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On November 25, 2019, the Securities and Exchange Commission (SEC) proposed rules to regulate the use of derivatives by mutual funds, exchange-traded funds, registered closed-end funds and business development companies (BDCs) (each a “fund,” and collectively, “funds”) and the sale of leveraged/inverse investment vehicles to retail investors. The SEC proposed a new rule to each the Investment Company Act of 1940, as amended (1940 Act), the Securities Exchange Act of 1934, as amended (Exchange Act) and the Advisers Act of 1940, as amended (Advisers Act).

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Re-proposed 1940 Act Rule 18f-4, if enacted, would provide investment companies and BDCs exemptive relief from the restrictions found in 1940 Act Sections 18 and 61, provided they comply with the rule’s conditions. The proposed rule would permit a fund to enter into derivatives transactions notwithstanding the prohibitions and restrictions on the issuance of senior securities found in the 1940 Act, so long as the fund adopts a written derivatives risk management program, implements oversight and reporting requirements, and limits leverage risk.

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A fund is not required to comply with Rule 18f-4 if it can comply with either of the following exceptions:

Written Derivatives Risk Management Program

Under the proposed rule, a fund would have to adopt and implement a written derivatives risk management program overseen by a derivatives risk manager, who would be approved by the fund’s board. The program would be required to include policies and procedures reasonably designed to manage the fund’s derivatives risks, including:

The proposed rule places requirements on a fund’s board and its derivatives risk manager:

The proposed rule would require a fund to comply with a VaR-based limit on fund leverage risk. The proposed limit would be based on a relative VaR test that compares the fund’s VaR to that of a “designated reference index,” as described below. If the fund’s derivatives risk manager cannot identify an appropriate designated reference index, the fund would then be required to comply with an absolute VaR test.

Relative VaR test. The fund must comply with the relative VaR test unless a designated reference index is unavailable. The proposed relative VaR test allows the fund to identify its leveraging risk by comparing its relative VaR to a baseline VaR that approximates the VaR of the fund’s unleveraged portfolio.

Designated reference index. The fund may satisfy the proposed relative VaR test so long as the VaR of its entire portfolio does not exceed 150% of the VaR of its designated reference index. The fund must disclose the designated reference index in its annual report. A designated reference index must meet the following requirements:

Absolute VaR test. The proposed rule allows the derivatives risk manager to utilize an absolute VaR test in lieu of the relative VaR test when he/she is unable to identify an appropriate designated reference index. Under the proposed absolute VaR test, the VaR of the fund’s portfolio cannot exceed 15% of the value of its net assets.

Choice of Model and Parameters for VaR Test

The proposed rule provides the following requirements for a fund’s VaR model:

The proposed rule would require a fund to determine its compliance with its applicable VaR test at least once each business day. If the fund is not in compliance with its VaR test, it must regain compliance promptly, which is considered to be no more than three business days. If the fund does not regain compliance within three business days:

The proposed rule provides exposure-based and currency hedging exceptions to the requirement to adopt a risk management program and comply with the VaR limitations. A fund is not required to adopt a risk management program if it either limits its derivative exposure to 10% of net assets or only uses derivatives to hedge certain currency risks.

Exposure-based exception. The fund would be permitted to rely upon a limited derivatives user exception if its derivatives exposure does not exceed 10% of its net assets. A fund’s derivatives exposure is measured as the sum of the notional amounts of the fund’s derivative instruments and with respect to short sale borrowings, the value of any asset sold short.

Currency hedging exception. Under this exception, the fund could use the currency derivatives user exception only if it limits its use of derivatives transaction to currency derivatives for hedging purposes.

Risk management. A fund relying upon either exception would still be required to manage the risks associated with its derivatives transactions by adopting and implementing policies and procedures reasonably designed to manage such risks. The policies and procedures must be tailored to appropriately address the fund’s use of derivatives.

Alternative Provisions for Leveraged/Inverse Funds

Under proposed Rule 18f-4, leveraged/inverse funds would exempt a fund from the proposed VaR-based leverage limit if it:

A leveraged/inverse fund that satisfies these conditions would be exempt from the VaR tests but would still be required to have a derivatives risk management program, board oversight and reporting, and to comply with the rule’s recordkeeping requirements.

In addition to re-proposing Rule 18f-4, the SEC announced that it was proposing two additional rules that regulate the use of inverse and leverage investment vehicles. Proposed Exchange Act Rule 15l-2 and proposed Advisers Act Rule 211h-1 (collectively, the “sales practice rules”), if enacted, would require a broker-dealer or adviser to exercise certain due diligence requirements before approving a retail client’s account to buy or sell shares of leveraged/inverse investment vehicles. Under the sales practice rules, a leveraged/inverse investment vehicle is defined as a registered investment company or an exchange-listed commodity pool or currency-based trust that seeks, 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. The proposed sales practice rules would require broker-dealers and advisers to conduct due diligence before accepting or placing retail investors’ trades in leveraged/inverse investment vehicles and to have a reasonable basis for believing that a retail investor has the financial knowledge and experience to be able to evaluate the risks of buying and selling leveraged/inverse investment vehicles. The sales practice rules require a broker-dealer or adviser to ascertain certain essential facts about a customer such as:

Based on its evaluation of the above information, the adviser or broker-dealer would be required to approve or deny the investor’s account for buying or selling shares of leveraged/inverse investment vehicles. If the adviser or broker-dealer approves the investment, such approval must be in writing and retained for six years.

The sales practice rules do not propose a bright-line test for determining whether the retail investor can evaluate the risks of buying or selling inverse/leveraged investment vehicles. Rather, the broker-dealer or adviser would base its determination on relevant facts and circumstances and information collected from the retail investor.

The SEC will accept comments for 60 days after the proposed rule is published in the Federal Register. In the meantime, funds should assess their use of derivatives and determine whether they will be able to comply with the proposed limitations. Further, funds, advisers and broker-dealers should consider adopting the policies and procedures necessary to comply with the proposed rules.

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

Owen J. Pinkerton 202.263.4144 <a href="mailto:Owen.Pinkerton@ThompsonHine.com">Owen.Pinkerton@ThompsonHine.com</a>

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

This advisory bulletin may be reproduced, in whole or in part, with the prior permission of Thompson Hine LLP and acknowledgment of its source and copyright. This publication is intended to inform clients about legal matters of current interest. It is not intended as legal advice. Readers should not act upon the information contained in it without professional counsel. This document may be considered attorney advertising in some jurisdictions.

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SEC Proposes Rules Governing Use of Derivatives

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