# Use of Derivatives by Registered Investment Companies and Business Development Companies; Required Due Diligence by Broker-Dealers and Registered Investment Advisers Regarding Retail Customers' Transactions in Certain Leveraged/Inverse Investment Vehicles > Briefs, arguments, decisions, and more. URL: https://www.frixlaw.com/law-library/documents/fr%3A2020-00040 ## Record - **Collection:** Federal Register - **Document type:** Proposed Rule - **Published:** January 24, 2020 - **Citation:** 85 FR 4446 ## Text SECURITIES AND EXCHANGE COMMISSION 17 CFR Parts 239, 240, 249, 270, 274 and 275 [Release No. 34-87607; IA-5413; IC-33704; File No. S7-24-15] RIN 3235-AL60 Use of Derivatives by Registered Investment Companies and Business Development Companies; Required Due Diligence by Broker-Dealers and Registered Investment Advisers Regarding Retail Customers' Transactions in Certain Leveraged/Inverse Investment Vehicles AGENCY: Securities and Exchange Commission. ACTION: Proposed rule. SUMMARY: The Securities and Exchange Commission (the “Commission”) is re-proposing rule 18f-4, a new exemptive rule under the Investment Company Act of 1940 (the “Investment Company 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 and the other transactions addressed in the proposed rule. The Commission is also proposing new rule 15 l -2 under the Securities Exchange Act of 1934 (the “Exchange Act”) and new rule 211(h)-1 under the Investment Advisers Act of 1940 (“Advisers Act”) (collectively, the “sales practices rules”). In addition, the Commission is proposing new reporting requirements and amendments to Form N-PORT, Form N-LIQUID (which we propose to be re-titled as “Form N-RN”), and Form N-CEN, which are designed to enhance the Commission's ability to effectively oversee funds' use of and compliance with the proposed rules, and for the Commission and the public to have greater insight into the impact that funds' use of derivatives would have on their portfolios. Finally, the Commission is proposing to amend rule 6c-11 under the Investment Company Act to allow certain leveraged/inverse ETFs that satisfy the rule's conditions to operate without the expense and delay of obtaining an exemptive order. DATES: Comments should be submitted on or before March 24, 2020. 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/proposed.shtml ); or • Send an email to rule-comments@sec.gov . Please include File No. S7-24-15 on the subject line. Paper Comments • Send paper comments to 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 of submission. The Commission will post all comments on the Commission's website ( http://www.sec.gov/rules/proposed.shtml ). Comments are also available for website 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. Persons submitting comments are cautioned that we do not redact or edit personal identifying information from comment 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 website. 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: Asaf Barouk, Attorney-Adviser; Joel Cavanaugh, Senior Counsel; John Lee, Senior Counsel; Sirimal Mukerjee, Senior Counsel; Amanda Hollander Wagner, Branch Chief; Thoreau Bartmann, Senior Special Counsel; or Brian McLaughlin Johnson, Assistant Director, at (202) 551-6792, Investment Company Regulation Office, Division of Investment Management; and with respect to proposed rule 15 l -2, Kelly Shoop, Senior Counsel; or Lourdes Gonzalez, Assistant Chief Counsel; Office of Chief Counsel, Division of Trading and Markets; Securities and Exchange Commission, 100 F Street NE, Washington, DC 20549-1090. SUPPLEMENTARY INFORMATION: Proposed rule 18f-4 would apply to mutual funds (other than money market funds), exchange-traded funds (“ETFs”), registered closed-end funds, and companies that have elected to be treated as business development companies (“BDCs”) under the Investment Company Act (collectively, “funds”). It would permit these funds to enter into derivatives transactions and certain other transactions, notwithstanding the restrictions under sections 18 and 61 of the Investment Company Act, provided that the funds comply with the conditions of the rule. The proposed sales practices rules would require a broker, dealer, or investment adviser that is registered with (or required to be registered with) the Commission to exercise due diligence in approving a retail customer's or client's account to buy or sell shares of certain “leveraged/inverse investment vehicles” before accepting an order from, or placing an order for, the customer or client to engage in these transactions. The Commission is proposing for public comment 17 CFR 270.18f-4 (new rule 18f-4) under the Investment Company Act, 17 CFR 240.15 l -2 (new rule 15 l -2) under the Exchange Act, 17 CFR 275.211(h)-1 (new rule 211(h)-1) under the Advisers Act; amendments to 17 CFR 270.6c-11 (rule 6c-11) under the Investment Company Act; amendments to Form N-PORT [referenced in 17 CFR 274.150], Form N-LIQUID (which we propose to re-title as “Form N-RN”) [referenced in 17 CFR 274.223], Form N-CEN [referenced in 17 CFR 274.101], and Form N-2 [referenced in 17 CFR 274.11a-1] under the Investment Company Act. Table of Contents I. Introduction A. Overview of Funds' Use of Derivatives B. Derivatives and the Senior Securities Restrictions of the Investment Company Act 1. Requirements of Section 18 2. Evolution of Commission and Staff Consideration of Section 18 Restrictions as Applied to Funds' Use of Derivatives 3. Need for Updated Regulatory Framework C. Overview of the Proposal II. Discussion A. Scope of Proposed Rule 18f-4 1. Funds Permitted To Rely on Proposed Rule 18f-4 2. Derivatives Transactions Permitted Under Proposed Rule 18f-4 B. Derivatives Risk Management Program 1. Summary 2. Program Administration 3. Required Elements of the Program C. Board Oversight and Reporting 1. Board Approval of the Derivatives Risk Manager 2. Board Reporting D. Proposed Limit on Fund Leverage Risk 1. Use of VaR 2. Relative VaR Test 3. Absolute VaR Test 4. Choice of Model and Parameters for VaR Test 5. Implementation 6. Other Regulatory Approaches to Limiting Fund Leverage Risk E. Limited Derivatives Users 1. Exposure-Based Exception 2. Currency Hedging Exception 3. Risk Management F. Asset Segregation G. Alternative Requirements for Certain Leveraged/Inverse Funds and Proposed Sales Practices Rules for Certain Leveraged/Inverse Investment Vehicles 1. Background on Proposed Approach to Certain Leveraged/Inverse Funds 2. Proposed Sales Practices Rules for Leveraged/Inverse Investment Vehicles 3. Alternative Provision for Leveraged/Inverse Funds Under Proposed Rule 18f-4 4. Proposed Amendments to Rule 6c-11 Under the Investment Company Act and Proposed Rescission of Exemptive Relief for Leveraged/Inverse ETFs H. Amendments to Fund Reporting Requirements 1. Amendments to Form N-PORT 2. Amendments to Current Reporting Requirements 3. Amendments to Form N-CEN 4. BDC Reporting I. Reverse Repurchase Agreements J. Unfunded Commitment Agreements K. Recordkeeping Provisions L. Transition Periods M. Conforming Amendments III. Economic Analysis A. Introduction B. Economic Baseline 1. Fund Industry Overview 2. Funds' Use of Derivatives 3. Current Regulatory Framework for Derivatives 4. Funds' Derivatives Risk Management Practices and Use of VaR Models 5. Leveraged/Inverse Investment Vehicles and Leveraged/Inverse Funds C. Benefits and Costs of the Proposed Rules and Amendments 1. Derivatives Risk Management Program and Board Oversight and Reporting 2. VaR-Based Limit on Fund Leverage Risk 3. Limited Derivatives Users 4. Reverse Repurchase Agreements and Similar Financing Transactions 5. Alternative Requirements for Certain Leveraged/Inverse Funds and Proposed Sales Practices Rules for Certain Leveraged/Inverse Investment Vehicles 6. Proposed Amendments to Rule 6c-11 Under the Investment Company Act and Proposed Rescission of Exemptive Relief for Leveraged/Inverse ETFs 7. Unfunded Commitment Agreements 8. Recordkeeping 9. Amendments to Fund Reporting Requirements 10. Money Market Funds D. Effects on Efficiency, Competition, and Capital Formation 1. Efficiency 2. Competition 3. Capital Formation E. Reasonable Alternatives 1. Alternative Implementations of the VaR Tests 2. Alternatives to the VaR Tests 3. Stress Testing Frequency 4. Alternative Exposure Limits for Leveraged/Inverse Funds 5. No Sales Practices Rules and No Separate Exposure Limit for Leveraged/Inverse Funds 6. Enhanced Disclosure F. Request for Comments IV. Paperwork Reduction Act Analysis A. Introduction B. Proposed Rule 18f-4 1. Derivatives Risk Management Program 2. Board Oversight and Reporting 3. Disclosure Requirement Associated With Limit on Fund Leverage Risk 4. Disclosure Requirement for Leveraged/Inverse Funds 5. Disclosure Changes for Money Market Funds 6. Policies and Procedures for Limited Derivatives Users 7. Recordkeeping Requirements 8. Proposed Rule 18f-4 Total Estimated Burden C. Proposed Rule 15l-2: Sales Practices Rule for Broker-Dealers 1. Due Diligence and Account Approval 2. Policies and Procedures 3. Recordkeeping 4. Proposed Rule 15l-2 Total Estimated Burden D. Proposed Rule 211(h)-1: Sales Practices for Registered Investment Advisers 1. Due Diligence and Account Approval 2. Policies and Procedures 3. Recordkeeping 4. Proposed Rule 211(h)-1 Total Estimated Burden E. Rule 6c-11 F. Form N-PORT G. Form N-RN H. Form N-CEN I. Request for Comments V. Initial Regulatory Flexbility Analysis A. Reasons for and Objectives of the Proposed Actions B. Legal Basis C. Small Entities Subject to Proposed Rules D. Projected Reporting, Recordkeeping, and Other Compliance Requirements 1. Proposed Rule 18f-4 2. Proposed Amendments to Forms N-PORT, N-LIQUID, and N-CEN 3. Proposed Sales Practices Rules 4. Proposed Amendments to Rule 6c-11 E. Duplicative, Overlapping, or Conflicting Federal Rules F. Significant Alternatives 1. Proposed Rule 18f-4 2. Proposed Sales Practices Rules 3. Proposed Amendments to Forms N-PORT, N-LIQUID, and N-CEN 4. Rule 6c-11 G. Request for Comment VI. Consideration of Impact on the Economy VII. Statutory Authority VIII. Appendix A IX. Appendix B I. Introduction The fund industry has grown and evolved substantially in past decades in response to various factors, including investor demand, technological developments, and an increase in domestic and international investment opportunities, both retail and institutional. 1 Funds today follow a broad variety of investment strategies and provide diverse investment opportunities for fund investors, including retail investors. As funds' strategies have become increasingly diverse, funds' use of derivatives has grown in both volume and complexity over the past several decades. 2 Derivatives may be broadly described as instruments or contracts whose value is based upon, or derived from, some other asset or metric. 3 Funds use derivatives for a variety of purposes. For example, funds use derivatives to seek higher returns through increased investment exposure, to hedge risks in their investment portfolios, or to obtain exposure to particular investments or markets more efficiently than may be possible through direct investments. 4 At the same time, derivatives can introduce certain new risks and heighten certain risks to a fund and its investors. These risks can arise from, for example, leverage, liquidity, markets, operations, legal matters ( e.g., contract enforceability), and counterparties. 1 For example, the investment company industry consisted of more than 3,500 investment companies, and held over $1.3 trillion in assets, as of the end of 1991. See SEC Division of Investment Management, Protecting Investors: A Half Century of Investment Company Regulation (1992), available at https://www.sec.gov/divisions/investment/guidance/icreg50-92.pdf . The assets held by U.S.-registered investment companies grew to approximately $7.1 trillion as of the end of 1999, and from then until the end of 2018 grew over 200%, to approximately $21.4 trillion. See Investment Company Institute, 2018 Investment Company Fact Book at 32, available at https://www.icifactbook.org/deployedfiles/FactBook/Site%20Properties/pdf/2019/2019_factbook.pdf . Similarly, the number of mutual funds, registered closed-end funds, and ETFs grew from 7,970, 512, and 30 (respectively) as of the end of 1999, to 9,599, 506, and 2,057 (respectively) as of the end of 2018. See id. at 50. The diversity of fund strategies has also increased over time, including, more recently, the introduction of funds pursuing so-called “alternative strategies” (which tend to use derivatives more than other fund types). See Daniel Deli, Paul Hanouna, Christof Stahel, Yue Tang & William Yost, Use of Derivatives by Registered Investment Companies, Division of Economic and Risk Analysis (2015), available at http://www.sec.gov/dera/staffpapers/white-papers/derivatives12-2015.pdf (“DERA White Paper”). 2 See Use of Derivatives by Registered Investment Companies and Business Development Companies, Investment Company Act Release No. 31933 (Dec. 11, 2015) [80 FR 80883 (Dec. 28, 2015)], at n.6 and accompanying text (“2015 Proposing Release”). 3 The asset or metric on which the derivative's value is based, or from which its value is derived, is commonly referred to as the “reference asset,” “underlying asset,” or “underlier.” See id. at n.3 and accompanying text (citing 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)], at n.3 (“2011 Concept Release”)). The comment letters on the 2011 Concept Release (File No. S7-33-11) are available at https://www.sec.gov/comments/s7-33-11/s73311.shtml . 4 See, e.g., My Nguyen, Using Financial Derivatives to Hedge Against Currency Risk, Arcada University of Applied Sciences (2012). Funds using derivatives must consider requirements under the Investment Company Act of 1940. 