Use of Derivatives by Registered Investment Companies and Business Development Companies

Federal RegisterDec 28, 2015

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SECURITIES AND EXCHANGE COMMISSION

17 CFR Parts 270 and 274

[Release No. IC-31933; File No. S7-24-15]

RIN 3235-AL60

Use of Derivatives by Registered Investment Companies and Business Development Companies

AGENCY:

Securities and Exchange Commission.

ACTION:

Proposed rule.

SUMMARY:

The Securities and Exchange Commission (the “Commission” or “SEC”) is proposing rule 18f-4, a new exemptive rule under the Investment Company Act of 1940 (the “Investment Company Act” or “Act”) designed to address the investor protection purposes and concerns underlying section 18 of the Act and to provide an updated and more comprehensive approach to the regulation of funds' use of derivatives. The proposed rule would permit mutual funds, exchange-traded funds (“ETFs”), closed-end funds, and companies that have elected to be treated as business development companies (“BDCs”) under the Act (collectively, “funds”) to enter into derivatives transactions and financial commitment transactions (as those terms are defined in the proposed rule) notwithstanding the prohibitions and restrictions on the issuance of senior securities under section 18 of the Act, provided that the funds comply with the conditions of the proposed rule. A fund that relies on the proposed rule in order to enter into derivatives transactions would be required to: comply with one of two alternative portfolio limitations designed to impose a limit on the amount of leverage the fund may obtain through derivatives transactions and other senior securities transactions; manage the risks associated with the fund's derivatives transactions by maintaining an amount of certain assets, defined in the proposed rule as “qualifying coverage assets,” designed to enable the fund to meet its obligations under its derivatives transactions; and, depending on the extent of its derivatives usage, establish a formalized derivatives risk management program. A fund that relies on the proposed rule in order to enter into financial commitment transactions would be required to maintain qualifying coverage assets equal in value to the fund's full obligations under those transactions. The Commission also is proposing amendments to proposed Form N-PORT and proposed Form N-CEN that would require reporting and disclosure of certain information regarding a fund's derivatives usage.

DATES:

Comments should be received on or before March 28, 2016.

ADDRESSES:

Comments may be submitted by any of the following methods:

Electronic Comments

• Use the Commission's Internet comment form (

http://www.sec.gov/rules/concept.shtml

);

• Send an email to

rule-comments@sec.gov

. Please include File Number S7-24-15 on the subject line; or

• Use the Federal eRulemaking Portal (

http://www.regulations.gov

). Follow the instructions for submitting comments.

Paper Comments

• Send paper comments to Brent J. Fields, Secretary, Securities and Exchange Commission, 100 F Street NE., Washington, DC 20549-1090.

All submissions should refer to File Number S7-24-15. This file number should be included on the subject line if email is used. To help the Commission process and review your comments more efficiently, please use only one method. The Commission will post all comments on the Commission's Internet Web site (

http://www.sec.gov/rules/proposed.shtml

). Comments also are available for Web site viewing and printing in the Commission's Public Reference Room, 100 F Street NE., Washington, DC 20549, on official business days between the hours of 10:00 a.m. and 3:00 p.m. All comments received will be posted without change; the Commission does not edit personal identifying information from submissions. You should submit only information that you wish to make publicly available.

Studies, memoranda or other substantive items may be added by the Commission or staff to the comment file during this rulemaking. A notification of the inclusion in the comment file of any such materials will be made available on the Commission's Web site. To ensure direct electronic receipt of such notifications, sign up through the “Stay Connected” option at

www.sec.gov

to receive notifications by email.

FOR FURTHER INFORMATION CONTACT:

With respect to proposed rule 18f-4, Adam Bolter, Jamie Lynn Walter, or Erin C. Loomis, Senior Counsels; Thoreau A. Bartmann, Branch Chief; Brian McLaughlin Johnson, Senior Special Counsel; or Aaron Schlaphoff or Danforth Townley, Attorney Fellows; and with respect to the proposed amendments to Form N-PORT and Form N-CEN, Jacob D. Krawitz, Senior Counsel, or Sara Cortes, Senior Special Counsel, at (202)-551-6792, Investment Company Rulemaking Office, Division of Investment Management, Securities and Exchange Commission, 100 F Street NE., Washington, DC 20549-8549.

SUPPLEMENTARY INFORMATION:

The Commission is proposing rule 18f-4 [17 CFR 270.18f-4] under the Investment Company Act of 1940 [15 U.S.C. 80a] and amendments to proposed Form N-PORT and proposed Form N-CEN.

Table of Contents

I. Introduction

II. Background

A. Background Concerning the Use of Derivatives by Funds

B. Derivatives and the Senior Securities Restrictions of the Investment Company Act

1. Requirements of Section 18

2. Investment Company Act Release 10666

3. Developments after Investment Company Act Release No. 10666

4. Current Views Concerning Section 18

C. Review of Funds' Use of Derivatives

D. Need for a New Approach

1. The Current Regulatory Framework and the Purposes and Policies Underlying the Act

2. Need for an Updated and More Comprehensive Approach

III. Discussion

A. Structure and Scope of Proposed Rule 18f-4

. Structure of Proposed Rule 18f-4

2. Definitions of Derivatives Transactions and Financial Commitment Transactions

B. Portfolio Limitations for Derivatives Transactions

1. Exposure-Based Portfolio Limit

2. Risk-Based Portfolio Limit

3. Implementation and Operation of Portfolio Limitations

C. Asset Segregation Requirements for Derivatives Transactions

1. Coverage Amount for Derivatives Transactions

2. Qualifying Coverage Assets

D. Derivatives Risk Management Program

1. Funds Subject to the Proposed Risk Management Program Condition

2. Required Elements of the Program

3. Administration of the Program

4. Board Approval and Oversight

E. Requirements for Financial Commitment Transactions

1. Coverage Amount for Financial Commitment Transactions

2. Qualifying Coverage Assets for Financial Commitment Transactions

F. Recordkeeping

G. Amendments to Proposed Forms N-PORT and N-CEN

1. Reporting of Risk Metrics by Funds That Are Required To Implement a Derivatives Risk Management Program

2. Amendments to Proposed Form N-PORT

3. Amendments to Proposed Form N-CEN

4. Request for Comment

H. Request for Comments

I. Proposed Rule 18f-4 and Existing Guidance

IV. Economic Analysis

A. Introduction and Primary Goals of Proposed Regulation

B. Economic Baseline

C. Economic Impacts, Including Effects on Efficiency, Competition, and Capital Formation

D. Specific Benefits and Quantifiable Costs

1. Exposure-Based Portfolio Limit

2. Risk-Based Portfolio Limit

3. Asset Segregation

4. Risk Management Program

5. Financial Commitment Transactions

6. Amendments to Form N-PORT To Report Risk Metrics by Funds That Are Required To Implement a Derivatives Risk Management Program

7. Amendments to Form N-CEN To Report Reliance on Proposed Rule 18f-4

E. Reasonable Alternatives

F. Request for Comment

V. Paperwork Reduction Act

A. Introduction

B. Proposed Rule 18f-4

1. Portfolio Limitations for Derivatives Transactions

2. Asset Segregation: Derivatives Transactions

3. Asset Segregation: Financial Commitment Transactions

4. Derivatives Risk Management Program

5. Amendments to Form N-PORT

6. Amendments to Form N-CEN

C. Request for Comments

VI. Initial Regulatory Flexibility Act Analysis

A. Reasons for and Objectives of the Proposed Actions

B. Legal Basis

C. Small Entities Subject to Proposed Rule 18f-4 and Amendments to Form N-PORT and Form N-CEN

D. Projected Reporting, Recordkeeping, and Other Compliance Requirements

1. Portfolio Limitations for Derivatives Transactions

2. Asset Segregation

3. Derivatives Risk Management Program

4. Financial Commitment Transactions

5. Amendments to Proposed Form N-PORT

6. Amendments to Form N-CEN

E. Duplicative, Overlapping, or Conflicting Federal Rules

F. Significant Alternatives

1. Proposed Rule 18f-4

2. Form N-PORT and Form N-CEN

G. General Request for Comment

VII. Consideration of Impact on the Economy

VII. Statutory Authority

I. Introduction

The activities and capital structures of funds are regulated extensively under the Investment Company Act,

Commission rules, and Commission guidance.

The use of derivatives by funds implicates certain requirements under the Investment Company Act, including section 18 of that Act. As discussed in more detail below, section 18 limits a fund's ability to obtain leverage or incur obligations to persons other than the fund's common shareholders through the issuance of senior securities, as defined in that section.

15 U.S.C. 80a. Unless otherwise noted, all references to statutory sections are to the Investment Company Act, and all references to rules under the Investment Company Act, including proposed rule 18f-4, will be to title 17, part 270 of the Code of Federal Regulations, 17 CFR part 270.

Our staff has also issued no-action and other letters that relate to fund use of derivatives. In addition to Investment Company Act provisions, funds using derivatives (and financial commitment transactions) must comply with all other applicable statutory and regulatory requirements, such as other federal securities law provisions, the Internal Revenue Code (the “IRC”), Regulation T of the Federal Reserve Board (“Regulation T”), and the rules and regulations of the Commodity Futures Trading Commission (the “CFTC”).

See also

Title VII of the Dodd-Frank Wall Street Reform and Consumer Protection Act, Public Law 111-203, 124 Stat. 1376 (2010) (the “Dodd-Frank Act”),

available at http://www.sec.gov/about/laws/wallstreetreform-cpa.pdf

Derivatives may be broadly described as instruments or contracts whose value is based upon, or derived from, some other asset or metric (referred to as the “reference asset,” “underlying asset” or “underlier”).

Funds employ derivatives for a variety of purposes, including to: Seek higher returns through increased investment exposures; hedge interest rate, credit, and other risks in their investment portfolios; gain access to certain markets; and achieve greater transaction efficiency.

At the same time, derivatives can raise risks for a fund relating to, for example, leverage, illiquidity (particularly with respect to complex over-the-counter (“OTC”) derivatives), counterparties, and the ability of the fund to meet its obligations.

See

Use of Derivatives by Investment Companies under the Investment Company Act of 1940, Investment Company Act Release No. 29776 (Aug. 31, 2011) [76 FR 55237 (Sept. 7, 2011)] (“Concept Release”), at n.3.

See

Concept Release,

supra

note 3, at n.5.

See

Concept Release,

supra

note 3, at n.6. As discussed in Open-End Fund Liquidity Risk Management Programs; Swing Pricing; Re-Opening of Comment Period for Investment Company Reporting Modernization Release, Investment Company Act Release No. 31835 (Sept. 22, 2015) [80 FR 62273 (Oct. 15, 2015)] (“Liquidity Release”), long-standing Commission guidelines generally limit an open-end fund's aggregate holdings of “illiquid” assets to 15% of the fund's net assets. Under these guidelines, an asset is considered illiquid if it cannot be sold or disposed of in the ordinary course of business within seven days at approximately the value at which the fund has valued the investment. These guidelines apply to all investments (including derivatives) held by an open-end fund. Proposed rule 22e-4, which we proposed in September 2015, would codify this standard along with other requirements that are designed to promote effective liquidity risk management for open-end funds.

We are committed, as the primary regulator of funds, to designing regulatory programs that respond to the risks associated with the increasingly complex portfolio composition and operations of the asset management industry. The dramatic growth in the volume and complexity of the derivatives markets over the past two decades, and the increased use of derivatives by certain funds,

led us to initiate a review of funds' use of derivatives under the Investment Company Act to evaluate whether the regulatory framework, as it applied to funds' use of derivatives, continues to fulfill the purposes and policies underlying the Act and is consistent with investor protection. We published a Concept Release on funds' use of derivatives in 2011 (the “Concept Release”) to assist with this review and solicit public comment on the current regulatory framework.

