On December 21, 2020, the SEC’s new exemptive Rule 18f-4, which sets forth the conditions under which mutual funds (other than money market funds), exchange-traded funds (ETFs), registered closed-end funds, and business development companies (collectively, “funds”) can enter into derivatives transactions, and related amendments were published in the Federal Register, establishing an effective date of February 21, 2021, and a compliance date of August 19, 2022. The transition period of 18 months is intended to give funds sufficient time to comply with the provisions of Rule 18f-4 and the related reporting requirements.
Rule 18f-4 under the Investment Company Act of 1940 (the “Act”) is 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 certain other transactions by replacing the existing SEC and staff guidance with a codified, consistent regulatory framework. In addition, the Rule establishes new fund reporting requirements designed to enhance the SEC’s ability to effectively oversee funds’ use of and compliance with Rule 18f-4 and to provide the SEC and the public additional information regarding funds’ use of derivatives.
The new Rule and related amendments permit funds to enter into derivatives transactions and certain other transactions, notwithstanding the restrictions under Sections 18 and 61 of the Act, provided that the funds comply with 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.
The conditions and other elements of the Rule include:
- A fund is generally required to adopt a written derivatives risk management program that includes risk identification and assessment, risk guidelines, stress testing, backtesting, internal reporting and escalation, and program review elements. The program must be administered by an officer or officers of the fund’s investment adviser, who will serve as the fund’s derivatives risk manager, as approved by the fund’s board. The rule requires a fund to reasonably segregate the functions of the program from its portfolio management and, accordingly, the rule prohibits the derivatives risk manager position from being filled by the fund’s portfolio manager, if a single person serves in this position.
- A fund is subject to an outer limit on the leverage-based risk that the fund may obtain based on a relative value-at-risk or “VaR” test that compares the fund’s VaR to the VaR of a “designated reference portfolio” for that fund. 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. The fund’s VaR generally is not permitted to exceed 200% (250% for a closed-end fund) of the VaR of the fund’s designated reference portfolio under the relative VaR test or 20% (25% for a closed-end fund) of the fund’s net assets under the absolute VaR test.
- A fund that limits its exposure to derivatives, excluding certain currency and interest rate hedging transactions, to 10% of net assets does not have to comply with the written derivatives risk management program or the VaR limits described above if the fund adopts and implements written policies and procedures reasonably designed to manage its derivatives risks.
- Leveraged and inverse funds are subject to all the provisions of Rule 18f-4, including the relative VaR test. Rule 18f-4 provides, however, an exception from the VaR test requirement for leveraged/inverse funds in operation as of October 28, 2020, that seek an investment result above 200% of the return (or inverse of the return) of an underlying index and satisfy certain additional conditions.
- A fund is permitted to enter into reverse repurchase agreements or similar financing transactions so long as it meets the relevant asset coverage requirements of Section 18. However, a fund has the option to treat reverse repurchase agreements or similar financing transactions as derivatives transactions, rather than including such transactions in the fund’s asset coverage calculations.
- A fund is permitted to enter into unfunded commitment agreements to make certain loans or investments if the fund reasonably believes, at the time it enters into such agreements, that it will have sufficient cash and cash equivalents to meet its obligations with respect to its unfunded commitment agreements. A fund should consider its unique facts and circumstances in forming such a reasonable belief.
- A fund, as well as a money market fund, is permitted 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 provided that fund intends to settle the transaction physically and the transactions must settle within 35 days.
In connection with the new Rule, Forms N-PORT and N-CEN will be amended to include new disclosures relating to a fund’s derivatives exposure. Additionally, Form N-LIQUID is being retitled “Form N-RN” and amended to require a fund that is not in compliance with the applicable VaR test within five business days after determining it is out of compliance to report this to the SEC on Form N-RN.
Lastly, effective August 19, 2022, the SEC is rescinding the 1979 General Statement of Policy (Release 10666) that provided guidance on how funds may engage in certain trading practices in light of Section 18’s restrictions. In addition, certain no-action letters and other guidance addressing funds’ use of derivatives and other transactions covered by Rule 18f-4 will be withdrawn.