SEC Adopts Fund Derivatives Rule, Expands Leverage Limits, Forgoes Sales Practice Rules

A divided U.S. Securities and Exchange Commission (SEC) approved a long-awaited derivatives risk management rule that pulls back from some of the more controversial aspects of the original 2019 reproposal.   

The new rule, which applies to mutual funds (other than money market funds), exchange-traded funds (ETFs), and registered closed-end funds (including business development companies), replaces the current decades-old approach that Chairman Jay Clayton called “outdated and unclear.” The rule provides for an 18-month compliance transition period.

Summary. Highlights of new Rule 18f-4, adopted by a 3-2 vote, include the following:

• Funds that use derivatives in more than a limited manner must adopt a derivatives risk management program permitting principles-based tailoring of each fund’s derivative’s risk.
  • A fund’s program must address stress testing, backtesting, internal reporting and escalation, and program elements.
• The fund’s board must designate a derivatives risk manager, who must report to the board at least annually (or more frequently upon the board’s request) on the program’s implementation and effectiveness.
• Funds are subject to an outer limit on leverage based on value at risk, or VaR, of 200% of a designated benchmark index, or, alternatively, an absolute VaR test equal to 20% of the fund’s net assets (changed from 150%/10% as proposed).
• Funds that make limited use of derivatives are exempt from the VaR test limits. This exemption is available to a fund that limits its derivatives exposure (excluding certain currency and interest rate hedging transactions) to 10% of its net assets. These funds must adopt and implement written policies and procedures reasonably designed to manage the fund’s derivatives risks.
• Closed-end funds may be subject to higher limits.
• Funds will be subject to increased reporting and recordkeeping requirements related to derivatives use.

Sales practice rules. The SEC did not adopt controversial proposed sales practices rules, which would have required a broker-dealer or investment adviser to assess the ability of an investor in leveraged and inverse funds to understand the risks of investing in those funds. Instead, the SEC published a statement on leveraged and inverse funds and required the staff to further study complex derivatives products. The SEC received more than 6,000 comments on the proposed rules, all but 70 of which related to the sales practice rules.

Leveraged and inverse funds. The new rules will allow any fund to offer leveraged/inverse funds up to 200%. The SEC grandfathered existing “3X” leveraged/inverse funds that provide returns (that is, funds that seek to provide returns of three times the return of a benchmark index, positive or inverse), exempting them from the VaR requirements, but will not allow any new funds that use limits of more than 200%.  

Reverse repurchase transactions. The rule will allow funds to enter into reverse repurchase agreements and similar financing transactions so long as they meet the Section 18 asset coverage requirements. Funds have the option of treating reverse repos as derivatives transactions rather than including them in the fund’s asset coverage calculations.  

Unfunded commitment agreements. The rule will also allow funds to enter into unfunded commitment agreements if the fund reasonably believes, at the time of entering into this agreement, that it will have sufficient cash and cash equivalents to meet its obligations under the agreement.

Rescind and withdraw existing guidance. The SEC rescinded Release 10666, which since 1979 has provided guidance with respect to senior securities, effective in 18 months. The SEC also withdrew other guidance, including certain derivatives-related no-action letters.

Remediation for violations. The new rule eased limits on a fund’s ability to remediate violations and eliminated a proposed limitation on the ability of a fund to enter new derivatives transactions while out of compliance.  

Statement on Complex Financial Products. In a separate statement, the SEC expressed concern that retail investors “may not fully appreciate” how complex products, including leveraged and inverse funds, operate. The statement noted that the concerns are heightened during times of market stress, when these complex products may not perform as expected. The statement noted that self-directed investors may not have the required protections that they would have when they receive advice from broker-dealers and investment advisers.

In light of these concerns, the SEC directed its staff to review the effectiveness of the existing investor protection requirements, particularly with respect to self-directed accounts that invest in leveraged and inverse funds.  

Dissenting Commissioners. The two dissenting Commissioners, Allison Herren Lee and Caroline A. Crenshaw, objected to the final rule generally because they believe it did not go far enough to address investor protection concerns. Commissioner Crenshaw said she believes that the rule “fails to provide a meaningful limit on registered funds’ ability to take on leverage.” Commissioner Lee said that while she supported the rule as proposed, the final rule “abandons much of what made it a reasonable balanced approach.” 

The final rule can be found here. 

We will publish a more detailed alert after evaluating the adopting release.