# Use of Derivatives by Registered Investment Companies and Business Development Companies > Briefs, arguments, decisions, and more. URL: https://www.frixlaw.com/law-library/documents/fr%3A2020-24781 ## Record - **Collection:** Federal Register - **Document type:** Rule - **Published:** December 21, 2020 - **Citation:** 85 FR 83162 ## Text SECURITIES AND EXCHANGE COMMISSION 17 CFR Parts 239, 249, 270, and 274 [Release No. IC-34084; File No. S7-24-15] RIN 3235-AL60 Use of Derivatives by Registered Investment Companies and Business Development Companies AGENCY: Securities and Exchange Commission. ACTION: Final rule. SUMMARY: The Securities and Exchange Commission (the “Commission”) is adopting 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 the new rule addresses. In addition, the Commission is adopting new reporting requirements designed to enhance the Commission's ability to effectively oversee funds' use of and compliance with the new rule, and to provide the Commission and the public additional information regarding funds' use of derivatives. Finally, the Commission is adopting amendments under the Investment Company Act to allow leveraged/inverse ETFs that satisfy the rule's conditions to operate without the expense and delay of obtaining an exemptive order. The Commission, accordingly, is rescinding certain exemptive relief that has been granted to these funds and their sponsors. DATES: Effective Date: This rule is effective February 19, 2021. Compliance Date: August 19, 2022. See Section II.L of the SUPPLEMENTARY INFORMATION . FOR FURTHER INFORMATION CONTACT: Blair Burnett, Senior Counsel; Joel Cavanaugh, Senior Counsel; Mykaila DeLesDernier, Senior Counsel, John Lee, Senior Counsel; Amy Miller, Senior Counsel; Amanda Hollander Wagner, Branch Chief; Thoreau A. Bartmann, Senior Special Counsel; or Brian McLaughlin Johnson, Assistant Director, at (202) 551-6792, Investment Company Regulation Office, Division of Investment Management; U.S. Securities and Exchange Commission, 100 F Street NE, Washington, DC 20549-1090. SUPPLEMENTARY INFORMATION: Regulations in 17 CFR 270.18f-4 (“rule 18f-4”) will 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 will 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 rule also permits money market funds (and other funds) to invest in securities on a when-issued or forward-settling basis, or with a non-standard settlement cycle, subject to conditions. The Commission is adopting rule 18f-4 under the Investment Company Act, amendments to 17 CFR 270.6c-11 (rule 6c-11), 17 CFR 270.22e-4 (rule 22e-4), and 17 CFR 270.30b1-10 (rule 30b1-10) under the Investment Company Act; amendments to Form N-PORT [referenced in 17 CFR 274.150], Form N-LIQUID (which we are re-titling 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. Investment Company Act Release 10666 and the Status of Derivatives Under Section 18 3. Need for Updated Regulatory Framework C. Overview of the Final Rule II. Discussion A. Scope of Rule 18f-4 B. Derivatives Risk Management Program 1. Program Administration 2. Required Elements of the Program C. Board Oversight and Reporting 1. Board Approval of the Derivatives Risk Manager 2. Board Reporting D. Limit on Fund Leverage Risk 1. Use of VaR 2. Relative VaR Test 3. Absolute VaR Test 4. Funds Limited to Certain Investors 5. Choice of Model and Parameters for VaR Test 6. Implementation E. Limited Derivatives Users 1. Derivatives Exposure 2. Limited Derivatives User Threshold 3. Risk Management 4. Exceedances of the Limited Derivatives User Exception F. Approach to Leveraged/Inverse Funds 1. Proposed Alternative Requirements for Leveraged/Inverse Funds 2. Treatment of Leveraged/Inverse Funds Under Rule 18f-4 3. Standards of Conduct for Broker-Dealers and Registered Investment Advisers 4. Staff Review of Regulatory Requirements Relating to Complex Financial Products 5. Treatment of Existing Leveraged/Inverse Funds That Seek To Provide Leveraged or Inverse Market Exposure Exceeding 200% of the Return of the Relevant Index 6. Amendments to Rule 6c-11 Under the Investment Company Act and Proposed Rescission of Exemptive Relief for Leveraged/Inverse ETFs G. Amendments To Fund Reporting Requirements 1. Amendments to Form N-PORT 2. Amendments to Current Reporting Requirements 3. Amendments to Form N-CEN H. Reverse Repurchase Agreements I. Unfunded Commitment Agreements J. Recordkeeping Provisions K. Conforming Amendments 1. Form N-PORT and Rule 22e-4 2. Form N-2 (Senior Securities Table) L. Compliance Date M. Other Matters III. Economic Analysis A. Introduction B. Economic Baseline 1. Fund Industry Overview 2. Funds' Use of Derivatives and Reverse Repurchase Agreements 3. Current Regulatory Framework for Derivatives 4. Funds' Derivatives Risk Management Practices and Use of VaR Models 5. Leveraged/Inverse Funds C. Benefits and Costs of the Final 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. Treatment of Existing Leveraged/Inverse Funds That Seek To Provide Leveraged or Inverse Market Exposure Exceeding 200% of the Return of the Relevant Index 6. Amendments to Rule 6c-11 Under the Investment Company Act and Rescission of Exemptive Relief for Leveraged/Inverse ETFs 7. Unfunded Commitment Agreements 8. Recordkeeping 9. Amendments To Fund Reporting Requirements 10. When-Issued and Forward-Settling Transactions 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. Enhanced Disclosure 5. Alternative Treatment for Leveraged/Inverse Funds IV. Paperwork Reduction Act Analysis A. Introduction B. Rule 18f-4 1. Derivatives Risk Management Program 2. Board Oversight and Reporting 3. VaR Remediation 4. Disclosure Requirement for Certain Leveraged/Inverse Funds 5. Disclosure Changes for Money Market Funds 6. Requirements for Limited Derivatives Users 7. Recordkeeping Requirements 8. Rule 18f-4 Total Estimated Burden C. Rule 6c-11 D. Form N-PORT E. Form N-RN and Rule 30b1-10 F. Form N-CEN V. Final Regulatory Flexibility Analysis A. Need for and Objectives of the Rule and Form Amendments B. Significant Issues Raised by Public Comments C. Small Entities Subject to the Final Rule D. Projected Reporting, Recordkeeping, and Other Compliance Requirements 1. Rule 18f-4 2. Amendments to Forms N-PORT, N-RN, and N-CEN 3. Amendments to Rule 6c-11 E. Agency Action To Minimize Effect on Small Entities 1. Alternative Approaches to Rule 18f-4 2. Alternative Approaches to Amendments to Forms N-PORT, N-LIQUID (N-RN), and N-CEN 3. Alternative Approaches to Rule 6c-11 VI. Statutory Authority I. Introduction The Commission is adopting rule 18f-4 under the Investment Company Act to provide an updated, comprehensive approach to the regulation of funds' use of derivatives. This rule, along with amendments that the Commission is adopting to rule 6c-11 and certain forms under the Investment Company Act, will modernize the regulatory framework for funds to reflect the broad ways in which funds' use of derivatives has developed over past decades, and also will address investor protection concerns related to funds' derivatives use. We are committed to designing regulatory programs that reflect the ever-broadening product innovation and investor choice available in today's asset management industry, while also taking into account the risks associated with funds' increasingly complex portfolio composition and operations. The rules we are adopting reflect these considerations, and are also informed by the Commission's ongoing exploration—particularly over the past decade—of the benefits, risks, and costs associated with funds' current practices regarding derivatives. 1 1 See, e.g., 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)] (“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. See also 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)] (“2015 Proposing Release”); 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, Investment Company Act Release No. 33704 (Nov. 25, 2019) [85 FR 4446 (Jan. 24, 2020)] (“Proposing Release”). The comment letters on both the 2015 Proposing Release and the Proposing Release (File No. S7-24-15) are available at https://www.sec.gov/comments/s7-24-15/s72415.shtml. Under this new framework, funds using derivatives generally will have to adopt a derivatives risk management program that a derivatives risk manager administers and that the fund's board of directors oversees, and comply with an outer limit on fund leverage risk based on value at risk, or “VaR.” Funds that use derivatives only in a limited manner will not be subject to these requirements, but they will have to adopt and implement policies and procedures reasonably designed to manage the fund's derivatives risks. Funds also will be subject to reporting and recordkeeping requirements regarding their derivatives use. Funds using derivatives must consider requirements under the Investment Company Act of 1940. 2 These include sections 18 and 61 of the Investment Company Act, which limit a fund's ability to obtain leverage or incur obligations through the issuance of “senior securities.” 3 The Commission and its staff have addressed 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 Commission and staff guidance, as well as staff no-action letters and the practices that other funds disclose in their registration statements. 4 2 15 U.S.C. 80a (the “Investment Company Act,” or the “Act”). Except in connection with our discussion of the proposed sales practices rules ( see infra paragraph following footnote 7) 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 rule 18f-4, will be to title 17, part 270 of the Code of Federal Regulations, 17 CFR part 270. 3 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 footnote 33 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. 4 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 November 2019, the Commission proposed rule 18f-4, an exemptive rule under the Act designed to address the investor protection purposes and concerns underlying section 18. 5 The proposal also was designed 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 by replacing the Commission and staff guidance with a codified, consistent regulatory framework. The Commission observed in proposing this rule that, in the absence of Commission rules and guidance that encompass the current broad range of funds' derivatives use, inconsistent industry practices have developed. 6 The proposal was designed to respond to the concern 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. By standardizing the regulatory framework governing funds' derivatives use, the proposal also was designed to respond to the concern that funds' disparate practices could create an un-level competitive landscape and make it difficult for funds and the Commission to evaluate funds' compliance with section 18. 7 5 See Proposing Release, supra footnote 1. This proposal was a re-proposal of rules that the Commission proposed in 2015 to address funds' derivatives use, which included an earlier version of proposed rule 18f-4. See 2015 Proposing Release, supra footnote 1. In developing the 2019 re-proposal, the Commission considered the approximately 200 comment letters in response to the 2015 proposal, as well as subsequent staff engagement with large and small fund complexes and investor groups. 