As noted in the Concept Release, our staff has been exploring the benefits, risks, and costs associated with funds' use of derivatives. Our staff's review of these and other matters, together with input from commenters on the Concept Release and others, have informed our consideration of the regulation of funds' use of derivatives, including in particular whether funds' current practices, based on their application of Commission and staff guidance, are consistent with the investor protection purposes and concerns underlying section 18 of the Investment Company Act.

See

Concept Release,

supra

note 3, at n.7.

See also infra

section II.

See

Concept Release,

supra

note 3.

Today, we are proposing new rule 18f-4, which is designed to address the investor protection purposes and concerns underlying section 18 and to provide an updated and more comprehensive approach to the regulation of funds' use of derivatives transactions and other transactions that implicate section 18 in light of the dramatic growth in the volume and complexity of the derivatives markets over the past two decades and the increased use of derivatives by certain funds. As discussed in more detail below, the proposed rule would permit a fund to enter into derivatives and financial commitment transactions, notwithstanding the prohibitions and restrictions on the issuance of senior securities under section 18 of the Act, provided that the fund complies with the conditions of the proposed rule. The proposed rule's conditions are designed both to impose a limit on the leverage a fund may obtain through the use of derivatives and financial commitment transactions and other senior securities transactions, and to require the fund to have assets available to meet its obligations arising from those transactions, both of which are central

investor protection purposes and concerns underlying section 18. The proposed rule also would require funds that engage in more than a limited amount of derivatives transactions or that use certain complex derivatives transactions, as defined in the proposed rule, to establish formalized risk management programs to manage the risks associated with such transactions.

II. Background

A. Background Concerning the Use of Derivatives by Funds

As noted above, derivatives may be broadly described as instruments or contracts whose value is based upon, or derived from, some reference asset. Reference assets can include, for example, stocks, bonds, commodities, currencies, interest rates, market indices, currency exchange rates, or other assets or interests.

Common examples of derivatives used by funds include forwards, futures, swaps, and options.

For example, the reference asset of a Standard & Poor's (“S&P”) 500 futures contract is the S&P 500 index.

See, e.g.,

Concept Release,

supra

note 3, at nn.35-46 and accompanying text.

Derivatives are often characterized as either exchange-traded or OTC.

Exchange-traded derivatives—such as futures,

certain options,

and options on futures

—are standardized contracts traded on regulated exchanges, such as the Chicago Mercantile Exchange and the Chicago Board Options Exchange. OTC derivatives—such as certain swaps,

non-exchange traded options, and combination products such as swaptions

and forward swaps

—are contracts negotiated and entered into outside of an organized exchange. Unlike exchange-traded derivatives, OTC derivatives may be significantly customized, and may not be cleared by a central clearing organization. OTC derivatives that are not centrally cleared may involve greater counterparty credit risk, and may be more difficult to value, transfer, or liquidate than exchange-traded derivatives.

The Dodd-Frank Act and rules thereunder seek to establish a comprehensive new regulatory framework for two broad categories of derivatives—swaps and security-based swaps. The framework is designed to reduce risk, increase transparency, and promote market integrity within the financial system.

See

Concept Release,

supra

note 3, at n.22.

A futures contract is a standardized contract between two parties to buy or sell a specified asset of standardized quantity and quality, for an agreed upon price (the “futures price” or “strike price”), with delivery and payment occurring at a specified future date (the “delivery date”). The contracts are negotiated on a futures exchange which acts as an intermediary between the two parties. The party agreeing to buy the underlying asset in the future, the “buyer” of the contract, is said to be “long,” and the party agreeing to sell the asset in the future, the “seller” of the contract, is said to be “short.” The long position (buyer) hopes or expects that the asset price is going to increase, while the short position (seller) hopes or expects that it will decrease. For a general discussion of futures contracts,

see, e.g.,

John C. Hull, Options, Futures, and Other Derivatives (9th ed. 2015), at 24.

An option is the right to buy or sell an asset. There are two basic types of options, a “call option” and a “put option.” A call option gives the holder the right (but does not impose the obligation) to buy the underlying asset by or at a certain date for a certain price. The seller, or “writer,” of a call option has the obligation to sell the underlying asset to the holder if the holder exercises the option. A put option gives the holder the right (but does not impose the obligation) to sell the underlying asset by or at a certain date for a certain price. The seller, or “writer,” of a put option has the obligation to buy from the holder the underlying asset if the holder exercises the option. The price that the option holder must pay to exercise the option is known as the “exercise” or “strike” price. The amount that the option holder pays to purchase an option is known as the “option premium,” “price,” “cost,” or “fair value” of the option.

See

Concept Release,

supra

note 3, at n.23.

Options on futures generally trade on the same exchange as the relevant futures contract. When a call option on a futures contract is exercised, the holder acquires from the writer a long position in the underlying futures contract plus a cash amount equal to the excess of the futures price over the strike price. When a put option on a futures contract is exercised, the holder acquires a short position in the underlying futures contract plus a cash amount equal to the excess of the strike price over the futures price.

See

Concept Release,

supra

note 3, at n.24.

A “swap” is generally an agreement between two counterparties to exchange periodic payments based upon the value or level of one or more rates, indices, assets, or interests of any kind. For example, counterparties may agree to exchange payments based on different currencies or interest rates.

See

Concept Release,

supra

note 3, at n.25. Except as otherwise specified or the context otherwise requires, we use the term “swap” in this Release to refer collectively to swaps, as defined in section 1a of the Commodity Exchange Act, 7 U.S.C. 1a (the “CEA”), and security-based swaps, as defined in section 3(a)(68) of the Exchange Act.

A “swaption” is an option to enter into an interest rate swap where a specified fixed rate is exchanged for a floating rate.

See

Concept Release,

supra

note 3, at n.26.

A forward swap (or deferred swap) is an agreement to enter into a swap at some time in the future (“deferred swap”).

See

Concept Release,

supra

note 3, at n.27.

An OTC derivative may be more difficult to transfer or liquidate than an exchange-traded derivative because, for example, an OTC derivative may provide contractually for non-transferability without the consent of the counterparty, or may be sufficiently customized that its value is difficult to establish or its terms too narrowly drawn to attract transferees willing to accept assignment of the contract, unlike most exchange-traded derivatives.

See

Concept Release,

supra

note 3, at n.28.

The Dodd-Frank Act,

supra

note 2, was signed into law on July 21, 2010. The Act mandates, among other things, substantial changes in the OTC derivatives markets, including new clearing, reporting, and trade execution mandates for swaps and security-based swaps, and both exchange-traded and OTC derivatives are contemplated under the new regime.

See

Dodd-Frank Act sections 723 (mandating clearing of swaps) and 763 (mandating clearing of security-based swaps). We have noted that these Dodd-Frank Act requirements “were designed to provide greater certainty that, wherever possible and appropriate, swap and security-based swap contracts formerly traded exclusively in the OTC market are centrally cleared.” Process for Submissions for Review of Security-Based Swaps for Mandatory Clearing and Notice Filing Requirements for Clearing Agencies; Technical Amendments to Rule 19b-4 and Form 19b-4 Applicable to All Self-Regulatory Organizations, Securities Exchange Act Release No. 67286 (June 28, 2012) [77 FR 41602 (July 13, 2012)], at text accompanying n.5.

While funds use derivatives for a variety of purposes, a common characteristic of most derivatives is that they involve leverage or the potential for leverage.

We have stated that “[l]everage exists when an investor achieves the right to a return on a capital base that exceeds the investment which he has personally contributed to the entity or instrument achieving a return.”

Many derivatives transactions entered into by a fund, such as futures contracts, swaps, and written options, involve leverage or the potential for leverage in that they enable the fund to participate in gains and losses on an amount of reference assets that exceeds the fund's investment, while also imposing a conditional or unconditional obligation on the fund to make a payment or deliver assets to a counterparty.

Other derivatives transactions, such as purchased call options, provide the economic equivalent of leverage because they expose the fund to gains on an amount in excess of the fund's investment but do not impose a payment obligation on the fund beyond its investment.

See, e.g., infra

notes 69-71.

See

Securities Trading Practices of Registered Investment Companies, Investment Company Act Release No. 10666 (Apr. 18, 1979) [44 FR 25128 (Apr. 27, 1979)] (“Release 10666”), at n.5.

See also infra

notes 21-22.

The leverage created by such an arrangement is sometimes referred to as “indebtedness leverage.”

See

Concept Release,

supra

note 3, at n.31.

See infra

notes 70-72 and accompanying text.

This type of leverage is sometimes referred to as “economic leverage.”

See

Concept Release,

supra

note 3, at n.32.

Funds use derivatives both to obtain investment exposures as part of their investment strategies and to manage risk.

A fund may use derivatives to

gain, maintain, or reduce exposure to a market, sector, or security more quickly and/or with lower transaction costs and portfolio disruption than investing directly in the underlying securities.

The comments we received on the Concept Release reflect some of the various ways in which funds use derivatives, including, for example: To hedge risks associated with the fund's securities investments; to equitize cash to gain exposure quickly, such as by purchasing index futures rather than investing in the securities underlying the index; and to obtain synthetic positions.

See

Concept Release,

supra

note 3, at n.33. A fund may also use derivatives to hedge current portfolio exposures (for example, when a fund's portfolio is structured to reflect the fund's long-term investment strategy and its investment adviser's forecasts, interim events may cause the fund's investment adviser to seek to temporarily hedge a portion of the portfolio's broad market, sector, and/or security exposures). Industry participants believe that derivatives may also provide a more efficient hedging tool than reducing exposure by selling individual securities, offering greater liquidity,

lower round-trip transaction costs, lower taxes, and reduced disruption to the portfolio's longer-term positioning.

Id. See also infra

note 25 and accompanying text.

See

Concept Release,

supra

note 3, at section I.

See, e.g.,

Comment Letter of BlackRock on Concept Release (Nov. 4, 2011) (File No. S7-33-11) (“BlackRock Concept Release Comment Letter”),

available at http://www.sec.gov/comments/s7-33-11/s73311-39.pdf

; Comment Letter of AQR Capital Management on Concept Release (Nov. 7, 2011) (File No. S7-33-11) (“AQR Concept Release Comment Letter”),

available at http://www.sec.gov/comments/s7-33-11/s73311-26.pdf

; Comment Letter of Vanguard on Concept Release (Nov. 7, 2011) (File No. S7-33-11) (“Vanguard Concept Release Comment Letter”),

available at http://www.sec.gov/comments/s7-33-11/s73311-38.pdf

; Comment Letter of Oppenheimer Funds on Concept Release (Nov. 7, 2011) (File No. S7-33-11) (“Oppenheimer Concept Release Comment Letter”),

available at http://www.sec.gov/comments/s7-33-11/s73311-44.pdf

; Comment Letter of Loomis, Sayles and Company on Concept Release (Nov. 7, 2011) (File No. S7-33-11) (“Loomis Concept Release Comment Letter”),

available at http://www.sec.gov/comments/s7-33-11/s73311-25.pdf

; Comment Letter of Investment Company Institute on Concept Release (Nov. 7, 2011) (File No. S7-33-11) (“ICI Concept Release Comment Letter”),

available at http://www.sec.gov/comments/s7-33-11/s73311-46.pdf

At the same time and as noted above, funds' use of derivatives may entail risks relating to, for example, leverage, illiquidity (particularly with respect to complex OTC derivatives), and counterparty risk, among others.

A fund's use of derivatives presents challenges for its investment adviser and board of directors in managing derivatives use so that they are employed in a manner consistent with the fund's investment objectives, policies, and restrictions, its risk profile, and relevant regulatory requirements, including those under the federal securities laws.

