The SEC adopted a revised version of a re-proposal of ICA Rule 18f-4 ("Exemption from the Requirements of Section 18 and Section 61 for Certain Senior Securities Transactions"). The new rule will replace SEC Release IC-10666 (April 18, 1979), which will no longer be effective.

As previously covered here and here, final ICA Rule 18f-4 provides an exemption from Section 18 ("Capital structure of investment companies") and Section 61 ("Board of Directors") under the Investment Company Act for mutual funds, exchange-traded funds ("ETFs"), registered closed-end funds, and business development companies ("BDCs") (collectively, "funds") when entering into derivatives transactions. Reliance on Rule 18f-4 will be subject to certain conditions, including:

  • the establishment of a written derivatives risk management program that includes, among other things, (i) a standardized risk management framework tailored to a fund's particular risks, (ii) the establishment, maintenance and enforcement of risk guidelines, and (iii) periodic review of the program;
  • designation by the fund's board of directors of a derivatives risk manager;
  • the establishment of an outer limit on fund leverage based on a relative value-at-risk ("VaR") test that compares the fund's VaR and the VaR of a "designated reference index"; and
  • recordkeeping requirements.

The final rule exempts (i) funds that use derivatives in a limited way from the derivatives risk management program requirement and the limit on fund leverage, and (ii) certain leveraged/inverse funds from the limit on fund leverage (permitting an investment return of 200% of the return, or its inverse, of the reference index).

The SEC also amended ICA Rule 6c-11 ("Exchange-Traded Funds") to permit certain leveraged or inverse ETFs to operate without receiving an individual exemptive order. (When that Rule was adopted to permit the establishment of ETFs without reliance on an individual exemptive order, the SEC had excluded leveraged ETFs from the ability to rely on the Rule. See 84 FR 57162 (Oct. 24, 2019).

The SEC also amended Forms N-PORT, N-LIQUID and N-CEN to require funds to provide certain information regarding the fund's derivatives exposure and VaR and VaR test breaches.

The SEC determined not to adopt (at this time) proposed Rule 15l-2 ("Broker and Dealer Sales Practices for Leveraged/Inverse Investment Vehicles") under the Securities Exchange Act and Rule 211(h)-1 ("Investment Adviser Sales Practices for Leveraged/Inverse Investment Vehicles") under the Advisers Act in order to address sales practices with respect to such vehicles. These rules, which were proposed in conjunction with Rule 18f-4, would have required broker-dealers and investment advisers to comply with "due diligence and approval" requirements prior to approving an order to buy and sell shares of leveraged investment vehicles, including a determination as to whether there is "reasonable basis" to believe that a retail customer or client can assess the risks associated with these products.

The final rule will go into effect 60 days after its publication in the Federal Register, and its compliance date is 18 months after its effective date.

SEC Commissioner Statements

SEC Chair Jay Clayton stated that the final rule allows funds to continue using derivatives in a way that adequately serves the investment goals of a fund, while also providing for Section 18 concerns to be addressed in a clear and consistent manner. Commissioner Elad Roisman also supported the final rule, stating that it achieves the goal of balancing careful risk management requirements with flexibility for advisers that is necessary for meeting investors' demands.

Commissioner Allison Herren Lee dissented, citing major differences between the proposal, which she supported, and the final rule. In particular, Ms. Lee expressed her disapproval of (i) the provision of the rule that doubles the leverage risk amount allowed by the SEC, (ii) the SEC's decision to remove "a significant amount of proposed disclosure around a fund's VaR" and (iii) the SEC's decision not to include the proposed sales practice rules. Commissioner Caroline Crenshaw also disapproved of the adoption, stating that it failed to adequately limit the ability of a registered fund to take on leverage.

While Commissioner Hester Peirce supported the adoption, she expressed concern that the rule "sets an unwelcome precedent" that imposes a duty (the selection of the fund's derivatives risk manager), which should belong to an advisor, on a fund's board. Additionally, Ms. Peirce questioned the decision of the SEC to prohibit new investors from investing in 300 percent ETFs, saying it raises "thorny questions of investor protection and investor opportunity."

Commentary

Rather than the SEC and CFTC reining in their staffs, they ought to be giving their staffs more authority to grant no-action relief. See CFTC Chair Tarbert Limits Authority of Staff to Grant Relief.

The interpretive release that Rule 18f-4 replaces is more than forty years old. As swaps developed and the use of listed futures increased over that time, it has become obvious that the original interpretive release treated similar transactions very differently, and produced economically irrational results.

The lesson to be learned is not that the Commissions should allow their staffs to engage in a comprehensive rulemaking as to the use of derivatives by registered investment companies. Rather, it is that the Commissions need to concentrate on the big stuff, such as this new Rule, and give more freedom to staff to allow divergences from rules. While it is of course uncomfortable to give up control, it should be even more uncomfortable to allow an interpretive release, in such an important area, to remain unfixed.

Bottom line: the Commissioners can only do so much. The less that they allow staff to make decisions, the more will simply go undone.

Primary Sources

  1. SEC Press Release: SEC Adopts Modernized Regulatory Framework for Derivatives Use by Registered Funds and Business Development Companies
  2. SEC Final Rule: Use of Derivatives by Registered Investment Companies and Business Development Companies
  3. SEC Statement, Allison Herren Lee: Final Rule on Funds' Use of Derivatives
  4. SEC Statement, Elad L. Roisman: Regulation of Funds' Use of Derivatives
  5. SEC Statement, Hester M. Peirce: Use of Derivatives by Registered Investment Companies and Business Development Companies
  6. SEC Statement, Jay Clayton: Modernizing the Regulatory Framework for Funds' Use of Derivatives
  7. SEC Statement, Caroline A. Crenshaw: Statement on Funds' Use of Derivatives

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