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/s72415260.pdf (“2016 DERA Memo”). 6 See infra section I.B.3 (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). 7 See Proposing Release, supra footnote 1, at n.9 and accompanying text (discussing funds that segregate the notional amount of physically-settled futures contracts, and those that segregate only the marked-to-marked obligation in respect of cash-settled futures, and the concern that these practices can result in differing treatment of arguably equivalent products). The rules that the Commission proposed in 2019 would permit a fund to enter into derivatives transactions, notwithstanding the restrictions under section 18 of the Investment Company Act, subject to certain conditions. These proposed conditions include adopting a derivatives risk management program and complying with a limit on the amount of leverage-related risk that the fund may obtain, based on VaR. Under the proposed rule, a streamlined set of requirements would apply to funds that use derivatives in a limited way. The proposed rule would also permit a fund 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. The proposal also included new reporting and recordkeeping requirements for funds using derivatives. Certain registered investment companies that seek to provide leveraged or inverse exposure to an underlying index—including leveraged/inverse ETFs—would not have been subject to the limit on fund leverage risk under the 2019 proposal but instead would be subject to alternative requirements. The 2019 proposal provided that sales of these funds also would be subject to new sales practices rules for brokers, dealers, and investment advisers that are registered with the Commission (collectively, the “proposed sales practices rules”). 8 Finally, the proposal would amend rule 6c-11 under the Investment Company Act to allow leveraged/inverse ETFs that satisfy that rule's conditions to operate without the expense and delay of obtaining an exemptive order. 8 As discussed in more detail in section II.G, the proposed sales practices rules would have covered 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.” The Commission received approximately 6,100 comment letters in response to the 2019 proposal. Of these comment letters, approximately 70 addressed proposed rule 18f-4, and the balance addressed the proposed sales practices rules. The majority of commenters who discussed proposed rule 18f-4 supported the Commission acting to provide an updated and more comprehensive approach to the regulation of funds' use of derivatives. 9 Commenters generally supported the proposal's derivatives risk management program requirement and use of VaR to provide a limit on fund leverage risk, while suggesting certain modifications. 10 Many commenters, however, expressed concerns with the proposed sales practices rules, and urged the Commission not to adopt these proposed rules (or to adopt alternative requirements designed to address the investor protection concerns underlying the proposed sales practices rules). 11 9 See, e.g., Comment Letter of the American Bar Association (May 2, 2020) (“ABA Comment Letter”); Comment Letter of Better Markets (Mar. 24, 2020) (“Better Markets Comment Letter”); Comment Letter of the U.S. Chamber of Commerce (“Chamber Comment Letter”); Comment Letter of Investment Company Institute (Apr. 20, 2020) (“ICI Comment Letter”); Comment Letter of New York City Bar (May 1, 2020) (“NYC Bar Comment Letter”). 10 See infra footnotes 125, 287 and accompanying text. 11 See, e.g., infra footnotes 579-584 and accompanying text. After consideration of the comments received, we are adopting rule 18f-4, with certain modifications. The final rule retains each of the elements of the proposed rule, as we continue to believe that these requirements provide important investor protections. We have, however, made modifications to the proposed rule to address the comments the Commission received. We are also adopting, with certain modifications, the proposed new reporting and recordkeeping requirements, as well as the proposed amendments to rule 6c-11. We are not, however, adopting the proposed sales practices rules. Instead, leveraged/inverse funds will generally be subject to rule 18f-4, like other funds that use derivatives. The enhanced standard of conduct for broker-dealers under Regulation Best Interest and the fiduciary obligations of registered investment advisers also apply to broker-dealer recommendations and advice from investment advisers in connection with leveraged/inverse funds, as well as with respect to the listed commodity pools following the same strategies that would have been subject to the proposed sales practices rules. 12 In addition, we have directed the staff to review the effectiveness of the existing regulatory requirements in protecting investors who invest in leveraged/inverse funds and other complex investment products. 12 See Regulation Best Interest: The Broker-Dealer Standard of Conduct, Exchange Act Release No. 86031 (June 5, 2019) [84 FR 33318 (July 12, 2019)] (“Regulation Best Interest Adopting Release”). The proposed sales practices rules would have applied to certain exchange-listed commodity- or currency-based trusts or funds. See proposed rule 15 l -2(d); proposed rule 211(h)-1(d). In this release we refer to these trusts or funds collectively as listed commodity pools. A. Overview of Funds' Use of Derivatives As we discussed in the Proposing Release, 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”). 13 13 Exchange-traded derivatives—such as futures, certain options, and options on futures—are standardized contracts traded on regulated exchanges. 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 Proposing Release, supra footnote 1, at n.14 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 footnote 3. 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.” 14 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. 15 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. 16 14 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”). 15 The leverage created by such an arrangement is sometimes referred to as “indebtedness leverage.” See Proposing Release, supra footnote 1, at n.16. 16 This type of leverage is sometimes referred to as “economic leverage.” See id. at n.17. The Proposing Release considered, and commenters also discussed, how 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. 17 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. 18 With respect to risk management, funds may employ derivatives to hedge currency, interest rate, credit, and other risks, as well as to hedge portfolio exposures. 19 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 ( e.g., contract enforceability). 20 17 See id. at n.18; see also, e.g., ICI Comment Letter; Comment Letter of SIFMA, Asset Management Group (Apr. 21, 2020) (“SIFMA AMG Comment Letter”). 18 See Proposing Release, supra footnote 1, at n.19; see also ICI Comment Letter. 19 See Proposing Release, supra footnote 1, at n.20; see also infra sections II.E.2.b and II.E.2.c. 20 See Proposing Release, supra footnote 1, at n.21. Section 18 is designed to limit the leverage a fund can obtain or incur through the issuance of senior securities. The Proposing Release discussed recent examples involving significant fund losses, which illustrate how a fund's use of derivatives may raise the investor protection concerns underlying section 18. 21 While the losses suffered in the examples discussed in the 2019 proposal are extreme, and funds rarely suffer such large and rapid losses, these examples 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. 21 See Proposing Release, supra footnote 1, at nn.22-23 and accompanying text (discussing 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); 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); 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); 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); In the Matter of Mohammed Riad and Kevin Timothy Swanson, Investment Company Act Release No. 33338 (Dec. 21, 2018) (settled action); In the Matter of Top Fund Management, Inc. and Barry C. Ziskin, Investment Company Act Release No. 30315 (Dec. 21, 2012) (settled action)). The Proposing Release also discussed the 2018 liquidation of the LJM Preservation and Growth Fund, which occurred after the fund—whose investment strategy involved purchasing and selling call and put options on the Standard & Poor's (“S&P”) 500 Futures Index—sustained considerable losses in connection with a market volatility spike in February 2018. See id. at nn.24-25 and accompanying text. Following the issuance of the Proposing Release, an additional settled action similarly illustrates substantial and rapid losses resulting from a fund's investment in derivatives. See In the Matter of Catalyst Capital Advisors, LLC and Jerry Szilagyi, Investment Advisers Act Release No. 5436 (Jan. 27, 2020) (settled action) (involving a mutual fund that advises and invests primarily in options on S&P 500 index futures contracts incurring losses of 20% of its net asset value—more than $700 million—during the period December 2016 through February 2017). The 2020 outbreak of coronavirus disease 2019 (COVID-19) and related effects on markets similarly have highlighted the importance of funds' derivatives risk management. Our staff has considered, and multiple commenters also discussed, the impact of COVID-19 both on funds' current derivatives risk management, as well as considerations relating to the Commission's 2019 proposal in light of market events stemming from this health crisis. The market volatility that followed the onset of this health crisis resulted in disruptions and challenges across asset classes. 22 In the context of derivatives, this volatility resulted in trading, liquidity, and pricing disruptions, valuation challenges, counterparty issues, and issues relating to derivatives' underlying assets, all of which emphasize the significance of robust derivatives risk management. 23 Certain leveraged/inverse ETFs changed their investment objectives and strategies during this period. 24 On the other hand, commenters observed that the recent market volatility has shown the importance for funds to be able to use derivatives both to hedge risk and the flexibility to respond to quickly-changing market demands. 25 Some commenters suggested changes to certain aspects of proposed rule 18f-4 that reflect their experiences with this market volatility. 26 The rules we are adopting here take these considerations into account. 22 See, e.g., Comment Letter of AQR Capital Management, LLC (Apr. 21, 2020) (“AQR Comment Letter I”) (observing “extremely high levels of market volatility driven by the COVID-19 pandemic”); Comment Letter of AQR Capital Management, LLC (Sept. 29, 2020) (“AQR Comment Letter II”) (discussing the impact and investment returns for certain alternative strategy funds at the onset of stressed market conditions related to the COVID-19 global health pandemic); see also ISDA COVID-19 Updates (July, 30, 2020), available at https://www.isda.org/2020/03/13/covid-19-isda-update/ (providing updates on trading suspensions and regulatory emergency relief relating to COVID-19). 