SEC Re-Proposes Rule on Fund's Use of Derivatives and Proposes Sales Practice Rules for Transactions in Leveraged/Inverse Investment Vehicles

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December 6, 2019 TO: ICI Members SUBJECTS: Closed-End Funds
Compliance
Derivatives
Disclosure
Exchange-Traded Funds (ETFs)
Risk Oversight
Systemic Risk RE: SEC Re-Proposes Rule on Fund's Use of Derivatives and Proposes Sales Practice Rules for Transactions in Leveraged/Inverse Investment Vehicles

 

The Securities and Exchange Commission last week proposed a three-part set of rules that would provide an updated approach to the regulation of derivatives and similar instruments used by mutual funds, exchange-traded funds, closed-end funds, and business development companies (collectively, “funds”).[1] The three parts would: 

• Create an exemptive rule permitting funds to enter into derivatives and certain other transactions, provided the funds comply with the exemptive rule’s conditions;[2] 

• Impose new reporting requirements designed to assist the Commission in overseeing funds’ use of derivatives and enhance public disclosure about the impact that derivatives have on a fund’s portfolio; and 

• Update requirements related to leveraged and inverse investment vehicles.[3] In this regard, the proposal would require SEC-registered brokers-dealers and investment advisers to exercise due diligence before accepting or placing orders for leveraged and inverse investment vehicles. It also would amend the recently adopted ETF rule to allow fund sponsors to launch leveraged and inverse ETFs without obtaining exemptive relief. 

The proposal is designed to promote fund's ability to continue to use derivatives in various ways that serve investors, while responding to the concerns under the Investment Company Act of 1940 and promoting a modern and comprehensive framework for regulating fund's use of derivatives and other specified transactions. 

The proposal replaces a 2015 rulemaking aimed at accomplishing similar goals.[4] Rather than restricting a fund’s use of derivatives based on the aggregate gross notional exposure of the fund’s derivatives as proposed in 2015, however, the proposal would set leverage restrictions based on a measure of the fund’s market risk under a value-at-risk or “VaR” test.[5] In addition, the proposal would eliminate current requirements for funds to segregate liquid assets to “cover” derivatives and other transactions. 

Below we summarize each of the three parts of the proposal and the proposed transition period. Comments on the proposal are due 60 days after it is published in the Federal Register. 

I. Exemptive Rule for Fund's Use of Derivatives and Certain Other Instruments 

The 1940 Act restricts fund's ability to issue “senior securities",[6] including derivatives,[7] reverse repurchase agreements,[8] unfunded commitments,[9] and other similar instruments. Proposed Rule 18f-4 under the 1940 Act would permit a fund to enter into these transactions under the following conditions:

A. Funds’ Use of Derivatives

As further described below, the proposed rule generally would impose two main conditions on a fund using derivatives. First, the fund must implement a derivatives risk management program that a derivatives risk manager (“DRM”) administers. Second, the fund must adhere to a VaR-based limit on fund leverage risk. The fund’s board would oversee the DRM. In addition, certain funds using derivatives would be excepted from these requirements.

i. Derivatives Risk Management Program and Derivatives Risk Manager

The proposed rule generally would require a fund using derivatives to adopt a written derivatives risk management program, with policies and procedures reasonably designed to manage the fund’s derivatives risks. A fund adviser’s officer or officers, and not any third party, would serve as the fund’s DRM and administer the program. The fund’s board would approve the DRM, each of whom must have relevant experience regarding derivatives risk management. Although the program must be segregated from portfolio functions, the SEC did not propose a communications firewall between the DRM and portfolio management, recognizing the important perspective portfolio management might provide to risk management.[10] Consistent with this, the proposal would prohibit a fund’s portfolio manager from solely filling the DRM position or constituting a majority of the officers who compose the DRM position but otherwise would allow fund portfolio managers to serve in the position.

