SEC Proposes New Rules to Further Regulate Funds’ Derivatives

By | 01/13/2020 | 2:06 pm ET

The Securities Exchange Commission (SEC) recently proposed new rules that aim to create a more comprehensive approach to the regulation of funds’ use of derivatives (i.e. through business development companies and Registered Funds). The proposal is comprised of three components: new SEC Rule 18f-4 under the Investment Company Act of 1940 (“Act”); SEC Rule 15l-2 under the Securities Exchange Act of 1934 and rule 211(h)-1 under the Advisers Act of 1940; SEC Rule 6c-11 under the Act related to funding reporting form amendments.

Proposed SEC Rule 18f-4

The new rule would permit mutual funds, ETFs, closed-ended funds, and companies that have decided to be treated as BDCs to enter into financial commitment and “derivative transactions” actions by providing an exemption from sections 18 and 61 of the ICA.

Specifically, “derivatives transaction” is defined as “any agreement, swap, option, future-forward, repurchase agreement, reverse purchase agreement or other transaction recognized as a derivative that has a valuation based (in whole or in part of) one or more commodities, securities, or other assets during the life of the instrument or at maturity or early termination”.

If a fund relies on the proposed rule to enter Derivative transactions they would be required to:

  • Manage any risks associated with the funds’ derivatives transactions by maintaining a number of certain assets, defined in the proposed rule as “qualifying coverage assets” that are designed to enable the fund to meet its obligations under its derivatives transactions
  • Comply with one of two portfolio limitations (these are designed to impose a limit on the amount of leverage that a fund may obtain through any derivative transaction)
  • Establish a formalized derivatives risk management program ( depending on the extent of its usage)

If a fund relies on the proposed rule to enter financial commitment transactions would be required to:

  • Daily maintenance of an amount qualifying coverage assets at least equal to the aggregate amount of all financial commitment transactions; and board approval of policies and procedures reasonably designed to provide for the required asset coverage.

SEC Rule 15l-2 under the Securities Exchange Act of 1934 and SEC Rule 211(h)-1 under the Advisers Act of 1940

The 15l-2 rule under the Securities Exchange Act and the 211(h)-1 act under the Advisers Act of 1940 describe new “sales practices” rules that require broker-dealers and investment advisers and their associated persons to exercise due diligence. This includes determining a “minimum” amount of certain information about a customer or client (who is a natural person or a legal rep. of the natural person). The form must be done before accepting or placing an order to buy or sell shares of a leveraged/inverse investment vehicle, or approving the retail investor’s account to engage in such transactions. The proposed rules would also require firms to implement written policies and procedures and to maintain certain records.

The proposed rules state that a firm can approve a purchase or sale of the shares leveraged/inverse investment vehicles in a retail investor’s account if the firm has a reasonable basis to believe the retailer is capable of understanding and evaluating the risks that are associated with the products. As with option accounts, there wouldn’t be a requirement for transaction-by-transaction approval. However, the proposed sales practice rules would apply regardless of whether a recommendation or investment advice is provided to the retail investor, including self-directed brokerage transactions.

As with Regulation Best Interest, the SEC does not propose in exchange Rule 15l-1 to exclude investors that are sophisticated or high net worth from the scope of covered customers. Rule 211(h)-1 effectively utilizes the definition of “retail customer” from Regulation Best Interest and applies it to investment advisers’ placement or approval of a retail investor’s transaction in a leveraged/inverse investment vehicle for firms. The proposal would also require firms to maintain certain records for at least six years after an account closing (including written approvals), which is inconsistent with the record keeping rules governing investment advisers.

Amendment to rule 6c-11 under the Act

Rule 6c-11 generally allows for Exchange-traded funds (ETFs) to operate without obtaining an SEC exemptive order, subject to certain conditions. The rule currently excludes leveraged/inverse ETFs from relying on the rule so that the SEC can consider section 18 issues raised by ETFs as part of the SEC’s broader consideration of derivatives used by registered funds and BDCs. The SEC is considering removing this portion of the rule because “the proposed sales practices rules and rule 18f-4 are designed to address these issues”.

The SEC is also planning on removing the exemption orders previously issued to the sponsors of leveraged/inverse ETFs. By doing this, the SEC believes it will “create a level playing field allowing any sponsor to form and launch a leveraged/inverse ETF subject to the conditions Rule 6c-11 and proposed rule 18f-4, with transactions in the fund subject to the proposed sales practices rules”. The SEC also plans to delay the effective date of the amendments to Rule 6c-11 for one year following the publication of any final rule.

SEC Forms that are filed pertaining new rules

Along with the previously mentioned new rules and amendments, the SEC proposes to amend forms N-PORT, N-LIQUID ( will be retitled form N-RN), and Form N-CEN. The committee justifies that doing this would allow for the SEC to oversee funds’ use of and compliance with proposed rules effectively, along with allowing the public to have greater insight into the impact that the funds’ would have on their portfolios.

Form N-PORT

Form N-PORT would add a new reporting item regarding the funds’ derivatives exposure as of the end of the reporting period. It also requires a  new reporting item that would require a fund to:

  • Report the funds’ highest daily and median VaR and VaR ratio during reporting period
  • The name of the funds designated reference index (if applicable) and the relevant identifier
  • The number of exceptions that the fund identified during the reporting period

This form would be publicly available for the final month of each funds’ quarter.

Amendments to N-RN and N-CEN

The proposed amendments to form N-RN would require funds subject to the VaR-based limit on fund leverage risk to file form N-RN in order to report certain information about VaR test breaches. This is necessary if the fund determines that  it is out of compliance with the VaR test and has not returned to compliance within three business days. The new form would be required to be completed within four business days after determination.

Additionally, the fund will be required to file a report form on form N-RN when it returns to compliance with the applicable VaR test. The SEC mentions that funds’ reporting on form N-RN regarding breaches on VaR tests is not available to the public.

Lastly, Form N-CEN would add an item requiring that funds report whether the fund relied on proposed Rule18f-4 (mentioned above) and any exceptions of the requirements stated in the proposed rule. It’s also required if the fund entered any reverse repurchase agreements, similar financing transactions or unfunded commitments
during the reporting period. This would exclude BDC’s because they are not required to file Form N-CEN or Form N-PORT.

The previously mentioned rules and amendments that the SEC is proposing include a great deal of requests and changes. Industries should carefully look into the requirements in rule 18f-4 and consider contacting an agent of the Colonial team to assist in these changes.

Contact Colonial to learn about our SEC Filing Services and how we can help you navigate the SEC filing requirements.