The Securities and Exchange Commission (SEC) voted 3-2 on October 28, 2020 to adopt Rule 18f-4 under the Investment Company Act of 1940, as amended (1940 Act), and related amendments (Rule 18f-4 or Final Rule) related to the use of derivatives by registered investment companies and business development companies (collectively, funds). Rule 18f-4 is designed to provide an updated and more comprehensive approach to the regulation of funds' use of derivatives and other transactions while enhancing investor protections. Rule 18f-4 will permit funds that meet its requirements to enter into derivatives transactions despite restrictions under Section 18 of the 1940 Act.
Section 18 restricts the ability of funds to issue “senior securities,” as defined in the 1940 Act, to protect investors from the risks associated with excessive leverage of investment companies. The SEC’s 1979 General Statement of Policy (Release 10666) and more than 30 no-action letters issued in the last four decades have provided guidance to allow funds to use certain forms of derivatives despite the restrictions of Section 18. However, the SEC recognized that as a result of market and industry developments in the past four decades, funds’ current practices on derivatives use may not address the concerns underlying Section 18.
In light of these concerns, the SEC proposed a new derivatives rule on November 25, 2019 (the 2019 Proposing Release), which was a re-proposal of an earlier 2015 proposal, in an attempt to replace its current multipart guidance framework with a comprehensive approach to regulating funds’ use of derivatives. Our previous alert on the 2019 Proposing Release summarizes its requirements and conditions, which included, among others, adopting a derivatives risk management program, designating a fund derivatives risk manager approved by the fund’s board, and complying with the outer value at risk (VaR) limit on fund leverage risk based on a relative VaR test.
The Final Rule, as adopted on October 28, 2020, is largely based on the 2019 Proposing Release, but it includes key differences as well. The requirements under the Final Rule and its differences from the 2019 Proposing Release are outlined below.
Overview of the Final Rule
The Final Rule provides a comprehensive approach to the regulation of funds’ use of derivatives. Rule 18f-4 will permit a fund to enter into derivatives transactions despite the restrictions under Section 18 of the 1940 Act, subject to the following conditions:
- Derivatives Risk Management Program. Rule 18f-4 will require a fund to adopt a written derivatives risk management program that contains policies and procedures reasonably designed to manage the fund’s derivatives risks. The program must be able to identify and assess the fund’s derivatives risks, establish and enforce measurable risk guidelines, provide for stress testing and backtesting, provide for internal reporting and escalation, and include program review elements. The program requirements are adopted largely as proposed in the 2019 Proposing Release.
- Board Oversight and Reporting. A fund’s board of directors will be required to approve the fund’s designation of its derivatives risk manager, who will be responsible for administrating the fund’s derivatives risk management program. The risk manager must be an officer or officers of the fund’s investment adviser and must have relevant experience regarding management of derivatives risk. The risk manager must at least annually evaluate the program’s effectiveness and provide written reports to the board regarding the program’s implementation and effectiveness as well as the results of the fund’s stress testing and backtesting and any exceedances of the fund’s guidelines. The requirements on board oversight and designation of the risk manager are adopted largely as proposed in the 2019 Proposing Release.
- Limit on Fund Leverage Risk. A fund engaging in derivatives transactions will have to comply with an outer VaR limit on fund leverage risk. The 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. The designated reference portfolio could be an index that meets certain requirements or the fund’s own securities portfolio (excluding derivatives transactions). The fund’s outer VaR limit is set at 200% of the VaR of the fund’s designated reference portfolio, unless the fund is a closed-end company that has then-outstanding shares of preferred stock issued to investors, in which case the VaR must not exceed 250% of the VaR of the fund’s designated reference portfolio. If a fund’s derivatives risk manager is unable to identify an appropriate designated reference portfolio, the fund will be subject to an absolute VaR test, under which the fund’s VaR cannot exceed 20% of the value of the fund’s net assets. A fund will be required to determine its compliance with the applicable VaR test at least once each business day, and if the fund is not in compliance, it would have to come back into compliance 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, the derivatives risk manager must analyze the circumstances that caused the fund to be out of compliance for more than five days and provide a written report to the board.
The Final Rule’s outer limits on VaR are an increase from the lower relative and absolute VaR limits of 150% and 15%, respectively, that were proposed in the 2019 Proposing Release. Moreover, under the 2019 Proposing Release, a fund would not have been permitted to use its own securities portfolio as the reference portfolio for purposes of the relative VaR test and a fund not in compliance with the VaR test would have been required to come back into compliance within three business days.
- Exception for Limited Derivatives Users. Rule 18f-4 will exempt a fund that limits its derivatives exposure to 10% of its net assets from the derivatives risk management program requirement, the VaR-based limit on fund leverage risk, and the related board oversight and reporting requirements. These limited derivatives users will still be required to adopt policies and procedures that are reasonably designed to manage derivatives risks. If a fund’s derivatives exposure exceeds the 10% threshold for more than five business days, the fund’s adviser must provide a written report to the fund’s board informing it whether (i) the adviser intends to reduce the exposure within no more than 30 days, or (ii) put in place a derivatives risk management program and comply with the VaR-based limit on fund leverage risk as soon as reasonably practicable.