23 See, e.g., ISDA and Greenwich Associates, The Impact of COVID-19 and Government Intervention on Swaps Market Liquidity (Q2 2020), available at https://www.isda.org/a/YfbTE/The-Impact-of-COVID-19-on-Swaps-Market-Liquidity.pdf ; CFTC, COVID-19 Commission Action, available at https://www.cftc.gov/coronavirus (discussing CFTC actions designed to help facilitate orderly trading and liquidity in the U.S. derivatives markets in response to the COVID-19 pandemic); CFTC Letter No. 20-17, Staff Advisory on Risk Management and Market Integrity Under Current Market Conditions (May 13, 2020), available at https://www.cftc.gov/coronavirus (advisory issued to remind certain CFTC-regulated market participants that they are expected to prepare for the possibility that certain contracts may continue to experience “extreme market volatility, low liquidity and possibly negative pricing”); Derivatives close-outs: COVID-19—Challenges to the valuation of derivatives upon early termination, FTI Consulting (June 2020), available at https://www.fticonsulting.com/~/media/Files/emea—files/insights/articles/2020/jun/covid-19-derivatives-close-outs-crisis.pdf ; COVID-19 Update: The Impact of COVID-19 on Financial Contracts, The National Law Review Vol. X, Number 111 (Apr. 20, 2020) (discussing market volatility arising from the restrictions imposed to reduce the risk of spread of COVID-19, the impact of this volatility on existing contractual relationships, and illustrating practical issues that a counterparty to a financial contract might take into account using, as an example, a derivative transaction). 24 In particular, one of the two ETF sponsors that currently relies on exemptive relief from the Commission permitting them to operate leveraged/inverse ETFs changed the objectives of a number of its funds, while also closing a number of its funds. See “Direxion Changes Objectives of Ten Leveraged Funds to Address Extreme Market Conditions, While Also Closing Eight Funds Due to Limited Interest Since Launch” (Mar. 24, 2020), available at https://www.direxion.com/uploads/Change-in-Investment-Objectives-and-Strategies-of-Ten-Daily-Leveraged-and-Daily-Inverse-Leveraged-Funds.pdf (“Direxion Press Release”); see also infra footnote 821 and accompanying text. 25 See, e.g., Comment Letter of BlackRock, Inc. (Apr. 22, 2020) (“BlackRock Comment Letter”); Comment Letter of International Swaps and Derivatives Association, Inc. (Apr. 24, 2020) (“ISDA Comment Letter”); see also, e.g., PIMCO: Taxonomy of Crisis, presentation to Commission's Asset Management Advisory Committee on May 27, 2020, available at https://www.sec.gov/files/marc-seidner-pimco.pdf. 26 See, e.g., AQR Comment Letter I; BlackRock Comment Letter; Comment Letter of Capital Research and Management Company (Apr. 21, 2020) (“Capital Group Comment Letter”). 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. 27 “Senior security” is defined, in part, as “any bond, debenture, note, or similar obligation or instrument constituting a security and evidencing indebtedness.” 28 27 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”); see also Proposing Release, supra footnote 1, at n.26. 28 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. As discussed in the Proposing Release, 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. 29 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”). 30 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. 31 Closed-end funds also may issue or sell senior securities that are a stock, subject to the limitations of section 18 (including that these funds must have asset coverage of at least 200% immediately after such issuance or sale). 32 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). 33 29 See Proposing Release, supra footnote 1, at n.28 and accompanying text (citing to discussion of each of these enumerated concerns in certain Investment Company Act provisions, Release 10666, supra footnote 14, and Senate Hearings, supra footnote 27). 30 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). 31 See section 18(a)(1) of the Investment Company Act. 32 See section 18(a)(2) of the Investment Company Act. 33 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. Investment Company Act Release 10666 and the Status of Derivatives Under Section 18 Investment Company Act Release 10666 As discussed in the Proposing Release, the Commission considered the application of section 18's restrictions on the issuance of senior securities to certain transactions—reverse repurchase agreements, firm commitment agreements, and standby commitment agreements—in a 1979 General Statement of Policy (Release 10666). 34 The Proposing Release discussed the Commission's conclusion that these agreements fall within the “functional meaning of the term `evidence of indebtedness' for purposes of Section 18 of the Investment Company Act.” 35 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.” 36 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, Release 10666 nonetheless permitted funds to use these and similar arrangements subject to certain constraints. 34 See Release 10666, supra footnote 14. 35 See Proposing Release, supra footnote 1, at n.34 and accompanying and following text. 36 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.” 37 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.” 38 The Commission stated that its expressed views were not limited to the particular trading practices discussed, emphasizing that Release 10666 discussed certain securities trading practices as examples and that the Commission sought to address the implications of all comparable trading practices that could similarly affect funds' capital structures. 39 37 See Proposing Release, supra footnote 1, at n.35 and accompanying text. 38 See id. at n.36 and accompanying text. 39 See id. at n.37 and accompanying text. The Commission in Release 10666 stated that although it was expressing its views about the particular trading practices discussed in that release, its views were not limited to those trading practices, in that the Commission sought to “address generally the possible economic effects and legal implications of all comparable trading practices which may affect the capital structure of investment companies in a manner analogous to the securities trading practices specifically discussed in Release 10666.” Transactions Involving Senior Securities for Purposes of Section 18 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. These transactions, as well as short sales of securities for which the staff initially developed the segregated account approach, 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. 40 These transactions therefore involve the issuance of a senior security for purposes of section 18. 41 40 See id. at n.38 and accompanying text. 41 See id. at n.38 and accompanying text (citing Release 10666, supra footnote 14, at “The Agreements as Securities” discussion and noting that the Investment Company Act's definition of the term “security” is broader than the term's definition in other federal securities laws); 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”). We also continue to apply the same analysis to all derivatives transactions that create future payment obligations. 42 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. 43 42 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. These payments—which may include payments of cash, or delivery of other assets—may occur as margin, as settlement payments, or otherwise. 43 See Proposing Release, supra footnote 1, at n.41 and accompanying text (stating that, as the Commission explained in Release 10666, the Commission continues to 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). Most commenters were silent on the Commission's interpretation. Some commenters, however, raised questions about whether all of the transactions covered in the rule's definition of “derivatives transaction” involve senior securities. For example, some of these commenters stated that derivatives such as swaps, options, and futures are not generally structured as “borrowings” and therefore questioned whether these derivatives represent “indebtedness.” 44 One of these commenters stated that the reverse repurchase agreements, firm commitment agreements, and standby commitment agreements that Release 10666 addresses “can fairly be characterized as `evidence of indebtedness,' ” but questioned whether those types of arrangements are derivatives “in today's parlance” and stated that Release 10666's discussion of those arrangements does not indicate that “today's derivatives—swaps, options, futures—represent `indebtedness.' ” 45 Certain commenters also questioned whether a fund “issues” senior securities when it engages in derivatives transactions, and some furthermore expressed the view that derivatives transactions do not involve senior securities under section 18. 46 44 See, e.g., Comment Letter of Nuveen Funds Advisors, LLC (Apr. 1, 2020) (“Nuveen Comment Letter”); Comment Letter of Rafferty Asset Management and Rafferty Capital Markets, LLC, including on behalf of the separate series of Direxion Funds and Direxion Shares ETF Trust (Mar. 31, 2020) (“Direxion Comment Letter”); Comment Letter of ProShares (Mar. 28, 2016) (“ProShares Comment Letter”). 45 See Nuveen Comment Letter; see also Direxion Comment Letter (stating that total return swap contracts should not qualify as “evidencing indebtedness” because they are not the type of long-term debt securities issued by a fund that Congress intended to be considered part of the fund's capital structure and thus subject to regulation under section 18, and stating also that the exception in section 18(f) for bank borrowings does not imply that all borrowings constitute “senior securities”); ProShares Comment Letter (arguing that derivatives such as options and futures are not “evidence of indebtedness”). 46 See, e.g., Comment Letter of James Angel, Associate Professor of Finance Georgetown University (Feb. 24, 2020); Comment Letter of Competitive Enterprise Institute (Apr. 30, 2020); Direxion Comment Letter; ProShares Comment Letter. As discussed in the Proposing Release, we continue to believe that the express scope of section 18, and the broad definition of the term “senior security” in section 18, support the interpretation that a derivatives transaction that creates a future payment obligation involves an evidence of indebtedness that is a senior security for purposes of section 18. 47 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. 48 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.” 49 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. 50 47 See Proposing Release, supra footnote 1, at paragraph accompanying nn.42-44. 48 Consistent with Release 10666, and as the Commission stated in the Proposing Release (as well as 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). 