5 These include sections 18 and 61 of the Investment Company Act, which limit 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.” 6 As we discuss more fully in this release, as derivatives markets have expanded and funds have increased their use of derivatives, the Commission and its staff have issued guidance addressing the use of specific derivatives instruments and practices, and other financial instruments, under section 18. In determining how they will comply with section 18, we understand that funds consider this Commission and staff guidance, as well as staff no-action letters and the practices that other funds disclose in their registration statements. 7 5 15 U.S.C. 80a (the “Investment Company Act,” or the “Act”). Except in connection with our discussion of proposed rule 15 l -2 under the Securities Exchange Act of 1934 and proposed rule 211(h)-1 under the Advisers Act or as 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. 6 See infra section I.B.1. Funds using derivatives must also comply with all other applicable statutory and regulatory requirements, such as other federal securities law provisions, the Internal Revenue Code, Regulation T of the Federal Reserve Board, 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 . Section 61 of the Investment Company Act makes section 18 of the Act applicable to BDCs, with certain modifications. See infra note 32 and accompanying text. Except as otherwise noted, or unless the context dictates otherwise, references in this release to section 18 of the Act should be read to refer also to section 61 with respect to BDCs. 7 Any staff guidance or no-action letters discussed in this release represent the views of the staff of the Division of Investment Management. They are not a rule, regulation, or statement of the Commission. Furthermore, the Commission has neither approved nor disapproved their content. Staff guidance has no legal force or effect; it does not alter or amend applicable law; and it creates no new or additional obligations for any person. In the absence of Commission rules and guidance that address the current broad range of funds' derivatives use, inconsistent industry practices have developed. 8 We are concerned that certain of these practices may not address investor protection concerns that underlie section 18's limitations on funds' issuance of senior securities. Specifically, certain fund practices can heighten leverage-related risks, such as the risk of potentially significant losses and increased fund volatility, that section 18 is designed to address. We are also concerned that funds' disparate practices could create an un-level competitive landscape and make it difficult for funds and our staff to evaluate funds' compliance with section 18. 9 8 See infra section I.B.2.b (discussing the asset segregation practices funds have developed to “cover” their derivatives positions, which vary based on the type of derivatives transaction and with respect to the types of assets that funds segregate to cover their derivatives positions). 9 See, e.g., Comment Letter of the Investment Company Institute on the 2011 Concept Release (Nov. 7, 2011) (File No. S7-33-11) at n.19 (“ICI Concept Release Comment Letter”) (noting that funds segregate the notional amount of physically-settled futures contracts, 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 2011 Concept Release that this “results in differing treatment of arguably equivalent products”). To address these concerns, in 2015 the Commission proposed new rule 18f-4 under the Investment Company Act, which would have permitted a fund to enter into derivatives transactions and “financial commitment transactions,” subject to certain conditions. 10 We received approximately 200 comment letters in response to the 2015 proposal. 11 In developing this re-proposal we considered those comment letters, as well as subsequent staff engagement with large and small fund complexes and investor groups. 12 10 For purposes of this release, we will refer to the version of rule 18f-4 that the Commission proposed in the 2015 Proposing Release as the “2015 proposed rule.” We will generally refer to rule 18f-4 as we propose it here as the “proposed rule.” The 2015 proposed rule included four principal elements for funds entering into derivatives transactions: (1) A requirement to comply with one of two alternative portfolio limitations designed to limit the amount of leverage a fund may obtain through derivatives and other senior securities transactions; (2) asset segregation for derivatives transactions, designed to enable a fund to meet its derivatives-related obligations; (3) a derivatives risk management program requirement for funds that engage in more than limited derivatives transactions or that use complex derivatives; and (4) reporting requirements regarding a fund's derivatives usage. The 2015 proposed rule included different requirements for derivatives transactions and “financial commitment transactions” (collectively, reverse repurchase agreements, short sale borrowings, or any firm or standby commitment agreement or similar agreement). Rule 18f-4 as we propose it here does not separately define “financial commitment transactions,” although the proposed rule does address—either directly or indirectly—all of the types of transactions that composed that defined term in the 2015 proposed rule. See infra section II. 11 The comment letters on the 2015 proposed rule (File No. S7-24-15) are available at https://www.sec.gov/comments/s7-24-15/s72415.shtml . 12 See also Division of Economic and Risk Analysis, Memorandum re: Risk Adjustment and Haircut Schedules (Nov. 1, 2016), available at https://www.sec.gov/comments/s7-24-15/s72415-260.pdf (“2016 DERA Memo”). We are re-proposing 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 certain other transactions. The proposed rule would permit funds to enter into these transactions, notwithstanding the restrictions under section 18 of the Investment Company Act, provided that they comply with the conditions of the rule. The proposed rule's conditions are designed to require funds to manage the risks associated with their use of derivatives and to limit fund leverage risk consistent with the investor protection purposes underlying section 18. Our proposal also includes requirements designed to address specific risks posed by certain registered investment companies and exchange-listed commodity- or currency-based trusts or funds that obtain leveraged or inverse exposure to an underlying index, generally on a daily basis. 13 The proposal also addresses funds' use of reverse repurchase agreements and similar transactions and certain so-called “unfunded commitments.” Finally, we propose to amend rule 6c-11 under the Investment Company Act to allow certain leveraged/inverse ETFs that satisfy that rule's conditions to operate without the expense and delay of obtaining an exemptive order. Together, the rules we are proposing are designed to promote funds' ability to continue to use derivatives in a broad variety of ways that serve investors, while responding to the concerns underlying section 18 of the Investment Company Act and promoting a more modern and comprehensive framework for regulating funds' use of derivatives and the other transactions addressed in the proposed rule. 13 As discussed in more detail in section II.G, the proposed sales practices rules would cover transactions in “leveraged/inverse investment vehicles,” which include registered investment companies and certain exchange-listed commodity- or currency-based trusts or funds that seek, directly or indirectly, to provide investment returns that correspond to the performance of a market index by a specified multiple, or to provide investment returns that have an inverse relationship to the performance of a market index, over a predetermined period of time. For purposes of this release, we refer to leveraged, inverse, and leveraged inverse investment vehicles collectively as “leveraged/inverse.” A. Overview of Funds' Use of Derivatives Funds today use a variety of derivatives. These derivatives can reference a range of assets or metrics, such as: Stocks, bonds, currencies, interest rates, market indexes, currency exchange rates, or other assets or interests. Examples of derivatives that funds commonly use include forwards, futures, swaps, and options. Derivatives are often characterized as either exchange-traded or over-the-counter (“OTC”). 14 14 Exchange-traded derivatives—such as futures, certain options, and options on futures—are standardized contracts traded on regulated exchanges. See 2015 Proposing Release, supra note 2, at nn.10-13 and accompanying text. OTC derivatives—such as certain swaps, non-exchange-traded options, and combination products such as swaptions and forward swaps—are contracts that parties negotiate and enter into outside of an organized exchange. See id. at nn.14-16 and accompanying text. Unlike exchange-traded derivatives, OTC derivatives may be significantly customized and may not be cleared by a central clearing organization. Title VII of the Dodd-Frank Act provides a comprehensive framework for the regulation of the OTC swaps market. See supra note 6. A common characteristic of most derivatives is that they involve leverage or the potential for leverage. The Commission has 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.” 15 Many fund derivatives transactions, such as futures, swaps, and written options, involve leverage or the potential for leverage because they enable the fund to magnify its gains and losses compared to the fund's investment, while also obligating the fund to make a payment or deliver assets to a counterparty under specified conditions. 16 Other derivatives transactions, such as purchased call options, provide the economic equivalent of leverage because they can magnify the fund's exposure beyond its investment but do not impose a payment obligation on the fund beyond its investment. 17 15 See Securities Trading Practices of Registered Investment Companies, Investment Company Act Release No. 10666 (Apr. 18, 1979) [44 FR 25128 (Apr. 27, 1979)], at n.5 (“Release 10666”). 16 The leverage created by such an arrangement is sometimes referred to as “indebtedness leverage.” See 2015 Proposing Release, supra note 2, at n.21 (citing 2011 Concept Release, supra note 3, at n.31). 17 This type of leverage is sometimes referred to as “economic leverage.” See id. at n.22 (citing 2011 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 with lower transaction costs and portfolio disruption, than investing directly in the underlying securities. 18 A fund also may use derivatives to obtain exposure to reference assets for which it may be difficult or impractical for the fund to make a direct investment, such as commodities. 19 With respect to risk management, funds may employ derivatives to hedge interest rate, currency, credit, and other risks, as well as to hedge portfolio exposures. 20 18 See, e.g., id. at n.24 and accompanying text (citing 2011 Concept Release, supra note 3, at section I). 19 See, e.g., Comment Letter of Stone Ridge Asset Management LLC (Mar. 28, 2016) (“[I]t is not possible for AVRPX [a Stone Ridge fund] to trade many of the physical assets underlying the derivatives included in our portfolio—Stone Ridge does not maintain facilities to store oil or live hogs, for example.”); Comment Letter of Vanguard (Mar. 28, 2016) (“Vanguard Comment Letter”) (stating that a fund may use a derivative, such as commodity futures, when it is impractical to take delivery of physical commodities). 20 See 2015 Proposing Release, supra note 2, at n.25 and accompanying text; see also 2011 Concept Release, supra note 3, at section I.B. At the same time, a fund's derivatives use may entail risks relating to, for example, leverage, markets, operations, liquidity (particularly with respect to complex OTC derivatives), and counterparties, as well as legal risks. 21 A fund's investment adviser, therefore, must manage (and the board of directors oversee) the fund's derivatives use, consistent with the fund's investment objectives, policies, restrictions, and risk profile. Furthermore, a fund's investment adviser and board of directors must bear in mind the requirements of section 18 of the Investment Company Act, as well as the Act's other requirements, when considering the use of derivatives. 21 See 2015 Proposing Release, supra note 2, at n.26 and accompanying text (citing 2011 Concept Release, supra note 3, at n.34). Section 18 is designed to limit the leverage a fund can obtain or incur through the issuance of senior securities. Although the leverage limitations in section 18 apply regardless of whether the relevant fund actually experiences significant losses, several recent examples involving significant losses illustrate how a fund's use of derivatives may raise the investor protection concerns underlying section 18. The 2015 proposal discussed several circumstances in which substantial and rapid losses resulted from a fund's investment in derivatives. 22 For example, one of these cases shows that further losses can result when a fund's portfolio securities decline in value at the same time that the fund is required to make additional payments under its derivatives contracts. 