December 18, 2015

Derivatives Alert: SEC’s Proposed Rule 18f-4 Would Impose Strict Obligations and Significantly Impact Registered Investment Companies Utilizing Derivatives

The Securities and Exchange Commission voted on December 11, 2015 to propose a rule that would greatly impact the use of derivatives and financial commitment transactions by mutual funds, exchange-traded funds (ETFs), closed-end funds and business development companies.1 The proposed rule—designated as Rule 18f-4 under the Investment Company Act of 1940 (the 1940 Act)—would require registered investment companies (funds) to comply with strict obligations such as limiting the amount of leverage a fund may obtain, requiring funds to hold more assets as cover to manage the derivatives risks, and, in certain circumstances, developing a derivatives risk management program. Therefore, the SEC’s proposed rule could greatly impact funds and their advisers and investors. In particular, leveraged ETFs and leveraged mutual funds may have difficulty continuing operations or adjusting their investment portfolio or strategy to comply with the proposed rule. The proposed rule would also create new supervisory and approval obligations on fund directors.

Along with the proposed rule, the SEC released a white paper that details the growth of derivative use as a whole, and within the registered investment company universe. In four years, from 2010 to 2014, the number of registered investment companies categorized as alternative strategy funds grew from 590 to more than 1,100, with total assets under management growing by almost $150 billion.2 SEC officials are concerned that the current use of derivatives by these funds is risky and occurring in volatile markets, and that retail investors in leveraged funds may not be fully informed, or may not fully comprehend, the extent or nature of the risks contained in their investments.

The proposed rule is promulgated under Section 18 of the 1940 Act, which was implemented to both curb a fund’s capacity to obtain leverage and limit those funds that were operating without adequate assets. The SEC, in light of the recent considerable growth of the derivatives market, is proposing to address concerns underlying Section 18 and provide a more comprehensive approach to regulating a fund’s use of derivatives transactions.

The proposed rule would not prohibit a fund’s use of derivatives but would impose sets of conditions that a fund must follow in order to engage in such transactions.

  • First, a fund must adhere to one of two different portfolio limitations on the amount of leverage that such fund may be able to obtain.
    • The first is the “exposure-based portfolio limit,” which would limit a fund’s exposure to derivatives to 150 percent of its net assets. A fund’s exposure is calculated as the aggregate notional amount of its derivatives transactions (subject to certain adjustments) in addition to its obligations under financial commitment transactions and other senior securities transactions.
    • The second limitation is the “risk-based portfolio limit.” This would allow a fund to undergo a risk assessment of the fund’s derivative use by using a test based on value-at-risk (VaR).3 After considering a fund’s derivative transactions in the aggregate, if the fund’s investment portfolio is subject to less market risk with the derivatives than without them, the fund may be allowed to obtain an exposure that is greater than that permitted under the exposure-based portfolio limit. Generally, however, the fund would be required to limit its exposure under all transactions to 300 percent of its net assets. A fund’s board of directors will be responsible for approving the selection of either the exposure-based portfolio limit or the risk-based portfolio limit.
  • Second, a fund must segregate and maintain “qualifying coverage assets,”4 thereby maintaining a certain amount of assets that would cover the fund’s derivative transactions obligations and additionally maintain a separate amount that would be used for future losses or obligations related to the transactions. The proposed rule requires that for each derivative transaction a fund should maintain qualifying coverage assets that have a value equivalent to the amount due if the fund were to exit such transaction at the time of determination (mark-to-market coverage amount). Furthermore, a fund would be required to maintain a second set of assets that is an estimate of the amount due if such fund were to exit the transaction under stressed conditions (risk-based coverage amount).
  • Finally, the proposed rule would require a fund to establish and implement a formal risk management program if it engages in complex derivative transactions5 or has substantial derivatives exposure (i.e., funds that exceed 50 percent notional derivatives exposure). If required, the risk management program and the appointment of its derivatives risk manager must be approved by the fund’s board of directors, including a majority of independent directors. This written derivatives risk management program must be reasonably designated to assess and manage the rights associated with the funds derivatives transactions and must be approved by the fund’s board of directors. It must (i) adopt and implement various written policies and procedures reasonably designed to, among other things, assess and monitor the risks associated with the fund’s derivatives transactions; (ii) inform portfolio management personnel regarding any material risks arising from such transactions; and (iii) review and update the risk management program on an annual or more frequent basis.


The rule would also allow funds to enter into financial commitment transactions, which include reverse repurchase agreements and short sale borrowings, so long as a fund maintains qualifying coverage assets that are equal to the amount (conditional or unconditional) that such fund must pay under each of its transactions. This contrasts with requiring a fund to pay a mark-to-market and risk-based coverage amount as necessary for derivatives transactions.

Finally, the rule also imposes recordkeeping obligations. The SEC is proposing amendments to Form N-PORT and Form N-CEN, both originally proposed by the SEC in May 2015. Funds would be required to report certain risk metrics and census-type information.

As the proposed rule is to be promulgated under the 1940 Act, it applies to registered investment companies. If promulgated as a final rule, Rule 18f-4 would be implemented with a phase-in period and would replace existing guidance and no-action relief related to the use of derivatives by registered investment companies. Private investment funds, commodity pools and exchange-traded notes not registered under the 1940 Act are not directly affected under the current draft of the proposed rule.

The proposal will be published both on the SEC’s website and in the Federal Register. The comment period will take place 90 days after publication.

>> See the proposed rule.

>> See the accompanying white paper.


[1]   The rule defines “derivatives transaction” as “any swap, security-based swap, futures contract, forward contract, option, any combination of the foregoing, or any similar instrument (‘derivatives instrument’) under which the 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 a margin or settlement payment or otherwise.” The rule defines “financial commitment transactions” as “any reverse repurchase agreement, short sale borrowing, or any firm or standby commitment agreement or similar agreement (such as an agreement under which a fund has obligated itself, conditionally or unconditionally, to make a loan to a company or to invest equity in a company, including by making a capital commitment to a private fund that can be drawn at the discretion of the fund’s general partner).”

[2]    Protecting Investors through Proactive Regulation of Derivatives and Robust Fund Governance, US Securities and Exchange Commission Public Statement, December 11, 2015.

[3]   The rule defines VaR as “an estimate of potential losses on an instrument or portfolio, expressed as a positive amount in U.S. dollars, over a specified time horizon and at a given confidence level.”

[4]   The rule defines Qualifying Coverage Assets as fund assets that are: “(i) Cash and cash equivalents; (ii) With respect to any derivatives transaction or financial commitment transaction under which the fund may satisfy its obligations under the transaction by delivering a particular asset, that particular asset; and (iii) With respect to any financial commitment obligation, assets that are convertible to cash or that will generate cash, equal in amount to the financial commitment obligation.”

[5]   The rule defines Complex Derivatives Transactions as “any derivatives transaction for which the amount payable by either party upon settlement date, maturity or exercise: (i) Is dependent on the value of the underlying reference asset at multiple points in time during the term of the transaction; or (ii) Is a non-linear function of the value of the underlying reference asset, other than due to optionality arising from a single strike price.”


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