49 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. 50 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 footnote 14, at “Reverse Repurchase Agreements” discussion. In addition to continuing to believe that section 18's scope supports the interpretation that a derivatives transaction creating a future payment obligation involves an evidence of indebtedness that is a senior security for purposes of section 18, we continue to believe that this interpretation 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. 51 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.” 52 51 Several commenters discussed the Commission's authority to adopt rules based on the policy considerations reflected in section 1 of the Act. See, e.g., Direxion Comment Letter; ProShares Comment Letter. The authority under which we are adopting rules today is set forth in section VI of this release and includes, among other provisions, section 6(c) of the Act. That section provides that “The Commission, by rules and regulations upon its own motion, or by order upon application, may conditionally or unconditionally exempt any person, security, or transactions . . . from any provision or provisions of this title or of any rule or regulation thereunder, if and to the extent that such exemption is necessary or appropriate in the public interest and consistent with the protection of investors . . . .” As discussed in the paragraph accompanying this footnote, the fundamental statutory policy and purposes underlying the Investment Company Act, as expressed in section 1(b) of the Act, continue to inform our interpretation of the scope of the term “senior security” in section 18. This also separately informs our consideration of appropriate conditions for the exemption that rule 18f-4 provides, as we discuss in sections II.B-II.F infra. 52 See Release 10666, supra footnote 14, at “Segregated Account” discussion. 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). 53 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. 54 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. 55 Some commenters mentioned undue speculation concerns underlying section 18 and discussed ways in which the Commission's 2019 proposal would address these concerns. 56 53 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. 54 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]”). 55 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., Comment Letter of the Investment Company Institute on the 2011 Concept Release (Nov. 7, 2011) (File No. S7-33-11) (“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 Proposing Release, supra footnote 1, n.49. 56 See, e.g., AQR Comment Letter I (“For a fund engaging in significant or complex derivative usage, the key to curbing excessive borrowing and undue speculation lies in implementing an effective risk management program.”); Capital Group Comment Letter (“We believe the Proposal is an effective way to address the investor protection concerns underlying Section 18 of the Investment Company Act of 1940 . . . In particular, we believe that creating leverage limits that constrain economic risk, coupled with a derivatives risk management program, is a better way to constrain leverage and prevent undue speculation by funds than limits based on the aggregate gross notional exposure of a fund's derivative transactions, as proposed in 2015.”); Comment Letter of Consumer Federation of America (Mar. 30, 2020) (“CFA Comment Letter”) (“Congress' findings and declaration of policy underlying Section 18 make clear that Congress was concerned with the potential for investment companies, through excessive borrowing, to engage in undue speculation and operate without sufficient assets to cover potential losses . . . While Section 18 does not explicitly refer to funds' use of derivatives, the concerns are the same.”); ICI Comment Letter (“We fully support the Commission's goal of addressing the investor protection concerns underlying Section 18 of the Investment Company Act of 1940, and the reproposed rule is an effective way to achieve that goal. In particular, the leverage limits coupled with elements of the derivatives risk management program, including required stress testing, will restrict the amount of exposure to economic risk that a fund could take when investing in derivatives. Creating leverage limits that confine economic risk is a far better way to addresses Section 18's “undue speculation” concerns than limits based solely on the aggregate gross notional exposure (“GNE”) of a fund's derivatives transactions, as proposed in 2015.”). 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. 57 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. 58 In an extreme situation, a fund could default on its payment obligations. 59 Some commenters mentioned asset sufficiency concerns underlying section 18 and discussed ways in which the Commission's 2019 proposal would address these concerns. 60 57 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. 58 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). 59 See ICI Concept Release Comment Letter, supra footnote 55, at 11 (noting that, “[h]ypothetically, in an extreme scenario, a fund that used derivatives heavily and segregated most of its liquid assets to cover its obligation on a pure mark-to-market basis could potentially find itself with insufficient liquid assets to cover its derivative positions”); see also Aditum Comment Letter (discussing asset sufficiency concerns in the context of unfunded commitment agreements and the recent market disruption associated with COVID-19). 60 See, e.g., Better Markets Comment Letter; Comment Letter of CBOE (May 1, 2020) (“CBOE Comment Letter”); Comment Letter of Dechert LLP (Mar. 24, 2020) (“Dechert Comment Letter I”); Comment Letter of Invesco, Ltd. (Mar. 24, 2020) (“Invesco Comment Letter”) (“Invesco agrees with the Commission that registered funds using derivatives transactions should be subject to a regulatory framework that requires them and their advisers to manage attendant risks, including the risk of leverage that implicates the “undue speculation” and “asset sufficiency” concerns expressed in Sections 1(b)(7) and 1(b)(8), respectively, of the Investment Company Act . . . We believe the Proposed Rule will aptly address the investor protection purposes and concerns that underlie Section 18 . . .”); Comment Letter of Vanguard Group, Inc. (Apr. 23, 2020) (“Vanguard Comment Letter”) (“We agree with the Commission's assessment that the proposed requirements for a derivatives risk management program, including VaR and stress testing, would appropriately address the asset sufficiency concerns underlying Section 18 with respect to derivatives use.”). Applying rule 18f-4 to derivatives transactions—including swaps, options, and futures—also is consistent with the Commission's views in Release 10666. As discussed above, in Release 10666, the Commission stated that its expressed views were not limited to the particular trading practices discussed, emphasizing that Release 10666 discussed certain securities trading practices as examples and that the Commission sought to address the implications of all comparable trading practices that could similarly affect funds' capital structures. 61 The Commission observed in Release 10666 that firm commitment agreements are also known as forward contracts, and that standby commitment agreements involve, in economic reality, the issuance and sale by the investment company of a “put.” 62 Both forward and futures contracts involve the agreement to buy or sell an underlying reference asset at a set price in the future, and a swap contract is structurally the equivalent of a series of forward contracts. 63 Moreover, derivatives transactions as defined in the final rule generally involve a synthetic borrowing, in that they provide a market exposure exceeding the fund's investment while also involving a future payment obligation. 64 61 See supra footnote 39. 62 See Release 10666, supra footnote 14, at nn.10-12 and accompanying text, and at “Standby Commitment Agreements.” 63 See e.g. John C. Hull, Options, Futures, and Other Derivatives, Prentice Hall, 7th Edition (2008) at 161. 64 For example, one commenter on the 2011 Concept Release observed that “a fund's purchase of an equity total return swap produces an exposure and economic return substantially equal to the exposure and economic return a fund could achieve by borrowing money from the counterparty in order to purchase the equities that are reference assets.” Comment Letter of BlackRock on the 2011 Concept Release (Nov. 4, 2011) (File No. S7-33-11). 3. Need for Updated Regulatory Framework Market and Industry Developments Following Release 10666 Following 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. 65 Funds have developed certain general asset segregation practices to cover their derivatives positions, considering at least in part the staff's no-action letters and guidance, which vary based on the type of derivatives transaction. 66 Funds also segregate a broader range of assets to cover their derivatives positions than those the Commission identified in Release 10666. 67 65 See Proposing Release, supra footnote 1, at paragraph accompanying n.53 (stating that, in these letters and through other staff guidance, staff addressed questions regarding the application of Release 10666 to various types of derivatives and other transactions); see also Concept Release, supra footnote 1, at section I. 66 See Proposing Release, supra footnote 1, at paragraph accompanying n.54 (discussing funds' practices for segregating 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”) for certain derivatives, and funds practices for segregating an amount equal to the fund's daily mark-to-market liability, if any (“mark-to-market segregation”) for certain cash settled-derivatives). 67 See id. at paragraph accompanying nn.56-57 (discussing Release 10666's statement that 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, and a subsequent staff no-action letter stating 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); see also Merrill Lynch Asset Management, L.P., SEC Staff No-Action Letter (July 2, 1996). 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. 68 As a result, a fund that segregates only the mark-to-market liability could theoretically incur virtually unlimited investment leverage. 69 68 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. 69 See Proposing Release, supra footnote 1, at n.59; see also BlackRock Comment Letter (“We agree with the Commission's view that the use of derivatives should not be unlimited or unregulated.”); Comment Letter of J.P. Morgan Asset Management (Mar. 24, 2020) (“J.P. Morgan Comment Letter”) (“Evolving market practices, together with staff guidance over the years, have enabled funds to segregate large portions of their portfolios, while using mark-to-market exposure amounts for many instruments. This approach to asset segregation could result in a fund obtaining a significant degree of leverage.”). Furthermore, as discussed in the Proposing Release, funds' current asset segregation practices also may not assure the availability of adequate assets to meet funds' derivatives obligations, on account of both the amount and types of assets that funds may segregate. 