Under the proposal, the program must include the following elements that should be tailored based on how the fund’s derivatives use might affect its investment portfolio and overall risk profile:

• Risk Identification and Assessment. The program must identify and assess a fund’s derivatives risks, considering the fund’s derivatives transactions and other investments. The proposed rule would define the derivatives risks that must be identified and managed to include leverage,[11] market,[12] counterparty,[13] liquidity,[14] operational,[15] and legal[16] risks, and other risks the DRM deems material. 
• Risk Guidelines. The program must establish, maintain, and enforce investment, risk management, or related guidelines that provide for quantitative or otherwise measurable criteria, metrics, or thresholds related to a fund’s derivatives risks.[17] The guidelines must specify the levels of the given criterion, metric or threshold that the fund does not normally expect to exceed and the measures to be taken if they are exceeded. In developing the guidelines, the fund should consider how to implement them in view of the fund’s investment portfolio and disclosure.[18] 
• Stress Testing. The program must stress test derivatives risks to assess a fund’s potential losses in response to extreme but plausible market changes or changes in market risk factors that would significantly and adversely affect the fund. It also must consider correlations of market risk factors and resulting payments to derivatives counterparties. The proposal would permit the fund to determine the stress test frequency in line with the frequency of changes in the fund’s investment strategy, investments, and market conditions, provided that the fund stress tests at least weekly. 
• Backtesting. The program must backtest the VaR test used to impose an outer limit on a fund's leverage risk. The proposed requirement must provide that, each business day, the fund compare its actual gain or loss with the VaR the fund had calculated for the day. The fund must identify exceptions in which the fund experiences a loss that exceeds the corresponding VaR calculation’s estimated loss.[19] 
• Internal Reporting and Escalation. The program must provide for the reporting of certain matters relating to a fund’s derivatives use to the fund’s portfolio management and board of directors. In particular, a program must identify the circumstances under which the fund must communicate with its portfolio management about the fund’s derivatives risk management, including its program’s operation. In addition, the DRM must communicate material risks to the fund’s portfolio management and, as appropriate, its board. The proposed rule would not require the DRM to escalate these material risks to the board, unless the manager determines board escalation to be appropriate. Material risks would include any material risks identified by the fund’s guidelines or stress tests. 
• Periodic Review. The DRM must periodically review the program, at least annually, to evaluate its effectiveness and to reflect changes in risk over time. The review would apply to the overall program, including each program element and the VaR model used to comply with the proposed VaR-based limit. The proposed rule would not prescribe review procedures or incorporate specific developments that a DRM must consider as part of its review. 

ii. Limit on Fund Leverage Risk

The proposed rule generally would require funds engaging in derivatives transactions to comply with an outer limit on fund leverage risk based on VaR.[20] The limit would be based on a relative VaR test that would restrict a fund’s VaR from exceeding 150 percent of the VaR of an unlevered “designated reference index” that the DRM chooses, tested at least once each business day. An unaffiliated organization must administer the designated reference index,[21] which must be unlevered and reflect the markets or asset classes in which the fund invests.[22] If the DRM cannot identify an appropriate designated reference index, the fund would be required to comply with an absolute VaR test restricting the VaR of a fund’s portfolio to no more than 15 percent of the value of the fund’s net assets.

The Commission would provide latitude in choosing a VaR model and its parameters but require that the model consider certain market risk factors.[23] In addition, the Commission would require the model to use a 99 percent confidence level, a time horizon of 20 trading days, and be based on at least three years of historical market data.