See

Concept Release,

supra

note 3, at n.34.

See, e.g.,

Comment Letter of Mutual Fund Directors Forum on Concept Release (Nov. 7, 2011) (File No. S7-33-11) (“MFDF Concept Release Comment Letter”),

available at http://www.sec.gov/comments/s7-33-11/s73311-32.pdf

, at 2 (agreeing with this statement in the Concept Release and suggesting that we “evaluate how any potential regulations will impact the ability of directors effectively to oversee their funds' use of derivatives”).

B. Derivatives and the Senior Securities Restrictions of the Investment Company Act

1. Requirements of Section 18

Section 18 of the Act imposes various limitations on the capital structure of funds, including, in part, by restricting the ability of funds to issue “senior securities.” The protection of investors against the potentially adverse effects of a fund's issuance of senior securities is a core purpose of the Investment Company Act.

Section 18(g) of the Investment Company Act defines “senior security,” in part, as “any bond, debenture, note, or similar obligation or instrument constituting a security and evidencing indebtedness.”

See, e.g.,

sections 1(b)(7), 1(b)(8), 18(a), and 18(f) of the Investment Company Act.

The definition of senior security in section 18(g) also includes “any stock of a class having priority over any other class as to the distribution of assets or payment of dividends” and excludes certain limited temporary borrowings.

Congress' concerns underlying the limitations in section 18 were focused on: (1) Excessive borrowing and the issuance of excessive amounts of senior securities by funds which increased unduly the speculative character of their junior securities;

(2) funds operating without adequate assets and reserves;

and (3) potential abuse of the purchasers of senior securities.

To address these concerns, section 18(f)(1) of the Investment Company Act prohibits an open-end fund

from issuing or selling any “senior security” other than borrowing from a bank and subject to a requirement to maintain 300% “asset coverage.”

Section 18(a)(1) of the Investment Company Act similarly prohibits a closed-end fund

from issuing or selling any “senior security that represents an indebtedness” unless it has at least 300% “asset coverage, ” although closed-end funds' ability to issue senior securities representing indebtedness is not limited to bank borrowings, and closed-end funds also may issue senior securities that are a stock, subject to limitations in section 18.

A BDC is also subject to the limitations of section 18(a)(1)(A) to the same extent as if it were a closed-end investment company except that the applicable asset coverage amount for any senior security representing indebtedness is 200%.

See

section 1(b)(7) of the Investment Company Act; Release 10666,

supra

note 20, at n.8.

See

section 1(b)(8) of the Investment Company Act; Release 10666,

supra

note 20, at n.8.

See

Investment Trusts and Investment Companies: Hearings on S. 3580 Before a Subcomm. of the Senate Comm. on Banking and Currency, 76th Cong., 3d Sess., pt. 1 (1940) (“Senate Hearings”) at 265-78.

See also Mutual Funds and Derivative Instruments,

Division of Investment Management Memorandum transmitted by Chairman Levitt to Representatives Markey and Fields (Sept. 26, 1994) (“1994 Report”),

available at http://www.sec.gov/news/studies/deriv.txt

, at 21 (describing the practices in the 1920s and 1930s that gave rise to section 18's limitations on leverage).

Section 5(a)(1) of the Investment Company Act defines “open-end company” as “a management company which is offering for sale or has outstanding any redeemable security of which it is the issuer.”

“Asset coverage” of a class of securities representing indebtedness of an issuer generally is defined in section 18(h) of the Investment Company Act as “the ratio which the value of the total assets of such issuer, less all liabilities and indebtedness not represented by senior securities, bears to the aggregate amount of senior securities representing indebtedness of such issuer.” Take, for example, an open-end fund with $100 in assets and with no liabilities or senior securities outstanding. The fund could, while maintaining the required coverage of 300% of the value of its assets subject to section 18 of the Act, borrow an additional $50 from a bank; the $50 in borrowings would represent one-third of the fund's $150 in total assets, measured after the borrowing (or 50% of the fund's $100 net assets).

Section 5(a)(2) of the Investment Company Act defines “closed-end company” as “any management company other than an open-end company.”

Section 18(a)(1)(A).

See

section 61(a)(1) of the Investment Company Act. BDCs, like registered closed-end funds, also may issue a senior security that is a stock (

e.g.,

preferred stock), subject to limitations in section 18.

See

section 18(a)(2) and section 61(a)(1) of the Investment Company Act.

2. Investment Company Act Release 10666

In Investment Company Act Release 10666, issued in 1979, we considered the application of section 18's restrictions on senior securities to the following transactions: reverse repurchase agreements, firm commitment agreements, and standby commitment agreements.

As we described in more detail in Release 10666, in a reverse repurchase agreement, a fund transfers possession of a security to another party in return for a percentage of the value of the security; at an agreed upon future date, the fund repurchases the transferred security by paying an amount equal to the proceeds of the transaction plus interest.

A firm commitment agreement is a buy order for delayed delivery under which a fund agrees to purchase a security—a Ginnie Mae, in the example we provided in Release 10666

—from a seller at a future date,

stated price, and fixed yield; a standby commitment agreement similarly involves an agreement by the fund to purchase a security with a stated price and fixed yield in the future upon the counterparty's exercise of its option to sell the security to the fund.

See

Release 10666,

supra

note 20.

See

Release 10666,

supra

note 20, at discussion of “Reverse Repurchase Agreements” (noting that a reverse repurchase agreement may not have an agreed upon repurchase date, and in that case, the agreement would be treated as if it were reestablished each day).

In Release 10666, we described reverse repurchase agreements and firm and standby commitment agreements involving debt securities guaranteed as to principal and interest by the

Government National Mortgage Associations, or “Ginnie Maes.” We noted, however, that we referenced Ginnie Maes only as an example of the underlying security and the reference should not be construed as delimiting our general statement of policy; we further noted that we sought in Release 10666 to “address generally the possible economic effects and legal implications of all comparable trading practices which may affect the capital structure of investment companies in a manner analogous to the securities trading practices specifically discussed [in Release 10666].”

Id.,

at discussion of “Areas of Concern.”

See also infra

section III.A.2.

See

Release 10666,

supra

note 20, at discussion of “Firm Commitment Agreements,” and “Standby Commitment Agreements.”

We concluded that such agreements, while not securities for all purposes under the federal securities laws,

“fall within the functional meaning of the term `evidence of indebtedness' for purposes of section 18 of the Act,” which we noted would generally include “all contractual obligations to pay in the future for consideration presently received,” and thus may involve the issuance of senior securities.

Further, we stated that “trading practices involving the use by investment companies of such agreements for speculative purposes or to accomplish leveraging fall within the legislative purposes of section 18.”

See

Release 10666,

supra

note 20, at “The Agreements as Securities” discussion.

See also infra

note 61.

Release 10666,

supra

note 20, at “The Agreements as Securities” discussion.

Id.

(stating, among other things, that, “[t]he gains and losses from the transactions can be extremely large relative to invested capital; for this reason, each agreement has speculative aspects. Therefore, it would appear that the independent investment decisions involved in entering into such agreements, which focus on their distinct risk/return characteristics, indicate that, economically as well as legally, the agreements should be treated as securities separate from the underlying Ginnie Maes for purposes of section 18 of the Act.”)

We recognized, however, that although reverse repurchase agreements, firm commitment agreements, and standby commitment agreements may involve the issuance of senior securities and thus generally would be prohibited for open-end funds by section 18(f) (and limited by the 300% asset coverage requirement for closed-end funds), these and similar arrangements nonetheless could appropriately be used by funds subject to the constraints we described in Release 10666. We analogized to short sales of securities by funds, as to which our staff had previously provided guidance that the issue of section 18 compliance would not be raised if funds “cover” senior securities by maintaining “segregated accounts.”

See

Release 10666,

supra

note 20, at text accompanying n.15 (citing Guidelines for the Preparation of Form N-8B-1, Investment Company Act Release No. 7221 (June 9, 1972) at 6-8).

We concluded that the use of segregated accounts “if properly created and maintained, would limit the investment company's risk of loss.”

To avail itself of the segregated account approach, we stated that a fund could establish and maintain with the fund's custodian a segregated account containing certain liquid assets, such as cash, U.S. government securities, or other appropriate high-grade debt obligations, equal to the obligation incurred by the fund in connection with the senior security (“segregated account approach”).

We stated that the segregated account functions as “a practical limit on the amount of leverage which the investment company may undertake and on the potential increase in the speculative character of its outstanding common stock,” and that it “[would] assure the availability of adequate funds to meet the obligations arising from such activities.”

See

Release 10666,

supra

note 20, at discussion of “Segregated Account.”

We stated that, under the segregated account approach, the value of the assets in the segregated account should be marked to the market daily, additional assets should be placed in the segregated account whenever the total value of the account falls below the amount of the fund's obligation, and assets in the segregated account should be deemed frozen and unavailable for sale or other disposition.

See id.

We also cautioned that as the percentage of a fund's portfolio assets that are segregated increases, the fund's ability to meet current obligations, to honor requests for redemption, and to manage properly the investment portfolio in a manner consistent with its stated investment objective may become impaired.

Id.

We stated that the amount of assets to be segregated with respect to reverse repurchase agreements lacking a specified repurchase price would be the value of the proceeds received plus accrued interest; for reverse repurchase agreements with a specified repurchase price, the amount of assets to be segregated would be the repurchase price; and for firm and standby commitment agreements, the amount of assets to be segregated would be the purchase price.

Id.

We did not specifically address derivatives in Release 10666.

We did, however, state that although we were expressing our views about the particular trading practices discussed in that release, our views were not limited to those trading practices, in that we sought to “address generally the possible economic effects and legal implications of all comparable trading practices which may affect the capital structure of investment companies in a manner analogous to the securities trading practices specifically discussed in Release 10666.”

The derivatives markets have expanded substantially since we issued Release 10666 in 1979. For example, the Options Clearing Corporation reports that in 1979, only 64 million contracts were traded on 220 equity issues. By 2014, those numbers had risen to 3,845 million contracts traded on 4,278 equity issues. The CME Group reports that 313 of its 335 derivatives products began trading after 1979 (

see http://www.cmegroup.com/company/history/cmegroupinformation.html

). For example, the Chicago Mercantile Exchange launched its first cash-settled futures contract in 1981 and its first successful stock index future (S&P 500 index) in 1982 (

see

http://www.cmegroup.com/company/history/timeline-of-achievements.html

See also

Jennifer Lynch Koski & Jeffrey Pontiff,

How Are Derivatives Used? Evidence from the Mutual Fund Industry,

54 The J. of Fin. 791, 792 (Apr. 1999),

available at http://onlinelibrary.wiley.com/doi/10.1111/0022-1082.00126/pdf

(observing that the Taxpayer Relief Act of 1997's repeal of the “short-short rule” would likely lead to increased derivative use by mutual funds because that rule “eliminate[d] preferential pass-through tax status for funds that realize more than 30 percent of their capital gains from positions held less than three months” and “inhibited derivative use because some derivative securities such as options and futures contracts involve realizing capital gains for holding periods of less than three months”).

Release 10666,

supra

note 20, at “Areas of Concern” and “Background” discussion.

3. Developments After Investment Company Act Release No. 10666

In the years following the issuance of Release 10666, our staff issued more than thirty no-action letters to funds concerning the maintenance of segregated accounts or otherwise “covering” their obligations in connection with various transactions that implicate section 18.