70 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. 71 70 See Proposing Release, supra footnote 1, at nn.60-62 and accompanying text (discussing: (1) Funds' segregation of assets that only reflect losses that would occur as a result of transaction termination; and (2) funds' practices of segregating any liquid asset, rather than the more narrow range of high-quality assets that the Commission described in Release 10666). 71 See id. at n.62 and accompanying text. Regulatory Framework To Address Concerns Underlying Section 18 in Light of Current Fund Practices As a result of market and industry developments over the past four decades, funds' current practices regarding derivatives use may not address the undue speculation and asset sufficiency concerns underlying section 18. 72 Additionally, a fund's derivatives use may involve risks that can result in significant losses to a fund. 73 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. 72 See Proposing Release, supra footnote 1, at n.63 and accompanying text; see also supra footnotes 56 and 60 and accompanying text (discussing, respectively, commenters' statements regarding undue speculation and asset sufficiency concerns underlying section 18 and their discussion of ways in which the Commission's 2019 proposal would address these concerns). 73 See supra paragraph accompanying footnote 21. We therefore are requiring funds that use derivatives in a more than limited way to adopt and implement formalized programs, which must cover certain elements but otherwise will be tailored to manage the risks that funds' derivatives use may pose. In addition, the framework we are adopting addresses our concern that funds today are not subject to a practical limit on potential leverage that they may obtain through derivatives transactions. We believe that a comprehensive approach to regulating funds' derivatives use also will 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. 74 74 See Proposing Release, supra footnote 1, at n.65 and accompanying text. 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. The new framework that we are adopting will replace the current, multi-part guidance framework with a unitary rule. This will level-set the regulation of funds' derivatives use in light of the breadth of fund strategies and the variety of ways that funds use derivatives today. C. Overview of the Final Rule We are adopting rule 18f-4 to provide an updated, comprehensive approach to the regulation of funds' use of derivatives and certain other transactions that the rule addresses. The amendments we are adopting to Forms N-PORT, N-LIQUID (which we are re-titling as “Form N-RN”), and N-CEN will enhance the Commission's ability to oversee funds' use of and compliance with the rules, and will provide the Commission, fund investors, and other market participants additional information regarding funds' use of derivatives. Rule 18f-4 will 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. 75 These conditions are designed to address the undue speculation and asset sufficiency concerns underlying section 18, and they support the Commission's conclusion that the exemptions that the rule provides are in the public interest and consistent with the protection of investors and the purposes fairly intended by the policy and provisions of the Act. 75 See rule 18f-4(b) and (d). Rule 18f-4(b) provides 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 conditions provide a tailored set of requirements for derivatives transactions, the rule also provides that a fund's derivatives transactions will not be considered for purposes of computing asset coverage under section 18(h). See infra section II.K. • Derivatives risk management program. The rule will generally require a fund to adopt a written derivatives risk management program with risk guidelines that must cover certain elements, but that will otherwise be tailored based on how the fund's use of derivatives may affect its investment portfolio and overall risk profile. The program also will include stress testing, backtesting, internal reporting and escalation, and program review elements. The program will 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. The program requirement that we are adopting retains the same framework and elements as the proposed program requirement. • Limit on fund leverage risk. The rule will generally require funds when engaging in derivatives transactions to comply with an outer limit on fund leverage risk based on VaR. This outer limit is based on a relative VaR test that compares the fund's VaR to the VaR of a “designated reference portfolio” for that fund. Under the final rule, a fund generally can use either an index that meets certain requirements, or the fund's own securities portfolio (excluding derivatives transactions), as its designated reference portfolio. If the fund's derivatives risk manager reasonably determines that a designated reference portfolio would not provide an appropriate reference portfolio for purposes of the relative VaR test, the fund would be required to comply with an absolute VaR test. In light of our consideration of comments received, the requirements we are adopting incorporate certain changes to the proposed VaR test. These include permitting a fund to use its securities portfolio as the reference portfolio for purposes of the relative VaR test (instead of requiring a fund to compare its VaR against the VaR of a designated index for the relative VaR test), and increasing the relative and absolute VaR limits from 150% and 15% to 200% and 20%, respectively. • Board oversight and reporting. The rule will require a fund's board of directors to approve the fund's designation of a derivatives risk manager, who will be responsible for administering the fund's derivatives risk management program. The fund's derivatives risk manager will 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 will have a direct reporting line to the fund's board. We are adopting these requirements substantially as proposed, with minor changes to clarify the requirements and conform to changes in other rule provisions. • Exception for limited derivatives users. The rule will except limited derivatives users from the derivatives risk management program requirement, the VaR-based limit on fund leverage risk, and the related board oversight and reporting requirements, provided that the fund adopts and implements written policies and procedures reasonably designed to manage the fund's derivatives risks. This exception will be available to a fund that limits its derivatives exposure to 10% of its net assets. In a change from the proposal, in calculating derivatives exposure to determine eligibility for the exception, a fund will be permitted to exclude derivatives transactions that it uses to hedge certain currency and interest rate risks. The exception also includes, in a change from the proposal, provisions for a fund with derivatives exposure that exceeds the 10% threshold. If the fund does not reduce its exposure within five business days, the fund's adviser must provide a written report to the fund's board informing it whether the adviser intends to reduce the exposure promptly, but within no more than 30 days, or put in place a derivatives risk management program and comply with the VaR-based limit on fund leverage risk as soon as reasonably practicable. • Alternative requirements for certain leveraged/inverse funds. After considering comments on the proposed sales practices rules, we have determined not to adopt them at this time. Leveraged/inverse funds instead will generally be subject to rule 18f-4 like other funds, including the requirement to comply with the VaR-based limit on fund leverage risk. This will effectively limit leveraged/inverse funds' targeted daily return to 200% of the return (or inverse of the return) of the fund's underlying index. The final rule also provides an exception from the VaR-based limit for leveraged/inverse funds in operation as of October 28, 2020 that seek an investment return above 200% of the return (or inverse of the return) of the fund's underlying index and satisfy certain conditions and the other requirements of rule 18f-4. The conditions to this exception are designed to allow these funds to continue to operate in their current form, but prohibit them from changing their index or increasing the amount of their leveraged or inverse market exposure. We believe that the enhanced standard of conduct for broker-dealers under Regulation Best Interest and the fiduciary obligations of registered investment advisers help address some of the sales practice concerns that leveraged/inverse funds and listed commodity pools following the same strategies may raise, in the context of recommended transactions and transactions occurring in an advisory relationship. To help ensure that our regulatory framework addresses all potential investor protection concerns associated with complex financial products, including those that use leveraged/inverse strategies and those that are available to investors who do not receive either recommendations subject to Regulation Best Interest or investment advice subject to an adviser's fiduciary obligation, we have directed the staff to begin a review. This review will assess the effectiveness of the existing regulatory requirements in protecting investors—particularly those with self-directed accounts—who invest in leveraged/inverse products and other complex investment products. • Recordkeeping. The final rule will require a fund to adhere to recordkeeping requirements that are designed to provide the Commission, and the fund's board of directors and compliance personnel, the ability to evaluate the fund's compliance with the rule's requirements. We are adopting these provisions largely as proposed, with certain conforming changes in light of modifications to other aspects of the final rule. Final rule 18f-4 also will 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. Under the final rule, a fund is 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. In a change from the proposal, a fund also will be permitted to enter into these transactions by electing to treat them as derivatives transactions under the final rule. This alternative approach will permit funds to apply a consistent set of requirements to its derivatives transactions and any reverse repurchase agreements or similar financing transactions. A fund will be permitted to enter into unfunded commitment agreements under the final rule if the fund reasonably believes that its assets will allow the fund to meet its obligations under these agreements, as proposed. This approach recognizes that, while unfunded commitment agreements may 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. In a change from the proposal, the final rule also includes a new provision that will permit