If a fund determines that it is not in compliance with the VaR test, a fund must come back into compliance within three business days after such determination. If not, then: (1) the DRM must report to the fund’s board and explain how and by when (i.e., the number of business days) the DRM reasonably expects that the fund will comply; (2) the DRM must analyze the circumstances that caused the compliance issue and update any program elements appropriate to address those circumstances; and (3) the fund may not enter into derivatives transactions (other than derivatives transactions that, individually or in the aggregate, are designed to reduce the fund’s VaR) until it has complied with the applicable VaR test for three consecutive business days and satisfied the board reporting and program “analysis and update” requirements.

iii. Board Oversight and Reporting

As noted above, the proposed rule would require the board of a fund with a derivatives risk management program to approve a DRM, who would have a direct reporting line to the board and be responsible for administering the program.[24] The DRM must report to the board on the program’s implementation and effectiveness and the results of the fund’s stress testing.[25] These reports must occur at least annually, and the DRM must provide regular written reports periodically as the board determines. The DRM must provide to the board, on or before the implementation of the program and at least annually thereafter, a written report providing a representation that the program is reasonably designed to manage the fund’s derivatives risks and incorporate the required elements of the program. The report must contain the basis for the representation. In addition, the report must analyze any exceedances of the fund’s risk guidelines and the results of the fund’s stress tests and backtesting. The proposed rule also would require the written report to include the DRM’s basis for selecting the designated reference index or an explanation as to why the DRM was unable to identify an appropriate index.

iv. Limited Derivatives Users Exceptions

The proposed rule would except limited derivatives users from the derivatives risk management program requirement and the limit on fund leverage risk. The exception would be available to a fund that either limits its derivatives exposure to 10 percent of its net assets or uses derivatives transactions solely to hedge certain currency risks and, in either case, that also adopts and implements policies and procedures reasonably designed to manage the fund’s derivatives risks.

• 10 Percent Exception. For purposes of the 10 percent exception, the proposed rule would generally define the term “derivatives exposure” to mean the sum of the notional amounts of the fund’s derivatives instruments and, for short sale borrowings, the value of any asset sold short. The proposed rule would permit funds to scale the notional amount of interest rate derivatives to a 10-year bond equivalent. It also would permit funds to delta adjust the notional amounts of options contracts.[26] Although the Commission notes that using notional amounts as a measure of market exposure is relatively blunt, the Commission states that it is using the test to identify funds that use derivatives in a limited way. 
• Currency Hedging Exception. Under the currency hedging exception, a fund only could use currency derivatives to hedge currency risk associated with specific foreign-currency-denominated equity or fixed-income investments in the fund’s portfolio. In addition, the notional amount of the fund’s currency derivatives could not exceed the value of the instruments denominated in the foreign currency by more than a negligible amount.

A fund relying on the limited derivatives users exceptions would be required to adopt policies and procedures that are reasonably designed to manage all of the fund’s derivatives risks.

v. Alternative Requirements for Leveraged/Inverse Funds

The proposed rule would except certain leveraged/inverse funds from the leverage risk limit in light of the additional safeguards that the proposed sales practices rules would provide. Specifically, a fund would not need to comply with the VaR-based test if it: (1) meets the definition of a “leveraged/inverse investment vehicle” in the sales practice rules; (2) limits the investment results it seeks to 3 times the return (or inverse of the return) of the underlying index; and (3) discloses in its prospectus that it is not subject to Proposed Rule 18f-4’s limit on fund leverage risk.

B. Funds’ Use of Reverse Repurchase Agreements and Unfunded Commitments

The proposed rule would permit funds to invest in reverse repurchase agreements, unfunded commitments, and similar transactions under specified conditions.

i. Reverse Repurchase Agreements

The Commission views reverse repurchase agreements and other similar financing transactions as allowing a fund to obtain additional cash that can be used for investment purposes or to finance fund assets. Accordingly, it proposes treating such transactions as bank borrowings or other borrowings and subject to the relevant asset coverage requirements of Section 18 of the 1940 Act. For example, this would permit an open-end fund to obtain financing by borrowing from a bank, engaging in reverse repurchase agreements, or any combination thereof, so long as all sources of financing are included when calculating the fund’s asset coverage ratio.[27] Reverse repurchase agreements and similar transactions would not be treated as derivatives under the proposed rule. Therefore, reverse repurchase agreements and similar financing transactions would not be included in calculating a fund’s derivatives exposure under the limited derivatives user exceptions.[28]

