SEC Adopts New Fund Derivatives Rule 18f-4 Under the 1940 Act
On October 28, 2020, a divided Securities and Exchange Commission (SEC) adopted a new rule, and related rule and form amendments, designed to provide a modernized, comprehensive approach to the regulation of the use of derivatives and other financial transactions by registered investment companies, i.e., mutual funds (other than money market funds), exchange-traded funds (ETFs), closed-end funds, and business development companies (collectively, funds).1The new rule, Rule 18f-4, and related rule and form amendments, which have been largely adopted as proposed2 but with certain modifications to address comments received by the SEC, permit funds to enter into derivatives and other financial transactions if they comply with certain conditions designed to protect investors and reflect developments over the past several decades. The SEC did not adopt certain proposed sales practices rules that would have been applicable to leveraged and inverse ETFs. Two of the Commissioners, Commissioner Crenshaw and Commissioner Lee, voted against adoption of Rule 18f-4 due to their opposition to the increase in the value-at-risk (VaR) limits relative to the proposed rule and the elimination of the sales practices rules.
Rule 18f-4 is an exemptive rule and permits funds to enter into “derivatives transactions”3 and certain other transactions notwithstanding the restrictions under Section 18 of the Investment Company Act of 1940 (1940 Act). To rely on Rule 18f-4 with respect to a fund’s derivatives transactions, a fund is required to meet the following conditions:1. Derivatives Risk Management Program. The rule requires a fund to adopt and implement a written derivatives risk management program,which includes policies and procedures reasonably designed to manage the fund’s derivatives risks. The fund’s program necessitates principles-based tailoring by a fund to its particular risks and is required to include elements covering: (i) risk identification and assessment of the fund’s derivatives transactions and how they interact with the fund’s other investments; (ii) risk guidelines incorporating quantitative or otherwise measurable criteria, metrics or thresholds related to the fund’s derivatives risks; (iii) weekly or more frequent stress testing and back-testing; (iv) internal reporting and escalation between the fund’s derivatives risk manager (see description below) and both portfolio management and the fund’s board; and (v) annual or more frequent program reviews.The derivatives risk management program requirement as adopted by the SEC retains the same framework and elements as the proposed program requirement.2. Limits on Fund Leverage Risk. A fund relying on the rule is required to comply with an outer limit on fund leverage risk based on the fund’s VaR.4 Specifically, the fund’s VaR is not permitted to exceed 200% of the VaR of the fund’s “designated reference portfolio” (the “relative VaR test”). A fund may use either a designated index that meets certain requirements5 or the fund’s own securities portfolio (excluding derivatives transactions) as its designated reference portfolio.If the fund’s derivatives risk manager reasonably determines that a designated reference portfolio would not provide an appropriate reference portfolio for purposes of the relative VaR test, taking into account the fund’s investments, investment objectives, and strategy, the fund’s VAR is not permitted to exceed 20% of the value of the fund’s net assets (the “absolute VaR test”). For registered closed-end funds that have issued and outstanding shares of preferred stock, the rule as adopted provides relative and absolute VaR limits of 250% and 25%, respectively. The rule requires a fund to determine its compliance with the applicable VaR test at least once each business day. If a fund determines that it is not in compliance with its applicable VaR test, it must become compliant promptly after such determination in a manner that is in the best interests of the fund and its shareholders. If the fund is not in compliance within five business days after such determination, it becomes subject to certain remediation provisions of the rule which include board and SEC reporting obligations.3. Board Oversight and Reporting.The rule requires specific oversight and reporting obligations, including that: (a) a fund’s board of directors (including a majority of independent directors) approve the designation of the fund’s derivatives risk manager; and (b) the derivatives risk manager provide regular written reports to the board regarding the derivative risk management program’s implementation and effectiveness, and analyzing exceedances of the fund’s guidelines and the results of the fund’s stress testing and back-testing. Additionally, the derivatives risk manager’s written report to the fund’s board must include, as applicable: (i) the derivatives risk manager’s basis for the approval of the designated reference portfolio (or the basis for any change in the designated reference portfolio) used under the relative VaR test, or (ii) an explanation of the basis