The Investment Company Act of 1940 limits how registered funds and business development companies can obtain leverage, which is commonly thought of in terms of purchasing securities with borrowed funds. Derivatives, such as forwards, futures, swaps, and written options, can also create future payment obligations. The proposed rule permits funds to use derivatives that create these obligations provided that the funds comply with certain conditions designed to protect investors. The conditions include adopting a derivatives risk management program and complying with a limit on the amount of leverage-related risk that the fund may obtain based on value-at-risk (VaR). For funds that use derivatives in a limited fashion, more streamlined requirements may apply.

In addition, under the new proposed rule, a fund may be able to enter reverse repurchase agreements and similar financing transactions, as well as “unfunded commitments” to make certain loads or investments subject to conditions specific to these types of transactions. Some registered investment companies seeking to provide leveraged or inverse exposure to an underlying index (including leveraged ETFs) would not be subject to the proposed limit on fund leverage risk but would instead be required to comply with alternative requirements. These funds would be limited to seeking 300% of the return (or inverse of the return) of their underlying index (i.e., three times leveraged). Sales of such funds would also become subject to new sales practices rules under which a broker, dealer, or investment adviser registered with the SEC would have to exercise due diligence in approving a retail customer or client’s account to buy or sell shares of these funds, as well as shares of exchange-listed commodity or currency pools that have similar investment strategies.

The proposal includes new rules, amendments to rules, and amendments to forms. Specifically, new rule 18f-4 under the Investment Company Act would permit funds, ETFs, registered closed-end funds, and business development companies to enter into derivatives transactions and certain other transactions notwithstanding the restrictions under section 18 of the Act. In addition, the SEC is proposing the sales practices rules mentioned above: rule 15I-2 under the Securities Exchange Act of 1934 and rule 211(h)-1 under the Investment Advisers Act of 1940, which will address specific considerations raised by certain leveraged or inverse funds and exchange-listed commodity or currency pools. Rule 6c-11 under the Investment Company Act would be amended to allow certain leveraged or inverse ETFs to operate without obtaining an exemptive order.

Proposed Rule 18f-4 Under the Investment Company Act

Rule 18f-4 would include the following set of uniform conditions and exemptions:

• Derivatives Risk Management Program. The new rule generally requires a fund to implement a written, formalized derivatives risk management program. The program would institute a standardized risk management framework for funds while mandating principles-based tailoring of the program by each fund to the fund’s particular risks. The program would require: risk guidelines, stress testing, backtesting, internal reporting and escalation, and review elements. A derivatives risk manager approved by the fund’s board of directors would administer the program. This manager would report to the board on the program’s implementation and effectiveness to facilitate the board’s oversight.
• Limit on Fund Leverage Risk. A fund relying on the proposed rule would have to comply with an outer limit on fund leverage risk based on relative VaR, which compares the fund’s VaR to the VaR of a “designated reference index” for that fund. The fund’s VaR would be not be permitted to exceed 150% of the VaR of that designated index. If the fund’s derivative risk manager cannot identify a designated reference index, the fund would then be required to comply with an absolute VaR test, under which the VaR of its portfolio cannot exceed 15% of the value of the fund’s net assets.
• Exception for Limited Users of Derivatives. The new rule would offer an exception from the program requirement and the VaR-based limit on fund leverage risk for funds that either 1) limit their derivative exposure to 10% of their net assets, or 2) uses derivatives only to hedge certain currency risks.
• Alternative Conditions for Certain Leveraged or Inverse Funds. The proposed rule includes alternative conditions for certain leveraged or inverse funds such that the fund would be exempt from the proposed limit on fund leverage risk, provided that it: 1) limits the investment results it seeks to 300% of the return (or the inverse of the return) of the underlying index, 2) discloses in its prospectus that it is not subject to the proposed limit on fund leverage risk, and 3) is a fund to which the new proposed sales practices rules would apply. This last item would prohibit a retail investor from trading through a broker-dealer or investment adviser unless the broker-dealer or adviser were to approve the investor’s account for such trading (see proposed sales practice rules).
• Reverse Repurchase Agreements and Unfunded Commitment Agreements. The proposed rule would permit a fund to enter in reverse repurchase agreements and similar financing transactions, as well as “unfunded commitments”, subject to specified conditions.

Proposed Sales Practice Rules and Amendments to Rule 6c-11

The proposed sales practice rules would establish a set of due diligence and approval requirements for broker-dealers and SEC-registered investment advisers. This would be in respect to trades of shares of certain leveraged investment vehicles (leveraged or inverse funds and exchange-listed commodity or currency pools). Under these new rules, firms must exercise due diligence in determining whether to approve a retail customer to buy or sell leveraged investment vehicles. The approval is contingent upon the broker-dealer or investment adviser believing, based on a reasonable basis, that the customer/client is capable of evaluating the risks associated with these investment products.

In addition, the proposed amendments to Investment Company Act rule 6c-11 would permit certain leveraged or inverse ETFs to rely on this rule. In connection with the adoption of these proposed amendments, the SEC has proposed to rescind the exemptive orders previously issued.

Reporting Requirements

If a fund is out of compliance with the VaR-based limit on fund leverage risk for more than three consecutive business days, it would be required to report confidentially to the SEC on a current basis on Form N-LIQUID, which will be renamed to Form N-RN. Forms N-CEN and N-PORT will also be changed to require that funds that currently file these forms to provide certain information regarding a fund’s derivatives exposure and the fund’s VaR as applicable. This information would become publicly available.

Review of Relevant Staff Guidance

The SEC has proposed to rescind a 1979 General Statement of Policy (Release 10666), which provides SEC guidance on how funds may use certain derivatives and derivatives-like transactions in light of section 18’s restrictions. In addition, staff in the Division of Investment Management is reviewing its no-action letters and other guidance addressing funds’ use of derivatives and other transactions covered by the new proposed rule 18f-4 to determine which letters and guidance should be withdrawn.

The full text of the proposed amendments is available here. You can submit comments using the form available on the SEC’s website or by e-mailing rule-comments@sec.gov with the reference number (S7-24-15) in the subject line. You can also use the Federal Rulemaking Portal to submit comments or send your comments by mail to Vanessa A. Countryman, Secretary, Securities and Exchange Commission, 100 F Street, NE, Washington, DC 20549-1090. Again, please remember to include reference number S7-24-15. The SEC also approved two short-form tear sheets to gather information. Funds are encouraged to submit additional feedback on proposed rule 18f-4 in light of their current risk management practices. Broker-dealers and investment advisers are encouraged to submit additional feedback on the proposed sales practice rules. While any commenter may use these tear sheets, they are particularly aimed at smaller funds, advisers, and broker-dealers, and are designed to help these smaller entities provide feedback on how the proposal would affect them.

Sources:

SEC Proposes to Modernize Regulation of the Use of Derivatives by Registered Funds and Business Development Companies (www.sec.gov)

SEC Release No. 34-87607: 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 (www.sec.gov)

Division of Economic and Risk Analysis Economics Note: The Distribution of Leveraged ETF Returns (www.sec.gov)