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On October 28, 2020, the Securities and Exchange Commission (the “Commission”) adopted Rule 18f-4 (the “Rule”) under the Investment Company Act of 1940 (the “1940 Act”). The Rule is designed to provide an updated and comprehensive approach to the regulation of derivatives use by registered investment companies and business development companies. Notwithstanding Section 18 restrictions, the Rule permits funds to enter into derivatives transactions subject to certain conditions.

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Section 18 of the 1940 Act limits the ability of mutual funds, exchange-traded funds, registered closed-end funds, and business development companies (collectively, “funds”) to obtain leverage which includes limiting a fund’s ability to engage in transactions that involve potential future payment obligations. While leverage is commonly viewed as purchasing securities with borrowed funds, derivatives, such as forwards, futures, swaps, and written options, can also create future payment obligations.

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Until recently, a patchwork system of Commission and staff guidance allowed funds to invest in derivatives. In an effort to create a consistent regulatory framework, the Commission proposed Rule 18f-4 on November 25, 2019. In its proposal, the Commission noted that inconsistent industry practices “may not address investor protection concerns that underlie Section 18’s limitation on funds’ issuance of senior securities.” Under the proposed rule, funds could enter into derivatives transactions notwithstanding Section 18 limitations. In order to address investor protection concerns, the proposed rule came subject to certain conditions, such as adopting a derivatives risk management program and limiting the amount of leverage-related risk that funds could obtain.

The Rule permits funds to enter into derivative transactions, meaning (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. The list of derivative instruments was designed to be sufficiently comprehensive to include derivatives that may be developed in the future. Also, the derivatives instrument definition provides that a derivatives instrument, for purposes of the Rule, must involve a future payment obligation. 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.

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, the Rule requires funds that are users of derivatives (other than limited derivatives users) to have a formalized risk management program with certain specified elements (a “program”). A fund must adopt and implement a written derivatives risk management program that includes policies and procedures reasonably designed to manage the fund’s derivatives risks. A fund’s board will be required to approve a derivatives risk manager, who will be responsible for administering the program. A fund’s program must include the following elements:

A fund’s board of directors must approve the designation of the fund’s derivatives risk manager and the derivatives risk manager must provide regular written reports to the board regarding the program’s implementation, effectiveness, exceedances of the fund’s guidelines, and the results of the fund’s stress testing.

When engaging in derivatives transactions, a fund must comply with a Value at Risk (“VaR”) based limit on leverage risk. A fund can use an index that meets certain requirements or its own investments, 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 will be required to comply with an absolute VaR test. A fund will satisfy the relative VaR test if its portfolio VaR does not exceed 200% of the VaR of its designated reference portfolio and will satisfy the absolute VaR test if its portfolio VaR does not exceed 20% of the value of the fund’s net assets.

VaR is an estimate of an instrument’s or portfolio’s potential losses over a given time horizon and at a specified confidence. VaR is not itself a leverage measure. A fund must calculate the VaR of its portfolio and compare it to the VaR of a “designated reference portfolio.” A fund must comply with the relative VaR test unless 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, taking into account the fund’s investments, investment objectives, and strategy.

The relative VaR test requires a fund to calculate the VaR of the fund’s portfolio and compare it to the VaR of a designated reference portfolio. A fund is permitted to use either an index that meets certain requirements (a “designated index”) or the fund’s own investments, excluding derivatives transactions (the fund’s “securities portfolio”), as its reference portfolio. A fund’s designated reference portfolio is designed to create a baseline VaR that functions as the VaR of a fund’s unleveraged portfolio. To the extent a fund entered into derivatives to leverage its portfolio, the relative VaR test is designed to identify this leveraging effect. If a fund is using derivatives and its VaR exceeds that of the designated reference portfolio, this difference may be attributable to leverage risk.

The Rule requires that if a fund uses a model to determine its VaR, the model must meet certain requirements such as:

Step 2: Determine the Fund’s Designated Reference Portfolio

Under the Rule, a fund can use a designated index or, if the fund is actively managed, it can utilize its securities portfolio.

Designated Index. A designated index is an unleveraged index, approved by the derivatives risk manager for purposes of the relative VaR test, that reflects the markets or asset classes in which the fund invests. The designated index cannot be an index that is administered by an organization that is an affiliated person of the fund, its adviser, or principal underwriter, or created at the request of the fund or its investment adviser, unless the index is widely recognized and used. However, a designated index does not have to a broad-based securities index or an additional index as those terms are defined on Form N-1A and Form N-2, respectively. A designated index must meet the following requirements: (1) must be unleveraged, (2) reflects the markets or asset classes in which the fund invests, and (3) must be widely recognized and used and must not be an index administered by an organization that is an affiliated person of the fund, its adviser, or its principal underwriter, or created at the request of the fund or its adviser.