The Final Rule, in contrast to the 2019 Proposing Release, excludes certain hedging transactions from the 10% derivatives exposure threshold and puts in place more specific guidelines for limited derivatives users that exceed the 10% threshold.
- Leveraged or Inverse Funds. Under the Final Rule, in stark contrast to the 2019 Proposing Release, leveraged and inverse funds will generally be subject to Rule 18f-4. The Final Rule provides an exception from the VaR-based limit for leveraged and inverse funds in operation as of October 28, 2020 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 and other requirements of Rule 18f-4. The Final Rule expands recently adopted Rule 6c-11, which currently does not apply to leveraged or inverse exchanged-traded funds (ETFs) and commodity pools, to allow these investment vehicles to rely on Rule 6c-11.
- Reverse Repurchase Agreements and Unfunded Commitment Agreements. The Final Rule permits a fund to engage in reverse repurchase agreements and other similar transactions as long as it is subject to the asset coverage requirements of Section 18. The Final Rule also permits a fund to enter into an unfunded commitment agreement if the fund reasonably believes, at the time it enters into such an agreement, that it will have sufficient assets to meet its obligations under the agreements as they come due. A fund’s reasonable belief would take into account the fund’s unique facts and circumstances as well as the fund’s reasonable expectations with respect to its other obligations, its strategy, its assets’ liquidity, its borrowing capacity and the contractual provisions of its unfunded commitment agreements.
The Final Rule, in contrast from the 2019 Proposing Release, will permit a fund to enter into reverse repurchase agreements and similar financing transactions by electing to treat them as derivatives transactions. This approach is designed to permit funds to apply a consistent set of requirements to its derivatives transactions and any reverse repurchase agreements or similar financing transactions.
- Delayed-Settlement Securities Provision. The Final Rule includes a provision that will permit a fund to invest in securities on a when-issued or forward-setting basis, or with a non-standard settlement cycle, and the transaction will be deemed not to involve a senior security. The scope of this delayed-settlement securities provision includes money market funds in addition to the other funds to which Rule 18f-4 applies. The provision is subject to two conditions: (i) the fund must intend to settle the transaction physically, i.e. actually purchase or sell the security, as opposed to executing an offsetting transaction, and (ii) the transactions must settle within 35 days. This delayed-settlement securities provision was not a part of the 2019 Proposing Release.
- Recordkeeping. A fund will be required to maintain records of documents related to the fund’s derivatives risk management program and VaR tests and materials provided to the board. A fund that is a limited derivatives user will be required to maintain records of its policies and procedures reasonably designed to manage its derivatives risks. A fund that enters into a reverse repurchase agreement or similar financing transaction must maintain a written record documenting whether the fund is treating these transactions under (i) an asset coverage requirements approach or (ii) a derivatives transactions approach. A fund that enters into unfunded commitment agreements will be required to maintain a record of its reasonable belief for entering into such agreements. The required records will have to be maintained for at least five years. The recordkeeping rules are largely adopted as proposed.
The Final Rule amends Forms N-PORT, N-LIQUID (which will be renamed Form N-RN) and N-CEN to include, among others, certain identifying information about the fund and information regarding the fund’s VaR and designed reference portfolio. Additionally, the Final Rule will rescind Release 10666 and certain of the SEC staff’s no-action letters and other guidance addressing derivatives transactions. The Final Rule will be effective 60 days after its publication in the Federal Register, but funds will have an 18-month transition period to come into compliance with Rule 18f-4 before Release 10666 is withdrawn.
Exclusion of the Proposed Sales Practices Rules
One of the most significant changes in the Final Rule from the 2019 Proposing Release is the Final Rule’s exclusion of the proposed sales practices rules. Under the 2019 Proposing Release, certain funds that seek to provide leveraged or inverse exposure to an underlying index, such as leveraged or inverse ETFs, would not have been subject to the limit on fund leverage risk. Instead, the 2019 Proposing Release had proposed sales practices rules designed to protect retail investors, which would have required broker-dealers and investment advisers to exercise due diligence on retail investors before approving retail investor accounts to invest in leveraged or inverse investment funds. The SEC, taking into consideration comments from the public on the 2019 Proposing Release, voted not to include the proposed sales practices rules in its Final Rule. As a result, under the Final Rule, leveraged and inverse funds will generally be subject to Rule 18f-4 similar to other funds that use derivatives.
During the SEC’s open meeting discussion held on October 28, 2020, one of the key points of contention among the Commissioners was the exclusion of the proposed sales practices rules in the Final Rule. Commissioners Allison Herren Lee and Caroline A. Crenshaw expressed concern that without the proposed sales practices rules, there would be limited protection for retail investors from the risk associated with investing in leveraged and inverse products. The Final Rule states that in order to address these concerns associated with risk to retail investors, the SEC has directed its staff to begin a review to assess the effectiveness of the existing regulatory requirements in protecting investors that invest in complex investment products including leveraged and inverse products.