The Commission would not treat securities lending arrangements, which are similar to reverse repurchase agreements,[29] to be “similar financing transactions” when: (1) the fund does not sell or otherwise use the non-cash collateral received for loaned securities to leverage the fund’s portfolio; and (2) the fund invests cash collateral received for loaned securities solely in cash or cash equivalents.[30]

The Commission also noted that tender option bonds may be similar to a reverse repurchase agreement in some circumstances and that funds may treat them as a reverse repurchase agreements or similar financings depending on the facts and circumstances.

ii. Unfunded Commitment Agreements

The Commission believes that unfunded commitment agreements should be treated differently from other derivatives because they are not used to leverage a fund’s portfolio or create undue speculation but could raise asset sufficiency concerns.[31] For example, if the fund is unable to meet its obligations under an unfunded commitment, it would be subject to a counterparty’s default remedies. To address this concern, the Commission proposes to permit a fund to enter into unfunded commitment agreements if the fund reasonably believes, at the time it enters such agreement, that it will have sufficient cash and cash equivalents to meet its obligations with respect to its unfunded commitment agreements, in each case as they come due. In formulating this belief, the proposed rule would require a fund to consider its reasonable expectations with respect to other obligations (including any obligation with respect to senior securities or redemptions).[32]

C. Other Requirements

The proposed rule would require a fund investing in derivatives, reverse repurchase agreements, unfunded commitment agreements, and other similar instruments to adhere to recordkeeping requirements. It also would eliminate current asset segregation requirements.

i. Recordkeeping

Funds relying on Proposed Rule 18f-4 would be required to maintain for a period of at least five years, as applicable:

• Certain records documenting the fund’s derivatives risk management program (e.g., policies and procedures designed to manage the fund’s derivatives risk, results of stress testing, results of VaR backtesting, any internal reporting or escalation of material risks under the program, any periodic review of the program); 
• Materials provided to the fund’s board related to the approval and designation of the DRM and any required written reports provided to the board regarding the fund’s non-compliance with the applicable VaR test; 
• For funds complying with the VaR-based limit, records documenting certain of the fund’s determinations (the VaR of the portfolio, the VaR of the designated reference index, the fund’s VaR ratio (value of the fund’s VaR divided by VaR of the designated reference index), any updates to the VaR models, and the basis for any material changes to those models); 
• For limited derivatives users, a written record of the fund’s policies and procedures that are reasonably designed to manage its derivatives risk; and 
• For funds that engage in unfunded commitment agreements, records documenting the fund’s belief that it has sufficient cash and cash equivalents to meet its obligations with respect to unfunded commitment agreements (made at the time the fund enters the agreements). 

ii. Elimination of Asset Segregation Requirements

The proposed rule would eliminate the Commission and staff’s historical positions that a fund could “cover” its obligations in connection with various transactions, including derivatives, by maintaining “segregated accounts.” The Commission did not propose a replacement asset segregation requirement because it does not believe that asset segregation is necessary in light of the proposed rule’s requirements for funds to establish risk management programs and comply with the proposed limit on fund leverage risk. Moreover, it believes that the requirement for funds to stress test under their derivatives risk management programs already require the fund to consider payments to derivatives counterparties that could result from losses in stressed conditions.

II. New Reporting Requirements

The Commission is proposing amendments to Form N-PORT, Form N-Liquid (which the Commission proposes to re-title as Form N-RN), and Form N-CEN to reflect new reporting requirements for funds relying on Proposed Rule 18f-4.[33]

A. Form N-PORT

The Commission proposes to amend Form N-PORT to add new items to Part B.[34] These items would be publicly disclosed with other Form N-PORT information for the third month of a fund’s fiscal quarter, 60 days after the quarter ends. A fund would be required to provide information about the fund’s derivatives and short sale exposure, as of the end of the reporting period. In addition, a fund would be required to report information about the fund’s VaR tests, including:

• The highest daily VaR and date for such VaR during the reporting period; 
• The median daily VaR for the reporting period; 
• For funds subject to the relative VaR test during the reporting period: (a) name of the designated reference index; (b) index identifier; (c) highest VaR ratio and date for such VaR during the reporting period; and (d) median VaR ratio during the reporting period. 
• Its backtesting results, showing the number of exceptions the fund identified as a result of its backtesting of its VaR model. 