23 22 See 2015 Proposing Release, supra note 2, at section II.D.1.d. (discussing, among other things, the following settled actions: In the Matter of OppenheimerFunds, Inc. and OppenheimerFunds Distributor, Inc., Investment Company Act Release No. 30099 (June 6, 2012) (settled action) (“OppenheimerFunds Settled Action”) (involving two mutual funds that suffered losses driven primarily by their exposure to certain commercial mortgage-backed securities, obtained mainly through total return swaps); In the Matter of Claymore Advisors, LLC, Investment Company Act Release No. 30308 (Dec. 19, 2012) and In the Matter of Fiduciary Asset Management, LLC, Investment Company Act Release No. 30309 (Dec. 19, 2012) (settled actions) (involving a registered closed-end fund that pursued an investment strategy involving written out-of-the-money put options and short variance swaps, which led to substantial losses for the fund); 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) (involving a registered closed-end fund that incurred significant losses due in part to large losses on the fund's credit default swap portfolio)). See also In the Matter of Team Financial Asset Management, LLC, Team Financial Managers, Inc., and James L. Dailey, Investment Company Act Release No. 32951 (Dec. 22, 2017) (settled action) (involving a mutual fund incurring substantial losses arising out of speculative derivatives instruments, including losing $34.67 million in 2013 from trading in derivatives such as futures, options, and currency contracts); In the Matter of Mohammed Riad and Kevin Timothy Swanson, Investment Company Act Release No. 33338 (Dec. 21, 2018) (settled action) (involving a registered closed-end fund incurring substantial losses resulting from the implementation of a new derivatives trading strategy); In the Matter of Top Fund Management, Inc. and Barry C. Ziskin, Investment Company Act Release No. 30315 (Dec. 21, 2012) (settled action) (involving a mutual fund engaged in a strategy of buying options for speculative purposes contrary to its stated investment policy, which permitted options trading for hedging purposes, losing about 69% of its assets as a result of this activity before liquidating). 23 See OppenheimerFunds Settled Action, supra note 22. Similarly, last year the LJM Preservation and Growth Fund liquidated after sustaining considerable losses (with its net asset value declining approximately 80% in two days) when market volatility spiked. The fund's principal investment strategy involved purchasing and selling call and put options on the Standard & Poor's (“S&P”) 500 Futures Index. 24 S&P 500 options prices are determined in part by market volatility, and a volatility spike in early February 2018 caused the fund to incur significant losses. The fund closed to new investments on February 7, 2018 and announced on February 27, 2018 that it would liquidate its assets and dissolve on March 29, 2018. 25 24 See Prospectus, LJM Preservation and Growth Fund (Feb. 28, 2017), available at https://www.sec.gov/Archives/edgar/data/1552947/000158064217001225/ljm485b.htm . 25 See Supplement to the Prospectus dated Feb. 28, 2017, LJM Preservation and Growth Fund (Feb. 27, 2018), available at https://www.sec.gov/Archives/edgar/data/1552947/000158064218001068/ljm497.htm . The losses suffered by this fund and in the other examples we discuss above are extreme. Funds rarely suffer such large and rapid losses. We note these examples to illustrate the rapid and extensive losses that can result from a fund's investments in derivatives absent effective derivatives risk management. In contrast, there are many other instances in which funds, by employing derivatives, have avoided losses, increased returns, and lowered risk. B. Derivatives and the Senior Securities Restrictions of the Investment Company Act 1. Requirements of Section 18 Section 18 of the Investment Company Act imposes various limits on the capital structure of funds, including, in part, by restricting the ability of funds to issue “senior securities.” Protecting investors against the potentially adverse effects of a fund's issuance of senior securities, and in particular the risks associated with excessive leverage of investment companies, is a core purpose of the Investment Company Act. 26 “Senior security” is defined, in part, as “any bond, debenture, note, or similar obligation or instrument constituting a security and evidencing indebtedness.” 27 26 See, e.g., sections 1(b)(7), 1(b)(8), 18(a), and 18(f) of the Investment Company Act; see also Provisions Of The Proposed Bill Related To Capital Structure (Sections 18, 19(B), And 21(C)), Introduced by L.M.C Smith, Associate Counsel, Investment Trust Study, Securities and Exchange Commission, Hearings on S.3580 Before a Subcommittee of the Senate Committee on Banking and Currency, 76th Congress, 3rd session (1940), at 1028 (“Senate Hearings”) (“Because of the leverage influence, a substantial swing of the securities market is likely to deprive the common stock of a leverage investment company of both its asset and market value. . . . [H]ad investment companies been simple structure companies exclusively, a very substantial part of the losses sustained by investors in the common stock would have been avoided.”). 27 See section 18(g) 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 limits in section 18 focused on: (1) Excessive borrowing and the issuance of excessive amounts of senior securities by funds when these activities increase unduly the speculative character of funds' junior securities; (2) funds operating without adequate assets and reserves; and (3) potential abuse of the purchasers of senior securities. 28 To address these concerns, section 18 prohibits an open-end fund from issuing or selling any “senior security,” other than borrowing from a bank (subject to a requirement to maintain 300% “asset coverage”). 29 Section 18 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. 30 Closed-end funds also may issue senior securities that are a stock, subject to the limitations of section 18. 31 The Investment Company Act also subjects BDCs to the limitations of section 18 to the same extent as registered closed-end funds, except the applicable asset coverage amount for any senior security representing indebtedness is 200% (and can be decreased to 150% under certain circumstances). 32 28 For discussion of the excessive borrowing concern, see section 1(b)(7) of the Investment Company Act; Release 10666, supra note 15, at n.8; see also Senate Hearings, supra note 26, at 1028 (“The Commission believes that it has been clearly shown that it is the leverage aspect of the senior-junior capital structure in investment companies . . . which may be held accountable for a large part of the losses which have been suffered by the investor who purchases the common stock of a leverage company.”). For discussion of concerns regarding funds operating without adequate assets and reserves, see section 1(b)(8) of the Investment Company Act; Release 10666, supra note 15, at n.8. For discussion of, among other things, potential abuse of the purchasers of senior securities, see Senate Hearings, supra note 26, 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), at 23, available at http://www.sec.gov/news/studies/deriv.txt (“1994 Letter to Congress”) (describing practices in the 1920s and 1930s that gave rise to section 18's limits on leverage). 29 See section 18(f)(1) of the Investment Company Act. “Asset coverage” of a class of senior 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, 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). 30 See section 18(a)(1) of the Investment Company Act. 31 See section 18(a)(2) of the Investment Company Act. If a closed-end fund issues or sells a class of senior securities that is a stock, it must have an asset coverage of at least 200% immediately after such issuance or sale. Id. 32 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 sections 18(a)(2) and 61(a)(1) of the Investment Company Act. In 2018, Congress passed the Small Business Credit Availability Act, which, among other things, modified the statutory asset coverage requirements applicable to BDCs (permitting BDCs that meet certain specified conditions to elect to decrease their effective asset coverage requirement from 200% to 150%). See section 802 of the Small Business Credit Availability Act, Public Law 115-141, 132 Stat. 348 (2018). 2. Evolution of Commission and Staff Consideration of Section 18 Restrictions as Applied to Funds' Use of Derivatives a. Investment Company Act Release 10666 In a 1979 General Statement of Policy (Release 10666), the Commission considered the application of section 18's restrictions on the issuance of senior securities to reverse repurchase agreements, firm commitment agreements, and standby commitment agreements. 33 The Commission concluded that these agreements fall within the “functional meaning of the term `evidence of indebtedness' for purposes of Section 18 of the Investment Company Act,” noting “the unique legislative purposes and policies underlying Section 18 of the Act.” 34 The Commission stated in Release 10666 that, for purposes of section 18, “evidence of indebtedness” would include “all contractual obligations to pay in the future for consideration presently received.” The Commission recognized that, while section 18 would generally prohibit open-end funds' use of reverse repurchase agreements, firm commitment agreements, and standby commitment agreements, the Commission nonetheless permitted funds to use these and similar arrangements subject to the constraints that Release 10666 describes. 33 See Release 10666, supra note 15. 34 See id. These constraints relied on funds' use of “segregated accounts” to “cover” senior securities, which “if properly created and maintained, would limit the investment company's risk of loss.” 35 The Commission also 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.” 36 The Commission stated that its expressed views were not limited to the particular trading practices discussed, but that the Commission sought to address the implications of comparable trading practices that could similarly affect funds' capital structures. 37 35 See 2015 Proposing Release, supra note 2, at nn.45-47 and accompanying text (discussing Release 10666's discussion of segregated accounts). 36 See Release 10666, supra note 15, at 25132; see also 2015 Proposing Release, supra note 2, at n.48 and accompanying text. 37 See 2015 Proposing Release, supra note 2, at nn.49-50 and accompanying text. We continue to view the transactions described in Release 10666 as falling within the functional meaning of the term “evidence of indebtedness,” for purposes of section 18. 38 The trading practices that Release 10666 describes, as well as short sales of securities for which the staff initially developed the segregated account approach that the Commission applied in Release 10666, all impose on a fund a contractual obligation under which the fund is or may be required to pay or deliver assets in the future to a counterparty. These transactions therefore involve the issuance of a senior security for purposes of section 18. 39 38 See Release 10666, supra note 15, at “The Agreements as Securities” discussion. The Investment Company Act's definition of the term “security” is broader than the term's definition in other federal securities laws. See 2015 Proposing Release, supra note 2, at n.61. Compare section 2(a)(36) of the Investment Company Act with sections 2(a)(1) and 2A of the Securities Act of 1933 (15 U.S.C. 77a et seq. ) (“Securities Act”) and sections 3(a)(10) and 3A of the Securities Exchange Act of 1934 (15 U.S.C. 78a et seq. ) (“Exchange Act”). See also 2011 Concept Release, supra note 3, at n.57 and accompanying text (explaining that the Commission has interpreted the term “security” in light of the policies and purposes underlying the Investment Company Act). 39 See Release 10666, supra note 15, 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”). The Commission received several comments on the 2015 proposal that objected to the Commission treating derivatives and financial commitment transactions as involving senior securities where a fund has “appropriately” covered its obligations under those transactions. These comments generally argued that this approach is not consistent with the Commission's views in Release 10666 and that funds have for many years addressed senior security concerns raised by these transactions by segregating assets or engaging in offsetting, or “cover,” transactions that take into account Release 10666 and staff guidance. See, e.g., Comment Letter of the American Action Forum (Mar. 25, 2016) (“AAF Comment Letter”); Comment Letter of Financial Services Roundtable (Mar. 28, 2016) (“FSR Comment Letter”); Comment Letter of Franklin Resources, Inc. (Mar. 28, 2016) (“Franklin Resources Comment Letter”); Comment Letter of Dechert LLP (Mar. 28, 2016) (“Dechert Comment Letter”). Whether a transaction involves the issuance of a senior security will depend on whether that transaction involves a senior security within the meaning of section 18(g). A fund's segregation of assets, although one way to address policy concerns underlying section 18 as the Commission described in Release 10666, does not, itself, affect the legal question of whether a fund has issued a senior security. We apply the same analysis to all derivatives transactions that create future payment obligations. This is the case where the fund has a contractual obligation to pay or deliver cash or other assets to a counterparty in the future, either during the life of the instrument or at maturity or early termination. 40 As was the case for trading practices that Release 10666 describes, where the fund has entered into a derivatives transaction and has such a future payment obligation, we believe that such a transaction involves an evidence of indebtedness that is a senior security for purposes of section 18. 41 40 These payments—which may include payments of cash, or delivery of other assets—may occur as margin, as settlement payments, or otherwise. 