In these letters and through other staff guidance, our staff has addressed questions as they were presented to the staff, generally on an instrument-by-instrument basis, regarding the application of our statements in Release 10666 to various types of derivatives and other transactions. As derivatives markets expanded and funds increased their use of derivatives,

industry practices have developed over time, based at least in part on our staff's no-action letters and other staff guidance, concerning the appropriate amount and type of assets that should be segregated in order to

“cover” various types of derivatives transactions.

The Concept Release includes a discussion of certain staff no-action letters.

See

Concept Release,

supra

note 3, at section I.

See, e.g.,

Comment Letter of Davis Polk & Wardwell LLP on Concept Release (Nov. 11, 2011) (File No. S7-33-11) (“Davis Polk Concept Release Comment Letter”),

available at http://www.sec.gov/comments/s7-33-11/s73311-49.pdf

(“[T]he Commission and the Staff, over the years, have addressed issues pertaining to the use of derivatives transactions by registered funds on an intermittent case-by-case basis. While this guidance has been helpful, it has not been able to keep pace with the dramatic expansion of the derivatives market over the past twenty years, both in terms of the types of instruments that are available and the extent to which funds use them.”).

Our staff also has stated that it would not object to a fund covering its obligations by entering into certain cover transactions or holding the asset (or the right to acquire the asset) that the fund would be required to deliver under certain derivatives.

See

Concept Release,

supra

note 3, at text following nn.70-71.

With respect to the amount of assets that funds have segregated, two general practices have developed:

• For some derivatives, funds generally segregate an amount equal to the full amount of the fund's potential obligation under the contract, where that amount is known at the outset of the transaction, or the full market value of the underlying reference asset for the derivative (collectively, “notional amount segregation”).

Funds have applied this approach to, among other transactions, futures, forward contracts and written options that permit physical settlement, and credit default swaps (“CDS”) regardless of whether physical settlement or cash settlement is contemplated.

See, e.g.,

Concept Release,

supra

note 3, at n.78 and accompanying text (explaining that, “[i]n determining the amount of assets required to be segregated to cover a particular instrument, the Commission and its staff have generally looked to the purchase or exercise price of the contract (less margin on deposit) for long positions and the market value of the security or other asset underlying the agreement for short positions, measured by the full amount of the reference asset,

i.e.,

the notional amount of the transaction rather than the unrealized gain or loss on the transaction,

i.e.,

its current mark-to-market value”).

See also, e.g.,

Davis Polk Concept Release Comment Letter, at 3 (“In Release 10666 and in no-action letters, the Commission and the Staff generally indicated that funds relying on the segregation method should segregate assets equal to the full notional value of the reference asset for a derivative (the `notional amount'), less any collateral or margin on deposit.”).

For example, if a fund enters into a long, physically settled forward contract, and the contract specifies the forward price that the fund will pay at settlement, the fund would, consistent with staff positions, segregate this forward/contract price.

See, e.g.,

Dreyfus Strategic Investing and Dreyfus Strategic Income, SEC Staff No-Action Letter (June 22, 1987) (“Dreyfus No-Action Letter”),

available at

http://www.sec.gov/divisions/investment/imseniorsecurities/dreyfusstrategic033087.pdf

. As another example, if a fund enters into a short, physically settled forward and the contract obligates the fund to deliver a specific quantity of an asset at settlement—but the total value of that deliverable obligation is unknown at the contract's outset—the fund would, consistent with staff positions, segregate, on a daily basis, liquid assets with a value equal to the daily market value of the deliverable.

See id.;

Robertson Stephens Investment Trust, SEC Staff No-Action Letter (Aug. 24, 1995) (“Robertson Stephens No-Action Letter”),

available at http://www.sec.gov/divisions/investment/imseniorsecurities/robertsonstephens040395.pdf

See also supra

note 47.

• For certain derivatives that are required by their terms to be net cash settled, and thus do not involve physical settlement, funds often segregate an amount equal to the fund's daily mark-to-market liability, if any (“mark-to-market segregation”).

Funds initially applied this approach to specific types of transactions addressed through guidance by our staff: first interest rate swaps and later cash-settled futures and non-deliverable forwards (“NDFs”).

We understand, however, that many funds now apply mark-to-market segregation to a wider range of cash-settled instruments.

Our staff has observed that some funds appear to apply the mark-to-market approach to any derivative that is cash settled.

See, e.g.,

Concept Release,

supra

note 3, at nn.75-77 and accompanying text (explaining that “[c]ertain swaps, for example, that settle in cash on a net basis, appear to be treated by many funds as requiring segregation of an amount of assets equal to the fund's daily mark-to-market liability, if any”).

Our staff provided this guidance in the context of its review of certain funds' registration statements.

See, e.g.,

Comment Letter of Ropes & Gray LLP on Concept Release (Nov. 7, 2011) (File No. S7-33-11) (“Ropes & Gray Concept Release Comment Letter”),

available at http://www.sec.gov/comments/s7-33-11/s73311-21.pdf

, at 4 (“It now appears to be an increasingly common practice for funds that engage in cash-settled swaps to segregate assets only to the extent required to meet the fund's daily mark-to-market liability, if any, relating to such swaps.”); Davis Polk Concept Release Comment Letter, at 3 (“[F]und registration statements indicate that, in recent years, the Staff has not objected to the adoption by funds of policies that require segregation of the mark-to-market value, rather than the notional amount, for a variety of swaps as well as for cash-settled futures and forward contracts.”).

As noted above, in Release 10666, we stated that the assets eligible to be included in segregated accounts should be “liquid assets,” such as cash, U.S. government securities, or other appropriate high-grade debt obligations. In a 1996 staff no-action letter, the staff took the position that a fund could cover its senior securities-related obligations by depositing any liquid asset, including equity securities and non-investment grade debt securities, in a segregated account.

With respect to the manner in which segregation may be effected, the staff took the position that a fund could segregate assets by designating such assets on its books, rather than establishing a segregated account at its custodian.

See

Merrill Lynch Asset Management, L.P., SEC Staff No-Action Letter (July 2, 1996) (“Merrill Lynch No-Action letter”),

available at http://www.sec.gov/divisions/investment/imseniorsecurities/merrilllynch070196.pdf

See

Dear Chief Financial Officer Letter from Lawrence A. Friend, Chief Accountant, Division of Investment Management (Nov. 7, 1997),

available at

http://www.sec.gov/divisions/investment/imseniorsecurities/imcfo120797.pdf

As this discussion reflects, funds and their counsel, in light of the guidance we provided in Release 10666 and that provided by our staff through no-action letters and otherwise, have applied the segregated account approach to, or otherwise sought to cover, many types of transactions other than those specifically addressed in Release 10666, including various derivatives and other transactions that implicate section 18. These transactions include, for example, futures, written options, and swaps (both swaps and security-based swaps).

4. Current Views Concerning Section 18

As we stated in Release 10666, we view the transactions described in that release as falling within the functional meaning of the term “evidence of indebtedness,” for purposes of section 18.

The trading practices described in Release 10666, as well as short sales of securities for which the staff initially developed the segregated account approach we applied in Release 10666, all impose on a fund a conditional or unconditional contractual obligation to pay or deliver assets in the future to a counterparty and thus involve the issuance of a senior security for purposes of section 18.

See

Release 10666,

supra

note 20, at “The Agreements as Securities” discussion. In addition, as we noted in the Concept Release, the Investment Company Act's definition of the term “security” is broader than the term's definition in other federal securities laws.

Compare

section 2(a)(36) of the Investment Company Act with sections 2(a)(1) and 2A of the Securities Act of 1933 (“Securities Act”) and sections 3(a)(10) and 3A of the Exchange Act.

See also

Concept Release,

supra

note 3, at n.57 and accompanying text (explaining that we have interpreted the term “security” in light of the policies and purposes underlying the Investment Company Act).

See

Release 10666,

supra

note 20, at “The Agreements as Securities” discussion.

See also

section 18(g) (defining the term “senior security,” in part, as “any bond, debenture, note, or similar obligation or instrument constituting a security and evidencing indebtedness”). Under the proposal, a fund would be permitted to enter into reverse repurchase agreements, short sale borrowings, or any firm or standby commitment agreement or similar agreement (collectively, “financial commitment transactions”), notwithstanding the prohibitions and restrictions on the issuance of senior securities under section 18, provided the fund complies with the proposed rule's conditions.

See infra

section III.A.

We apply the same analysis to derivatives transactions under which the fund is or may be required to make any payment or deliver cash or other assets during the life of the instrument or at maturity or early termination, whether as a margin or settlement payment or otherwise (a “future payment obligation”). As was the case with respect to the trading practices we described in Release 10666, where the fund has entered into a derivatives transaction and has a future payment obligation—a conditional or unconditional contractual obligation to

pay in the future

—we believe that such a transaction involves an evidence of indebtedness that is a senior security for purposes of section 18.

Unless otherwise specified or the context otherwise requires, the term “derivative” or “derivatives transaction” as used in this Release means a “derivatives transaction,” as defined in proposed rule 18f-4(c)(2), which describes derivatives that impose a payment obligation on the fund.

As we explained in Release 10666, we believe that an evidence of indebtedness, for purposes of section 18, includes not only a firm and un-contingent obligation, but also a contingent obligation, such as the obligation created by a standby commitment or a “put” (or call) option sold by a fund.

See

Release 10666,

supra

note 20, at “Standby Commitment Agreements” discussion. We understand that it has been asserted that a contingent obligation created by a standby commitment or similar agreement does not implicate section 18 unless and until the fund would be required under generally accepted accounting principles (“GAAP”) to recognize the contingent obligation as a liability on the fund's financial statements. The treatment of derivatives transactions under GAAP, including whether the derivatives transaction constitutes a liability for financial statement purposes at any given time or the extent of the liability for that purpose, is not determinative with respect to whether the derivatives transaction involves the issuance of a senior security under section 18. This is consistent with our analysis of a fund's obligation, and the corresponding segregated asset amounts, under the trading practices described in Release 10666.

See supra

note 47 (describing the amount of assets to be segregated for the trading practices described in Release 10666, including that a fund should segregate the full purchase price of a standby commitment beginning on the date the fund entered into the agreement, which would represent a contingent obligation of the fund).

This interpretation is supported by the express scope of section 18, which defines the term senior security broadly to include instruments and transactions that might not otherwise be considered securities under other provisions of the federal securities laws.

For example, section 18(f)(1) generally prohibits an open-end fund from issuing or selling any senior security “except [that the fund] shall be permitted to borrow from any bank.”

This statutory permission to engage in a specific borrowing makes clear that such borrowings are senior securities, which otherwise would be prohibited absent this specific permission.

Section 18(c)(2) similarly treats all promissory notes or evidences of indebtedness issued in consideration of any loan as senior securities except as specifically otherwise provided in that section.

Consistent with Release 10666, we are only expressing our views concerning section 18 of the Investment Company Act.

Recognizing the breadth of the term “senior security,” we observed in the Concept Release that, “[t]o address [Congress' concerns underlying section 18], section 18(f)(1) of the Investment Company Act prohibits an open-end fund from issuing or selling any `senior security' other than borrowing from a bank.” (footnotes omitted)

We similarly observed in Release 10666 that section 18(f)(1), “by implication, treats all borrowings as senior securities,” and that “[s]ection 18(f)(1) of the Act prohibits such borrowings unless entered into with banks and only if there is 300% asset coverage on all borrowings of the investment company.”

See

Release 10666,

supra

note 20, at “Reverse Repurchase Agreements” discussion.

Section 18(c) provides further limitations on a closed-end fund's ability to issue senior securities, in addition to the asset coverage and other limitations provided in section 18(a), with the proviso in section 18(c)(2) that “promissory notes or other evidences of indebtedness issued in consideration of any loan, extension, or renewal thereof, made by a bank or other person and privately arranged, and not intended to be publicly distributed, shall not be deemed to be a separate class of senior securities representing indebtedness within the meaning of [section 18(c)].”