B. Form N-Liquid (to be renamed Form N-RN)

The Commission proposes current reporting requirements on Form N-RN to report information about VaR breaches that last longer than three business days.[35] Specifically, if a fund’s VaR under the relative VaR test were to exceed 150 percent of the VaR of its designated reference index for three business days, the Commission proposes to require such fund to report: (1) the dates on which the fund’s VaR exceeded 150 percent of the designated reference index’s VaR; (2) the VaR of its portfolio for each of these days; (3) the VaR of its designated reference index for each of these days; (4) the name of the designated reference index; and (5) the index identifier.

Similarly, if the VaR for a fund subject to the absolute VaR test were to exceed 15 percent of the value of the fund’s net assets for three business days, the Commission proposes to require such fund to report: (1) the dates on which the fund’s VaR exceeded 15 percent of the value of its net assets; (2) the VaR of its portfolio for each of these days; and (3) the value of the fund’s net assets for each of these days.

Funds would have to file the Form N-RN one business day after the third business day of the breach. They also would have to file another Form N-RN when the fund is back in compliance with the relevant VaR test.

The Commission notes that public disclosure of real-time reporting of VaR breaches could lead to investor confusion, as investors might mistakenly assume that a fund that breaches the applicable VaR test actually suffered substantial losses or that substantial losses were imminent. Accordingly, the Commission proposes to make fund reports on Form N-RN non-public because the public disclosure is neither necessary nor appropriate in the public interest or for the protection of investors.

C. Form N-CEN

The Commission proposes amendments to Form N-CEN to require funds to identify whether they relied on Proposed Rule 18f-4 during the reporting period. Funds also would report whether: (1) the fund is a limited derivatives user excepted from the program requirement because it limited its derivatives exposure to 10 percent of its net assets or limited its derivatives use to certain currency hedging; or (2) the fund is a leveraged/inverse fund and is excepted from the proposed limit on fund leverage risk. In addition, funds would have to identify whether they entered into reverse repurchase agreements or similar financing transactions, or unfunded commitment agreements as provided under Proposed Rule 18f-4.

III. Leverage/Inverse Investment Vehicles

As a complement to Proposed Rule 18f-4, the Commission is proposing new sales practice rules and amendments for leveraged/inverse investment vehicles.

A. Sales Practice Rules

The sales practice rules would require broker-dealers and investment advisers to exercise due diligence on retail investors before approving accounts to invest in leveraged/inverse investment vehicles.[36] Under both proposed sales practice rules, a firm could approve the retail investor’s account to transact in leveraged/inverse investment vehicles only if the firm had a reasonable basis to believe that the investor is capable of evaluating the risks associated with these vehicles.[37]

i. Approval and Due Diligence in Opening Accounts

Under the proposal, broker-dealers and investment advisers only could conduct transactions for a retail investor in leveraged/inverse investment vehicles if the firm complies with certain conditions. These would require the firm to: (1) approve the retail investor’s account for transacting in leveraged/inverse investment vehicles pursuant to a due diligence requirement; and (2) adopt and implement policies and procedures reasonably designed to achieve compliance with the proposed rules. As part of the due diligence, a firm must seek to obtain, at a minimum, information about a retail investor’s:

• Investment objectives and time horizon; 
• Employment status; 
• Estimated annual income from all sources; 
• Estimated net worth (exclusive of family residence); 
• Estimated liquid net worth; 
• Percentage of liquid net worth that he or she intends to invest in leveraged/inverse investment vehicles; and 
• Investment experience and knowledge.

