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ICI Recommends Enhancements to SEC Proposal on Investment Companies' Use of Derivatives

The Investment Company Institute ("ICI") provided recommendations to the SEC on its "re-proposal" of Investment Company Act Rule 18f-4 ("Exemption from the requirements of section 18 and section 61 for certain senior securities transactions").

As previously covered, the SEC proposed ICA Rule 18f-4, which would provide an exemption from Section 18 under the Investment Company Act for mutual funds, exchange-traded funds, registered closed-end funds and business development companies (collectively, "funds") when entering into derivatives transactions. 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 with certain recordkeeping requirements.

ICI Comment Letter

In a comment letter, the ICI emphasized its support for the proposed amendments while offering several recommendations to varying aspects of the proposal. These include:

  • clarifying that the definitions of "derivatives transaction" and "senior security" do not include (i) firm or standby commitment agreements that feature a forward settlement beyond regulatory-way settlement or (ii) commitments whose yields are based on prevailing market interest rates on the date of delivery;

  • modifying the proposed relative VaR to require a "designated reference index" to reflect the fund's actual investment strategies, which the ICI argued would strengthen the SEC's approach to managing and limiting risk;

  • adjusting its derivatives risk management program requirements by (i) making clear that fund directors should continue to operate within their "traditional oversight role" (i.e., overseeing each fund's derivatives use) and (ii) widening the scope of entities eligible to act as a derivatives risk manager to include a fund's investment adviser, while removing the requirement that a manager's experience in derivatives risk management be evaluated;

  • combining the "currency hedging exception" with the "exposure-based exception" in order to allow funds to exclude hedging and offset transactions from related exposure-based exception calculations; and

  • allowing funds that engage in financing transactions such as reverse repurchase agreements to have the option of (i) complying with statutory asset coverage requirements or (ii) covering the obligations from such transactions in accordance with a modified asset segregation regime.

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