SEC Proposes Requirements For Funds' Use Of Derivatives And Other Financial Transactions

If adopted, the proposed requirements would significantly alter funds' ability to enter into derivatives and other financial transactions, present new operational challenges, expand reporting requirements, and impose new and enhanced oversight responsibilities on funds' boards of directors.

On December 11, the US Securities and Exchange Commission (SEC) voted three-to-one in favor of proposing a new rule—Rule 18f-4 under the Investment Company Act of 1940 (1940 Act)—that would significantly change the way the SEC regulates the use of derivatives and other financial transactions by registered investment companies (i.e., mutual funds, exchange-traded funds, and closed-end funds) and business development companies.1

This is the third significant proposed rulemaking for the registered fund industry this year2—as first outlined by SEC Chair Mary Jo White in December 2014—which together represent a significant departure from the SEC's traditional approach to the regulation of not just derivatives, but funds generally.3 This proposal comes more than four years after the SEC issued a Concept Release on funds' investments in derivative instruments, and would effectively replace a patchwork of SEC Staff positions that has evolved over the last 35-plus years with a comprehensive approach of proactive oversight that is intended (among other things) to limit funds' economic exposures that result from derivatives investments and other financial transactions.4

In support of its proposal, the SEC cited the need to protect investors and a concern for potential losses in funds that make extensive use of derivatives, as well as the desire to implement a more comprehensive approach to the regulation of funds' use of derivative transactions. Comments on the proposal will be due sometime in March 2016—90 days after the proposal is published in the Federal Register.

Under the proposal, "derivatives transactions" would be broadly defined to include swaps, security-based swaps, futures contracts, forward contracts, and options, as well as any combination of those instruments and any similar instrument under which a fund is or may be required to make any payment or delivery of cash or other assets. In addition, the proposal would regulate funds' "financial commitment transactions," which would include reverse repurchase agreements, short sales, and any firm or standby commitment agreements or similar agreements (including promises to make a loan or capital commitments).

The proposal would regulate fund investments in derivatives in three ways: (i) by imposing certain portfolio limitations on leverage, which would act to limit the exposure a fund may obtain through derivatives, (ii) by requiring assets to be segregated and significantly limiting the types of assets that can be used for segregation, and (iii) by requiring certain funds to adopt a formal derivatives risk management program. Funds would also face new recordkeeping and reporting requirements.

Portfolio Limitations for Derivative Transactions

As proposed, funds would be required to comply with one of two alternative portfolio limitation tests that would limit the amount of leverage a fund can obtain through derivative transactions. A fund's board of directors would have to approve the portfolio limitation test the fund would use. Compliance requirements and board oversight would be based on the test selected by the fund.

Exposure-Based Portfolio Limitation Test

The first test would be an exposure-based portfolio limitation, under which a fund would be required to limit its aggregate exposure to derivatives to 150% of its net assets, calculated...