FYI: Rules Proposed to Govern Use of Derivatives by RICs and BDCs

FYI: Today the SEC voted to propose a series of new rules and amendments aimed at better regulating the use of derivatives by business development companies and registered investment companies, including mutual funds, exchange-traded funds (ETFs) and closed-end funds. The major components of the proposal are:

  • Proposed new Investment Company Act Rule 18f-4, which would allow a fund to enter into derivatives and certain other transactions, notwithstanding the restrictions under Sections 18 and 61 of the Investment Company Act, provided that the fund complies with the conditions of the rule, including the adoption of a derivatives risk management program and complying with a limit on the amount of leverage-related risk that the fund may assume, based on value-at-risk (VaR). Exceptions from certain requirements would be provided for funds that limit their derivatives exposure to 10% of net assets, or that use derivatives only to hedge certain currency risks.
  • Proposed new “sales practices rules” under the ’34 Act (for BDs) and the Advisers Act (for IAs), which would require a registered broker, dealer or investment adviser to exercise due diligence in approving a retail customer’s or client’s account to buy or sell shares of certain “leveraged/inverse investment vehicles” (like certain leveraged ETFs) before accepting an order from, or placing an order for, the customer or client to engage in these transactions.
  • Proposed new derivatives reporting requirements on Forms N-PORT, N-LIQUID (to be renamed N-RN) and N-CEN, to assist the SEC and the public in understanding a fund’s use of derivatives and its impact.
  • Proposed amendments to Investment Company Act Rule 6c-11, which would allow certain leveraged/inverse ETFs that satisfy the rule’s conditions to operate without the expense and delay of obtaining an exemptive order.

Today’s proposals would supersede the fund derivatives proposals that the SEC put out in December 2015. Various features of today’s proposals are similar to various other proposals the SEC has adopted since that time, such as the requirement for funds to adopt a derivatives risk management program (reminiscent of the liquidity risk management program requirement previously adopted for funds), the recent heightened focus on retail investor protection when working with BDs and IAs, the use of new forms/reporting to enhance SEC oversight, and new rules allowing funds that used to require exemptive orders to instead operate by meeting standardized rule conditions.

The comment period for today’s proposals will be open for 60 days following publication in the Federal Register.

Proposing Release:

SEC Press Release with Fact Sheet:

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