41 As the Commission 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 a standby commitment or a “put” (or call) option sold by a fund. See Release 10666, supra note 15, at “Standby Commitment Agreements” discussion. We understand it has been asserted that a contingent obligation that a standby commitment or similar agreement creates does not involve a senior security under section 18, unless and until generally accepted accounting principles (“GAAP”) would require the fund 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 the Commission's analysis of a fund's obligation, and the corresponding segregated asset amounts, under the trading practices that Release 10666 describes. See id. The express scope of section 18 supports this interpretation. Section 18 defines the term “senior security” broadly to include instruments and transactions that other provisions of the federal securities laws might not otherwise consider to be securities. 42 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.” 43 This statutory permission to engage in a specific borrowing makes clear that such borrowings are senior securities, which otherwise section 18 would prohibit absent this specific permission. 44 42 Consistent with Release 10666, and as the Commission stated in the 2015 Proposing Release, we are only expressing our views in this release concerning the scope of the term “senior security” in section 18 of the Investment Company Act. See also section 12(a) of the Investment Company Act (prohibiting funds from engaging in short sales in contravention of Commission rules or orders). 43 Section 18(c)(2) similarly treats all promissory notes or evidences of indebtedness issued in consideration of any loan as senior securities except as section 18 otherwise specifically provides. 44 The Commission 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 15, at “Reverse Repurchase Agreements” discussion. This interpretation also is consistent with the fundamental policy and purposes underlying the Investment Company Act expressed in sections 1(b)(7) and 1(b)(8) of the Act. 45 These respectively declare 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.” The Commission emphasized these concerns in Release 10666, and we continue to believe 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.” 46 Funds' use of derivatives, like the trading practices the Commission addressed in Release 10666, may raise the undue speculation and asset sufficiency concerns in section 1(b). 47 First, funds' obtaining leverage (or potential for leverage) through derivatives may raise the Investment Company Act's undue speculation concern because a fund may experience gains and losses that substantially exceed the fund's investment, and also may incur a conditional or unconditional obligation to make a payment or deliver assets to a counterparty. 48 Not viewing derivatives that impose a future payment obligation on the fund as involving senior securities, subject to appropriate limits under section 18, would frustrate the concerns underlying section 18. 49 45 The Commission received several comments on the 2015 proposal asserting that the provisions in section 1(b) of the Investment Company Act do not, themselves, provide us authority to regulate senior securities transactions. See, e.g., AAF Comment Letter; Franklin Resources Comment Letter; Comment Letter of the Securities Industry and Financial Markets Association (Mar. 28, 2016) (“SIFMA Comment Letter”). The fundamental statutory policy and purposes underlying the Investment Company Act, as expressed in section 1(b) of the Act, inform our interpretation of the scope of the term “senior security” in section 18, as we discuss in the paragraph accompanying this note (and separately inform our consideration of appropriate conditions for the exemption that proposed rule 18f-4 provides, as we discuss in sections II.B-II.G infra ). The authority under which we are proposing rules today is set forth in section VII of this release and includes, among other provisions, section 6(c) of the Act. 46 See Release 10666, supra note 15, at “Segregated Account” discussion. 47 As the Commission 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.” Id. 48 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), at 8 (“2010 ABA Derivatives Report”) (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”; noting, for example, that an “[interest rate] swap presents the possibility that the fund will be required to make payments out of its assets” and that “[t]he same possibility exists when a fund writes puts and calls, purchases short and long futures and forwards, and buys or sells credit protection through [credit default swaps]”). 49 One commenter on the 2011 Concept Release made this point directly. See Comment Letter of Stephen A. Keen on the 2011 Concept Release (Nov. 8, 2011) (File No. S7-33-11), at 3 (“Keen Concept Release Comment Letter”) (“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., 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.”). The Commission similarly 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. See 2015 Proposing Release, supra note 2, at text preceding n.76. Second, with respect to the Investment Company Act's asset sufficiency concern, a fund's use of derivatives with future payment obligations also may raise concerns regarding the fund's ability to meet those obligations. Many fund derivatives investments, 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. 50 Losses on derivatives therefore can result in counterparty payment obligations that directly affect the capital structure of a fund and the relative rights of the fund's counterparties and shareholders. These losses and payment obligations also can force a fund's adviser to sell the fund's investments to meet its obligations. When a fund uses derivatives to leverage its portfolio, this can amplify the risk of a fund having to sell its investments, potentially generating additional losses for the fund. 51 In an extreme situation, a fund could default on its payment obligations. 52 50 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. 51 See, e.g., Markus K. Brunnermeier & Lasse Heje Pedersen, Market Liquidity and Funding Liquidity, 22 The Review of Financial Studies 6, 2201-2238 (June 2009), available at https://www.princeton.edu/~markus/research/papers/liquidity.pdf (providing both empirical support as well as a theoretical foundation for how short-term leverage obtained through borrowings or derivative positions can result in funds and other financial intermediaries becoming vulnerable to tighter funding conditions and increased margins, specifically during economic downturns (as in the recent financial crisis), thus potentially increasing the need for the fund or intermediary to de-lever and sell portfolio assets at a loss). 52 See 2015 Proposing Release, supra note 2, at n.80. b. Market and Industry Developments Following Release 10666 Following the issuance of Release 10666, Commission 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 otherwise restricted by section 18. 53 In these letters (issued primarily in the 1970s through 1990s) and through other staff guidance, Commission staff has addressed questions—generally on an instrument-by-instrument basis—regarding the application of the Commission's statements in Release 10666 to various types of derivatives and other transactions. 53 See id. at n.51 and accompanying text (citing 2011 Concept Release, supra note 3, at section I). Funds have developed certain general asset segregation practices to cover their derivatives positions, based at least in part on the staff's no-action letters and guidance. Practices vary based on the type of derivatives transaction. For certain derivatives, funds generally segregate an amount equal to the full amount of the fund's potential obligation under the contract, or the full market value of the underlying reference asset for the derivative (“notional amount segregation”). 54 For certain cash-settled derivatives, funds often segregate an amount equal to the fund's daily mark-to-market liability, if any (“mark-to-market segregation”). 55 54 See id. at nn.54-55 and accompanying text. 55 See id. at nn.56-58, 96-98 and accompanying text (stating that funds initially applied the mark-to-market approach to segregation to specific types of transactions addressed through guidance by our staff (interest rate swaps, cash-settled futures, non-deliverable forwards), but that funds now apply mark-to-market segregation to a wider range of cash-settled instruments, with our staff observing that some funds appear to apply the mark-to-market approach to any derivative that is cash settled). Similarly, funds use different practices regarding the types of assets that they segregate to cover their derivatives positions. Release 10666 states 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. 56 However, a subsequent staff no-action letter stated that the staff would not recommend enforcement action if a fund were to segregate any liquid asset, including equity securities and non-investment grade debt securities, to cover its senior securities-related obligations. 57 56 See id. at n.47 and accompanying text. 57 See id. at n.59 and accompanying text (citing Merrill Lynch Asset Management, L.P., SEC Staff No-Action Letter (July 2, 1996), available at https://www.sec.gov/divisions/investment/imseniorsecurities/merrilllynch070196.pdf). As a result of these asset segregation practices, funds' derivatives use—and thus funds' potential leverage through derivatives transactions—does not appear to be subject to a practical limit as the Commission contemplated in Release 10666. Funds' mark-to-market liability often does not reflect the full investment exposure associated with their derivatives positions. 58 As a result, a fund that segregates only the mark-to-market liability could theoretically incur virtually unlimited investment leverage. 59 58 For example, for derivatives where there is no loss in a given day, a fund applying the mark-to-market approach might not segregate any assets. This may be the case, for example, because the derivative is currently in a gain position, or because the derivative has a market value of zero (as will generally be the case at the inception of a transaction). The fund may, however, still be required to post collateral to comply with other regulatory or contractual requirements. 59 See, e.g., Comment Letter of Ropes & Gray LLC on the Concept Release (Nov. 7, 2011) (File No. S7-33-11), at 4 (stating that “[o]f course, in many cases [a fund's daily mark-to-market liability, if any] will not fully reflect the ultimate investment exposure associated with the swap position” and that, “[a]s a result, a fund that segregates only the market-to-market liability could theoretically incur virtually unlimited investment leverage using cash-settled swaps”); Keen Concept Release Comment Letter, at 20 (stating that the mark-to-market approach, as applied to cash settled swaps, “imposes no effective control over the amount of investment leverage created by these swaps, and leaves it to the market to limit the amount of leverage a fund may use”). These current asset segregation practices also may not assure the availability of adequate assets to meet funds' derivatives obligations, as the Commission contemplated in Release 10666. A fund using the mark-to-market approach could segregate assets that only reflect the losses (and corresponding potential payment obligations) that the fund would then incur as a result of transaction termination. This practice provides no assurances that future losses will not exceed the value of the segregated assets or the value of all assets then available to meet the payment obligations resulting from such losses. 60 We also recognize that when a fund segregates any liquid asset, rather than the more narrow range of high-quality assets the Commission 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. 61 In this case, or when a fund's derivatives payment obligations are substantial relative to the fund's liquid assets, the fund may be forced to sell portfolio securities to meet its derivatives payment obligations. These forced sales could occur during stressed market conditions, including at times when prudent management could advise against such liquidation. 62 60 A fund's mark-to-market liability on any particular day, if any, could be substantially smaller than the fund's ultimate obligations under a derivative. See 2015 Proposing Release, supra note 2, at n.113. 61 See id. at n.115. 62 The Commission 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 15, at “Segregated Account” discussion. 3. Need for Updated Regulatory Framework As the Commission observed in the 2015 proposal and for the reasons discussed above, we continue to be concerned that funds' current practices regarding derivatives use may not address the undue speculation and asset sufficiency concerns underlying section 18. 63 Additionally, as recent events demonstrate, a fund's derivatives use may involve risks that can result in significant losses to a fund. 64 Accordingly, we continue to believe that it is appropriate for funds to address these risks and considerations relating to their derivatives use. Nevertheless, we also recognize the valuable role derivatives can play in helping funds to achieve their objectives efficiently or manage their investment risks. 63 See 2015 Proposing Release, supra note 2, at sections II.D.1.b and II.D.1.c; see also supra paragraphs accompanying notes 58-62. 