SEC Adopts Sweeping New Rules for Use of Derivatives by RICS and BDCS
40 Years in the Making: SEC Adopts Sweeping New Rules for Use of Derivatives by RICS and BDCS
After a protracted rulemaking comment period and re-proposal1, the SEC adopted a new exemptive rule 18f-4 (the “Rule” or “Rule 18f-4”), under the Investment Company Act of 1940 (the “40 Act”).2 In essence, the Rule will allow registered investment companies (“funds,” including BDCs) to engage in transactions involving “derivatives” by providing certain exemptions from Section 18 (and, as applicable to BDCs, Section 61) of the 40 Act. The final rulemaking also replaces, by the adoption of the Rule, a key SEC interpretive release3 and a host of related SEC staff no-action letters issued to date, beginning from 1979.
The Rule, along with complimentary amendments to other rules,4 provides an exemption from Sections 18 (Capital Structure of Investment Companies)5 and 61 (Capital Structure)6 of the 40 Act. According to the SEC, Rule 18f-4 “and rule amendments will provide a modernized, comprehensive approach to the regulation of these funds’ derivatives use that addresses investor protection concerns and reflects developments over the past decades.”7
Who is affected?
Rule 18f-4 applies to the following funds:
mutual funds (other than money market funds)
exchange-traded funds (ETFs)
registered closed-end funds, and
What are the conditions that must be met to use the exemptions afforded by Rule 18f-4?
Reliance on the Rule requires that a fund meet the following conditions:
Derivatives Risk Management Program
A Fund must establish a written program that articulates a standardized risk management program tailored to the fund’s specific risks. This program must be administered by a derivatives risk manager (who must be an officer or officers of the fund’s investment adviser other than the fund’s portfolio manager) approved by the fund’s board of directors, who will report to the board periodically (at least annually) on the program’s implementation and effectiveness.
The written Derivatives Risk Management Program should include provisions addressing:
backtesting (no less frequently than weekly);
internal reporting and escalation, and program review elements; and
administration by a derivatives risk manager (who must be an officer or officers of the fund’s investment adviser other than the fund’s portfolio manager)
Limits on Fund Leverage Risk
A fund relying on the exemptions under the Rule generally must comply with an outer limit on fund leverage risk based on either (i) a comparison of the fund’s “value-at-risk” (“VaR”) to the VaR of a “designated reference portfolio” (the “relative VaR limit”)8 or (ii) the VaR of the fund capped as a prescribed percentage of the fund’s net assets (the “absolute VaR limit”). The fund’s VaR generally is not permitted to exceed 200% of the VaR of the fund’s designated reference portfolio under the relative VaR limit or 20% of the fund’s net assets under the absolute VaR limit.9
Exception for Limited Users of Derivatives
Rule 18f-4 provides an exemption from the Derivatives Risk Management Program and Limit on Fund Leverage Risk requirements if the fund: (i) adopts and implements written policies and procedures reasonably designed to manage derivatives risk; and, (ii) has derivatives exposure limited to 10% or less of its net assets, excluding certain currency and interest rate hedging transactions. The Rule also provides an exemption from the VaR limits for leveraged or inverse leveraged 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 further conditions.
Reverse Repurchase Agreements and Unfunded Commitment Agreements
Funds may enter into reverse repurchase agreements and similar financing transactions (as well as “unfunded commitments” to make certain loans or investments), either by: (i) satisfying the asset coverage requirements of Section 18; or, (ii) treating reverse repurchase agreements or similar transactions as derivatives transactions for purposes of this section.
Rule 18f-4 requires that funds which do not comply with the VaR limits for more than 5 business days, report to the SEC on a current basis on Form N-RN.10 Funds currently required to file reports on Forms N-PORT and N-CEN will be required to provide certain information regarding a fund’s Derivatives use, including VaR and (for funds relying on the limited derivatives user exception to Rule 18f-4) other derivatives exposure information.