Based on this information, the firm must approve or disapprove the account for transacting in leverage/inverse investment vehicles, determining whether the retail investor has the financial knowledge and experience to reasonably be expected to evaluate the risks of buying and selling leverage/inverse investment vehicles. If approved, the approval must be in writing. These due diligence and account approval requirements would apply not only to retail accounts established after the compliance date, but to all accounts before an investor could make additional investments in leverage/inverse vehicles.

Finally, the proposed sales practice rules would require firms to adopt and implement written policies and procedures addressing compliance with the applicable sales practice rules.

ii. Recordkeeping

Under the proposed sales practice rules, a firm would have to maintain a written record of the investor information that it obtained under the due diligence requirements, the firm’s written approval of the retail investor’s account, and the versions of the firm’s policies and procedures that it adopted under the proposed rules that were in place when it adopted or disapproved the account. These records would be required to be maintained for a period of not less than six years (the first two in an easily accessible place) after the date of the closing of the investor’s account.

B. Amendments to ETF Rule

The Commission also proposes to amend the ETF Rule (Rule 6c-11 under the 1940 Act) to allow leveraged/inverse ETFs to operate without obtaining an exemptive order from the Commission.

IV. Transition Periods

The Commission proposes to rescind a 1979 General Statement of Policy (Release 10666), which states that funds could engage in reverse repurchase agreements and firm and standby commitment agreements, so long as they use “segregated accounts” to “cover” those securities to limit the fund’s risk of loss.[38] In addition, the SEC’s Division of Investment Management is reviewing no-action letters and other guidance addressing derivatives and other transactions that Proposed Rule 18f-4 would cover to determine whether those positions should be withdrawn.

The Commission proposes a one-year transition period from the date the final rules are published in the Federal Register before rescinding Release 10666 and withdrawing any relevant letters or guidance. At such time, funds would no longer be able to rely on those positions to engage in derivatives or other transactions.

Similarly, the Commission would require broker-dealers and investment advisers to comply with the new sales practice rules and would allow leveraged and inverse ETFs to rely on the amended ETF rule one year after the publications of any final rules in the Federal Register.

 

Kenneth Fang
Assistant General Counsel

 

endnotes

[1] See Use of Derivatives by Registered Investment Companies and Business Development Companies; Required Due Diligence by Broker-Dealers and Registered Investment Advisers Regarding Retail Customers’ Transactions in Certain Leveraged/Inverse Investment Vehicles, Investment Company Act Release No. 33704 (Nov. 25, 2019), available at https://www.sec.gov/rules/proposed/2019/34-87607.pdf.

[2] Money market funds and unit investment trusts would be excluded from the rule and could not enter into these transactions. The Commission believes that money market funds would not invest in such transactions, because they are inconsistent with money market funds maintaining a stable share price or limiting principal volatility. In addition, the Commission would exclude UITs because they are not management investment companies.

[3] The proposal would define a “leveraged/inverse investment vehicle” as “a registered investment company . . . or commodity- or currency-based trust or fund, 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 pre-determined period of time.” See Proposed Rule 15l-2(d) under the Securities Exchange Act of 1934; Proposed Rule 211(h)-1(d) under the Investment Advisers Act of 1940.

[4] For a description of the 2015 rulemaking, see ICI Memorandum No. 29566 (Dec. 17, 2019), available at https://www.ici.org/my_ici/memorandum/memo29566.

[5] VaR tests are estimates of an instrument or portfolio’s potential losses over a given time horizon and at a specific confidence level. According to the SEC, VaR is a commonly-known and broadly-used industry metric that integrates the market risk associated with different instruments into a single number that provides an overall indication of market risk, including market risk associated with a fund’s derivatives transactions.