64 See supra paragraph accompanying notes 22-25. We therefore believe funds that significantly use derivatives should adopt and implement formalized programs to manage the risks derivatives may pose. In addition, a more modern framework for regulating funds' derivatives use would respond to our concern that funds today are not subject to a practical limit on potential leverage that they may obtain through derivatives transactions. The risk management program requirement and limit on fund leverage risk we are proposing are designed to address these considerations, in turn. A comprehensive approach to regulating funds' derivatives use also would help address potential adverse results from funds' current, disparate asset segregation practices. The development of staff guidance and industry practice on an instrument-by-instrument basis, together with growth in the volume and complexity of derivatives markets over past decades, has resulted in situations in which different funds may treat the same kind of derivative differently, based on their own view of our staff's guidance or observation of industry practice. This may unfairly disadvantage some funds. 65 The lack of comprehensive guidance also makes it difficult for funds and our staff to evaluate and inspect for funds' compliance with section 18 of the Investment Company Act. Moreover, where there is no specific guidance, or where the application of existing guidance is unclear or applied inconsistently, funds may take approaches that involve an extensive use of derivatives and may not address the purposes and concerns underlying section 18. 65 See, e.g., Comment Letter of Davis Polk on the 2011 Concept Release (Nov. 11, 2011), at 1-2 (stating 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”); see also Comment Letter of Federated Investors, Inc. (Mar. 23, 2016) (“Federated Comment Letter”); Comment Letter of Salient Partners, L.P. (Mar. 25, 2016) (“Salient Comment Letter). C. Overview of the Proposal Our proposal consists of three parts. Proposed rule 18f-4 is designed to provide an updated, comprehensive approach to the regulation of funds' use of derivatives and the other transactions that the proposed rule addresses. The proposed sales practices rules are designed to address investor protection concerns with respect to leveraged/inverse funds by requiring broker-dealers and investment advisers to exercise due diligence on retail investors before approving retail investor accounts to invest in leveraged/inverse funds. The proposed amendments to Forms N-PORT, N-LIQUID (which we propose to re-title as “Form N-RN”), and N-CEN are designed to enhance the Commission's ability to oversee funds' use of and compliance with the proposed rules, and for the Commission and the public to have greater insight into the impact that funds' use of derivatives would have on their portfolios. Proposed rule 18f-4 would permit a fund to enter into derivatives transactions, notwithstanding the prohibitions and restrictions on the issuance of senior securities under section 18 of the Investment Company Act, subject to the following conditions: 66 66 See proposed rule 18f-4(b) and (d). Proposed rule 18f-4(b) would provide an exemption for funds' derivatives transactions from sections 18(a)(1), 18(c), 18(f)(1), and 61 of the Investment Company Act. See supra section I.B.1 of this release (providing an overview of the requirements of section 18). Because the proposed conditions are designed to provide a tailored set of requirements for derivatives transactions, the proposed rule would also provide that a fund's derivatives transactions would not be considered for purposes of computing asset coverage under section 18(h). Applying section 18(h) asset coverage to a fund's derivatives transactions appears unnecessary in light of the tailored restrictions we are proposing. See also infra section II.M. • Derivatives risk management program. 67 The proposed rule would generally require a fund to adopt a written derivatives risk management program with risk guidelines that must cover certain elements, but that otherwise would be tailored based on how the fund's use of derivatives may affect its investment portfolio and overall risk profile. The program also would have to include stress testing, backtesting, internal reporting and escalation, and program review elements. The program would institute a standardized risk management framework for funds that engage in more than a limited amount of derivatives transactions, while allowing principles-based tailoring to the fund's particular risks. We believe that a formalized derivatives risk management program is critical to appropriate derivatives risk management and is foundational to providing exemptive relief under section 18. 67 See proposed rule 18f-4(c)(1); infra section II.A.2. • Limit on fund leverage risk. 68 The proposed rule would generally require funds when engaging in derivatives transactions to comply with an outer limit on fund leverage risk based on value at risk, or “VaR.” This outer limit would be based on a relative VaR test that compares the fund's VaR to the VaR of a “designated reference index” for that fund. If the fund's derivatives risk manager is unable to identify an appropriate designated reference index, the fund would be required to comply with an absolute VaR test. These proposed requirements are designed to limit fund leverage risk consistent with the investor protection purposes underlying section 18 and to complement the proposed risk management program. Because VaR is a commonly-known and broadly-used industry metric that enables risk to be measured in a reasonably comparable and consistent manner across the diverse instruments that may be included in a fund's portfolio, the proposed VaR-based limit is designed to address leverage risk for a variety of fund strategies. 68 See proposed rule 18f-4(c)(2); infra section II.D. • Board oversight and reporting. 69 The proposed rule would require a fund's board of directors to approve the fund's designation of a derivatives risk manager, who would be responsible for administering the fund's derivatives risk management program. The fund's derivatives risk manager would have to report to the fund's board on the derivatives risk management program's implementation and effectiveness and the results of the fund's stress testing. The derivatives risk manager would have a direct reporting line to the fund's board. We believe requiring a fund's derivatives risk manager to be responsible for the day-to-day administration of the fund's program, subject to board oversight, is consistent with the way we understand many funds currently manage derivatives risks and is key to appropriately managing these risks. 69 See proposed rule 18f-4(c)(5); infra section II.C. • Exception for limited derivatives users. 70 The proposed rule would except limited derivatives users from the derivatives risk management program requirement and the VaR-based limit on fund leverage risk. This proposed exception would be available to a fund that either limits its derivatives exposure to 10% of its net assets or uses derivatives transactions solely to hedge certain currency risks and, in either case, that also adopts and implements policies and procedures reasonably designed to manage the fund's derivatives risks. Requiring a derivatives risk management program that includes all of the program elements specified in the rule for funds that use derivatives only in a limited way could potentially require these funds to incur costs and bear compliance burdens that are disproportionate to the resulting benefits. 70 See proposed rule 18f-4(c)(3); infra section II.E. • Alternative requirements for certain leveraged/inverse funds. 71 The proposed rule would provide an exception from the limit on fund leverage risk for certain leveraged/inverse funds in light of the additional safeguards provided by the proposed requirements under the sales practices rules that broker-dealers and investment advisers exercise due diligence on retail investors before approving the investors' accounts to invest in these funds. 72 The conditions of this exception are designed to address the investor protection concerns that underlie section 18 of the Investment Company Act, while preserving choice for investors the investment adviser or broker-dealer reasonably believes have such financial knowledge and experience that they may reasonably be expected to be capable of evaluating the risk of these funds. 71 See proposed rule 18f-4(c)(4); infra section II.G. 72 In our discussion in this release of the entities subject to the proposed sales practices rules, we use “broker-dealer” to refer to a broker-dealer that is registered with, or required to register with, the Commission. Similarly, we use “investment adviser” to refer to an investment adviser that is registered with, or required to register with, the Commission. • Recordkeeping. 73 The proposed rule would require a fund to adhere to recordkeeping requirements that are designed to provide the Commission's staff, and the fund's board of directors and compliance personnel, the ability to evaluate the fund's compliance with the proposed rule's requirements. 73 See proposed rule 18f-4(c)(6); infra section II.K. Proposed rule 18f-4 would also permit funds to enter into reverse repurchase agreements and similar financing transactions, as well as “unfunded commitments” to make certain loans or investments, subject to conditions tailored to these transactions. 74 A fund would be permitted to engage in reverse repurchase agreements and similar financing transactions so long as they meet the asset coverage requirements under section 18. If the fund also borrows from a bank or issues bonds, for example, these senior securities as well as the reverse repurchase agreement would be required to comply with the asset coverage requirements under the Investment Company Act. This approach would provide the same asset coverage requirements under section 18 for reverse repurchase agreements and similar financing transactions, bank borrowings, and other borrowings permitted under the Investment Company Act. A fund would be permitted to enter into unfunded commitment agreements if the fund reasonably believes that its assets will allow the fund to meet its obligations under these agreements. This approach recognizes that, while unfunded commitment agreements do raise the risk that a fund may be unable to meet its obligations under these transactions, such unfunded commitments do not generally involve the leverage and other risks associated with derivatives transactions. 74 See proposed rule 18f-4(d) and (e); infra sections II.I and II.J. The proposed sales practices rules are designed to address certain specific considerations raised by certain leveraged/inverse funds and listed commodity pools that obtain leveraged or inverse exposure to an underlying index, on a periodic (generally, daily) basis. 75 These rules would require broker-dealers and investment advisers to exercise due diligence in determining whether to approve a retail customer or client's account to buy or sell these products. A broker-dealer or adviser could only approve the account if it had a reasonable basis to believe that the customer or client is capable of evaluating the risk associated with these products. In this regard, the proposed sales practices rules would complement the leveraged/inverse funds exception from proposed rule 18f-4's limit on leverage risk by subjecting broker-dealers or advisers to the proposed sales practices rules' due diligence and approval requirements. 75 See infra note 327 and accompanying text (defining “listed commodity pools”). In connection with proposed rules 15 l -2, 211(h)-1, and 18f-4, we are proposing amendments to rule 6c-11 under the Investment Company Act. Rule 6c-11 generally permits ETFs to operate without obtaining a Commission exemptive order, subject to certain conditions. 76 The rule currently excludes leveraged/inverse ETFs from relying on the rule, however, to allow the Commission to consider the section 18 issues raised by these funds' investment strategies as part of a broader consideration of derivatives use by registered funds and BDCs. 77 As part of this further consideration, we are proposing to remove this provision and permit leveraged/inverse ETFs to rely on rule 6c-11 because the proposed sales practices rules and rule 18f-4 are designed to address these issues. In this regard, we are also proposing to rescind the exemptive orders previously issued to the sponsors of leveraged/inverse ETFs. Amending rule 6c-11 and rescinding these exemptive orders would promote a level playing field by allowing any sponsor (in addition to the sponsors currently granted exemptive orders) to form and launch a leveraged/inverse ETF subject to the conditions in rule 6c-11 and proposed rule 18f-4, with transactions in the fund subject to the proposed sales practices rules. 76 See generally Exchange-Traded Funds, Investment Company Act Release No. 33646 (Sept. 25, 2019) [84 FR 57162 (Oct. 24, 2019)] (“ETFs Adopting Release”). 