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Federal Register: SEC Proposes Amendments on Investment Companies' Use of Derivatives

The SEC "re-proposal" of ICA Rule 18f-4 ("Exemption from the requirements of section 18 and section 61 for certain senior securities transactions") was published in the Federal Register. Comments on the proposal must be submitted by March 24, 2020.

Proposed ICA Rule 18f-4 would provide an exemption from Section 18 under the Investment Company Act for mutual funds, exchange-traded funds ("ETFs"), registered closed-end funds and BDCs (collectively, "funds") when entering into derivatives transactions (see prior coverage). The SEC explained that reliance on 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 standardized 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 exempt (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 ("Use of the Term 'Adviser' or 'Advisor'") under the Securities Exchange Act and Rule 211(h)-1 ("Disclosure of Registration Status") 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.

Finally, 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.

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