The US Securities and Exchange Commission (SEC) proposed new rules and amendments on November 25 that establish requirements for the use of derivatives and other financial transactions by registered investment companies, i.e., mutual funds, exchange-traded funds (ETFs), and closed-end funds, and business development companies (collectively, funds). The Proposing Release consists of three parts: (1) new Rule 18f-4 under the Investment Company Act of 1940, as amended (the 1940 Act), which is designed to provide a comprehensive approach to the regulation of funds’ use of derivatives and other financial transactions; (2) proposed sales practices rules designed to address investor protection concerns with respect to leveraged/inverse funds; and (3) proposed amendments to Forms N-PORT, N-LIQUID, and N-CEN.
If adopted, the changes in the Proposing Release would 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.
Proposed Rule 18f-4 is a re-proposal of a 2015 proposed rule of the same name (the 2015 proposed rule), which would have permitted a fund to enter into derivatives transactions and “financial commitment transactions,” subject to certain conditions. Proposed Rule 18f-4 would be an exemptive rule and would permit funds to enter into “derivatives transactions” and certain other transactions notwithstanding the restrictions under Section 18 of the 1940 Act. To rely on proposed Rule 18f-4, with respect to a fund’s derivatives transactions, a fund would be required to meet the following conditions:
Unlike the 2015 proposed rule, proposed Rule 18f-4 does not include a specific asset segregation requirement for derivatives or other financial transactions to which the proposed rule would apply. The Proposing Release explains that the SEC believes asset segregation is unnecessary in light of the proposed rule’s requirements, including the requirements that funds establish derivatives risk management programs and comply with the proposed VaR-based limit on fund leverage risk. In addition, proposed Rule 18f-4 does not contain a limit based on notional size which had been criticized by several market commentators and trade associations as being too restrictive, particularly with respect to those funds which use derivatives to offset risks (e.g., use of interest rate swaps to help offset duration risk).
Alternative Requirements Under Proposed Rule 18f-4
Under proposed Rule 18f-4, leveraged/inverse funds would not have 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 proposed Rule 18f-4’s limits on leverage risk.
Sales Practices Rules
The SEC is also proposing Rule 15l-2 under the Securities Exchange Act of 1934, as amended, and Rule 211(h)-1 under the Investment Advisers Act of 1940, as amended (the Advisers Act), collectively deemed the “sales practices rules.” These sales practices rules would require broker-dealers, investment advisers, and their associated persons to exercise due diligence before accepting or placing orders for a leveraged/inverse investment vehicle on behalf of a retail investor, which the SEC defines as all natural persons, including high-net-worth individuals and nonprofessional legal representatives of natural persons. Under the proposed sales practices rules a broker-dealer or investment adviser would only be able to approve retail investors for transacting in leveraged/inverse investment vehicles if the firm has exercised due diligence to ascertain certain facts regarding the retail investor and, as a result, has a reasonable basis for believing that the retail investor has the knowledge and experience in financial matters to be capable of evaluating the risks associated with these vehicles. The SEC notes this requirement is almost taken verbatim from the “knowledge and experience” test in the FINRA options rule. The due diligence requirement is applicable without regard to whether the investor is trading leveraged/inverse investment vehicles on their own initiative or on the broker-dealer’s recommendation or the adviser’s advice. The SEC further specified that the proposed rules would only require that a broker-dealer or investment adviser approve the investor’s account before the investor begins investing in such vehicles and that firms would not need to reevaluate a retail investor before each individual transaction involving leveraged/inverse investment vehicles. The sales practices rules would still require due diligence for clients with existing accounts, but not for already existing positions in leveraged/inverse investment vehicles.
The sales practices rules also require that broker-dealers and investment advisers adopt and implement policies and procedures reasonably designed to achieve compliance with the rules’ requirements. Firms would also have to maintain records of the firm’s written approval of investor accounts and of the firm’s policies and procedures for a period of six years.
The SEC added that compliance with the proposed sales practices rules would not supplant or by itself satisfy a broker-dealer’s or an investment adviser’s existing obligations, such as a broker-dealer’s duties under Regulation Best Interest or an adviser’s fiduciary duties under the Advisers Act.