77 See id. at nn.72-74 and accompanying text. The proposed amendments to Forms N-PORT, N-LIQUID, and N-CEN would require a fund to provide information regarding: (1) The fund's exposure to derivatives; (2) the fund's VaR (and, if applicable, the fund's designated reference index) and backtesting results; (3) VaR test breaches, to be reported to the Commission in a non-public current report; and (4) certain identifying information about the fund ( e.g., whether the fund is a limited derivatives user that is excepted from certain of the proposed requirements, or whether the fund is a “leveraged/inverse fund”). Finally, in view of our proposal for an updated, comprehensive approach to the regulation of funds' derivative use, we are proposing to rescind Release 10666. In addition, staff in the Division of Investment Management is reviewing certain of its no-action letters and other guidance addressing derivatives transactions and other transactions covered by proposed rule 18f-4 to determine which letters and other staff guidance, or portions thereof, should be withdrawn in connection with any adoption of this proposal. Upon the adoption of any final rule, some of these letters and other staff guidance, or portions thereof, would be moot, superseded, or otherwise inconsistent with the final rule and, therefore, would be withdrawn. We would expect to provide funds a one-year transition period while they prepare to come into compliance with rule 18f-4 before Release 10666 is withdrawn. II. Discussion A. Scope of Proposed Rule 18f-4 1. Funds Permitted To Rely on Proposed Rule 18f-4 The proposed rule would apply to a “fund,” defined as a registered open-end or closed-end company or a BDC, including any separate series thereof. The rule would therefore apply to mutual funds, ETFs, registered closed-end funds, and BDCs. The proposed rule's definition of a “fund” would, however, exclude money market funds regulated under rule 2a-7 under the Investment Company Act (“money market funds”). Under rule 2a-7, money market funds seek to maintain a stable share price or limit principal volatility by limiting their investments to short-term, high-quality debt securities that fluctuate very little in value under normal market conditions. As a result of these and other requirements in rule 2a-7, we believe that money market funds currently do not typically engage in derivatives transactions or the other transactions permitted by rule 18f-4. 78 We believe that these transactions would generally be inconsistent with a money market fund maintaining a stable share price or limiting principal volatility, and especially if used to leverage the fund's portfolio. 79 We therefore believe that excluding money market funds from the scope of the proposed rule is appropriate. 78 See infra note 583. 79 See Money Market Fund Reform; Amendments to Form PF, Investment Company Act Release No. 31166 (July 23, 2014) [79 FR 47735 (Aug. 14, 2014)] (discussing (1) retail and government money market funds, which seek to maintain a stable net asset value per share and (2) institutional non-government money market funds whose net asset value fluctuates, but still must stress test their ability to minimize principal volatility given that “commenters pointed out investors in floating NAV funds will continue to expect a relatively stable NAV”). Section 18 applies only to open-end or closed-end companies, i.e., to management investment companies. Proposed rule 18f-4 therefore also would not apply to unit investment trusts (“UITs”) because they are not management investment companies. In addition, as the Commission has noted, derivatives transactions generally require a significant degree of management, and a UIT engaging in derivatives transactions therefore may not meet the Investment Company Act requirements applicable to UITs. 80 80 See section 4(2) of the Investment Company Act; see also Custody Of Investment Company Assets with Futures Commission Merchants And Commodity Clearing Organizations, Investment Company Act Release No. 22389 (Dec. 11, 1996), at n.18 (explaining that UIT portfolios are generally unmanaged). See also ETFs Adopting Release, supra note 76, at n.42. We request comment on all aspects of the proposed rule's definition of the term “fund,” including the following items. 1. The proposed definition excludes money market funds. Should we include money market funds in the definition? Why or why not? 2. Do money market funds currently engage in any transactions that might qualify as derivatives transactions under the rule or any of the other transactions permitted by the rule? For example, do money market funds engage in reverse repurchase agreements, “to be announced” dollar rolls, or “when issued” transactions? If so, which transactions, to what extent, and for what purpose? For example, do money market funds engage in reverse repurchase agreements for liquidity management purposes but not to leverage the fund's portfolio? If so, what effects would the proposed rule have on money market funds' liquidity management if they are excluded from the rule's scope as proposed? To the extent money market funds engage in any of the transactions that the proposed rule would permit, how do money market funds analyze them under rule 2a-7? 3. Should we permit money market funds to engage in some of the transactions that the rule would permit? If so, which transactions and why, and how would the transactions be consistent with rule 2a-7? If we were to include money market funds in the rule, or permit them to engage in specific types of transactions, should the rule provide specific conditions tailored to money market funds entering into those transactions? What kinds of conditions and why? Should they be permitted to engage in all (or certain types) of derivatives transactions, or reverse repurchase or similar financing transactions, for liquidity management or other purposes that do not leverage the fund's portfolio? If money market funds were permitted to rely on the rule for any transactions, should those transactions be limited in scale? For example, should that limit be the same as the proposed approach for limited derivatives users that limit the extent of their derivatives exposure, as discussed below in section II.E.1? Would even such limited use be consistent with funds that seek to maintain a stable share price or limit principal volatility? 4. If we were to include money market funds in the scope of rule 18f-4, should we revise Form N-MFP so that money market funds filing reports on the form could select among the list of investment categories set forth in Item C.6 of Form N-MFP derivatives and the other transactions addressed in the proposed rule 18f-4? 81 Why or why not? 81 See infra note 583. 2. Derivatives Transactions Permitted Under Proposed Rule 18f-4 The proposed rule would permit funds to enter into derivatives transactions, subject to the rule's conditions. The proposed rule would define the term “derivatives transaction” to mean: (1) Any swap, security-based swap, futures contract, forward contract, option, any combination of the foregoing, or any similar instrument (“derivatives instrument”), under which a fund is or may be required to make any payment or delivery of cash or other assets during the life of the instrument or at maturity or early termination, whether as margin or settlement payment or otherwise; and (2) any short sale borrowing. 82 82 Proposed rule 18f-4(a). The 2015 proposal similarly defined a derivatives transaction as including enumerated derivatives instruments “under which the fund is or may be required to make any payment or delivery of 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.” 2015 proposed rule 18f-4(c)(2). Most commenters did not address the proposed definition of the term “derivatives transaction,” although those commenters who did address the definition generally supported it. Some commenters more generally supported the view, or sought confirmation, that a derivative does not involve the issuance of a senior security if it does not impose an obligation under which the fund is or may be required to make a future payment ( e.g., a standard purchased option). See, e.g., Comment Letter of The Options Clearing Corporation (Mar. 25, 2016); Comment Letter of Investment Adviser Association (Mar. 28, 2016) (“IAA Comment Letter”); FSR Comment Letter. The first prong of this proposed definition is designed to describe those derivatives transactions that involve the issuance of a senior security, because they involve a contractual future payment obligation. 83 When a fund engages in these transactions, the fund will have an obligation (or potential obligation) to make payments or deliver assets to the fund's counterparty. This prong of the definition incorporates a list of derivatives instruments that, together with the proposed inclusion in the definition of “any similar instrument,” covers the types of derivatives that funds currently use and that the requirements of section 18 would restrict. This list is designed to be sufficiently comprehensive to include derivatives that may be developed in the future. We believe that this approach is clearer than a more principles-based definition of the term “derivatives transaction,” such as defining this term as an instrument or contract whose value is based upon, or derived from, some other asset or metric. 83 See supra note 27 and accompanying text, and text following note 34 (together, noting that “senior security” is defined in part as “any . . . similar obligation or instrument constituting a security and evidencing indebtedness,” and that the Commission has previously stated that, for purposes of section 18, “evidence of indebtedness” would include “all contractual obligations to pay in the future for consideration presently received”); see also infra notes 85-87 (recognizing that not every derivative instrument will involve the issuance of a senior security). This prong of the definition also provides that a derivatives instrument, for purposes of the proposed rule, must involve a future payment obligation. 84 This aspect of the definition recognizes that not every derivatives instrument imposes an obligation that may require the fund to make a future payment, and therefore not every derivatives instrument will involve the issuance of a senior security. 85 A derivative that does not impose any future payment obligation on a fund generally resembles a securities investment that is not a senior security, in that it may lose value but will not require the fund to make any payments in the future. 86 Whether a transaction involves the issuance of a senior security will depend on the nature of the transaction. The label that a fund or its counterparty assigns to the transaction is not determinative. 87 84 Under the proposed rule, a derivatives instrument is one where the fund “is or may be required to make any payment or delivery of cash or other assets during the life of the instrument or at maturity or early termination, whether as margin or settlement payment or otherwise.” 85 See 2015 Proposing Release, supra note 2, at paragraph accompanying nn.82-83. A fund that purchases a standard option traded on an exchange, for example, generally will make a non-refundable premium payment to obtain the right to acquire (or sell) securities under the option. However, the option purchaser generally will not have any subsequent obligation to deliver cash or assets to the counterparty unless the fund chooses to exercise the option. 86 See id. at n.82. 87 For example, the Commission received a comment on the 2015 proposal addressing a type of total return swap, asserting that “[t]he Swap operates in a manner similar to a purchased option or structure, in that the fund's losses under the Swap cannot exceed the amount posted to its tri-party custodian agreement for purposes of entering into the Swap,” and that, in the commenter's view, the swap should be “afforded the same treatment as a purchased option or structured note” because “[a]lthough the Swap involves interim payments through the potential posting of margin from the custodial account, the payment obligations cannot exceed the [amount posted for purposes of entering into the Swap].” See Comment Letter of Dearborn Capital Management (Mar. 24, 2016) (“Dearborn Comment Letter”). Unlike a fund's payment of a one-time non-refundable premium in connection with a standard purchased option or a fund's purchase of a structured note, this transaction appears to involve a fund obligation to make interim payments of fund assets posted as margin or collateral to the fund's counterparty during the life of the transaction in response to market value changes of the underlying reference asset, as this commenter described. The fund also must deposit additional margin or collateral to maintain the position if the fund's losses deplete the assets that the fund posted to initiate the transaction; if a fund effectively pursues its strategy through such a swap, or a small number of these swaps, the fund may as a practical matter be required to continue reestablishing the trade or refunding the collateral account in order to continue to offer the fund's strategy. The transaction therefore appears to involve the issuance of a senior security as the fund may be required to make future payments. See also infra section II.J (discussing the characterization of “unfunded commitment” agreements for purposes of the proposed rule, and as senior securities). Unlike the 2015 proposal, this proposal does not include references to, or a definition of, “financial commitment transaction” in addition to the proposed definition of “derivatives transaction.” The 2015 proposal defined a “financial commitment transaction” as any reverse repurchase agreement, short sale borrowing, or any firm or standby commitment agreement or similar agreement. 88 Because our proposal addresses funds' use of reverse repurchase agreements and unfunded commitment agreements separately from funds' use of derivatives, the proposed definition of “derivatives transaction” does not include reverse repurchase agreements and unfunded commitment agreements. 89 88 See 2015 Proposing Release, supra note 2, at section III.A.2; 2015 proposed rule 18f-4(c)(4); see also supra note 10. 89 See infra section II.I. Short sale borrowings, however, are included in the second prong of the proposed definition of “derivatives transaction.” We appreciate that short sales of securities do not involve derivatives instruments such as swaps, futures, and options. The value of a short position is, however, derived from the price of another asset, i.e., the asset sold short. A short sale of a security provides the same economic exposure as a derivatives instrument, like a future or swap, that provides short exposure to the same security. The proposed rule therefore treats short sale borrowings and derivatives instruments identically for purposes of funds' reliance on the rule's exemption. 