio during the reporting period; the name of the fund’s designated reference index (if applicable) and the relevant index identifier; and the number of exceptions the fund identified during the reporting period arising from backtesting. This Form N-PORT information would be publicly available for the final month of each fund’s quarter.

The proposed amendments to re-titled Form N-RN would require funds subject to the proposed VaR-based limit on fund leverage risk to file Form N-RN to report certain information about VaR test breaches, if the fund determines that it is out of compliance with the VaR test and has not returned to compliance within three business days after the determination. Form N-RN would be required to be filed within four business days following the determination. The fund also would be required to file a report on Form N-RN when it returns to compliance with the applicable VaR test. In addition, the SEC is proposing a related amendment to Rule 30b1-10 under the 1940 Act to reflect the requirement that all funds subject to the VaR test (not just registered open-end funds) file current reports. The SEC is proposing to make funds’ reporting on Form N‑RN regarding VaR test breaches non-public.

The proposed amendments to Form N-CEN would add an item requiring funds (other than BDCs, which are not required to file Form N-CEN or Form N-PORT) to indicate whether: the fund has relied on proposed Rule 18f-4 and any of the exceptions from various requirements under the proposed rule; or the fund entered any reverse repurchase agreements or similar financing transactions, or unfunded commitments, during the reporting period.

The SEC also is proposing to amend Form N-2 to provide that closed-end funds and BDCs relying on proposed Rule 18f-4 would not be required to include their derivatives transactions or unfunded commitment agreements in the senior securities table disclosure on Form N-2.

Next Steps

The proposing release sets forth a number of requests for comment regarding each element of the proposed rule changes. Industry participants should carefully consider the implications of the conditions to reliance on Rule 18f-4 and the requirements under the other rule changes, and should consider submitting feedback to the SEC on these proposed changes. The public comment period will remain open for 60 days after the proposal is published in the Federal Register, which at the time of publication of this OnPoint has not yet taken place.

An upcoming OnPoint will provide further analysis of these matters.

Footnotes

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. Nos. 34-87607; IA-5413; IC-33704.

2) For further information regarding the 2015 proposed rulemaking, please refer to Dechert OnPoint, SEC Proposes Significant New Restrictions on the Use of Derivatives and Other Transactions by Registered Funds and BDCs. For further information regarding the industry response to the 2015 proposed rulemaking, please refer to Industry Response to SEC Derivatives and Senior Securities Rule Proposal, The Investment Lawyer, Vol. 23, No. 6 (June 2016).

3) Notably, the proposal addresses only compliance with Section 18 of the 1940 Act, and does not address other issues that arise under the 1940 Act with respect to the use of derivatives, such as the appropriate treatment of derivatives under the provisions of the 1940 Act governing issuer diversification, industry concentration and investments in securities-related issuers.

4) Securities Trading Practices of Registered Investment Companies, Investment Company Act Release No. 10666 (Apr. 18, 1979).

5) Under Rule 18f-4, the term “value at risk” would mean “an estimate of potential losses on an instrument or portfolio, expressed as a percentage of the value of the portfolio’s net assets, over a specified time horizon and at a given confidence level, provided that any VaR model used by a fund for purposes of determining the fund’s compliance with the relative VaR test or the absolute VaR test must: (1) Take into account and incorporate all significant, identifiable market risk factors associated with a fund’s investments, including, as applicable: (A) Equity price risk, interest rate risk, credit spread risk, foreign currency risk and commodity price risk; (B) Material risks arising from the nonlinear price characteristics of a fund’s investments, including options and positions with embedded optionality; and (C) The sensitivity of the market value of the fund’s investments to changes in volatility; (2) Use a 99% confidence level and a time horizon of 20 trading days; and (3) Be based on at least three years of historical market data.”

Rule 18f-4 would define the term “designated reference index” to mean an “unleveraged index” that: “is selected by the derivatives risk manager and that reflects the markets or asset classes in which the fund invests;” is not administered by an affiliated person of the fund or certain other persons or created at the request of the fund or its investment adviser, unless the index is widely recognized and used; and is an “appropriate broad-based securities market index” or “additional index,” as defined in the instruction to Item 27 of Form N-1A.

6) Rule 18f-4 would define the term “derivatives exposure” as “the sum of the notional amounts of the fund’s derivatives instruments and, in the case of short sale borrowings, the value of the asset sold short.” This definition includes two adjustments to address certain limitations associated with measures of market exposure that use notional amounts without adjustments. For this purpose, “a fund may convert the notional amount of interest rate derivatives to 10-year bond equivalents and delta adjust the notional amounts of options contracts.”

7) Rule 18f-4 would define the term “unfunded commitment agreement” to mean “a contract that is not a derivatives transaction, under which a fund commits, conditionally or unconditionally, to make a loan to a company or to invest equity in a company in the future, including by making a capital commitment to a private fund that can be drawn at the discretion of the fund’s general partner.”

8) The proposing release notes the SEC’s views on two specific transactions under this requirement. A fund’s obligation to return securities lending collateral would not be treated as a “similar financing transaction” for purposes of Rule 18f-4, so long as the fund: does not sell or otherwise use non-cash collateral received for loaned securities to leverage the fund’s portfolio; and invests cash collateral solely in cash or cash equivalents. However, depending on the facts and circumstances, a fund’s obligations with respect to a tender option bond financing may be a “similar financing transaction.”

9) The proposal includes “non-professional” legal representatives and excludes institutions and certain professional fiduciaries from the scope of customer or client in the new sales practices rules.

10) The proposed sales practices rules do not use or track the definition of “retail customer” in Regulation Best Interest or “retail investor” in Form CRS, but introduce a variation of those definitions that are not limited by whether the transaction or account is “primarily for personal, family, or household purposes.” In the SEC's companion interpretative release regarding an investment adviser’s standard of conduct, the SEC did not define “retail client;" however, the SEC suggested that the nature and scope of duties owed, and how those duties are discharged, require consideration of the client’s sophistication (rather than merely whether the client is a natural person). Commission Interpretation Regarding Standard of Conduct for Investment Advisers, 84 Fed. Reg. 33669 (Jul. 12, 2019).

11) A “leveraged/inverse investment vehicle” is proposed to be defined under both rules as “a registered investment company (including any separate series thereof), or commodity- or currency-based trust or fund, that seeks, directly or indirectly, to provide investment returns that correspond to the performance of a market index by a specified multiple, or to provide investment returns that have an inverse relationship to the performance of a market index, over a predetermined period of time.”

12) Pursuant to Rule 204-2 under the Advisers Act, advisers are required to maintain records for at least five years from the end of the fiscal year during which the last entry was made on the respective record. This record retention requirement is, however, consistent with Rule 17a-4(c) under the Exchange Act, which requires broker-dealers to maintain customer account information for not less than six years after the closing of the account.

13) For a detailed discussion of Rule 6c-11, please refer to Dechert OnPoint, SEC Adopts Final ETF Rule and Issues Related Exchange Act Relief.

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