This view also is consistent with the fundamental statutory policy and purposes underlying the Act, as expressed in section 1(b) of the Act. Section 1(b) provides that the provisions of the Act shall be interpreted to mitigate and “so far as is feasible” to eliminate the conditions and concerns enumerated in that section. These include the conditions and concerns enumerated in sections 1(b)(7) and 1(b)(8) which declare, respectively, that “the national public interest and the interest of investors are adversely affected” when funds “by excessive borrowing and the issuance of excessive amounts of senior securities increase unduly the speculative character” of securities issued to common shareholders and when funds “operate without adequate assets or reserves.” Funds' obligations under derivative transactions can implicate each of these concerns.

As we stated in Release 10666, leveraging an investment company's portfolio through the issuance of senior securities “magnifies the potential for gain or loss on monies invested and therefore results in an increase in the speculative character of the investment company's outstanding securities” and “leveraging without any significant limitation” was identified “as one of the major abuses of investment companies prior to the passage of the Act by Congress.” We emphasized in Release 10666, and we continue to believe today, that the prohibitions and restrictions under the senior security provisions of section 18 should “function as a practical limit on the amount of leverage which the investment company may undertake and on the potential increase in the speculative character of its outstanding common stock” and that funds should not “operate without adequate assets or reserves.”

Funds' use of derivatives, like the trading practices we addressed in Release 10666, implicate the undue speculation concern expressed in section 1(b)(7) and the asset sufficiency concern expressed in section 1(b)(8) as discussed below.

See

Release 10666,

supra

note 20, at “Segregated Account” discussion.

First, with respect to the undue speculation concern expressed in section 1(b)(7), we noted above and in the Concept Release that a common characteristic of most derivatives is that they involve leverage or the potential for leverage because they typically enable the fund to participate in gains and losses on an amount that substantially exceeds the fund's investment while imposing a conditional or unconditional obligation on the fund to make a payment or deliver assets to a counterparty. For example, a fund can enter into a total return swap referencing an equity or debt security and, in exchange for a contractual obligation to make payments in respect of changes in the value of the referenced security and the delivery of a limited amount of collateral, obtain exposure to the full notional value of the referenced security.

As one commenter observed, “a fund's purchase of an equity total return swap produces an exposure and economic return substantially equal to the exposure and economic return a fund could achieve by borrowing money from the counterparty in order to purchase the equities that are reference assets.”

This same analysis applies to various other types of derivatives under which the fund posts a small percentage of the notional amount as initial margin or collateral—or is not required to make any up-front payment or receives a premium payment—but is exposed to the gains or losses on the full notional amount of the reference asset.

See, e.g., The Report of the Task Force on Investment Company Use of Derivatives and Leverage,

Committee on Federal Regulation of Securities, ABA Section of Business Law (July 6, 2010) (“2010 ABA Derivatives Report”),

available at https://apps.americanbar.org/buslaw/blt/content/ibl/2010/08/0002.pdf,

at 8 (stating that “[f]utures contracts, forward contracts, written options and swaps can produce a leveraging effect on a fund's portfolio” because “for a relatively small up-front payment made by a fund (or no up-front payment, in the case with many swaps and written options), the fund contractually obligates itself to one or more potential future payments until the contract terminates or expires”).

See also infra

notes 72-74.

BlackRock Concept Release Comment Letter, at 4.

See, e.g., Board Oversight of Derivatives,

Independent Directors Council Task Force Report (July 2008) (“2008 IDC Report”),

available at http://www.ici.org/pdf/ppr_08_derivatives.pdf,

at 3 (“The leverage inherent in these [derivatives] instruments magnifies the effect of changes in the value of the underlying asset on the initial amount of capital invested. For example, an initial 5% collateral deposit on the total value of the commodity would result in 20:1 leverage, with a potential 80% loss (or gain) of the collateral in response to a 4% movement in the market price of the underlying commodity.”); Andrew Ang, Sergiy Gorovyy &

Gregory B. van Inwegen,

Hedge Fund Leverage,

NBER Working Paper 16801 (Feb. 2011) (“Ang, Gorovyy & Inwegen”),

available at http://www.nber.org/papers/w16801.pdf,

at Table 1 (showing that under prevailing margin rates as of March 2010, a market participant could in theory obtain 10 times implied leverage under a total return swap (because the exposure under the swap would be ten times the initial margin amount); 33 times implied leverage under a financial future; and 100 times implied leverage under a foreign exchange or interest rate swap).

As discussed in more detail in sections II.D and III.B.1.c, our staff's evaluation of the use of derivatives by funds also indicates that some funds make extensive use of derivatives to obtain notional investment exposures far in excess of the funds' respective net asset values.

Our staff's review of funds' use of derivatives found that, although many funds do not use derivatives, and most funds do not use a substantial amount of derivatives, some funds do use derivatives extensively. Some of the funds that use derivatives more extensively have derivatives notional exposures that are substantially in excess of the funds' net assets, with notional exposures ranging up to almost ten times a fund's net assets.

These highly leveraged investment exposures appear to be inconsistent with the purposes and concerns underlying section 18 of the Act.

For more information on the staff's review, including the staff's measurement of derivatives exposures,

see infra

section III.B.1.c and the White Paper entitled “Use of Derivatives by Investment Companies,” which was prepared by staff in the Division of Economic and Risk Analysis (“DERA”) and will be placed in the comment file for this Release contemporaneously with our publication of the Release. Daniel Deli, Paul Hanouna, Christof Stahel, Yue Tang & William Yost

Use of Derivatives by Registered Investment Companies

Division of Economic and Risk Analysis (2015) (“DERA White Paper”),

available at http://www.sec.gov/dera/staff-papers/white-papers/derivatives12-2015.pdf.

Id.

See also infra

section II.D (discussing concerns with the current approach and providing examples of situations in which funds' use of derivatives has led to substantial losses).

We noted in Release 10666 that, given the potential for reverse repurchase agreements to be used for leveraging and their ability to magnify the risk of investing in a fund, “one of the important policies underlying section 18 would be rendered substantially nugatory” if funds' use of reverse repurchase agreements were not subject to limitation. We similarly believe that if funds' use of derivatives that impose a future payment obligation on the fund were not viewed as involving senior securities subject to appropriate limitations under section 18, the concerns underlying section 18, including the undue speculation concern expressed in section 1(b)(7) as discussed above, would be frustrated.

One commenter made this point directly.

See

Comment Letter of Stephen A. Keen on Concept Release (Nov. 8, 2011) (File No. S7-33-11) (“Keen Concept Release Comment Letter”),

available at http://www.sec.gov/comments/s7-33-11/s73311-45.pdf,

at 3 (“If permitted without limitation, derivative contracts can pose all of the concerns that section 18 was intended to address with respect to borrowings and the issuance of senior securities by investment companies.”).

See also, e.g.,

Second, a fund's use of derivatives under which the fund has a future payment obligation also raises concerns with respect to a fund's ability to meet its obligations, implicating the asset sufficiency concern expressed in section 1(b)(8) of the Act. Many derivatives investments entered into by a fund, such as futures contracts, swaps, and written options, pose a risk of loss that can result in payment obligations owed to the fund's counterparties.

Losses on derivatives therefore can result in payment obligations that can directly affect the capital structure of a fund and the relative rights of the fund's counterparties and fund shareholders, in that the fund would be required to make payments or deliver fund assets to its derivatives counterparties under the terms negotiated with its counterparties. Because of the leverage present in many types of derivatives as discussed above, these senior payments of additional collateral or termination payments to counterparties can be substantially greater than any collateral initially delivered by the fund to initiate the derivatives transaction.

Some derivatives transactions, like physically settled futures and forwards, can require the fund to deliver the underlying reference assets regardless of whether the fund experiences losses on the transaction.

See, e.g., supra

note 72.

Losses on a fund's derivatives transactions, and the resulting payment obligation imposed on the fund, can force a fund's adviser to sell the fund's investments to generate liquid assets in order for the fund to meet its obligations. The use of derivatives for leveraging purposes can exacerbate this risk and make it more likely that a fund would be forced to sell assets, potentially generating losses for the fund.

In an extreme situation, a fund could default on its payment obligations.

The risks associated with derivatives transactions that impose a payment obligation on the fund differ from the risk of loss on other investments, which may result in a loss of asset value but would not require the fund to deliver cash or assets to a counterparty. The examples of fund losses discussed below in section II.D demonstrate the substantial and rapid losses that can result from a fund's investments in derivatives, as well as the forced sales and other measures a fund may be required to take to meet its derivatives payment obligations, implicating the undue speculation concern expressed in section 1(b)(7) and the asset sufficiency concern expressed in section 1(b)(8).

See, e.g.,

Peter Breuer,

Measuring Off-Balance-Sheet Leverage,

IMF Working Paper (Dec. 2000) (“Off-Balance-Sheet Leverage IMF Working Paper”),

available at http://www.imf.org/external/pubs/ft/wp/2000/wp00202.pdf,

at 7-8 (“[A] more leveraged investor facing a given adverse price movement may be forced by collateral requirements (

i.e.

margin calls) to unwind the position sooner than if the position were not leveraged. The unwinding decision of an unleveraged investor depends merely on the investor's risk preferences and not on potentially more restrictive margin requirements.”).

See, e.g.,

ICI Concept Release Comment Letter, at 11 (noting that, “[h]ypothetically, in an extreme scenario, a fund that used derivatives heavily and segregated most of its liquid assets to cover its obligation on a pure mark-to-market basis could potentially find itself with insufficient liquid assets to cover its derivative positions”).

In this regard, we note that proposed rule 22e-4 would, among other things, require an open-end fund (other than a money market fund) to: Classify, and review on an ongoing basis the classification of, the liquidity of each of the fund's portfolio positions (or portions of a position), including derivatives, into one of six liquidity categories; and assess and periodically review the fund's liquidity risk, considering various factors specified in the rule, including the fund's use of borrowings and derivatives for investment purposes. Assessing liquidity risk under rule 22e-4 would involve an assessment of the fund's derivatives positions themselves, and also may generally include an evaluation of the potential liquidity demands that may be imposed on the fund in connection with its use of derivatives. To the extent the fund is required to make payments to a derivatives counterparty, those assets would not be available to meet shareholder redemptions.

See

Liquidity Release,

supra

note 5, at sections III.B.2. and III. C.1.c.

We recognize, however, that not every derivative will involve the issuance of a senior security because not every derivative imposes a future payment obligation on the fund. A fund that purchases an option, for example, generally will make a non-refundable premium payment to obtain the right to acquire (or sell) securities under the option but generally will not have any subsequent obligation to deliver cash or assets to the counterparty unless the fund chooses to exercise the option. A derivative that does not impose a future payment obligation on a fund in this respect generally resembles non-derivative securities investments in that these investments may lose value but will not require the fund to make any

payments in the future.

Consistent with the views expressed by commenters, we preliminarily believe that a derivative that does not impose a future payment obligation on the fund would not involve a senior security transaction for purposes of section 18.

At least one commenter on the Concept Release asserted that a purchased option would impose a payment obligation on the fund because “[i]f the option is in the money at the time it expires, the fund's manager has a fiduciary obligation to realize the intrinsic value of the option” and “to exercise the option, the fund must either pay the full strike price (for a call) or deliver the notional amount of the underlying asset (for a put).”

See

Keen Concept Release Comment Letter, at 16.