funds, as well as money market funds, to invest in securities on a when-issued or forward-settling basis, or with a non-standard settlement cycle, subject to conditions. Money market funds, for example, will continue to be able to invest in when-issued U.S. Treasury securities under this provision notwithstanding that these investments trade on a forward basis involving a temporary delay between the transaction's trade date and settlement date. The amendments we are adopting to Forms N-PORT, N-LIQUID, and N-CEN will require each fund to provide information regarding its compliance with rule 18f-4. This information includes: (1) Certain identifying information about the fund ( e.g., identifying the provisions of rule 18f-4 that the fund is relying on to engage in derivatives transactions and the other transactions that the rule addresses); (2) as applicable, information regarding a fund's VaR and designated reference portfolio, and VaR backtesting results; (3) VaR test breaches, to be reported to the Commission in a non-public current report; and (4) for a fund that is operating as a limited derivatives user, information about the fund's derivatives exposure and the number of business days that its derivatives exposure exceeded 10% of its net assets. We are adopting these amendments largely as proposed, with certain modifications, such as streamlining the VaR information and exposure information that certain funds would provide, and requiring additional information about funds operating as limited derivatives users that exceed the 10% threshold. We also are making certain of these data elements non-public in response to comments. In connection with our adoption of rule 18f-4, we are also adopting 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 When the Commission adopted rule 6c-11, the rule prohibited leveraged/inverse ETFs from relying on the rule, 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, and in connection with the adoption of rule 18f-4, we are modifying this provision to permit leveraged/inverse ETFs to rely on rule 6c-11 if they comply with all applicable provisions of rule 18f-4. This will permit new leveraged/inverse funds that can satisfy the requirements of rule 18f-4 to come to market under rule 6c-11 without first being required to receive a separate ETF exemptive order. We also are rescinding exemptive orders the Commission previously issued to sponsors of leveraged/inverse funds permitting these funds to operate as ETFs, as these orders will be superseded. Amending rule 6c-11 and rescinding these exemptive orders will help promote a more 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 rule 18f-4. 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. Finally, in view of the updated, comprehensive approach to the regulation of funds' derivative use that the final rules provide, we are rescinding Release 10666. In addition, staff in the Division of Investment Management has reviewed certain of its no-action letters and other guidance addressing derivatives transactions and other transactions covered by rule 18f-4 to determine which letters and staff guidance, or portions thereof, should be withdrawn in connection with our adoption of the final rules. As discussed in section II.L below, some of these letters and staff guidance, or portions thereof, are moot, superseded, or otherwise inconsistent with the final rule and, therefore, will be withdrawn. We are providing funds an eighteen-month transition period while they prepare to come into compliance with rule 18f-4 before Release 10666 is withdrawn. II. Discussion A. Scope of Rule 18f-4 As proposed, the rule will apply to a “fund,” defined as a registered open-end or closed-end company or a BDC, including any separate series thereof. 78 The rule will therefore apply to mutual funds, ETFs, registered closed-end funds, and BDCs. 79 The rule's definition of a “fund” excludes money market funds regulated under rule 2a-7 under the Investment Company Act (“money market funds”), as proposed. 80 78 See rule 18f-4(a); see also proposed rule 18f-4(a). 79 Section 18 of the Investment Company Act applies only to open-end or closed-end companies ( i.e., management investment companies). Rule 18f-4 therefore will not apply to unit investment trusts (“UITs”) because they are not management investment companies. 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. 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 footnote 76, at n.42. 80 See rule 18f-4(a); see also proposed rule 18f-4(a). Commenters generally supported the scope of funds that are permitted to rely on the proposed rule. 81 Some commenters also specifically expressed support for excluding money market funds from the full scope of rule 18f-4 because money market funds do not typically engage in derivatives transactions. 82 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, money market funds do not enter into derivatives such as futures, swaps, and options. These instruments are not eligible securities in which money market funds are permitted to invest under rule 2a-7. We also believe that entering into these transactions would be inconsistent with a money market fund maintaining a stable share price or limiting principal volatility, especially if the money market fund were to use derivatives to leverage the fund's portfolio. 83 We therefore continue to believe that generally excluding money market funds from the full scope of the rule is appropriate. As discussed in more detail below, we are, however, including a targeted provision in the final rule that permits funds (including money market funds) to continue to invest in securities on a when-issued or forward-settling basis, or with a non-standard settlement cycle. 81 See, e.g., Dechert Comment Letter I; Comment Letter of Fidelity Investments (Mar. 24, 2020) (“Fidelity Comment Letter”); Comment Letter of T. Rowe Price (Apr. 14, 2020) (“T. Rowe Price Comment Letter”). 82 See, e.g., Fidelity Comment Letter; J.P. Morgan Comment Letter; SIFMA AMG Comment Letter; Comment Letter of Stephen A. Keen (Aug. 11, 2020) (“Keen Comment Letter”). 83 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 nevertheless seek to minimize principal volatility given that, as “commenters pointed out[,] investors in floating NAV funds will continue to expect a relatively stable NAV”). The final rule will permit funds to enter into derivatives transactions, subject to the rule's conditions. The rule defines 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; (2) any short sale borrowing; and (3) reverse repurchase agreements and similar financing transactions, for those funds that choose to treat these transactions as derivatives transactions under the rule. 84 84 See rule 18f-4(a); see also infra section II.H (discussing the provision in the final rule that provides an option for funds to manage reverse repurchase agreements and similar financing transactions under the asset coverage provisions of section 18 applicable to bank borrowings. If a fund does not choose to use this option, then reverse repurchase agreements and similar financing transactions would instead be derivatives transactions under the final rule.). The first prong of this definition is designed to describe those derivatives transactions that involve the issuance of a senior security, because they involve a contractual future payment obligation. 85 This prong of the definition incorporates a list of derivatives instruments that, together with “any similar instrument,” covers the types of derivatives that funds currently use and that section 18 would restrict because they impose on the fund a contractual obligation (or potential obligation) to make payments or deliver assets to the fund's counterparty. This list is designed to be sufficiently comprehensive to include derivatives that may be developed in the future. 85 See supra footnotes 28, 36 and accompanying text (together, observing 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 footnotes 86-87 (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 rule, must involve a future payment obligation. 86 This aspect of the definition recognizes that not every derivatives instrument imposes such an obligation, and therefore not every derivatives instrument will involve the issuance of a senior security. 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 but generally will not have any subsequent obligation to deliver cash or assets to the counterparty unless the fund chooses to exercise the option. 87 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 it will not require the fund to make any payments in the future. 88 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. 89 86 Under the 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.” 87 See 2015 Proposing Release, supra footnote 1, at paragraph accompanying nn.82-83. A few commenters suggested we address these purchased options specifically in rule 18f-4. See Comment Letter of Guggenheim Investments (Apr. 27, 2020) (“Guggenheim Comment Letter”); see also CBOE Comment Letter. We do not believe that further revisions to address these comments are necessary, however, because rule 18f-4's definition of a derivatives transaction is limited to derivatives instruments that involve a future payment obligation. 88 See 2015 Proposing Release, supra footnote 1, at paragraph accompanying n.82. 89 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). 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.I (discussing the characterization of “unfunded commitment” agreements for purposes of the rule, and as senior securities). A few commenters suggested that the Commission further revise the definition of a derivatives transaction to address situations where several derivatives instruments considered together, or a derivatives instrument and a securities position, in commenters' view did not involve the same risks as the derivatives transactions considered in isolation. For example, commenters urged that the definition exclude purchased option spread transactions because commenters asserted that the options together would not create a fund payment obligation that will exceed the payment potential of a purchased option involved in the transaction. 90 Commenters also suggested that the scope of the rule should exclude written covered calls, which involves a fund selling a call option where the fund agrees to deliver an asset already held by the fund if the option is exercised. 91 Because the fund holds the asset underlying the option, commenters asserted that the leverage risk of the option is eliminated. 92 90 See Comment Letter of CBOE Vest Financial LLC (Mar. 24, 2020) (“CBOE Vest Comment Letter”) (stating that a “purchased-options-spread position is entered by buying and selling an equal number of options of the same class ( i.e., options on the same underlying security), same options style ( i.e., either only exercisable at expiration or exercisable at times prior to expiry), and same expiration date, but with different strike prices”); see also Guggenheim Comment Letter. 