On October 28, 2020, the Securities and Exchange Commission (referred to as SEC or Commission) voted to adopt new rules, and rule and form amendments, designed to provide an updated, comprehensive approach to the regulation of funds’ use of derivatives.1 The new rule, Rule 18f-4, permits funds to enter into derivative transactions if they comply with certain conditions designed to protect investors. These conditions include adopting a derivatives risk management program and complying with a limit on the amount of leverage-related risk that the fund may obtain based on value-at-risk, or “VaR.”
In light of the adoption of Rule 18-f4, funds currently entering into derivative transactions will need to review, assess and update their policies and procedures regarding senior securities and (under an “evidence of indebtedness” analysis) derivatives. For example, funds currently entering into derivative transactions rely on 1979 General Statement of Policy (Release 10666), which provided Commission guidance on funds’ use of derivatives. Release 10666 will be withdrawn in connection with Rule 18f-4 becoming effective, as will certain other as yet unspecified staff no-action letters and guidance on the use of derivatives by funds. The SEC also indicated that it intends to withdraw Section 18(f) exemptive orders given to certain fund groups that permit investments in futures, related options or options on stock indexes.
Fortunately, the Commission is providing a transition period to give funds time to comply with the provisions of Rule 18f-4 and the related reporting requirements. Specifically, the Commission has adopted a compliance date that is 18 months after the effective date, which is 60 days after publication in the Federal Register (publication in the Federal Register has not yet occurred). The rescission of Release 10666 also will be effective 18 months after the effective date.
We will provide a detailed analysis of Rule 18f-4 and key action items in a forthcoming post. For now, please see the SEC’s Fact Sheet below, and the link to the SEC’s press release.
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Use of Derivatives by Registered Investment Companies and Business Development Companies
October 28, 2020
The Commission voted to adopt new rules, and rule and form amendments, designed to provide an updated, comprehensive approach to the regulation of funds’ use of derivatives and certain other transactions. New rule 18f-4, an exemptive rule under the Investment Company Act of 1940 (the “Act”), permits mutual funds (other than money market funds), exchange-traded funds (“ETFs”), registered closed-end funds, and business development companies (collectively, “funds”) to enter into derivatives transactions and certain other transactions notwithstanding the restrictions under section 18 of the Act. In connection with these new rules, the Commission amended rule 6c-11 under the Act to allow leveraged or inverse ETFs to operate without obtaining an exemptive order. Finally, the Commission adopted new reporting requirements and amendments to certain disclosure forms.
Rule 18f-4 provides certain exemptions from the Act subject to conditions. The conditions and other elements of the rule include the following:
Amendments to Investment Company Act rule 6c-11 permit leveraged or inverse ETFs to rely on rule 6c-11 if they comply with all applicable provisions of rule 18f-4. The Commission is rescinding the exemptive orders previously issued to the sponsors of leveraged or inverse ETFs in connection with these amendments.
Funds will be required to report confidentially to the Commission on a current basis on Form N-RN if the fund is out of compliance with the VaR-based limit on fund leverage risk for more than five business days. Funds currently required to file reports on Forms N-PORT and N-CEN will be required to provide certain information regarding a fund’s derivatives use. This will include information regarding the fund’s VaR, as applicable, and information about the fund’s derivatives exposure (for funds that rely on the limited derivatives user exception in rule 18f-4).
The Commission is rescinding the 1979 General Statement of Policy (Release 10666) that provided Commission guidance on how funds may engage in certain trading practices in light of section 18’s restrictions. In addition, staff in the Division of Investment Management has reviewed its no-action letters and other guidance addressing funds’ use of derivatives and other transactions covered by rule 18f-4. Some of these staff letters and staff guidance will be withdrawn.
The new rule, and related rule and form amendments, will be published on the Commission’s website and in the Federal Register. All will be effective 60 days after publication in the Federal Register.
The Commission is providing a transition period to give funds time to comply with the provisions of rule 18f-4 and the related reporting requirements. The Commission has adopted a compliance date that is 18 months after the effective date. The rescission of Release 10666 also will be effective 18 months after the effective date. The withdrawal by the staff of staff letters and staff guidance addressing funds’ use of derivatives and other transactions covered by rule 18f-4 will be effective upon the rescission of Release 10666.
1 Along with adopting Rule 18f-4, the SEC amended the following items in connection with the adoption of Rule 18f-4: (i) the ETF rule, Rule 6c-11; (ii) Rule 22e-4, which governs Liquidity Risk Management Programs; (iii) the rule applying to Form N-LIQUID, Rule 30b1-10 (Form N-LIQUID governs reports on liquidity); (iv) Form N-LIQUID, which is renamed Form N-RN; (v) Form N-CEN, the fund census data reporting form; and (vi) Form N-2, the registration statement form for closed-end funds.