for the derivatives risk manager’s determination that a designated reference portfolio would not provide an appropriate reference portfolio for purposes of the relative VaR test such that the fund relied on the absolute VaR test instead.A fund’s derivative’s risk manager must be an officer of the investment adviser and may be an individual (but not a portfolio manager of the fund) or a committee or group (but a majority of such committee or group cannot be portfolio managers of the fund). Also, the derivatives risk manager must have relevant experience regarding derivatives risk management. The Adopting Release also clarified that, in the context of sub-advised funds, an officer of the fund’s sub-adviser could serve as the fund’s derivatives risk manager either alone (in the case of a “single sleeve” sub-advised fund) or as a member of a committee or group, and, in any event, the fund’s derivatives risk manager may delegate specific risk management activities to sub-advisers, subject to appropriate oversight.The SEC adopted the board oversight and reporting requirements substantially as proposed, but with minor clarifying changes made in response to comments received. One change clarifies that the derivatives risk manager’s written report to the board should not simply include a list of every single exceedance of the risk guidelines during the period covered by the report, but rather an analysis of exceedances that occurred during the period (as well as stress testing and back-testing results). The SEC made this clarification because it believed that a simple listing of exceedances (along with stress testing and back-testing results) would provide less useful information to a fund’s board in contrast to an analysis of these matters.4. Exception for Limited Users of Derivatives. The rule provides an exception from the derivatives risk management program requirement and the VaR-based limit on fund leverage risk for a fund that limits its derivatives exposure6 to 10% of its net assets, excluding 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 fund’s borrowings. A fund that relies on the exception would still be required to adopt policies and procedures that are reasonably designed to manage its aggregate derivatives risk.In a change from the exception as proposed, the exception as adopted provides two options for a fund with derivatives exposure that exceeds the 10% threshold. If such a fund does not reduce its exposure within five business days, the fund’s investment adviser must provide a written report informing the fund’s board of the adviser’s intent to promptly reduce exposure (in no case greater than thirty (30) days), or, put in place a derivatives risk management program and comply with the VaR-based limit on fund leverage risk as soon as reasonably practicable.
Funds of Funds – VaR Testing
With respect to those funds (funds of funds) that invest in other funds (underlying funds), the SEC confirmed in the Adopting Release that a fund of funds that does not directly use derivatives transactions is not required to comply with Rule 18f-4 or look through to an underlying fund’s use of derivatives transactions for purposes of determining the fund of funds’ risk exposure.7 The SEC further confirmed that when a fund of funds directly engages in derivatives transactions beyond 10% of its net assets (in addition to holding shares of underlying funds), the fund of funds is required under the rule to calculate its own VaR. In recognition of the compliance challenges associated with obtaining daily transparency into the holdings of underlying funds, the SEC notes that the fund of funds may use the historic returns of the underlying funds in calculating the fund of funds’ VaR. The SEC further notes, however, that it would not be appropriate for the fund of funds to use its own historic return for purposes of calculating its VaR.
No Asset Segregation Required
Rule 18f-4 does not include a specific asset segregation requirement for derivatives or other financial transactions to which the rule applies. As in the Proposing Release, the Adopting Release explains that the SEC continues to believe that asset segregation is unnecessary in light of the rule’s requirements, including the requirements that funds establish derivatives risk management programs and comply with the VaR-based limit on fund leverage risk.
No Special Rules for Leveraged/Inverse Funds
No Alternative Requirements for Most Leveraged/Inverse Funds Under Rule 18f-4
Under Rule 18f-4 as proposed, a leveraged/inverse fund8 would not have been required to comply with the proposed VaR-based leverage risk limit provided the fund limits the investment results it seeks to 300% of the return (or inverse return) of its underlying index and discloses in its prospectus that it is not subject to Rule 18f-4’s limits on leverage risk. The SEC determined not to include these alternative requirements for leveraged/inverse funds in adopted Rule 18f-4, noting that, in light of the adjustments to the relative VaR test, many leveraged/inverse funds will be able to comply with the rule including the VaR-based leverage risk limit.