Amendments to Rule 6c-11
Earlier this year the SEC specifically excluded leveraged/inverse ETFs from Rule 6c-11 under the 1940 Act (the ETF Rule) which permits ETFs to operate without first obtaining exemptive relief, provided the ETF meets certain conditions. In light of the requirements of proposed Rule 18f-4 and the sales practices rules, the SEC is proposing to amend the ETF Rule to remove the exclusion of leveraged/inverse ETFs. In connection with the proposed amendment, the SEC also proposes to rescind 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.
The SEC is further proposing amendments to Forms N-PORT, N-LIQUID, and N-CEN to incorporate derivatives exposure information from funds that would rely on proposed Rule 18f-4.
Funds subject to the proposed VaR-related N-PORT item would be required to provide their median daily VaR for the monthly reporting period, as well as the highest daily VaR and its corresponding date for the reporting period. In addition, funds subject to the relative VaR test would need to report the fund’s designated reference index, including the index identifier; the fund’s median VaR ratio (the fund’s VaR over the reference index’s VaR) for the reporting period; and its highest VaR ratio for the period, as well as its corresponding date. Further, a fund would have to report the number of exceptions it identified when backtesting its VaR calculation model.
Form N-LIQUID would be retitled to “Form N-RN” and amended to include events for VaR test breaches. If a fund fails to come back into compliance within three business days after a VaR test breach, it would be required to file a report on Form N-RN within one business day following the third business day of noncompliance. A fund subject to the relative VaR test would need to report the date of the breach, the VaR of each date that it is not in compliance, the VaR of its designated reference index for those days, and the index name and identifier. A fund subject to the absolute VaR test will need to report the dates of noncompliance, the VaR of its portfolio on each of those days, and the value of its net assets on those days. A fund would then need to file another report on Form N-RN when it returns to compliance. The SEC is also proposing to amend Rule 30b1-10 under the 1940 Act to reflect that all funds subject to VaR tests, and not just registered open-end funds, must file current reports regarding VaR test breaches on Form N-RN. VaR test breach related filings on Form N-RN would be nonpublic.
The proposed amendments to Form N-CEN would require funds to identify whether they relied on proposed Rule 18f-4 or any exceptions during the reporting period. Funds would also have to identify whether they entered into any unfunded commitment agreements or reverse repurchase agreements, or similar agreements, during the reporting period.
The SEC is also proposing to amend Form N-2 to provide that closed-end funds relying on proposed Rule 18f-4 would not be required to report derivatives transactions and unfunded commitment agreements in the senior securities table of Form N-2.
Reverse repurchase agreements and similar financing transactions are not treated as derivatives transactions under proposed Rule 18f-4 because, as the SEC explained in the Proposing Release, such agreements and transactions “have the economic effects of a secured borrowing, and thus more closely resemble bank borrowings with a known repayment obligation rather than the more-uncertain payment obligations of many derivatives.” Thus, proposed Rule 18f-4 would treat them differently than derivatives and would allow a fund to enter into a reverse repurchase agreement or other similar financing transaction so long as the fund meets the relevant asset coverage requirements of Section 18 under the 1940 Act.
Proposed Rule 18f-4 would also allow a fund to enter into “unfunded commitment agreements,” 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 Proposing Release notes that a fund should consider its unique facts and circumstances when determining whether such a reasonable belief exists, and the proposed rule includes specific factors that the fund must take into account when making such a determination.
Proposed Rule 18f-4 would also require 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 proposed rule’s requirements. The proposed 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; (iii) the fund’s determination of its VaR and any VaR calculation models; (iv) the fund’s written record of its policies and procedures designed to manage its derivatives risk, if the fund is a limited derivatives user; and (v) the basis for the fund’s belief regarding its ability to meet its obligations with respect to its unfunded commitment agreements.
Comments on the proposal are due 60 days after the Proposing Release is published in the Federal Register. This publication process typically takes less than two weeks, so we expect comments will be due during the first calendar quarter of 2020.
In connection with the Proposing Release, the SEC is also proposing to rescind its release on Securities Trading Practices of Registered Investment Companies from April 1979 (Release 10666). In addition, the staff in the SEC’s Division of Investment Management is reviewing no-action letters and other guidance addressing derivatives and other transactions covered by proposed Rule 18f-4 to determine which letters and other staff guidance, or portions thereof, should be withdrawn if Rule 18f-4 is adopted.