[6] See Section 18 of the 1940 Act. Section 18(g) of the 1940 Act defines a “senior security,” in part, as “any bond, debenture, note, or similar obligation or instrument constituting a security and evidencing indebtedness.”

[7] The proposed rule would define a “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; and (2) any short sale borrowing.” See Proposed Rule 18f-4(a). The Commission believes that the term “any similar instrument” would include firm and standby commitment agreements. The Commission views a firm commitment agreement to have the same economic characteristics as a forward contract and a standby commitment agreement to have the same economic characteristics as a put option that a fund has issued.

[8] In a reverse repurchase agreement, a fund transfers a security to another party in return for a percentage of the value of the security. At an agreed-upon future date, the fund repurchases the transferred security by paying an amount equal to the proceeds of the initial sale transaction plus interest.

[9] The proposed rule would define an “unfunded commitment agreement” as “a contract that is not a derivatives transaction, under which a fund commits, conditionally or unconditionally, to make a loan to a company or to invest equity in a company in the future, including by making a capital commitment to a private fund that can be drawn at the discretion of the fund’s general partner". See Proposed Rule 18f-4(a).

[10] The proposed rule would require a fund to reasonably segregate the program from portfolio management to promote objective independent identification, assessment, and management of the risks associated with derivatives use.

[11] “Leverage risk” generally refers to the risk that derivatives transactions can magnify the fund’s gains and losses.

[12] “Market risk” generally refers to risk from potential adverse market movements in relation to the fund’s derivatives positions, or the risk that markets could experience volatility changes that adversely impact fund returns and the fund’s obligations and exposures.

[13] “Counterparty risk” generally refers to the risk that a derivatives counterparty may not be willing or able to perform its obligations under the contract, and the related risks of having concentrated exposure to such counterparty.

[14] “Liquidity risk” generally refers to risk involving the liquidity demands that derivatives can create to make payments of margin, collateral, or settlement payments to counterparties.

[15] “Operational risk” generally refers to risk related to potential operational issues, including documentation issues, settlement issues, system failures, inadequate controls, and human failure.

[16] “Legal risk” generally refers to insufficient documentation, insufficient capacity or authority of a counterparty, or enforceability of a contract.

[17] The SEC provides examples of quantitative models and methodologies used to evaluate various risks, including for market risk (VaR, stress testing or horizon analysis), counterparty risk (concentration at various counterparties), and liquidity risk (liquidity models identifying margin requirements over a specified period under specified volatility scenarios).

[18] The SEC notes, for example, that a fund may wish to establish corresponding investment size controls or lists of approved transactions.

[19] As described below, the VaR test must have a 99 percent confidence level. Therefore, a fund would be expected to experience a backtesting exception approximately 2.5 times a year or 1 percent of the 250 trading days in a given year.

[20] The Commission acknowledges some concerns about using a VaR test to limit leverage risk, including that it may not reflect the size of losses that occur on the trading days during which the greatest losses occur. It notes, however, that the VaR test is intended to be a complementary measure and not a stand-alone risk management tool.

[21] The organization must not be an affiliated person of the fund, its investment adviser or principal underwriter, and the index must not be created at the request of the fund or its investment adviser, unless the index is widely recognized and used. In addition, the index must be either an “appropriate broad-based securities market index” or an “additional index” as defined in Item 27 of Form N-1A. A fund must disclose its designated reference index in its annual report, together with a presentation of the fund’s performance relative to the index.

[22] The Commission reasons that a relative VaR test comparing a fund’s VaR to an unlevered index that reflects the markets or assets in which the fund invests, can be used to analyze whether a fund uses derivatives to leverage a fund’s portfolio. It proposes using a relative VaR test to limit fund leverage risk because it resembles the way that Section 18 of the 1940 Act limits fund leverage risk. Section 18 limits the extent to which a fund can potentially increase its market exposure through leveraging by issuing senior securities, without limiting risk or volatility. The proposed relative VaR test likewise is designed to limit the extent to which a fund increases its market risk by leveraging its portfolio through derivatives, without limiting derivatives for other purposes.

