SEC Proposes Amendments on Investment Companies' Use of Derivatives

The SEC reproposed a rule designed to "enhance" regulations on the use of derivatives by registered investment companies and business development companies ("BDCs").

According to the SEC, Proposed Rule 18f-4 under the Investment Company Act of 1940 would provide an exemption from Section 18 under the ICA for mutual funds, exchange-traded funds ("ETFs"), registered closed-end funds and BDCs (collectively, "funds") when entering into derivatives transactions.

The SEC explained that reliance on Proposed Rule 18f-4 would be subject to certain conditions, including:

  • the establishment of a written derivatives risk management program that includes, among other things, (i) a standardised risk management framework tailored to a fund's particular risks, (ii) the establishment, maintenance and enforcement of risk guidelines, and (iii) periodic review of the program;
  • designation of a derivatives risk manager by a fund's board of directors;
  • compliance with an outer limit on fund leverage based on a relative value-at-risk ("VaR") test that compares the fund's VaR and the VaR of a "designated reference index" for the fund; and
  • compliance to certain recordkeeping requirements.

The proposed rule would except (i) certain funds that use derivatives in a limited way from the derivatives risk management program requirement and the limit on fund leverage, and (ii) certain leveraged/inverse funds from the limit on fund leverage.

In addition, the proposal would create Rule 15l-2 under the Securities Exchange Act and Rule 211(h)-1 under the Investment Advisers Act in order to address sales practices with respect to leveraged or inverse funds and exchange-listed commodity or currency pools (a/k/a "leveraged investment vehicles"). These rules would require broker-dealers and investment advisers to comply with "due diligence and approval" requirements prior to approving an order to buy and sell shares of leveraged investment vehicles, including a determination as to whether there is "reasonable basis" to believe that a retail customer or client can assess the risks associated with these products. The proposal would also amend ICA Rule 6c-11 to permit certain leveraged or inverse ETFs to operate without receiving an exemptive order.

Additionally, the proposal would amend Forms N-PORT, N-LIQUID and N-CEN to require funds to provide certain information regarding (i) the fund's derivatives exposure and (ii) VaR and VaR test breaches.

Comments on the proposal must be submitted within 60 days after publication in the Federal Register.


The SEC has not undertaken a truly comprehensive review of its policies on the use of derivatives or effective leverage since its 1979 Release IC-10666. Since that time, the SEC has come out with guidance as to different types of derivative and credit transactions, but such guidance treated economically similar products in dissimilar manners - an approach that reflects the absence of any well-defined agency policy. It is past due for the SEC to take a step back and to formulate (with investor and industry input) guidance as to all types of derivative and financing transactions - swaps, forwards, futures, securities loans, repos - that will subject products with similar economics to similar rules.

The proposal of SEA Rule 15l-2 and ICA Rule 211(h)-1 is interesting. These proposed rules, if adopted, would build on the SEC's recent adoption of Regulation Best Interest. The proposal appears to signal that the SEC is continuing to move in the direction of being a "suitability" regulator as well as a disclosure regulator. That said, here the focus is on a well-defined and high risk product where the broker-dealer's task is reasonably well-defined (e.g. does the customer understand the risk of a leveraged investment vehicle?) In that, the proposal is not as open-ended and indeterminate in scope as Regulation Best Interest.

This article is provided as a general informational service and it should not be construed as imparting legal advice on any specific matter.

Steven Lofchie, a partner in the Financial Services Group at Cadwalader, Wickersham & Taft LLP, advises financial institutions on regulatory issues and financial instruments. His regulatory practice encompasses the securities laws, the CEA and related bankruptcy issues. His transactional practices focuses on securities credit and derivative transactions.

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