Exception for Certain Existing Leveraged/Inverse Funds Under Rule 18f-4
In the Adopting Release, the SEC recognizes that there are certain existing leveraged/inverse funds that seek an investment return above 200% of the return (or inverse of the return) of the fund’s underlying index, and that such funds, absent significant changes to their investment strategies, generally would not be able to satisfy the limit on fund leverage risk included in adopted Rule 18f-4. Accordingly, Rule 18f-4 includes a provision permitting these existing leveraged/inverse funds to continue operating at their current leverage levels, provided they comply with the other provisions of Rule 18f-4 and meet certain additional requirements.9
No Sales Practices Rules
In connection with proposing Rule 18f-4, the SEC also proposed new rules under the Securities Exchange Act of 1934, as amended, and the Investment Advisers Act of 1940, as amended, collectively referred to as the “sales practices rules.” These sales practices rules would have required broker-dealers, investment advisers, and their associated persons to exercise due diligence before accepting or placing orders for a leveraged/inverse fund. In adopting Rule 18f-4 and in response to significant comments received on the proposed sales practices rules, the SEC determined not to adopt the sales practices rules noting that the rules would have provided few additional protections for investors since their requirements are duplicative of existing SEC requirements for the activities of broker-dealers and investment advisers in the recommended transaction context, including Regulation Best Interest and investment advisers’ fiduciary obligations to their clients.10
Amendments to Rule 6c-11
In September 2019, the SEC adopted Rule 6c-11 under the 1940 Act (the ETF Rule) which permitted ETFs to operate without first obtaining exemptive relief provided the ETF met certain conditions. The ETF Rule when adopted specifically excluded leveraged/inverse ETFs. In light of the requirements of adopted Rule 18f-4, the SEC is amending the ETF Rule to remove the exclusion of leveraged/inverse ETFs, provided any such ETFs also comply with all of the applicable provisions of Rule 18f-4. In connection with the amendment to the ETF Rule, the SEC is also rescinding the exemptive orders previously issued to existing leveraged/inverse ETFs in an effort to establish a more level playing field and greater competition by having all sponsors be subject to the same conditions of the ETF Rule.
Reverse Repurchase Agreements, Similar Financing Transactions & Unfunded Commitment Agreements
Rule 18f-4, as adopted, allows a fund to enter into reverse repurchase agreements and similar financing transactions but, as the SEC explained in the Adopting Release, such agreements and transactions can represent either secured loans, which can be used to introduce leverage into a fund’s portfolio just like other forms of borrowings, or they can represent derivatives transactions.11 Accordingly, the rule permits a fund to choose either to limit its reverse repurchase and other similar financing transaction activity to the applicable asset coverage limit of the 1940 Act for senior securities representing indebtedness, or a fund may choose instead to treat them as derivatives transactions for purposes of the rule. A fund’s election in this regard will apply to all of its repurchase agreements and similar financing transactions so that all such transactions are subject to a consistent treatment under the rule.Rule 18f-4, as adopted, also allows a fund to enter into “unfunded commitment agreements,”12 if the fund reasonably believes, at the time it enters into such an agreement, that it will have sufficient cash and cash equivalents to meet its obligations with respect to all of its unfunded commitment agreements, in each case as they come due. The Adopting Release notes that a fund should consider its unique facts and circumstances when determining whether such a reasonable belief exists, and the rule, as adopted, includes specific factors that the fund must take into account when making such a determination.
When-Issued and Forward-Settling Transactions
In adopting Rule 18f-4, the SEC included a provision in the rule that allows funds (including money market funds) to invest in securities on a when-issued or forward-settling basis, or with a non-standard settlement cycle, and the transaction will be deemed not to involve a senior security. This provision is subject to the following two conditions: (i) the fund must intend to settle the transaction physically; and (ii) the transaction must settle within thirty-five (35) days.