If the proposed changes are adopted, the Proposing Release states that following the publication of any final rules in the Federal Register, a one-year transition period would be provided for funds, broker-dealers, and investment advisers to prepare to come into compliance with the new rules and amendments. The SEC noted that until the end of the one-year transition period following the adoption of the proposed changes, its current guidance, including Release 10666 and all related no-action letters, will remain in place.
If you have any questions or would like more information on the issues discussed in this LawFlash, please contact any of the following Morgan Lewis lawyers:
Michael M. Philipp
Thomas V. D’Ambrosio
Laurie A. Dee
 See Use of Derivatives by Registered Investment Companies and Business Development Companies, Investment Company Act Rel. No. 31,933 (Dec. 11, 2015). For further information regarding the 2015 proposed rulemaking, please refer to Morgan Lewis’ LawFlash: SEC Proposes Requirements for Funds’ Use of Derivatives and Other Financial Transactions, January 14, 2015.
 The Proposing Release 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; and (2) any short sale borrowing.
 The Proposing Release does not address compliance with other issues that arise under the 1940 Act with respect to the use of derivatives, such as the appropriate treatment of derivatives under the provisions of the 1940 Act governing issuer diversification, industry concentration and investments in securities-related issuers.
 Rule 18f-4 would define the term “designated reference index” to mean an “unleveraged index” that: “is selected by the derivatives risk manager and that reflects the markets or asset classes in which the fund invests;” is not administered by an affiliated person of the fund or certain other persons or created at the request of the fund or its investment adviser, unless the index is widely recognized and used; and is an “appropriate broad-based securities market index” or “additional index,” as defined in the instruction to Item 27 of Form N-1A. If the fund is complying with the relative VaR test, an open-end fund must disclose in its annual report the fund’s designated reference index as the fund’s “appropriate broad-based securities market index” or an “additional index” and a registered closed-end fund or business development company must disclose its designated reference index in the annual report, together with a presentation of the fund’s performance relative to the designated reference index.
 Under Rule 18f-4, the term “value at risk” would mean “an estimate of potential losses on an instrument or portfolio, expressed as a percentage of the value of the portfolio’s net assets, 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: (A) Equity
price risk, interest rate risk, credit spread risk, foreign currency risk and commodity price risk; (B) Material risks arising from the nonlinear price characteristics of a fund’s investments, including options and positions with embedded optionality; and (C) 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.”
 The Proposing Release defines “derivatives exposure” to mean the sum of the notional amounts of the fund’s derivatives instruments and, for short sale borrowings, the value of any asset sold short. As a result, “a fund may convert the notional amount of interest rate derivatives to 10-year bond equivalents and delta adjust the notional amounts of options contracts.”
 The Proposing Release defines “leveraged/inverse funds” to include funds “that seek, directly or indirectly, to provide investment returns that correspond to the performance of a market index by a specified multiple, or to provide investment returns that have an inverse relationship to the performance of a market index, over a predetermined period of time.”
 The Proposing Release uses “leveraged/inverse investment vehicle” to expand the definition of “leveraged/inverse funds” to include exchange-listed commodity- or currency-based trusts or funds (or “listed commodity pools”) covered by the proposed rule.
 The Proposing Release’s interpretation of “legal representative” is in line with the interpretation for Form CRS and Regulation Best Interest.
 Rule 2360(b)(19)(B) (“such knowledge and experience in financial matters that he may reasonably be expected to be capable of evaluating the risks of the recommended transaction”).
 See Exchange-Traded Funds, Investment Company Act Rel. No. 33,646 (Sept. 26, 2019).
 The Proposing Release notes the SEC has permitted only three ETF sponsors to operate such ETFs and has not granted such exemptive relief since 2009.
 The Proposing Release notes the SEC expects most business development companies to qualify for the limited derivatives user exception and thus elected not to expand Forms N-PORT and N-CEN to include business development companies.
 The Proposing Release notes the SEC’s views on two specific transactions under this requirement. First, a fund’s obligation to return securities lending collateral would not be treated as a “similar financing transaction” for purposes of Rule 18f-4, so long as the fund: (1) does not sell or otherwise use non-cash collateral received for loaned securities to leverage the fund’s portfolio; and (2) invests cash collateral solely in cash or cash equivalents. Second, a fund’s obligations with respect to a tender option bond financing may be a “similar financing transaction” depending on the facts and circumstances.
 The Proposing Release defines an “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.
 See Securities Trading Practices of Registered Investment Companies, Investment Company Act Release No. 10666 (Apr. 18, 1979).