Securities Portfolio (Actively Managed Funds Only). An actively managed fund can use its securities portfolio as the reference portfolio for the relative VaR test. A fund’s securities portfolio is the fund’s portfolio of securities and other investments, excluding any derivatives transactions. The securities portfolio must be approved by the derivatives risk manager for purposes of the relative VaR test and must reflect the markets or asset classes in which the fund invests (i.e., the markets or asset classes in which the fund invests directly through securities and other investments and indirectly through derivatives transactions).

Step 3: Compare the Fund’s VaR to the Fund’s Designated Reference Portfolio

200% Limit. A fund’s VaR must not exceed 200% of the VaR of the fund’s designated reference portfolio, unless the fund is a closed-end fund that has then-outstanding shares of a preferred stock issued to investors. A fund’s VaR may exceed 250% if it is a closed-end fund that has outstanding shares of a preferred stock issued to investors.

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 must comply with an absolute VaR test. A fund complying with the absolute VaR test will satisfy the test if its VaR does not exceed 20% of the value of the fund’s net assets, unless the fund is a closed-end fund that has then-outstanding preferred stock. For such closed-end funds, the VaR must not exceed 25% of the value of the fund’s net assets.

A fund must determine its compliance with the applicable VaR test at least once each business day. If a fund determines that it is not in compliance with its applicable VaR test, then the fund must come back into compliance promptly after such determination in a manner that is in the best interests of the fund and its shareholders. If the fund is not in compliance within five business days:

The Rule includes an exemption from the rule’s general requirements to adopt a derivatives risk management program, comply with the VaR-based limit on fund leverage risk, and comply with the related board oversight and reporting provisions (“derivatives risk management program”) for funds that use derivatives in a limited manner, if the fund:

Limited Derivatives Exposure. In order to identify funds that use derivatives in accordance with the 10% threshold, the Rule includes an expanded definition regarding what transactions must be included when a fund is contemplating its derivatives exposure. Derivatives exposure is defined as the sum of gross notional amounts of the fund’s derivatives instruments and, in the case of short sale borrowings, the value of any asset sold short, subject to certain adjustments for interest rate derivatives and options. The Rule also clarifies that derivatives instruments that do not involve future payment obligations are not included in a fund’s derivatives exposure. Additionally, a fund is permitted to exclude from its derivative exposure any closed-out positions. These positions must be closed out with the same counterparty and must result in no credit or market exposure to the fund.

Hedging Transactions. In the alternative, a fund may also qualify for exemption from certain requirements if it uses derivative transactions to hedge certain interest rate or currency hedging transactions directly matched to particular investments held by the fund, or the principal amount of borrowings by the fund.

Exceeding the Threshold. In contrast to the proposing release, the Rule puts in place more specific guidelines for funds that exceed the limited use threshold. If a fund’s derivatives exposure exceeds the 10% threshold for five business days (“temporary exceedance”), the adviser must notify the fund’s board of directors, via written report, whether it intends to:

Additionally, if a Fund exceeds the 10% threshold, beyond a temporary exceedance, the Fund must disclose the number of days it has exceeded the 10% threshold in the Fund’s next filing on Form N-PORT.

Generally, leveraged/inverse funds will be required to comply with the Rule. However, the Rule provides an exception for a fund that cannot comply with the VaR-based leveraged risk limit if the fund:

Rule 6c-11 previously excluded leveraged/inverse ETFs from the scope of ETFs permitted to rely on that rule. However, the SEC amended Rule 6c-11 to permit a leveraged/inverse ETF to rely on that rule under certain conditions. For example, a fund must comply with the requirements of the Rule. As a result of the amendment to Rule 6c-11, the exemptive orders previously provided to leveraged/inverse ETFs will be rescinded on the compliance date for Rule.

The Commission is providing a transition period to give funds sufficient time to comply with the provisions of the Rule and the related reporting requirements. Specifically, the Commission adopted a compliance date that is 18 months after the Rule is published in the Federal Register and will rescind Release 10666 on the effective date.

Andrew J. Davalla 614.469.3353 <a href="mailto:Andrew.Davalla@ThompsonHine.com">Andrew.Davalla@ThompsonHine.com</a>

Brian Doyle-Wenger 614.469.3294 <a href="mailto:Brian.Doyle-Wenger@ThompsonHine.com">Brian.Doyle-Wenger@ThompsonHine.com</a>

Tashia Love 614.469.3284 <a href="mailto:Latashia.Love@ThompsonHine.com">Latashia.Love@ThompsonHine.com</a>

Kaylie Ruff* Law Clerk 614.469.3225 <a href="mailto:Kaylie.Ruff@ThompsonHine.com">Kaylie.Ruff@ThompsonHine.com</a>

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SEC Adopts New Fund Derivatives Rule

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