Friday, October 30. 2020
SEC Revises Regulations for Derivatives Usage by Registered Funds and Business Development Companies
The modifications include:
- new rule 18f-4, which is an exemptive rule under the Investment Company Act of 1940 (the “Act”) subject to conditions
- revised rule 6c-11 under the Act, which allows leveraged or inverse ETFs to operate without obtaining an exemptive order
- new reporting requirements and amendments to certain disclosure forms
Rule 18f-4 Under the Investment Company Act
Rule 18f-4 provides certain exemptions from the Act and allows mutual funds (except for money market funds), exchange-traded funds (“ETFs”), registered closed-end funds, and business development companies (collectively, “funds”) to engage in derivatives transactions and certain other transactions, aside from the restrictions under section 18 of the Act. Conditions and other elements of the rule include the following:
Derivatives Risk Management Program. The new revisions generally require a fund to implement a derivatives risk management program that would concurrently establish a standardized risk management framework for funds while also allowing principles-based customizing by each fund to the fund’s specific risks. The fund’s derivatives risk manager is required to report to the fund’s board on the derivatives risk management program’s implementation and effectiveness to facilitate the board’s oversight of the fund’s derivatives risk management. The program must be administered by a derivatives risk manager approved by the fund’s board of directors, and the program must also incorporate: 1) stress testing and back testing, 2) risk guidelines and internal reporting and escalation, and 3) program review elements.
Limit on Fund Leverage Risk. A fund dependent on the rule generally must comply with an outer limit on fund leverage risk based on VaR. This outer limit is based on a relative VaR test that compares the fund’s VaR to the VaR of a “designated reference portfolio” for that fund. A fund usually can use either the fund’s own securities portfolio (excluding derivatives transactions) or an index that satisfies certain conditions as its designated reference portfolio. If the fund’s derivatives risk manager determines that a designated reference portfolio would not provide an appropriate reference portfolio for purposes of the relative VaR test, the fund would be required to comply with an absolute VaR test. The fund’s VaR generally is not allowed to exceed 200% of the VaR of the fund’s designated reference portfolio under the relative VaR test or 20% of the fund’s net assets under the absolute VaR test.
Recordkeeping. The rule mandates that the fund comply with certain recordkeeping requirements. Funds will be subject to recordkeeping stipulations regarding their derivatives usage.
Exception for Limited Users of Derivatives. Funds that utilize derivatives in a limited way will be assigned a streamlined set of requirements. The rule provides an exception from the program and VaR test requirements if the fund adopts and implements written policies and procedures reasonably designed to manage its derivatives risks. A fund may rely on this exception if the fund’s derivatives exposure is limited to 10% of its net assets, not including certain currency and interest rate hedging transactions.
Alternative Requirements for Certain Leveraged /Inverse Funds. As with other funds, leveraged/inverse funds will generally be subject to rule 18f-4, including the requirement to comply with the VaR-based limit on fund leverage risk. This will effectively restrict leveraged or inverse funds’ daily return goal to 200% of the return (or inverse of the return) of the fund’s underlying index. The final rule offers an exception from the VaR requirement for leveraged or inverse funds currently in operation that seek an investment return above 200% of the return (or inverse of the return) of the fund’s underlying index and satisfy certain conditions.
Reverse Repurchase Agreements and Unfunded Commitment Agreements. The rule permits a fund to enter into reverse repurchase agreements and comparable financing transactions, and “unfunded commitments” to make certain investments or loans, subject to conditions specific to these transactions. Under the rule, funds (including money market funds) will now be allowed to invest in securities on a forward-settling basis.
Forward-Settling, When-Issued, and Non-Standard Settlement Cycle Securities. The rule allows funds, including money market funds, to invest in securities on a forward-settling, when-issued basis, or with a non-standard settlement cycle, subject to conditions.
Amendments to Rule 6c-11
Modifications to Investment Company Act rule 6c-11 allow leveraged or inverse ETFs to rely on rule 6c-11 if they comply with all applicable provisions of rule 18f-4. The SEC is overturning the previously issued exemptive orders to the sponsors of leveraged or inverse ETFs in connection with the new amendments.
Funds will be required to report, in confidence, to the SEC on a current basis on Form N-RN if the fund does not comply with the VaR-based limit on fund leverage risk for more than five business days. Funds currently required to file reports on Forms N-PORT and N-CEN will need to provide certain information pertaining to a fund’s derivatives usage, more specifically, information regarding the fund’s VaR, as applicable, and details about the fund’s derivatives exposure (for funds that rely on the limited derivatives usage exception in rule 18f-4). There therefore will be forthcoming changes to Forms N-PORT, N-CEN, and N-RN (currently called Form N-LIQUID) to address new requirements.
Until the SEC completes the process of updating current Form N-LIQUID on EDGAR to reflect the amendments, including renaming the form as Form N-RN, a fund relying on rule 18f-4 may satisfy the requirement to file a report on Form N-RN by including information that Form N-RN requires in a report on Form N-LIQUID filed on EDGAR. Please contact the SEC with any questions regarding this process.
Relevant Staff Guidance
The SEC is overturning the 1979 General Statement of Policy (Release 10666) that provided SEC guidance on how funds may engage in certain trading practices considering section 18’s restrictions. Also, staff in the Division of Investment Management has reviewed its no-action letters and other guidance addressing funds’ use of derivatives as well as other transactions covered by rule 18f-4. Some of these staff letters and staff guidance will be removed. The SEC has instructed its staff toreassess the effectiveness of current regulatory requirements for protecting investors, specifically those with self-directed accounts, who invest in complex investment products (including inverse or leveraged products). The staff will also consider whether the SEC’s announcement of any added requirements for these products are appropriate.
The new amendments will be published on the SEC’s website and in the Federal Register. The rule and related rule and form amendments will go into effect 60 days following publication in the Federal Register. The SEC has adopted a compliance date that is eighteen months after the effective date, allowing a transition period for funds to comply with the provisions of rule 18f-4 and the related reporting requirements. The overturning of Release 10666 also will be effective eighteen months following the effective date.