SEC Commissioners issued recommendations on the agency's "re-proposal" to update the regulation on the use of derivatives by SEC-registered investment companies and business development companies ("registered funds") (see here and here).
As previously covered, proposed Rule 18f-4 under the Investment Company Act ("ICA") provides a conditional exemption from ICA Section 18 for registered funds when entering into derivatives transactions.
In addition, the proposal creates 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"). The proposed rules would require (i) broker-dealers and investment advisers to comply with due diligence and approval requirements prior to approving orders to buy and sell shares of leveraged investment vehicles, and (ii) include a determination as to whether there is a "reasonable basis" to believe 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 exchange-traded funds ("ETFs") to operate without receiving exemptive orders.
"Modernization" of Regulatory Framework
SEC Commissioners Hester M. Peirce and Elad L. Roisman commended the Division of Investment Management for providing an updated framework concerning funds' use of derivatives. The Commissioners "welcome[d]" the departure from the current regime, calling it an "outdated patchwork" of requirements and exemptions. Commissioners Robert J. Jackson Jr. and Allison Herren Lee also expressed approval of "establishing a systematic approach" to limiting fund risk-taking.
Ms. Peirce and Mr. Roisman added that the "re-proposal" has been revised to address criticism by commenters on the 2015 proposal (see previous coverage) for limiting funds' ability use derivatives for non-speculative purposes. Proposed Rule 18f-4 is intended to allow funds somewhat greater freedom.
Leveraged and Inverse ETFs
Ms. Peirce and Mr. Roisman cautioned that the proposed Rule's alternative conditions for leveraged and inverse (a/k/a "geared") ETFs may not be "the best way" to address risks associated with those products.
Specifically, Ms. Peirce and Mr. Roisman raised several concerns with the proposed alternative approach, arguing that:
Ms. Peirce and Mr. Roisman supported the Division of Investment Management's recommendation to allow ETF sponsors to "rely" on Rule 6c-11 in order to establish new leveraged and inverse ETFs.
Mr. Jackson and Ms. Lee called on commenters to provide feedback on ways to strengthen the investors protections included in the proposal.
According to Mr. Jackson and Ms. Lee, the proposal should address three critical areas. Specifically, they called for feedback on:
The SEC reproposed a rule designed to "enhance" regulations on the use of derivatives by registered investment companies and business development companies.
In a 3-to-1 vote, the SEC proposed a new rule that would restrict the use of derivatives by registered investment companies, including mutual funds, exchange-traded funds and closed-end funds as well as business development companies that are subject to Investment Company Act Section 18 ("Capital Structure of Investment Companies").
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