Amendments to Fund Reporting Requirements
The SEC also adopted, with certain modifications from the proposal, amendments to Forms N-PORT, N-LIQUID (which is to be re-titled “Form N-RN”), and Form N-CEN to enhance the SEC’s ability to oversee funds’ use and compliance with Rule 18f-4, as well as to provide the SEC and the public additional information regarding funds’ use of derivatives.13
Form N-PORT is amended to include a new non-public reporting item applicable to limited derivatives users. This new item requires a limited derivatives user to report (as a percentage of the fund’s net asset value): (1) the fund’s derivatives exposure; and (2) the fund’s derivatives exposure attributable to currency or interest rate derivatives entered into for hedging purposes. Furthermore, if a fund relying on that exception had derivatives exposure exceeding 10% of the fund’s net assets during the reporting period, and this exceedance persisted beyond the five-business-day remediation period permitted under Rule 18f-4, the fund will have to report the number of business days beyond the five-business-day remediation period that its derivatives exposure exceeded 10% of net assets.In addition, Form N-PORT is amended to include a new reporting item for funds that are subject to the rule’s VaR-based leverage risk limit. This information includes the fund’s median daily VaR for the reporting period. Funds subject to the relative VaR test also will have to report: (1) the name of the fund’s designated index or a statement that the fund used its securities portfolio as its designated reference portfolio; (2) the index identifier (if applicable); and (3) the fund’s median daily VaR Ratio for the reporting period. Finally, all funds that are subject to the VaR-based leverage risk limit also will have to report the number of exceptions that the fund identified as a result of the back-testing of its VaR calculation model. Information about a fund’s designated index will be made publicly available, but not a fund’s median daily VaR, median daily VaR ratio, and back-testing information.
Form N-LIQUID (to be re-titled “Form N-RN”)
Form N-LIQUID is to be re-titled to “Form N-RN” and amended to include reporting of VaR test breaches. Specifically, if a fund is subject to the relative VaR test, and the VaR of its portfolio exceeds 200% ( or 250% if the fund is a closed-end fund for which the higher threshold is applicable) of the VaR of its designated reference portfolio for five business days, the fund will be required to file a non-public report on Form N-RN.14 The report must include the following information: (1) the dates on which the fund’s portfolio VaR exceeded 200% (or 250%, as applicable) of the VaR of the designated reference portfolio; (2) the fund’s portfolio VaR for each of these days; (3) the VaR of the designated reference portfolio for each of these days; (4) the designated index or statement that the fund used its securities portfolio as its designated reference portfolio; and (5) the index identifier, if applicable. The fund also will have to file a report on Form N-RN when it is back in compliance with its applicable VaR test, indicating the dates on which the fund’s VaR exceeded the limit and the current VaR of the fund’s portfolio. Similarly, if a fund is subject to the absolute VaR test, and its absolute VaR exceeds 20% (or 25%, as applicable) of the fund’s net asset value for five business days, the fund will be required to file a comparable report on Form N-RN and a report when the fund is back in compliance.
Form N-CEN is amended to require funds to identify whether they relied on Rule 18f-4 during the reporting period. Funds also have to identify: (1) whether they are a limited derivatives user excepted from the rule’s program requirement and VaR tests; (2) whether they are a leveraged/inverse fund as defined in the rule; (3) whether they have entered into reverse repurchase agreements or similar financing transactions, either under the provision of the rule that requires a fund to comply with the asset coverage requirements of Section 18 or under the provision that requires a fund to treat such transactions as derivative transactions under the rule; (4) whether they have entered into unfunded commitment agreements under the rule; and (5) whether they are relying on the provision of the rule that addresses investment in when-issued and forward-settling securities. All of this information will be available to the public.
The SEC is also amending Form N-2 to provide that closed-end funds relying on Rule 18f-4 will not be required to report derivatives transactions and unfunded commitment agreements in the senior securities table of Form N-2.