90 90 See proposed rule 18f-4(b). While this proposal does not specifically list firm or standby commitment agreements in the definition of “derivatives transaction,” we interpret the definitional phrase “or any similar instrument” to include these agreements. A firm commitment agreement has the same economic characteristics as a forward contract. 91 Similarly, a standby commitment agreement has the same economic characteristics as an option contract, and the Commission has previously stated that such an agreement is economically equivalent to the issuance of a put option. 92 To the extent that a fund engages in transactions similar to firm or standby commitment agreements, they may fall within the “any similar instrument” definitional language, depending on the facts and circumstances. 93 91 Indeed, the Commission noted in Release 10666 that a firm commitment is known by other names such as a “forward contract.” See Release 10666, supra note 15, at nn.10-12 and accompanying text. 92 See id. at “Standby Commitment Agreements” (“The standby commitment agreement is a delayed delivery agreement in which the investment company contractually binds itself to accept delivery of a Ginnie Mae with a stated price and fixed yield upon the exercise of an option held by the other party to the agreement at a stated future date. . . . The Commission believes that the standby commitment agreement involves, in economic reality, the issuance and sale by the investment company of a `put.' ”). 93 See, e.g., infra paragraph accompanying notes 419-420 (discussing agreements that would not qualify for the proposed rule's treatment of unfunded commitment agreements because they are functionally similar to derivatives transactions). We request comment on all aspects of the proposed rule's definition of the term “derivatives transaction,” including the following items. 5. Is the definition of “derivatives transaction” sufficiently clear? Are there additional types of derivatives instruments, or other transactions, that we should include or exclude? Adding additional transactions to the definition would permit a fund to engage in those transactions by complying with the proposed rule, rather than section 18. Are there transactions that we should exclude from the definition so that funds must comply with the limits of section 18 (to the extent permitted under section 18) with respect to these transactions, rather than the proposed rule's conditions? 6. The proposed rule's definition of the term “derivatives transaction” is designed to describe those derivatives transactions that would involve the issuance of a senior security. Do commenters agree that derivatives transactions that involve obligations to make a payment or deliver assets involve the issuance of a senior security under section 18 of the Act? Does the rule effectively describe all of the types of derivatives transactions that would involve the issuance of a senior security? Conversely, are there any types of transactions that are included in the proposed definition of “derivatives transaction” that should not be considered to involve the issuance of a senior security? If so, which types of transactions and why? 7. Is it appropriate that the proposed rule's definition of “derivatives transaction” incorporates a list of derivatives instruments plus “any similar instrument,” rather than a principles-based definition, such as an instrument or contract whose value is based upon, or derived from, some other asset or metric? Why or why not? Is the reference to “any similar instrument” in the proposed definition sufficiently clear to address transactions that may be developed in the future? If not, how should we modify the rule to provide additional clarity? 8. Should the proposed definition of “derivatives transaction” include short sale borrowings? Would this approach cause any confusion because short sales are not typically understood as derivatives instruments? If the latter, what alternative approach would be preferable? 9. Should we specifically list firm or standby commitments in the proposed definition of “derivatives transaction”? Would funds understand the phrase “or any similar instrument” in the proposed definition to include these agreements? Do funds currently use the terms “firm commitment agreement” or “standby commitment agreement” to describe any of their transactions? 10. Are there any transactions similar to firm or standby commitments that we should specifically address, either in the proposed definition of “derivatives transaction” or otherwise as guidance? Are there any other types of transactions that the Commission should address—either in the proposed definition or as guidance—as transactions that fall within the “any similar instrument” definitional language? B. Derivatives Risk Management Program 1. Summary Fund investments in derivatives transactions can pose a variety of risks, and poor risk management can cause significant harm to funds and their investors. Derivatives can raise potential risks such as market, counterparty, leverage, liquidity, and operational risk. Although many of these risks are not limited to derivatives, the complexity and character of certain derivatives—such as their multiple contingencies and optionality, path dependency, and non-linearity—may heighten these risks. 94 Even simple derivatives without multiple contingencies and optionality, for example, can present additional risks beyond a fund's investment in the underlying reference assets, such as the risk that a fund must have margin-eligible assets on hand to meet margin or collateral calls. We also recognize the valuable role derivatives can play in helping funds to achieve their objectives efficiently or manage their investment risks. 94 See European Securities and Markets Authority (formerly Committee of European Securities Regulators), Guidelines on Risk Measurement and the Calculation of Global Exposure and Counterparty Risk for UCITS, CESR/10-788 (July 28, 2010), at 12, available at https://www.esma.europa.eu/sites/default/files/library/2015/11/10_788.pdf (“CESR Global Guidelines”). An investment adviser of a fund that uses derivatives therefore should manage this use to ensure alignment with the fund's investment objectives, policies, and restrictions, its risk profile, and relevant regulatory requirements. In addition, a fund's board of directors is responsible for overseeing the fund's activities and the adviser's management of risks, including any derivatives risks. 95 Given 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 and their related risks, we believe that requiring funds that are users of derivatives (other than limited derivatives users) to have a formalized risk management program with certain specified elements (a “program”) supports exempting these transactions from section 18. 95 See, e.g., Interpretive Matters Concerning Independent Directors of Investment Companies, Investment Company Act Release No. 24083 (Oct. 14, 1999) [64 FR 59877 (Nov. 3, 1999)]; Role of Independent Directors of Investment Companies, Investment Company Act Release No. 24816 (Jan. 2, 2001) [66 FR 3733 (Jan. 16, 2001)]; Independent Directors Council, Fund Board Oversight of Risk Management (Sept. 2011), available at http://www.ici.org/pdf/pub_11_oversight_risk.pdf (“2011 IDC Report”). Under the proposed program requirement, a fund would have to adopt and implement a written derivatives risk management program, which would include policies and procedures reasonably designed to manage the fund's derivatives risks. 96 A fund's risk management program should take into the account the way the fund uses derivatives, whether to increase investment exposures in ways that increase portfolio risks or, conversely, to reduce portfolio risks or facilitate efficient portfolio management. 97 96 Proposed rule 18f-4(c)(1). 97 See supra note 4 and accompanying text; infra section II.B.3.a. The program requirement is designed to result in a program with elements that are tailored to the particular types of derivatives that the fund uses and their related risks, as well as how those derivatives impact the fund's investment portfolio and strategy. The proposal would require a fund's program to include the following elements: • Risk identification and assessment. 98 The program would have to provide for the identification and assessment of a fund's derivatives risks, which would take into account the fund's derivatives transactions and other investments. 98 Proposed rule 18f-4(c)(1)(i); see also infra section II.B.3.a. • Risk guidelines. 99 The program would have to provide for the establishment, maintenance, and enforcement of investment, risk management, or related guidelines that provide for quantitative or otherwise measurable criteria, metrics, or thresholds related to a fund's derivatives risks. 99 Proposed rule 18f-4(c)(1)(ii); see also infra section II.B.3.b. • Stress testing. 100 The program would have to provide for stress testing of derivatives risks to evaluate potential losses to a fund's portfolio under stressed conditions. 100 Proposed rule 18f-4(c)(1)(iii); see also infra section II.B.3.c. • Backtesting. 101 The program would have to provide for backtesting of the VaR calculation model that the fund uses under the proposed rule. 101 Proposed rule 18f-4(c)(1)(iv); see also infra section II.B.3.d. • Internal reporting and escalation. 102 The program would have to provide for the reporting of certain matters relating to a fund's derivatives use to the fund's portfolio management and board of directors. 102 Proposed rule 18f-4(c)(1)(v); see also infra section II.B.3.e. • Periodic review of the program. 103 A fund's derivatives risk manager would be required to periodically review the program, at least annually, to evaluate the program's effectiveness and to reflect changes in risk over time. 103 Proposed rule 18f-4(c)(1)(vi); see also infra section II.B.3.f. The proposed program requirement is drawn from existing fund best practices. We believe it would enhance practices for funds that have not already implemented a derivatives risk management program, while building off practices of funds that already have one in place. 104 104 See, e.g., Aviva Comment Letter (discussing the implementation of formalized derivatives risk management programs); Vanguard Comment Letter. Most commenters generally supported the 2015 proposal's derivatives risk management program requirement, which had many similar foundational elements to those of the program we are proposing here. These commenters stated that the use of derivatives transactions by a fund should be subject to a comprehensive and appropriate written risk management program, which would benefit investors. 105 Our proposal includes elements from the 2015 proposal's derivatives risk management program framework, and adds elements that take into account our analysis of the comments we received. 105 See, e.g., Comment Letter of AFG-French Asset Management Association (Mar. 25, 2016) (“AFG Comment Letter”); Comment Letter of American Beacon Advisors (Mar. 28, 2016) (“American Beacon Comment Letter”); Comment Letter of AQR Capital Management (Mar. 28, 2016) (“AQR Comment Letter”); Federated Comment Letter; Comment Letter of Fidelity (Mar. 28, 2016) (“Fidelity Comment Letter”); Comment Letter of AFL-CIO (Mar. 28, 2016); Comment Letter of Alternative Investment Management Association (Mar. 28, 2016) (“AIMA Comment Letter”); Comment Letter of Aviva (Mar. 28, 2016) (“Aviva Comment Letter”); Comment Letter of BlackRock (Mar. 28, 2016) (“BlackRock Comment Letter”); Comment Letter of Capital Research and Management Company (Mar. 28, 2016) (“CRMC Comment Letter”). 2. Program Administration The proposed rule would require a fund adviser's officer or officers to serve as the fund's derivatives risk manager. 106 This requirement is designed to centralize derivatives risk management and to promote accountability. The designation of the derivatives risk manager must be approved by the fund's board of directors, and the derivatives risk manager must have direct communication with the fund's board of directors. Allowing multiple officers of the fund's adviser (including any sub-advisers) to serve as the fund's derivatives risk manager is designed to allow funds with differing sizes, organizational structures, or investment strategies to more effectively tailor the programs to their operations. 107 We understand that many advisers today involve committees or groups of officers in the vetting and analysis of portfolio risk and other types of risk. 108 Although the proposed rule would not permit a third party to serve as a fund's derivatives risk manager, the derivatives risk manager could obtain assistance from third parties in administering the program. For example, third parties could provide data relevant to the administration of a fund's program or other analysis that may inform the fund's derivatives risk management. 106 Proposed rule 18f-4(a). 107 The term “adviser” as used in this release and rule 18f-4 generally refers to any person, including a sub-adviser, that is an “investment adviser” of an investment company as that term is defined in section 2(a)(20) of the Investment Company Act. 108 See, e.g., IAA Comment Letter. The proposed rule would also require that the fund's derivatives risk manager have relevant experience regarding derivatives risk management. 109 This requirement is designed to reflect the potential complex and unique risks that derivatives can pose to funds and promote the selection of a derivatives risk manager who is well-positioned to manage these risks. As discussed below, under the proposed rule, a fund's board must approve the designation of the fund's derivatives risk manager, taking into account the derivatives risk manager's relevant experience regarding derivatives risk management. 110 109 Proposed rule 18f-4(a). 