See, e.g.,

ICI Concept Release Comment Letter, at 8 (“The Act is thus designed to regulate the degree to which a fund issues any form of debt—including contractual obligations that could require a fund to make payments in the future. By adopting a definition of `leverage' in the context of section 18 that relates solely to indebtedness leverage and clearly distinguishes it from economic leverage, the Commission could alleviate some of the confusion in this area while appropriately protecting investors and serving the purposes of the Act.”). Although some derivatives instruments may not involve the issuance of a senior security for purposes of section 18, we generally would expect the fund's adviser to consider the potential risks associated with these instruments, including the “economic” leverage they involve.

C. Review of Funds' Use of Derivatives

As we explained in the Concept Release, we now seek to take an updated and more comprehensive approach to the regulation of funds' use of derivatives.

To inform our consideration of the regulation of funds' use of derivatives, we initiated a review of funds' use of derivatives under the Investment Company Act. As we noted in the Concept Release, our staff has been exploring the benefits, risks, and costs associated with funds' use of derivatives, as well as various issues relating to the use of derivatives by funds, including whether funds' current practices, based on their application of Commission and staff guidance, are consistent with the investor protection purposes and concerns underlying section 18 of the Investment Company Act.

See

Concept Release,

supra

note 3, at section I (“The Commission or its staff, over the years, has addressed a number of issues relating to derivatives on a case-by-case basis. The Commission now seeks to take a more comprehensive and systematic approach to derivatives-related issues under the Investment Company Act.”).

In considering these and other issues, our staff has engaged in a range of activities to inform our policymaking relating to the use of derivatives by funds. These include reviewing funds' derivatives holdings and other sources of information concerning funds' use of derivatives; examining advisers to funds that make use of derivatives; discussing funds' use of derivatives with market participants; and considering other relevant information provided to the Commission concerning funds' use of derivatives, including comment letters submitted in response to the Concept Release. This review has also included an evaluation of the comment letters submitted in response to a notice issued by the Financial Stability Oversight Council (“FSOC”) requesting comment on aspects of the asset management industry.

Although our proposal is independent of FSOC, some commenters responding to the FSOC notice discussed issues concerning leverage, and we have considered and cited to relevant comments throughout this Release.

See

Notice Seeking Comment on Asset Management Products and Activities 79 FR 77488 (Dec. 24, 2014) (“FSOC Request for Comment”).

Comments submitted in response to the FSOC Notice are available at

http://www.regulations.gov/#!docketDetail;D=FSOC-2014-0001

The staff's review of funds' use of derivatives includes, as discussed below, a review of the derivatives and other holdings of a random sample of funds, as reported by those funds in their annual reports to shareholders. As part of this effort, the staff reviewed and compiled information concerning the holdings of randomly selected mutual funds (including a focused review and separate sampling of alternative strategy funds

), closed-end funds, ETFs, and BDCs. Information derived from this review is discussed throughout this Release, and more details concerning the staff's review and findings are provided in the DERA White Paper, which was prepared by staff in the Division of Economic and Risk Analysis and which will be placed in the comment file for this Release contemporaneously with our publication of the Release.

As discussed below, in developing proposed rule 18f-4, we considered the information derived from our staff's review concerning funds' use of derivatives and other considerations, including the investor protection purposes and concerns underlying section 18 as reflected in sections 1(b)(7) and 1(b)(8).

We refer to alternative strategy funds in the same manner as the staff classified “Alt Strategies” funds in the DERA White Paper,

supra

note 73, as including the Morningstar categories of “alternative,” “nontraditional bond” and “commodity” funds.

See supra

note 73.

D. Need for a New Approach

1. The Current Regulatory Framework and the Purposes and Policies Underlying the Act

a. Background and Overview

We have determined to propose a new approach to funds' use of derivatives in order to address the investor protection purposes and concerns underlying section 18 of the Act and to provide an updated and more comprehensive approach to the regulation of funds' use of derivatives transactions in light of the dramatic growth in the volume and complexity of the derivatives markets over the past two decades and the increased use of derivatives by certain funds. In Release 10666, we took the position that funds might engage in the transactions described in that release using the segregated account approach, notwithstanding the limitations in section 18.

We took this position because we believed that the segregated account approach would address the investor protection purposes and concerns underlying section 18 by: (1) Imposing a “practical limit on the amount of leverage which the investment company may undertake and on the potential increase in the speculative character of its outstanding common stock”; and (2) “assur[ing] the availability of adequate funds to meet the obligations arising [from the transactions described in Release 10666].”

Section 18 provides very limited statutory permission for open-end funds to borrow from any bank subject to the 300% asset coverage requirement and excludes from the definition of the term “senior security” any loans made for temporary purposes by a bank or other person and privately arranged in an amount not exceeding 5% of total assets. Release 10666 thus provided guidance for certain transactions that would otherwise be prohibited under the requirements of section 18, and open-end funds have used this guidance to enter into derivatives transactions that would otherwise be prohibited under section 18.

See also infra

note 141.

Release 10666,

supra

note 20, at “Segregated Account” discussion. These concerns are reflected in sections 1(b)(7) and 1(b)(8) of the Act, as discussed above. We also noted in Release 10666 that “segregated accounts, if properly created and maintained, would limit the investment company's risk of loss.”

Id.

We continue to believe that these are relevant considerations and that it may be appropriate for a fund to enter into transactions that create fund indebtedness, notwithstanding the prohibitions in section 18, if such transactions are subject both to a limit on leverage to prevent undue speculation and to measures designed to require the fund to have sufficient assets to meet its obligations.

We are

concerned, however, that funds' current practices, including their application of the segregated account approach to certain derivatives transactions, in some cases may not adequately address these considerations.

We also believe these considerations are relevant when considering, as we are required to do

for this proposed rule for purposes of section 6(c) of the Act, whether it would be necessary or appropriate in the public interest and consistent with the protection of investors and the purposes fairly intended by the policy and provisions of the Act to provide an exemption from the requirements of sections 18 and 61 of Act and the appropriate conditions for any exemption.

The segregated account approach described in Release 10666 required a fund engaging in the transactions described in that release to segregate liquid assets, such as cash, U.S. government securities, or other appropriate high-grade debt obligations, equal in value to the full amount of the obligations incurred by the fund.

A fund segregating an amount of the highly liquid assets described in Release 10666 equal in value to the full amount of potential obligations incurred through the transactions described in Release 10666 would be subject to a practical limit on the amount of leverage the fund could obtain through those transactions. The fund would not be able to incur obligations in excess of liquid assets that the fund could place in a segregated account, which generally would limit the fund's obligations to the fund's net assets, even if the fund's net assets consisted solely of the high-quality assets we described in Release 10666.

Segregating liquid assets equal in value to the full amount of the fund's obligations—and doing so with the types of high-quality liquid assets we described in Release 10666—also provided assurances that the fund would have adequate assets to meet its obligations.

The liquid assets we described in Release 10666 generally are less likely to experience volatility or to decline in value than lower quality debt securities or equity securities, for example, and the amount of the fund's obligation under the trading practices addressed in Release 10666 generally would be known at the outset of the transaction.

See

Release 10666,

supra

note 20, at “Segregated Account” discussion.

See also supra

note 47.

See, e.g.,

Ropes & Gray Concept Release Comment Letter, at 3 (in the context of Release 10666 “[a]s originally conceived by the Commission,” explaining that “[a]s a practical matter, requiring the segregation of assets but not limiting the permitted segregation to cash equivalents effectively permitted funds to incur investment leverage up to a theoretical limit equal to 100% of a fund's net assets.”) In addition and as we explained in Release 10666, as the percentage of a fund's portfolio assets that are segregated increases, the fund's ability to meet current obligations, to honor requests for redemption, and to manage properly the investment portfolio in a manner consistent with its stated investment objective may become impaired.

See

Release 10666,

supra

note 20, at “Segregated Account” discussion.

See also supra

note 47.

See also infra

section III.B.1.d.

108

See

Concept Release,

supra

note 3, at text accompanying n.83.

See also supra

note 106.

109

When a fund purchases a total return swap, the fund agrees with a counterparty that the fund will periodically pay a specified fixed or floating rate and will receive any appreciation and any interest or dividend payments on a specified reference asset(s), and will pay any depreciation on the reference asset(s).

See, e.g.,

ISDA Product Descriptions and Frequently Asked Questions,

available at http://www.isda.org/educat/faqs.html#28

(“A total return swap is a agreement in which one party (total return payer) transfers the total economic performance of a reference obligation to the other party (total return receiver). Total economic performance includes income from interest and fees, gains or losses from market movements, and credit losses.”).

110

See

BlackRock Concept Comment Letter, at 4 and accompanying text.

c. Concerns Regarding Funds' Ability To Meet Their Obligations

Funds' current practices also may not “assure the availability of adequate [assets] to meet the obligations arising from [funds' derivatives transactions],” as we contemplated in Release 10666, and thus may implicate the asset sufficiency concern expressed in section 1(b)(8) of the Act. In Release 10666, we stated a fund should segregate liquid assets equal in value to the fund's full obligation under the transactions described in that release from the outset of the transaction.

111

Consistent with Release 10666, funds applying the notional amount segregation approach segregate an amount of assets equal in value to the full amount of the fund's potential obligation under derivatives, where that amount is known at the outset of the transaction, or the full market value of the underlying reference asset for the derivative.

112

Segregating assets equal in value to the fund's full potential obligation under a derivative generally would be expected to enable the fund to meet that obligation.

111

See supra

note 47.

112

See supra

notes 54-55 and accompanying text.

A fund using the mark-to-market approach, however, segregates assets the fund deems liquid in an amount equal to the fund's daily mark-to-market liability on the derivative, if any. This approach looks only to losses, and corresponding potential payment obligations under the derivative, that the fund already has incurred. A fund that follows this approach is not necessarily segregating assets in anticipation of possible future losses and any corresponding payment obligations, and the fund's segregation of assets equal to its mark-to-market liability on any particular day provides no assurances that future losses will not exceed the amount of assets the fund has segregated or would otherwise have available to meet the payment obligations resulting from such losses. A fund's mark-to-market liability on any particular day could be substantially smaller than the fund's ultimate obligations under a derivative.

113

noted above, if there is no mark-to-market liability for the fund on a given day, for example because the derivative is currently in a gain position or the fund has just entered into a derivative like a swap for which there is no daily loss for either party at inception, the fund might not segregate

any

assets.

114

113

See, e.g.,

ICI Concept Release Comment Letter, at 11 (noting that “calculating a fund's exposure daily based only on its net obligations—the `mark-to-market' approach—may create a risk that market movements could increase a fund's exposure, so that the segregated assets are worth less than the fund's obligation” and that “[h]ypothetically, in an extreme scenario, a fund that used derivatives heavily and segregated most of its liquid assets to cover its obligation on a pure mark-to-market basis

could potentially find itself with insufficient liquid assets to cover its derivative positions”); Vanguard Concept Release Comment Letter, at n.15 (noting that “using a market value [asset segregation] test for certain transactions can result in the under-segregation of assets”); AQR Concept Release Comment Letter, at 4 (“The current asset segregation approach, while it has been effective in mitigating the risks section 18 was designed to address (

i.e.,

excessive borrowing and operating without adequate assets and reserves), has some weaknesses. In particular, as applied to swaps, the daily end-of-day segregation of changes in market value do not reflect the likelihood of loss or volatility of the reference instrument. Intra-day value fluctuations are ignored. For futures, the issues are similar.”); Ropes & Gray Concept Release Comment Letter, at 4 (noting that a swap's mark-to-market liability, if any, “in many cases . . . will not fully reflect the ultimate investment exposure associated with the swap position”).

114

See supra

note 104 and accompanying text.

Where a fund segregates any liquid asset, rather than the more narrow range of high-quality assets we described in Release 10666, the segregated assets may be more likely to decline in value at the same time as the fund experiences losses on its derivatives than if the fund had segregated the types of liquid assets we described in Release 10666.