[23] These risks include: (1) equity price risk, interest rate risk, credit spread risk, foreign currency risk, and commodity price risk; (2) material risks arising from the nonlinear price characteristics of a fund’s investments (including options and positions with embedded optionality); and (3) the sensitivity of the market value of the fund’s investments to changes in volatility.

[24] The proposed rule would not require the board to approve the program, but the proposal notes that the board would be responsible for overseeing compliance with Rule 38a-1 under the 1940 Act. That rule requires boards to approve policies and procedures reasonably designed to prevent violation of the federal securities laws.

[25] The Commission cautions that board oversight should not be a passive activity. Rather, the board should understand the program and the derivatives risks it is designed to manage as well as participate in determining who should administer the program, ask questions and seek relevant information regarding the adequacy of the program and the effectiveness of its implementation.

[26] Delta refers to the ratio of change in the value of an option to the change in value of the asset into which the option is convertible. A fund would delta adjust an option by multiplying the option’s unadjusted notional amount by the option’s delta.

[27] Open-end funds are permitted to borrow money from a bank, provided they have 300 percent asset coverage. Therefore, under the proposed rule, the combination of the bank borrowings and reverse repurchase transactions would have to have 300 percent asset coverage.

[28] Because the proposed VaR tests estimate a fund’s risk of loss taking into account all of its investments, including reverse repurchase agreements and similar investments, however, any portfolio leveraging effects from reverse repurchase agreements would be included in the proposed-VaR-based limit.

[29] The Commission states that securities lending arrangements are structurally similar to reverse repurchase agreements in that, in both cases, a fund transfers a portfolio security to a counterparty in exchange for cash (or other assets).

[30] The Commission states that, when a fund engaged in securities lending transactions under those circumstances, it is limited in its ability to use securities lending transactions to increase portfolio leverage.

[31] Any transaction that meets the proposed rule’s definition of a “derivatives transaction” would not be deemed an “unfunded commitment.

[32] A fund may not consider cash that may become available from issuing additional equity but may consider cash from the issuance of debt or other borrowings.

[33] In addition, the Commission proposes to amend Form N-2 for closed-end funds, so closed-end funds relying on Proposed Rule 18f-4 would no longer need to include their derivatives transactions and unfunded commitment agreements in the form’s senior securities table. It believes that the extensive reporting that closed-end funds make on Form N-PORT render the requirement unnecessary. Further, the Commission determined not to propose additional reporting requirements on BDCs in the same manner as registered funds. BDCs are required to invest at least 70 percent of their total assets in “eligible portfolio companies,” which may limit the role derivatives play in a BDC’s portfolio relative to other funds. BDCs, however, would be required to file Form N-RN as registered funds do.

[34] The Commission also proposes conforming changes to the Form’s General Instructions.

[35] The Commission also proposes conforming changes to the Form’s General Instructions.

[36] Specifically, Proposed Rule 15l-2 under the Securities Exchange Act of 1934 would require a broker-dealer (or any associated person of a broker-dealer) to exercise due diligence to ascertain certain facts about a retail investor before accepting a customer order or approving the customer’s account to engage in those transactions. Similarly, Proposed Rule 211(h)-1 under the Investment Advisers Act of 1940 would require the same from an investment adviser (or any supervised person of an investment adviser).

[37] These requirements are modeled after the FINRA options account approval requirements for broker-dealers, because when leverage/inverse investments are held over longer periods of time, they may have certain similarities to options. See, e.g ., FINRA Rule 2360(b)(16), (17) (requiring for options accounts, firm approval, diligence, and recordkeeping).

[38] See Securities Trading Practices of Registered Investment Companies, Investment Company Act Release No. 10666 (Apr. 18, 1979), available at https://www.sec.gov/divisions/investment/imseniorsecurities/ic-10666.pdf.