Rule 18f-4, as adopted, also requires a fund to maintain certain records for a period of five years to allow the SEC staff and the fund’s compliance personnel to evaluate the fund’s compliance with the rule’s requirements. The rule requires that a fund maintain certain records related to the following, among other things: (i) the fund’s derivatives risk management program; (ii) the designation of the fund’s derivatives risk manager and any written reports provided to the board of directors; (iii) the fund’s determination of its VaR and any VaR calculation models; (iv) if the fund is a limited derivatives user, the fund’s written record of its policies and procedures designed to manage its derivatives risk; and (v) the basis for the fund’s belief regarding its ability to meet its obligations with respect to each unfunded commitment agreement entered into. In adopting the rule, the SEC added a requirement that funds that enter into reverse repurchase agreements or similar financial transactions maintain written records documenting whether a fund is complying with the asset coverage requirements of Section 18 of the 1940 Act or is treating them as derivatives transactions under Rule 18f-4.
Effective & Compliance Dates, Transition Period & Effect on Existing Guidance
Rule 18f-4, and the related rule and form amendments, will be effective sixty (60) days after publication in the Federal Register. The SEC has adopted a compliance date that is eighteen months after the effective date, which the SEC believes will provide funds a sufficient transition period to come into compliance with the rule and related reporting requirements.In connection with the adoption of the Rule 18f-4, and related rule and form amendments, the SEC is rescinding its release on Securities Trading Practices of Registered Investment Companies from April 1979 (Release 10666), effective eighteen months after the rule’s effective date.15 In addition, the staff in the SEC’s Division of Investment Management has reviewed no-action letters and other guidance addressing derivatives or other transactions covered by Rule 18f-4 to determine which letters and other SEC staff guidance , or portions thereof, should be withdrawn. Upon review, the SEC determined that certain of these letters and other SEC staff guidance will be moot, superseded, or otherwise inconsistent with Rule 18f-4 and, therefore, will be withdrawn effective upon the rescission of Release 10666.Funds may rely on Rule 18f-4 after its effective date but before the compliance date, provided that they satisfy the rule’s conditions.16 Any fund, however, that elects to rely on Rule 18f-4 prior to the date when Release 10666 is rescinded may rely only on the rule, and not also consider Release 10666, staff no-action letters, or other SEC staff guidance in determining how it will comply with respect to its use of derivatives.
The adoption of Rule 18f-4, along with the related rule and form amendments, significantly alter funds’ ability to enter into derivatives and other financial transactions, present new operational challenges, expand reporting requirements, and impose new and enhanced oversight responsibilities on funds’ boards of directors. Despite the significant transition period provided by the SEC, we recommend that fund sponsors begin drafting and/or reviewing policies, processes and procedures sooner rather than later in order to ensure ample time to come into compliance with the new rule and amended reporting requirements.Please contact Steve King, Ethan Corey, or the Practus LLP attorney who usually advises you with any questions you may have or if you would like additional information.Article Footnotes
Rule 18f-4 defines “derivatives transaction” to mean: (1) any swap, security-based swap, futures contract, forward contract, option, any combination of the foregoing, or any similar instrument (derivatives 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 margin or settlement payment or otherwise; (2) any short sale borrowing; and (3) any reverse repurchase agreement and similar financing transaction, for those funds that choose to treat these transactions as derivatives transactions under the rule.
Under Rule 18f-4, the term “value-at-risk” or “VaR” means “an estimate of potential losses on an instrument or portfolio, expressed as a percentage of the value of the portfolio’s assets (or net assets when computing a fund’s VaR), 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: (i) equity price risk, interest rate risk, credit spread risk, foreign currency risk and commodity price risk; (ii) material risks arising from the non-linear price characteristics of a fund’s investments, including options and positions with embedded optionality; and (iii) 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 defines the term “designated index” to mean an “unleveraged index” that: “(1) is approved by the derivatives risk manager for purposes of the relative VaR test and that reflects the markets or asset classes in which the fund invests and (2) is not 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 definition in the rule further specifies that “[i]n the case of a blended index, none of the indexes that compose the blended index may 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.”