115

In this case, or when a fund's derivatives payment obligations are substantial relative to the fund's assets, the fund may be forced to sell portfolio securities to meet its derivatives payment obligations, potentially in stressed market conditions.

116

That a fund has segregated assets it deems sufficiently liquid to cover a derivative's daily mark-to-market liability, if any, thus may not effectively assure the fund will have liquid assets to meet its future obligations under the derivative.

117

115

See, e.g.,

Comment Letter of Better Markets, Inc. on Concept Release (Nov. 7, 2011) (File No. S7-33-11),

available at http://www.sec.gov/comments/s7-33-11/s73311-42.pdf

, at 5 (stating that “the broadening of segregated assets [permitted by the Merrill Lynch No-Action letter] increases the probability that the embedded credit associated with the derivatives will result in a senior payment of money from the Funds” . . . and, in addition, “the assets could be positively correlated with the derivatives risk being offset” and that “[l]oss on the derivatives risk could be compounded by loss on the asset”); 2010 ABA Derivatives Report,

supra

note 70, at 16 (where only the mark-to-market liability, if any, is segregated, “a fund's exposure under a derivative contract could increase significantly on an intraday basis, resulting in the segregated assets being worth less than the fund's obligations (until the fund is able to place additional assets in the segregated account . . . . To the extent that a fund relying on the Merrill Lynch Letter segregates assets whose prices are somewhat volatile, this `shortfall' could be magnified”).

116

We noted in Release 10666 that “in an extreme case an investment company which has segregated all its liquid assets might be forced to sell non-segregated portfolio securities to meet its obligations upon shareholder requests for redemption. Such forced sales could cause an investment company to sell securities which it wanted to retain or to realize gains or losses which it did not originally intend.”

See

Release 10666,

supra

note 20, at “Segregated Account” discussion.

See also infra

note 123 and accompanying text.

117

See, e.g.,

Keen Concept Release Comment Letter, at 20 (“The out-of-the money value of a swap [segregated under the mark-to-market approach] only represents how much the fund

already

has lost, not the

potential

loss that might be incurred during the term of the swap. The potential loss represents the risk of investment leverage, but the Division's position [regarding the mark-to-market approach] does not require the fund to maintain any assets to cover this risk. The only practical limit is the fund's need to maintain a buffer of unsegregated assets to cover fluctuations in the swap's out-of-the-money value.”) (emphasis in original); MFDF Concept Release Comment Letter, at 4 (“A fund can also have significant liability exposures connected with a derivative position, particularly if that position does not perform as expected. Because the extent of these liabilities can far outweigh the initial investment in the instrument, the use of derivatives raises potentially serious concerns under the Investment Company Act of 1940 . . . .”).

Some commenters on the Concept Release appear to have recognized that segregation of a fund's daily mark-to-market liability alone may not be sufficient in at least some cases. As discussed in more detail below in section III.C of this Release, some commenters have suggested that we impose asset segregation requirements under which a fund would include in its segregated account for a derivative an amount determined by the fund, in addition to the daily mark-to-market liability, designed to address future losses.

118

Some commenters stated that it may be appropriate for a fund to maintain this additional amount, sometimes referred to as a “cushion” by commenters, in addition to assets used to cover any daily mark-to-market liability.

119

Some of these commenters further recommended that such an asset segregation requirement be complemented by additional guidance or requirements, with at least one commenter suggesting that we may wish to consider also imposing an “overall leverage limit.”

120

118

See, e.g.,

ICI Concept Release Comment Letter; Comment Letter of Invesco Advisers, Inc. on Concept Release (Nov. 7, 2011) (File No. S7-33-11) (“Invesco Concept Release Comment Letter”),

available at http://www.sec.gov/comments/s7-33-11/s73311-20.pdf

(supporting the ICI's recommendation concerning asset segregation); BlackRock Concept Release Comment letter; Comment Letter of Securities Industry and Financial Markets Association on Concept Release (Nov. 23, 2011) (File No. S7-33-11) (“SIFMA Concept Release Comment Letter”),

available at http://www.sec.gov/comments/s7-33-11/s73311-51.pdf

; Vanguard Concept Release Comment Letter.

119

See, e.g.,

ICI Concept Release Comment Letter, at 3 (“When segregating less than the most conservative full notional amount, the segregation policy should require a more in depth analysis to ensure that the fund has a `cushion' to address the potential loss from derivative contracts that could arise before the next time obligations are marked to market (often, the end of the next day”); SIFMA Concept Release Comment Letter, at 4 (“The `cushion' would address some potential shortcomings of a simple mark-to-market value measure, such as the risk that a Fund's indebtedness under a derivative could increase significantly on an intraday basis, resulting in a gap between the value of a Fund's segregated assets and its actual payment obligations under the derivative.”).

120

See

Vanguard Concept Release Comment Letter, at n.18 (“We recognize that the SEC may have concerns about allowing funds to develop their own asset segregation approach based upon SEC examples. To allay those concerns, the SEC may wish to consider adopting an overall leverage limit that funds would be required to comply with, notwithstanding that they have segregated liquid assets to back their obligations.”).

See also, e.g.,

ICI Concept Release Comment Letter, at 12 (“For funds that choose to segregate assets at less than the most conservative levels, we recommend that the SEC or its staff set forth general guidance that provides `guardrails' to ensure appropriate protections for investors.”).

For all of these reasons, funds' current practices, based on their application of Commission and staff guidance, may in some cases fail to impose an effective limit on the amount of leverage that funds can obtain through derivatives or necessarily require that funds have adequate assets to meet their obligations arising under the derivatives transactions.

121

This is not consistent with our stated expectations in Release 10666 that funds' use of the segregated account approach as described in that release would achieve these goals, consistent with the undue speculation concern expressed in section 1(b)(7) and the asset sufficiency concern expressed in section 1(b)(8).

122

121

We observed in the Concept Release the concern that the mark-to-market segregation approach, which we understand is increasingly used by funds with respect to various derivatives, “may understate the risk of loss to the fund, permit the fund to engage in excessive leveraging, fail to adequately set aside sufficient assets to cover the fund's ultimate exposure, and, therefore, perhaps not adequately fulfill the purposes underlying the segregated account approach and section 18.”

See

Concept Release,

supra

note 3, at text accompanying n.83.

122

See

Release 10666,

supra

note 20, at “Segregated Account” discussion (stating that “[i]f an investment company continues to engage in the described securities trading practices and properly segregates assets, the segregated account

will

function as a practical limit on the amount of leverage which the investment company may undertake and on the potential increase in the speculative character of its outstanding common stock” and that “such accounts

will

assure the availability of adequate funds to meet the obligations arising from such activities”) (emphasis added).

d. Examples of Substantial Derivatives-Related Losses

Three relatively recent settled enforcement actions provide examples of situations in which funds' use of derivatives caused significant losses and

are relevant to our consideration of whether funds' current practices, based on their application of Commission and staff guidance, are consistent with the investor protection purposes and concerns underlying section 18 of the Investment Company Act. The funds' experiences in these cases demonstrate the substantial and rapid losses that can result from a fund's investments in derivatives. The first action also demonstrates the further losses that can arise when a fund's portfolio securities also experience declines in value at the same time that the fund is required to make additional payments under the derivatives contracts.

The first action involved two mutual funds that suffered losses driven primarily by their exposure to certain commercial mortgage-backed securities (“CMBS”), obtained mainly through TRS.

123

Unlike an actual purchase of CMBS, these TRS contracts required no initial commitment of cash; this allowed the funds to take on large amounts of CMBS exposure without having to liquidate other positions, but it also caused them to take on leverage by adding market exposure on top of other assets on their balance sheets.

123

See

In the matter of OppenheimerFunds, Inc. and OppenheimerFunds Distributor, Inc., Investment Company Act Release No. 30099 (June 6, 2012) (settled action).

In late 2008, CMBS spreads widened to unprecedented levels, triggering substantial payment obligations for the funds under the TRS contracts while market values for the funds' portfolio securities also fell, further driving down the funds' net asset value per share. Amidst this declining market the funds also were required to sell portfolio securities to raise cash to meet their obligations under the TRS contracts. In addition, the adviser provided sponsor support to one of the funds by investing $150 million in the fund in November 2008 to provide the fund with liquidity after its anticipated TRS payments for that month totaled approximately one-third of the fund's net assets and almost twice its available cash. Both of the funds experienced losses far greater than those suffered by their peer funds. One fund's share price declined nearly 80% (compared to an average decline of approximately 26% among its peers), far more than any sector in which the fund invested. This occurred because the fund was substantially leveraged as a result of its derivatives, particularly TRS contracts. The other fund's share price declined approximately 36% (compared to an average decline of approximately 4% among its peers).

The second action

124

involved a registered closed-end fund that pursued an investment strategy involving written out-of-the money put options and short variance swaps.

125

These derivatives transactions led to substantial losses for the fund in September and October 2008, when the fund realized a loss of approximately $45.4 million, or 45% of the fund's net assets as of the end of August 2008, on five written put options and variance swaps, contributing to a 72.4% two-month decline in the Fund's net asset value. The fund was liquidated in May 2009.

124

See

In the matter of Claymore Advisors, LLC, Investment Company Act Release No. 30308 (Dec. 19, 2012); In the matter of Fiduciary Asset Management, LLC, Investment Company Act Release No. 30309 (Dec. 19, 2012) (settled actions).

125

Variance swaps are essentially a bet on whether the actual or realized market volatility will be higher or lower than the market's expectation for volatility (or “implied volatility”). A party with a “long variance” position profits when realized volatility for the contract period is greater than the implied volatility. A party with a “short variance” position profits whenever realized volatility is less than the implied volatility.

The third action

126

involved a registered closed-end fund that primarily invested in distressed debt until 2008, when it changed course and shorted credit by purchasing large amounts of CDS. In 2008 and early 2009, the fund's short exposure significantly increased as a result of large CDS purchases. The large CDS portfolio dramatically changed the fund's risk profile. Starting around April 2009, credit conditions began to improve and distressed debt increased in value, leading to large mark-to-market losses for the fund's CDS portfolio. In addition, the high cost of maintaining the CDS positions contributed to the fund's losses. In 2012, the fund performed very poorly in large part because of its short-credit CDS portfolio, and the fund's board voted to liquidate the fund.

126

See

In the Matter of UBS Willow Management L.L.C. and UBS Fund Advisor L.L.C., Investment Company Act Release No. 31869 (Oct. 16, 2015) (settled action).

Examples of the use of derivatives by investment funds that are not subject to the limitations under the Investment Company Act, including private funds, such as hedge funds, that are excluded from regulation under the Investment Company Act by section 3(c)(1) or 3(c)(7) of the Act also may be relevant in considering registered funds' use of derivatives.

127

Private funds' experience with the use of derivatives can help demonstrate the risks associated with derivatives generally, and private funds' experience also may be more directly relevant to the extent registered funds are obtaining leverage to a similar extent as private funds and pursuing similar investment strategies.

127

Section 3(c)(1) excludes from the definition of “investment company” any issuer whose outstanding securities are beneficially owned by not more than one hundred persons and which is not making and does not presently propose to make a public offering of its securities (other than short term paper). Section 3(c)(7) excludes from the definition of “investment company” any issuer, the outstanding securities of which are owned exclusively by persons who, at the time of acquisition of such securities, are qualified purchasers, and which is not making and does not at that time propose to make a public offering of such securities. Private funds that rely on section 3(c)(1) or 3(c)(7) are not required to comply with any of the capital structure or leverage limitations under the Act, and the use of leverage by private funds, including hedge funds, may be an important component of their investment strategies.