Other provisions of The Rule
In enacting Rule 18f-4, the SEC is withdrawing prior guidance on derivative use, including: (i) Release 10666; (ii) no-action letters and other guidance addressing funds’ use of derivatives as well as other transactions covered by the Rule; and, (iii) some but not all staff letters and guidance addressing fund derivatives usage as covered by Rule 18f-4.
The Rule permits funds, as well as money market funds, to, subject to conditions, invest in securities on a when-issued or forward-settling basis, or with a non-standard settlement cycle.
The Rule 18f-4 will be effective 60 days after publication in the Federal Register. Given the sweeping revisions contained therein, compliance with the Rule and related reporting requirements will be required after the expiration of an 18-month transition period following the effective date – i.e., in July 2022.
Rule 18f-4 provides for a sweeping change in the regulation of funds’ investment in derivatives. Among other things, the Rule imposes significant new compliance obligations including newly written programs and reporting obligations as well as increased oversight responsibilities for the fund boards of directors.
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1 The SEC proposed a new Rule 18f-4 in December 2015. See Use of Derivatives by Registered Investment Companies and Business Development Companies, Release No. IC-31933 (Dec. 11, 2015) (the “2015 Proposing Release”) viewable here: https://www.sec.gov/rules/proposed/2015/ic-31933.pdf. After extensive comments, the SEC offered a substantially different proposed Rule 18f-4 in November 2019. See Use of Derivatives by Registered Investment Companies and Business Development Companies; Required Due Diligence by Broker-Dealers and Registered Investment Advisers Regarding Retail Customers’ Transactions in Certain Leveraged/Inverse Investment Vehicles, Release No. 34-87607; IA-5413; IC-33704 (Nov. 25, 2019) (the “Re-proposal Release”) viewable here: https://www.sec.gov/rules/proposed/2019/34-87607.pdf.
2 Use of Derivatives by Registered Investment Companies and Business Development Companies, Release No. IC-34084, adopted October 28, 2020 (the “Adopting Release”) viewable here: https://www.sec.gov/rules/final/2020/ic-34084.pdf.
3 General Statement of Policy Release, Securities Trading Practices of Registered Investment Companies, Release No. IC-10666 issued on April 18, 1979.
4 Along with adopting Rule 18f-4, the SEC also amended other 40 Act rules prescribing the submission, by funds and BDCs, of various regulatory filings; namely: (i) the “ETF rule,” Rule 6c-11; (ii) Rule 22e-4, which governs Liquidity Risk Management Programs; (iii) Rule 30b1-10, the rule promulgating Form N-LIQUID, now renamed Form N-RN; (iv) Form N-CEN, the fund census data reporting form, as addressed by Rule 30a-1; and (vi) Form N-2, the 40 Act and public offering registration statement form for closed-end funds and BDCs as promulgated by various rules adopted under the 40 Act and the Securities Act of 1933. See Adopting Release at p. 2.
5 Among other things, Section 18 of the 40 Act imposes limits on a fund’s ability to effect borrowings or issuance of “senior securities”.
6 As applicable to closed-end funds electing to be treated and regulated as “business development companies” (“BDCs”) pursuant to sections 54 to 65 of the 40 Act.
7 SEC Adopts Modernized Regulatory Framework for Derivatives Use by Registered Funds and Business Development Companies, Press Release dated October 28, 2020. (the “Press Release”). https://www.sec.gov/News/press-release/2020-269
8 A fund generally can use either an index that meets certain requirements 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 be appropriate to use for purposes of the relative VaR limit, the fund would be required to comply with the absolute VaR limit.
9 Closed-end funds that have issued preferred stock are permitted to operate subject to moderately loosed risk limits, namely 250% of the VaR of the fund’s designate reference portfolio, by way of the relative VaR limit, or 25% of such fund’s net assets, by way of the absolute VaR limit.
10 The Adopting Release at p. 32.
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