91 See Comment Letter of Refinitiv US SEF LLC (Mar. 24, 2020) (“Refinitiv Comment Letter”); see also CBOE Vest Comment Letter (stating that “[a]lthough sold call options in isolation do expose the fund to a potential future obligation, that obligation will be entirely offset by the position in the underlying security”). 92 Refinitiv Comment Letter. Each of these examples, however, involves derivatives transactions that involve future payment obligations. We do not believe it would be appropriate or feasible to identify in rule 18f-4 combinations of derivatives instruments or other investments that, together, may involve less risk or different risks than the constituent transactions considered in isolation. We believe these kinds of relationships are appropriate to assess as part of a fund's derivatives risk management, but do not support excluding the kinds of transactions commenters identified from the rule's derivatives transaction definition. Additionally, a commenter urged the Commission to exclude certain foreign exchange derivatives instruments from the scope of transactions covered by the rule because the commenter believes that these instruments have limited exposure to market fluctuations and do not introduce section 18 leverage concerns. 93 However, funds may use foreign currency derivatives to take speculative positions on the relationships between different currencies just as funds may use derivatives to obtain exposures to other rates or metrics or changes in asset prices. 94 Therefore, we do not believe that there is a principled basis to treat foreign currency derivatives, such as foreign currency forwards and swaps, differently than other derivatives that involve a potential future payment obligation and are encompassed within the rule's “derivatives transaction” definition. 93 Id. (requesting that FX forwards, FX swaps, non-deliverable forwards involving FX, and FX options be excluded from the scope of the rule). 94 See 2015 Proposing Release, supra footnote 1, at paragraph accompanying n.239. Short sale borrowings are included in the second prong of the rule's 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 rule therefore treats short sale borrowings and derivatives instruments identically for purposes of funds' reliance on the rule's exemption. 95 Commenters did not address the treatment of short sale borrowings in the proposal's definition of “derivatives transactions,” and we are adopting it as proposed. 95 See rule 18f-4(b). The third prong of the definition reflects the final rule's treatment of reverse repurchase agreements and similar financing transactions. In a change from the proposal and as discussed further in section II.H below, a fund may either elect to treat reverse repurchase agreements and similar financing transactions as derivatives transactions under the rule or elect to subject such transactions to the asset coverage requirements of section 18. 96 The final rule's definition of “derivatives transaction” therefore includes a conforming change to reflect the final rule's treatment of these transactions. 96 See rule 18f-4(d); see also infra section II.H. Similarly, because rule 18f-4 addresses funds' use of unfunded commitment agreements separately from funds' use of derivatives, the definition of “derivatives transaction” does not include unfunded commitment agreements. See infra section II.J. The final rule, like the proposed rule, does not specifically list firm or standby commitment agreements in the definition of “derivatives transaction.” However, as the Proposing Release discussed, 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. 97 Similarly, the Commission has previously stated that a standby commitment agreement is economically equivalent to the issuance of a put option. 98 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. 99 97 Indeed, the Commission stated in Release 10666 that a firm commitment is known by other names such as a “forward contract.” See Release 10666, supra footnote 14, at nn.10-12 and accompanying text. 98 See id. at “Standby Commitment Agreements.” 99 For example, a fund that enters into a binding commitment to make a loan or purchase a note upon demand by the borrower, with stated principal and term and a fixed interest rate, would appear to have entered into an agreement that is similar to a standby commitment agreement or a written put option. This transaction would expose the fund to investment risk during the life of the transaction because the value of the fund's commitment agreement will change as interest rates change. Such an agreement thus would fall within the rule's definition of “derivatives transaction.” Several commenters urged the Commission to exclude certain firm and standby commitment agreements from the scope of the rule or to subject them to different conditions. 100 Many commenters urged that money market funds, in particular, engage in these transactions and urged that the Commission clearly permit money market funds to continue to do so. 101 In particular, these commenters identified transactions that trade on a when-issued basis, or that involve a settlement cycle that exceeds the “T+2” settlement cycle applicable to most securities transactions but that nonetheless settle within a short period of time. Commenters urged that these transactions limit the ability of funds to leverage their portfolios where the delay between trade date and settlement date is short, this delay is a result of the manner in which the securities are customarily issued or traded, and the fund intends to physically settle the transaction. 102 Commenters explained that funds engage in these transactions to purchase the underlying securities rather than as a means of obtaining an unfunded investment exposure to the underlying security that may be effectively used by funds to leverage their portfolios. 103 Further, commenters stated that the use of when-issued U.S. Treasury securities transactions is an important tool to enhance transparency and pricing stability in the U.S. Treasury market, and subjecting the use of these transactions to the rule could diminish their use and negatively impact the short-term fixed income market. 104 100 See, e.g., ICI Comment Letter; Invesco Comment Letter; SIFMA AMG Comment Letter. 101 See, e.g., ICI Comment Letter; Fidelity Comment Letter; T. Rowe Price Comment Letter. 102 See SIFMA AMG Comment Letter; see also Keen Comment Letter. 103 See, e.g., ICI Comment Letter; Invesco Comment Letter; SIFMA AMG Comment Letter. 104 See SIFMA AMG Comment Letter. Investments in when-issued securities enable market participants to contract for the purchase and sale of a new security before the security has been issued. The most common type of when-issued trading involves U.S. Treasury securities. For example, on Monday, October 19th, the U.S. Treasury may announce that it will hold an auction of a specified quantity of new U.S. Treasury bills on Wednesday, October 21st with the securities being issued on Monday, October 25th. Following the announcement, market participants may begin to trade the new security on a when-issued basis. Settlement of the securities purchased on a when-issued basis as well as those purchased at auction will occur on the issue date. We agree with commenters that the potential for leveraging is limited in these transactions, particularly because of the short period of time between trade date and settlement date and the fund's intention to physically settle the transaction rather than to engage in an offsetting transaction. Accordingly, we have included a provision in the final rule that allows funds to invest in securities on a when-issued or forward-settling basis, or with a non-standard settlement cycle, and the transaction will be deemed not to involve a senior security (“delayed-settlement securities provision”). 105 While the final rule generally excludes money market funds from its scope, the scope of the rule's delayed-settlement securities provision includes money market funds, as well as the other funds to which the rule applies. This provision is subject to two conditions. 105 Rule 18f-4(f). First, as some commenters suggested, the fund must intend to settle the transaction physically. 106 Physical settlement may occur electronically through the Depository Trust Company or other electronic platforms. This condition distinguishes these investments from bond forwards and other derivatives transactions where a fund commonly intends to execute an offsetting transaction rather than to actually purchase (or sell) the security. The provision is designed to permit funds to invest in the underlying security rather than to obtain unfunded investment exposure to the underlying security beyond the limited period of time between trade and settlement date. 107 106 SIFMA AMG Comment Letter; Fidelity Comment Letter. The discussion in this release regarding this condition and any future interpretation of this condition do not apply to the exclusion from the swap and security-based swap definitions for security forwards. See section 1a(47)(B)(ii) of the Commodity Exchange Act, 7 U.S.C. 1a(47)(B)(ii) (excluding from the swap and security-based swap definitions “any sale of a . . . security for deferred shipment or delivery, so long as the transaction is intended to be physically settled”). 107 Commenters suggested that the final rule also require that these transactions involve a defined delivery obligation, to distinguish these investments from the kinds of instruments included in the derivatives transaction definition. See Invesco Comment Letter; ICI Comment Letter; SIFMA AMG Comment Letter. Many derivatives transactions, however, such as forwards and futures contracts, involve a delivery obligation fixed at trade date. We therefore do not believe this condition is useful to distinguish when-issued and similar securities, and believe that the requirement that the fund intend to physically settle the transaction will serve to distinguish a fund's intent to invest in the underlying securities from a fund engaging in derivatives transactions. Second, the transactions must settle within 35 days. Commenters addressing the short-term nature of these transactions offered differing suggestions for the permissible length of their settlement period. 108 Some commenters simply urged that we permit transactions with a “relatively short” delay between trade date and settlement date without specifying a particular number of days, while other commenters suggested a more precise 35-day period between trade date and settlement for a threshold. 109 The final rule's 35-day settlement threshold reflects our view that securities that trade on a when-issued or forward-settling basis, or with a non-standard settlement cycle that have a settlement cycle of 35 days or less, more closely resemble regular-way securities transactions that are not covered by the rule rather than forwards and similar transactions that involve a greater potential for leveraging. 110 108 See, e.g., Invesco Comment Letter; ICI Comment Letter; Fidelity Comment Letter; SIFMA AMG Comment Letter. 