SEC Adopts Modernized Framework For Fund Derivatives Rule
On October 28, 2020, the US Securities and Exchange Commission (SEC) adopted Rule 18f-4 under the Investment Company Act of 1940 (1940 Act), which governs the use of derivatives by investment companies registered under the 1940 Act and business development companies.1 The adoption of Rule 18f-4, which applies to mutual funds (other than money market funds), exchange-traded funds (ETFs), registered closed-end funds, and business development companies (collectively, Investment Companies), appears to be the culmination (at least the current culmination) of the SEC’s attempts to accommodate industry initiatives in the arena of product development with respect to Investment Companies that utilize derivatives and other instruments that have leveraging characteristics, while at the same time balancing its shareholder protection policy objectives. To date, the SEC’s guidance in the area of derivatives (and leveraged instruments/transactions) by Investment Companies has consisted of a patchwork of formal SEC releases, SEC staff no-action letters and other less formal and authoritative sources (e.g., speeches of SEC staff members and the often inconsistent guidance given by SEC staff examiners in the examination process or in the review of filings). The guidance, to date, has been a mixed bag that is either highly prescriptive, principles-based and/or just pure silence with respect to certain instruments. The industry has, nonetheless, learned to live with it. Now, we have Rule 18f-4, which imposes a new regulatory framework that will require modifications to existing procedures, adoption of new procedures and implementation of new operational processes. Whether the new rule will deliver the protections to shareholders that are sought by the SEC while also not hindering product innovation is a question that the industry will be sure to be paying attention to as we all become more familiar with the new rule.
The New Rule
Rule 18f-4 permits an Investment Company to enter into derivatives transactions notwithstanding the prohibitions and limitations on the issuance of senior securities under Section 18 of the 1940 Act, subject to the conditions of the rule. These conditions generally require the Investment Company to: (a) adopt a written derivatives risk management program; (b) comply with an outer limit on leverage risk based on a value-at-risk metric (VaR) of 200% of the Investment Company’s “designated reference portfolio” (250% for closed-end fund) which may be (i) an index meeting certain requirements, (ii) the Investment Company’s own securities portfolio (excluding derivatives transactions), or (iii) an absolute VaR of 20% of the Investment Company’s net assets (25% for closed-end funds); (c) have a board-designated derivatives risk manager; and (d) comply with certain recordkeeping requirements.
Investment Companies limiting their derivatives exposure to 10% or less of net assets will be exempt from the written derivatives risk management program and VaR limitations but will be required to adopt and implement written policies and procedures reasonably designed to manage their derivatives risks.
Leveraged and inverse Investment Companies will generally be subject to Rule 18f-4, which will limit their ability to leverage to 200%. Leveraged and/or inverse Investment Companies currently in operation that are designed to utilize leverage in a manner that would exceed the new rule’s limitations are permitted to continue operating at their current leverage limits, subject to certain conditions.
Exchange Traded Funds
The SEC also adopted amendments to Rule 6c-11 under the 1940 Act to permit leveraged or inverse ETFs to rely on Rule 6c-11 if they comply with the conditions of Rule 18f-4 – as originally adopted the ETF rule prohibited these types of funds from relying on the rule and, as a result, such vehicles had to continue to seek exemptive relief.
With respect to reverse repurchase agreements, Rule 18f-4 permits an Investment Company to either comply with the asset coverage requirements of Section 18 of the 1940 Act or treat such transactions as derivatives transactions for all purposes under Rule 18f-4. An Investment Company may enter into unfunded commitment agreements if it reasonably believes, at the time it enters into such agreements, that it will have sufficient cash and cash equivalents to meet its obligations under such agreements as they come due (effectively, what appears to be a traditional coverage standard, although there is a bit of relaxation of the actual coverage requirements in that compliance appears to be based solely on a “belief” about coverage). The basis for its reasonable belief must be documented and retained. Rule 18f-4 also permits an Investment Company to invest in when-issued, forward-settling, and non-standard settlement cycle securities, provided the underlying security settles physically within 35 days of trade date.
The SEC did not adopt certain proposed sales practices rules that would have been applicable to leveraged and inverse Investment Companies. Instead, the SEC directed its staff to review the effectiveness of the existing regulatory requirements in protecting investors who invest in leveraged/inverse products, particularly those with self-directed accounts (i.e. those not utilizing a financial professional).
Two Commissioners voted against approval of Rule 18f-4. The dissenting Commissioners opposed the increase of the relative and absolute VaR limits in the final rule, which were 150% and 15%, respectively, in the proposed rule, and the elimination of the proposed sales practices rules.
Rule 18f-4 will be effective 60 days after publication in the Federal Register, with a compliance date 18 months after the effective date. We will publish a more detailed summary of Rule 18f-4 shortly.
- Use of Derivatives by Registered Investment Companies and Business Development Companies, Investment Company Act Rel. No. 34078 (Oct. 28, 2020) (“Adopting Release”). The Adopting Release is available at https://www.sec.gov/rules/final/2020/ic-34078.pdf.