As one example, a private fund with approximately $10.2 billion of net assets lost $4.9 billion in natural gas futures positions in a period of a few weeks in August and September 2006 and was forced to liquidate its entire portfolio and close.

128

While the fund engaged in a range of investment strategies, its primary strategy involved a long-short strategy in one type of energy commodity—natural gas—that it traded through NYMEX futures and OTC swaps. The fund's exposure on its long and short natural gas positions in August 2006 could have been viewed as balanced or hedged at the time it made the investments, in that the fund reportedly had a net exposure that was much less substantial than the fund's substantial long and short gross exposures.

129

However, losses incurred on a portion of the fund's positions (which were not offset by gains on its other positions) resulted in substantial margin calls on the fund that it was unable to meet with its available cash, and the fund's adviser liquidated the fund's entire portfolio of natural gas positions and closed the fund, with losses to investors of almost 50% of the fund's net asset value.

128

See

Ludwig B. Chincarini,

A Case Study on Risk Management: Lessons from the Collapse of Amaranth Advisors L.L.C.,

18 J. of Applied Fin. 152 (Spring/Summer 2008),

available at http://ludwigbc.com/pubs/pub9.pdf

129

See id.,

at 159 (“The position is `hedged' in the sense that if natural gas futures prices rise or fall, one position's loss will be partly offset by the other's gain. However, the position is focusing on a spread bet.”).

This example demonstrates the challenges in assessing whether ostensibly hedged or covered positions will perform as intended (for example, whether a position intended to hedge another exposure may fail to have a hedging effect and instead result in additional, speculative exposure). In the example above, the private fund's adviser may have expected that the fund's long and short positions would

hedge a substantial amount of the risk inherent in each set of positions, and this could have been the case under various circumstances. But it was not the case in August and September of 2006, when the fund experienced the substantial losses discussed above leading to its liquidation.

2. Need for an Updated and More Comprehensive Approach

We now propose to take an updated and more comprehensive approach to the regulation of funds' use of derivatives and the application of the senior security restrictions in section 18. The current approach has developed over the years since we issued Release 10666 as funds and our staff sought to apply our statements in Release 10666 to various types of derivatives and other transactions on an instrument-by-instrument basis. We understand that, in determining how they will comply with section 18, funds consider various no-action letters issued by our staff. These letters were issued in the 1970s, 1980s, and 1990s, and addressed particular questions presented to the staff concerning the application of the approach enunciated in Release 10666 to various types of derivatives on an instrument-by-instrument basis.

130

We understand that funds also consider, in addition to these letters, other guidance they may receive from our staff and the practices that other funds disclose in their registration statements.

130

See Registered Investment Company Use of Senior Securities-Select Bibliography, available at http://www.sec.gov/divisions/investment/seniorsecurities-bibliography.htm

(prepared by the staff and citing staff no-action letters).

The current approach's development on an instrument-by-instrument basis, together with the dramatic growth in the volume and complexity of the derivatives markets over the past two decades, has resulted in situations for which there is no specific guidance from us or our staff with respect to various types of derivatives.

131

We noted in the Concept Release the concern that the segregated account approach, by calling for an instrument-by-instrument assessment of the amount of cover required, may create uncertainty about the treatment of new products, and that new product development will inevitably lead to circumstances in which available guidance does not specifically address each new instrument subject to section 18 constraints.

132

131

See, e.g.,

ICI Concept Release Comment Letter, at 9 (“A principles based approach is necessary because the SEC staff's traditional instrument by instrument approach to guidance has created, and would continue to create, regulatory uncertainty.”).

132

See

Concept Release,

supra

note 3, at n.79 and accompanying text.

Under the current approach, different funds may treat the same kind of derivative differently, based on their own application of our staff's guidance and observation of industry practice, which at least one commenter noted “may unfairly disadvantage some funds.”

133

Where there is no specific guidance, or where the application of existing guidance is unclear, funds may take approaches that involve a more extensive use of derivatives and that may not address the purposes and concerns underlying section 18 of the Act, as discussed above. The lack of guidance addressing some derivatives may create competitive pressures for funds to take approaches that involve a more extensive use of derivatives. The current approach, having developed over time, may treat similar derivatives in a manner that results in substantially different amounts of segregated assets, and may itself influence funds' investment decisions.

134

The lack of comprehensive guidance also makes it difficult for funds and our staff to evaluate and inspect for funds' compliance with section 18. A number of commenters on the Concept Release supported a more comprehensive and systematic approach, rather than an approach in which we or our staff provide guidance on an instrument-by-instrument basis, which these commenters generally suggested would be less effective.

135

133

See, e.g.,

Davis Polk Concept Release Comment Letter, at 1-2 (noting that “funds and their sponsors may interpret the available guidance differently, even when applying it to the same instruments, which may unfairly disadvantage some funds”).

134

See, e.g.,

ICI Concept Release Comment Letter, at n.19 (noting that funds segregate the notional amount of physically settled futures contracts, consistent with the Dreyfus no-action letter, while some funds disclose that they segregate only the marked-to-marked obligation in respect of cash-settled futures and agreeing with the concern reflected in the Concept Release that this “results in differing treatment of arguably equivalent products”); Davis Polk Concept Release Comment Letter, at 3 (noting that “[t]he current approach to segregation leaves many open questions and may lead to inconsistent results for financially similar instruments,” noting for example that very few funds use physically settled futures contracts because staff guidance has applied the notional segregation approach to these contracts and, “[i]nstead, funds enter into over-the-counter swaps that provide similar economic exposure, even though swaps tend to be more expensive and present other potential risks, such as counterparty risk and lack of liquidity”).

135

See, e.g.,

ICI Concept Release Comment Letter, at 9 (advocating for a principles-based approach and noting, among other things, that “the SEC staff's approach to date of providing guidance with respect to specific types of instruments has created a patchwork of interpretations that is neither practical nor sustainable”); Davis Polk Concept Release Comment Letter, at 1 (noting that while guidance from the Commission and staff “has been helpful, it has not been able to keep pace with the dramatic expansion of the derivatives market over the past twenty years, both in terms of the types of instruments that are available and the extent to which funds use them,” and that resulting “regulatory uncertainty may lead a fund to select one type of instrument or transaction over another for non-investment reasons, or to avoid certain instruments or transactions altogether,” which “can lead to inefficiencies that are detrimental to funds and their shareholders”); BlackRock Concept Release Comment Letter, at 5 (“Any set of mechanical rules cannot take account of the diversity of derivatives and the multiplicity of ways they may be used by portfolio managers.”); Invesco Concept Release Comment Letter; Loomis Concept Release Comment Letter; Comment Letter of American Bar Association on Concept Release (Nov. 11, 2011) (File No. S7-33-11) (“ABA Concept Release Comment Letter”),

available at http://www.sec.gov/comments/s7-33-11/s73311-47.pdf

; MFDF Concept Release Comment Letter; Comment Letter of T. Rowe Price Associates, Inc. on Concept Release (Nov. 7, 2011) (File No. S7-33-11) (“T. Rowe Price Concept Release Comment Letter”),

available at http://www.sec.gov/comments/s7-33-11/s73311-35.pdf

; Vanguard Concept Release Comment Letter.

A fund's use of derivatives may involve counterparty, liquidity, leverage, market, and operational risks, as noted above. As we observed in the Concept Release, “[a] fund's use of derivatives presents challenges for its investment adviser and board of directors to ensure that the derivatives are employed in a manner consistent with the fund's investment objectives, policies, and restrictions, its risk profile, and relevant regulatory requirements, including those under federal securities laws.”

136

In light of these considerations and those we discuss in section III.D below, we believe that funds that make significant use of derivatives, or that use certain complex derivatives, should have formalized risk management programs to manage the risks that derivatives may pose and to help address the challenges and investor protection concerns presented by their use.

137

136

Concept Release,

supra

note 3, at 14.

See also, e.g.,

Comment Letter of Capital Market Risk Advisors on Concept Release (Nov. 1, 2011) (File No. S7-33-11),

available at http://www.sec.gov/comments/s7-33-11/s73311-19.pdf

(supporting risk management for derivatives, but also for all more complex and less liquid instruments).

137

See, e.g.,

Oppenheimer Concept Release Comment Letter, at 3 (stating that “a core component in the oversight of the use of derivatives by funds should be the board's awareness of the controls in place, and the effectiveness of the adviser's governance of risk in maintaining this awareness” and that “[w]e believe it is reasonable for the SEC to expect large and sophisticated investment advisers to have in place a well-developed risk governance framework incorporating an independent risk management function, governance structures designed to ensure the comprehensive review by appropriate levels of management of risk issues and reporting to a fund's

board designed to facilitate and enhance effective board oversight”).

III. Discussion

As noted above, the dramatic growth in the volume and complexity of the derivatives markets over the past two decades, and the increased use of derivatives by certain funds, led us to initiate a review of funds' use of derivatives under the Investment Company Act. Based on that review, including the considerations we discussed in section II.D above and throughout this Release, we are today proposing rule 18f-4, an exemptive rule designed to address the investor protection purposes and concerns underlying section 18 and to provide an updated and more comprehensive approach to the regulation of funds' use of derivatives transactions and financial commitment transactions. This proposal is part of a broader set of initiatives designed to address the increasingly complex portfolio composition and operations of the asset management industry.

138

Other initiatives include modernizing investment company reporting and disclosure and proposing liquidity risk management programs for open-end funds, including exchange-traded funds.

See

Investment Company Reporting Modernization, Investment Company Act Release No. 31610 (May 20, 2015) [80 FR 33590 (June 12, 2015)] (“Investment Company Reporting Modernization Release”); Amendments to Form ADV and Investment Advisers Act Rules, Advisers Act Release No. 4091 (May 20, 2015) [80 FR 33718 (June 12, 2015)]; Liquidity Release,

supra

note 5.

Proposed rule 18f-4 would permit a fund to enter into derivatives transactions, as defined in the rule, provided that the fund complies with three primary sets of conditions of the rule designed to address the purposes and concerns underlying section 18.

139

First, the fund would be required to comply with one of two alternative portfolio limitations designed to impose a limit on the amount of leverage the fund may obtain through derivatives transactions and other senior securities transactions. The first portfolio limitation would place an overall limit on the amount of exposure (as defined in the rule) to underlying reference assets, and potential leverage, that a fund would be able to obtain through derivatives transactions and other senior securities transactions by limiting the fund's exposure under these transactions to 150% of the fund's net assets. The second portfolio limitation would focus primarily on a risk assessment of the fund's use of derivatives, and would permit a fund to obtain exposure in excess of that permitted under the first portfolio limitation where the fund's derivatives transactions, in aggregate, result in an investment portfolio that is subject to less market risk than if the fund did not use such derivatives, evaluated using a value-at-risk-based test.

139

The proposed rule would provide an exemption from certain provisions of section 18 and 61 of the Act, subject to conditions. The proposed rule could be used by any fund subject to the requirements of section 18 or 61, including mutual funds, closed-end funds, BDCs, most ETFs, and exchange-traded managed funds. (Exchange-traded managed funds, a hybrid between a traditional mutual fund and an ETF, are open-end funds that the Commission has approved.

See

Eaton Vance Management, et al., Investment Company Act Release Nos. 31333 (Nov. 6, 2014) (notice) and 31361 (Dec. 2, 2014) (order)). The rule would not apply to unit investment trusts (“UITs”), including ETFs structured as UITs, because UITs are not subject to the requirements of section 18. However, as the Commission has noted (in addressing futures contracts and commodities options), derivatives transactions generally require a significant degree of management and may not meet the requirements imposed on a UIT by the Investment Company Act, including section 4(2) thereof.

See

section 4 of the Act;