109 See, e.g., Invesco Comment Letter; ICI Comment Letter; Fidelity Comment Letter; SIFMA AMG Comment Letter; Keen Comment Letter. 110 As one commenter observed, this 35-day period is consistent with the threshold under Regulation T, which provides that a transaction that settles in T+35 or sooner and has an extended settlement date due to the mechanics of the transaction, is not an extension of credit under the rule. See SIFMA AMG Comment Letter; see also Regulation T, Section 220.8(b)(2). We are not subjecting these transactions to an asset segregation requirement, as some commenters suggested, because we believe the conditions discussed above render that additional requirement unnecessary. 111 Because funds will be required to intend to settle these transactions physically, funds must have sufficient assets to meet that obligation regardless of any separate asset segregation requirement in the final rule. 111 See, e.g., SIFMA AMG Comment Letter; Dechert Comment Letter I; Keen Comment Letter. Commenters separately recommended that we provide an asset segregation approach for firm and standby commitment agreements generally. 112 For example, some commenters recommended a specific provision to address securities transactions that settle within a short period of time, similar to the delayed-settlement securities provision in the final rule. 113 These commenters also urged that the Commission should permit funds the option of adopting an alternative asset segregation regime for when-issued securities, to-be-announced investments (“TBAs”), dollar rolls, and bond forwards, that have characteristics that would make them ineligible for such a provision, such as delays between trade date and settlement date that do not settle within a short period of time. 114 Commenters asserted that any risks associated with these firm and standby commitment agreements can be appropriately managed by requiring funds to maintain assets sufficient to cover the obligations of the transactions, similar to the approach the Commission proposed for these transactions in 2015. 115 112 See, e.g., Dechert Comment Letter I; ICI Comment Letter; Comment Letter of Calamos Investments LLC (May 1, 2020) (“Calamos Comment Letter”). 113 ICI Comment Letter; Calamos Comment Letter; Dechert Comment Letter I. 114 See ICI Comment Letter; Calamos Comment Letter; see also Dechert Comment Letter I (urging that, for purposes of the limited derivatives user exception, firm and standby commitment agreements should be excluded from a fund's derivatives exposure threshold if a fund segregates liquid assets sufficient to cover such obligations). 115 See ICI Comment Letter; see also 2015 Proposing Release supra footnote 1, at section III.C. Where these firm and standby commitment agreements and similar transactions do not satisfy the conditions in the delayed-settlement securities provision, we do not see a basis to differentiate the transactions from other instruments included in the derivatives transactions definition. For example, this suggested approach would treat a bond forward differently than an equity or currency forward. Moreover, we understand that funds typically settle forward contracts in cash, by an offsetting transaction, or by “rolling” the exposure via subsequent transactions. Therefore, bond forward contracts, and other transactions identified by commenters, could involve many of the same kinds of risks as other transactions that are considered derivatives transactions under the rule, such as futures contracts. We believe it is appropriate for the final rule to provide a consistent set of requirements for funds engaging in transactions that present the same kinds of risks rather than providing separate requirements for economically similar transactions. The delayed-settlement securities provision also applies to money market funds. Commenters urged that the Commission permit money market funds to continue to invest in eligible securities under rule 2a-7, as they do today, even where those investments may involve when-issued securities or securities with a forward-settling convention or a non-standard settlement cycle. 116 Money market funds today segregate assets in connection with these transactions under Release 10666, which we are rescinding. The delayed-settlement securities provision is designed to address commenters' concerns that the proposed rule would have resulted in uncertainty for money market funds that invest in certain when-issued securities or securities with a forward-settling convention or a non-standard settlement cycle. The final rule permits money market funds to continue to engage in these and the other types of transactions covered by the delayed-settlement securities provision. 117 We have not, however, modified the rule to provide an exemption in rule 18f-4 for any eligible security as defined in rule 2a-7, as some commenters recommended. 118 Rule 2a-7 imposes protective conditions on money market funds tailored to these funds' operations, including requirements for a money market fund to maintain a significant amount of liquid assets and invest in assets that meet the rule's credit quality, maturity, and diversification requirements. Rule 2a-7 is not, however, designed to address senior security concerns and its conditions alone do not provide a basis for an exemption from section 18. 116 See, e.g., T. Rowe Price Comment Letter; Vanguard Comment Letter; ICI Comment Letter; Dechert Comment Letter I. Several commenters expressed particular concern that the proposed exclusion of money market funds from the scope of the rule would result in uncertainty with respect to the ability of money market funds to continue to invest in when-issued U.S. Treasury securities. See, e.g., ICI Comment Letter; Fidelity Comment Letter; T. Rowe Price Comment Letter. 117 The final rule provides that these transactions are not senior securities, but a money market fund must of course also comply with rule 2a-7 in connection with the investments. 118 See, e.g., BlackRock Comment Letter; Keen Comment Letter; T. Rowe Price Comment Letter; Vanguard Comment Letter. In addition, although a fund or money market fund may invest in TBAs under the delayed-settlement securities provision, we are not excluding TBAs from the scope of the rule generally, as one commenter recommended. 119 The TBA market facilitates the trading of forward-settling mortgage-backed securities by allowing participants to enter into a contract agreeing to purchase mortgage-backed securities issued by Fannie Mae, Freddie Mac and Ginnie Mae at a later date, typically, two or three months from the transaction date. 120 The commenter urged that the Commission reconsider the inclusion of TBAs within the rule's derivatives transaction definition to avoid the possibility of a chilling effect on the market and because these transactions may be subject to margin requirements under FINRA rules. 121 The other commenters who addressed TBAs, however, recommended that we clarify that TBAs are derivatives transactions under the rule. 122 119 See Fidelity Comment Letter. 120 See Comment Letter of Putnam Investments (Apr. 1, 2020) (“Putnam Comment Letter”) (stating that “[i]n a TBA trade, the parties agree on six parameters of the securities to be delivered (issuer, maturity, coupon, price, par amount and settlement date), but the actual identity of the securities to be delivered at settlement is not specified [until 48 hours prior to the settlement]”). 121 See Fidelity Comment Letter. Under amended FINRA Rule 4210, effective March 25, 2021, brokers will be required to collect mark-to-market margin from counterparties engaging in TBA transactions. 122 See, e.g., Putnam Comment Letter; SIFMA AMG Comment Letter; ICI Comment Letter; cf. Invesco Comment Letter (recommending we permit certain short-term when-issued or forward-settling transactions and observing that the settlement periods for these transactions “are still relatively short compared to TBAs and other forward contracts captured by the Proposed Rule's derivatives transaction definition”). TBAs and dollar rolls are included in the final rule's derivatives transaction definition because we believe they are forward contracts or “similar instruments.” 123 We recognize the importance of TBAs to the market for forward-settling mortgage-backed securities and the importance of the FINRA margin requirements to the TBA market. However, TBAs, like other forwards and similar instruments can be used to leverage a fund's portfolio by permitting funds to take unfunded positions in the underlying reference assets and involve a potential future payment obligation. The investor protection concerns the final rule is designed to address do not turn on the nature of a derivatives transaction's underlying reference assets. We do not see a basis to differentiate TBAs for purposes of the final rule from other types of transactions included in the derivatives transaction definition, where the fund's TBA investment does not satisfy the conditions of the delayed-settlement securities provision. 123 See, e.g., SIFMA AMG Comment Letter. Some of the commenters who sought clarity that TBAs would be derivatives transactions under the final rule also argued that TBAs are not “similar financing transactions” that would be treated like reverse repurchase agreements under the final rule. We agree that TBAs are not reverse repurchase agreements or “similar financing transactions” under the rule. B. Derivatives Risk Management Program A fund should manage its derivatives 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. 124 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. A fund's program would be part of an adviser's overall management of portfolio risk and would complement—but would not replace—a fund's other risk management activities, such as a fund's liquidity risk management program adopted under rule 22e-4. 124 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”). As proposed, under the program requirement we are adopting, a fund will have to adopt and implement a written derivatives risk management program that includes policies and procedures reasonably designed to manage the fund's derivatives risks. A derivatives risk manager whom the fund's board approves will be responsible for administering the program. A fund's derivatives risk management program should take into 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. 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. A fund's program must include the following elements: • Program administration. As proposed, the program will have to be administered by an officer or officers of the fund's investment adviser serving as the fund's derivatives risk manager. • Risk identification and assessment. As proposed, the program will have to provide for the identification and assessment of a fund's derivatives risks, which must take into account the fund's derivatives transactions and other investments. • Risk guidelines. As proposed, the program will 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 relat [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%3A2020-24781. Public record. Not legal advice.