110 See infra section II.C.1. The proposed rule would require a fund to reasonably segregate the functions of the program from its portfolio management. 111 Segregating derivatives risk management from portfolio management is designed to promote objective and independent identification, assessment, and management of the risks associated with derivatives use. Accordingly, this element is designed to enhance the accountability of the derivatives risk manager and other risk management personnel and, therefore, to enhance the program's effectiveness. 112 We understand that funds today often segregate risk management from portfolio management. Many have observed that independent oversight of derivatives activities by compliance and internal audit functions is valuable. 113 Because a fund may compensate its portfolio management personnel in part based on the returns of the fund, the incentives of portfolio managers may not always be consistent with the restrictions that a risk management program would impose. Keeping the functions separate in the context of derivatives risk management should help mitigate the possibility that these competing incentives diminish the program's effectiveness. 111 Proposed rule 18f-4(c)(1). 112 See, e.g., Comptroller of the Currency Administrator of National Banks, Risk Management of Financial Derivatives: Comptroller's Handbook (Jan. 1997), at 9 (discussing the importance of independent risk management functions in the banking context). 113 See, e.g., Kenneth K. Marshall, Internal Control and Derivatives, The CPA Journal (Oct. 1995), available at http://archives.cpajournal.com/1995/OCT95/f461095.htm. Separation of functions creates important checks and balances, and funds could institute this proposed requirement through a variety of methods, such as independent reporting chains, oversight arrangements, or separate monitoring systems and personnel. The proposed rule would require reasonable segregation of functions, rather than taking a more prescriptive approach, such as requiring funds to implement strict protocols regarding communications between specific fund personnel, to allow funds to structure their risk management and portfolio management functions in ways that are tailored to each fund's facts and circumstances, including the size and resources of the fund's adviser. In this regard, the reasonable segregation requirement is not meant to indicate that the derivatives risk manager and portfolio management must be subject to a communications “firewall.” We recognize the important perspective and insight regarding the fund's use of derivatives that the portfolio manager can provide and generally understand that the fund's derivatives risk manager would work with the fund's portfolio management in implementing the program requirement. For similar reasons, the proposed rule would also prohibit the derivatives risk manager position from being filled solely by the fund's portfolio manager, if a single fund officer serves in the position. 114 The proposed rule also would prohibit a majority of the officers who compose the derivatives risk manager position from being portfolio managers, if multiple fund officers serve in the position. 114 Proposed rule 18f-4(a). Commenters generally supported the 2015 proposal's requirement that a fund's derivatives risk management program be administered by a derivatives risk manager and that the fund's derivatives risk management be segregated from the fund's portfolio management. 115 Commenters did, however, express concern about the 2015 proposal's requirement that there be a single derivatives risk manager and urged that the Commission permit a fund's portfolio managers to provide some input into the fund's derivatives risk management function. 116 This re-proposal addresses these concerns by permitting a group or committee to serve as a fund's derivatives risk manager, a portion of whom could be portfolio managers. 115 See, e.g., BlackRock Comment Letter. 116 See, e.g., BlackRock Comment Letter; Comment Letter of Morningstar (Mar. 28, 2016) (“Morningstar Comment Letter”); Comment Letter of the Investment Company Institute (Mar. 28, 2016) (“ICI Comment Letter I”); Comment Letter of WisdomTree (Mar. 28, 2016). We request comment on the proposed requirements that a fund's derivatives risk manager administer the fund's program, and that the derivatives risk management function be reasonably segregated from the fund's portfolio management. 11. Is the proposed definition of “derivatives risk manager” sufficiently clear? Why or why not? Should the rule, as proposed, require that a fund's derivatives risk manager be an officer or officers of the fund's adviser, and would this requirement further the goals of centralizing derivatives risk management and promoting accountability? Why or why not? Should the rule, as proposed, permit a fund's derivatives risk manager to be an officer or officers of the fund's sub-advisers? Why or why not? If so, should the rule require that at least one of the officers be an officer of the adviser or otherwise limit the number of sub-adviser officers? Why or why not? Would a fund's program be more effective if we required the derivatives risk manager to be a single individual? Why or why not? If so, should this individual be required to be an officer of a fund's adviser? 12. Should the rule, as proposed, require that a fund's derivatives risk manager have relevant experience regarding derivatives risk management? Why or why not? Is the proposed requirement that the derivatives risk manager have “relevant experience regarding the management of derivatives risk” sufficiently clear? Would this raise questions about whether portfolio management experience, or experience outside of formal derivatives risk management, would suffice for purposes of the rule? Should the rule, instead, require that a fund's derivatives risk manager simply have “relevant experience”? Should the rule specify that the derivatives risk manager must have relevant experience as determined by the fund's board, to allow a board to determine the experience that would be appropriate? Or should the rule identify specific qualifications, training, or experience of a fund's derivatives risk manager? Why or why not? If so, what should they be and why? 13. Should the rule, as proposed, require a fund to segregate derivatives risk management functions from portfolio management? Why or why not? If we were not to require independence between a fund's derivatives risk manager and the fund's portfolio managers, how could we ensure that a fund's portfolio management personnel, who may have conflicting incentives, do not unduly influence the fund's program management? 14. Should we provide any additional clarification regarding the proposed reasonable segregation requirement? If so, what changes should we make? Should we add any specific requirements? For example, should we limit the extent to which fund risk management personnel can be compensated in part based on fund performance? 15. Is our understanding that many funds already segregate functions correct? If so, how and why do current approaches differ from the proposed rule's requirement to segregate functions? 16. Are there other ways to facilitate objective and independent risk assessment of portfolio strategies that we should consider? If so, what are they and how would these alternatives be more effective than the proposed rule's requirement to reasonably segregate functions? 17. Rule 22e-4 under the Investment Company Act, similar to the proposed rule, requires certain funds to implement a risk management program. In particular, rule 22e-4 requires person(s) designated to administer a fund's liquidity risk management program to be the fund's investment adviser, officer, or officers (which may not be solely portfolio managers of the fund) (the “liquidity risk manager”). Should we amend rule 22e-4 to more closely align the definition of “liquidity risk manager” with the proposed definition of “derivatives risk manager” by prohibiting a fund's adviser from serving as a liquidity risk manager? Why or why not? Conversely, should we align the standard for derivatives risk manager with the liquidity risk manager standard under rule 22e-4? 18. Would the proposed derivatives risk manager requirement raise any particular challenges for funds with smaller advisers and, if so, what could we do to help mitigate these challenges? For example, should we modify the rule to permit funds to authorize the use of third parties not employed by the adviser to administer the program and, if so, under what conditions? Why or why not? Would allowing third parties to act as derivatives risk managers enhance the program by allowing specialized personnel to administer the program or detract from it by allowing for a derivatives risk manager who may not be as focused on the specific risks of the particular fund or as accountable to its board? Would the proposed requirement that a fund reasonably segregate derivatives risk management from portfolio management pose particular challenges for funds with smaller advisers? If so, how and why, and would additional guidance on this proposed requirement or changes to the proposed rule be useful? Conversely, would this proposed requirement (which does not prescribe how funds must segregate functions) provide appropriate flexibility for funds with smaller advisers? 19. Rule 38a-1(c) under the Investment Company Act prohibits officers, directors, and employees of the fund and its adviser from, among other things, coercing or unduly influencing a fund's chief compliance officer in the performance of his or her duties. Should we include such a prohibition on unduly influencing a fund's derivatives risk manager in the proposed rule? Why or why not? 20. Should we include any other program administration requirements? If so, what? For example, should we include a requirement for training staff responsible for day-to-day management of the program, or for portfolio managers, senior management, and any personnel whose functions may include engaging in, or managing the risk of, derivatives transactions? If we require such training, should that involve setting minimum qualifications for staff responsible for carrying out the requirements of the program? Why or why not? Should we require training and education with respect to any new derivatives instruments that a fund may trade? Why or why not? Should we require a new instrument review committee? 3. Required Elements of the Program a. Risk Identification and Assessment The proposed program requirement would require a fund to identify and assess its derivatives risks in order to manage these risks. 117 It would require that the fund's identification and assessment take into account the fund's other investments as well as its derivatives transactions. An appropriate assessment of derivatives risks generally involves assessing how a fund's derivatives may interact with the fund's other investments or whether the fund's derivatives have the effect of helping the fund manage risks. For example, the risks associated with a currency forward would differ if a fund is using the forward to hedge the fund's exposure to currency risk associated with a fund investment denominated in a foreign currency or, conversely, to take a speculative position on the relative price movements of two currencies. We believe that by assessing its derivatives use holistically, a fund will be better positioned to implement a derivatives risk management program that does not over- or understate the risks its derivatives use may pose. Accordingly, we believe that this approach would result in a more-tailored derivatives risk management program. 117 Proposed rule 18f-4(c)(1)(i). The proposed rule would define the derivatives risks that must be identified and managed to include leverage, market, counterparty, liquidity, operational, and legal risks, as well as any other risks the derivatives risk manager deems material. 118 In the context of a fund's derivatives transactions: 118 Proposed rule 18f-4(a). In the case of funds that are limited derivatives users under the proposed rule, the definition would include any other risks that the fund's investment adviser (as opposed to the fund's derivatives risk manager) deems material, because a fund that is a limited derivatives user would be exempt from the requirement to adopt a derivatives risk management program (and therefore also exempt from the requirement to have a derivatives risk manager). See infra section II.E. • Leverage risk generally refers to the risk that derivatives transactions can magnify the fund's gains and losses; 119 119 See, e.g., Independent Directors Council, Board Oversight of Derivatives Task Force Report (July 2008), at 12 (“2008 IDC Report”). • Market risk generally refers to risk from potential adverse market movements in relation to the fund's derivatives positions, or the risk that markets could experience a change in volatility that adversely impacts fund returns and the fund's obligations and exposures; 120 120 Funds should consider market risk together with leverage risk because leveraged exposures can magnify such impacts. See, e.g., NAPF, Derivatives and Risk Management Made Simple (Dec. 2013), available at https://www.jpmorgan.com/cm/BlobServer/is_napfms2013.pdf?blobkey=id&blobwhere=1320663533358&blobheader=application/pdf&blobheadername1=Cache-Control&blobheadervalue1=private&blobcol=urldata&blobtable=MungoBlobs . • Counterparty risk generally refers to the risk that a counterparty on a derivatives transaction may not be willing or able to perform its obligations [Text truncated at 120,000 characters. The full text is on the page linked above.] --- Source: Frix Law Library, https://www.frixlaw.com/law-library/documents/fr%3A2020-00040. Public record. Not legal advice.