Rule 18f-4 defines the term “derivatives exposure” to mean the sum of: (1) the gross notional amounts of a fund’s derivatives transactions such as futures, swaps, and options; and (2) in the case of short sale borrowings, the value of the assets sold short.
For funds that enter into derivatives transactions indirectly through controlled foreign corporations, the SEC notes in the Adopting Release that these derivatives transactions are treated as direct investments of the fund for purposes of Rule 18f-4.
Rule 18f-4 defines a “leveraged/inverse fund” to include a fund “that seeks, directly or indirectly, to provide investment returns that correspond to the performance of a market index by a specified multiple (“leverage multiple”), or to provide investment returns that have an inverse relationship to the performance of a market index (“inverse multiple”), over a predetermined period of time.” The Proposing Release used the term “leveraged/inverse investment vehicle” to expand the definition of a “leveraged/inverse fund” to include exchange-listed commodity- or currency-based trusts or funds (or “listed commodity pools”) covered by the proposed rule.
These additional requirements include: (i) that the fund be in existence as of October 28, 2020 and have outstanding shares issued to public investors; (ii) that the fund currently discloses in its prospectus a leverage multiple or inverse multiple that exceeds 200% of the performance or the inverse of the performance of the underlying index; (iii) that the fund may not change the underlying market index or increase the level of leveraged or inverse market exposure the fund seeks, directly or indirectly, to provide; and (iv) that the fund disclose in its prospectus that it is not subject to the limiting fund leverage risk condition of Rule 18f-4.
Notwithstanding the decision not to include the sales practices rules in Rule 18f-4 as adopted, the SEC has directed its staff to review the effectiveness of existing regulatory requirements in protecting investors, particularly those with self-directed accounts, who invest in complex investment products including leveraged or inverse products. As part of this review, the SEC staff will consider whether the SEC’s promulgation of any additional requirements for these products may be appropriate. See Joint Statement Regarding Complex Financial Products and Retail Investors, SEC (Oct. 28, 2020), available at https://www.sec.gov/news/public-statement/clayton-blass-hinman-redfearn-complex-financial-products-2020-10-28.
In both the Proposing Release and Adopting Release, the SEC notes that “similar financing transactions” may include securities lending arrangements and tender option bonds. With respect to securities lending arrangements, which the SEC notes are structurally similar to reverse repurchase agreements, the SEC explains that it would not view a fund’s obligation to return securities lending collateral as a “similar financing transaction” for purposes of Rule 18f-4, provided: (i) the fund reinvests cash collateral in cash or cash equivalents; and (ii) the fund does not sell or otherwise use non-cash collateral to leverage its portfolio. With respect to tender option bond financings, which the SEC similarly notes are economically similar to reverse repurchase agreements, the SEC explains that a fund’s obligations with respect to such a financing may be a “similar financing transaction,” for purposes of Rule 18f-4, depending on the facts and circumstances.
Rule 18f-4 defines “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.”
The additional reporting requirements resulting from the amendments to Form N-PORT and Form N-CEN do not apply to business development companies, which are not currently required to file reports on Form N-PORT or Form N-CEN.
Currently, only open-end funds (excluding money market funds) are required to file reports on Form N-LIQUID. In connection with the change to Form N-RN and amendments to the information to be reported, the SEC is requiring that all funds that are subject to Rule 18f-4’s VAR-based leverage risk limit be required to file current reports on Form N-RN regarding VaR test breaches.
See Securities Trading Practices of Registered Investment Companies, Investment Company Act Release No. 10666 (Apr. 18, 1979).
These conditions include: (i) if a fund experiences a reportable event on Form N-RN, the fund must file a Form N-RN with the SEC in a timely manner and in accordance with instructions specified in that form; and (ii) a fund must also comply with the amendments to Form N-PORT and Form N-CEN.
Practus, LLP provides this information as a service to clients and others for educational purposes only. It should not be construed or relied on as legal advice or to create an attorney-client relationship. Readers should not act upon this information without seeking advice from professional advisers.