On October 28, 2020, the SEC adopted, by a 3-2 vote, new rule 18f-4 under the Investment Company Act of 1940—a new rule governing the use of derivatives by mutual funds, closed-end funds, ETFs and business development companies (the Rule). As adopted, the Rule reflects changes to the SEC’s initial proposal in December 2015 and subsequent re-proposed rule in November 2019, and represents a comprehensive overhaul of the current regulatory framework governing the use of derivatives by registered investment companies.

The Rule 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 1940 Act, subject to the following conditions:

• Derivatives Risk Management Program. Funds—other than those that are limited derivatives users—must adopt and implement a written, multifaceted derivatives risk management program (DRMP) with, among other things, policies and procedures reasonably designed to manage the fund’s derivatives risks, and risk guidelines reflecting how the fund’s use of derivatives may affect its investment portfolio and overall risk profile. A fund’s derivatives risk manager (DRM) will be required to periodically review the DRMP, at least annually, to evaluate the program’s effectiveness and to reflect changes in risk over time.
• Limit on Fund Leverage Risk. A fund engaging in derivatives transactions must comply with an outer limit on leverage based on a comparison of the fund’s value at risk (VaR) to the VaR of a “designated reference portfolio” for that fund—referred to as the “relative VaR test.” In a change from the SEC’s November 2019 proposal, a designated reference portfolio may be either an index that meets certain requirements, or, for an actively managed fund, the fund’s own securities portfolio (excluding derivatives transactions). If—in considering the fund’s investments, investment objectives and strategy—the fund’s DRM 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” instead.
• Board Oversight. A fund’s board of directors must approve and oversee the fund’s DRM, who will be responsible for administering the fund’s DRMP. However, unlike the liquidity risk management program required by Rule 22e-4 under the 1940 Act, the board does not need to approve the DRMP itself. The fund’s DRM—who generally must be an officer of the adviser but not a portfolio manager (if a single individual serves as DRM)—is required to report to the fund’s board on the implementation and effectiveness of the DRMP and the results of the fund’s stress testing.

Other elements of the Rule and related amendments adopted by the SEC include:

• Exception for Limited Derivatives Users. Limited derivatives users will be excepted from the DRMP 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 risk. This exception is available to a fund that limits its derivatives exposure (excluding certain currency and interest rate hedging transactions) to 10 percent of its net assets. If such a fund exceeds the 10 percent threshold and 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 (1) reduce the exposure promptly, but within no more than 30 days of the breach, or (2) put in place a DRMP, comply with the VaR-based limit on fund leverage risk and comply with the related board oversight and reporting requirements, as soon as reasonably practicable (i.e., to no longer rely on the limited derivatives user exception).
• Flexibility for Treatment of Reverse Repurchase Agreements and Similar Financing Transactions. The Rule will permit funds to enter into reverse repurchase agreements and similar financing transactions, as well as “unfunded commitments” to make certain loans or investments by either meeting the asset coverage requirements under Section 18 of the 1940 Act or by electing to treat these transactions as derivatives transactions under the Rule.
• Ability for Funds to Invest in Securities on a Non-Standard Settlement Cycle. The Rule includes a new delayed-settlement securities provision that will permit funds, including money market funds (otherwise excluded from the Rule), to invest in securities on a when-issued or forward-settling basis, or with a non-standard settlement cycle, subject to conditions. If the conditions of the delayed-settlement securities provision are satisfied, these transactions are deemed not to involve a senior security.Reporting Amendments. In conjunction with the Rule’s adoption, the SEC adopted amendments to Form N-PORT, Form N-LIQUID (which will be renamed Form N-RN) and Form N-CEN to require funds to provide information regarding compliance with the Rule, including: (1) certain identifying information about the fund (e.g., identifying the provisions of the Rule that the fund is relying on to engage in derivatives transactions and other transactions addressed by the Rule); (2) as applicable, information about a fund’s VaR and designated reference portfolio, and VaR backtesting results; (3) VaR test breaches, to be reported to the SEC in a non-public current report; and (4) for a fund 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.
• Amendments to Rule 6c-11 under the 1940 Act for Leveraged/Inverse ETFs. The SEC also adopted amendments to Rule 6c-11 under the 1940 Act to permit new leveraged/inverse ETFs to come to market if they comply with all applicable provisions of the Rule, effectively limiting the market exposure of such new leveraged/inverse ETFs to 200 percent of the return of the relevant index. After considering comments, the SEC determined not to adopt the proposed sales practices rules for leveraged/inverse products or the proposed exception from the VaR-based limits that was predicated on those rules. Nevertheless, existing leveraged/inverse ETFs with market exposure exceeding 200 percent of the return of the relevant index will be permitted to operate subject to certain conditions.

Attorneys in Vedder Price’s Investment Services Group have prepared a more detailed summary of the Rule, which is available here.